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Highlights

The US dollar is lower against most currencies with the European currencies leading.  Talk of an EU rescue package for Greece on the order of 55 bln euros has contributed to the moves helping to trigger stops.  The euro briefly broke up out of the $1.3436-$1.3788 range in which the currency has been trading since Feb 17th although the breakout has not been sustained.  The Swiss franc is outperforming the euro with the euro cross breaking down to set another new low for the cycle.  The Scandinavian currencies, which tend to benefit as risk subsides, are amongst the top performing currencies today and in the absence of any key Scandinavian news.  The central European currencies are the top performers amongst emerging currencies.  Warnings from Japanese FM Kan about possible intervention has helped bolster the crosses against the yen and limited the currency’s gains against the dollar.  The Canadian dollar is at new highs for the cycle with the US dollar trading below C$1.02 after details of Canadian Feb employment showed a sharp, 60K gain in full time workers.  A drop in temp workers still saw jobs rise 20K (15K exp.)  The data could shift expectations in favor of an early H2 hike.  As our intraday note suggested, Canada shares a number of favorable fundamentals with the US and is likely to match US growth with the BoC hiking before the Fed.   

Global equity markets are generally firmer.  In Asia, Japan’s Nikkei continued to rise, helped by the softer yen.  The index closed up 0.6% today and 3.7% on the week.  Talk of an extension of Q/E at next week’s BoJ meeting also supported shares with all sectors except oil and gas gaining on the day.  By contrast, China’s Shanghai Composite closed down -1.2% while the Hang Seng and Taiex lost modest ground amidst speculation of a hike in the reserve requirement this weekend.  Yesterday’s firm CPI data is playing a role but the market is also focusing on the fact that today is Mar 12th and the last time China raised reserves was Feb 12 and the time before was Jan 12.  Chinese yuan forwards have continued to rise amidst the speculation with non deliverable forwards pricing in a 2.97% appreciation over the next 12 months, near the highest level in 2 months.  European bourses are firmer on the day with the Stoxx Europe 600 gaining for the second consecutive week.  Early indications suggest US markets will also open higher. The MSCI Emerging Markets index is up 0.4% on the day.

Global sovereign bonds are generally softer.  In Europe the German 2- and 10-year bonds remain near their lowest levels in three-weeks with the yields up 1 bp amidst talk of a Greek bailout.  However, Greek yields are only slightly lower with the 2- and 10-year down about 5 bp.  Spanish and Portuguese 10-year yields are up just 2 bp.  Indonesia’s debt rating was raised one level to BB by S&P with a positive outlook.  The rating was last increased in 2006 and is now on par with Turkey.  Fed Pres Yellen is rumored to be Pres Obama’s choice to replace retiring Fed Vice Chairman Kohn.  She is known as a dove but that may reflect the fact that as San Francisco Fed President, she oversees a region hit hard by the real estate collapse.  Over the years she has proven to be pragmatic.

Currency Markets

The euro has set a marginal new high in what appears to be a short covering rally.  The single currency took out the $1.3788 high reached Feb 17th and approached the $1.3800 area but is now trading back below the $1.3788 area.  News from an Austrian newspaper (Der Kurier) claiming that a German and French led bailout for Greece on the order of 55 bln euros is in the works has contributed to the euro’s gains.  We estimate that up until last week, Greece had raised roughly a quarter of this year’s funding needs.  Given the recent bond sales, the amount the country needs to raise for this year is now 35 bln euros.  The 55 bln euro package that the Austrian paper is discussing is said to be comprised of 20 bln from Germany of which 10 bln is in loan guarantees.  France is said to be providing an additional 10 bln euros with the remainder coming from other EU countries but excluding Spain, Portugal and the UK.  It is expected to be unveiled in early April before the second evaluation report due in May.  After drifting higher in Asia, this report helped spur the euro rally that lifted the single currency toward $1.3800 in the European session.  This is not the first report of a bailout.  So far bailout strategies seem to be trial balloons.  We note that an article in Le Monde today suggests that EU finance ministers will consider two options, one including bilateral loans from the EU states to Greece and the second involving EU borrowing on behalf of Greece with the loans guaranteed by EU state.  Le Monde cites confidential documents as its source.  With nothing concrete, today’s moves appear to be driven simply by speculation that helped fuel some position squaring in an overextended market.  

The US dollar’s broad pullback is obscuring two otherwise noteworthy developments in Japan.  First, both the prime minister and the finance minister made a none-too-thinly veiled threat of foreign exchange intervention.  Although one investment house was quoted on the wires late yesterday suggesting the odds of intervention stood at 47%, we suspect this verbal outburst is part of the on-going battle between the MOF and BOJ.  Even though the latter may take another step this month or next to combat deflation, the MOF wants more action.  As we have suggested one of the possible actions is to simply increase the JPY10 trillion 3-month financing facility launched at the end of last year and that has nearly been exhausted.  The government could order intervention if it so decided and that was the message the government was sending.  The fact of the matter is that 3-month implied dollar-yen volatility is today at its lowest level since the Lehman collapse.  The three-month risk reversals, which are a gauge of the market’s bias toward dollar-yen calls or puts is the smallest since early 2007.  Lastly we have acknowledged that the new budget includes an increase in financing bills, which are used to raise intervention funds.  However, the JPY5 trillion increase is modest compared with the existing authority for another JPY30 trillion before hitting the current cap.  The real obstacle to intervention has not been material capability but political will.  With the trade surplus growing and exports growing and the yen volatility steadily declining for the better part of the past two months, intervention threats are best understood within the context of Japanese domestic debate and not an international signal.

Upcoming Economic Releases

US retail sales are due at 8:30AM EDT/13:30 GMT.  The consensus expects headline sales to fall -0.2% in Feb (after gaining 0.5% in Jan) while the ex-auto and gas component is expected up 0.3% (vs. 0.6% in Jan.)  The risk is to the upside given the improvement in the retail component of ISM and of payrolls.  At 9:55AM/14:55 the Michigan confidence data for March are expected to rise to 74.0 from 73.6 in Feb.  That would be the second highest reading since Jan08.  The 5-year inflation expectations component is likely to remain subdued.  At 10AM/15:00 Jan business inventories are exp up 0.1% vs. -0.2% in Dec.  The ECB’s Trichet speaks at 3:45PM/20:45 in Stanford Conn.  There are no scheduled Fed speakers ahead of next week’s FOMC meeting.  Note that the US shifts their clocks ahead one hour to daylight savings time on Sunday.

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Marc Chandler is the global head of Brown Brother Harriman’s top ranked Currency Strategy Team. For more of BBH’s currency views, please visit the BBH FX website here.

This material has been prepared by Brown Brothers Harriman & Co. (“BBH”) and is intended for information purposes only.  This communication should not be relied upon as financial, investment, tax or legal advice.  This communication should not be construed as a recommendation to invest or not to invest in any country or to undertake any specific position or transaction in any currency.  This information may not be suitable for all investors depending on their financial sophistication and investment objectives.  The services of an appropriate professional should be sought in connection with such matters.  The information contained herein has been obtained from sources believed to be reliable, but is not necessarily complete in its accuracy and cannot be guaranteed. Sources used are available upon request. Any opinions expressed are subject to change without notice. Please contact your BBH representative for additional information. BBH’s partners and employees may own currencies in the subject of this communication and/or may make purchases or sales while this communication is in circulation.

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The Financial Times has caught wind of a letter sent by U.S. Treasury Secretary Timothy Geithner to to the EU’s Michel Barnier. In only thinly-veiled language Mr. Geithner accused the EU of financial protectionism for the way Brussels is moving forward with rules to regulate hedge funds and other parts of the shadow banking system. This marks the most open sign of the deteriorating US-EU relationship on matters of financial reform.

The letter is embedded below.

Geithner Letter to Michel Barnier accusing EU of Protectionism

This latest development should not come as a surprise given the outline of EU-US disputes I put forward on 9 March. Europeans have shut the American firms out of sovereign bond deals. Meanwhile, European firms are fully able to participate as underwriters of Build America Bonds that are racking up huge fees for large banks.  I began my post Wall Street barred from European bond sales in retaliation for credit crisis saying:

We have a bit of a divide developing between the EU and the U.S. on banking and bank reform. The most significant move in this tiff has come in retaliation for Wall Street’s role in helping countries like Greece hide their debt burdens. According to the Guardian newspaper, all American banks have been shut out of the sovereign bond market in Europe. While many might think the U.S. government does not have a role to play in this dispute, I know from my own experience as a diplomat that the U.S. government is very aggressive about advocating for U.S. firms abroad.

I ended the bond sale piece noting:

how much of this is just politics.  In the Greek case, up to fifteen banks may have helped Greece hide debt. Yet, the focus here is on Wall Street firms – I suspect purely for demagoguery. Should we expect a tit-for-tat move of some sort?

In this context, Geithner’s letter makes perfect sense.  The financial services industry is an important profit center for American business. Therefore, Geithner feels compelled to advocate on its behalf in Europe – as the American government is prone to do. Think of Geithner as lobbyist for American finance in Europe. The difference between the US Treasury Secretary and a mere lobbyist, however, is the veiled threats Geithner can make.

What appears to be happening is that the Americans are focused on regulating the banks by trying to force them to reduce size via size penalties, size caps, or extra regulatory premiums. The Europeans, on the other hand, are much more worried about ‘the wild west’ of the shadow banking industry that includes hedge funds. The fact that most of the EU is heavily dependent for lending on banks which are thinly capitalized too big to bail behemoths may explain why there is such resistance to size caps in Europe. The British have sided with the Americans in this dispute as London is home to a large hedge fund community.

This divide further explains why Greek Prime Minister George Papandreou asked US President Barack Obama to crack down on American speculators in the credit default swaps market when they met recently. This also explains why the Europeans are looking to ban naked credit default swaps outright. The Americans are resistant to this idea.

White House officials said Greece should focus on righting its economy and lowering its crushing debt.

“This is something the Europeans can, and should, solve on their own,” White House spokesman Robert Gibbs said, as Mr. Obama and Mr. Papandreou met in Washington on Tuesday.

The White House’s cool response to Greece’s call for a regulatory crackdown shows there’s still no consensus on what – if anything – to do about the problem of speculators.

After the meeting, however, Mr. Papandreou insisted that Mr. Obama reacted favourably to European ideas on curbing speculators.

-White House resists Greek pressure for crackdown on speculators, Globe & Mail

The spin after the meeting makes sense. Obama is still fixated on showing he is friendly to Wall Street. Hence, spokesman Gibbs’ remarks. Papandreou needs to cast blame on speculators in order to deflect attention away from the government in order to counteract social unrest domestically.

