Too Soon To Cry Victory?

Confidence Has Returned To Europe’s Financial Markets, But Lasting Economic Growth May Not Be So Easy To Achieve

ECB president Jean-Claude Trichet was in rather optimistic, one might even say jovial, mood at the press conference which followed this week's central bank rate-setting meeting. Second-quarter GDP growth in the 16-nation euro zone would prove "really exceptional," he stated, while the July bank stress tests marked “an important step forward in restoring market confidence.”

And it wasn't only that pre-holiday bonhomie - as Ralph Atkins also reports M. Trichet was about to head off for some well earned rest in the Brittany seaport of Saint-Malo - which was lifting M. Trichet's spirits, recent data - especially from France and Germany - has been reasonably encouraging. Indeed, M. Trichet’s comments came just hours after Germany reported a stronger-than-expected 3.2 per cent rise in industrial orders in June, which came hot on the heels of some pretty strong PMI readings and a further rise in confidence among those living in the Euro Area about the immediate economic outlook, which hit its highest level in more than two years in July according to the EU economic sentiment indicator. Nevertheless, as the EU Commission itself points out, a substantial part of the most recent improvement is due to the improved mood in Germany.



But this is still very much a tale of two Europes, with German industry receiving a large boost from growth in emerging markets, and France consumers taking advantage of the ultra low interest rates on offer to go on a spending boom, while, on the other hand, the overindebted peripheral economies - Greece, Ireland, Portugal, Spain and Italy - still struggle to find growth.

The German July manufacturing PMI showed strong growth



as did the French services one:



while Spanish services registered only feeble growth:



and Greek manufacturing continued to contract:



And despite attempts by IMF and EU representatives to put a positive note on this growing divergence, nothing here is going to be easy. Despite the important progress being made by Greece in implementing its emergency economic restructuring programme, it is still widely anticipated that the Greek economy will shrink by anything up to 4% this year, and possibly by another 2% next year, making for the worst recession in the country's history.

Although the IMF recently lowered its 2011 growth forecast for the Spanish economy to 0.6% – down from the 0.9% it predicted in April - and warned the any recovery in Spain "is likely to be weak and fragile" their medium term forecasts still look rather optimistic, especially given the heavy levels of indebtedness in the private sector, and the underlying weaknesses in export competitiveness.

Not unrealistically, the IMF predicts the Spanish economy will contract by 0.4% this year, but looking farther ahead it goes on to forecast growth of 1.7% in 2012, of 1.9% in both 2013 and 2014 and a 1.8% expansion in 2015. Certainly the numbers look very nice, but it is hard to see the Spanish economy enjoying trend growth of just under 2% in the coming years, given the size of the correction which is still to occur, and the concern is that these numbers may spur complacency, rather than acting as a call to action.

It's The Export Share Silly!

To offer just one example of the problems which lie ahead, while Spain's exports have grown more or less as fast as German ones in recent months (on an interannual basis), Spain's exports only amount to around 16% of GDP, while German exports account for more like 40%. Now that Spain's economy depends much more on exports than it did (construction activity is not coming back as a growth driver), the rate of growth in exports in Spain needs to be much more rapid than in Germany.

Does this seem like an extremely difficult task? Then this is exactly why it is hard to be optimistic about trend growth for Spain in the coming years. Put another way a 17% increase in Spanish exports (more or less the interannual rate in May) is an increase over 16% of GDP, or has an impact of around 2.7% on headline GDP, whereas a 17% increase in German imports is an increase over 40% of GDP, which exerts a 6.8% upward push on GDP. Of course, what matters is the net trade impact, but in any event the point holds, Spain is trying to leverage over a much smaller part of her economy, and in doing so cannot hope to equal the results obtained in Germany.





All this worked for as long as it did, and for as long as international markets were willing to fund an internal consumption boom in Spain. This is now no longer the case, and Spain is thus forced to rely on its export sector to drive the economy, and this is going to be difficult given how small it is (even allowing for the role of the important tourism sector). What is even more difficult is to see how expansion in this sector is going to give the kinds of rates of growth the IMF are assuming over the time frame in question. Spain's export sector needs to expand to occupy between 25% and 30% of economic activity if the economy is to expand fast enough to enable the debts to be paid down, and I don't see how there is any real way round that reality.

