Inconclusively Italian

I'm not sure what you could call Italy in the EZ drama. I've heard elephant in the room somewhere but I don't think it's entirely true. 

I think the problem with the Italian economy is the size. And the vulnerability. And the politics. And the...you get the point. 

In fact, Italy's special place in the eurozone has a chicken-and-egg element to it. Its fate is intertwined with the evolution of the crisis; but in return, Italy's position and size can also affect the markets in very drastic ways. 

RGE's Italian scenario is aptly titled "Ending la Dolce Vita". There are three bogeymen in any trouble nation that no one wants to hear - political instability, stagnant growth and a large 'debt overhang'. Check. Check. And Check.

Various analyses seem to be of the opinion that Italy's vulnerability to financial market stress will be its undoing and force it to seek external assistance within the coming year time-period. The problem is in the prognosis, and it applied to all the troubled euro nations. Staying in the EZ would mean years of low growth, structural reform and balancing and other austere measures concerning wages, pensions etc.

And although Italian economic fundamentals (low growth aside) are in a better place than Spain's, their paths seem similar - as do their bond yields. 

As the latest WEO Chapter 3 states, Italy's problems have been consistent with the path to Euro membership. Post 1992, for example, the debt-to-GDP ratio shot up from the 100% threshold to about 120% in the mid 90's. Of course, 1992 was also characterized by the European ERM crisis and a devaluation of the lira which set off the typical cycle - export competitiveness - inflation+inflationary expectations - rising interest rates - burden of payments. 

On the road to the euro however, with the Maastricht criteria in sight, necessary fiscal measures were taken and the primary balance improved 10 percentage points during the period!

Then of course, you have the story of the crisis. Borrowing costs converged (read: lowered), maturities were extended, the primary surplus declined as most of the previous fiscal measures were temporary and eventually, capital flows flowed in from the north increasing asset prices, setting up bubbles etc etc. All this with low growth. 

That's what makes Italy's public finances appealing. It's the primary surplus! For a huge economy with a massive debt burden, it's not entirely fiscal profligacy that is the undoing. 

The 80's is almost symmetric and accompanied by a significant rise in the debt burden. Post 1992, growth is consistently lower but there's a bell curve of primary surpluses and the debt normalized back from 120% to a trough of about 105% in 2004. And then the crisis hits, growth zeroes out, recession strikes and debt balloons. 

The patterns in Italy's numbers are lucid and can be divided into phases that is evidenced in the WEO by the decomposition of the debt changes. One would expect that in the decade from '92 to '02, the primary surpluses would have a significant negative impact while the interest rate should have a high contribution pre-1992 (because the interest-rate & inflation dynamic looks like is pretty consistent internally). 

Sure enough, the decomposition is clear:

A consistent growth contribution, a dwindling primary balance (surplus) and of course, the massive interest rate burden pre-1997. 

If the ECB's OMT actions aren't able to suppress bond yields, it's practically possible that Italy is forced into a bailout. Its speed of fiscal tightening under Monti has further undermined growth prospects and the pain will show up as discontent in Monti's mandate. 

The technocrats in government have been brave, but they have also been forced to act with the threat of potential catastrophe looming. Nevertheless, necessary and unpopular reforms always give rise to political opposition and instability and Italy's problems in this sphere remain far from addressed. 

The Lost De(bt)cade

The IMF released the analytical segment of its latest WEO (the full release occurs in the second week of October before the IMF-WB meetings). Two chapters (3&4), one focussing on the debt-overhang in advanced economies, the other on the 'resilience' of emerging markets and the link to economic policies. Chapter 3 offers a country-specific analysis of debt dynamics at certain threshold levels and is historically focussed (in line with the FAD's data compilation of over a century's worth of debt data). It deals with 'episodes' as related to the sustainability factor upon crossing thresholds. Naturally, the 100% mark is frequently used as:

"First, it is most relevant today given the number of countries currently close to or above that threshold. Second, 100 percent is high relative to historical experience: only 15 percent of the observations in our advanced economy database are above 100 percent. Third, our analysis suggests that political and economic forces do not tend to exert downward pressure on debt on average until public debt reaches this level." 