Nevertheless, on the continent, we hear politicians looking to attack the shadow banks time and again. The latest in this move is Bundesbank head Axel Weber.

The Irish Times reported on this.

Financial regulation should be strengthened by improving existing rules on how much capital banks must hold rather than by capping the size of banks or setting up bailout funds, the head of the German Bundesbank has said.

Speaking at Trinity College Dublin, Dr Axel Weber, a member of the European Central Bank’s governing council, criticised US plans to limit the risky activities of banks and to cap the size of the institutions. The plans would be “the most severe intervention” by a regulator in the sector, he said.

Such a move could lead to an unregulated “shadow banking” system where riskier investment banking, hedge funds and private equity firms’ activities would be forced outside regulated banking.

I seriously doubt the EU and the US will find common ground on these issues. I hope I am wrong as a number of smaller EU countries have taken issue with specific points in the proposal. However, if these disputes cannot be resolved – or worse still, if they escalate – the likelihood that another financial crisis spreads catastrophically is much greater.

Related posts:

• Wall Street barred from European bond sales in retaliation for credit crisis
• ‘Buy American’ will translate into a 21st century Smoot-Hawley
• Madoff as a signal to go for “regulation heavy”
• Economic nationalism and GM’s decision to keep Opel and Vauxhall
• Too big to rescue

Seasonally-adjusted jobless claims dipped 6,000 to 462,000 for the week ending 6 Mar 2010. This is significantly lower than the revised 498,000 number we saw two weeks prior. Nevertheless, 4-week average jobless claims are still over 475,000. This number is actually higher than the previous week’s 470,500 average.

At least we are seeing some incipient signs that hiring is likely to pick up. The JOLTS (Job Openings and Labor Turnover Survey) released yesterday showed a nice pickup in open position and a fall in total layoffs. As the data are not as real-time as the jobless claims data, things might be a bit better still for data released about February and March.

Bottom Line: The labor market remains weak. I had anticipated growth in non-farm payrolls by the end of this quarter. However, given the still elevated claims numbers, we may not get there.

Related posts:

• Jobless claims up another 25,000 in US
• Jobless claims: curiously large drop in unadjusted number
• Jobless claims 470,000, average rises for 2nd week
• Average U.S. jobless claims top 600,000
• Jobless claims still above 600,000

So why did we rescue this institution with a massive bailout? Elizabeth Warren, who chairs the Congressional Oversight panel of the TARP program, doesn’t understand any more than taxpayers do. This is another example of the malinvestment and zombie finance which bailouts have fostered.

Here’s a question for you: if GMAC was a U.S. auto financing company, why was it speculating in mortgage finance… in Spain?  That’s what I was asking back in July:

I would love to know what GMAC is doing in the Spanish mortgage market. Considering GMAC just got a second bailout in May, American taxpayers have the right to know what GMAC is doing and where.

Wrong country, wrong industry segment. It’s good to see Elizabeth Warren asking similar questions about the need to bailout GMAC in the video below. It runs six minutes.

Related posts:

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Canada reported a larger than expected trade surplus earlier today.  At C$0.8 bln, it was four times larger than expected and the December figures were revised to show a C$0.1 bln surplus instead of a C$0.2 bln deficit.  Canada also reported a strong rise in Q4 capacity utilization rate to 70.9% from a revised 68.7% in Q3 (previously estimated at 67.5%).    Tomorrow Canada will report February employment figures tomorrow. The unemployment rate is expected to have remained steady at 8.3%.  It appears that Canadian unemployment may have peaked in the middle of Q3 09 at 8.7%.

A favorable fundamental case for the US dollar can be built on ideas that the output gap will close in the US before Japan and Europe.  However, Canada appears to be the only other G7 country that can match the US.  Canada is expected to either match US growth this year or nearly match it.

Canada often experiences price pressures earlier on its the expansion phases.  This, coupled with a healthier banking system, which is an important transmission mechanism of monetary policy, will likely result in the Bank of Canada hiking rates before the Federal Reserve.  Canada’s 2-year note yields 62 bp more than the US currently.  Last week it reached 66 bp, the most in about 6 months.

The US dollar has fallen about 4.5% against the Canadian dollar since testing CAD1.07 on February 25th.  If one shares 1) our view that through the growth differentials, North America will close the output gap before Europe and Japan;  2) that this will be a key driver of the foreign exchange market; and 3) the Bank of Canada will raise rates before the Federal Reserve, then the Canadian dollar looks attractive.  The US dollar tested the CAD1.0220 area years and bounced to CAD1.0320 today.  The risk extends toward CAD1.04.  However, if this analysis is accurate, then the Canadian dollar will do even better against Europe.  We have a constructive outlook of the euro against sterling, so long CAD short sterling, which we had been recommending last month, may also offer a new opportunity now that the Loonie has pulled back.

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Marc Chandler is the global head of Brown Brother Harriman’s top ranked Currency Strategy Team. For more of BBH’s currency views, please visit the BBH FX website here.

This material has been prepared by Brown Brothers Harriman & Co. (“BBH”) and is intended for information purposes only.  This communication should not be relied upon as financial, investment, tax or legal advice.  This communication should not be construed as a recommendation to invest or not to invest in any country or to undertake any specific position or transaction in any currency.  This information may not be suitable for all investors depending on their financial sophistication and investment objectives.  The services of an appropriate professional should be sought in connection with such matters.  The information contained herein has been obtained from sources believed to be reliable, but is not necessarily complete in its accuracy and cannot be guaranteed. Sources used are available upon request. Any opinions expressed are subject to change without notice. Please contact your BBH representative for additional information. BBH’s partners and employees may own currencies in the subject of this communication and/or may make purchases or sales while this communication is in circulation.

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I hadn’t seen an advance release of the January German export data, when I wrote the following on Tuesday, honest injun I hadn’t:

Well, this is only a hypothesis. But if the hypothesis has any validity we should be able to make some predictions on the basis of it. I would make two. Firstly, since East Europe’s economies are often dependent for their growth on exports to the West, and in particular to Germany, then we should be able to see some “shadow” of this German process cast out into the East.

In the second place, we should see the process continue to some extent in Q1 2010. That is, based on what we have seen so far, in Q1 imports should rise, as industrial output in the early parts of the supply chain surges, and net trade should as a consequence be less positive than in Q4 2009. On the other hand, all the imported components awaiting processing should make inventories rise. So that’s a prediction. Now we need to wait and see how good it is.

I think I outlined in the post itself just how much you could see the impact of the long Eastward shadow cast by the German economy in the industrial output performance in Central Europe, but little did I expect, when I wrote those words that further confirmation of the hypothesis would come within a mere 24 hours:

Germany’s exports unexpectedly declined in January compared to the previous month, official data showed on Wednesday, highlighting risks of a bumpy recovery in Europe’s largest economy.Exports, adjusted for seasonal and calendar effects, dropped 6.3% in January compared to December 2009, the Federal Statistical Office, or Destatis, reported.

Most analysts expected a 0.5% increase in exports, which posted a monthly rise of 3.4% in December. Imports posted a monthly rise of 6% in January after gaining 5% in the previous month..

So we are seeing the imports rising effect, which suggests, since domestic consumption is falling at this point, that those inventories are starting to rise again, given that the expected follow through on exports is nothing like as dynamic as most analysts are suggesting. Oh, I know, I know, we have been having some very bad weather of late…

Axel Weber is forecasting a slight negative performance of the German economy in the first quarter, but in fact things are still not so clear since, as I wrote on Tuesday:

“Given everything I have said above about swings in imports and inventories, I would say German GDP will be very near to stationary again this quarter, with a possible slight upside depending on the inventory swing, but whatever upside we do see will more than likely disappear as quickly as it came when we get to the Q2 2010 data.”

In other words, it is all down to inventories again, and these are very difficult to foresee. Nonetheless I would make two more points:

Firstly, the Bundesbank’s forecast for growth of 1.6 percent in 2010 is looking rather optimistic at this point, even though GDP was at a very low level last year, so in theory getting some growth should not be that hard.

And secondly, that German recessionary “double dip” that I mentioned back in November does not look so implausible at all at this point. All that is needed is a very slight downward revision to the Q4 2009 data, and Axel Weber’s own prediction for very slight negative growth in this quarter to be confirmed, and there we will be, back in recession. Which would only leave us with the French economy – among the EU majors – showing any sign of a robust recovery.

Of course the implications of all this rather technical argumentation are fairly profound. In the first place, as I noted in this post, any talk of the ECB raising interest rates either this year, or in the first half of 2011, would seem to be way, way too premature. And secondly, it is becoming increasingly obvious that Europe’s (theoretically) stronger economies are inexorably yoked together with all those supposedly weaker ones, via the Eurozone (and EU27) current account imbalances.

So solving one problem also implies solving the other. Never has the case for a “united we stand, divided we fall” approach been clearer. So gentlemen, please, let’s get a note of reality back into all those deliberations about what to do with the problems being faced in countries like Latvia, Hungary, Greece and Spain. We need common solutions to common problems, and we need solutions that work.

Edward Hugh also blogs at Global Economy Matters.

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August 2009 was the high point of American’s satisfaction with the economy during Barack Obama’s tenure. Interestingly, this meshes with the data on the ground. In a recent interview, Simoleon Sense quoted James Montier as saying that his favourite real-time economic indicator is the ADS Business Conditions Index charted below (hat tip Philly Fed via the Pragmatic Capitalist).

What is this telling us?  I’m not sure yet. The pink shading in the Philly Fed chart indicates recession. So, implicitly the Philly Fed is saying recession ended in August 2009, right about the ABS Business Conditions Index was peaking for the first time (a subsequent peak came in December 2010).  This view that the recession ended in August is one I share (see my comments in Readers of this blog expect the recession to last redux and Is the recession dating committee preparing for a double dip?). Perhaps, this indicates an economy softening toward a potential double dip. I don’t know. All I know is that the ABS data are worrying.

As for the Gallup data, these paragraphs stand out for me.

Gallup has tracked Americans’ satisfaction with national conditions since 1979. Since that time, there have been three other periods of sub-20% satisfaction ratings, all during difficult economic times for the United States. These include 1979 to 1981, when the nation dealt first with an energy crisis during the latter part of the Carter presidency and high unemployment in the early part of the Reagan presidency; 1992, as the U.S. was coming out of a recession; and 2008 to early 2009, during the economic downturn and the financial crisis, including a record-low 7% reading in October 2008.

Current satisfaction levels among all party groups are low, including 11% among Republicans, 17% among independents, and 29% among Democrats.

The recent decline in satisfaction has come almost exclusively among Democrats.

Translation? The Democratic Party meltdown of 2010

Source

U.S. Satisfaction Drops Below 20% – Gallup

Related posts:

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This is pretty cool. Now I know why my mother told me to stay away from power.

