Spain
The Worst Is Yet to Come
November 17, 2008

By Carlos Caceres | London

Economic Outlook for 2008-10: Back to the Early 1990s

As recently as August, we considered the possibility of a significant contraction in the Spanish economy similar to that recorded following the ERM crisis, in which real GDP fell by 1.0% in Spain in 1993 (see Spanish Banks: Testing an ERM Crisis Replay, August 4, 2008). At the time, we attributed only a small probability to such a gloomy scenario. However, with the ongoing correction in the construction sector, combined with turmoil in financial markets and a poor outlook for the European and global economy (we are now expecting GDP growth in the euro area around -0.7% in 2009 – see Euroland Economics: Cutting Forecasts Further, November 10, 2008), we think that the ‘ERM crisis’ scenario has now become the most likely scenario. Indeed, we expect the Spanish economy to experience a 1% fall in GDP growth in 2009, and to see only a timid rebound the following year, with real GDP growth around 0.5% in 2010.

Construction Activity Is Slowing Sharply

The construction sector is experiencing a significant slowdown. Most activity indicators for this sector show a continuously deteriorating picture since the beginning of 2007. In fact, construction investment contracted in the previous two quarters – for the first time since 1999 – and is likely to have fallen again in 3Q08. Construction approvals are falling by more than 60%Y. Once the main engine of growth and job creation, the construction sector will likely experience a noticeable correction in the next couple of years. On our forecasts, construction investment is likely to fall for at least three consecutive years (2008-10). This time round, construction investment will likely be the weakest link in the Spanish economy.  

Corporate Investment Is Likely to Fall as Well

The private sector in Spain, and in particular the (non-financial) corporate sector, is highly geared. Thus, a tightening of credit conditions will likely affect the Spanish economy significantly. In particular, corporate investment would be the clear victim of a protracted ‘credit crunch’. In addition, the expected earnings recession throughout Europe (see European Strategy: Back to Basics: The Earnings Recession, October 27, 2008) is likely to induce companies to cut further their investment plans in the coming quarters. The combination of falling construction investment and that of machinery and equipment will represent a double blow for overall fixed investment in this cycle. We have penciled in a contraction in overall investment of around 1.4% this year, 5.1% in 2009, and 0.9% in 2010.

House Prices Likely to Fall in the Next Couple of Years

Real house prices have been falling (on a year-on-year basis) since the beginning of this year. Nominal house prices have just reached a standstill in September. This compares to growth rates above 15% in 2002-05. Indeed, we expect house prices to fall noticeably in the next couple of years. This phenomenon could be amplified by a collapse in mortgage loan growth. Furthermore, we think that any sudden and sharp correction in the current account deficit – which cannot be accompanied by a depreciation of the nominal exchange rate – could put significant downward pressure on Spanish asset prices, and in particular, on property prices. Overall, we think that house prices could fall by around 25-30% from peak to trough, according to our forecasts.

Private Consumption Would Not Escape the Downturn

We think that private consumption growth is likely to have remained in positive territory in 3Q08, thanks to the tax rebate. Indeed, we think that the €400 cheques sent back to the taxpayer are likely to have had a positive effect on private consumption in 3Q08, although we believe that around half of this rebate is likely to have been saved by the recipients. However, we think that consumption is likely to show a clear contraction in 4Q08, partly as a payback from the tax rebate, and partly due to the sharp deceleration in employment growth, which will certainly contain real disposable income growth despite the ease in inflation. In fact, despite the sharp falls in headline inflation, the ‘misery index’ (unemployment + inflation) has remained broadly stable in the last couple of months, due to the sharp rises in the unemployment rate in Spain. We think that negative employment growth, combined with the negative wealth effects from falling equity prices, will take their toll on consumption in the next few quarters. (Although these wealth effects are still important for Spain, the latter are smaller than in countries like the US or the UK. In fact, this is even more the case for house prices, as mortgage equity withdrawals, home equity loans, piggyback loans, etc. are extremely rare in Spain. Hence, we expect the wealth effects from the fall in house prices to be rather small in Spain.)

