Relevant and even prescient commentary on news, politics and the economy.

The re-balancing of trade within the Euro area: some improvement but not enough

I thought that the whole point of fiscal austerity was to turn the balance of trade and capital flow within the Euro area: debtors becoming savers and capital flows out of the Periphery and into to the core. We’re seeing the outset of such a shift; but it’s probably too slow in the making.

The chart below illustrates the trade balance (exports minus imports) within the Euro area (17) for key austerity – Ireland, Greece, Spain, and Italy – and core – Germany, France, and the Netherlands – countries. The data span the last six months and are normalized by the European Commission’s 2010 GDP estimate for each country (listed on the Eurostat website).

(Let me be clear here: the trade balances illustrated below include only trade flows within the Euro area.)

It should be noted that this is an incomplete picture, since there are 17 Euro area countries. However, the following point is worth noting: the balance of trade is arduously improving in Spain and Greece at the cost of just a small share of surplus in the core. To me, policy makers are grasping at straws when they stick to the ‘exports will grow the Periphery out of their debt problems’ story.

* The Netherlands’ intra-Euro area trade surplus increased near 2 pps to 22.6%.
* Italy’s intra-Euro area trade deficit hovered at just under -1% of GDP.
* Spain’s trade deficit improved somewhat, falling roughly 50 basis points to -0.5% of GDP – probably nothing to write home about, given that the economy’s facing a 20%+ unemployment rate.
* The Greek trade deficit improved 90 bps to -5.3% of GDP.
* Ireland remains as open as ever.
* The German surplus dropped 15 bps to 1.3% of GDP.

It is true, that the re-balancing will take time. Some will argue that it’s extra-euro area trade that will provide the impetus for growth in some of these countries (Spain, Ireland, Greece, the usual suspects). However, while exports to the extra-Euro area market have played an important role in some growth trajectories – Spain, for example – intra-Euro area trade is critical. Below I list the average share of total export income derived from within the Euro area:

Average share of exports (source: Eurostat and Angry Bear calcs)
40.9% 38.8% 41.5% 55.7% 48.6% 43.8% 62.0%
Germany Ireland Greece Spain France Italy Netherlands

How much more austerity and ‘competitiveness’ will it take to turn the tide here? Probably more than some are willing to give. A nominal devaluation is needed. Without that, it’s ultimately ‘bailout’ or ‘default’, or both.

A side note: it would have really helped if the ECB allowed prices in Germany, for example, to overshoot the 2% Euro area inflation target.

Rebecca Wilder

Greece will not be ‘allowed’ to default until policy shores up the Irish bond market

Just look at Tracy Alloway’s imagery at FT Alphaville, and you’ll know what’s expected: an imminent Greek default. I still argue no, although European policy tactics are quite enigmatic and their next move is really anyone’s guess. Alas, here’s mine.

Assuming that Greece does not secede from the Euro area, I give you three reasons why Greece will not be allowed to default soon (at least the next 12 months, given current market conditions). I say ‘allowed’ because true to the IMF legacy, EU/Euro area officials very likely see restructuring as a ‘gift’ for good fiscal behavior.

(1) Moral hazard is an important issue in Europe, and Greece has only begun its austerity program. We’ll need confirmation that they are not on track in order to assess the timing of default, in my view.

Ironically, the EU/IMF/Euro area are sticking to the ‘exports will grow the Greek economy’ story. I say ironically because Greece was exporting a larger share of GDP before the recession, average 22.6% spanning 2005-2007, than it is now, 19.8% in 2010 (average Q1-Q3).

(2) The banking system’s not ready. Unless the Germans want to instantly recapitalize the Landesbanks this year, I’d argue that the Euro banking system remains overly exposed to mark-to-market accounting (i.e. holding the assets at fair value not wishful thinking) for all of the crappy debt that it holds on balance.

In fact, the German banks purchased 11bn 1.1bn euro in Greek sovereign bonds in January. That’s the most current data available; but I bet they’re simply moving debt out of the Greek banks and corporates and into the sovereign as the probability of default rises (see chart below).

