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Thursday, December 3, 2009

Global Manufacturing Loses Momentum In November

Operating conditions in global manufacturing industry improved for the fifth successive month in November, although there was an evident slowdown in the overall rate of expansion, with differences between countries accentuating and not diminishing. The JPMorgan Global Manufacturing PMI aggregate reading came in at 53.6, down from October's 39-month high of 54.4, and signalling that the first wave of post crisis momentum may be losing force as governments slowly start to remove stimulus measures.

Also notable in this month's survey was the unevenness of the expansion which was registered, with some emerging economies - like China and Brazil - continuing to experience a solid expansion, others - like India, Turkey and Russia, showed some slowing in activity. South Africa returned to expansion for the first time in many moths. Among mature economies Japan showed a notable relaxation in the pace of expansion, with a significant drop in new export orders, and a fall in the backlog of work, while in Europe the "usual suspects" of uncompetitive contracting economies - Greece, Ireland, Spain and Hungary in particular - are still to really to show clear signs of recovery. Spain once more trailed the rest of the world, at least in terms of those countries included in the survey.

Commenting on the survey, David Hensley, Director of Global Economics Coordination at JPMorgan, said: "The headline PMI fell back slightly in November, but the global new orders and production indexes remained at very elevated levels. National PMIs point to broadly-based manufacturing growth. With final sales rising and inventories falling, the stage is set for continued, strong output growth. Encouragingly, the PMI indicates that the pace of job-shedding is easing although employment growth has yet to resume despite robust output gains."

Brazil And China Continue To Surge

The Brazil PMI rose to its highest level for two years driven by faster expansions in output, new order and employment The headline PMI at 55.5, from 53.7 in October, suggested a marked expansion in Brazil’s manufacturing economy. Furthermore, the latest reading was above the pre September 2008 series.

Underlying demand for Brazilian manufactures increased during November, as indicated by a sharp rise in total new business, with growth primarily coming from the domestic market, as new export orders were largely unchanged on the month. Companies generally linked improved domestic demand with better economic conditions inside Brazil itself, while survey respondents suggested that foreign demand weakened due to the strong real and difficult business conditions in key export markets.

China's November PMI pointed to another strong improvement in manufacturing operating conditions in the country. The headline HSBC China Manufacturing PMI rose to 55.7 in November, from 55.4 in October, pointing to a continuation in the most marked period of improvement in operating conditions since the start of data collection in April 2004, with Chinese manufacturers reporting that output growth was maintained for the eighth month running in November.

Data suggested that export sales rose again in November, increasing at the fastest rate since March 2005. Those firms that reported an increase in new export business widely attributed this to stronger external demand. November data signalled that staffing levels in the Chinese manufacturing sector increased at the second-fastest rate in the survey history, extending the current period of growth to six months.

Uneven Trend in Eastern Europe

Activity in Eastern Europe was very uneven, with Polish industry putting in its best performance in recent months, and Czech industry just sneaking over the dividing line between growth and contraction, while Russian industry continued to fall back for a second month, and Hungary remained well behind the rest of the group.

Survey data for the Polish manufacturing sector showed that business conditions generally improved in November, bringing to an end a downturn that had lasted a year-and-a-half. The headline HSBC Poland Manufacturing PMI posted a record month-on-month gain in November, rising from 48.8 to 52.4. This reading was the fourth consecutive monthly improvement and was the highest activity level since March 2008.

Survey responses suggested that the improvement was evenly distributed across both the domestic and export markets. Falling employment remained a drag on the overall recovery, although the rate of job loss slowed sharply during the month, to the weakest seen in the current nineteen-month sequence.

November saw the first overall improvement in operating conditions at Czech manufacturers since June 2008, with the headline HSBC Czech Republic Manufacturing PMI rising for the tenth consecutive month to hit 50.6 (from 49.8 in October), thus registering expanison for the first time in almost a year-and-a-half. Output and new order growth both gained traction, while employment fell at the slowest rate since September 2008. This was the fourth consecutive month in which manufacturing production rose and although it remained well below the long-run survey average, the rate of expansion marked an acceleration on October. Underpinning rising workloads was a fourth straight monthly increase in new orders. Incoming new business increased in both domestic and export markets, with demand slightly stronger in the former.

In Russia in contrast November saw an overall deterioration in business conditions for the second month running. Output rose only marginally, while incoming new orders fell for the first time since June. Growth of purchasing activity was maintained, but at a slow pace, while employment continued to fall. The headline seasonally adjusted Russian Manufacturing PMI remained below the no-change mark of 50.0, although the November figure of 49.1 indicated only a marginal rate of deterioration, even if it was a slightly worse one than the 49.6 posted in October. The fall in the PMI primarily reflected slower output growth and falling new orders.

Hungary remains the outlier among those East European countries who have PMI surveys, and the manufacturing PMI dropped 0.8 percentage points to hit 47.5 points in November, according to the Hungarian Association of Logistics, Purchasing and Inventory Management. It is now clear that the steady improvement that started in the spring has now ground to a complete halt, and even moved into reverse gear as conditions in the Hungarian economy continue to remain extremely poor. Before the present crisis the Hungarian index had been above the 50 level for more than three years until it slumped to 42.6 last October, going on to hit its all-time low of 38.5 in January. This is thus the longest stretch of contraction in activity since the survey was first launched, and there appears to be no immininent end to Hungary's industrial agony in sight at this point.

Eurozone Also Uneven

The final Markit Eurozone Manufacturing PMI rose to a 20-month high of 51.2 in November, up slightly from 50.7 in October and above the flash estimate of 51.0.

The headline PMI has now remained above the neutral 50.0 mark for two successive months. Growth of output and new work received was the fastest for 26 and 27 months respectively and, for both variables, stronger than earlier flash estimates. Manufacturing production increased for the fourth consecutive month in November, led by the strong performances of the intermediate and investment goods producing sectors. Higher output was also signalled among consumer goods producers, but the rate of expansion remained weak.

Disparities between the performances of the various member states continued in November, with growth in the headline index again being predominantly driven by Germany and France. The rate of expansion of output eased back slightly in France, but remained amongst the strongest gains seen since mid-2006, while in Germany growth hit a 26-month high. An increase in the output component was recorded for the Netherlands (25-month high), Italy (26-month peak), Austria and Ireland (the first production gain since February 2008). The contraction continued in both Spain and Greece, with rates of decline accelerating over those seen in October.


German manufacturers indicated robust rises in output and new orders in November, with rates of expansion in both cases accelerating to the fastest since the third quarter of 2007. Growth was supported by improved global economic conditions, which led to a resurgence of new export orders alongside higher spending among domestic clients. Meanwhile, with backlogs increasing for the second month running and the ratio of new orders to inventories at a comparatively high level, a number of forward-looking survey indicators now suggest that firms may well continue raising output from the depressed levels seen earlier in the year.

At 52.4 in November, up from 51.0 in October, the headline seasonally adjusted Markit/BME Purchasing Managers’ Index suggested there had been a solid improvement in business conditions over the month, although substantial job shedding persisted. Lower employment numbers have been recorded continuously since October 2008, with the latest fall linked to low levels of capacity utilisation following the slump in demand earlier in the year.