Infrastructure Spending Remains a Story for 2H09, or Later

With the tax rebate now a thing of the past, we turn to the ‘second phase’ of the fiscal package announced by the Spanish government. This consists of an infrastructure spending plan amounting to around 2.5% of GDP. We reiterate here the fact that we view this public capital expenditure as positive for the Spanish economy in the long term. Yet, we think that the effects of the latter are likely to be too little, too late to prevent a sharp fall in output in 2009. In fact, this fiscal stimulus is likely to become apparent only from 2H09 onwards, and in this way, it should prevent another full-year contraction for the Spanish economy in 2010. This fiscal stimulus, however, will obviously come at a cost. Overall, we think that the respectable fiscal surplus recorded by the government in 2007 (close to 2.2% of GDP) will soon turn into a sizable deficit. Indeed, the fiscal deficit is likely to reach close to 3.0% of GDP in 2009.

Risks to the Economy Are Still Skewed to the Downside

Despite the rather gloomy scenario described here, we think that risks to growth in Spain are still skewed to the downside. First, the ‘credit crunch’ and the banking crisis might prove longer lasting and more severe than we are currently expecting. This could prove to be important for both corporate (capex) and construction investment. In addition, loan defaults could rise sharply, inducing a vicious circle of shrinking credit supply and a further weakening of the economy, which in turn implies further loan defaults. Second, the fiscal stimulus might have a more muted effect than we expect, and the savings ratio could increase significantly in anticipation of higher taxes in the future. Finally, the exposure of Spanish corporations to emerging markets could switch from being a blessing to a curse. Indeed, taking these risks into account, in our bear case scenario we envisage the possibility of seeing GDP falling by almost 2% in 2009, followed by another contraction (-0.3%) in 2010.

Currencies
The RUB – Eastern Europe – EMU Nexus
November 17, 2008

By Stephen Jen & Spyros Andreopoulos | London

Summary and Conclusions

The next pressure point in the currency markets could be Russia-Eastern Europe-Eurozone nexus.  We continue to believe that the bias of risks is skewed in favour of the dollar, against the European currencies and most EM (emerging market) currencies.  While the dollar has traded sideways against these currencies for much of the past three weeks, it has just begun to rally again due to the slowing global economy.  We expect this strong-dollar trend to continue well into 1H09, with the immediate pressure point being centred on the Russia-EE-Eurozone nexus.  

A Weakening Global Economy Should Be Dollar-Positive

While market positioning and ebb and flow of risk-taking are important in the short run, the broad trend of the global economy, in our view, will be the overwhelming driver of currencies.  Specifically, we have been arguing that, as long as the world drifts towards a deep recession, it is likely that risk capital will be retracted from the European and EM markets, back towards the two favourite ‘funding currencies’ – the US dollar and the Japanese yen.  In other words, as the global economy falls into a recession, the world will move up on the left side of the ‘Dollar Smile’. 

When the global business cycle approaches its trough, we will be ready to take profit on the long-dollar strategic posture, and be prepared to see a bit of a ‘give-back’ in the dollar strength.  We expect the dollar rally to be front-loaded in this down cycle partly because the rising US private savings rate – which we suspect will be a powerful trend in the coming year – should temper the vigour of the prospective US recovery several quarters from now (see A Fundamental and Critical Reconsideration of EM, November 6, 2008).    Even though the US C/A deficit is likely to be compressed at a rapid pace in the coming quarters, we suspect that the dollar will likely be punished then for the sub-par US recovery pace, rather than rewarded for the smaller C/A deficit. 

Given that the global economy appears to have just commenced its recession, it is important that investors, for now, focus on the rally in the dollar.  The time to look for the dollar to plateau may be three to six months away. 

