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Economy in Brief

Real Euro Digs In Its Heels Despite Weak Growth
by Robert Brusca  May 14, 2009

GDP: more reports coming - The bulk of the euro-countries’ GDP reports will begin to be released on Friday. For now we have the Q/Q number for Spain and a release for the UK (an EU member country) and a comparison available to the US. France’s Finance Minister, Christine Lagarde, is on record saying that the French GDP result will be ‘bad.’ She has not put a figure to that. Germany has been releasing results and projections for tax revenues that increasingly are falling behind what was anticipated, tipping off the weakness in German GDP. France is headed to bust the Maastricht rules for fiscal deficits. Spain’s GDP has made the largest quarterly drop and Yr/Yr drop in four decades as its property boom gone-bust is taking its toll on the economy. Spain’s 4 million people out of work account for about 70% of the increase in all of the euro area. And…Spain’s adjustment is still in progress.

Europe’s IP has been horrifically weak -- The large EMU economies have already posted weak results for industrial output with that sector showing declines at horrifically negative growth rates in the first quarter, clustering around -30% annualized and ranging from -25% to -45% here.

Euro FX rate is resilient - For all of that weakness the euro exchange rate has held up pretty well and even advanced, reversing its recent down cycle. The chart (above) shows the level of the EMU area’s real effective exchanger rate up 25.5% from its year 2000 level. This rate compares the euro’s many bilateral values compressing them to a single number using trade-weights, (hence it is ‘effective’, or ‘multilateral’). It also accounts for inflation differences in doing so (hence it is ‘real’). The euro is off peak but it is still strong.

Euro is still ‘strong’ -- Counting from all its monthly values since 1973, the synthetic euro stands at about the 79Th percentile of its range of values. The synthetic euro uses actual euro weighting against non euro currencies and hypothetically calculates what the euro exchange rate would have been had the EMU currency value arrangement been in existence since 1973. On this basis the value of the euro is in the top 20th percentile of its range. That is a relatively strong showing, despite its recent backtracking.

Relativity has helped to stabilize the euro -- In April of 2008 the synthetic euro reached its ‘all time’ high for this same period. It since has dropped and regained some momentum. While the euro area remains quite weak with output still declining with vigor, currency values are a relative thing. The rest of the world is experiencing output declines as well. But the declines in US output, plus the well-publicized banking problems and investment losses in certain classes of dollar assets, have harmed the aura of security surrounding the dollar and the US. In truth ‘the US’ has been more of an issue than ‘the dollar.’

Relativity and perception - In fact, European banks are troubled as well. I will not try and make any comparative statement on their health. But international agencies are urging European authorities to do more to help them. Germany has just taken steps to bolster the Landesbanks and to set up a German ‘bad bank.’ In France authorities have promised to back stop French banks. After the failure of the US investment bank Lehman Brothers, the US has taken steps to prop up banks as well although small- to moderate-sized banks have been allowed to go out of business. Those are not usually the sorts of banks that would affect overseas investors. A big issue for investors has been the threat to Fannie Mae and Freddie Mac which they once saw as a gold standard and from losses on various mortgage backed securities in the US as well as to losses in equities and directly in real estate, each of which has a more global dimension.

The Fed and monetary policy prospects: While the US dollar remains backed by a careful and watchful US monetary policy the Fed’s balance sheet has expanded greatly. US inflation is still tempered but some harbor concerns about the future. The most recent rumblings come from a Fed conference in Sea Island Georgia where John Taylor, inventor of ‘The Taylor Rule,’ has suggested that, according to that rule, the Fed is close to needing to hike rates.

Underpinning the dollar: Currencies are underpinned by their central banks and the policies they follow, particularly when it comes to inflation. The US central bank has undertaken to stock pile a hoard of private sector assets as collateral as it has provided financial assistance to the beleaguered US financial sector. In Europe the ECB has just agreed to do the same to a much more modest extent overriding German opposition within the ECB. Certainly the asset quality at the central bank is an issue for the credit worthiness of the bank itself. But the real issue is it what a bank’s policies mean for the evolution of inflation. There, some see a link between this asset quality and future inflation. Given the odd sort of business cycle we have had in the US that point is much more debatable. For the moment that asset quality issue favors the ECB and the euro. But does it really matter?