Related posts:

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By Rob Parenteau, CFA, sole proprietor of MacroStrategy Edge, editor of The Richebacher Letter, and a research associate of The Levy Economics Institute.

The question of fiscal sustainability looms large at the moment – not just in the peripheral nations of the eurozone, but also in the UK, the US, and Japan. More restrictive fiscal paths are being proposed in order to avoid rapidly rising government debt to GDP ratios, and the financing challenges they may entail, including the possibility of default for nations without sovereign currencies.

However, most of the analysis and negotiation regarding the appropriate fiscal trajectory from here is occurring in something of a vacuum. The financial balance approach reveals that this way of proceeding may introduce new instabilities. Intended changes to the financial balance of one sector can only be accomplished if the remaining sectors also adjust in a complementary fashion. Pursuing fiscal sustainability along currently proposed lines is likely to increase the odds of destabilizing the private sectors in the eurozone and elsewhere – unless an offsetting increase in current account balances can be accomplished in tandem.

To make the interconnectedness of sector financial balances clearer, proposed fiscal trajectories need to be considered in the context of what we call the financial balances map. Only then can tradeoffs between fiscal sustainability efforts and the issue of financial stability for the economy as a whole be made visible. Absent consideration of the interrelated nature of sector financial balances, unnecessarily damaging choices may soon be made to the detriment of citizens and firms in many nations.

Navigating the Financial Balances Map

For the economy as a whole, in any accounting period, total income from producing final goods and services must equal total expenditures on final products. There are, after all, two sides to every transaction: a spender of money and a receiver of money income. Similarly, total saving out of income flows must equal total investment in tangible capital during any accounting period.

For individual sectors of the economy, these equalities need not hold. The financial balance of any one sector can be in surplus, in balance, or in deficit. The only requirement is, regardless of how many sectors we choose to divide the whole economy into, the sum of the sectoral financial balances must equal zero.

For example, if we divide the economy into three sectors – the domestic private (households and firms), government, and foreign sectors, the following identity must hold true:

Domestic Private Sector Financial Balance + Fiscal Balance  + Foreign Financial Balance = 0

Note that it is impossible for all three sectors to net save – that is, to run a financial surplus – at the same time. All three sectors could run a financial balance, but they cannot all accomplish a financial surplus and accumulate financial assets at the same time – some sector has to be issuing liabilities.

Since foreigners earn a surplus by selling more exports to their trading partners than they buy in imports, the last term can be replaced by the inverse of the trade or current account balance. This reveals the cunning core of the Asian neo-mercantilist strategy. If a current account surplus can be sustained, then both the private sector and the government can maintain a financial surplus as well. Domestic debt burdens, be they public or private, need not build up over time on household, business, or government balance sheets.

Domestic Private Sector Financial Balance + Fiscal Balance – Current Account Balance = 0

Again, keep in mind this is an accounting identity, not a theory. If it is wrong, then five centuries of double entry book keeping must also be wrong. To make these relationships between sectors even clearer, we can visually represent this accounting identity in the following financial balances map as displayed below.

On the vertical axis we track the fiscal balance, and on the horizontal axis we track the current account balance. If we rearrange the financial balance identity as follows, we can also introduce the domestic private sector financial balance to the map:

Domestic Private Sector Financial Balance = Current Account Balance – Fiscal Balance

That means at every point on this map where the current account balance is equal to the fiscal balance, we know the domestic private sector financial balance must equal zero. In other words, the income of households and businesses just matches their expenditures (or alternatively, if you prefer, the saving out of income flows by the domestic private sector just matches the investment expenditures of the sector). The dotted line that passes through the origin at a 45 degree angle marks off the range of possible combinations where the domestic private sector is neither net issuing financial liabilities to other sectors, nor is it net accumulating financial assets from other sectors.

Once we mark this range of combinations where the domestic private sector is in financial balance, we also have determined two distinct zones in the financial balance map. To the left of the dotted line, the current account balance is less than the fiscal balance: the domestic private sector is deficit spending. To the right of the dotted line, the current account balance is greater than the fiscal balance, and the domestic private sector is running a financial surplus or net saving position.

This follows from the recognition that a current account surplus presents a net inflow to the domestic private sector (as export income for the domestic private sector exceeds their import spending), while a fiscal surplus presents a net outflow for the domestic private sector (as tax payments by the private sector exceed the government spending they receive).

Accordingly, the further we move up and to the left of the origin (toward the northwest corner of the map), the larger the deficit spending of households and firms as a share of GDP, and the faster the domestic private sector is reducing the stock of net financial assets it holds. This usually entails an increasing its private debt to income ratio, or a falling net worth to income ratio (absent an asset bubble, which would raise the valuation of assets held). Moving to the southeast corner from the origin takes us into larger domestic private surpluses, where households and firms can increase their holdings of net financial assets.

The financial balance map forces us to recognize that changes in one sector’s financial balance cannot be viewed in isolation, as is the current fashion. If a nation wishes to run a persistent fiscal surplus and thereby pay down government debt, it needs to run an even larger trade surplus, or else the domestic private sector will be left stuck in a persistent deficit spending mode.

When sustained over time, this negative cash flow position for the domestic private sector will eventually increase the financial fragility of the economy, if not insure the proliferation of household and business bankruptcies. Mimicking the military planner logic of "we must bomb the village in order to save the village", the blind pursuit of fiscal sustainability may simply induce more financial instability in the private sector. Fiscal sustainability may ultimately prove destabilizing to the economy.

Leading the PIIGS to an (as yet) Unrecognized Slaughter

The rules of the eurozone are designed to reduce the room for policy maneuver of any one member country, and thereby force private markets to act as the primary adjustment mechanism. Each country is subject to a single monetary policy set by the European Central Bank (ECB). One policy rate must fit the needs of all the member nations in the eurozone. Each country has relinquished its own currency in favor of the euro. One exchange rate must fit the needs of all member nations in the eurozone. The fiscal balance of member countries is also, under the provisions of the Stability and Growth Path, supposed to be limited to a deficit of 3% of GDP. The principle here is one of stabilizing or reducing government debt to GDP ratios. Assuming economies in the eurozone have the potential to grow at 3% of GDP in real terms, and inflation is held to 2%, nominal GDP growth of 5% will be likely over the medium term. Starting from a 60% government debt to GDP ratio nominal terms, which is also the proposed public debt limit, a  fiscal deficit of 3% of nominal GDP, when combined with a 5% nominal GDP growth tendency, will stabilize the government debt ratio at this limit (.03/.05 = .6, and the average debt ratio will migrate toward the marginal over time).

In other words, to join the European Monetary Union, nations have substantially diluted their policy autonomy.Markets mechanisms must achieve more of the necessary adjustments – policy measures are circumscribed. Policy responses are constrained by design, while experience suggests relative price adjustments in the marketplace have a difficult time at best of automatically inducing private investment levels consistent with desired private saving at anything approach the level of full employment income. This is a recipe for subpar growth outcomes, if not stagnation, and it presents quite a challenge if growth paths are knocked down by a global financial crisis, for instance.

Now let’s layer on top of this structure three complicating developments of late. First, current account balances in a number of the peripheral nations have fallen, in part due to the prior strength in the euro. Second, fiscal shenanigans along with a very sharp global recession have led to very large fiscal deficits in a number of peripheral nations. Third, following the Dubai World debt restructuring, global investors have become increasingly alarmed about the sustainability of fiscal trajectories, and there is mounting pressure on governments to commit to tangible plans to reduce fiscal deficits over the next three years, with Ireland and Greece facing the first wave of demands for fiscal retrenchment. 

We can apply the financial balances approach to make the current predicament plain. If, for example, Spain is expected to reduce it’s fiscal deficit from roughly 10% of GDP to 3% of GDP in three years time, then the foreign and private domestic sectors must be together willing and able to reduce their financial balances by 7% of GDP. Spain is estimated to be running a 4.5% of GDP current account deficit this year. If Spain cannot improve its current account balance (in part because it relinquished its control over its nominal exchange rate the day it joined EMU), the arithmetic of sector financial balances is clear. Spain’s households and businesses would, accordingly, need to reduce their current net saving position by 7% of GDP over the next three years. Since they are currently estimated to be net saving 5.5% of GDP, Spain’s domestic private sector would move to a 1.5% of GDP deficit, and  thereby enter a path of increasing leverage.

Spain already is running one of the higher private debt to GDP ratios in the region. In addition, Spain had one of the more dramatic housing busts in the region, which Spanish banks are still trying to dig themselves out from (mostly, it is alleged, by issuing new loans to keep the prior bad loans serviced, in what appears to be a Ponzi scheme fashion). It is highly unlikely Spanish businesses and households will wish to raise their indebtedness in an environment of 20% plus unemployment rates, combined with the prospect of rising tax rates and reduced government expenditures as fiscal retrenchment is pursued. More likely, they will try to preserve their recent net saving or financial surplus position.

Alternatively, if we assume Spain’s private sector will attempt to preserve its estimated 5.5% of GDP financial balance, or perhaps even attempt to run a larger net saving or surplus position so it can reduce its private debt faster, Spain’s trade balance will need to improve by more than 7% of GDP over the next three years. Barring a major surge in tradable goods demand in the rest of the world (especially demand for Spanish tradable goods by chronic current account surplus nations in the eurozone like Germany), or a rogue wave of rapid product innovation from Spanish entrepreneurs, there is an additional way for Spain to accomplish such a significant reversal in its current account balance.

Prices and wages in Spain’s tradable goods sector will need to fall precipitously, and labor productivity will have to surge dramatically, in order to create a large enough real depreciation for Spain that its tradable products gain market share (at, we should mention, the expense of the rest of the eurozone members). Arguably, the slack resulting from the fiscal retrenchment is just what the doctor might order to raise the odds of accomplishing such a large wage and price deflation in Spain. But how, we must wonder, will Spain’s private debt continue to be serviced during the transition as Spanish household wages and business revenues are falling under higher taxes or lower government spending? 

Spain Ensnared in the EMU Trap

As evident from the financial balances map, there are a whole range of possible combinations of current account and domestic private sector financial balances which could be consistent with the 7% of GDP reduction in Spain’s fiscal deficit. But the simple yet still widely unrecognized reality is as follows: both the public sector and the domestic private sector cannot deleverage at the same time unless Spain produces a nearly unimaginable trade surplus – unimaginable especially since Spain will not be the only country in Europe trying to pull this transition off.

As an admittedly rough exercise, we can assume each of the peripheral nations will be constrained to achieving a fiscal deficit that does not exceed 3% of GDP in three years time. In addition, we will assume each nation finds some way to improve its current account imbalances by 2% of GDP over the same interval. What, then, are the upper limits implied for domestic private sector financial balances as a share of GDP for each nation?

