After the furore which has surrounded the Euro zone and its peripheral economies the last few days and indeed weeks I wish to return to another subject which is bubbling away in the background. That subject is China and how much she can grow without generating more inflation. As I reported on the 11th of November her stock market has become increasingly nervous that policy will have to be tightened further to try to control inflation. These fears were exacerbated on Monday when attention was focused on the 7 day repo rate which had risen from 2.7% to 3.3% over the past fortnight leading to fears of more general rate hikes. In response to this the Shanghai Composite stock index fell by 1.3%. This morning we have seen further news on that front with the latest Purchasing Managers Index for China rising from 54.7 to 55.2 which means that it has now risen for four months in a row. Whilst this is good news in itself eyes will be turning to the input prices measure which was strong. In response to this the stock market did not move much but it has fallen considerably since it closed at 3159 on the 8th of November to 2823 today or a fall of 10.6%. Any weak numbers lead to fears of a slowdown and any stronger ones lead to fears of inflation. Not quite fair,perhaps, but that appears to be the state of play right now. As the rest of the world is hoping for some economic growth from China these developments are troubling for us all.
Inflationary Trends: The State of Play
If you look at the indices which give us an idea of inflationary trends then at first look you may feel that the problem has reduced recently. For example the CRB commodity spot index has drifted back from around 502 to 484 and the crude oil price ( West Texas Intermediate) has fallen from a recent closing high of 87.87 to just under 84 US dollars per barrel. So consumers in US dollars will have seen a slowdown in some inflationary trends. The problem for everyone else is that most commodities are priced in US dollars and so their price depends on their exchange rate for dollars. Over the same time period the US dollar index which is trade weighted has risen from 77.5 to 81.27 for an overall rise of 4.6% so on this basis allowing for exchange rate fluctuations for non-US dollar consumers commodity prices will have edged up slightly. Not perhaps quite what you expected but a clear dichotomy between those who consume in US dollars and those who do not.
If we consider the Euro zone then the recent sharp fall in the Euro from around 1.40 to 1.306 or 6.7% will led to inflationary trends from commodity price rises as they feed in assuming the Euro stays at this sort of level. This will have many different effects from the extreme of Greece where consumer price inflation is 5.5% to the other extreme of Ireland where her two measures are either side of zero.
Longer-term interest rates: Safe haven status for the UK and US?
As the storm has whipped around the Euro zone it would appear that two nations have acquired “safe haven” status in terms of their interest rates. The ten-year gilt or UK government bond rallied by one point yesterday reducing its yield by 0.12% to 3.22%. Government bond yields fell too in the United states with the ten-year falling to 2.81% and the thirty-year to 4.11% for falls of around half that of the UK. Putting this another way and looking at the spread between German ten-year bunds and UK gilts it narrowed by 0.05% yesterday. So considering each countries own problems something of a surprising result as UK inflationary trends point to a rather different ten-year yield in my view, but nonetheless there they are.
The European Central Bank has uncomfortable choices ahead of it
The Head of the European Central Bank spoke yesterday and some consider that his speech was a threat to the markets and a promise of further action. Having read it I am not sure if this is a promise or mere bluster but tomorrow afternoon we will find out. The particular phrase which had pundits wondering was this.
pundits are under-estimating the determination of governments
Actually I have always thought that Euro zone politicians are completely committed to the Euro but that problems have arisen because of the flaws in its construction and indeed in their responses to the consequences of the flaws. But it leads to the question of what can the ECB do?
The Current Position
In terms of current policies the ECB has an official interest rate of 1% and is providing quite a lot of liquidity in the short-term mostly these days in the up to 3 month maturity. It has been reducing some of its liquidity operations with a clear change coming in July when twelve month repos were ended.However some banking systems such as Portugal,Greece, Ireland and Spain have become very reliant on ECB liquidity with for example the main 6 Irish domestic institutions being provided with somewhere around 90 billion Euros worth. In effect it is propping up the financial systems in these countries and an example of this is that the last bond issue from a company domiciled in Spain, Portugal or Ireland came from Iberdrola, the Spanish utility, on October 6,according to the Financial Times. So the ECB is actively operating as a lender of last resort in these countries. However it does currently plan to exit such strategies with most of the exiting to be done on current plans over the next couple of months.