In France the manufacturing sector also registered another strong expansion in November, with both production and new orders continuing to rise strongly. On the other hand, there were signs of some underlying weakness since employment and output prices both fell further. The headline Purchasing Managers’ Index posted 54.4, down slightly from 55.6 in the previous month, but still the second-highest reading in the past three years.

French manufacturers continued to reduce their staffing levels during the survey period, with many firms citing restructuring plans, but the pace of job shedding remained weaker than the steep rates seen in the early part of 2009.


November saw the first overall improvement in operating conditions in Italian manufacturing industry since February 2008. Both output and new business rose at their fastest rates over two years, while new orders from abroad increased for the first time since January 2008. This being said, as Markit point out the data show only a fractional improvement and continued to highlight underlying weaknesses in the Italian economy in general. In particular workloads were too low to maintain current workforce numbers, and pricing power remained subdued.

The seasonally adjusted Markit/ADACI Purchasing Managers’ Index came in at 50.1, up from 49.2 in October, but only fractionally above the 50.0 no-change mark that separates improving from deteriorating conditions. Despite higher demand and production volumes, firms continued to cut staffing numbers, and manufacturers reported that lower workloads continued to reveal spare capacity at their plants. As a consequence staffing numbers were reduced for the twenty-second straight month, and at a marked pace.


Spanish manufacturing is evidently the worst of the bunch for yet another month, and November data pointed to a further deterioration in operating conditions across the manufacturing sector. Worse, the rates of decline of key variables such as output, new orders and employment all accelerated during the month.

In fact the seasonally adjusted Markit Purchasing Managers’ Index fell to 45.3 in November, from 46.3 in October. The PMI has now stood below the neutral 50.0 mark for two years, with the latest reading showing the strongest contraction since last June. Panellists indicated that lower demand, particularly from domestic sources, led to the latest drop in new business, which was the fastest since May. New export orders also contracted during the month.

With new orders continuing to decrease, Spanish manufacturers utilised spare capacity through the completion of backlogs of work. Excess capacity led firms to restructure their workforces accordingly, resulting in another sharp decline in employment. Moreover, the rate of job cuts was the fastest since June. And Spanish manufacturers continue to cut back on their holding of stocks, indeed the pace of reduction remained substantial despite easing from the month before. Stocks of finished goods also fell sharply in November, extending the current period of decline to thirteen months, as firms depleted stocks in line with lower new orders and production volumes.

Commenting on the Spanish survey data, Andrew Harker, economist at Markit, said:

“The Spanish manufacturing sector looks set to endure a bleak winter period, characterised by falling new business, job cuts and heavy price discounting. The glimpse of a possible recovery seen during the summer appears to have been only a temporary reprieve, with even the stabilisation of demand now seeming some way off again.”


Greece also retained its status as another of the Eurozone's weak spots, with business conditions continuing to be difficult for Greek manufacturers, while demand for their goods fell at an accelerated rate. The seasonally adjusted Markit Greece Manufacturing PMI slipped further, hitting a six month low of 47.3. If we exclude the brief respite registered in August, the headline index has now remained below the no-change threshold since October 2008.

Overall, new business fell at a strong pace, and dat showed that foreign demand was particularly weak, with incoming new work from abroad decreasing markedly since October. Backlogs were reduuced, and both unfinished work and employment continued to fall, the former at an accelerated pace. Respondents linked further workforce rationalisation to lower production requirements and cost pressures. Employment has now contracted during every month since May 2008.


November data indicate the first joint increase in both production and new business registered by Irish manufacturing in twenty-one months. Employment continued to fall, but at the slowest rate for a year-and-a-half. As a result the seasonally adjusted NCB Purchasing Managers’ Index rose slightly to 48.8, from 48.0 in October. This result still means that overall operating conditions in the Irish manufacturing sector continued to deteriorate during the months, extending a run that has now lasted for two years.

Higher output during the month largely reflected new order growth, which in turn was attributed to strengthening demand. New export orders increased for the second time in three months, and at a faster pace than overall new business. Despite the expansion in new business, Irish manufacturers continued to reduce the backlog of outstanding work as the spare capacity resulting from the severe economic downturn remains only too evident.

Outside the Eurozone Sweden Slows Slightly Following A Strong Run

Sweden's seasonally adjusted purchasing managers' index dipped back to 56.0 in November from 56.7 p in October, according to data compilers Silf and Swedbank. However November was the sixth straight month that the index has been over 50 following the sustained rebound from a low of 32.7 hit in December last year. One of the problems in November was that the sub-index for order eased back to 57.9 from 60.8 in October, suggesting that while new orders continued to increase they did so at a slower rate. The sub-index for order backlogs also fell back, by an even greater amount, retreating to 53.6 points from 58.9 points, but it should be remembered that both the order bookings index and the backlog index had readings over 50 and thus showed continued growth. The employment sub-index, on the other hand rose, climbing 4.9 points to reach 48.7, suggesting that although companies continued to scale back on staff they did so at a slower rate. This easing in the Swedish PMI expansion rate is hard to interpret at this point, although it could be connected with the recent rise in the krona (since September). It could also be a result of the earlier strong bounceback from very low levels losing some of its force.

While Turkey's Expansion Continues To Lose Momentum

The Turkish headline PMI posted 51.8 in November, indicating that business conditions in the Turkish manufacturing sector improved for the seventh consecutive month. They did so however at a rate which eased again since October and indeed one which hit a six-month low.

New order growth although still solid, slowed from October, with the rate of increase being the lowest registered during the current seven-month expansion. The rate of growth of new export orders also eased during November, although it was higher than the average recorded for the earlier seven-month period of increasing export business. The overall rise in new orders led to a further rise in output during November, although the rate of increase fell for the fifth successive month from the series high posted in June 2009. Backlogs of work fell markedly in November, indicating that capacity constraints remained largely non-existent. In addition, anecdotal evidence suggested that companies were utilising stocks of finished goods to partially fulfil order obligations, and stocks of finished goods fell for a fourteenth successive month.

South Africa Returns To Growth

The Kagiso South Africa Purchasing Managers Index rose back above the neutral 50-index point level in November, even if the rebound in South Africa’s manufacturing sector is expected to be muted compared with historical experience, especially given the strength of the rand. The November PMI poked its nose over the 50 neutral mark and hit to 50,3 points, the first time this has happened since May 2008. This was the fourth consecutive gain for the PMI and bringing to a close the run of 18 months of below 50-index point readings, by far been the longest (and most severe) decline in the South African factory sector since the survey started in 1999. The previous record contraction had been the six months between May 2003 and October 2003. Nevertheless, PMI readings from the first two months of the fourth quarter suggest that the third-quarter manufacturing sector rebound has most probably been sustained during the fourth quarter. The average PMI for October and November stood at 49 points, compared with the average 41 points recorded for the third quarter.

The annual decline in South Africa’s manufacturing output has slowed, contracting by 11,4% year-on-year in September, compared with 15,2% in August. This was an improvement on the 17,1% year-on-year contraction in output recorded in June, the 17,2% year-on-year decline recorded in May and the record 21,6% slump in manufacturing output in April.

At the same time it should be noted that the expected business conditions subindex fell for a second consecutive month to 65, down 5.3 index points since the start of October. Kagiso and the Bureau of Economic Research (BER), which conducted the PMI survey, suggest that this could indicate that purchasing managers were becoming less optimistic about future prospects.