(3) This one’s critical: policy makers must shore up Ireland and Portugal in order to avoid a quick contagion across the European banking system. They haven’t done that yet. In fact, the Finnish election results exposed the tenuous negotiation process overall.

See, the Greek yield curve is inverted – so are the Portuguese and Irish yield curves, albeit to a much lesser degree. The point is, that Portugal and Ireland are very close to the Greek brink.
(read more after the jump!)

Inversion matters. Currently a Greek 10yr bond yields 14.5% with a euro price of 59, while a 2-yr bond yields 21.4% with a euro price of 73. Bond investors are going for the cheapest bond not the highest yield (at the end of the yield curve) as a bet on a binary situation: haircut or no haircut. When a curve is inverted, it’s all about price not yield.

Portugal and Ireland are already inverted and close to the Greek brink. If Greece were to restructure without a full-fledged backstop from the Euro area governments, the Portuguese and Irish curves would swiftly turn over. And if European policy makers could stop the contagion there, then that would be a true feat….

Spain, the economic ‘line in the sand’, would be next. We saw last week how markets view the Spanish sovereign, still risky. Bond yields on the Spanish 10yr broke out of a 4-month trading band, hitting 5.55% on April 18 (latest number is 5.47%).

More on Ireland

I assure you, that it’s too early to deem the Irish sovereign as impervious to the Irish banking system’s fake asset base. The banking system is living on emergency liquidity assistance (ELA) and the ECB’s marginal refinancing operations (currently Irish banks can borrow as much as they want on a short-term basis from the ECB at the current rate, 1.25%).

By my calculations, the Central Bank of Ireland (via the ELA) and the ECB are subsidizing – I say subsidizing because market funding costs are proxied by the sovereign borrowing costs of 10% – 16% of the Irish banking system’s balance sheet. As such, profit margins are thin, and mortgage rates are running low at 3-4%. (see CBI website for plenty of data.) These funding costs are not sustainable – not to mention the Irish stress tests assume that they remain fixed at Q4 2010 levels (see exhibit 2 in Appendix C of the stress test documentation). Nonperforming loans will rise.

I leave you with this illustration of possible non-performing loans when mortgage rates rise on the following:

(A) ECB rate hikes – mortgages are tied to 12-month euribor and most Irish mortgages are variable.
(B) the dissipation of record-low bank borrowing costs (this also is another post, but the ECB has yet to release its medium-term funding program for Ireland).

Note: if/when they do default, Kash at the Street Light blog provides an overview of some technical considerations.

Rebecca Wilder

ECB policy is tightening – has been for some time

Update: Nouriel Roubini front pages this post on Euromonitor here.

The ECB dove in and hiked its policy rate by 25 basis points to 1.25%. I had the pleasure of listening to Wolfgang Munchau on Thursday, and he reiterated what I reluctantly understood: the ECB’s strict inflation target is ridiculously simple for such a complex region; but more importantly, the Governing Council is just itching to tighten.

Eurointelligence blog highlights the various interpretations of the ECB’s shift in policy: Thomas Mayer at Deutsche Bank suggests that the ECB’s normalization is appropriate, while David Beckworth and others (links at Beckworth’s site) are more sympathetic to the impact on the Periphery. They highlight that relative price fluctuations could facilitate the much-needed redistribution of capital flows (i.e., the current account); and furthermore, that ECB policy is even too tight for the core (a google translation of Kantoos Economics). Yours truly has written extensively about this – among others, here’s one, another, and another. Who’s right? Ultimately time will tell.

But I do suspect that we haven’t seen the end of this crisis. The ECB is squeezing out liquidity when more liquidity is needed. Furthermore, the core remains subject to export shocks via external demand; and there’s building evidence that global growth will slow (see this excellent post on global PMIs by Edward Hugh).

It’s ironic, too. While the ECB is currently being heralded or chastised for raising rates, monetary and financial conditions in Europe have been tight for some time, both on a relative and stand-alone basis!
(read more after the jump!)

First, the ECB’s bond purchase programs, the Securities Market Programme and the Covered Bond Purchase program, amount to just 1.4% of 2010 Eurozone GDP. In stark contrast, the size of the Fed’s program broke 16% (and is rising) and the Bank of England’s purchase program remains firm at around 13% of GDP.