Pressure on Russia and Eastern European (EE) Currencies

Pressures continue to mount on the RUB basket peg.  The CBR (Central Bank of Russia) has announced that its official reserves declined from around US$600 billion in early August to US$485 billion in late October.  Since then, Russia’s official reserves have declined further to US$474 billion.   (The OSF (Oil Stabilisation Fund) and National Wealth Fund together account for US$197.4 billion of this total. We are grateful to our colleague Oliver Weeks for supplying the exact figures.)   This rapid pace of official intervention averages out to be around US$10 billion a week during this period.  Russia still runs a large trade surplus position of around US$17 billion a month, despite the lower oil prices, while net capital outflows average US$8 billion a week.  These are very sizable outflows. 

Intensifying pressures on the RUB, if they persist, could have a negative contagion effect on the EE currencies, including those of the countries receiving IMF assistance.  The IMF’s SBAs are not meant to immediately stabilise currencies.  (The IMF’s Stand-By Arrangement is not meant to halt the slide in the currency of the country in question.  Rather, it is meant to reform the economy so as to prevent the next balance of payments crisis.  This is why, more often than not, currency depreciation continues despite the commencement of an IMF program.)       

EUR, GBP and CHF to Be Negatively Impacted

The main channel through which stresses and strains in EE could be transmitted to the Eurozone, the UK and Switzerland is bank loans.  As we wrote in Europe More Exposed to EM Bank Debt than the US or Japan (October 23, 2008), as a percentage of GDP, European and UK banks are five times more exposed to EM – especially to EE – through bank debt than the US and Japanese banks.  This dramatic shift in Europe’s exposure to EM may be fuelled by petrodollars deposited with European and UK banks by oil exporters.   (Although we have no hard evidence, we suspect this to be the case, as follows: In Econ 101, we learned that, back in the early 1980s, the Latin American debt crisis had its origin rooted in the surge in oil prices in the mid- and late-1970s.  Massive petrodollar flows into American commercial banks were recycled into floating-rate loans to Latin America.  But when the interest rates in the US began to rise in 1981, Mexico began to struggle with its repayments on these debts, which were eventually defaulted.  Ultimately, in 1989 Treasury Secretary Brady introduced ‘Brady Bonds’, which allowed Mexico and other highly indebted countries to repay parts of the defaulted loans.  It is possible that, a quarter of a century later, there is a link between petrodollars and EM bank loans.  However, this time around, petrodollars may have been deposited with European banks, which in turn lent aggressively to EM economies in all three time zones.  Assuming that this thesis is correct, sharply lower oil prices will constrain the recycling of petrodollars, and constrained risk-taking appetite of European banks could choke off loan flows into EE.)

The mutually reliant relationship between the EMU and EE – EMU banks with large exposure to EE, and with the bulk of EE’s exports going to Europe – has led to the ECB extending liquidity support for Hungary.  It seems likely that such an arrangement will be broadened for several other countries in EE.  One question is whether the ECB will be able and wiling to extend the same liquidity support for Russia, if that proves necessary.  In any case, investors need to start to ask whether the ECB’s operations in non-member countries will ultimately erode the intrinsic quality of the EUR. 

While Europe and the UK’s bank exposure to EM is about 21% and 24% of GDP, respectively, Switzerland’s exposure to EM is around 50% of its GDP.  Historically, CHF is seen as a safe-haven currency, just like JPY and the USD.  However, with this rather special concern, we are no longer convinced that CHF could perform like a safe-haven currency in this cycle.  The JPY tends to rally in bad times mainly because of Japanese investors repatriating their overseas investments; the dollar rallies as risk rises because EM investors expatriate into the USD and, more recently, American investors repatriate.  CHF’s performance as a safe-haven currency, however, is likely to be propelled not by Swiss investors repatriating (the Japan model), but by non-Swiss investors expatriating into CHF.  While the dollar could rally despite the problems in the US, we are not convinced that CHF could do the same: CHF is not the USD.  Being aware of the Swiss banks’ exposure to EE, we doubt that non-Swiss investors will hide in CHF. 