Greece and Portugal appear most at risk of facing deeper private sector deficit spending under the above scenario, while Spain comes very close to joining them. But that obscures another point which is worth emphasizing. With the exception of Italy, this scenario implies declines in private sector balances as a share of GDP ranging from 3% in Portugal to nearly 9% in Ireland.

Private sectors agents only tend to voluntarily target lower financial balances in the midst of asset bubbles, when, for example home prices boom and gross personal saving rates fall. Alternatively, during profit booms, firms issue debt and reinvest well in excess of their retained earnings in order take advantage of an unusually large gap between the cost of capital and the expected return on capital. We have no compelling reasons to believe either of these conditions is immediately on the horizon.  If peripheral eurozone private sectors try to maintain something close to their current financial surpluses, current account balances will not to improve more dramatically, or nominal income growth will slow, if not fall into deflation.

The above conclusion regarding the need for a substantial trade balance swing in nations pursuing fiscal retrenchment flows straight from the financial balance approach, and yet it is obviously being widely ignored, because the issue of fiscal retrenchment is being discussed as if it had no influence on the other sector financial balances. This is unmitigated nonsense. It is even more retrograde than primitive tales of "twin deficits" (fiscal deficits are nearly guaranteed to produce offsetting current account deficits) or Ricardian Equivalence stories (fiscal deficits are nearly guaranteed to produce offsetting domestic private sector surpluses) mainstream economists have been force feeding us for the past three decades. Both of these stories reveal an incomplete understanding of the financial balance framework – or at best, one requiring highly restrictive (and therefore highly unrealistic) assumptions.

The EMU Triangle

This observation is especially relevant in the eurozone, as the combination of the policy constraints that were designed into the EMU, plus the weak trade positions many peripheral nations have managed to achieve, have literally backed these countries into a corner. To illustrate the nature of their conundrum, consider the following application of the financial balances map.

First, a constraint on fiscal deficits to 3% of GDP can be represented as a line running parallel to and below the horizontal axis. Under Stability and Growth Pact rules, we must define all combinations of sector financial balance in the region below this line as inadmissible. Second, since current account deficits as a share of GDP in the peripheral nations are running anywhere from near 2% in Ireland to over 10% in Portugal, and changes in nominal exchange rates are ruled out by virtue of the currency union, we can provisionally assume a return to current account surpluses in these nations is at best a bit of a stretch. This eliminates the financial balance combinations available in the right hand half of the map.

If peripheral eurozone nations wish to avoid a return to private sector deficit spending – and realistically, for most of the peripheral countries, the question is whether private sectors can be induced to take on more debt anytime soon, and whether banks and other creditors will be willing to lend more to the private sector following a rash of burst housing bubbles, as well as a severe recession that is not quite over – then there is a very small triangle that captures the range of feasible solutions for these nations on the financial balance map.

It is the height of folly to expect peripheral eurozone nations to sail their way into the EMU triangle under even the most masterful of policy efforts or price signals. More likely, since reducing trade deficits is likely to prove very challenging (Asia is still reliant on export led growth, while US consumer spending growth is still tentative, and, as mentioned earlier, most of the eurozone trade takes place within the eurozone itself), the peripheral nations in the eurozone will find themselves floating somewhere out to the northwest of the EMU triangle. The sharper their fiscal retrenchments, the faster their private sectors will tend to run up their debt to income ratios.

Alternatively, if households and businesses in the peripheral nations stubbornly defend their current net saving positions, the attempt at fiscal retrenchment will be thwarted by a deflationary drop in nominal GDP. Demands to redouble the tax hikes and public expenditure cuts to achieve a 3% of GDP fiscal deficit target will then arise. Private debt distress will also escalate as tax hikes and government expenditure cuts the net flow of income to the private sector.  Call it the paradox of public thrift.

As it turns out, pursuing fiscal sustainability as it is currently defined will in all likelihood just lead many nations to further destabilization of private sector debt. European economic growth will prove extremely difficult to achieve if the current fiscal "sustainability" plans are carried out over the next three years. Realistically, policy makers are courting a situation in the region that will beget higher private debt defaults in the quest to reduce the risk of public debt defaults through fiscal retrenchment. European banks, which remain some of the most leveraged banks, will experience higher loan losses, and rating downgrades for banks will substitute for (or more likely accompany) rating downgrades for government debt. A fairly myopic version of fiscal sustainability will be bought at the price of a larger financial instability involving private debt as well.

Summary and Conclusions

These types of tradeoffs are opaque now because the fiscal balance is being treated in isolation. Implicit choices have to be forced out into the open and coolly considered by both investors and policy makers. It is not out of the question that fiscal rectitude at this juncture could place the private sectors of a number of nations on a debt deflation path – the very outcome policy makers were frantically attempting to prevent but a year ago.

There may be ways to thread the needle – Domingo Cavallo’s [Argentina] recent proposal to pursue a "fiscal devaluation" by switching the tax burden in Greece away from labor related costs like social security taxes to a higher VAT could be one way to effectively increase competitiveness without enforcing wage deflation (http://www.voxeu.org/index.php?q=node/4666). The cost of exported goods is thereby lowered (as in a currency devaluation) without the need for domestic wage cuts and nominal income deflation, and this introduces the possibility of an improved trade balance with an unchanged fiscal balance.

Cavallo’s claims to the contrary, however, it was not the IMF that tripped him up in pursuing this fiscal devaluation angle. Cavallo was, like Greece, under pressure to reduce Argentina’s fiscal deficit. Fiscal expenditure cuts and tax hikes begat lower domestic income flows, which led to subsequent tax shortfalls, missed fiscal balance targets, and another round of fiscal retrenchment, in a vicious spiral fashion (another illustration of the paradox of public thrift).

Regardless, more innovative and effective solutions than the fiscal devaluation approach, need to be considered. Financial stability, not just fiscal sustainability, must be taken into account. But such solutions will not even be brought to light unless policy makers and investors begin to think coherently about how sector financial balances interact.

Or to put it more bluntly, if eurozone countries try to return to 3% fiscal deficits by 2012, as many of them are now pledging, unless the euro devalues enough or some other measure produces a large current account swing, then either a) the domestic private sectors of many nations will have to adopt a deficit spending trajectory, or b) nominal private income will deflate, and Irving Fisher’s paradox will apply (as in the very attempt to pay down debt leads to more indebtedness), thwarting the ability of policy makers to achieve fiscal targets. In the case of Spain, (or adjacent to the eurozone, the UK) with large private debt/income ratios, this is an especially critical issue. In addition, given the eurozone tended to run a minor current account surplus (until recently) as a whole, falling nominal incomes in the peripheral nations, or improved current account balances in the periphery, will tend to come at the expense of growth in the eurozone’s current account surplus nations. This introduces a possible contagion vector for Germany in particular, one that lies beyond the exposure of German banks to peripheral nation public debt or private debt. It is not obvious Germany’s policy makers have fully considered these possible feedback effects which could lead to larger. Ironically, Germany’s own fiscal balance could decline if these effects prove large enough on German income growth.

The underlying principle flows from the financial balance approach: the domestic private sector and the government sector cannot both deleverage at the same time unless a trade surplus can be achieved and sustained. Yet the whole world cannot run a trade surplus. More specific to the current predicament, we remain hard pressed to identify which nations or regions of the remainder of the world are prepared to become consistently larger net importers of Europe’s tradable products. Countries currently running large trade surpluses view these as hard won and well deserved gains. They are unlikely to give up global market shares without a fight, especially since they are running export led growth strategies. Then again, it is also said that necessity is the mother of all invention (and desperation, its father?), so perhaps current account deficit nations will find the product innovations or the labor productivity gains that can lead to growing the market for their tradable products. In the meantime, for the sake of the citizens in the peripheral eurozone nations now facing fiscal retrenchment, pray there is life on Mars that exclusively consumes olives, red wine, and Guinness beer.

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Bundesbank President Weber has been the most candid to date about what the ECB could do in case Greece is downgraded again, especially by Moody’s.  Recall the problem:  Prior to the crisis, the ECB would take as collateral only paper rated A- or better.  During the crisis they have extended it to BBB-.  It is due to revert back at the end of the year.  Fitch and S&P rates Greece below A-, leaving only Moody’s above the normal threshold.

The ECB seems to loathe to postpone the return to normalcy again.  And yet as Austrian central banker Notwotny pointed out earlier this week, it seems unfair and untenable that a single rating agency determines whether a sovereign has access to the ECB’s lending facilities.

A solution, Weber suggests, could be that the ECB accepts the lower quality of collateral in exchange for a larger discount–or what the market calls a haircut.  There is precedent.  For example, some non-sovereign securities used as collateral are given a 20% haircut.

Weber acknowledges this is not the only solution, suggesting that this is a dynamic situation and the ECB has not made any hard and fast decisions.  At the same time, it indicates that although many ECB members, like Weber himself, are insisting on a narrow construction of the Maastricht and Lisbon Treaties, it is not above using monetary operations to assist fiscal objectives.

For example, some of the 12-month money the ECB provided at 1% appears to have been used in part to finance the purchases of European sovereign debt.  Indirectly, but no less significantly, the ECB helped support the weaker credits in Europe.  On July 1st the ECB’s 12-month massive 442 bln euro provision expires.  The ECB will seek to smooth this out by offering 6 month funds at the end of March and then a special tender at the end of June. Meanwhile, reports suggest that Greece has made an early preliminary report to the EU (due March 16th) that claims that it is ahead of schedule in implementing its austerity measures.  It is said to acknowledge that, as we pointed out, Greece’s 2009 GDP was revised lower and that this lowers the 2010 base.  Accounts also suggest that report notes that civil servant wage cuts will will crimp consumption.  This is one of the ironies.  Efforts to address the structural deficit risks adding to the cyclical deficit.

The markets have responded favorably to these developments and Greek bonds and the other weaker credits in the euro zone have rallied.  Ten year yields are off 2-4 bp and credit default swap prices have eased.  Note that current market conditions appear favorable for new issuance and there is already talk that Greece could come back to the market as early as next week to raise more funds.  Last week’s bond sale and the next ones, are part of the official effort to pre-fund a good part of the more than 20 bln euros in maturity and coupon payments due in the April and May period.

The euro has also moved higher on the news.  Resistance at yesterday’s high near $1.3635 needs to be overcome to spur a retest of the week’s high near $1.3705.  While many would like to see a near-term euro bounce to sell into, the shallowness of the upticks, given the more positive developments in Greece, over the past week disappoints.

Marc Chandler
Global Head of Currency Strategy
Brown Brothers Harriman & Co.

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The preceding is a post by Marc Chandler. For more of BBH’s currency views, please visit the BBH FX website here.