The asset purchase programs are emergence liquidity programs and are not normal monetary policy tools. But while the Fed and the BoE do not sterilize their flows, the ECB does. And my interpretation of ECB rhetoric and policy as of late is that they want out of the secondary-bond purchase business. For example, they’ve slowed their SMP purchases markedly in 2011 (see the ad-hoc announcements here).

Second, Eurozone financial conditions have been tightening since August 2010, while those in the US and England loosened up. Goldman Sachs constructs a financial conditions index, which is comprised of real interest rates (long and short), real exchange rates, and equity market capitalization. I love this index (subscription required), as it represents a broad measure of monetary policy pass-through.

Even though the ECB just started its rate-hiking cycle, they’ve been effectively tightening for some time.

I would say that Eurozone (as a whole) growth prospects are seriously challenged at this time, especially by comparing monetary policy to that in England and the US. We’ll see if the ECB’s able to push its target rate back to 2.5-3% through 2012 – I suspect that may be just a pipe dream, as tight liquidity and a slowing global economy drag economic growth.

The ECB’s actions imply to me that they still do not understand the following: Europe faces a banking crisis not a fiscal crisis!

Rebecca Wilder

Germany is competitive on a relative basis as measured by productivity, standard of living or prices

The point of this article is to demonstrate that Germany has enjoyed increased ‘competitiveness’ as measured by productivity levels and relative prices. But the clarity of Germany’s ‘competitiveness’ cannot be established by using German data in the form of a black box – a bird’s-eye view of the region is the only way to see this.

In a very well written piece, Kantoos highlights that the German current account surplus is more a function of reduced investment and productivity passing through to low market-clearing wages than it is ‘competitiveness’, per se. While I agree with his economic analysis, I disagree that Germany is not competitive – Italy, yes; Germany, no.
(read much more after the jump!)

The term ‘competitiveness’ is rather non-discriminatory. It can refer to a lot of things. Below, I discuss national competitiveness, i.e., measuring a country’s relative position in the global market place. In contrast, micro-level competition – firms compete in various industries for market share and profits – is not really relevant here. The fact that we’re talking about a nation’s competitiveness means that it’s not clear how to measure competitiveness. Let’s explore.

In order for Germany to be deemed sufficiently ‘uncompetitive’ globally, relatively weak productivity gains would have left German wages relatively low compared to major trading partners. And by extension, Germany’s standard of living must also have suffer compared to its trading partners. From what I can see, only relative wages have been surpressed. Therefore, I conclude that Germany is competitive.

Exhibit 1: German productivity gains over the last decade – I use the period 2000-2008, so as to not bias the results downward from the global recession – have not been striking, but positive nevertheless.


German productivity has increased on a cumulative basis compared to Euro area trading partners, like France and Italy. Notably, the Euro area average is down, which is probably biased by Italy’s 8.7% cumulative drop in productivity. So on a relative basis, Germany’s productive and second only to Spain in this sample (notably Spain gained a whopping 4.1%!). (Also, please see Chart 18 of this ECB research paper for a broader comparison – it’s a .pdf file).

Exhibit 2: Despite the relatively weak productivity gains, albeit positive I remind you, the standard of living has increased in line with other Eurozone economies, like France, and surpassed others, like Italy.

This chart, to me, illustrates that productivity gains have been ‘competitive’ enough to support decent growth in the average standard of living (as measured by real per-capita GDP from the IMF).

And to really hammer down the point, please see page 24 in a recent ECB research report, Chart 18 referenced above, on the impact of the global recession on Euro area competitiveness. Germany’s 2000-2008 annual average productivity gains are in line with many other European economy, but wage compensation is relatively muted. In fact, German average annual compensation per employee is the lowest of the cross-section (according to Chart 18). My point is, that productivity gains were not fully passed on to workers via nominal compensation gains (probably a better comparison would be real compensation per employee).

Exhibit 3: It’s all about levels; and Germany’s 2010 average income is relatively high (measured in GDP per-capita PPP dollars for comparability across exchange rate regimes).