EMU: Little Risk of Breakage, but Risk of Stress Fracture

The structural integrity of the EMU is being questioned.  My colleague Joachim Fels commented on this issue (see “Euro Wreckage? A Remix”, The Global Monetary Analyst, November 5, 2008).  This issue will not go away.  Investors know that, in history, no monetary union without political union has ever survived.  Since the EMU is being stress-tested for the first time since its inception, nothing should be ruled out.  We have these thoughts to add to the discussion: 

First, stresses and strains on the individual EMU member countries could expose the structural ambiguities of the monetary union and raise the risk premium of EUR assets.  For example, Austrian banks’ exposure to EM is the highest in the world – at 85% of GDP.  If much of this debt is defaulted, and if Austria’s government is forced to bail out its banks, will Germany or other EMU members provide a backstop for Austria’s government?  The lack of a federal fiscal framework is at the heart of this ‘risk premium’ for the EUR. 

Second, as a result of the lack of federal fiscal framework, individual countries’ sovereign bond markets should show wider spreads relative to German Bunds.  These spreads effectively make the ‘EUR sovereign bond market’ more fragmented.  In other words, from the perspective of an Asian bond investor, for example, no longer is there a collection of similar bond markets to access to build up a certain exposure to the EUR.  While the US still has a monolithic – and therefore very liquid – US Treasury market, Euroland will have a collection of increasingly fragmented bond markets.  The greater the stress on the EMU, the more fragmented these markets become, and the greater the ‘risk premium’ attached to the EUR. 

Third, one key difference between the EMU and the US is ‘sovereignty’.  The lack of total political union in Europe is the fundamental reason, in our view, why European economic policies tend to be rules-based, while US policies are more discretion-based.  We fear that the relaxation of the Maastricht Criteria (on fiscal deficits and debt) on the existing members and the risk that euro-aspirant countries may be allowed to become EMU members on an expedited basis could undermine the structural integrity of the EMU.  If those aspirants are subject to legitimate macroeconomic misalignments that make some of these currencies particularly vulnerable, the EMU won't help them. 

Bottom Line

We continue to look for further USD strength, as the global economy descends into a deep recession.  The next pressure point, we suspect, could be the nexus of Russia-EE-EMU.  Pressures in EE will continue to expose the structural ambiguities of the EMU.  While outright breakage of the EMU is still unlikely, ‘stress fractures’ are a legitimate risk, as extraordinary policies by the EMU to ameliorate short-term shocks ultimately undermine the structural integrity of the EMU.  The dollar rallies both because of cyclical reasons as well as it being seen as a superior reserve currency.

Global
Policy Measures to Match the Deeper Recession
November 17, 2008

By Manoj Pradhan | London

2009 is shaping up to be a lot worse than our global economics team envisaged just a month ago. The global economy is now expected to register just 1.7% growth, down from a 2.5% expectation in October. Growth in the industrial economies will likely contract nearly 1% in 2009 while inflation should fall sharply. Headline inflation in the US is expected to go into deflationary territory for some time in 1H09, but we see this as a temporary phenomenon rather than a sustained period of negative inflation. Emerging market economies are expected to slow down also but there is a lot of differentiation among regions for the growth outlook. We expect Asia ex-Japan (AXJ) and China in particular to consistently outperform other regions of the world, while the CEEMEA and Latin American economies should experience a sharper slowdown.

The monetary and fiscal policy stimuli that have been put in place or are expected to likely gain traction in 2H09, leading to a slow recovery in 2010. We expect policy rates in the industrialised economies to start slowly moving back towards neutral in 2010 after spending 2009 in expansionary territory. In emerging market economies, most central banks are likely to take rates lower in 2009, but 2010 serves up a mixed picture. We expect policy rates across and within regions to either stay at the trough of the policy rate cycle or move up gradually.