Before picking on a few charts and conclusions, the basic framework of course is this:
Five variables - the stock of debt, the interest paid on this stock of debt, the inflation rate for the deflator, the real growth rate and the primary balance (ratio of GDP). So essentially - 

d(t)= ((1+i)/(1+pi)(1+g) )*d(t-1) + pb + e

where d(t) and d(t-1) is the stock of debt at time t. i is the interest paid on the stock of debt. pi is the inflation rate for the deflator, g is the real growth rate, pb is the primary balance ratio and e is the residual which accounts for accounting valuation differences and adjustments. 

For Japan, I'll try and incorporate the fiscal balance, debt, real growth and inflation into one and the bond yields and policy rate into another. Here's what they look like:

Good historical perspective on the 'liquidity trap'. The second graph shows the low borrowing costs the government has had for over a decade. This 'over-a-decade' time frame is also one characterized by the zero-bound. Japan's debt progression has been steady and unhindered (most of the debt is public). You can see two episodes of the deflationary spiral in the 90's as well as a steady stream of persistently higher fiscal deficits. What's interesting is the brief period pre-crisis when the debt dynamics stabilize accompanied by consistent 2% growth and a much-needed increase in price levels as well as a severe reduction in the deficit before slipping into recession again. 

The most interesting data comes from the actual decomposition of the debt dynamics. That is, categorizing by time-period. what percent of GDP each debt-dynamic factor contributed to the change in debt. This is what it looks like: 

Only in the '02-'07 period does growth contribute significantly to the change in debt whereas inflation has a minimal contribution during the same time frame. The consistency in the interest rates across such a long period of time is reflected in the lack of change in contribution. The '02-'07 period incidentally, is the period characterized by literally zero interest rates and low borrowing costs.

I suppose 1997 could be somewhat of a midpoint for the 'lost decade'. It's the point where Japan's debt-to-GDP ratio touched the 100% threshold and the country found itself mired in a mild deflation trap with stagnant output levels - significant repercussions of the devastating aftermath of the real estate and stock market bubble bursts. What followed immediately was near-panic monetary policy and fiscal stimulus, evidenced by a severe deterioration in the fiscal balance. The problem was that the slashing of interest rates was overshadowed by the accompanying drastically low levels of inflation and inflation expectations (The Japanese REER appreciated 60% in the early 90's!), that gives you a  sense of what happened to the nominal effective rate at those inflation levels!

The WEO says that "This episode highlights the need to deal with banking sector weakness and ensure a supportive monetary environment before fiscal consolidation can succeed."

Furthermore, "When structural weakness in the financial system prevents the normal transmission of monetary stimulus and when policy rates are constrained by the zero lower bound, the risk of anemic and fragile growth is high regardless of the fiscal setting."

There's a lot of truth, intuition as well as evidence behind that supposition. 

Despedida Espana

What's certain is that this is the last thing Spain needs right now. What's less certain is whether it can survive.

A couple of weeks ago, Catalonia's President Arturo Mas stated, "If we cannot reach a financial agreement, the road to freedom for Catalonia is open," which naturally invited a backlash from Rajoy's conservative political allies.

The Rajoy argument is essentially the issue of infighting. That during a time of serious crisis, this separatist surge is a major fundamental distraction when compared to Spain's grave needs as a sovereign. Catalan autonomy, since the '78 adoption of the constitution has after all, been a part of Spain. That may not be what Rajoy is hostile to.

The Catalan argument is simple in the short term and more abstruse over the long. During a period of prolonged austerity and sacrifice, Catalonia is disproportionately suffering far more, because the richness of Catalan as a region, requires it "to transfer up to 9% of its GDP " each year to Madrid. The autonomy issue arises over fiscal authority. They quite simply want a greater say in taxation policy.

Catalonia for the record, represents about a fifth of Spain's GDP, is the nation's most heavily indebted region and like all others, is suffering under exhaustive austerity measures forcing it to request a fresh five billion euro credit line to cover its existing maturities. Stung by a fiscal refusal from the centre, it seems to want out

Believe me, no matter how this plays out, it will be a crisis. A crisis on top of a crisis? Yes, very much so.

As it stands, Rajoy has hordes of Catch-22's on his hands. While Europe waits for him to request assistance (ECB bond-buying), he has to contend with sovereignty issues and bail-out conditions. On top of that he has angry protesters and the pressure to announce a "credible" budget which would imply...more protests!