The German standard of living (i.e., relative per-capita GDP) fairs well against a cross-section of developed economies in Europe and abroad. Average income (standard of living) is the fourth highest behind Norway (for comparison to Kantoos’ article), the US, and Canada. Italy runs low current account deficits (trade is pretty well balanced), and average income falls at the bottom of this sample. That’s very uncompetitive in the relative sense.

The second issue that I mentioned is measurement – i.e., there’s a problem with using just unit labor costs to measure ‘competitiveness’ (see a recent Naked Capitalism article to the point).

However, no matter how you look at relative prices – the real exchange rate, relative export prices, relative unit labor costs, relative GDP deflators, etc. – Germany stands out as very ‘competitive’, or at least ‘exportable’. I have no direct chart to support my previous statement; but the European Commission does. The EC publishes a quarterly report on price and cost competitiveness; and according to the most recent report, 2Q 2010 (.pdf), Germany is very competitive by any measure of relative prices(see pages 15-16 of the .pdf).

In conclusion, it’s difficult for me to see how Germany is not ‘competitive’ on a relative basis, if ‘competitive’ is either (1) standard of living and relative productivity gains, or (2) in a relative prices sense.

I would state here that within the Eurozone, a healthy rebalancing of current accounts is underway (i.e., typical creditors dissaving and typical debtors saving). This would be made much easier if the ECB would run looser policy and allow German inflation to overshoot, effectively facilitating the relative price adjustements. Please see David Beckworth’s article to this point.

Rebecca Wilder

Greece is not Argentina

I politely disagree with the conclusions of the article written by my Angry Bear colleague, Kash, where he envisages Greece defaulting in 2011 similarly to Argentina in 2001.

I do agree, that the macroeconomic initial conditions in Greece scream default (actually, if you focus just on the measurable factors, like the current account, debt levels, or fiscal imbalances, Greece is much worse than Argentina in 2001 – see Table 4 of this IMF paper to see Argentina’s initial conditions and compare them to Greece in 2009 using the IMF World Economic Outlook Database).

Where I disagree, arguing that Greece is not like Argentina, is that the debt crisis in Argentina didn’t bring down the banking system of Latin America overall. In contrast, the default of Greece has the potential to do just that in Europe.

Update: see David Beckworth’s Macro Market Musings includes Rebecca’s thoughts on ECB

In Argentina, the Latin American banking system (and sovereign bonds, for that matter) was quite resilient in the face of the sovereign default in Argentina. Uruguay was the exception, whose two largest private banks, Banco Galicia Uruguay(BGU) and Banco Comercial (BC), which account for 20% of the country’s total, saw near-term liquidity pressure and an ensuing banking crisis in 2002 (see this IMF paper for a history of banking crises). All else equal, the IMF reports only minor impact to the region as a whole:

With the possible exception of Uruguay, economic and financial spillovers from the Argentine crisis appear to have been generally limited to date—as indicated, for example, by the muted reactions of bond spreads in most other regional economies and their declining correlation with those of Argentina, together with other favorable trends in financial market access and the general stability of exchange rates over recent months.


In contrast, the European banking system is highly interconnected. For example, according to the German Bundesbank, Germany’s bank exposure to Spain was roughly 136 bn euro in December 2010, where most of it is held in the form of Spanish bank paper, 56.4 bn euro, and Spanish enterprises, 58.3 bn euro; the rest is in sovereign debt. Furthermore, German banks are sitting atop 25 bn euro in (worthless) Greek paper, primarily in the form of sovereign debt. Euro area countries are exposed to other banks AND the sovereign; but more importantly, the ones that save (run current account surpluses) are the ones holding the worthless (in some cases) bank and government debt. (read more after the jump)

Bank risk is a big risk in Europe. Based on the consolidated banking data at the Bank for International Settlements (BIS), German banks hold 22% of the Greek external debt load i.e., bank debt + sovereign debt + corporate debt), while French banks hold 32% (see Tables below). Furthermore, German banks accumulated 20% of all Irish external debt, 14% of Italy’s, and 21% of Spain’s.