Of the 36 central banks that our economics team covers, 27 banks (over 75%) will show policy rates lower by the end of 2009 than they currently are, with five policy rates moving higher, on our estimates. The notable hikers are the central banks of the UK, Russia and Israel. The Brazilian central bank’s next move is expected to be a hike but policy rates should end 2009 lower than they are now. By end-2010, the hikers club will have eight members, with the US, Canada and Switzerland pushing rates higher.

The Global Policy Machine

The global policy machine has demonstrated in ample measure by now that it will go as far as needed in order to stem the risk of systematic collapse. The coordinated policy rate cut by six major central banks on October 8 seems to have acted as a catalyst or a signaling device. Central banks around the world have since responded by cutting policy rates earlier and faster than anticipated. Governments have also been hyperactive, responding first to stem the risk of further bank failures and then turning their attention to reviving economic activity.

G10 Central Banks Lead the Way

In the G10, the slowdown in economic activity is severe enough to convince central banks that inflation is not currently a problem. Concerns about a deflationary outcome in the developed countries highlight that inflation expectations are not a constraint, giving central banks more latitude to cut rates. In fact, while nominal rates are more importance to markets, central bankers think in terms of real rates and the rapid fall in inflation, which means that real policy rates are not falling as fast as nominal rates.

Our US team expects the Fed to cut rates further before the year is over to 0.5% and keep rates there for the duration of next year before raising them to 3% by the end of 2009. The ECB will likely ease more gradually, reaching 2% by 2Q09 and then moving back towards neutral by 2Q10. Our Japan team now expects a return to ‘zero interest rate policy’ (ZIRP) by 2Q09. A moderate move above the 0% floor is expected only in the latter half of 2009.

After the unprecedented 150bp cut by the Bank of England, our UK economics team thinks that the single most likely outcome is for rates to stay on hold at the current level of 3% through 2Q09, followed by a gradual move to 4.5% by the end of 2010.  Other central banks in the G10 are expected to follow a roughly similar path, with an upward drift in policy rates in 2010.

With downside risks to our global forecasts, other central banks could join the BoJ in adopting a ZIRP regime. Some central banks are already allowing their balance sheets to expand in an effort to supplement traditional interest rate policy with ‘quantitative easing’ (QE). Monetary policymakers also retain the option of targeting other market interest rates or interest rates further along the yield curve.

These are strong actions and options and their impact on the economy should not be underestimated. What will make these policies more effective is that the deterioration of international credit markets has produced a forced synchronisation of business cycles, policies and asset prices in emerging and industrial economies. We believe that these policy measures will begin to gain traction in 2H09, leading to a slow recovery for the industrial countries in 2010. However, the economic recovery will also bring with it upward pressure on commodity prices and an increase in inflation in the industrial world from 1% in 2009 to 2.2% in 2010. Breakeven inflation rates in the major economies do not reflect these developments. The risk of inflation is not negligible if central banks keep monetary conditions easy for longer to ensure economic recovery. After all, such a strategy has some parallels to the easy monetary conditions following the 2001 recession, which sowed the seeds of the last inflationary episode.

EM Central Banks Selectively Reading the Script

In emerging markets, there is a greater differentiation of policy responses from central banks.

AXJ: Central banks in the AXJ region have moved decisively to support growth. Led by the Reserve Bank of India (150bp of cuts so far) and the People’s Bank of China (81bp of cuts so far), most central banks in the region are expected to continue to cut rates further through 2009. Qing Wang thinks that the PBoC will take rates to 5.31% by 2Q09 and stay on hold for the foreseeable future after that. Chetan Ahya, however, sees a trough for RBI policy rates at 6% by early next year, with rates gradually moving to 7% by 4Q10. Within the AXJ region, monetary and fiscal policy responses will differ depending on current account surpluses/deficits, fiscal positions and the dependence on capital flows.