On the other hand the new sales orders index recorded a 5.5 point increase to 54.4 in November, the highest level since April 2008, suggesting that demand for manufactured goods has returned in South Africa, at least for the time being. Job shedding continued, albeit at a slower pace, with the employment index improving to 46.6, compared with 45 in October.

“Although the level of the index suggests continued factory job cuts, it does indicate that the rate of retrenchment is moderating. This is welcome news from an economywide employment perspective as official statistics showed that the manufacturing sector was the hardest hit by job losses during the third quarter of the year,” According to the comment from André Coetzee for the survey organisers.

Japan's Production Surge Fades

Despite remaining above the neutral level of 50.0 for yet another month , the seasonally adjusted headline Nomura/JMMA Purchasing Managers’ Index fell in November to a four-month low of 52.3, signalling that growth in the Japanese manufacturing sector continues to lose momentum. In particular the survey organisers noted slower growth of output and new business, even if job shedding eased to its weakest rate for fifteen months, even as output price deflation the hit the fastest rate since December 2001.

November’s survey pointed to weaker rises in output and incoming new business, while pre-production inventories were reduced for the ninth month running. Suppliers’ delivery times lengthened at an accelerated rate, while the pace at which job cuts were implemented continued to ease.

Those survey participants that reported greater inflows of new work generally attributed this to firmer demand, with China mentioned in particular. However, growth was partly offset by subdued market conditions as customers remained wary about the immediate outlook for economic activity.

Commenting on the Nomura/JMMA Japan Manufacturing PMI data, Minoru Nogimori, Economist of Financial & Economic Research Centre at Nomura, said:

“The Japan Manufacturing PMI fell 2.0 points to 52.3 in November. Although it remains above the key dividing line of 50.0, it fell for the second consecutive month, suggesting that the pace of improvement in operation conditions is slowing. The New Export Orders Index also fell by 1.1 points to 50.5, signalling that the rate of expansion in export orders has obviously slowed. We see growth of Japanese production activity decelerating, owing to the fading impact of economic rebounds overseas, yen appreciation and as government stimulus measures start to wane.”

And The US Expansion Also Eases

The US manufacturing sector expanded for a fourth month running in November but at a slower pace than expected. The Institute for Supply Management said its manufacturing index fell to 53.6 percent from 55.7 percent in October. The slowdown was sharper than the average analyst forecast of a 55.0 percent reading. Regarding the sub-indexes, the ISM said its index of new orders was 60.3 percent, 1.8 percentage points above October's level, suggesting accelerating growth. The production index however fell 2.3 points to 50.8 percent, indicating output expanded more slowly. Employment also grew more slowly, with the index at 50.8 percent from 53.1 percent a month earlier.

Saturday, November 28, 2009

Is There A Double Dip Risk In Germany?

This is not an idle question. Despite all those bullish headlines in the press, most informed observers - including Bundesbank head Axel Weber - are only to well aware of just how fragile the German recovery actually is. Indeed only last week the OECD warned that Germany’s economy, may only recover slowly next since investment “is lagging,”. The OECD now predict that German gross domestic product will expand 1.4 percent in 2010 and 1.9 percent in 2011 after shrinking 4.9 percent this year, which is in fact up on their earlier estimate, where the OECD predicted German growth of 0.2 percent next year. So whichever way you look at it, output at the end of 2010 will still be well down of 2008 levels. Worse, events like the recent upheaval in Dubai start to cast doubts on whether even the rather optimistic 1.4 percent growth level may now not be excessively optimistic for next year. The problem is that the recent rebound in Eurozone growth is extremely uneven as between countries, and, given its long standing export dependence, the German economy is hardly going to be leading the charge. As I said in my most recent post on the Eurozone :

"The question in hand is the Eurozone third quarter growth one, and the story is all about differences (between countries) and these differences in the key cases (France and Germany) are in many ways all about inventories......Now if you look at the chart below, you will see that German growth was in the second quarter was, more than anything, a statistical quirk which resulted from a balancing act between strong swings in inventories and in net trade. In the third quarter, as far as we can see (since we don’t have that ever so important detailed breakdown), this position has quite literally been inverted, as the earlier trade bonus has been eaten away by growth in imports (largely to stock up on export oriented inventories, not items destined towards domestic consumption) and this part we more or less know, since we do have all the trade data in for the quarter. "

Well, now we have the detailed German third quarter breakdown, and interesting reading it makes. According to the federal statistics office "economic growth in the third quarter of 2009 was supported by capital formation" - since compared with the previous quarter capital formation was up 1.5% in construction and 0.8% in machinery and equipment. As they also note, however, all this really means is that following the slump in the first quarter of 2009 (–18.5% on the fourth quarter of 2008), capital formation in machinery and equipment has now "stabilised at a low level". In fact, this "support" from capital formation was quite marginal, offering only 0.2 percentage points to growth.

While a positive contribution to growth was made by goods exports, which were up 4.9% on the previous quarter, imports also rose , and by more than exports (up by 6.5%), and the resulting trade balance had a negative effect on growth of –0.5 percentage points. This was more or less the same as the contribution from household consumption (which was also negative by 0.5 percentage points). But what really, really mattered here - see the chart below - was the inventory build-up which added a staggering 1.5 percentage points to growth., while government final consumption expenditure only increased slightly (+0.1%) over the period and effectively had zero impact on the growth number. So, as I said, it is all about inventories in Q3.

And now we need to make an assessment of how much this can unwind in the final quarter, since the current position is very reminiscent of Q1 2008, when the German economy put in a record annualised growth rate (1.7% q-o-q, 7.2% annually) only then to slouch off into recession and four consecutive quarters of GDP contraction. One reason for that surge in GDP, then (as now), was the massive inventory pile-up (see chart for what happened next to GDP), a pile up which was precisely the result of an anticipated continuation in demand - demand which, as it happened, never materialised.

Now, the pile up in inventories in Q3 was not so spectacular as the one seen at the start of 2008, nor is the medium term growth outlook so gloomy as it was back then, but there are certain structural similarities in the situation, and these are worth exploring.

Basically a build up in inventories may be no bad thing, inventories need to be rebuilt after the massive rundown which followed the failure of Lehman Brothers, and a healthy build-up (and rise in capital investment) would be something we should look forward to. But there are grounds at this point for thinking that things are no so straightforward this time.

The Fourth Quarter Looks Weaker Than The Third One

We will now try and take a look at some of the information we have so far on the last quarter of 2009. Sources of information here are really of two kinds, the Purchasing Managers Indexes (PMIs) which are based on surveys, but do give us quite a reliable indication of the state of play well before the official data arrives, and sentiment indexes.

Let's start with the PMIs. In the first place consumer demand remains weak. The key points, as identified by Markit, are as follows:

- The Retail PMI was at its lowest level for five months.
- Actual sales short of targets by greatest degree for five-and-a-half years.
- Retail margins fell at fastest rate since January.