So the question is, not what will happen if Greece defaults, per se; but will a Greek default set off a chain reaction liquidity crunch that challenges asset valuations in the other Euro area banking systems (for bank paper and sovereign paper)? I suspect that it will, since the European banks are still building their capital buffers.

My point is, the Germans are partial to NOT letting Greece default. All fiscal austerity aside, the Germans have demonstrated that they’d rather write a check than take the writedowns, at this time. Therefore, from this perspective, I find it very unlikely that Greece defaults this year (or next, really).

Now, you’re probably thinking: well, it’s in Greece’s best interest to default. Willem Buiter calls Greece leaving the Euro area ‘irrational’. An irrational chain of events must be put in place in order to presage such a disorderly default (see 8. ‘Break-Up Scenarios for the euro area’ in the publication). We’re not there yet, since Greece is still in asset-selling austerity mode.

It’s political repression.

BIS data representation I: in Shares of external debt outstanding (click to enlarge)

BIS data representation II: in levels of external debt outstanding (click to enlarge)

Rebecca Wilder

Europe’s industrial new orders: 3 very different stories

Spain vs. Germany vs. UK: production trends showing holes in some growth stories

Eurostat reports new orders for January:

In January 2011 compared with December 2010, the euro area1 (EA17) industrial new orders index2 rose by 0.1%. In December 20103 the index grew by 2.7%. In the EU271, new orders increased by 0.2% in January 2011, after a rise of 2.9% in December 20103. Excluding ships, railway & aerospace equipment4, for which changes tend to be more volatile, industrial new orders increased by 1.6% in the euro area and by 1.9% in the EU27.


This was a disappointing report, as Bloomberg consensus was expecting a 1% monthly gain. The Eurostat press release reports new orders by country and production type only(capital, consumer, intermediate, durable, and nondurable). However, I look at the origination of orders by region: domestic, non-domestic extra-euro (which is the same as non-domestic for the Euro area as a whole), and non-domestic intra-euro.

The idea is, that with ubiquitous fiscal austerity, Euro area countries rely on external demand for growth. So here’s my question: how’s Spain to survive? (more after the jump)

Exhibit 1: Spain’s industrial sector is barely growing amid fiscal austerity

No industrial production growth = a big problem. It’s not just fiscal austerity, per se, it’s that the economy needs plenty of nominal income gains to improve the cyclical budget deficit in order to even see the benefits of structural adjustment. The structural balance cyclically adjusts the government deficit (or surplus) for non-structural items to leave just the structural deficit (net spending on pension payments, unemployment insurance, normal capital expenditures, etc.).

Without growth to increase nominal revenues, the negative cyclical balance will keep the overall balance very much in the red. Spain needs growth! Apparently, it’s not coming from the industrial sector.


Spain was deriving quite a bit of industrial demand from within the Eurozone (the red line in the chart above) through the end of September 2010; however, that source of order growth is tapering off. Now, it seems that extra-euro industrial orders growth (the green line) may start a sideways trend, too. Normally I wouldn’t put too much stock in one data point – but with tightening across Asia and possibly the UK (not the US for a bit), slower orders growth is inevitable.

Exhibit 2: The German industrial machine

The German machine is also deriving industrial production growth from extra-euro orders. Notably, too, domestic orders have been strong. But for all of the talk about Germany’s overheating export sector, industrial production is still near 6% below its Q1 2008 level.

And finally,

Exhibit 3: The poster child for fiscal austerity, the UK.

Why? Because they’re nominal exchange rate depreciated quite markedly, allowing the trade-sensitive industrial base to find a very shallow bottom. On a trade-weighted basis, the British pound is 24% lower than in mid-2007, according to the JP Morgan nominal effective exchange rate index.

I’d like to hear how you all think that Spain’s going to get through this as the ECB raises short-term rates (for those of you who do not know my Euro-centric commentary, you can see a list of my recent commentary on the Eurozone, which includes articles on the ECB by my name on the AB sidebar), Germany slows, the US struggles to keep the consumer alive, and emerging Asia tightens its belt.

