Enough Italy Bashing
Oct 25, 2006
Eric Chaney (Paris)
The downgrade of Italy by two credit rating agencies is likely to re-invigorate a theory that has some popularity in the financial markets, namely that Italy could well be the first casualty of an ill-conceived monetary union. The rationale: Italy has suffered from a huge loss of competitiveness, its productivity is at a standstill and its public debt is running out of control. Real life has demonstrated that the country cannot compete with her neighbours on a level playing field, i.e., not without the repeated ‘shots in the arm’ provided by devaluations. According to this line of reasoning, investors should ultimately impose a higher risk premium and, as debt servicing becomes more costly, their pessimism would turn into a self-fulfilling prophecy: Italians would start dreaming of a 1992-style devaluation as the only way to bail out their flagging economy, at the expense, of course, of their main trading partners.
I am afraid that the script of this horror movie is based on flawed macroeconomic analysis and poor use of dubious statistics. On the contrary, I believe that Italy is on the mend and likely to attract considerably more foreign capital than it has done in the past. First, three key hard facts do not square with this ‘Italy bashing’. Since the inception of EMU, Italian GDP has increased by 1.33% per year versus 1.31% for Germany. I wonder which economy was the sickest. Italy’s trade balance was in perfect equilibrium in 2005, with the non-oil balance posting a hefty 2.4% GDP surplus. In contrast, Britain’s and Spain’s trade deficits were, respectively, 5.6% and 7.6% of GDP last year. Last, Italy’s harmonised unemployment rate dropped from 11.4% just before EMU started, to 7.4% on the latest reading, only two points above the UK level. This is a much larger decline than in France or Germany and comes second only to Spain. Italy bashers, who are at pains to explain how a lame duck could manage to reduce unemployment without fuelling wage inflation, may question the quality of unemployment statistics. However, these measures are based on large-sample household surveys and are therefore more reliable and consistent than claimant counts, which are reliant on national unemployment insurance systems. Nevertheless, they have some idiosyncratic features on which I will comment later. So why are so many analysts convinced that Italy has been priced out of the game by super-competitive Germany? Because they look at measures of competitiveness such as unit labour costs or export volumes. On these criteria, the Italian situation looks truly desperate. Take, for example, the relative unit labour costs in the manufacturing sector calculated by the EU Commission. On this measure, Italy’s competitive position relative to its euro area partners has lost 23.5% since 1999 while Germany’s position has improved by 17.6%. There is worse to come: on the OECD measure of real export market performance, Italy has lost 27 points of market share since 1999, twice as much as France, while Germany has gained 4.1 points. Clearly, something must be wrong: how could an economy suffering enormous losses of competitiveness boast a falling unemployment rate and a balanced trade account? In my view, both unit labour costs and export volumes are tainted by serious statistical uncertainties. Starting with unit labour costs, the weak link is not the measure of costs, but that of productivity, a notorious headache for statisticians. On data gathered by the US Bureau of Labour Statistics, Italian hourly productivity in manufacturing was the same in 2005 as it was in 1999, while it increased by 27% in Germany and France over the same period. I find it hard to believe that Italian hourly productivity has really stagnated for six years, and suspect that a combination of large-scale regularisation of illegal immigrants and tax incentives for employers to hire employees who were working without being recorded in payrolls have distorted productivity data. In short, hundreds of thousands of workers in Italy have moved from the black to the legal economy, artificially bringing down productivity data and probably flattering unemployment numbers as well: It is likely that black economy workers answered ‘No’ when asked the question ‘Are you working?’ in the household survey, and now say ‘Yes’ if they have been hired legally in the meantime. In fact, since the output of the underground economy is included in GDP as measured by ISTAT, it is fair to say that both past productivity and past unemployment levels were artificially inflated and that current data are closer to reality. From this angle, the fact that a four-point cut in the unemployment rate did not fuel wage inflation becomes less intriguing: in reality, unemployment has declined less than official measures suggest. Back to productivity, the rate of growth was underestimated because of these changes in the structure of the labour market. In the real world, hourly labour productivity has probably increased in Italy about as fast as in the average of mature economies, as a result of technological progress and capital deepening. The problem is that we do not know exactly at what rate. Turning to exports, here is the conundrum: standard indicators say that Italy’s competitiveness has been seriously eroded and, yet, Italian exports are doing well, compared with its peers. On OECD data, Italy’s market share of global trade, measured in current dollars, was 3.7% in 2005 versus 4.1% in 1999, a 10% decline. The OECD bloc suffered from the same loss — its market share dropping from 74.5% to 66.9% over the same period, in favour of China and oil-exporting countries. A more relevant measure of Italy’s export performance is to compare its nominal exports with those of the euro area. On this yardstick, the only one that really makes sense in a currency union, Italy actually outperformed its peers: Italian nominal exports have increased by 4% more than the average of EMU country exports since the inception of the monetary union. Here, I believe that the statistical flaw is in the measure of prices. In reality, for lack of a direct measure, ISTAT is using unit values, i.e., export values divided by quantities. When the euro shot up, in 2002-03, a very counterintuitive fact was that Italian export ‘prices’ (in fact unit values) increased. In my view, this point, which escaped analysts’ attention, reveals the underlying and hidden truth: