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3 Sep'10:
The final Purchasing Managers'
survey for Aug'10 for the euro zone services
sector confirmed that growth is being sustained at a
robust rate, on a par with the growth achieved in Q2'10
(chart of the day below).
Accelerating new business, continued job creation and
rising optimism point to a high level of activity being
sustained in the months ahead.
Growth is, however, not broadly based. The advance is
still led by France, followed by Germany. Growth in
Italy is at a pedestrian pace, while in Spain business
activity fell back into contraction. (more at
surveys)
3 Sep'10:
Retail sales in Jul'10 rose by a mere 0.1% on the month,
but the results of previous months have been revised up
and the trend since mid-2009 is moderately upwards
(rather than only modestly upwards).
The results and prospects vary widely by country with
core-Europe benefitting from improving labour markets
and rising confidence while many peripheral countries do
not and are additionally burdened by rising taxes. (more
at
growth variables)
2 Sep'10:
The ECB maintained its accommodating monetary stance at
its Governing Council meeting. President Trichet
signalled that its main refinance rate would remain at
1% for some time to come. Banks continue to have access
to unlimited funds to at least early 2011. (more at
financial variables)
2 Sep'10:
Details of Q2'10 GDP indicate that the growth of 1.0%
q/q came from final domestic demand, not inventories as
in Q1'10. There was a remarkable turn-around in fixed
investment while the contribution to growth from
consumer spending is rising. Growth in some previous
quarters were revised up. (more at
growth
variables)
Q2'10 GDP is now reckoned to be 1.9% up on the year,
well above the consensus forecast and about in line with
the Euroeconomics forecast.
|
Forthcoming:
week 36
|
7 Sep:
German industrial orders for Jul'10
8 Sep:
German, French Jul'10 exports; German Jul'10 industrial
production; Bank of France Aug'10
business
survey
9 Sep: French Q2'10 payrolls
10 Sep: French, Italian industrial orders for Jul'10 |
Chart of the day

Summary of recent trends (weeks 30-35)
While financial markets have focused on
signs of weakening global growth, driving Bund yields to
extraordinary low levels and weakening stock markets, the
growth statistics for the euro zone have been overwhelmingly
positive. GDP growth in Q2'10 surpassed all expectations
while the survey results for Jul-Aug'10 point to robust
growth being pretty much sustained in Q3'10.
For
Euroeconomics 2010-11 forecasts updated 3 Sep'10 see
below.
Growth: robust in core-Europe, increasingly driven by
domestic demand
The business surveys for Aug'10 indicate that activity
remained at a high level, losing only a little momentum in
spite of fears of a global growth slowdown.
The advance is led by core-Europe with
the most indebted peripheral countries failing to keep up.
There are more signs that the upswing in core-Europe is less reliant
on exports. An improvement in consumer confidence may
foreshadow gains in consumer spending. Global growth indicators, notably for the US,
have recently been on the weak side, pointing to a slowdown
in global growth.
(for full coverage of all euro zone surveys see
surveys)
The "hard" statistics
portray a surging recovery in industry in Q2'10. Though the industrial production
statistics for Jun'10 indicated a pause, new
orders have soared. Exports are on a steep uptrend.
Employment data have been unexpectedly positive. Overall
employment stabilised in Q1'10 and the unemployment rate was stabile over the Mar-Jul'10 months,
though
at a still high 10.0%.
The surveys suggest
a slight rise in private sector employment in
May-Aug'10. Retail sales are on a moderate uptrend.
Results for the construction sector, however, are still
poor and the trend in new car sales is sharply down.
GDP in Q2'10 brought an unexpectedly
steep gain of 1.0%, spearheaded by
Germany. By sector growth came from fixed investment and
consumer spending. Surveys suggest
quite a strong start to Q3'10. But expectations among most
forecasters are now that strength may not be fully maintained in
subsequent months because of the faltering US economy.
(for full coverage of all
euro zone growth statistics see growth variables)
For
Euroeconomics 2010-11 growth forecasts see
below.
Inflation: well contained below the
ECB's inflation target
The annual inflation rate for Aug'10 moderated to 1.6% (from
1.7%).
Though inflation should remain moderate in the months ahead (and
below the ECB's inflation target), the
earlier depreciation of the EUR may
prevent a return to rates below 1%.
Producer prices,
after being virtually stable for most of 2009, have risen, the result of the earlier surge in oil and commodity prices.