Spain’s a trillion dollar economy, and the fourth in terms of GDP in the Eurozone…

Rebecca Wilder

It’s not structural unemployment, it’s the corporate saving glut

Mark Thoma rightly points out the hypocrisy of the deficit hawks’ intent to cut spending while approving military spending in the same sentence. Ryan Avent furthers the dicussion by stating that Washington has used the ‘dire fiscal’ rhetoric to sell short-term cuts that were unwarranted, given that the fiscal problems are structural in nature.

Me, I’d argue that the fiscal deficit is simply the consequence of corporate America’s excess saving: the corporate saving glut – no I didn’t mean the ‘global saving glut’. Furthermore, the corporate saving glut is manifesting itself into the labor market, creating high and persistent unemployment. Some economists are wrongly referring to this as higher structural unemployment.

Exhibit 1: The 3-sector financial balance model demonstrates that elevated excess private saving (firms and households) keeps the government deficit in the red. For a discussion of the 3-sector financial balances, see Scott Fullwiler and Rob Parenteau; and I’ve written on this as well.

The excess saving rate for the public sector, external sector, and household sector is constructed using the Federal Reserve’s Flow of Funds accounts as: (Gross Saving – Gross Investment)/GDP. The excess corporate saving rate is the residual of the Current Account (external saving) net of government and household excess saving. If the corporate excess saving rate is positive, then investment spending falls short of asset purchases (financial or tangible).

* In Q4 2010, the household excess saving rate dropped to +3.5% of GDP
* In Q4 2010, the government excess saving rate dropped to -10.4% of GDP
* In Q4 2010, the current account deficit dropped to -3% of GDP
* In Q4 2010, the corporate excess saving rate jumped to 3.9% of GDP – this is the Corporate Saving Glut because while firms are investing, they’re saving more, thereby breaking the positive feedback loop.

The positive feedback loop remains broken: higher demand increases sales rates, revenues and production which grows firm profits that are translated into wage and income gains, only to drive demand further upward. It’s broken right between ‘grows firm profits’ and ‘translated into wage and income gains’.

The funny thing is, too, that economists sell this broken feedback loop as rising structural unemployment. Actually, unemployment is not structurally higher, it’s that when firms do not reinvest corporate profits, the lack of income flow manifests itself into the unemployment rate.

Exhibits 2 and 3. It’s not structural unemployment, it’s the corporate saving glut!

The chart below illustrates a simple univariate regression of the unemployment rate on the corporate saving glut. The correlation is very strong, 85%, and suggests that the structural unemployment rate is less than 5.8%. Furthermore, while the unemployment rate seems to be perpetually higher than normal (the upper-right circle), that perfectly coincides with a high corporate saving glut.

If the corporate excess saving glut just equaled zero, i.e., firms invested and saved at the same rate, the unemployment rate would be 5.8%. Now, if the corporate saving glut fell below zero to -2%, i.e., firms reinvested in the economy by way of capital investment in excess of saving, the simple model implies an unemployment rate of 4.7%.

The government doesn’t need to add jobs, per se, the government needs to figure out how to get corporate America to drop the saving glut and re-invest in the economy.

Rebecca Wilder

It’s lonely at the top: now it’s up to the Bank of Japan to hold the yen down

Wow, FX space is totally rattled this week: the yen hit 76.25 against the dollar at the end of the day on March 16 and has since rebounded to current levels 80.90 (1:50pm in NY on 3/18). What happened over this time span? Mass speculation on yen appreciation due to earthquake-related repatriation, followed by technical levels being hit that drove the yen up against the dollar, and a collapse of the dollar against the yen (spike downward in the chart below). And then yesterday the G7 central banks (the Bank of Japan, Bank of England, European Central Bank, the Federal Reserve, and the Bank of Canada) agreed to coordinate a weak-yen effort. Today the yen is off 2.7% against the dollar.

Note: In the chart above, a decline in the USD/YEN is an appreciation of the Japanese yen and a depreciation of the US dollar. The chart above illustrates the daily fluctuation of USD/Yen since the Tōhoku earthquake on March 11.