Italian producers have reacted to globalisation by off-shoring production centres to low-cost countries such as Romania and Tunisia and, more importantly, by upgrading their product mix towards more expensive products, in the fashion sector to take a well-known example. Here again, the problem is that there is convincing indirect evidence, such as the export performance, that corporate Italy has changed for the better, but no direct and reliable statistics. Don’t get me wrong. I’m not saying that Italy is the new corporate Eldorado or the next stellar macro performer in Europe. The public debt inherited from the past is a permanent sword of Damocles. Labour laws, especially redundancy rules, are rigid, corporate governance is weak, the internal market is inefficient, especially for services, the commercial property market is opaque and in the hands of a small group of investors, bureaucrats and their love affair with ‘documenti’ are not particularly business-friendly, the population is ageing, pension reform is still ‘a work in progress’ and healthcare reform is still in limbo. And yet, at the margins, Italy might be the place where change is taking place at the greatest speed. In this regard, Mr. Prodi’s strategy is the right one, I believe: commitment to budget consolidation, reduction in non-wage labour costs in order to boost employment and reduce further structural unemployment, and supply-side reforms such as the liberalisation of services. In fact, I would have a wager that the credit rating agencies may sooner rather than later have to re-evaluate the Italian case in a more positive light, given faster potential growth and lower budget deficits. Investors should not wait until then.
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The Distribution of Risks About Monetary Policy
Oct 25, 2006
David Miles (London)
It is always nice to get a simple answer to a simple question. The trouble is that many questions that sound simple are not. Here is what sounds like a simple question: “Where do you think interest rates will be by June 2007?” It looks like the sort of question that can be answered with one word, and it often is - “5%”; “4.25%”; “6%”. It is unclear what the answer really means, just as it is unclear what the numbers we regularly produce in tables showing forecasts really mean. Are they an assessment of the single most likely outcome (the mode)? Are they an assessment of the average outcome — that is, a probability-weighted average of all the things that could happen (the mean)? Are they the outcome that is in the middle of a range of possible outcomes, so there is an equal chance things are above or below the forecast (i.e., the median)? These numbers — mean, median and mode — will not generally coincide. That will certainly be the case if the range of outcomes — weighted by their assessed probabilities — are skewed. And even when there is no skew, a single point forecast tells you absolutely nothing about risk and uncertainty. All this is of particular relevance to an assessment of where interest rates might be going over the next year. Obviously there is uncertainty about that, but it is also our assessment that the risks around any central forecast are not now symmetric. Because of that, we will now be producing simple summaries of our judgment of the relative likelihoods of different outcomes for rates. This is not an alternative to a single point forecast — it is instead a fleshing out of the economic thinking that lies behind it and an explicit statement about what that single point forecast means. Here we focus on the range of possible outcomes for UK base rate at June 2007. The probability distribution for that rate we have constructed is based on a judgement about the chances of inflation and output (and other drivers of monetary policy) following certain paths. That in turn depends on views about labour market outcomes and the degree of asymmetry between upside risks and downside risks. In weighing all this up, we rely on some formal models — for example of inflation and the degree of uncertainty about it based on past volatility — but we also add a heavy dose of outright judgement. For example, we judge that the risk that inflation expectations in the UK rise over the next few months and become reflected in higher wage settlements early next year is greater than the chance that further waves of immigration drive wage settlements even lower. This judgment — which is not based on a statistical model — gets reflected in the assessed chances of the Bank of England raising rates several times between now and June 2007. Based on our judgement on the probability distribution of UK rates for June 2007, we make several observations: 1. It is a summary of our judgment about the likelihood of different outcomes based on a range of economic factors. But it is a judgement and clearly not a statement of mathematical precision (unlike, say, the probability distribution for the outcomes of tossing a fair coin several times). Mean = 5.20%; Mode = 5.00%; Median = 5.25 2. The three measures of a central outcome — the mode, mean and median — do not in our view coincide. We think the most likely outcome for the level of rates in June 2007 is 5%; but the mean outcome is higher at about 5.2%; and the median outcome is slightly higher again. This upside skew relative to the single most likely outcome reflects our economic judgement that inflation risks are asymmetric and skewed to the upside. Output risks are likely more symmetric around our central forecast of trend growth. 3. When we have provided our single forecast for UK rates, we have consistently over many months given a central forecast of 5% for mid-2007. This was, and remains, our assessment of the single most likely outcome (the mode). But what use is having an assessment about the whole probability distribution? Some will think it enough to know ‘our call’, but with an indication of where we see the balance of risks lying: “5%, but with upside risks”. In valuing derivatives — most obviously options — knowing something more concrete is important. So one of the potential uses of showing an assessment of the chances of the full range of outcomes is that it can be compared with the distribution implied by option prices. This comparison between option-implied probability distributions and one based on a judgement about the economic drivers of monetary policy is one we aim to analyse regularly with our colleague, Laurence Mutkin.