But the Purchasing Managers' surveys indicate that
the inflationary pressures clearly visible in manufacturing in
recent months, have now subsided.
In the services sector prices remain becalmed, mainly because
wage increases have moderated and unit labour costs are declining.
(for full coverage of all
euro zone inflation statistics see
inflation variables)
For 2010-11 inflation forecasts see
below.
Financial variables: EU and ECB provide
massive support to counter debt crisis
After the financial markets threatened to run out of
control as the euro zone's sovereign debt crisis intensified, the
ECB 10 May'10 announced wide ranging support measures for the
euro zone financial system, including buying bonds and
providing unlimited liquidity to the banking system.
The ECB has of late
displayed greater confidence that the debt crisis is
under control and wishes to "normalise" monetary policy -
i.e. move away from all out stimulation. But until end-2010
at least banks may still be able to borrow unlimited funds
from the ECB at 1%.
The EU itself announced a "big number" EUR750bn financial rescue
package, one third of which is to come from the IMF.
Assistance is to be linked to measures to reduce budget
deficits. It is hoped that this facility may not have to be
used.
Fiscal policies are this year becoming less expansionary. The south
European countries have been obliged to introduce
fiscal restrictions. The rest of the euro zone is
expected to follow in 2011.
(for full coverage of all euro zone financial indicators see
financial variables)
For money market rate forecasts for 2010-11 see
below.
Financial markets:
recovering their poise after global growth fears abate
Financial markets
in Aug'10 focused on the potential for a major slowdown in
global growth after a long series of poor growth indicators
from the US and a few indications that growth in China may
also be moving down a gear. This boosted safe haven
flows into USD and (massively) into government bonds at the expense of
stock markets.
The first days of Sep'10 brought more positive news on
growth, boosting stock markets and driving bond yields up
from the extraordinary low levels reached end-Aug'10. The
EUR similarly benefitted as safe haven flows into the USD
ceased and the euro zone sovereign debt crisis faded after
the measures taken by the ECB and the EU gained credibility.
(for fuller coverage of the main euro zone financial markets see financial markets)
For stock and bond market forecasts for 2010-11 see
below.
Sovereign debt crisis:
easing
The Greek debt crisis and its spreading to other
deeply indebted euro zone countries focused
attention on the increasingly divergent trends in the euro
zone countries' current account balances, unit labour costs
and employment. Speculation intensified about whether the euro
zone's divergent member countries can sustain a monetary
union.
Rather than an EMU break up, a change in its constitution may be
the result of the crisis, allowing for bail-outs and introducing
more effective
constraints on the fiscal policies of member countries to cover
the shortcomings of the Stability & Growth Pact.
Those that predict
failure, a break up of the euro zone, one or other country
leaving, fail to appreciate just how impossible an
undertaking this would be in practice.
(for a thorough and detailed discussion of the obstacles
facing a country leaving the monetary union see
Eichengreen)
(for full coverage of euro zone institutions and their
shortcomings see
constitution)
New members euro adoption prospects:
Estonia to become 17th member 1 Jan'11
The latest Convergence Report by the European Commission was
published 12 May'10. It gave the green light for Estonia
adopting the euro on 1 Jan'11.
After the problems with Greece the entry criteria are now more harshly scrutinised.
Also doubts about the benefits of euro adoption have
multiplied among the candidate countries.
The table below indicates
the earliest year in
which
other countries may adopt the euro. Entry usually takes place at start of year. (more at
members)
Many commentators, mostly in the UK and the US, believe that
membership of the euro zone is more likely to shrink than
expand. (more at constitution)
| 2009 |
2010 |
2011 |
2012 |
2013 |
2014 |
2015 |
2016 |
2017 |
| Slovakia |
|
Estonia |
|
|
Latvia
Lithuania
Denmark |
Poland
Bulgaria |
Czech Republic
Hungary
Romania
Sweden |
|
| 16 members |
|
17 members |
|
|
20 members |
22 members |
26 members |
|
| Subject to change. For
current observance of convergence requirements see
members. |
News:
-
Estonia received the final
go-ahead for adopting the euro on 1 Jan'11 when the EU
finance ministers approved 13 Jul'10 the
conversion rate of 15.6466 Estonian Kroon (EEK) to the
EUR. The Kroon has been pegged to the EUR at this rate
since the start of the euro zone in 1999. The European
Commission reported 12 May'10 that Estonia passes the
tests to join. Standard & Poor raised Estonia's
sovereign credit rating to A (from A1) on 10 Jun'10.