So the November data suggests that household expenditure in Germany remains relatively weak, with retailers indicating a further month-on-month reduction in sales. The seasonally adjusted Retail PMI fell from 48.8 in October to 46.0 in November, the lowest reading since June and below the neutral 50.0 mark for the eighteenth consecutive month. Anecdotal evidence from survey respondents suggests that a resistance among households to purchasing non-essential items contributed to the lower sales. The end of the scrap bonus was also commonly cited by retailers in the automobiles sector.

German retailers indicated that like-for-like sales were considerably lower than one year earlier, with the rate of reduction the sharpest since March. Survey respondents commented that short working hours and weak economic conditions meant that consumers’ purchasing power was much weaker than last November.

If we move over now to the relevant sentiment index, we find some confirmation for this weakening, since the GFK forward looking indicator for December fell back again for the second consecutive month, and now stands at 3.7.

As Gfk themselves say in their monthly report, even if experts are generally predicting an economic upswing for the coming months, consumers seem to be regarding such statements with caution, at least for the moment, and the economic expectations indicator indicator lost just under 8 points to currently stand at just 0.9 points. To put this in perspective though this is increase of 31 points over the level in November 2008.

However, it is apparent that after their continuous upward trend during the past seven months, German economic expectations dropped back again in November, primarily - according to Gfk - as a result of growing public fears of rising unemployment. In the wake of this, income expectations also fell, in particular, given the fact of the reduced effect of the low energy prices, which have been fuelling purchasing power.

In fact German unemployment unexpectedly fell in October, with the number of people out of work falling a seasonally adjusted 26,000 to 3.43 million. Frank-Juergen Weise, the head of the Federal Labour Agency attributed the good performance to government measures including the Kurzarbeit short-time work ones which offer incentives to hold on to staff. According to the latest comparable figures published by the Organization for Economic Cooperation and Development, Germany’s jobless rate was at 7.6 percent in September, up from a 2008 average of 7.3 percent. Nonetheless, in the absence of a strong recovery in global demand many German jobs are still at risk, and these are the worries which are reflected in the consumer confidence reading.

The picture of a divergent economy with fairly weak domestic consumption and a rather more robust export sector is further reinforced by the flash November PMI data, which while it showed a slight improvement in the level of German economic activity over October, revealed divergent trends between manufacturing and services. According to the Markit report the recovery in service sector activity remained relatively weak, with underlying client demand subdued and new business levels falling for the first time since July.

Thus while there was a fairly robust rise in new orders received by the manufacturing sector, with the rate of growth the strongest since August 2007, in the service sector, new work dropped moderately over the month as difficulties in securing new contracts continued. Job shedding remained evident in the German economy in November, with employment numbers falling for the fourteenth successive month. Reduced workforces were seen in both the manufacturing and service sectors, and it is thus not surprising to note in this context that the existing Kurtzarbeit (short time working) schemes were renewed last Wednesday, and will now remain in force until the end of 2010 (at least).

Backlogs data also pointed to divergent trends between the manufacturing and service sectors. Since while the latter saw the fastest drop for four months, partly as a result of lower volumes of new work, levels of unfinished business in the manufacturing sector rose at the sharpest pace since March 2008, suggesting further pressure on firms to increase capacity utilisation at their plants.

Interestingly all of this is being now reflected on the price level, since increased demand for raw materials continued to filter through to input prices in the manufacturing sector, with average purchasing costs close to stabilisation in November, and indeed the flash consumer price index for Germany .

This contrasted with the record declines in costs seen in the first quarter of 2009. In the service sector, input prices rose for the second month running, contributing to a fractional increase in average costs in the private sector as a whole. Consequently, firms were less able to discount their output prices, with the latest decline the slowest since December 2008.

Construction Woes

On the other hand if we look at construction, the October construction PMI suggested there had been the sharpest decline in construction output for four months, with new orders and employment levels fell again, and the strongest rate of input cost inflation since September 2008. The PMI report spoke of October data pointing to "another difficult month" for the German construction sector. The headline seasonally adjusted Construction Purchasing Managers’ Index registered 43.4 in October, well below the neutral 50.0 mark and the lowest reading for four months. The latest overall decline in output reflected falling activity in all three broad areas of the construction sector. Commercial activity registered the steepest reduction over the month in October. Data also pointed to the fastest drop in civil engineering activity since February and a further marked fall in housing construction. Anecdotal evidence from survey respondents suggested that weak underlying market conditions and a corresponding lack of incoming new work contributed to falling levels of construction output. Levels of new business have now dropped for twenty consecutive months. So it is hard to anticipate any positive impact on GDP from the construction sector this time round.

Business and Investor Sentiment

On the business sentiment front we have two divergent trends, on the one hand German analyst and investor sentiment - as measured by the ZEW index - declined by more than most observers expected in November, falling to its lowest level in four months.The drop is hardly surprising, and suggests somewhat more realistic expectations are being adopted by financial analysts on the economic outlook. In this sense earlier excesses of enthusiasm are now gradually giving way to realism.

On the other hand German business confidence increased to a 15-month high in November, suggesting that many German managers expect the economic recovery to gather pace next year. The Ifo institute business climate index, based on a survey of 7,000 executives, rose to 93.9 from 92 in October, the highest reading since August last year. The index reached a 26-year low of 82.2 in March.

Which means that in Q4 it is all going to be about trade. Since if German exports hold up, then the run down in inventories need not be that strong, but if exports don't sustain momentum in December - and what just happened in Dubai is making me very nervous on that front - then German GDP will almost certainly fall back into negative territory in the fourth quarter. On the other hand, if I am jumping the gun slightly here, and German economic activity does manage to eke out some small increase at the end of the year, then I think a return to negative growth in the first quarter of 2010 is almost guaranteed. That is to say, we have a double dip on the horizon. At least, that is my call. Now it is over to you.

Tuesday, October 27, 2009

The French Rebound Continues In October While Germany Moves Sideways

Whoever would have thought that some people once called economics the most dismal of sciences? Certainly, as the current crisis goes on and on, those of us who consider ourselves to be economists scarcely are able to find the time to squeeze in a dull moment, even here and there. But even at a broader level, interest in that most dismal of dismal topics - the theory and practice of central banking - seems now to fire up levels of enthusiasm here in Spain that make even the appetising prospect of a forthcoming Real Madrid-Barça football match pale in intensity. Even if it is the case, I have to admit, that the everyday Johnny (or Jill) come lately sitting in the bar still - truth be told - prefers the sports columns of the daily newspapers, or the lacivious details of the latest romantic adventure of one of the rich and famous to a careful perusal of the detailed minutes of the last policy rate setting meeting over at the central bank.

The reason for the sudden and unexpected upsurge in interest should, I would have thought, be obvious - since with 85% of Spanish mortgages being variable (and thus determined by the ECB policy rate), and Spain's economy sinking into an ever deeper pit, the impact of the coming decisions (or even the hints at possible future decisions) have entered peoples lives like never before. And this is doubly the case in an environment where - as Bloomberg inform us this morning - central bankers from across the global, from Washington, to Sydney, to Oslo are likely to take increasing account of future accelerations in asset prices in an attempt to avoid repeating policy mistakes that are presumed to have inflated two speculative bubbles in a decade, culminating in the worst financial crisis since the Great Depression.