This material has been prepared by Brown Brothers Harriman & Co. (“BBH”) and is intended for information purposes only.  This communication should not be relied upon as financial, investment, tax or legal advice.  This communication should not be construed as a recommendation to invest or not to invest in any country or to undertake any specific position or transaction in any currency.  This information may not be suitable for all investors depending on their financial sophistication and investment objectives.  The services of an appropriate professional should be sought in connection with such matters.  The information contained herein has been obtained from sources believed to be reliable, but is not necessarily complete in its accuracy and cannot be guaranteed. Sources used are available upon request. Any opinions expressed are subject to change without notice. Please contact your BBH representative for additional information. BBH’s partners and employees may own currencies in the subject of this communication and/or may make purchases or sales while this communication is in circulation.

Related posts:

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• Debt concealment in Greece
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• Greece sees credit rating cut by S&P

Highlights

The US dollar is mixed against the major and emerging market currencies.  The euro is consolidating in yesterday’s range as bonds stabilize and despite a smaller than expected German trade surplus.  Comments from EU spokesperson Altafaj just before the NY open that measures taken by Greece are sufficient have so far failed to take the currency above yesterday’s high around $1.3635.  By contrast, the pound came under further pressure extending losses against both the dollar and the euro overnight, hit by another round of weak data (industrial and manufacturing production.)  While the currency was oversold and has managed to recovery some modest ground, gains are likely to be limited with resistance around $1.4980 and support on the cross at around 0.9080.  The New Zealand dollar is one of the top performing currencies today on position squaring ahead of this afternoon’s RBNZ meeting.  The central bank is expected to leave rates unchanged but the market will be looking for any signals about the timing of the first hike.  Recent data have been mixed and given that households remain cautious and employment has softened, the RBNZ may leave its statement unchanged, a negative for the kiwi.  Amongst emerging market currencies, the Asian countries, many of whom export to China, saw their currencies gain after Chinese imports jumped. 

Global equity markets are firmer but with several exceptions.  In Asia, Japan’s Nikkei and Topix closed down (a modest -0.04% and -0.2% dragged lower by declines in energy related and tech shares.  China’s Shanghai Composite also slipped, down 0.7% as consumer related shares fell amidst concern rising exports and inflation (due in the next few days) could lead to tightening and despite reassurances from the Commerce Dept that stimulative fiscal policies will remain in place.  Most other Asian markets as well as the European bourses have posted modest gains while early indications suggest US markets may open flat. The MSCI Emerging Markets index is up 0.5% today and is now up on the year.

Global sovereign bonds are narrowly mixed.  In Europe, the German 2- and 10-year yields are up just 1 to 2 bp after successful 2- and 10-year auctions totaling 7 bln euros.  The comparable Greek yield is down 3 bp while Portuguese yields are down 2 bp.  Portugal’s 11-year 990 mln euro bond auction, like the German auctions, also saw good demand.

Currency Markets

The British pound’s poor performance in the European session was exacerbated by worse than expected Jan industrial production data. Output contracted -0.4% m/m (vs. an expected gain of 0.3% and after a 0.5% gain in Dec) leaving the yearly rate well in negative territory, at -1.5% (vs -3.6% in Dec.)  Manufacturing production also contracted unexpectedly by -0.9% m/m (vs +0.9% prior) and for a yearly rate at a very sluggish +0.2% (from -2.0% in Dec).  Poor weather contributed to the disappointing performance, but it is not all due to weather.  Yesterday’s Jan trade figures (and considering the highly manufacturing orientated nature of the UK external sector) hinted at a likely disappointment on the industrial production front too. Moreover, it should be noted that the French Jan industrial production also released this morning came out on the strong side of expectations (at +1.6% m/m) yet the weather conditions were dreadful in France too in January.  The bottom line is the UK economy has started the year on a poor note and this has implications for both the monetary policy outlook (i.e. extra QE could be considered again) and for the fiscal prospects (the weaker growth profile means lower growth generated revenues and a deteriorating fiscal position), risking exacerbation of current UK credit concerns.

China reported stronger export and import figures for February than expected, with the net result of a smaller than expected trade surplus.  In fact, February’s trade surplus of $7.6 bln is the smallest in a year and a bit more than half of the January surplus.  This is consistent, however, with an under-appreciated development that we think is important.  In terms of global imbalances, the US trade deficit and the Chinese trade surplus have been roughly halved as a percentage of GDP over the last couple of years.  In the US case, it seems largely cyclical and the growth differentials that we expected to close the output gap in the US before Europe and Japan will likely see the US trade deficit grow again, though from a lower base.  In China’s case, the possibility of a structural shift is greater, though too early to tell.  China’s exports rose 45.7% in February from the depressed year-ago levels. Yet this is more than twice the pace in January and may also have been distorted by the earlier lunar New Year.  Imports jumped almost 45%, better than the 39.7% expectations, but well off the mind-boggling 85.5% pace reported in January.  There are several implications of today’s Chinese trade report.  First, with foreign demand improving and domestic demand still appearing robust, it can only add to the near-term inflation pressures.  CPI figures are due out as early as tomorrow and the expected 2.5% year-over-year pace would be the fastest pace in 16 months and spur the already growing expectation for a PBOC rate hike.  In this regard, note that China reported that commercial and residential real estate in 70 cities rose at an almost 11% clip, which plays on fears of over-heating.  Second, although the US Congress is seeking action to try to pressure China into allowing its currency to appreciate, the decline in China’s trade surplus makes it all the more difficult for the Obama Administration to cite China as a currency market manipulator in next month’s Treasury report.  There has been some speculation that China would be cited as the Obama Administration seeks to pre-empt Congressional action and seeks to get support for some of the outstanding free trade agreements.  Some observers note the weapon sales to Taiwan, the Dalai Lama visit to Washington and the trade frictions all as signs that the Administration is edging toward a more direct confrontation with China.  Meanwhile, the 12-month non-deliverable forwards are fairly stable today, ahead of more macro economic data; implying almost a 3% appreciation of the yuan over the next year.  We suspect that a rate hike is still several months, with additional administrative moves, like the increase in reserve requirements and tweaking money market rates, continuing to be seen first.

Japan’s economy may be benefiting from the revival in its neighboring Asian economies, but domestic demand remains very sluggish and deflationary forces continue.  Feb machinery orders were softer than expected at down 3.7% m/m (vs +20.1% in Dec.) That put the yearly rate at -1.1% (vs -0.6% exp). Machinery orders are a good proxy for business investment, so this disappointing January performance is not particularly promising for Q1GDP.

 
Upcoming Economic Releases

US Jan wholesale inventories, which represent about a quarter of business inventories, are due at 10AM EDT/15:00 (0.2% m/m exp vs. -0.8% prior.)  The RBNZ announces its policy decision at 3PM EDT/20:00 GMT (rate expected unchanged at 2.5%.)

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The preceding is a post by Marc Chandler, global head of Brown Brother Harriman’s top ranked Currency Strategy Team. For more of BBH’s currency views, please visit the BBH FX website here.

This material has been prepared by Brown Brothers Harriman & Co. (“BBH”) and is intended for information purposes only.  This communication should not be relied upon as financial, investment, tax or legal advice.  This communication should not be construed as a recommendation to invest or not to invest in any country or to undertake any specific position or transaction in any currency.  This information may not be suitable for all investors depending on their financial sophistication and investment objectives.  The services of an appropriate professional should be sought in connection with such matters.  The information contained herein has been obtained from sources believed to be reliable, but is not necessarily complete in its accuracy and cannot be guaranteed. Sources used are available upon request. Any opinions expressed are subject to change without notice. Please contact your BBH representative for additional information. BBH’s partners and employees may own currencies in the subject of this communication and/or may make purchases or sales while this communication is in circulation.

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The Bloomberg video is a bit sensationalist in my opinion. But it gets to the heart of the problem in Europe, namely Spain. Spain has an economy and debt which is an order of magnitude larger than Greece. That means that problems in Spain are more critical than in Greece. But it also means that an EU bailout would simply not be feasible.

Watch the video and I will make a few other remarks below.

The first thing to realize is that government deficits are balanced by imports and private savings. I’m talking here about the financial sector balances, of course.

The chart to the left from the FT shows you that the collective financial balances in each individual Eurozone country must sum to zero.  Where there is a government surplus it is matched by either the capital account or private balances. The same is true for deficits.  Take Spain, for example. There, the government’s budget was in surplus in 2006 and it had a very large capital account surplus (the financial sector equivalent of a current account/trade deficit). This was matched by a substantial private sector deficit. By 2009, due in large part to an unprecedented housing bust, the government’s finances were in tatters. Look at the chart. This is matched by net private sector savings and a capital account surplus.  The financial sectors must balance.

This brings me to the second thing to realize. Spain is to Germany as the United States is to China. In a fixed exchange rate environment, the U.S. is running an astonishing current account deficit while China runs an equally outsized surplus. Similarly, you can’t have Germany and Spain both running current account surpluses, unless the EU as a whole runs a current account surplus. So, if Germany (or the Netherlands) wants to be the export juggernaut and run a massive current account surplus, this has intra-EU ramifications. The most important is that Germany’s (or the Netherlands’) current account surplus (capital account deficit) is matched by current account deficits (capital account surpluses) in Spain (Portugal, Greece, Ireland and Italy). That’s how it works, folks. You sell more to me than I do to you and I get more cash than you do. There are always two sides to every transaction. It’s right there in the data.

The FT’s Martin Wolf is on to this and notes in his column yesterday:

In the short run, it is impossible to shift external balances quickly, particularly when domestic demand in the surplus countries is so weak.

Now Germany insists that every country should eliminate its excess fiscal deficit as quickly as possible. But that can only happen if current account balances improve or private balances deteriorate. If it is to be the latter, there needs to be a resurgence in private, presumably debt-financed, spending. If it is to be the former, there are two choices: first, current account balances must deteriorate elsewhere in the eurozone, entailing a move to smaller private surpluses in countries like Germany. Or, second, the overall balance of the eurozone must shift towards surplus – a “beggar my neighbour” policy.

In practice, the most likely outcome of such fiscal retrenchment would be a slump in countries with large external and fiscal deficits. Given the lack of competitiveness of such external deficit countries and the weakness of demand elsewhere in the eurozone, such slumps might become very long-lasting. The question is whether populations would put up with this. If not, political crises will emerge, with inherently uncertain consequences.

I would add to this by running a brief two-stage analysis of what happens under austerity (sorry, no charts yet).  In stage one, we have the FT chart for 2009. Spain has an enormous budget deficit, which is offset by private savings and a capital surplus (more imports than exports). Germany has a smaller deficit and a capital deficit (more exports than imports) matched by a huge private sector savings.