-
Hungary's new
government intends to cut taxes and
stimulate the economy, but also to respect budget deficit
target. The lack of clarity has unsettled financial
markets and placed the government at odds with
European Commission and IMF. Negotiations about a bailout
package were suspended 17 Jul'10. Hungary's euro
adoption appears further away than ever.
-
Czech PM Necas said (29
Jul'10) government won't commit to target date for euro
adoption. Nor is entry into the Exchange Rate Mechanism
ERM II being considered. Central bank
Governor Singar said (22 Jun'10) that euro area has become
less attractive. The independent monetary policy and
currency allowed the country to better cope with the
financial crisis. Target to be set once
euro zone countries themselves meet the Maastricht
criteria on budget deficits they demand from those
wishing to join.
-
Poland's
central bank Deputy Governor said 7 May'10 that because
of the Greek debt crisis Poland could not commit itself
to a fixed date for adopting the euro. PM Tusk said 6
May euro adoption not priority. CBOS opinion poll
conducted 18-19 Apr'10 showed for first time since 2007
more Poles opposed to adopting euro (49%) than in favour
(41%). IMF said 10 May'10 Poland should not rush
replacing zloty.
-
Bulgaria's
plan to adopt euro in disarray when government revealed 8 Apr'10 off-budget spending by previous government.
Intention to join ERM II this year abandoned. European
Commission is sending a mission to Bulgaria to
investigate public sector finances.
-
Romanian government stated
(22 Mar'10) that Jan'15 remains its target date for
adopting the euro. But European Commission critical of lack
of reforms, high level corruption and organised crime (23
Mar'10).
-
Fitch on 8 Mar'10 raised
Lithuania's rating outlook to stable (from negative) on
successful implementation of austerity. Moody's on 31 Mar'10
raised credit rating of Lithuania, Latvia and
Estonia based on success achieved in surmounting
recession and cutting wages to restore competitiveness.
(more at
members)
F O
R E C A S T S
See below for Euroeconomics forecasts of euro zone 1.
growth
2. inflation,
3. money market rates 4. Bund yields
5. stock market
6. commodity price index
7. EUR/USD rate
| FORECAST SUMMARY |
| |
|
2008actual |
2009actual |
2010 |
2011 |
| GDP official
consensus |
%change y/y |
0.6 |
-4.1 |
1.2 |
1.6 |
|
Euroeconomics |
" |
|
|
1.8 |
2.5 |
| Inflation
official consensus |
" |
3.3 |
0.3 |
1.3 |
1.3 |
|
Euroeconomics |
" |
|
|
1.4 |
1.4 |
| |
|
|
|
|
|
| |
latest: average of week
35 |
end-2010 |
end-2011 |
| ECB main refinance
rate % |
1.0 |
1.0 |
2.0 |
| 10-year
German Bund yield % |
2.25 |
2.8 to 3.2 |
4.0 to 4.5 |
| DJ EURO STOXX 50
index |
2700 |
3000 to 3200 |
3700 to 3900 |
| Commodity
prices in EUR index
2000=100 |
162.1 |
150 to 170 |
170 to 190 |
| EUR/USD exchange rate |
1.2805 |
1.20 to 1.35 |
1.35 to 1.50 |
Euroeconomics forecasts have been reviewed 3 Sep'10 in the
light of the latest developments:
Fears of a slowdown in global growth, mainly fanned by poor
US growth indicators, lessened in week 35 (which ended 3 Sep).
In the euro zone the growth outlook
shown by the latest surveys and indicators has been
positive. Our GDP growth forecast for 2010 has been raised
to 1.8% while the forecast for 2011 has been reduced to 2.5%
(as the recovery is coming earlier).
Inflation indicators remain innocuous. The earlier uptrend
in commodity
prices and the oil price has partially stalled on global
growth slowdown fears.
Though the ECB would like its monetary
policies to be a little less accommodating and a little
more "normal", this may only be contemplated in
Q1'11. In America the
Fed may introduce additional stimulatory measures if the
poor run of US growth indicators continues.
1. Growth: how rapid a recovery?
Weak official forecasts
The currently
available indicators leave little doubt that quite robust growth is
underway in the euro zone. Official forecasts are still cautious even after a
long series of upward revisions: euro zone GDP
is seen to grow by 1.2% in 2010 (table below).