By way of illustration for their feature story the Blomberg reporters single out the prime example cases of Norway and Australia, countries whose recent stronger than average inflation and growth performance is now so well known to regular investors for the mention of their name in such reports to have become a mere commonplace, with the respective currencies being eagery purchased to the sound of hearty lipsmaking at the thought of all the juicy carry which lies ahead. Personally though, had I been doing the writing, I would have chosen a rather different example, one much nearer to the heart of Europe (and thus a little closer to my own) - France.

And why France you may ask? Well quite simply because the French economy is now plainly and evidently on the mend. That is the big, big news which can be gleaned from last Friday's Flash Markit PMI readings (see detailed breakdown below). Now those who regularly follow this blog will know that this seemingly unexpected leap into poll position hardly comes as a surprise to me, since I have long been arguing that the French economy would emerge as the strongest among the EU economies from the present deep recession, and some of the theoretical justification for this view can be found in this post here, while an earlier piece from Claus Vistesen in 2006 also gives an illustration of how we might conceptualise the problem.

So one epoch ends, and another begins, inauspicious as the beginnings may be. To summarise briefly the argument which will be presented below, there is both good and bad news here, since this early and isolated recovery in France is bound to create difficulties of the "exit thinking" kind for policymakers over at the ECB. The most pressing of the problems will concern what to do about containing French inflation if exit dependency in Germany means that a full recovery there remains out of reach, while Italy languishes where it has always languished and Spain's seemingly intractable difficulties only increase. In other words, what will happen if - as seems obvious - the eurozone economies are in fact diverging, and not converging, and the divergence far from reducing is in fact increasing.

As we will see in the charts which follow the long term decline in the GDP share of French manufacturing, which is closely associated with the steady opening of a trade deficit there, poses special threats and problems for ECB monetary policy. This long term manufacturing decline and growing external deficit are, in my opinion, the tell tale first signs of larger structural problems to come should inappropriate monetary policy be applied too hard for too long. That is to say France is well positioned to get a distortionary bubble next time round (of the exactly the kind the newly vigilant central banks should be at pains to avoid, and indeed precisely the bubble they successfully avoided last time round) unless the ECB and the French government are very clever and very agile indeed.

Above-par Inflation Looming Just Over The Horizon

In essence the return of growth in France will be welcomed with open arms across the euro area, since with it comes the prospect of opening up a larger French current account deficit and this will, of course, clearly help soak up all that newly found need to export which exists elsewhere in Europ (and especially in the South and the East). But if this should be the fate which befalls an unsuspecting French citizenry, and living in a Spain which has already been processed along this very same pipeline, then all I can say is "heaven help them" for what will then follow.

Again, all the early warning signs are there, including the prospect that France will begin to sustain above eurozone average inflation starting next year, and this will be the first time - as can be seen in the chart below - this has really happened on any sustained basis since the euro was introduced.

In fact, if we look at the second chart, which is only the above one with the reverse overlay, we can see that French inflation really only peaked its head above the average in late 2003/early 2004, and the overshoot was not that substantial.

This time things could well be very, very different, and the big change here is of course a direct result of what has just happened to Spain. Since given that Spain has now been catapulted from a high to a low growth (or even negative growth) mode, France has been ramped up the euro league table, moving from Mr Average to Monsieur Outperform, and this will have the consequence that the ECB policy rate - which will, remember, target eurozone average inflation -will be below the one which the French economy will, in reality, need. What this will mean in practice is that there is a real danger the French inflation rate will be above the policy rate - that is that negative interest rates will be applied. As we can see in the chart below, negative interest rates were applied to the Spanish economy between early 2002 and late 2006, and we all know what happened afterwards. With the return to growth French inflation is likely to rebound, and an annual rate of headline consumer price inflation of between 1.3% and 1.5% seems not unrealistic, which means, should the ECB not start to raise its refi rate early next year then France will be rebounding strongly under the twin tailwind effect of significant fiscal stimulus AND negative interest rates.

So France is about to become the ECB's stellar pupil, but looking at what actually happened to the previous prize students (Ireland and Spain) somehow I doubt that those responsible for running things at La Banque de France and the Elysee Palace will be jumping up and down with joy at the prospect. The bottom line then is that lots of difficult decisions are now looming for European policymakers - assuming they are sharp enough to spot them at this point.

Note - the next section is essentially a detailed breakdown of this month's Flash PMI data (the flash historically bears a reasonably good resemblance to the final data). If you are not especially interested in such detail you may be well advised to glance at the charts and skip to the section - France, Not Spain, Is Different!.

Eurozone Composite PMI


Flash Eurozone Composite Output Index(1) at 53.0 (51.1 in September). 22-month high.

Flash Eurozone Services Business Activity Index(2) at 52.3 (50.9 in September). 20-month high.

Flash Eurozone Manufacturing PMI(3) at 50.7 (49.3 in September). 18-month high.

Flash Eurozone Manufacturing Output Index(4) at 54.1 (51.7 in September). 23-month high.

The Markit Flash Eurozone Composite Output Index, based on around 85% of normal monthly survey replies, rose from 51.1 in September to 53.0 in October, registering an increase in private sector output for the third successive month and the strongest monthly gain since December 2007.

Commenting on the flash PMI data, Chris Williamson, Chief Economist at Markit said:

“The flash PMIs indicate that the Eurozone economy has entered Q4 on a strong note, with growth accelerating in both manufacturing and services. The data are consistent with GDP rising at a quarterly rate of around 0.4% in October. Reassuringly, job losses also slowed, and forward-looking indicators such as service sector confidence and manufacturing order-to-inventory ratios suggest that the labour market could stabilise early next year.”

Employment in the Eurozone fell for the sixteenth successive month, even if the rate of job loss eased compared to September. The rate of decline is much slower than that seen in the spring but remains high by historical standards. Both manufacturing and services saw reduced rates of job losses, though the former continued to see the sharper rate of job shedding, despite seeing the smallest cut in headcounts for a year.

Growth was driven primarily by manufacturing, where output rose for the third month running and new orders showed the strongest gain since August 2007. Despite the recent strength of the euro, new export orders showed the largest rise since January 2008, but the rate of growth remained very subdued.

Activity in the Eurozone services sector meanwhile rose for the second month, expanding at the sharpest rate since February of last year, though the rate of increase remained modest and continued to trail that of manufacturing.

German PMIs Dissapoint

Key points:

Flash Germany Composite Output Index(1) at 52.6 (52.4 in September), 2-month high.

Flash Germany Services Activity Index(2) at 50.9 (52.1 in September), 3-month low.

Flash Germany Manufacturing PMI(3) at 51.1 (49.6 in September), 16-month high.

Flash Germany Manufacturing Output Index(4) at 54.9 (52.8 in September), 17-month high.

Output levels in the German private sector economy continued to expand in October, led by the strongest rise in manufacturing production for seventeen months. Service sector business activity also increased again, but at the slowest rate in the current three-month period of growth. The seasonally adjusted Markit Flash Germany Composite Output Index, which is based on around 85% of normal monthly survey replies, rose fractionally from 52.4 in September to 52.6. The index has now registered above the 50.0 no-change mark for three consecutive months, yet the rate of expansion has remained extremely modest.