The coordinated depreciation of the yen against its major trading partners is ‘concerted’, and such an effort has not occurred since September 2000 when the G7 bid up the euro. The yen effort is very different, as I’ll explain below. Furthermore, ongoing weakness in the yen against the rest of the G7 currencies depends on further actions by the Bank of Japan into next week and beyond.

Some thoughts:

* In 2000 the wedge between the eurodollar spot and its PPP estimate of fair value diverged throughout the year. The spot rate became increasingly undervalued, hitting a wide in October 2000 (according to Bloomberg estimates of PPP). This seems to be a traditional initial condition for intervention. In contrast, though, the USD/YEN spot is seriously overvalued according to a similar measure of PPP fair value. I should note that currency fair value is a contentious topic. (more after the jump)

* The NY Fed makes available balances through 1999 only, so I am unable to ascertain the impact on the Fed balance sheet of the coordinated efforts from the 1987 Louvre Accord nor the 1985 Plaza Accord . I digress. In the 2000 effort, the euro bottomed in 9/21 at 0.8460 in dollars during the day, reaching an intra-day high of 0.8992 on 9/22. The closing impact of the G7 coordination was roughly a 2.7% appreciation of the euro against the USD. Efforts, however, were quickly retraced (see chart below).

* We are already there in yen space: the yen is down 2.7% in just one 24-hour session. It’s likely that this effort lasts throughout next week, since (1) a retrenchment of the dollar would challenge global central bank credibility, and (2) the statement is more explicit in its mention of “readiness to provide any needed cooperation”.

* In 2000 the Fed purchased roughly 10% of its stock of euro holdings, or $1.3 bn worth of euros (see second table below). Using 2000 as a guide, this would imply that the Fed purchases roughly $2.3bn this time around. However, given the size of the ‘model’ trading flows and technical barriers, this time’s flows are likely to be bigger. We’ll see in coming months when the Fed releases its FX holdings update.

* There is a limit to the Fed’s buying of yen, since the Fed is selling yen assets. The Fed and the Treasury (the Fed manages two accounts of FX holdings, the SOMA and ESF account for the Treasury) hold $23 bn in yen-denominated assets (see second table below) – that’s an absolute upper bound on purchases, although FX swaps do allow some room for maneuvering (although I find it very unlikely that the Fed would print currency for this effort). In 2000, the Fed purchased roughly $1.3 bn euro – that number should be at least doubled this time around, given that FX markets are bigger now. In comparison, Wall Street estimates that the BoJ bought $12bn-$40bn..

If there’s going to be succes, it depends on the Bank of Japan’s flows, not those of the other central banks.

My take is that given the size of today’s move, the 2000 effort was not nearly as concerted as has been demonstrated thus far. Next week will be interesting. The goal, I guess, is to get the currency back into a range that will not be prone to technical bounces. I think that the BoJ’s going all in.

Rebecca Wilder

Chart and Table Appendix:

Eurodollar in 2000

FX holdings in 2000

FX holdings in 2010

Q4 2010 Flow of Funds: Household leverage down, wealth effect dead, and equities surge

The Federal Reserve released the Q4 2010 Flow of Funds Accounts for the US. On the household balance sheet, net worth (total assets minus total liabilities) was estimated at $56.8 trillion, which is up $2.1 trillion over the quarter. Notably, household net worth has increased $6.4 trillion since the recession’s end (Q2 2009). Moreover, personal disposable income increased another $918 billion over the quarter, which dropped household leverage (total liabilities/disposable income) 1.1% to 116%.

Personal saving as a percentage of disposable income rose markedly in Q4 2010 to 10.9% (based on the BEA’s measurement of saving using flow of funds data – see Table F.10, lines 49-52).

The chart above illustrates the the wealth effect – the wealth effect is the propensity to consume (save) as wealth increases/decreases. In the Flow of Funds data, this is best approximated by the ratio of net worth (wealth) to disposable income. In Q4 2010, wealth rose 0.15 times disposable income to 4.9, while the saving rate surged 6 pps to 10.9%.

I conclude from the near-term times series illustrated above, that the wealth effect is very weak, and the incentive to save outweighs the desire to consume one’s wealth. Better put: households are increasing consumption, but that’s due to increased income not wealth.

