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Tuesday, July 15, 2014

Spain and the IMF: Round the Bend or Out of the Woods?

"Spain has turned the corner". With this stark statement the IMF opened it's annual Article IV consultation report for 2014. Naturally the statement rankled, with this author among others, because at first sight it seems to be saying something which on closer reading of the report you find it isn't. At best it's misleading, possibly from a PR point of view intentionally so, but then Article IV reports are supposed to be more sober, measured assessments. One Spanish journalist summed up the surprise many felt in the following tweet.
Dear IMF, You can't say "Spain has turned the corner" and "the unemployment remains unacceptably high" in the same paper It's silly Yours, C
 What I suppose the authors of the report were trying to convey was the feeling that an important turning point had been passed along the long winding road out of the mess that was generated in Spain in the first seven years of the Euro's existence. Personally I can't help feeling the expression would have been none the less prosaic and much more complete had they added the line from a well know Jimmy Cliff song - yet there are still "many rivers left to cross". Equally, "not through the rapids yet" comes to mind.

The danger of putting things in the way the IMF Spain team just did is that you open yourself up to the accusation of being complacent, even self-congratulatory, and almost lacking in the necessary even handedness since it could be seen as lending a helping hand to a struggling government which is about to ramp up its 2015 election campaign. Indeed more than one journalist took it this way.

There's a danger here, one of institutional credibility, should the economy once more succumb and fall back into a triple dip. Indeed the downside risks detailed in the report  offer plenty of arguments as to why just that might well happen. In any event this wouldn't be - as Landon Thomas pointed out in this article - the first time the Fund has gotten things badly wrong on Spain.

 Fair And Balanced?

The thing is, once you get past that troublesome first phrase, much of the report - leaving aside one or two topics I will draw attention to - seems remarkably unobjectionable. The opening paragraph continues, "Growth has resumed, labor market trends are improving, the current account is in surplus, banks are healthier, and sovereign yields are at record lows", most of which is unquestionably true.

And then those positive evaluations are suitably and appropriately counterbalanced by a string negatives, "But unemployment is unacceptably high, incomes have fallen, trend productivity growth is low, and the deleveraging of high debt burdens—public and private—is weighing on growth".

So actually the fund isn't at all saying that all is well in Spain, and that the level 5 alert is now all but over - far from it. Perhaps an opening phrase more in tenor with the general drift would have been "Spain's recovery continues to gain traction".

Export Lead Recovery?

As I say, most of the positive assessment offered is valid. Most, but not all. There is one exception: the state of the current account. It is no longer positive.

Surely it is true to say, as the authors do, that "Spain has managed a remarkable improvement in its current account". During the last 5 years the balance improved by 11 percent of GDP, moving from a deficit of 10 percent in 2007 to a 1 percent surplus in 2013. But that was then, and this is now, and as the recovery has progressed part of the improvement has been lost. During the 8 months between May and December 2013 the account was in positive territory. 8 months in something like the last 150. For each of the five months of 2014 however - just as the economy has been accelerating - it has been consistently negative. Indeed the fact this might happen was expressed as a constant concern in earlier editions of the report (namely, that as things improved the CA balance would once more turn negative). Now it has, which is perhaps one of the reasons why they were ill-advised to use that "corner turning" phrase.


As the Fund points out, only one other advanced large non-commodity exporting country has managed to achieve a current account improvement of a similar order, and that was South Korea in 1997–98 (so comparisons and precedents here are few and far between), and the key factor in the Korean case was the ability to devalue the Won. As the Fund says:
"Spain’s current account improvement is particularly notable given that it was achieved without nominal depreciation. South Korea’s adjustment was facilitated by a large nominal exchange rate depreciation, an option that was not available to Spain. While Spain’s real effective exchange rate (REER) did depreciate significantly based on unit labor costs, it largely reflected labor shedding. The CPI-based REER has not depreciated much."
What the authors are getting at here is that Spain's nominal internal devaluation was very small, and indeed the overwhelming majority of Spanish experts have consistently argued that more wasn't needed since the economy hadn't lost as much competitiveness as "outsiders" claimed. On the other hand there was a large improvement in Unit Labour Costs produced by the comparatively small fall in GDP output (roughly 7%) and the very large drop in the number of those working (about 20%), but this way of doing things always left the concern that as the economy started creating jobs again the average Unit Labour Cost would start to rise again, as we have seen happen in Ireland (see chart below).


 In fact there is even some indication that this may already be happening. In the 12 months to March the economy grew by 0.6% while the number of those paying national insurance contributions (a reasonable proxy for employment) rose by 115,000 (or 0.7%). As a result the rate of productivity improvement has declined sharply.


The danger thus is that many of the hard won gains of the crisis years are unwound during recovery. The current account deficit  fell sharply on the back of the drop sharp drop in employment which accompanied the crisis as consumption collapsed (retail sales are still down 30% from 2007 peak) and imports followed suit. Little by little this process is now reversing, imports are once more rising as domestic consumption starts to recover and the goods trade surplus is once more deteriorating.


So the correction is far from complete at this point and the risk the corner has been not been completely turned is not negligible. Which bring me to another minor quibble with this section of the report. "Exports are performing well," the authors tell us. Well perhaps the best thing that can be said about this statement is that it is a little bit out of date. In the three months to May Spain's goods exports were up by 2.75% over the same period a year earlier. In comparison in 2013 they were up by 6.5%. Spain's export machine has been losing momentum, and - as I argue in this post -exports are now roughly stuck at the level  they were at in June last year. Naturally there are reasons for this, emerging markets who were strong Spanish customers last year have had their own crisis, and now tensions in Eastern Europe surrounding Ukraine may be leading the Euro Area itself to loose momentum. But this is just it, a fragile and tenuous recovery is easily knocked off balance.