So while the export charts don't look that different, there is a huge difference in the industrial output ones.





This evident difference is due to the fact that Spanish industry is far more geared to the domestic market than it is to the external one, and the domestic market is Spain is weak, and will remain so for years to come, while in Germany, even though the internal market is weak, the export orientation of the economy means that growth elsewhere pulls it along. I don't think the different current growth performances need any further explanation at the macro economic level. What I think someone somewhere needs to explain is how - other than via what is, in reality, a rather tepid labour market reform - Spain is conceivably going to arrive at the sort of rates of growth between now and 2015 that many seem to be assuming. The Standard and Poor's estimate of an average of 0.7% between now and 2017 seems much more realistic, and even that only assuming that nothing seriously untoward happens between now and then (which it easily might).




Another interesting detail about the German differential performance is the way in which German industry has sidestepped the apparent weaknesses in demand in Southern and Eastern Europe by expanding its markets elsewhere. Thats what competitiveness means, agility and the ability to adapt to changed circumstances. As Unicredit's Alexander Koch points out (see chart below), a glance at the recent German foreign trade figures reveals that while the most important export market by far remains the European Union, growth has been coming from elsewhere. In the first five months of this year, more than 60% of all merchandise exports were shipped to neighboring countries. Asia (including Japan) had a 12% share, the US a 7% one and Latin America a "measly" 2.5%.

But recent reports from German export firms suggest that these weights are shifting drastically. Above all in the key vehicle manufacturing sector, additional demand from emerging markets currently plays a decisive role. Vehicle exports to China have jumped by as much as 170% so far this year (over the equivalent period last year). Koch's chart shows us the difference between current export levels and those which existed in 2007. Over this time frame Emerging Asia has gained more than 3 percentage points – of which the vast majority is accounted for by China (2.5 percentage points). Also Latin America recorded a significant increase, a rise which more or less compensates for the decline in the US share. In fact Central and Eastern Europe was the only emerging country region which didn't increase its importance - a reflection of the serious economic crisis which still pertains in most of the region.



The sizeable drop in the export share going to the Euro Area (down by 2.5 percentage points) is largely accounted for by the periphery countries. Greece, Ireland, Portugal, Spain and Italy together currently make up 11.5% of German exports down from almost 14% in 2007.


Differential Credit Impacts

More evidence of the disparities that exist within the Euro Area can be found in the lending data for house purchases which on an aggregate level rose at an annual rate of 3.4 per cent in June – the fastest since September 2008. But while in France such lending was up by 5.3%, in Spain the change was only 0.9%.

Much as expected M. Trichet continued to brush aside concerns expressed about this kind of disaggregated data, along with the apparent credit tightening revealed in the second quarter bank lending survey, by arguing (not altogether unreasonably) that the survey had been conducted at the height of the European sovereign debt crisis, and before the publication of those famous stress tests. But still, credit seems to be flowing in some countries, and not in others.






Still Under Stress?

As for the stress tests themselves, are they working? Well the evidence is mixed. Certainly the atmosphere in the short-term European interbank market has improved, and there is some evidence that, little by little, things are improving. On the other hand we also have the recent surge in 3 month Euribor rates, which rose above the 0.9% threshold for the first time in over a year on Thursday. Twelve month Euribor is also on the rise, and stood at 1.373% in June, up from 1.281% in May. Still it remained 0.039% below the level of June 2009, but the rise seems relentless, and this is not without significance, since it is the benchmark from which over 85% of Spanish mortgages are set.

So, are these movements, as some claim evidence that the market is finally functioning, and that demands for loans are on the rise? Or do they, as others claim, reflect continuing nervousness about the decisions the ECB will eventually take in connection with its short term liquidity provision to banks? Remember, borrowing by Spanish banks from the ECB shot up in June, and September will see the final bout of three month tenders, which were introduced by the ECB in June to ease the pressure on Europe's banks given the tensions in the interbank market. Seeing whether the level of dependency of Spain's banks on the ECB can be substantially reduced will offer us one measure of the degree of success of the confidence raising exercise which lay behind the stress tests.