Of note, since 1997 the volatility of household net worth to disposable income is near 2.5 times that which preceded 1997. Households are fed up; and at least for the time being, the positive wealth effect may be effectively dead.

As an aside, I put something out there: the ‘measure’ of saving is becoming increasingly unreliable. Spanning the years 2008-current, the average discrepancy between the Flow of Funds measure of saving and the BEA’s measure of the same definition of saving (the NIPA construction) is more than 2 times what it was in the 2 years leading up to the recession. This is worth more investigation; but historically, the FOF measure (the change in net worth) has been more reliable.

Breaking down household assets from liabilities, you see what’s driven most of the cumulative gain in net worth: financial assets, which are up near 16% since the recession’s end. During the recovery to Q4 2010, pension fund assets are up 22%; mutual fund holdings gained 32%; and here’s the Fed’s baby, corporate equities (stocks) surged 41% (and more, of course, since this data is truncated at December 2010). Credit market instruments are up 6%.


The asset gains outweigh the drop in liabilities, as mortgages and consumer credit have dropped near 4% and 2%, respectively, since the end of the recession. Consumer credit is making a comeback, though, growing 1% over the quarter, while households continue to reduce mortgage liabilities.

I will comment sometime over the weekend or next week about corporate excess saving, which also is constructed using the Flow of Funds data.

Rebecca Wilder

It’s pretty obvious how China can achieve its top economic priority of price stability

Premier Wen Jiabao made stabilizing prices China’s top economic priority for 2011. Amid the surge in world energy costs, this story didn’t make the front page. However, Chinese policymakers did take their time spent out of the limelight to allow the Chinese yuan to appreciate roughly 0.3% against the US dollar.

Chinese inflation is elevated and near 5% (4.9% is the official rate as of January 2011). I understand that China’s growth adjustment will take time; but if you’ve got unwanted inflation, then domestic policy is too loose (fiscal or monetary). And in this case, it’s the monetary policy that’s too loose – that goes for both currency and rates policies.

On the rates front: there’s a very frothy feel in domestic asset markets, specifically the property market. Low rates and easy money have sparked a(nother) property boom in China, one that policymakers are trying to tamp down. The Economist published a recent article to the point.

But it’s going to take much, much more than raising down payments and reserve requirements to shore up demand for risk assets. I mean, it really doesn’t take a genius to see that real rates are entirely too low. What’s the investment strategy here: nominal GDP is expected to grow at a 11% in 2011 (according to Economic Intelligence Unit, no link), while the lending rate is just 6.06%. There’s no rocket science here: money’s entirely too easy and inflationary pressures are there.

Furthermore, deposit rates are too low and capping domestic consumer demand. Rates need to rise.


On the currency front. Although there’s been some appreciation in the nominal currency, the yuan, Chinese policymakers only recently allowed their currency to fluctuate at all (again) on an annual basis (see chart below). Notice how the annual appreciation was near 0% spanning Q3 2009 to Q4 2010 (October). Since the central bank doesn’t fully sterilize the inflows of foreign currency from export sales, the depressed nominal rate on the yuan feeds through to the economy via inflation.


Inflation is rising, which is perking up the Chinese real exchange rate. In January 2011, the trade-weighted real effective exchange rate appreciated at a 4% annual rate (according to the JP Morgan Index). The real exchange rate takes into account the nominal rate plus shifts in the purchasing power of the domestic currency, as measured by relative price fluctuations.

The chart illustrates that the nominal exchange rate is now gaining traction on an annual basis, since the Chinese government halted its movement against the USD in 2009. I suspect that the nominal momentum will continue to grind upward throughout this year in order to temper some of the inflationary impetus coming from outside its borders (like Fed policy). But as I said before, it’s Chinese policy that’s too loose at home.

The problem is, that Chinese policymakers want to rein in accommodative policy without raising rates too much because they don’t want the currency to appreciate markedly and are unable to fully sterilize all the flows. Inflation results.

If Chinese policymakers question how to achieve their top economic priority, price stability, then the answer to this self-induced problem is pretty obvious: significantly raise rates and the value of the currency.

Rebecca Wilder