If Spain is forced to run austerity measures as seems likely, in stage two, this shifts their government deficit markedly down. Given Spain’s poor labour competitiveness, sticky wage prices and inability to depreciate the currency, all of the adjustment falls onto the private sector in the form of reduced net savings (which could include larger debt burdens). But, the thing to realize is that total GDP in Spain is lower in this scenario, which means total imports are lower, which means Germany’s total export volume is lower. This is a deflationary scenario.

I know for a fact that Germany and Austria (another net exporter) are already cutting back their deficits, Austria via higher taxes. We see Ireland, Spain, Greece and Portugal doing ‘austerity’ measures to rein in government deficits too. Meanwhile, having seen the financial sector balances chart, you know that austerity means higher debt burdens in those countries, but also lower exports in Germany, which is also cutting back its own Government spending. So, austerity not only kills the Spanish economy and makes it prone to a debt deflation scenario, it also hurts the German export economy while they themselves are cutting back on government deficits.

What you have here is a perfect recipe for a double dip and a serious economic nightmare.  Unless Germany can get its consumers to start spending more, the Eurozone is going to double dip.

Source

Germany’s eurozone crisis nightmare – Martin Wolf, FT

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Related posts:

• Links: 2010-02-12 – European recovery falters and mortgage problems
• Links: 2010-02-26 – credit cards, reinflating the bubble and more
• Links: 2010-02-21 – shadow inventory, depression in Latvia and more
• Links: 2010-02-18 – fallacies of composition, housing bubbles, taxes and more
• Links: 2010-02-17 – Bubbles, Greece, Irish banks and Japanese consumers

Ann Lee and Dan Alpert joined Bloomberg’s Pimm Fox today to talk about the housing market recovery. Lee, a professor of finance at New York University, was sceptical that population growth predicts any substantial increase in housing transactions and prices simply due to the continued pressure on wages and disposable income. and Dan Alpert, managing director at Westwood Capital LLC, said we are not looking at market-clearing prices in the near-term because home ownership percentages need to drop. This process will take two to two and a half years in his view.

Short clip below.

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You!

Hat tip Prieur du Plessis.

Source

Dave Granlund, Comics.com

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According to Bundesbank President Axel Weber, Germany’s economic recovery is “essentially intact”, and is now set to benefit from stronger demand in countries outside the euro region.

“I firmly believe that the recovery process that began in summer 2009 is essentially intact, and that it will continue despite the slower growth dynamic in the winter semester. An additional factor in this context is that the German labor market continues to be in extremely robust shape.”

What exactly it means to say that an economy is intact we will explore below, but it is clear that some confirmation for the view that the German economy is benefiting from increased demand originating outside the Eurozone can be found in the latest press release on manufacturing industry turnover from the Federal Statistics Office, where they note that while January’s manufacturing sector turnover surpassed that of January 2009 – by a working day adjusted 2.6% – domestic sales actually fell (by 1.1%), and export turnover rose by 7.3%. Most interestingly, as between destinations, sales to euro area countries only increased by 2.4%, while those to other foreign countries were up 12.0%. This illustrates two points: that the German economy is now more dependent than ever on exports, and that sales to emerging markets are what is really driving export growth at this point. This latter development is hardly surprising given the strong fiscal corrections being applied in many of Germany’s former customer countries.

In fact, while German industry is surely now in "recovery mode", the process is something of a stop-start one (see chart below), since even though according to the latest data from the technology ministry output was up by an estimated 0.6% in January over December (and even up by 2.2% over the very low level hit in January last year) it is still down by 18.5% over the March 2008 peak.

More Export Dependent Than Ever

Still the story of the German economy remains very much one of a tale of two components, with net trade offering some relief to pretty negative domestic demand data. According to the Federal Statistical Office, German gross domestic product stagnated in the fourth quarter of 2009, remaining unchanged from the level of the previous quarter level(0.0% change). Thus the slight upward trend noted during the second (+0.4%) and third quarters of 2009 (+0.7%) did not continue.

GDP from October to December was down by 1.7% on a year earlier. The decrease, which was smaller than in the previous quarters of 2009 still meant that German GDP fell by 5% in 2009 as a whole when compared with 2008.

Economic growth in the fourth quarter of 2009 was, in fact, only really supported by foreign trade: exports rose 3.0% on the previous quarter, while imports decreased 1.8%.

The resulting balance of exports and imports contributed 2.0 percentage points to GDP growth. That positive contribution was, however, entirely offset by a fall of 2 percentage points in total domestic demand (including inventory movements). Both household consumption expenditure and gross fixed capital formation exerted a negative impact on growth.

Final private consumption expenditure fell by 1.0% shaving 0.6 percentage points from headline GDP growth.

Interestingly German wage rates rose (see chart below) in the second half of 2009 (although due to significant quantities of short time working, gross wages were more or less stationary), but even this surge seems to have had little in the way of positive impact on consumption.

Gross fixed capital formation fell back, and was down by 0.5% (spending on machinery and equipment fell by 1.5%).

In addition the German government started to rein in spending (after many quarters of significant support) following the election, and government final consumption expenditure fell by 0.6%.

So We Are Back To Inventories

In fact however, the biggest drop in domestic demand did not come from household spending, or from fixed capital investment, or from government consumption: it came from movement in inventories. Inventories were cut back sharply again during the quarter, and made a negative contribution to growth of 1.2 percentage points (out of the 2 percentage point negative contribution from domestic demand as a whole). This drop followed a considerable increase in inventories in the third quarter, whereby they contributed 1.5 percentage to growth.

Now, I think I am beginning to discern a pattern in these large swings in trade and inventories which characterise German GDP movements. Basically, it is important to keep in mind the East European component in German manufacturing (Hans Werner Sinn’s Bazaar – not bizarre – economy idea). Basically a significant part of German exports are assembled products put together from materials manufactured in the East (a process which Delia Marin suggestively calls Maquilladores in reverse), and thus there may well be a correlation between high imports in one quarter (based on anticipated demand) and rising inventories (and falling imports) in the subsequent one as demand expectations systematically fail to be achieved (the excessive business expectations factor). Let’s see.

Below you will find three charts summarising movements in the key components of German GDP during the last three quarters of 2009. In Q2, as you will see, trade is up (as exports rise much faster than imports), while inventories are down, as accumulated stocks are exported.

The in Q3 we see the opposite phenomenon, as inventories pile up, as imports surge without the expected growth in exports.

Then finally we have Q4, and the opposite happens again, imports fall, exports rise, net trade is a growth positive, and inventories are cut back. In each case the other components of growth are rather insignificant, and have in fact weakened as the recession has progressed – I hope this is not what Axel Weber means by saying that the German economy has survived the recession "intact" (namely that it is as export dependent now as ever it was).

Well, this is only a hypothesis. But if the hypothesis has any validity we should be able to make some predictions on the basis of it. I would make two.

Firstly, since East Europe’s economies are often dependent for their growth on exports to the West, and in particular to Germany, then we should be able to see some "shadow" of this German process cast out into the East.

In the second place, we should see the process continue to some extent in Q1 2010. That is, based on what we have seen so far, in Q1 imports should rise, as industrial output in the early parts of the supply chain surges, and net trade should as a consequence be less positive than in Q4 2009. On the other hand, all the imported components awaiting processing should make inventories rise. So that’s a prediction. Now we need to wait and see how good it is.

But on the upstream components, maybe we can learn something from the East. Let’s start with Hungary, which has Germany as its largest single customer, and the manufacturing Purchasing Manager’s Index (PMI).

Well, basically if we think about the fact that German inventories were run down in Q4 last year, and imports slumped, then it is interesting to note that Hungarian manufacturing, after improving steadily during the earlier part of the year (barring August), slumped back again in the three months from October to December.

If we also look at Czech industry, a similar sort of picture emerges – stagnation in Q4 2009, and a surge in activity in this quarter.

When we come to Poland things are rather different, since the Polish economy have vibrant autonomous demand, so the Polish industrial sector has local market growth to give some impetus, but things did taper off a bit in Q4, and they have now rebounded.

So What Does "Intact" Really Mean In The German Case?

So, to come back to Axel Weber’s point, I fear intact does mean "business as usual".

Certainly, if we look at the most recent manufacturing PMI, the pace of expansion has improved slightly over the previous quarter, which may mean that those good old inventories are simply piling up again.

While the services element has, if anything, lost momentum over Q4.

Bad weather seems to have sent construction falling off a cliff – falling an estimated 14.3% in January:

And the February construction PMI looks even worse, with the indicator showing the worst decline in activity since the survey was introduced in September 1999.

Poor weather conditions continued to have a negative impact upon the construction sector in February. Anecdotal evidence pointed to widespread weather disruptions, alongside relatively weak underlying demand. As a result, the headline seasonally adjusted Construction Purchasing Managers’ Index – a single-figure snapshot of overall activity in the construction economy – fell sharply from 40.2 in January to 28.9 in February. This was the lowest reading in the survey’s ten-and-a-half year history.

Consumer and business confidence readings are faltering:

Retail sales have been in serial decline since the VAT increase in January 2007.

And the February retail PMI showed another sharp contraction, although again, weather conditions do seem to have played a part.

Retail sales in Germany declined sharply on a month-on-month basis in February. At 42.1, down from 42.7 in January, the seasonally adjusted Retail PMI was below the 50.0 no-change threshold, continuing the trend observed since June 2008.The latest reading pointed to the sharpest rate of contraction since January 2009, which survey respondents linked to a combination of bad weather and unfavourable economic conditions. A post-scrappage scheme downturn in demand for new cars was also cited by those in the automobiles sector.

So, to conclude where we started, we can well agree with Axel Weber that the German economy is indeed intact – intact and near stationary. If we look at the composite PMI below (which is the nearest thing we have to a GDP indicator), it does show slight improvement over Q4 2009, but only a very slight one. Given everything I have said above about swings in imports and inventories, I would say German GDP will be very near to stationary again this quarter, with a possible slight upside depending on the inventory swing, but whatever upside we do see will more than likely disappear as quickly as it came when we get to the Q2 2010 data.

Edward Hugh also blogs at Global Economy Matters.

Related posts:

• German Exports and that Looming Double Dip
• ISM: February 2010 manufacturing data slightly lower, report still good
• GDP revised to down 5.7% for Q1 2009
• Third quarter GDP growth comes in at 3.5%
• Highlights from report with Q1 U.S. GDP down 6.1%

About a month ago I wrote a post called “The coming wave of second mortgage writedowns” the gist of which was that the big four banks (Citi, JP, BofA, and Wells) had a shed load of exposure to now worthless second mortgages. With many first mortgages now hopelessly underwater, it stands to reason that second mortgages on those same properties have zero value.