There are sound reasons for forecasting a
difficult recovery. In the past recoveries have mostly been V
shaped, but recoveries from recessions caused by banking crises
have been more laboured. Any boost provided by restocking and
fiscal support measures may be temporary. Moreover a
sovereign debt crisis has erupted of unsuspected severity.
It is good to be cautious
Having failed to forecast the 2008-09 recession forecasters are
reluctant to be caught out again. It is more acceptable to
underestimate growth than to overestimate it ("...we are pleased
to say that growth is better than expected..." is a good deal
more acceptable than "...we failed to see the recession dragging
on..."). It is "good" to be cautious.
This is particularly so in the current period of financial
uncertainty when sight is lost of the fundamental forces
driving economies. Forecasting is a subjective exercise, unduly influenced by the
recent past.
The consensus forecast for 2010 already had to be
raised a number of times as the leading indicators strengthened
in the summer of 2009. For instance in May'09 the European
Commission expected euro zone GDP to decline by 0.1% in 2010. By
May'10 it was revised to +1.0%.
After the unexpectedly steep rise in Q2'10 GDP further upward
revisions will have to be made.
|
Factors making for a weak recovery:
-
over borrowed
companies and households still need to de-leverage
-
weak labour market
inhibits consumer spending
-
low capital
utilisation inhibits fixed investment
-
repair of
the banking sector is seen to take time as more
write-downs on loans and securities impair banks'
ability to provide the economy with the finance
considered necessary to support a sustained recovery
-
the
financial troubles of Greece and other deeply indebted
euro zone countries have undermined confidence
-
Greece,
and to a lesser extent other southern countries
(Italy, Spain, Portugal), are introducing austerity
measures
Pre-crisis growth (2003 to 2007) was supported by
favourable financial conditions which proved unsustainable,
restricting post-crisis growth. Growth beyond 2010 may be hampered
by higher cost of
capital due to higher risk premiums and lower leverage in
private sector.
|
EURO AREA – GDP GROWTH FORECASTS |
|
|
|
Volume
(in prices of 2000) |
2008 |
2009 |
2010 |
2011 |
2009 |
2010 |
|
|
|
Q1 |
Q2 |
Q3 |
Q4 |
Q1 |
Q2 |
Q3 |
Q4 |
|
|
% change
y/y |
% change q/q,
seasonally adjusted |
|
Actual
Official consensus forecast:
(European
Commission,
OECD, ECB Staff, IMF)*
Euroeconomics
|
0.6
|
-4.1
|
1.2
1.8 |
1.6
2.5 |
-2.5 |
-0.1 |
0.4
|
0.2
|
0.3
|
1.0
|
0.7
|
0.5 |
|
*for detail see
growth variables |
Factors making for a stronger recovery: pent
up demand boosting domestic demand, weak EUR
boosting exports
In the autumn of 2008 the euro zone economy suffered a severe
and unexpected shock. Suddenly money markets no longer
functioned and bank loans became difficult or impossible to
secure. The unavailability of finance and magnified uncertainty
forced companies to slash inventories, investments and
employment and hoard cash. Economic meltdown appeared to lie ahead.
By the spring of 2009 government fiscal policies and central
bank monetary policies stabilised the economy, albeit at a low
level. The world had not come to an end. The future looked less
bleak. Financial markets began a sustained recovery. The
need for spending restraint eased.
-
Spending
decisions which were put off during the crisis are being
revisited
-
Replacement demand for machinery & equipment and durable
consumer goods have built up and will increasingly be
released
-
The
underlying forces which drive economies forward may have
been blunted in the short term, but are progressively
reasserting themselves. Technological progress is
on-going spurring new investments and boosting
productivity
-
New
households are being formed, spurring purchases of
houses and household equipment, new consumer products
and services are coming to market and attract spending
-
Resources
are released from shrinking sectors and are available
for deployment in growing sectors
-
The
computer revolution has reached maturity and the work
force is replenished by computer literates (taking the
place of the computer illiterates moving into
retirement), boosting productivity
-
The steep decline in the EUR in H1'10 provides euro zone
exporters with a powerful competitive advantage in selling
to the newly industrialising countries, as well as to the
developed countries
-
J. M.
Keynes's "animal spirits" (the "spontaneous urge to
action rather than inaction") are particularly alive and
well in the newly industrialising countries
-
Growth in the global
economy, spearheaded by the full blown boom in the newly
industrialising countries, may again pick up momentum
once the current soft spot in the US economy is overcome.