Whichever version of the story has it right, there can be no doubt about the consequence of this inching upwards in rates, the interest rate differential with the US Federal Reserve continues to rise, and with it the parity of the Euro, which is now being valued at over 130 to the dollar, following hitting a low of 119 back in May. What this will do for the Eurozone’s export-lead recovery remains to be seen. M Trichet is probably right to be nervous about the kind of slowdown we could see in the third and fourth quarters of the year.

In fact the ECB President effectively denied that the higher market borrowing costs and recent rise in the euro constituted an effective tightening of monetary policy, one which would ultimately slow the recovery. Indeed, he saw “exactly the contrary”, arguing that such developments reflected growing confidence and thus boosted Euro Area growth prospects. Let’s hope, like Nelson before him, he wasn’t holding his telescope up to a blind eye when he was looking.

At this point in time the differences in posture between the ECB and the Federal Reserve remain marked, and while the European bank left its main rate unchanged at the record low of 1 per cent for the 15th consecutive month, its President continued to emphasise the process of policy normalisation, resisting all questions which invited him to speculate about future decisions either on interest rates or on liquidity provision. The difference in tone with a US central bank manifestly concerned with perceived weaknesses in the recovery and the deflation danger could not be greater at this point.

Yet, as M Trichet acknowledged, while some of the worst of the financial crisis has now abated it is definitely far too soon to “cry victory” in the battle against Europe’s sovereign debt woes, and the second half of 2010 may well not be anything like as positive as the first half has been in terms of the real economy. Still, as Europe’s citizens lie outstreched on their beaches of preference, or search for the cooler climes of those mountain peaks, maybe it would be better for them to contemplate the recent performance of some of the continent’s key football teams, and leave the dreary task of preparing for their autumn “belt tightening” until their return to the fray in September. As I say at the start of this post, Jean Claude Trichet, for his part, informed us that after the meeting he was headed straight for Saint-Malo, and I wish him a very restful “time-out” there, recovering all that energy that he is most certainly going to need for the difficult decisions he will have to take in the months to come.

Stressing the European Stress Tests

Guest Post by Jordi Molins Coronado


The stress tests corresponding to the European financial system have been already published by CEBS. The total recapitalization needs for the whole 91 banks included in the tests, accounting approximately two thirds of the European financial system, is about €3.5bn.

I urge the reader to read again the last statement. Yes, €3.5bn. Not €35bn or €350bn. To put figures into perspective, €3.5bn is the bonus pool of a few big European banks.

Can anybody believe that with an additional recapitalization of €3.5bn, the European financial system would be sound again? That the blockade we have had in the wholesale and money markets could have been avoided by a recapitalization of €3.5bn?

One cannot say the calculations performed by the CEBS, with the support of the ECB and the EC, are wrong. I have been able to follow some of the presentations of the results, and they are quite sound. One can see that a lot of great work has been performed, and brilliant minds are behind the calculations.

How can it be then that the final result is an absurd one?

And definitely one can state the result is nonsensical. I understand that European governments already recapitalized their domestic financial systems with about €200bn. I understand that these stress tests only consider solvency risks, not liquidity risks. And from solvency risks, some of them are discarded (eg, sovereign risk in the banking book, even though officially policymakers argue on the contrary).

One can critize other aspects of the stress tests: tier I capital has been used instead of core tier I, the usual measure of capital among financial analysts, with the argument that there is no common, accepted definition of core tier I capital across European nations. I prefer the argument that Commerzbank, for example, has a core tier I capital of about 3.5% and a tier I capital of 10.5%.

I have seen all those criticisms. However, I do not think they are the core of the problem. In fact, policymakers have been diverting the problem towards a sovereign one, when in reality, it is a banking book one. Well, that is not true in all cases. For example, Greece has a serious problem of sovereign debt. French and German banks are loaded with periphery sovereign bonds, whose haircuts would imply heavy losses for them. But the key of these stress tests is not Greece, but Spain.