But wait, there's more! November 25th will see snap elections where the ballot will be "seen as a de facto referendum on President Arturo Mas's demands for greater independence". 

Mas was naturally emboldened by the protests and surge in sentiment while obviously stinging from the refusal of Madrid to negotiate a change in the fiscal pact. Sounds like a risky but popular gamble to me - the vote was, after all called  two years ahead of time! 

Meanwhile, as Peter Spiegel reports from Brussels, the political eruption was amidst signs that Germany, Holland and Finland were trying to back-track on an agreement in June that would relieve Spanish bank-debt to the tune of tens of billions of euros. The statement said that "the plan to move bad bank assets would not apply to 'legacy assets' (a reference to wound-down banks under the Irish bailout program)". 

Wait. There's more. Next week, the budget will be announced and likely to have overshot budget deficit estimates in the agreement with Brussels. 

Ambrose Evans-Pritchard has a moving and sentimental piece in the Telegraph where he remembers how two weeks before he told a Catalonia newspaper how it "would be unthinkable for the Spanish state to stop Catalan secession by military force". That doing so would lead to a violation of EU treaties and thus Spain being suspended from the EU. 

Now he's not so sure. 

Colonel Francisco Alaman compared the crisis to 1936 (yes,  1936!) and stated, "Independence for Catalonia? Over my dead body". 

Hyperbole indeed, but an accurate indicator of the dangerous sentiment descending over Spain's populace. 

As the crisis digs deeper and becomes more entrenched, the focus shifts rapidly away from economics into politics and then into people. The horrible realization of the powerlessness of the government. The permanent scarring of austerity, a compounding of the debt-deflation nightmare and the reluctance to accept a fate dictated by a centre that lacks confidence. 

As I wrote earlier, on Friday Madrid will reveal its funding needs for its broken domestic banking sector. This will kick off negotiations (a euphemism for arguments!) as to how much of the ESM pledged funds will be used and where the responsibility would lie. 

Meanwhile, the sentiment and actions in the north nudge Spain towards a constitutional crisis, buoyed by a vocal and unrepentant leader. When you have approximately a million people marching for a common cause (Catalonia's population is 7.5 million), voices will be raised and anger will be directed. 

Nothing encapsulates this best (not the blame, but the sentiment!), of the Popular party's Catalan leader Alicia Sanchez-Comacho who lashed out in reply to Mas stating that he was "leading us into a very dangerous process in which civic and social co-existence will be ruptured". 

It seems like a perfect storm.

What Am I Reading?

1) In the mood for a history lesson? Noah Smith has an interesting take on Mankiw's Scientists vs Engineers macro paradigm.

2) David Glasner has a quick (sure!) response to QE bashers specifically detailing the misconception of Bernanke targeting asset prices rather than arguing that there was some correlation between the movement in stock prices and the expectations of future performance.

3) Gideon Rachman has a stern piece in today's FT on the Indian spectrum. There's an irony that while funding IMF bailouts to troubled EU economies, India's own living standards pale in comparison to Greece/Ireland etc.  "You stay sane in India by looking at the medium-term". Don't ask me who said this!

4) The best social policy is full employment? Jack Ewing has a piece in the NYT on Germany and Jobs.

5) The Big Picture has a link to charts I've been wanting to look at. Global growth rates and Equity market returns (through JPAM). A noticeable difference in the weighting pie. 

6) ...and....HARRY POTTER's BACK!! Or atleast Rowling is...

Cut That Rate!

More on the grand Indian attempt to rekindle those "animal spirits". Here are some views held by economists monitoring the RBI's monetary policy stance (which incidentally looks like this):

M3 is the y-o-y growth percentage of broad money. Both the rates are on the right axis while the WPI % yoy (This is because WPI inflation (and non-food manufactured goods component) is significantly more sensitive to international commodity prices than the typical consumer price index (CPI)-based inflation)  and M3 are on the left axis.

RGE analysis and forecasts "does not see the RBI cutting rates again until Q1 2013". Furthermore, "the decision by the RBI to go for a 50 bps rate cut in April was in anticipation of an imminent correction in diesel prices" that is only coming along now. Changes in the external scenario (impact of QE3 on commodity prices etc.) further contribute to the RBI's hawkish stance whilst simultaneously being mindful of over-tight liquidity conditions. 