Euroeconomics forecast: greater emphasis
put on the positive factors
Growth in the euro area is expected to be in the 2% to
3% region for the remainder of 2010 and for 2011. Though
"optimistic" compared to the consensus forecast, this forecast
still leaves by 2011 an output gap of 7%, representing the loss
of output due to the financial crisis. (The output gap according
to the consensus forecast amounts to 10%)
gdp.jpg)
Comment on this forecast
2.
Inflation: to remain moderate
Low official inflation
forecasts
The severity of the financial crisis has brought very low,
even (briefly) negative, inflation rates. According to the
official consensus forecast inflation will remain low: 1.3% is
forecast for 2010 for the harmonised index of consumer prices
(HICP). Even for 2011 the official consensus foresees inflation
rising to only 1.5%, thus still clearly below the ECB's
inflation target of "below but close to 2%."
|
EURO AREA – INFLATION FORECASTS |
|
%
change y/y |
|
Harmonised index of
consumer prices |
2008 |
2009 |
2010 |
2011 |
2009 |
2010 |
|
|
|
Q1 |
Q2 |
Q3 |
Q4 |
Q1 |
Q2 |
Q3 |
Q4 |
|
|
|
|
Actual
Official consensus forecast:
(OECD, ECB Staff, IMF,
European Commission*)
Euroeconomics |
3.3
|
0.3
|
1.3
1.4 |
1.3
1.4 |
1.0 |
0.2 |
-0.4
|
0.4
|
1.1
|
1.5
|
1.6 |
1.6 |
|
*for detail see
inflation variables |
Factors making for moderate inflation: ample spare capacity, high unemployment,
declining unit labour costs
Ample scare capacity is the major reason for expecting
moderate
inflation. As indicated above, GDP even in 2011 may still be
some 7% below capacity limits.
Under pressure from still high unemployment, wage
increases can be expected to be modest for a while yet. As output recovers
unit labour costs decline.
This allows companies to reap high profits even if
prices charged remain stable.
Factors boosting inflation: vigorous commodity prices,
weak EUR
Commodity prices in 2008, unsurprisingly, plunged from their
pre-crisis peaks. Rather surprising was their steep recovery
in 2009 and their continued, if at times more halting,
rise in H1'10. Pre-crisis booming commodity prices
reflected the global economic boom and, more particularly,
the voracious demand for commodities from Asia's newly
industrialising countries, China in the forefront.
The financial crisis has only briefly dented the expansion
of these countries and probably accounts for much of the
rapid recovery in commodity prices. Fears are that this
relatively new and potent demand for natural resources,
placed against inherently sluggish expansion in supply
capacities, may lead to another commodities boom and
eventually rekindle inflationary pressures in the developed
world.
A relatively new element in the inflation outlook is the
slide in the EUR to a value which, unless soon reversed,
will have a moderate but perceptible impact on the euro zone inflation rate.
Taking these factors into account our own forecast for inflation
are about in line with the consensus forecast.
HICP.jpg)
Comment on this forecast
3. Money markets:
interest rates may return to normal in course of 2011
ECB to hike rates in 2011
Prospects of an export driven recovery in growth, coupled
with subdued inflation, suggest
that monetary policy may remain supportive in H2'10, then
making way for gradual tightening.
money_market_rates.jpg)
The ECB, given its attachment to low inflation (see
crusade
against inflation), will wish to raise its main refinance
rate from the current crisis level of 1% to a more "normal" 2%
as soon as it considers that the recovery in growth has been
secured. Supporting this move is the likelihood that inflation
may move closer to the ECB's target rate of just below 2% now that
the EUR has depreciated against the USD.
Our current forecast is for the ECB to maintain its main
refinance rate at 1% in H2'10, then to raise it to 2% in
the course of 2011. Money market rates which are currently
sill below the main refinance rate may in the course of H2'10
continue to narrow the
gap and converge on the main refinance rate in 2011.
Comment on this forecast
4. Government bond
markets: Bund yields to rise, eventually
After rebounding in H1'09 from their recession lows, 10-year
Bund yields again declined in H2'09 on prospects that inflation
would remain low for an extended period and hence monetary
policy would remain accommodating for an extended period.
Moreover the consensus view was that the recovery would be slow and
fragile, further encouraging central bank docility.
In H1'10 the
yield on Bunds declined further because of Greece's debt problems
while the yield gap with US Treasuries for a while widened on strong US growth
indicators. Towards mid-year the sovereign debt problem assumed
major proportions bringing large safe haven flows into Bunds
and US Treasuries. (see weekly
chart).