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Solid Growth Confirmed, but Best Is Probably Behind Us
Oct 25, 2006
Sharon Lam (Hong Kong)
Today’s GDP report confirmed a rebound in sequential quarter-on-quarter growth in 3Q from 2Q. GDP growth improved to +0.9% qoq in 3Q (slightly beating consensus) from +0.8% in 2Q. On a year-on-year basis, however, GDP growth continues to show a normalization trend due to a higher base effect. GDP growth slowed to +4.6% yoy in 3Q (in line with consensus) from +5.3% in 2Q. Overall, this report is pretty much in line with expectations, and so the market impact should be muted. A brief glance at the growth breakdown: Private consumption(in line): As already reflected in weakened sentiment, private consumption growth cooled gradually (+3.9% yoy in 3Q versus +4.4% in 2Q). We expect consumption to continue to slow down as sentiment remains under the shadow of North Korea’s nuclear threat. Big-ticket item spending, which is most dependent on wealth effect and sentiment, will be most affected, in our view. Facility investment(upside surprise): Despite concerns over a slowing economy, oil prices and currency appreciation, facility investment ticked up again (+9.6% in 3Q versus +7.4% in 2Q). This capex recovery cycle has extended longer than our expectations, even though we were already relatively more bullish than the market. This again illustrates the real need for more capex in Korea, in our view, as capacity growth is falling short of production needs. As we expect external demand next year to be weaker, the growth in capex is likely to be coming to an end. Nevertheless, we should note that this capex recovery is built on a very low base — Korea’s capex growth has been sluggish for years, and therefore the coming downturn should not be significant either. Construction (in line): Construction investment appeared to have bottomed in 2Q (-1.3% in 3Q versus -3.9% in 2Q), and we are expecting no more new tightening measures from the government and no more interest rate hikes in this cycle. We look for a more visible pick-up in construction investment in 4Q, as some projects were delayed by bad weather in 3Q. Exports(in line): Exports of goods in volume terms was slightly weaker in 3Q (+13% in 3Q versus +16.2% in 2Q), indicating that there was an improvement in export prices since the total value of exports actually increased in 3Q. We expect volume to gradually ease next year due to a China slowdown. Yet, we believe that Korea’s terms-of-trade will continue to improve in the coming months as commodity prices are easing while product export prices are holding up. Exports are still likely to be the growth driver in the near term over consumption, especially in 4Q, with an expected rebound in Europe and US. Bottom line The market has been worrying about a slowing economy since the beginning of this year but it has not happened so far. Indeed, the Korean economy has remained solid, with momentum picking up in 3Q over 2Q, looking at sequential growth. While our relatively positive view on the economy has been realized, we now believe the best is probably behind us, as consumption will likely continue to slow with weak sentiment, and external demand is also expected to cool gradually into next year. Construction activity, however, should remain solid next year, but not enough to offset the consumption and export slowdown. We remain comfortable with our 2006 GDP forecast at 5.1%, meaning that 4Q growth will likely remain resilient. Yet, we expect to see a more visible slowdown in the beginning of next year. We look for 2007 GDP growth at 4.3% — slightly below trend.
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