In addition over the period of the credit crunch the ECB has purchased assets to support markets. In an earlier stage of the crisis it conducted a Covered Bond Purchases programme of some 60.9 billion Euros to support that market as part of policies which Mr. Trichet felt were more effective than Quantitative Easing.Since the announcement of the shock and awe package on May 10th it has under its Securities Markets Programme been buying mostly government bonds in the peripheral Euro zone nations. Last week it announced purchases of 1.3 billion Euros making the total some 67.2 billion Euros. Thus it is holding some 128.1 billion of assets on its books.
What could it now do?
There are two moves which are most likely.
1. Rather than pursuing an exit strategy the ECB announces that all current monetary measures will remain in place well into 2011. If it wished to be more aggressive it could announce new 6 month repos which would allow banks in the peripheral nations some certainty of funding. Even more aggressive but less likely would be to have a new 12 month repo as this would allow these same banks to load up on cash (and use it to buy government bonds).
2. It could expand the size of purchases of debt under the Securities Markets Programme. Last week’s purchases at 1.3 billion Euros were higher than recent amounts but look dwarf like when compared with the 16 billion of the first week and the 10 billion of the second week. When I wrote yesterday about the way Greek bond yields fell after May 10th part of the reason for this was the size of the purchases by the ECB. ( There was also a discussion on the comments section about the treatment of these assets in terms of accountancy, I would just like to add that there must be at this time considerable losses on all 26 billion purchases in the first two weeks on a “mark to market” basis).
A More Aggressive Alternative
This would be to openly conduct a Quantitative Easing programme in the way that the UK or US has. So the ECB would set out a target number of purchases of Euro zone government bonds and start to buy them. The amounts required are likely to be higher than before as larger bond markets have become involved, for example Spanish government debt is around 550 billion Euros.
The choices in front of the ECB are quite plain and let us be clear that they will be unpalatable to some of the Governing Council. The President of the German Bundesbank Axel Weber has recently given speeches praising the ECB’s exit strategy and he has always been against the asset purchases under the Securities Markets Programme. So there will be a debate and some dispute but both measures I suggest are likely so that we may see an extension of liquidity provision and a possible expansion of the SMP.
The real issue with these as policies is that they suppress the symptoms but do not provide a cure. If you keep extending liquidity what is your end-game? Also you can buy these assets but who do you eventually plan to sell them too? Or when they mature who will replace the funding? Someone along that road the ECB is in my opinion exceeding its authority. It is not its role to fund governments and slowly but surely an expansion of the SMP would lead it to taking on such a role. One day European taxpayers will wake up and make enquiries as to what the ECB is doing with the credit card their politicians are supplying it with.
As to full Quantitative Easing I do not expect that tomorrow as it is likely to be a step too far for much of the ECB.There is the obvious flaw that there is no common fiscal policy in the Euro zone. But even here care is needed because only 4 days before asset purchases started under the SMP the ECB denied it had even discussed the matter leading to the suspicion the Europe’s politicians had overruled the ECB. If they can do it once….
At this point we see the impotence of conventional monetary policy. The ECB could announce an interest rate cut but I cannot see this doing any good at all.
Late last night to a crescendo of stable doors closing Standard and Poors announced this.
Standard & Poor’s Ratings Services today said it placed its ‘A-’ long-term and ‘A-2′ short-term foreign and local currency sovereign credit ratings on the Republic of Portugal on CreditWatch with negative implications.
There was also an interesting development in the statement as to why this move was taking place.
However, we see the government as having made little progress on any growth-enhancing reforms to offset the fiscal drag from these scheduled 2011 budgetary cuts. In particular, we believe that policies the government has pursued have done little to boost labor flexibility and productivity. As a consequence of the Portuguese economy’s structural rigidities and the volatile external conditions, we project that the economy will contract by at least 2% in 2011 in real terms.
So as well as austerity the ratings agencies now want growth enhancing reforms which is something of a change. I also note the very downbeat view on Portuguese economic growth for next year.
At its meeting tomorrow the European Central Bank has some difficult choices to make. It is not easy setting monetary policy for 16 rather disparate nations and each possible solution brings with it a set of problems. In virtually every case the essential problem is that they all involve an element of “kicking the can down the road” and I think that markets and indeed the Governing Council are increasing wonderingly what is the way out of this and what are the future implications of prospective moves? So the period in which it could make such moves almost scot-free is over.
In many ways the failures of Euro zone politicians have passed the economic baton to the ECB which in my view does not have the tools for the task. An example of this is back in the years of the previous decade when its compromise on interest-rates led to them being at levels which stoked property booms in Ireland and Spain in particular.
The one move which would improve things in the longer-term which is some form of debt restructuring is not within their control.