The big four are certainly well aware of this problem and are looking for ways to extend the wherewithal of underwater borrowers and pretend they don’t need to take losses on these loans. On paper, these companies are very well capitalized. However, in the real world, the likely losses they must eventually take on loans already on their books would probably render them insolvent. This is what I hinted yesterday in my post on the stress tests.

I said:

I would say the stress tests were a mock exercise to instil confidence in the capital markets. This was important first and foremost because it would induce private investors to pay for bank recapitalization instead of taxpayers. But it was also important for the economy as a whole as the sick banking sector was dragging the whole economy down. The key, however, is that the tests were a mock exercise. Despite the additional capital, banks are still hiding hundreds of billions of dollars in losses in level three, hold to maturity, and off balance sheet asset pools. If asset prices fall and/or the economy weakens, all of this subterfuge would be for nought.

-Geithner: jusqu’ici tout va bien

And when I use the phrase ‘mock exercise,’ by mock, I mean fake. Mike Konczal has done a remarkable job of putting these two concepts – the worthless second mortgages and the stress tests – together.

He writes in a recent post:

Let’s talk specifics: Last June I made a DIY Stress Test, using values reversed-engineered from the public documents, where you could play around with the values online or download an excel spreadsheet yourself (it’s still one of my favorite blogging items). The backbone of the overview of results, page 9 from the Federal Reserve’s document, looks like this:

I’m going to isolate the four largest banks Frank questioned about second-liens, along with their loses as they’ve legally sworn to being accurate during the stress test:

Again, this is data as reported to the government by the major banks during the stress test of 2009. So what’s going on here? The four major banks have about $477 billion in junior liens, either in the form of a second mortgage or a home equity line of credit. If you go to the Fed Funds data online, you’d see that there’s about a trillion dollars of 2nd/Juniors out there, so the four major players have about half the market.

The four major players each report that they expect to have a 13-14% loss on these items under an “adverse scenario”, with Citi reporting a 20% loss under an adverse scenario. That means of the $477bn, $68.4 bn is junk that’ll never be collected on. This, combined with all the other expected losses (see the link to the stress test for the rest) meant that the four biggest players needed around $53bn to be raised.

Notice how Frank’s letter, and pretty much anyone you’d speak to who isn’t working for the four largest banks, assume that second liens in the country aren’t worth 86% of their value (for a 14% loss). You see in Frank’s letter “no economic value.” Huh. Well, that’s a problem.

Let’s look at these values again, assuming that the expected total loss would be 40%, and then 60%.

So the original loss from second-liens, as reported by the stress tests, was $68.4 billion for the four largest banks. If you look at those numbers again, and assume a loss of 40% to 60%, numbers that are not absurd by any means, you suddenly are talking a loss of between $190 billion and $285 billion. Which means if the stress tests were done with terrible 2nd lien performance in mind, there would have been an extra $150 billion dollar hole in the balance sheet of the four largest banks. Major action would have been taken against the four largest banks if this was the case.

See what I mean by fake?  The point is this whole charade is transparent to anyone who actually runs the numbers. Yet, you have people like John Cassidy spreading disinformation in the New Yorker, writing puff pieces of zero negative value with drivel like this:

Other critics dismissed the tests as a sham, arguing that the economic assumptions underpinning them were too benign. As the tests unfolded, however, it became evident that the government’s loss projections were quite high, and that many banks would be forced to raise considerable sums of money—in some cases, more than ten billion dollars.

Baloney. Run the numbers like Mike did, John; and then you wouldn’t make such asinine comments. Of course the stress tests were a sham.  They were a confidence trick to raise more capital and buy time for the banks to earn yet more still. The point was to allow the banks to ease into their losses. And that’s exactly what’s been happening for the past year.

The problem with the stress tests, however, is they gave the banks a way to get from under the yoke of the government’s TARP program. The banks said, “look, we are now well-capitalized even in the worst case scenario of the stress test. We want out of TARP.”

This is bad for three reasons.

• The big banks all paid back $25 billion in TARP funds. Smaller banks like Northern Trust paid back $10 billion or less. That’s hundreds of billions of capital that they all could have as a buffer against losses. Some of them raised additional capital to replenish the coffers. Nevertheless, net-net, we had less banking capital in the system after the repayments than before.
• Banks free of TARP paid out a lot of cash in bonuses that could have gone to shoring up their capital base.  Every dollar paid in cash compensation to staff is a dollar less of capital.  Had these banks been under TARP, they would have been forced to pay lower bonuses – if only for this year.
• The lower capital – and the fact that banks know that having renewed capital problems would mean the end of the line for them – means that banks are less likely to lend freely.  They understand that now is the time to husband capital. Heads would roll if a big bank or super regional which had repaid TARP had another capital shortfall.

The real question is: why is the Obama Administration running victory laps, unrolling the ‘Mission Accomplished’ banner on the credit crisis, as Mike Konczal describes it? I suspect this is just a political stunt to provide cover in the mid-term elections to somehow demonstrate that the Democrats fixed the problem which the Republicans created. 

I think it could backfire if only because the underemployment rate is still 17%. Nobody wants to hear the “I saved the economy routine” when they’re unemployed and losing their home.

Related posts:

• The coming wave of second mortgage writedowns
• Black: Stress tests and the Big Lie
• At least six banks need more capital under stress tests
• Bank by bank breakdown of stress test results
• Geithner: jusqu’ici tout va bien

I almost have to laugh at this. But, a proposal is afoot to require all employed persons in America submit biometric data as a control against illegal immigrants. This is part of an Immigration Bill now wending its way though the Senate.

The Wall Street Journal writes ID Card for Workers Is at Center of Immigration Plan:

Lawmakers working to craft a new comprehensive immigration bill have settled on a way to prevent employers from hiring illegal immigrants: a national biometric identification card all American workers would eventually be required to obtain.

Under the potentially controversial plan still taking shape in the Senate, all legal U.S. workers, including citizens and immigrants, would be issued an ID card with embedded information, such as fingerprints, to tie the card to the worker.

The ID card plan is one of several steps advocates of an immigration overhaul are taking to address concerns that have defeated similar bills in the past.

The uphill effort to pass a bill is being led by Sens. Chuck Schumer (D., N.Y.) and Lindsey Graham (R., S.C.), who plan to meet with President Barack Obama as soon as this week to update him on their work. An administration official said the White House had no position on the biometric card.

"It’s the nub of solving the immigration dilemma politically speaking," Mr. Schumer said in an interview. The card, he said, would directly answer concerns that after legislation is signed, another wave of illegal immigrants would arrive. "If you say they can’t get a job when they come here, you’ll stop it."

Wow. Who said you couldn’t get bipartisan efforts into Congress. Good thing the Ministry of Truth has authorized me to inform you that data from this national database will be used only to police immigration. As I said, I almost have to laugh at this.

It’s stuff like this that rightly imbues the citizenry with a certain knee-jerk distrust of government.

No related posts.

This 30 Rock parody almost has it down.

No related posts.

This is the fifth in a series of posts about ideas for financial reform generated by the “Make Markets Be Markets” conference I attended yesterday in New York City on 3 Mar 2010. You can download all of the written presentations here.

Let’s talk about regulatory capture and financial reform for a few minutes. Arnold Kling has an interesting take on last week’s conference. He wasn’t there, but did see the videos online.  In a recent post, he says:

What is ironic to me is that the Roosevelt Institute people can cite clear evidence of government failure while proposing more government. For example, Richard Cornell points out that bank soundness regulators have every incentive to be lax until it is too late, yet his proposed solution is to consolidate bank regulation. Cornell begins his talk by listing comic book characters who never seem to learn (Charlie Brown, Wylie Coyote). In my opinion, he could be talking about policy wonks who think that regulation can be reformed so that special interests can be curbed and regulators will act wisely.

In selective cases, and without consciously realizing it, these folks apply public choice theory. But they assume it away when making their proposals.

I think he makes a good point here. He’s saying in effect that many regulators are captured by the industries they are supposed to regulate. Everyone knows this – and many of the Roosevelt Institute presentations point this out. Yet, those very same presenters seem to think the solution is to just get different regulators who aren’t captured or change the structure of who does the regulating.  Kling is suggesting that doesn’t work. If market failure is what caused the credit crisis to spiral out of control, you’re just replacing market failure with regulatory failure.

So, how do we deal with this problem? 

Self-regulation. The ivory tower libertarian solution would be to de-regulate i.e. reduce regulatory oversight and permit self-regulation to rule the roost. I liken this to having citizen police officers (with guns) to police criminals. If an individual is caught stealing a car, the self-regulating community can apprehend the criminal and let the court system adjudicate his sentence. Quite frankly, I think this solution is nuts. This is the Libertarian paradise in Somalia – and it’s called anarchy. Moreover, it assumes the economy tends to equilibrium i.e. when a large bankruptcy disrupts the economy, eventually things will right themselves. This is a false neo-classical assumption.

Trust but verify. A better approach would be to operate a two-stage system that I will call “trust but verify.” Judge Stanley Sporkin was right when he voiced his frustration in Q&A at the end of the conference that you can’t have a good regulatory system without regulators who actually regulate. So, I agree with him that stage one is filling regulatory seats with real regulators, rather than anti-regulators like Alan Greenspan, who believed that markets could self-regulate fraud. But that still leaves you with a potential that those same regulators could be captured or that at a later date different regulators could be captured.

As a result, you need a second fallback mechanism. It’s called bankruptcy.  The problem with having let Lehman Brothers fail was not that it failed, but that a mechanism was not in place to limit the damage of that failure. Of course, Lehman should have been bankrupted. That’s the price you pay in a capitalist society for failure – and it’s the reason we have bankruptcy laws. Now, for most firms, bankruptcy is not destabilizing to the entire national or global economy. However, large financial companies like Fannie Mae, Freddie Mac, Citigroup, AIG, and Bank of America are too big to fail (TBTF). We have to deal with this problem by breaking them up – or in the case of Fannie and Freddie, eliminating them. If you have another solution i.e. a failsafe TBTF resolution mechanism, please chime in.

So, I say install the right people as regulator and trust the regulator to her job. But verify that the job is being done by first allowing firms to fail and then replacing incompetent regulators.

Related posts:

• Mark to market is beside the point
• The failure to address the looming too-big-to-fail issue
• Jamie Dimon makes the best case for not breaking up banks
• Bill Black and The Federal Reserve’s War Against Effective Regulation
• The FSA signals a need for regulation-heavy

We have a bit of a divide developing between the EU and the U.S. on banking and bank reform. The most significant move in this tiff has come in retaliation for Wall Street’s role in helping countries like Greece hide their debt burdens. According to the Guardian newspaper, all American banks have been shut out of the sovereign bond market in Europe. While many might think the U.S. government does not have a role to play in this dispute, I know from my own experience as a diplomat that the U.S. government is very aggressive about advocating for U.S. firms abroad.