Rajiv Malik, of CLSA thinks that, "the RBI was correct in leaving the repo rate unchanged, as it had already anticipated some action from the government ...A rate cut today would have made the RBI a laughing stock..."

Victor Mallet reported for the FT a week ago that the diesel price increase will ultimately not reduce the fuel bill all that much and he quotes a senior government official as saying, "what's creating the space for doing these things is a growing sense of crisis. The crisis helps you override gridlock, vested interests...there's a sense of urgency." 

That's good news, but we've known that all along!  How many crises must we learn from in hindsight? The Indian parliament may be a mess but that's no excuse to divert attention from it! This is evidenced by two officials from the FICCI who felt that the central bank, in restricting M3, would be constraining economic activity and thereby indirectly nudge the rate up while trying to prevent a depreciation of the rupee.

Meanwhile, outgoing CEA Mr. Basu believes that the right stance has been taken with inflation being "uncomfortably high". As growth can be expected to be feeble at best, "the onus is on the government to bring about changes."

DBS Group research a few months ago opined that, "rate cuts are premature and (we) have pencilled in cuts only because the central bank and the government appear to worry more about slowing growth than about inflation." It goes on further to state that while conventionally a central bank plays ahead of the curve by easing conditions on the back of under-potential growth, India's economy is "undergoing structural changes", making it harder to "judge with reasonable confidence that the output gap is negative".

Lastly, Saajid Chinoy (a JP Morgan economist) stated that by sticking to their stance, the RBI had "increased the sense of urgency in Delhi". He cited scant evidence that "a small cut in interest rates would stimulate economic demand". 

My sense is that any loosening may well be too premature and a bit too arrogant. Hoping that lowering rates will brighten business sentiment and investment without adversely affecting price levels goes beyond being optimistic. The bottom line is that the RBI has a paramount duty of maintaining price stability and ensuring an adequate flow of credit to productive sectors as evidenced and restated in the Mid-Quarter Monetary Policy Review. 

No one's denying that monetary policy has a crucial role in reviving growth but it must be used judiciously and not as a tool to try and account (read: cover up) for the paralysis in the centre and the structural deficiencies in areas of the real economy. 

There's a consensus that, the RBI needs to be internally consistent, credible (like any central bank) and above all, immune to immense market pressure. India's growth has suffered, its currency taken a beating and there are glaring weaknesses in some broader underlying macro fundamentals. 

Global headwinds and downside risks disrupt the scope of policy change but the direction must be made clear - the RBI cannot and must not underestimate the inflationary effects on a fragile economy suspect to external developments. 

What Am I Reading?

What Am I Reading?

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- Wolfgang Munchau has a hard-hitting metaphorical diatribe on Weidmann, Merkel, Draghi and the German public (your usual players). You have to read this to believe it

" It should be clear by now what game Mr Weidmann is playing. He is sabotaging the euro through the most effective means he has at his disposal – by reinforcing people’s innate fears about the common currency. He cannot outvote the governing council of the ECB. He is in a minority of one. He also knows that he cannot overturn the ECB’s policy through the legal route. Anybody who decided to drag Mario Draghi in front of the European Court of Justice would lose. Mr Weidmann no longer has any pull over Angela Merkel, the German chancellor he once advised.

But make no mistake: he is very effective in encouraging a creeping euroscepticism among Germans. In doing so, he may well succeed in undermining the chance of the euro’s survival because euroscepticism limits the German government’s political room for manoeuvre."

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- Ed Luce has a kind of confusing indictment on the current state of politics in the US and the outlook for the economy in terms of productivity, competitiveness and the coming "energy boom" (Really?)

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- John Taylor has a blog blurb on the impact of negative regulatory policy contributing to the dampened recovery of the US economy. In fact, he compares it to the early 80's and cites data of federal workers in regulatory activities. What's funny is that he states, "While correlation does not prove causation..." and then proceeds to forget all about it!