Spain is on the core of the problems within the European financial system. Greece, Portugal and Ireland are small economies. Spain is a big European economy, and highly interconnected with its Central European counterparts. And definitely, the main problem of Spain is not a sovereign debt one, but a private debt one.

My main criticism to the stress tests is the treatment of the loan book. To make a long story short, losses in the banking book are computed in the standard way in the credit arena: exposure at default times probability of default times loss given default. The crux of the matter is how PDs and LGDs are computed: in the stress tests, one takes an estimation of PDs and LGDs as per their realized value on 2009, and then computes a regression that determines the macroeconomic relationship between PDs and LGDs on one hand, and on the other hand, macroeconomic variables like GDP, interest rates or unemployment rate.

Once this relationship has been entertained, one can 'stress' the macroeconomic variables (-2.6% GDP, shift upwards the interest rates by 75/125bp ...) and find, through the macroeconomic relationship, which impact there would be on PDs and LGDs if such a macroeconomic shock were realized.

Then, using those PDs and LGDs, calculating expected losses in the loan book is just a question of doing the arithmetic right.

What is the problem with this approach?

The problem is that in order to compute a regression, one needs historical data. As such, the results are dependent on the previous relationships among the variables, in our case, PDs and LGDs vs GDP, interest rates and unemployment. A regression gives us the 'best' (in a technically defined sense) relationship among those variables in the past.

However, in practice theory is challenged through the so-called 'outliers'. Outliers are data points that are not well represented by the regressed relationships. An outlier is a PD or an LGD that is very far away from the predicted value, assuming a set of macroeconomic data. And clearly there are outliers all the time, especially when the economic environment changes, for example when there is a financial crisis.

I have not done the math, but I would be extremely surprised if the 30%-40% loss rates in US subprime, or the 47% haircut in commercial real estate in the Irish NAMA, could have been explained with a regression using macroeconomic data. These data points are outliers because once a financial crisis bursts, the dynamics linking the economic variables (PDs and LGDs vs macroeconomic data) changes dramatically, and the past relationships break down completely during the crisis.

Which are these new dynamics? This is a very hard question, but I would like to stress at least a part responsible of the change. Non-linear network effects. For example, when Detroit lost approximately about half of its population, it was not (at least, not only) because of the unemployment rate of that city spiking up. It was also because if your brother or your friend left the city, why should you stay there? Definitely, macro effects continue playing a role. But the dramatic outliers are caused by positive/negative feedback loops, created by network effects leading to non-linearities.

If you allow me to be a bit pedantic, I would like to present an analysis from physics I like very much, and it could shed a bit of light why a macroeconomic regression between PDs and LGDs vs GDP, interest rates and unemployment rate could not be the meaningful way to forecast PDs and LGDs in a stressed scenario.

The analogy is a piece of iron. A piece of iron can be modeled as many atoms of iron next to each other. Simplifying as much as possible, each atom can be in two 'magnetic' states, up or down. The analogy in the credit world would be that an economy can be understood as a series of 'atoms' (households and / or corporations) that can be in two states: default or non-default.

Things start to become more interesting when a magnetic field is applied to the piece of iron. The magnetic field makes that most atoms take a preferred direction, say 95% of them are in the up state (and 5% in the down state). The analogy is that in an economy, say 95% of households and corporations are in a non-default state, and about 5% are in default.

This magnetic field, in the case of the economy, would be the result of the regression: given an array of macroeconomic data, say GDP, interest rates and unemployment rate, PD is given, and as such, the percentage of households and corporations in default is fixed.

In fact, if one uses a well-known model from statistical physics under this same situation that most physics undergraduates learn to compute, the final function is the same as one of the formulas for PD for credit risk in Basel II.

Until now, we have not done anything new: we have just renamed things from our framework (credit risk) into a new framework (the physics of solid state). However, a solid state physicist would soon point out that this model is not interesting at all, and that interesting models include not only magnetic fields, but most importantly, network effects among the iron atoms.