Latin America: Policy rates in Latin America are close to their peak. Our Latin America Economics team sees another 50bp of hikes to come in Brazil and Peru, but thinks that Mexico and Colombia are most likely done hiking. Risks are rising for the Chilean central bank to stop its hiking cycle. Policymakers have continued to keep real policy rates higher in this region than the rest of the world. Recent signs of a shift to lower growth have not convinced central banks that inflation is under control in a context of sharply weaker currencies across the region and uncertainty about the potential pass-through to inflation going forward. Brazilian rates are expected to peak at 14.25% (50bp higher than the current rate) by the end of the year, with rate cuts starting in 4Q09 taking the policy rate to 12.25% by end-2010. Mexico is an exception, with growth more at risk there than in the rest of the region. Accordingly, our team sees rates in Mexico going from 8.25% currently to 4.5% by end 2010.

CEEMEA: The EMEA region has witnessed considerably greater economic turmoil than AXJ or Latin America. Recent hikes there have been for the defence of the currency, but we expect gradual easing of policy rates, with the exception of Russia and Ukraine (where rates are likely to go higher). Oliver Weeks believes that Russian rates will climb further on top of the recent 100bp hike to reach 12% by the end of 2009. A combination of higher policy rates and ample reserves should be enough to see the Russian economy through this turbulent period, though risks from capital flight and oil prices should not be overlooked. The vulnerability of economies in Eastern Europe depends on their exposure to foreign currency liabilities, size of bank lending and terms of trade shocks. Hungary and Ukraine are the most susceptible economies in the region, but will likely tide over the crisis with IMF funds. IMF packages could mean restrictive fiscal policy at a time when the economy needs stimulus the most. Finally, we expect interest rates in Turkey to stay on hold through part of 2009 to stay watchful for currency and inflation developments, and ease gradually thereafter. Israel, on the other hand, will likely have policy rates fairly steady in 2009 and follow the Fed on its way up in 2010.

Our global economics forecasts indicate that the AXJ region will see the most pronounced benign improvements in inflation. This is in direct contrast with the CEEMEA and Latin America theatres, where inflation will likely fall but consistently and significantly exceed global inflation over the next few years. This contrast likely explains the alacrity of monetary policymakers in the AXJ region in cutting rates. Latin American and CEEMEA central banks (with the notable exception of Russia and Ukraine) are expected to cut rates gradually, but the constraints outlined above will prevent them from cutting fast enough to support growth in the near term.

It is important, however, to keep in mind that the transmission mechanism for monetary policy in emerging economies is not as clear-cut or stable as it is in the industrialised economies even under normal market conditions, and is likely to be quite impaired, given the dislocations in global financial markets. A combination of rate cuts and fiscal stimulus packages is therefore a likely development in economies that are most concerned about growth.

The Monetary-Fiscal Policy Mix

Most of the fiscal measures announced in the G10 region until the end of October have been directed towards recapitalising banks or providing guarantees against liabilities of financial institutions. Where governments have taken a stake in financial institutions, government spending is best seen as an investment (see Do Global Financial Assistance Plans Menace Inflation and Sovereign Debt? Miles/Berner/ Greenlaw, October 21, 2008). However, more recent discussions and announcements of fiscal policy around the world – notably in the US through the incoming administration, the UK as discussed by Prime Minister Brown and in China where a sizeable fiscal package has been announced – are the more garden-variety discretionary fiscal policy measures. Because of the nature of this global recession and the slow recovery, fiscal stimulus packages are likely to be passed swiftly and will arrive in time to help with the process of economic recovery. However, an increase in indebtedness through these fiscal programmes could raise the risk of an inflationary outcome should central banks monetise the debt at some point in the future. This is likely to be a greater concern in emerging economies where monetary and fiscal policy measures often intertwine to support growth.