Commenting on the Markit Flash Germany PMI survey data, Tim Moore, economist at Markit said:

“The German economy started the final quarter of the year in growth territory, with the manufacturing sector the main driver of expansion. Manufacturing firms posted the fastest rise in new orders since August 2007 while employment fell more slowly, contributing to an above-50 Manufacturing PMI reading for the first time in 15 months. Meanwhile, service providers saw only a modest improvement in activity as demand continued to recover only gradually in the sector.”

Signs of excess capacity in the German economy persisted in October, despite solid rises in output and new business. Latest data indicated a further drop in backlogs of work and continued job shedding among private sector companies. Reduced staffing numbers were recorded in both the manufacturing and service sectors, primarily reflecting workforce restructuring following sharp declines in new work at the start of the year. Some firms also commented on the need to cut costs as margins remained under pressure in October.

Average prices charged by private sector firms in Germany were reduced for a twelfth month running and again at a faster pace than input costs. Manufactures and service providers both signalled marked declines in average output charges. Panellists generally attributed this to strong market competition and a resultant lack of pricing power. Meanwhile, input costs dropped only marginally in October and at the slowest rate in the current twelve-month period of decline. Data indicated that lower costs were largely confined to the manufacturing sector. Those reporting a reduction in purchasing costs frequently commented that subdued demand for raw materials had contributed to successful price negotiations with suppliers.

In the manufacturing sector, higher levels of private sector business activity were driven by a further solid expansion of incoming new work. The latest increase in new business was the strongest for a year-and-a-half. The manufacturing sector continued to lead the way, as new order volumes rose at the fastest pace since August 2007. This was supported by a robust increase in new export orders, with a number of firms pointing to stronger demand from China and Eastern Europe.

Meanwhile, service providers recorded only a modest improvement in new business levels in October. Anecdotal evidence suggested that clients remained hesitant to commit to new expenditure, leading to only a gradual recovery in demand. Nonetheless, service sector companies were confident regarding the twelve-month outlook for activity at their units, with 32% expecting a rise against just 18% thatforecast a decline.

French PMI - Robust Growth Registered

What stands out in this months data, however, is the performance of the French economy. The output Index, which is based on around 85% of normal monthly survey replies, indicated that growth of the French private sector was sustained into a third successive month – and at an accelerated rate. Climbing to 58.4, from 54.8 in September, the headline index indicated that growth accelerated markedly to reach its steepest in nearly three years.

Commenting on the Markit/CDAF Flash France PMI data, Paul Smith, Senior Economist at Markit, said:

“Expansion of the French private sector continued to gather pace in October, reaching its highest in just shy of three years. Output was sustained through higher gains in new business, particularly from the domestic market, although in part this was driven by continued discounting amid strong competitive pressures. While employment continues to fall, emerging signs of capacity pressures and optimism in the strength of the upturn raise hopes that job losses will dwindle over the coming months.”

Higher output was again broad-based, with both manufacturing and service sectors registering strong growth. Manufacturing output increased for a fourth successive month and at the steepest pace since May 2006. Outstanding business in the French private sector rose in October for a second successive month. In a sign of emerging capacity pressures – particularly in manufacturing – overall growth was the steepest in 19 months.

Despite rising backlogs, French private sector companies continued to reduce employment in October. The rate of contraction remained historically marked, with job losses most acute in services (job losses in manufacturing were the slowest for 14 months). Cost cutting and restructuring were noted by panellists. Input prices continued to fall in October, extending the current period of deflation to 12 months.

However, the rate at which costs declined was only modest, with manufacturing registering a net rise in their purchase prices. Inflation here was linked to higher steel and oil-related product prices. Strong competitive pressures led to another reduction in output prices during October, with the rate of decline remaining sharp. Output charges have now fallen throughout the past year.

Services activity rose at a slower pace than manufacturing output, but still - at a level of 57.8 - registered a strong gain, indeed the rate of expansion was the best since February 2008.

This Time France, Not Spain, Is Different, But Is It Really A Case Of Vive La Difference?

So French industrial production has been steadily recovering in recent months and the latest business surveys show this should continue, even if activity is still significantly (12%, much less than many other euro area countries) below its pre-crisis level. Consumer confidence has been steadily rising for over a year - even if, again, it continues to be weak by historic standards. Household consumption has also been rising, and in fact remained positive on an annual basis throughout the crisis (see chart below), and even if the potential for substantial further acceleration seems limited, this is still the key difference between France - where there is sufficient autonomous domestic demand left for the stimulus package to work - and the other euro area economies.

Why should this resilience be? Well in the first place I would single out France's rather favouralable demographics. But this alone cannot explain the situation. In addition I would add France also probably has had:

i) much better lending regulation than some of the bubble economies in the key years.
ii) no housing BUBBLE (as opposed to boom)
iii) a large population on fixed as opposed to variable interest rates for mortgages

France was also the only eurozone country who really had a more or less approriate interest rate applied by the ECB during the critical years from 2001 to 2007, so there are less structural distortions in the economy (not NONE, but less). On the other hand, as far as France's fiscal budget trajectory goes there are both long term structural and short term fine-tuning deficit issues to think about. The deficit has nearly doubled during the first eight months of this year (widening from EUR 67.6bn in 2008 to EUR 127.6bn in 2009), and although the French budget normally has a surplus in the last four months of the year, this is unlikely to be the case this year, so the deficit will undoubtedly widen further possibly reaching 7.3% of GDP (or 8.2% including social security).

The main reason for the increasing deficit is evident - the collapse on the revenue side. VAT income, for example, fell by EUR 10.4bn, or 12.0%, over the first eight months of the year. Overall total income fell 23.1% during the first eight months of the fiscal year, and although the pace of decline may slow over the whole year the government still expect the 2009 deficit to reach EUR 141bn for the central government and EUR 158bn (or 8.2% of GDP) for the government spending in general (including social security).

Since the various French stimulus packages only amount to an estimated 1.2% of GDP this means that the so called automatic stabilisers (i.e. the “natural” drift of the deficit on a no policy change assumption) account for 3.6 percentage points of the 4.8% of GDP increase in the general government deficit from 2008.

Looking forward, France's 2010 budget is based on a reasonably cautious economic forecast of 0.75% growth, following something like a 2.5% - 2.25% contraction in 2009. Despite this cautious approach there is still a considerable degree of uncertainty about the behaviour of tax income in the wake of the recession, and this is why the budget deficit is also expected to grow. On the inflation side the government forecasts an inflation rate of 1.2% in 2010, following 0.4% in 2009, but since the growth forecast is conservative the inflation outlook will be subject to upside risk, which is why I think 1.3% to 1.5% is a much more likely band.

Part of the deficit will naturally disappear as tax revenues recover. However, due to structural biases in the cost components of the budget there is still plenty of upside potential in debt to GDP moving forward - the latest forecast is for around 91% in 2013/14 - and substantial action will still be needed to lower the deficit in the years ahead. The public deficit is currently expected to fall in 2011 (from 8.5% in 2010 to 7.0%), but the numbers involved are still very large, and France is one of the best case scenarios, so this really begin to give us a picture of the severity of the downturn we have just been through. And of course we are by no means out of the woods yet.

French GDP On The Rebound, And Looking Onwards And Upwards

French GDP surprised positively with a 0.3% quarterly gain in the second quarter. Given the data we are seeing, a forecast of 0.2% quarterly growth for both the third and final quarters would not seem to be an unreasonable expectation at this point, which would mean the French economy would shrink by something under 2.5% in 2009, well below the average Eurozone contraction rate.