This is easy to understand in an economic environment: a company may have a probability of default given the economic environment, ie if the economy is going great, the probability of default is very low. Instead, if the economy is tanking, the probability that it defaults increases. However, companies depend on other variables than macroeconomic ones: even though the economy may be running at full speed, if an important provider defaults (for any reason) the company may be on the verge of bankruptcy.

And in the same way, even though the economy is in recession, if a given corporation receives a new important contract (or equivalently, an important competitor defaults) its probability of default decreases.

As a consequence, a default in a given company can lead to a domino effect for other corporations that are linked through a supplier chain with the first one.

My intuition here is banks are the most important nodes in an economy. Banks have very strong links with many corporations, many more links than a usual corporation has with other counterparts, and more intense at this. If a bank defaults (or stops providing financing) these effects spread out to many of its clients. At the same time, if corporations fail to get new financing, this may affect other corporations, which will have an influence on other banks, and so on.

This kind of strong chain of relationships is well-known among condensed matter physicists: the Ising model (and variants). The Ising model includes not only a magnetic field (a macroeconomic variable that affects all the agents in the economy) but also direct relationships among the agents. To describe the overall behaviour of the Ising model is out of the scope of this note, but just let me state than once one includes direct relationships among the agents, the simple behaviour of the model under a magnetic field changes dramatically.

Under only a magnetic field (and no direct relationships) the behaviour is simple and predictable. As we have discussed above, undergraduates in physics may compute that relationship easily. However, once one includes direct relationships, everything changes. The relationship between the variables (ie, the dependence of PD or LGD vs the macroeconomic variables) stops being a linear one, and they become highly non-linear. In particular, there may have phase transitions: a small change in a macroeconomic variable may lead of an abrupt change in PD. This is not unlike to the case when a small change in temperature leads to water to freeze.

A study on these lines, that relates these physics models with credit portfolio models, was analyzed by Eduard Vives, a physics professor and myself, and can be found here. I do not argue this is the last word on the relationships between PD and macroeconomic variables, but apart from the appealing theoretical framework around it, one can see that it introduces the possibility to deal with outliers, and to try and understand how is it possible that loss rates in the US subprime and the Irish commercial real estate were so large, when no macroeconomic model could have forecasted such jumps.

The final suggestion, using the physics analogy, is the following: once network effects are present (mainly through the strong relationship lender - borrower) the traditional macroeconomic relationship between PDs and macroeconomic variables breaks down, and a more complex dynamics is required to model such a new reality.

To sum up:

a macroeconomic model like the ECB one relating PDs and LGDs with macroeconomic variables will never be able to model big jumps in PDs and LGDs, as they have occured in the past with the US subprime or the Irish commercial real estate experience. These models are too slow to accomodate abrupt regime changes. However, there is a series of models, coming from condensed matter physics, that have the potential to accomodate such changes, and that comprise the regression macroeconomic models as particular cases.

This is essential due to the fact that recapitalizations coming from the stress tests, even though very small (€3.5bn) are the difference of two very big numbers. For example, the Bank of Spain has computed recapitalization needs as (simplifying) the difference between gross impairments and available resources. Available resources are more or less well-known (provisions, both specific and general, net operating income, capital gains, tax impact ...) but gross impairments are highly dependent on the PDs and LGDs chosen to perform the exercise.

For example, the most toxic exposure in Spain, developer loans, assumes in the BoS calculations a 17% haircut. However, other estimations, like Luis Garicano's one, with a PD of 70% and LGD of 70% for that portfolio (as such, total losses around 50%), would immediately increase (without taking into account any other changes in other parts of the loan book, that could also add to the recapitalization needs) the recapitalization easily to the €100-€150bn mark.

As such, this strong dependency of gross impairments on the estimated PDs and LGDs in the adverse stress scenario leads us to suggest that a better model than a simple macroeconomic regression like the one used by CEBS should be entertained, especially models that could accomodate outliers like the US subprime or Irish commercial real estate ones. But for that, one would need non-linear models that could explain and predict abrupt regime changes.