Bund bulls say:
-
Buyers of
government paper are still bidding
substantial amounts at auctions. Euro zone governments
other than the most deeply indebted ones, have so far had no difficulty in selling the
large quantities of securities required to cover
their much enlarged budget deficits.
-
The
economic recovery may be slow and fragile, keeping
the ECB from raising interest rates anytime soon.
-
Generally, the ample liquidity made available to
banks at exceptionally low
interest rates allowed banks to borrow cheaply
and invest the proceeds in higher yielding
government bonds, boosting bank earnings and
capital.
-
Any problems
afflicting the world economy or the euro zone economy in
particular (such as the euro zone's sovereign debt
crisis) may bring renewed
safe haven flows into Bunds.
Bund bears say:
-
The
"safe haven flows" into Bunds
on the sovereign debt crisis may reverse once the
problem recedes.
-
Budget
deficits have exploded, requiring massive
sales of government securities for years to come even as
deficits are whittled down by restrictive fiscal
measures.
-
In the early months of 2010 Bund
yields mostly fluctuated in the 3.1% to 3.4%
range, then were dragged well below 3% as the Greek debt
crisis spread and intensified. These rate are
exceptionally low in a historical perspective.
In 2009
inflation too was historically low. Thus real
yields (nominal yields adjusted for inflation) were
high. In H1'10 inflation
has risen while Bund yields have declined, substantially
compressing real yields.
-
In longer
term inflation may rise further and monetary policy
may tighten, pushing bond yields sharply higher.
bund_yield.jpg)
Our medium term outlook of accelerating growth with inflation creeping upwards and ECB policy
normalising, implies that Bund yields will rise steeply.
Public sector debt may have reached a peak but remains massive, requiring massive sales of
government securities for years to come. Bund yields are
expected to rise towards the 4.5% mark over our forecast
horizon.
5. Stock markets: bright prospects
Stock markets made a steep recovery from the
crisis low reached in Mar'09. During the following seven months
to Oct'09 the recovery was almost as steep as the preceding
slump. To a large extend this was because the initial fears of an
economic collapse were not realised. As the government measures
started to stabilise the situation stock markets recouped the
losses resulting from those fears which proved overblown.
H1'10 brought setbacks as the Greek debt crisis
intensified and broadened. Even the survival of Europe's
monetary union was increasingly questioned. Fears of a
global growth slowdown further undermined confidence
around mid-year.
Favourable factors for the
period ahead:
- exceptionally low money market interest
rates
- recovery of growth
boosting profits
- rapid deceleration in wage
increases, coupled with rising output, to bring steeply
declining unit labour costs
The early stages of an economic recovery are
typically highly beneficial for corporate profits. Cost cutting
during the recession, followed by rising sales during the
recovery, make for a major boost to profits. Even moderate
increases in GDP, i.e. moderate increases in corporate sales,
generate disproportionately large gains in corporate earnings.
6. Commodity markets: strong demand, tight supply
Commodity producers (mostly located outside the
euro zone) may be the major beneficiaries of the global economic
recovery. Pre-crisis commodity prices soared as rapidly growing
demand from the newly industrialising countries was amplified by
speculative demand. The reversal of commodity prices during the
crisis was brutal, but did not bring them back to their 2000-04
levels.
commodity_prices.jpg)
After being on a declining trend for the quarter
of a century to 2000, real commodity prices have been lifted on
to a rising trend thanks to the new demand from the newly
industrialising countries. They still have a long way to go.
Per capita consumption of commodities in developing countries is
still only a fraction of the level in developed countries.
Supply for many commodities is slow to adapt to the increase of
demand due to long lead times. The recession and the associated
difficulty of securing capital have brought further delays to
capacity expanding projects.
7. EUR/USD exchange rate:
weak now, to strengthen later
After the EUR
declined against the USD in H2'08 on safe haven flows into the
American currency,
2009 brought a substantial recovery. Irregular early in the
year, the EUR embarked on a sustained rise from April till
early in December as the financial crisis faded and an
economic recovery got underway. The USD lost its "safe haven"
status.
The subsequent steep decline in H1'10 is due to
Greece's excessive budget deficit and the difficulties it
faces to finance it. This has unsettled markets, undermining
the credit worthiness of other deeply indebted euro zone
countries and even raising questions about the viability of the monetary union.
The outlook is now for the EUR to remain around the
lower levels reached in mid-year, then strengthening once the
euro area has recovered its balance and the defects the USD
labours under move back into the limelight.