Private asset values matter too -- The asset price declines in the US have been varied and, because more foreign money has been invested in the US, more foreign investors have been burned on their ‘dollar’ exposures. While that is not a foreign exchange issue per se, it is when viewed in a broader sense. Foreign money will not flow in unless it has a place to be invested. Up to this point there has been no other place to go other than to the US. More money has been lost in US based investments than in dollar exposures- indeed the dollar has risen since the crisis began. What is interesting is that there are concerns about the dollar - even though we have not yet had dollar problems attached to this crisis. The real concerns are about recycling savings surpluses and those are not dollar issues per se.

Earlier experiences with ‘recycling of savings surpluses’ -- In the early 1970s surplus funds from OPECs price hikes went to banks for recycling. They proved to be poor custodians as a binge of international lending, much of it to Latin America, went bust. Next, Japan’s surpluses helped to fuel a rise in US indebtedness and a global stock market boom until the turn off the century. The fallout from that was a rise in the yen that eviscerated Japan’s competitiveness that thrust it into a lost decade of growth while Japan outsourced to regain its industrial standing. The recent recycling was funneled more directly though various securities markets (not just equity markets) as China’s surpluses grew then as oil prices jolted savings in OEPC and other oil-producing countries. The consequences again have been devastating. Perhaps the lesson here is more about sudden international shifts in savings imbalances than about currencies and the dollar in particular. So far the dollar has weathered the storm well and has even risen in value. The real problem for the global financial system and its financial intermediaries has been the inability to weather sudden shifts in various national savings rates be they in OPEC nations, China, Japan or elsewhere. (In the case of Japan is was more a case of a shift of funds on the margin to a country with an already high saving rate.)

Europe: better or just less exposed? Had relatively more international funds been invested in Germany or in France in this cycle similar losses would have been experienced there since real estate and asset prices have declines there more or less in step with the losses in the US. But since the US was amore advanced in securitization, that market lent itself more readily to an influx of foreign investors who now must deal with the consequences.

Outlook: Looking ahead the issue for the euro’s value is going to be much more about growth, inflation and rate-of-return issues than about safety and soundness. Stock markets already are being led higher by their cyclical components as the ‘low beta’ or ‘safe’ stock market sectors languish. Investors who were ‘once bit, twice shy’ with their dollar assets are going to have to decide if the US has become a safe place to invest again or they will have to look elsewhere. It they look elsewhere, will that place be any safer than the US, if global saving imbalances are allowed to grow again? These decisions carry with them exchange rate implications. If the ‘Chinas’ of the world want to (and are allowed to) preserve their competitiveness positions Vs the dollar they need to continue to push funds into the US to support current dollar levels. Otherwise, switching funds to other countries will drop the dollar’s value and hike the exchange rate of the yuan undercutting their competitiveness. There is no de-linking these issues. Decisions have consequences and consequences breed new decisions. There is no doubt that the lessons of this cycle have important implications for the period ahead and for the evolution of asset values. The question is if those implications make the US and other places a safer place for foreign monies or if foreign monies will now begin to deploy elsewhere. And if they deploy elsewhere will that be to a destination of greater safety or just to make a ‘new’ mistake in the future?

The currency values should tell much of the story of the shifts in these flows of funds in the times ahead.

E-Zone and main G-10 country GDP Results
  Quarter over quarter-Saar Year/Year
GDP Q1-09 Q4-08 Q3-08 Q1-09 Q4-08 Q3-08 Q2-08
Spain -7.0% -3.8% -1.2% -2.9% -0.7% 0.9% 1.8%
UK -7.4% -5.9% -2.8% -4.2% -2.0% 0.4% 1.8%
US -6.1% -6.3% -0.5% -2.6% -0.8% 0.7% 2.1%
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