All the data we have seen for August and September confirm the view that the French economic environment is improving considerably, although the presence of continuing weak spots (especially on the employment front) mean real GDP growth will probably remain modest during the rest of this year.
The monthly survey of business sentiment was up sharply in September (at 92 against 89 in July). This indicator has moved even further away from its all-time low (68 in February and March), while remaining far below its long-run average.

Order books are also picking up -59 showing in September versus -68 in July. Export order books are also looking better too at -65 versus -66 in July. The consumer goods component in industrial goods orders improved markedly in September (-32 versus -37 for total orders, and -39 versus -33 for export orders), which indicates that domestic consumption spending is likely to be less depressed than it was in July and August. Likewise "capital goods" orders showed a slight improvement in September ( -68 for total and -70 for export orders versus -69 and -73 in July). If this improvement continues in October the ongoing deterioration in investment spending (see chart below) might be drawing to a close.

This improvement is also corroborated by the surge in the October manufacturing PMI. Activity in services also picked up again sharply in October as did activity in the construction sector - hence the interannual drop in GDP should be significantly under the Q2 level of 2.6% by the time we reach the end of the year.

It is also worth remembering that long term growth in French GDP has really been remarkably constant in recent times (see ten year moving everage chart below), at just a little over 2%. Previously this might have been considered rather low by many commentators, but in the light of what we have just seen happen to the "out-performers" the French result looks reasonably solid and sustainable, which means we could expect a pretty solid "V" shaped rebound in 2010 (especially during the second half) and the big danger is that excessively loose monetary conditions for the Eurozone as a whole and ongoing fiscal stimulus could send the French economy shooting upwards above its long term sustainable trend.

Industrial Output

French industrial output rose more than expected in August, rising 1.8 per cent from the previous month on the back of a surge in car production, according to new data. The monthly rise contrasted with a forecast rise of 0.5 per cent from economists and was fuelled by an 11 per cent rise in production of transport equipment, including an 18.2 per cent rise in the car component. Nonetheless French industrial output remains down around 12% in comparison with a year earlier, even though - as I keep stressing - this is considerably less than the drop in most other Eurozone economies.

Although the industrial output collapse has been a little less dramatic than in other eurozone countries, the rebound in France seems to remain largely in line with its peers. Industrial production in fact outpaced the GDP collapse in late 2008, so that it may now also be overstating the rebound.

French retail sales have been falling, but not to anything like the extent we have seen elsewhere in Europe. They were down 3.75% year on year in July.

France's construction sector also seems to be on the long road to recovery, thanks to a correction in the housing sector. A combination of lower prices and very low interest rates have boosted new home sales. Housing investment dropped over the last five quarters, losing an annual 8.7%, making for the worst recession in the sector in the last thirty years. Housing affordability has now rebounded sharply thanks to the interest rate component and a sharp fall in existing home prices (down about 10% year on year) which has allowed a rebound in new home sales and a decline in the stock of new homes for sale. To get some sort of comparison France had approximately 100,000 unsold new housing units at the end of 2008, compared with over a million in Spain. This inventory has now fallen to around 80,000.

According to the latest provisional INSEE data French household spending decreased slightly in Q3 (-0.2% q/q), despite the end of quarter rebound recorded in September (up a monthly 2.3%). Real spending was up a monthly 2.3% in September, after following a 1.1% fall in July and a 1.0% drop in August - so the long march upwards in consumption is not yet that robust. In fact the stats office data show that this September rise was mainly due to a surge in car sales. In line with a sharp rebound of new vehicles registrations (up 7.3% on the month), car sales were up by 10.2% in September over August, offsetting the falls recorded from the beginning of the quarter. Consequently, car sales were roughly flat in Q3 (down 0.1% over Q2), following a 5.7% quarterly rise in Q2.

On the other hand, general sales were down by a quarterly 2.5% in Q3, while "other manufactured products" sales, that represent more than 40% of the consumption, remain sluggish, rising by a quarterly 0.1% in Q3 following a drop of 0.1% in Q2. So at the end of the day the data tend to confirm the idea that the evolution of total spending has been largely dependant on car sales and government incentive scheme since the beginning of the year. Despite the rebound recorded in September, the stabilisation of car sales in Q3 resulted in a slight decrease of overall spending, that was down by 0.2% in Q3 when compared with Q2, following a 0.7% rise in Q2. As can be seen in the chart below (which was prepared by Dominique Barbet and Martine Borde for PNB Paribas) even while headline GDP shot down at the end of 2008 Private Consumption Expenditure (PCE) recovered rapidly due to the impact of the stimulus programme.

And as we can see in the following chart, while consumption in France has proved quite robust over the years, the manufacturing share in GDP has been declining steadily. This is, of course, quite a worrying trend. We can also see quite a clear indication of why France doesn't have the kind of problems Ireland and Spain have when we look at the construction share, since while this rose slightly between 2004 and 2007, at around 6% of GDP it was a far cry from the Irish and Spanish levels (which were twice as big at around 12%), and hence the French economy now has far less difficulty sweating down the capacity and inventory overhang.

And lastly (in this set of charts) we can see that while the trade share in French GDP has been growing steadily since the early 1990s, this increase in trade openness has also been accompanied by an increase in import penetration, and a steady widening of the trade deficit. It is this problem which could well turn critical during the next upturn if corrective measures are not taken in time.

Evidently French exports remain weak, and can in no way explain the recent recovery in industrial pooduction. The export rebound which took place in July was short-lived, and the narrowing of the deficit we have seen between 2008 and 2009 has primarily been due to lower crude oil prices. On the other hand euro appreciation is not the main reason for the poor export performance, as the deficit is wider with eurozone trading partners than with others. The drop in imports is adequately explained by the fall in domestic demand, and is not a sign of improved domestic competitiveness. At the same time the non-goods surplus has narrowed significantly, because of smaller surplus on services and the decline of the surplus on the income account. Thus while the current account deficit has narrowed somewhat, and is expected to stay contained over the next twelve months, the risk of a sharp widening in the years to come is clear enough.

A Tale Of Two Population Pyramids

Basically, a large part of the differential performance between France and Germany can be explained by comparing the two population pyramids. France has an annual population growth rate of around 0.5% while Germany has a population SHRINKAGE rate of around 0.1%. France has a total fertility rate of around 2.0, while the German one is around 1.35.

Thus the French population pyramid (above) is evidently far more stable than the German one (following), and this means that:

a) French domestic consumption is far more stable and dynamic (I would say that this by now should have attained the status of being a "self evident truth").

b) the French government debt to GDP problem, while being important, can be corrected over a longer period than the German one, since France is not ageing so rapidly. This does NOT mean that France should not be doing anything to put its house in order, clearly the underlying structural problems in the public deficit situation - health and pensions - need addressing, but France has more margin of manoeuvre to do this. The important thing is that the French administration do not put this off and off until they reach the same state of mess that the Germans are now in. France should, nonetheless be given credit for having done her homework on fertility.

Basically one look at the unstable shape of this pyramid should give us plenty of course for concern about Germany's future.