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Brad DeLong has a take down of a ridiculous (yes ridiculous!) article in the WSJ by Taylor and the high-priest of regulation Phil Gramm regarding the QE3 impact. You think what bothers Krugman is that they claim the impending required contraction to today's expansionary monetary policy is a downside?? 

Nope. It's that they rolled out Mr. "Mental Recession" to validate such claims.

The absurd part (and there are many) is the refusal to acknowledge that no matter who owns the treasuries, the stock remains the same. Then again, Phil Gramm isn't exactly world famous for calling a recession when he sees one. 

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Here's an interesting read on the WSJ's reporting, the "fat-finger" error and of course (where would we be without this!), the price of oil. 

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The Indian Deficit

Manmohan may have got his mojo back and India may have hit a homer with all bases loaded but the stark reality hasn't changed all that much. Andy Mukherjee has a succinct piece on the twin-deficit issue in a BreakingViews column where he points out politely that fiscal profligacy (more like idiocy), took off in February 2008, when the government irresponsibly announced a $15 billion "farm-debt waiver". 

What he goes on to state is that the current account must be viewed from the savings-investment dynamic. (Note that if a nation earns more than it spends the overall effect will be to build up savings, unless those savings are being used for investment. If consumers can be encouraged to spend more instead of saving; or if the government runs a fiscal deficit to offset private savings; or if the corporate sector divert more of their profits to investment, then any surplus will tend to disappear).

Look at this from the Indian view - the corporate sector diverting profits towards investment? Consumers spending more? Government running a fiscal deficit thus offsetting private savings? Check

Mukherjee then says that households, seeking cover as an inflation-hedge to this fiscal profligacy turned to imported gold and the household investment in 'valuables' increased 5 times over the past five years! Hence, the domestic corporate sector couldn't maintain the pace at which they were issuing debt and equity securities which further led to an increased reliance on external financing. 
Current account deficit - up. Stock of foreign debt - up. Reserves - down.

I never thought (and still don't think) we're close to a BOP crisis a la 1991 but significant and persistently high deficits feeding off each other tend to lead to a sense of drag and extremely negative sentiment in the broader economy adversely affecting investment and consumer behaviour. 

Anyway, here's the interlinked and tricky solution!

1) Competitive exchange rate - The rupee has taken blow after blow of late, unable to sustain itself due to (among numerous other factors), persistent dollar demand and India's import composition, but what's happened to the REER?

Nomura's Sonal Varma says this year there's been a real depreciation of only 3% last FY (i don't get that - looks more like 10-11% to me), and 7.7% YTD which should narrow the CA gap by about 0.8% subject to the price of crude oil. The problem is that this is an unfavourable scenario for competitiveness because global demand is damp and tepid and on the domestic front, higher inflation leads to less of a 'real' adjustment.

2) Further Reductions in Subsidies - The issues here are more than a few. Further reductions in subsidies could lead to a bullish sentiment in equities and thereby put pressure on the rupee to appreciate. The counter-move would be for the RBI to snap up dollars and maintain the level of liquidity in the economy which leads to a dilemma on the direction of monetary policy during a period of relatively stagnant growth. 

3) Inflation - This would certainly be the most worrisome and sensitive issue. As experienced over the past year, any depreciation of the rupee coupled with a jump in the price of crude oil could have a significant negative effect in the form of imported inflation. Poor infrastructural bottlenecks and negative sentiment make the issues of supply-side solutions that much harder. 
The whole FDI-reform saga could encourage more private investment but this is far from a short-term effect. Fiscal reform in the form of a disinflationary GST tax for example can be thrown out of the window as a result of parliamentary legislative gridlock.  
Mukherjee concludes that the whole inflation nightmare is why the RBI has to tread extremely cautiously and remain hawkish to "control aggregate demand" even though it might not be the popular move to make. Those expecting and demanding a further rate cut must be postponed for later, only after the government has demonstrated some semblance of fiscal resolve.

Which means, that in the face of volatile headwinds further exacerbated by the moves of the Fed and the ECB's fluctuating sentiments, India would do well to leave the "growth-fixation" aside very temporarily and attend to far more difficult matters at hand. 

A prolonged sense of malaise and despair is the last thing that any economy needs and neither is a more austere agenda. What can push it along in a favourable direction is accepting that there are serious structural flaws and constraints and that most of the time, good economics must trump good politics.