Factors boosting USD currently:
-
US has moved first out of recession
and may be first to tighten monetary policy. Relatively
high US interest rates then to attract more capital
inflows. US Treasuries already yield more than German
Bunds.
-
Renewed flaring up of financial
crisis or other mishap (e.g. geo-political, or
directly undermining the euro zone such as the
recent Greek financial crisis) may
bring renewed safe haven flows into USD.
-
Purchasing power calculations
indicate that EUR (at USD1.27) may still be overvalued by
some
10%.
-
Lack of internal cohesion of euro
block due to divergent competitiveness of its
members undermines confidence in EUR. Also recent
problems have shown euro zone decision making to be
slow and indecisive while divisions within the block
led to weak compromises.
-
Reputation and inflation fighting
qualities of ECB undermined by events surrounding
sovereign debt crisis.
Factors which may undermine USD
later:
-
Once euro zone's debt problems
are resolved safe haven flows into USD may be
reversed.
-
Ongoing diversification of
international reserves away from USD and towards
other currencies, among which the EUR figures
largely, may resume.
-
Possible loss of confidence in USD due to
America's deep budget and current account deficits, and fear of resurgent inflation.
-
Though less substantial than
earlier, US current account remains in substantial
deficit (around USD500bn in 2010). May deepen again
once
consumer spending accelerates and/or oil and other
commodity prices strengthen again. US current account deficit in 2010
is expected to
amount to 3.7% of GDP, euro zone's to 0.3% (European
Commission May'10 forecast).
-
US budget deficit expected to
amount to 10% of GDP in 2010, the euro zone's to
6.6% (European Commission May'10 forecast)
-
US indebtedness to the rest of
the world continues to increase from an already
startlingly elevated level. At some unknown point the US may
stop being credit worthy.
EUR-USD.jpg)
Comment on this forecast
Background of 2008
financial crisis
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US property boom goes bust
After years of rapidly rising property prices, boosted by a
surfeit of liquidity, the decline in the US housing market which
got underway early in 2006, and then gathered pace, led to
rapidly growing defaults on subprime mortgages. The first
warning shots of an impending financial crisis came from the
bankruptcy of two US mortgage lenders, one towards the end of
2006, the other in Apr'07.
The first substantive manifestation of trouble in the financial
markets then came in Jun'07 when two highly leveraged hedge
funds run by Bear Stearns suffered severe losses on subprime
mortgage backed securities. This led to a collapse in the prices
of ever wider types of asset backed securities.
A long interlude followed with sporadic difficulties in the
financial sector more or less contained by various interventions
by the authorities. The majority view was that the financial
institutions would somehow muddle through and that economies
would continue to grow, if at a more subdued pace.
Lehman bankruptcy shuts down global financial markets
The concrete manifestation that the underlying financial
situation had deteriorated to the point of becoming
catastrophic, arrived more than a year later with the bankruptcy
of Lehman Brothers in Sep'08. Fears that other institutions may
follow and the general lack of transparency (who held toxic
assets?) resulted in the evaporation of trust. Large sections of
the financial markets shut down, depriving the economy of
capital.
Many companies and other institution which depended on borrowing
for their daily operations were cut off from funds. Bank
failures were only averted by state support. The deep
integration of global financial markets meant that America's
problems rapidly spread to the euro zone and elsewhere. It
turned out that euro zone banks and other European financial
institutions were major holders of American securities which had
become "toxic".
Securities slump
The earlier credit boom led to excessive borrowing and asset
price bubbles. After bursting, deleveraging set in which put
asset prices on a downward spiral. The steep loss in value of
previously highly regarded innovative securities brought severe
liquidity problems and even insolvency to many banks and other
financial institutions. Particularly those institutions suffered
which borrowed short term in rollover money markets and invested
in longer term assets which lost value and/or became illiquid.
Then the adverse feedback loop between the real economy and the
financial sector put the whole economy on a steep downward spiral.
"Moral hazard"
Besides the granting of mortgages to people who could not afford
them, the quality of loans generally had deteriorated under the
originate-to-distribute model of securitisation. As the
originator of the loan intended to sell the loan on, less
attention was paid to the creditworthiness of the borrower
("moral hazard").
Insufficient spreading risk
In the course of the intermediation process the credit risk was
to be transferred down the line, from lender to investor. This
dispersal of risk was supposed to make the financial system
safer. In reality banks, often indirectly through off-balance
sheet entities, remained substantial holders of the debt instruments. Credit
risk did not sufficiently pass to investors outside the banking
system.