The Guardian says:

European countries are blocking Wall Street banks from lucrative deals to sell government debt worth hundreds of billions of euros in retaliation for their role in the credit crunch.

For the first time in five years, no big US investment bank appears among the top nine sovereign bond bookrunners in Europe, according to Dealogic data compiled for the Guardian. Only Morgan Stanley ranks at number 10.

Goldman Sachs doesn’t make the table. Goldman made it to number five last year and in 2006, and number eight in 2007, the data shows. JP Morgan was in the top ten last year and in 2007 and 2006 but doesn’t appear this year.

"Governments do not have the confidence that the excessive risk-taking culture of the big Wall Street banks has changed and they still cannot be trusted to put the stability of the financial system before profit," said Arlene McCarthy, vice chair of the European parliament’s economic and monetary affairs committee. "It is no surprise therefore that governments are reluctant to do business with banks that have failed to learn the lesson of the crisis. The banks need to acknowledge the mistakes that were made and behave in an ethical way to regain the trust and confidence of governments."

European sovereign bond league tables are now dominated by European banks such as Barclays Capital, Deutsche Bank, and Société Générale, the Dealogic table shows. Their business model is usually seen as more relationship-based, while US investment banks have traditionally been focused on immediate deal-making.

Being left out of government bond sales means missing out on one of the top fee-earning opportunities this year, given the relative drought in mergers and acquisitions and stock market flotations. Western European governments need to raise an estimated half a trillion dollars this year to refinance debts and pay for bank bailouts and rising unemployment.

I would expect the U.S. bank lobby to pressure the Obama Administration into developing demarche communiqués at the State and Commerce Departments condemning this as a protectionist move. This is the type of work that State and Commerce does regularly on behalf of companies like Chiquita Brands International. The bank lobby is much more powerful. So, one should expect this to rise to an Ambassador-level talking point.

But apart from American firms being shut out of European sovereign debt deals, there are a lot of other ideas in the hopper which indicate an increasing friction between Europe and the United States on bank reform. Obama proposed a $117 billion bank levy (the so-called “financial crisis responsibility fee”) which is to tax banks in order to pay back taxpayers for the bailout he and President Bush conducted. European leaders have been cool to this plan. Obama received support from Bank of England Governor Mervyn King on the issue of banning proprietary trading under the Volcker rule. But, on other meaningful banking sector reforms, there has been little agreement.

Moreover, an influential German politician has floated a contentious idea for a European Monetary Fund to replicate the functions of the International Monetary Fund. The fund proposal is an implicit recognition that the IMF would be a palatable option for a workout of the Greek sovereign debt crisis if not for American influence and control at the IMF. This idea has been panned by other leading German political figures. However, German Chancellor Merkel has some praise for it. The fact that plans for an EMF are proceeding despite its irrelevance to the current debt crisis in Europe tells you that it is a political move to gain independence from the IMF.

On the surface, relations between Europe and the U.S. appear to be mostly harmonious. However, recent developments demonstrate a significant divide on finance and banking between the U.S. and Europe. To date, President Obama’s popularity in Europe has not translated into any substantive trans-Atlantic initiatives, at least on the banking and finance front. And judging from this anti-Wall Street move, I don’t imagine it will anytime soon.

The interesting bit is how much of this is just politics.  In the Greek case, up to fifteen banks may have helped Greece hide debt. Yet, the focus here is on Wall Street firms – I suspect purely for demagoguery. Should we expect a tit-for-tat move of some sort?

Stay tuned.

Sources

Europe bars Wall Street banks from government bond sales – Guardian

Bananas and ‘1992′: the Battle to Preserve Protected Trade from the Caribbean – Trocaire

Related posts:

• The Europeanisation of the Credit Crisis
• Rumours, Rumours, and No Greek Bond Sales To China
• Geithner accuses the EU of protectionism in financial services
• Crisis in Europe: an article I wrote in today’s Guardian
• Will we have to blow up a continent (again) before we stop Wall Street?

Highlights

The US dollar and yen are trading with a firmer tone against the major and emerging market currencies.  But the markets still appear to be consolidating and we expect the “rule of alternation” to remain in play meaning that the top side of the euro’s range was tested yesterday and the bottom side around $1.3500 is likely to be tested today in the absence of any key news.  The pound has been rocked by weak data (retail sales, housing data and a worse than expected trade deficit despite the pound’s slide in recent months) and another warning from Fitch that the country is not moving fast enough to address its structural imbalances.  (Fitch also warned Portugal and Spain to put their houses in order.)  That said, the pound is oversold around the $1.4940 support area and amidst talk of M&A related demand for pounds against the Scandinavian currencies.  The Swedish krona is now the worst performer on the day amidst cross related selling and after Moody’s warned the outlook for the Swedish banking system is improving but remains negative. 

Global equity markets are mixed.  The MSCI Asia-Pacific index was barely changed, gaining just 0.1% after reaching a six-week high yesterday.  Japan’s Nikkei was also relatively unchanged, down just 0.2%.  Materials related shares were amongst the hardest hit as gold slipped after China’s Yi Gang, the Director of SAFE, said gold was unlikely to become a primary investment for China’s reserves but noted that given the size of the country’s reserves, the US Treasury market is “an important one to [China]”.  The comments are not overly surprising despite recent rumors China could buy gold from the IMF.  China’s gold holdings make up a very small proportion of the country’s almost $3 tln of reserves.   European bourses have given up early gains with the key bourses down about -0.7% while early indications suggest US markets may open lower.

Global sovereign bonds are firmer.  In Europe, the German and French 10-year bond yields are down 4 bp.  The comparable Greek yield is down 5 bp despite differences of opinion over the German Finance Minister’s proposal yesterday to establish a European Monetary Fund with some officials unwilling to change the rules at this juncture.  That suggests formation of an EMF would come too late to help address current problems in the euro area.  Spanish and Portuguese yields are flat with Fitch warning of a downgrade in Portugal if consolidation is insufficient and that Spain is vulnerable given an inflexible labor market that could prolong a recovery and reduce tax revenue.  At the same time, Fitch said a European sovereign default would not cause a break-up of the euro zone and said the US had no short or medium term problems.  US 10-year Treasury yields are down 4 bp.

Currency Markets

Sterling has come under renewed pressure after a mini perfect storm consisting of weaker than expected data (retail sales, housing and trade), new opinion polls and further warnings from Fitch and Moody’s.  Fitch indicated the UK has a serious row to hoe and that the authorities are not moving fast enough in addressing the deficit.  Last week, Fitch warned the UK is the most vulnerable of the AAA rated countries to financial crisis and should trim its budget deficit more sharply in the next four years.  Today’s warning from Moody’s focused on the UK banks and lenders.  Moody’s said those lenders that have not improved their financial position could be downgraded as government support is withdrawn.  The rating agency had taken the UK government’s GBP1 tln ($1.5 tln) of assistance into account in rating banks but will cease this practice as the money is withdrawn.  The announcements came after the UK released a much weaker than expected housing report from RICs (with real estate agents saying house prices had risen vs. those saying they fell at 17%, vs. 30% exp and down from 31% in Jan) and Feb BRC retail sales monitor confirming a sluggish consumer sector (up 2.2% y/y but from an extremely low Jan 09 base, so far from impressive.)  That was coupled with a widening of the trade deficit despite the weakness of the pound.  The deficit was £7.98bn in Jan (vs -£7bn previously and vs -£7bn expected) while the non-EU trade gap widened to -£3.8bn (from -£2.6bn). This was the worse trade performance since Aug 08 and resulted from a 6.7% monthly drop in exports while imports were down 1.6%. The slump in exports is disappointing at a time of sterling weakness but one should not forget that the UK main trading partner (the euro zone) recovery is extremely sluggish and a weaker currency will do little in the near-term if external demand is very weak to start with. Coupled with the negative adverse effects that the poor Q110 weather will have on GDP growth, the highly disappointing trade figures underline a further drag on economic activity.  It looks increasingly likely that Q1 GDP (due on April 23rd) will be very weak – an unfortunate timing for Chancellor Brown ahead of the May 6th general elections. In this context, some would argue that the case to call the elections before April 23rd is growing by the day.  Note that the most recent Populus poll of 100 key seats shows both Labour and the Tories at 38%.  On the downside for PM Brown, a YouGov poll puts the Tories at 39% with Labour at 34% while the LibDems, which according to leader Clegg, won’t form a coalition with Labour if Brown runs the party, have 16%.  

The Federal Reserve continued its slow but steady march preparing the normalization of monetary policy.  Yesterday, it announced it would expand the counterparties it would use for the reverse repos (which are one of the tools the Fed has indicated it will use to neutralize the excess reserves before it raises rates) to include large money market mutual funds.  Usually the Fed’s activity is focused on the primary dealer community.  Like the earlier steps, there is no policy implication per se, but taken together, would seem to reflect a central bank committed to this process and continuing to "get its ducks lined up" so that it is prepared for the eventual rate hike.  The Fed also indicated that it would use a range of instruments in its reverse repo operations, including Treasuries of course, but also mortgage-backed securities and agency bonds.  Several large money market mutual funds seemed eager to participate, according to news wire accounts.   The Fed’s long-term asset purchase program winds down this month.  It is interesting to note that despite the supply and the absence of the Fed’s buying, the US 10-year yield is off 15 bp this year.  And even though the Fed’s buying of agency securities has slowed, the yields on Fannie Mae and Freddie Mac mortgage securities appears to be the tightest on record compared to Treasuries.

Upcoming Economic Releases

There are no key US or Canadian data releases today.  The Fed’s Evans speaks at 9:30AM EDT/14:30 GMT.

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The preceding is a post by Marc Chandler, global head of Brown Brother Harriman’s top ranked Currency Strategy Team. For more of BBH’s currency views, please visit the BBH FX website here.

This material has been prepared by Brown Brothers Harriman & Co. (“BBH”) and is intended for information purposes only.  This communication should not be relied upon as financial, investment, tax or legal advice.  This communication should not be construed as a recommendation to invest or not to invest in any country or to undertake any specific position or transaction in any currency.  This information may not be suitable for all investors depending on their financial sophistication and investment objectives.  The services of an appropriate professional should be sought in connection with such matters.  The information contained herein has been obtained from sources believed to be reliable, but is not necessarily complete in its accuracy and cannot be guaranteed. Sources used are available upon request. Any opinions expressed are subject to change without notice. Please contact your BBH representative for additional information. BBH’s partners and employees may own currencies in the subject of this communication and/or may make purchases or sales while this communication is in circulation.

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