Oh It's All Gone Quiet Over In The Eurozone!

Or has it? According to Anchalee Worrachate in Bloomberg:

"A report from the Bank of Spain showed Spanish lenders borrowed a record 126.3 billion euros ($161 billion) from the ECB in June as investors shunned the nation’s banks. Spain’s banks increased borrowing 48 percent from 85.6 billion euros in May. That compares with a drop of 4 percent to 496.6 billion euros that the ECB provided lenders in the whole euro area. Spanish banks haven’t sold any bonds publicly in the past two months on concern the nation won’t be able to cut its deficit without hurting the economy."



Pretty hard to argue now the Spanish bank borrowing from the ECB is simply in line with the country's share of total GDP I would have thought. Also, after having trended upwards ever so slightly for a couple of months, Spain's industrial output actually fell back again in May (by 0.3%) while output in Germany roared ahead by 2.9%. Obviously not everyone is getting the same benefit from the weaker euro, could competitiveness have anything to do with it, I wonder?




Quoted in the Financial Times earlier today Klaus Regling, chief executive of the European Financial Stability Facility said the fund would be "ready to act whenever the politicians tell us to act.” I guess the situation of Spain's banks would be one of the things he must have had in mind.

Using a footballing analogy, you get to see a lot in the press about how this club is chasing this player, while that one is chasing another one, until the moment of the actually negotiations comes. Somehow, at that point the sporting press goes strangely silent.

Of course, when those much talked of stress test finally come out, we'll all be able to see for ourselves that Spain's banks - apart from a few ropey old Cajas that no one in their right mind would be interested in anyway - are in absolutely sterling and tip top condition (and not like their shabby German counterparts at all). Won't we José (Viñals)?

Or are those reponsible for the Spanish banking system finally going to face up to their responsibilities, amble out of that closet they have been tightly locked away inside for the last three years, and follow the advice of Jacques Cailloux, chief European economist at RBS, by seizing opportunity provided by this months "getting it all out in the open" fest to start restoring investor confidence by really getting down to straightening out the mess?


Postscript

The number of people employed continues to fall, unabated, as measured by contributers to the social security system. On a seasonally adjusted basis the number hit 17.66 million in June, down from the January 2008 peak of 19.42 million.



Seasonally adjusted unemployment in Spain - as reported to Eurostat - was at 19.9% in May, up slightly from the previous month, and with no real sign of reducing.



House prices continue to fall slowly according to the TINSA index.



and in June were down 16.5% from the December 2007 peak.



The goods trade deficit deteriorated again in April.

As did the current account deficit, which has now widened again considerably from the lows reached in the autumn of 2009.



The manufacturing sector showed very slight growth in June, as both output and new order growth fell back.



As Markit's Andrew Harker said in his report:

“Latest PMI data highlight the continued uncertainty surrounding the Spanish economy. Output growth slowed for the second month running and firms still do not have the required workloads or confidence to prevent job losses. With the VAT rise kicking in and further austerity measures to follow, there appears to be a real risk of the private sector falling back into recession.”

While services activity actually contracted for the first time in four months.



Again, I will leave Andrew Harker to sum the situation up:

“Latest Spanish service sector PMI data provide some worrying signs regarding the path of the sector. Foremost among these is the first drop in new business since February. Also of note is the marked weakening of sentiment seen in the previous two months amid worries surrounding austerity measures in Spain and the effects these will have on the fragile economy.”

And finally, we have the inflation data, were I have put the CPI up against the German one. Worryingly, after falling sharply at one point in 2009, Spain's inflation is now once more back over Germany's.



Which means the the Spanish economy is once more losing competitiveness against the German economy, the exact opposite of what you want to see. And in July VAT went up two percent. Many argue this move is totally benign, but it will be interesting to see how Spain's retail sales move over the months to come, and how the inflation differential with Germany is affected. Didn't anyone tell them there are no free lunches in economics? And how cutting back on government fiscal spending - necessary as it is, since more government deficit is only going to get the country more into debt, not to mention the impact on investors - is going to help sort all this lot out, well I'm afraid that's a complete mystery to me.