Frankly this differential situation, and its implications, has still failed to sink in in many quarers. The Economist Intelligence Unit, for example, in their recent piece - France Easy Does It (20th October 2009) - says the following:

"However, after several years of budgetary vigour Germany's public finances are now in far better shape than those of France, while the German government has secured approval of a law establishing the principle of a balanced budget in the German constitution. A persistent, large-scale asymmetry in the fiscal policies of the euro area's two largest member states could become a significant source of tension in the period ahead."

This is simply nonesense. German finances (despite the sacrifices which ordinary Germans have evidently made) are NOT in better longer term shape than French finances, and this for the reason that:

a) German trend growth (under 1%) is now significantly below French trend growth (around 2%).

b) German structural deficits related to ageing are going to be much more serious in the coming decade.

And signs of the problems this is creating are to be found all over the place. Only last week the two parties in the new German government coalition were toying with the idea of setting up a €60bn fund whose explicit objective was to cover expected welfare-system deficits over the next four years. That would have raised new government borrowing for 2009 from just under €50bn to over €90bn – but would have had the advantage that it would have made it easier for the government to fulfil a constitutional amendment passed this year, which obliges the federal and state governments to reduce their deficits year by year starting in 2011. Basically, what is the value of having a constitutional ammendment to limit the deficit, if the very next minute you start to look for ways to get around it in order to meet the needs of short term expediency?

Clemens Fuest, head of the finance ministry’s council of economic advisers, accused the incoming government of “false labelling” in claiming the special fund was just to cover welfare cost overruns. “The real reason is tax cuts,” he told the Financial Times. “The coalition has manoeuvred itself into a kind of cul-de-sac by saying on the one hand we’re going to have broad income-tax cuts, but on the other, we won’t do that by borrowing more. Of course that’s impossible.”

Rainer Brüderle, one of the FDP’s economics experts, on the other hand denied the plan was mere "trickery” and noted that special funds had been used before to finance the extraordinary burdens of German unification and the recent bank bail-out fund. The point here is not to get bogged down in the ins and outs of fiscal rectitude, but to see the stark and evident fact that the German government far from having, as the EIU puts it, secured a law which means their fiscal position is in better shape than that of French faces stark and difficult choices in carrying through what will remain a knife edged balancing act over the years to come.

The background here is that in June 2009, Germany introduced ammended its constitution by passing a law that will only allow federal deficits of up to 0.35% of GDP during normal times starting in 2016. After 2020, regional state deficits are to be abolished, while parliament can only suspend the rule in the event of “natural catastrophes or other unusual emergency situations."

The very presence of this law should give us an indication of just how critical German public finances may become. In order to comply with the law, Germany will have to implement spending cuts or raise taxes starting in 2011 regardless of whether they have weaker tax revenue, rising welfare bills, or need more stimulus measures and spending for bank bailouts.

On October 8, 2009, the German newspaper Handelsblatt reported that till 2013 Germany will have to raise taxes or cut spending equivalent to 34.3 billion euros in order to comply with the debt brake. Even if growth should be a full percentage point above the current forecasts the hole in German government finances will still stand at 29 billion euros. Therefore even if the economy improves more than expected the coalition will not enjoy ample scope with regards to public finances. (Handelsblatt; October 8, 2009)

In the end the proposal to borrow extra money this year was ditched even though a 24 billion- euro tax cut programme aimed at low and mid-level earners was adopted. Basically the "creative accounting" proposal might well have satisfied the needs of the new constitutional law, but they would not have helped with the excess deficit criteria applied by Eurostat and the EU Commission, since when the German social security system (which - remember - forms part of the government sector according to the Eurostat rules) spent the money and actually ran the deficits in 2011 or 2012, this would have been recorded as a deficit for the German public sector according to the Eurostat rules no matter when the money was borrowed. So the new government now adding tax cuts to the earlier deficits is very likely to put it in breach of the EU's Stability and Growth Pact concept of a 3-percent limit and will in all likelihood put Berlin in conflict with Brussels.

According to the most recent government forecast Germany GDP will now contract by 5% in 2009 (as compared to around minus 2.5% in France) and will the grow by about 1.2% next year. As a result net new borrowing is forecast by the latest government budget calculations to almost double next year to 86.1 billion euros from a record 47.6 billion euros this year. In an interview with Financial Times Deutschland, Jurgen von Hagen from the Institute for International Economics put it like this "Germany’s fiscal policy has been totally misguided, as it persistently ignored the inter-relationship between deficits and growth. Debt ceilings, such as the recently agreed constitutional change, do not work as they are too mechanistic, and lead to policy mistakes."

Germany's debt to GDP is estimated at 79% for 2009 and 87% for 2010, up from 67% in 2008, according to the IMF (World Economic Outlook) and on October 7, 2009, the European Commission issued a formal warning about Germany's large deficit - normally the initial step before opening an excessive deficit procedure.

To return German public debt to a sustainable path, UniCredit have calculated that the primary balance (budget balance minus debt interest payments on debt) would have to be increased by close to a full percentage point. This is equivalent to savings or additional revenues of almost EUR25 billion. To bring the debt ratio back below 60% in the next 20 years, the primary balance would have to be increased by 2 percentage points, and of course stay there (Unicredit research note, 25 June 2009)

Keeping Credit Growth In France Under Control

In this post we have covered a lot of ground. We have:

a) suggested that the whole covergence idea (that all eurozone economies where converging to a common profile) did not offer an adequate description of the actually economic processes we can see on the ground, and that, in fact, the economic profile varies widely from one country to another. It is more a question of "vive la difference"

b) examined how, in terms of the Eurozone's two largest economies - France and Germany - the paths are very divergent. Germany has an export dependent economy, which has been severely savaged by the present deep recession, and recovery is fragile (Axel Weber's expression) and will remain so until other economies recover and export growth can resume.

c) seen that while both countries suffer from important structural problems in the public finances, with debt to GDP in both cases being around 90% of GDP in 2011, in fact the country which is likely to face the more extreme difficulties over the coming decade is likely to be Germany due to the more rapid population ageing which is taking place there and the excessive dependency on exports which this produces.

d) spelt out how the ECB may well now be facing its "finest hour", as it has to rise to the challenge of adapting a one size fits all interest rate policy to a world where one size evidently doesn't fit all, and where the danger of fuelling an excessive consumer boom in one country (France) will have to be set against the risk of sending the banking system of into meltdown in another (Spain). This is clearly the banking equivalent of being stuck between a rock and a hard place new tools and new thinking will need to be developed if we are to finally steer that path between the insatiable appetite of Scylla and the never ending thirst of Charybdis.

Finally, just to make all of this very concrete, lets take a look at the different rates of new credit creation as between French and Spanish households - courtesy again of one of those very useful charts prepared by Dominique Barbet and Martine Borde for PNB Paribas). As we can see in the following chart, annual growth in total household credit in France never went about around 11% to 12% during the boom, and has now not fallen much below 3% during the slump.

In Spain in contrast, the annual rate of new household credit creation was more like 20% during the boom years, and this has steadily dropped since the start of 2007, and finally went negative in August (latest data). It is of course still falling. And this is the danger, that consumer borrowing in Spain remains weak (even as exports are lacklustre), while in France the excessively loose monetary conditions send consumers off to the banks to borrow and then on to the shops to spend.