Negative feedback loop: damage of deleveraging The severe losses on the securities owned by the banks reduced
their capital, impelling banks to curtail or withdraw loans.
This in turn forced borrowers (such as hedge funds) to sell
assets, bringing further declines in asset prices. This in turn
reduced the value of collateral on secured loans.
As economic activity decelerated, losses on loans made to
companies outside the financial sector also began to accelerate,
depleting bank capital further. And so the vicious spiral
spiralled on. The spiral of deleveraging did more damage than
the raft of measures to aid the banks could repair.
Having been so badly burned, banks sought to get back on a
healthy financial footing. Among these measures, however, were
those which pushed the economies deeper into recession. Lending
was cut back to all but the most credit-worthy borrowers. High
interest rates were charged on loans in spite of the deep cuts
in official interest rates. Various fees were increased, loan
covenants made more restrictive. Internally, banks cut costs and
staff. Policy makers in uncharted waters: uncertainty reigned At each downward lurch of the financial markets the authorities
took palliative measures, which, shortly afterwards, were
overtaken by a renewed downward lurch. Whereas the US
administration accepted that all the monetary and fiscal levers
needed to be activated to cushion and shorten the recession,
there was much uncertainty about which measures would do the
job.
In the euro zone it took a while before the severity of the
crisis registered. Initial counter measures by the monetary
authorities were restrained. The pace was subsequently upped,
though the feeling lingered that the countervailing measures
lagged behind those being taken by the US and behind those that
were needed.
Co-ordinating the euro zone response: difficult Though a plethora of measures were eventually taken, it is
inherently more difficult for the block of sixteen countries in
the euro area, or the 27 countries of the EU, to make an
efficient and timely response to a global crisis such as the
recent one. Many vital functions are still in the national
domain (notably fiscal policy and bank supervision). A unified
approach had to be agreed upon among sixteen, or 27, member
countries with divergent interests. Another difficulty is that the ECB is expressly prohibited from
bailing out individual countries which may be unable to roll
over their debts. Individual countries are unable to monetise
their debt (i.e. print money) as the ECB is the sole note
issuing authority. The (young) ECB is also still preoccupied
with cementing its anti-inflationary credibility and for long
was widely perceived as being "behind the curve".
The European Commission is charged with ensuring a level playing
field in the single market. Any support measures taken by
individual countries have to be investigated (and usually
require approval) by the Commission to ensure that the
competition in the single market is not distorted by bestowing a
(unfair) benefit on a company, or a sector. This narrows the
scope for supportive measures and causes delays.
The blame game: ex-Fed Chairman Greenspan from hero to
villain Some see the reason for the
financial crisis in the expansionary US monetary policies
pursued by the US Federal Reserve. Under the chairmanship of
(the previously much acclaimed) Alan Greenspan, US interest rates were kept too low for too long,
allowing lending to spiral out of control. This criticism
is coupled with too great a faith in self regulation by the
financial markets which led to inadequate supervision by the
authorities of the financial system.
Cheap money and lax oversight produced the catastrophe.
The blame game: China's current account surpluses
After the 1998 financial crisis in the developing
countries, Asian developing countries, China in the forefront,
adopted export-led growth strategies based on undervalued
currencies. Large current account surpluses resulted, boosting
foreign exchange reserves. These were mostly invested in US
treasuries. These capital inflows into the US made for abundant
liquidity in the US economy, depressing interest rates and bond
yields and encouraging excessive lending.
Under this view Greenspan can be seen as an agent rather than an
independent actor.
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ABOUT EUROECONOMICS
Euroeconomics was formed in London, UK, in 1987
by Krafft Holtz (German national). Since 2000 it has operated
out of offices in Cheney Longville in the county of Shropshire,
England.
Most of the work of Euroeconomics has been directed at the
European economy and, since 1999, at the euro zone. Its client
base has mainly been major European banks, particularly Swiss
and Liechtenstein banks. It has also written reports on a
variety of other economic topics.
Before founding Euroeconomics Krafft Holtz was for eight years
General Motors’ Director for European Economics, based in
London. He started his economics career in Paris, France, with
an eight year stint at Eurofinance.
Contact us:
EUROECONOMICS
Cheney Longville
Shropshire
SY7 8DR
United Kingdom
Tel: 44 (0) 1588 676 107
e-mail: euroeconomics@btconnect.com
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