The current position can perhaps be best summed up by the situation described in the chart below. Between 2010 and 2013 the economy was re-balancing nicely with external demand doing the heavy lifting while the current account moved towards balance, but over the last twelve months things have changed and external demand is now, once more, a negative drag on the economy as imports rise. This is obviously a worrying development, and naturally a cause for concern.


Indeed the authors of the IMF report more or less implicitly accept that the external correction is far from complete when they say:
"Model-based and historical REER analysis suggests the real effective exchange rate is some 5– 15 percent above the level consistent with medium-term fundamentals and desirable policies. However, achieving significantly lower unemployment rates closer to international peers in the medium term may require an even larger adjustment in the exchange rate".
What Does Unacceptably Mean?

 I think we are all in agreement on one thing: Spain's unemployment remains unacceptably high. But what does "unacceptable" mean? Well normally it means you don't continue to accept it and do something about it. And this is just the part I find missing from this year's IMF report.


If we go back twelve months, and take a look at last years report, then it's easy to notice a clear difference: the IMF offered a proposal for doing something. Essentially the proposal, which naturally was not at all popular in Spain, was to move towards a wage cut in return for job sharing (indeed I myself agreed with this proposal - see my "Doing Nothing Is Not An Option", and even wrote a chapter arguing for it in my Spanish book on Spain).

Another possibility, which I have personally advanced inside Spain, would be to temporarily change the retirement regulations to allow people to retire from 60 onwards on the condition that their employer replaces them with someone previously unemployed and under 30 (not obviously job for job) on a long term contract.

Now, you will say, doesn't this roll back the 2010 pension reform which tied retirement ages to life expectancy and saw a progressive increase in retirement age from 65 to 67? This reform was much applauded at the time, and was indeed a core part of the Zapatero government's attempt to regain market credibility. My response to this objection is, indeed it would, but lets think about the situation for a moment, and in particular about the meaning of Keynes's oft over-cited phrase, "in the long run we are all dead". What Keynes is getting at here is that we need to be "nimble of thought" enough to be able to distinguish between the different time horizons involved in economic policy. (And not simply shrug our shoulders because "in the long run it will all sort itself out). Simply because something is advantageous in the long run, doesn't mean that a policy to promote it is what is needed in the shorter term. There can be a trade-off of interests, and doing something which might be harmful in the longer run (running up government debt), could be not only a palliative in the short run but could lead to a superior long run outcome if it is done wisely. The dilemma we face in Spain was summed up in more theoretical terms by the founder of modern growth theory - Robert Solow - when he admitted in his Nobel acceptance speech, that "the problem of combining long-run and short-run macroeconomics has still not been solved".

In the long run, despite the fact that we will all die, we are all living longer, and having longer working lives makes sense. But in the short run, in a country with 5.9 million people unemployed (half of them for over a year) and over 50% of those between 16 and 24 who are looking for work unable to find it, asking people to work longer doesn't seem to make that much sense.

Letting people retire to be replaced by people with a younger mindset makes obvious economic and productivity sense, but what about the implications of such a decision for the pensions system? Wouldn't this be moving backwards? Well this is where the second (2013) pension reform comes in. That reform introduced the principle of "sustainability" into the Spanish pension system. Sustainability means - across the economic cycle - as much money needs to come in as goes out. I think this is a good reform, indeed a vital one, since it turns Spanish pensions from being a defined benefits system (which would be unable to live up to its promise) into an easy to understand defined contributions one. The pension system becomes an implicit contract between those working and those receiving benefits and takes the government (and most importantly its finances) out of the middle. There is a formula to decide how much can be paid in any given time period, so if more people suddenly start claiming pensions naturally pensions will go down proportionately, but there is no system to collapse, and there will be no knock on effect on government finances.

What both these proposals have in common is that they involve solidarity and they involve sacrifice, and neither of these seem to be very much in fashion at the moment. But people need to be aware of the longer run consequences of doing nothing. And this is just where expressions like "Spain has turned the corner" don't really help, since they don't put people in the right frame of mind. If unemployment is unacceptably high then it is an urgent matter to do something more about it, and not just sit there with our arms folded to see if the IMF forecast of unemployment moving under 20% in 2019 is fulfilled or whether it happens in 2018, or 2020. These kind of outcomes simply won't do, and as we will see below they will have long run consequences for Spain.

Long Run Growth Potential

I think virtually everybody agrees that the Spanish economy will grow this year at a rate lying somewhere between 1% and 2%. Naturally a lot of debate and energy has been invested in arguing about just which end of the range will be nearer the final mark. The end result, whatever it is, will be better than expected six months or so ago but at the same time it will hardly constitute an economic revolution. No game changer to see here, please move along.

The issue is really what we can expect from Spain in the years ahead, well beyond 2014 and 2015, and in approaching that tricky question there is no piece of current economic data that can help us decide. We need a different approach: growth analysis.

To put things into some sort of perspective on this account it is worth perhaps noting Spanish retail sales were up a mere 0.3% in the three months through May over the same period a year earlier, while industrial output was up around 2.5% over the same time horizon. The notable difference between these two numbers reflects the fact that at the end of the day the future of Spain's economy is now more linked to the sale of industrial products abroad than it is to the level of shop sales at home. But the second thought to take away is the sobering one that  both of these indicators are still down around 30% since 2007, and that at current rates the economy will need over a decade to get them back to earlier levels, if it ever does.




I say *if* it ever does, since a clear possibility exists we may not ever see Spanish retail sales activity in getting back to their earlier pre-crisis highs. The reasoning behind this idea is simple: after rising rapidly in the first decade of the century Spain's population is now falling and aging at quite a rapid rate, and if that rate isn't at least slowed then a decade from now (whatever the reform progress the country makes) it is hard to see the Spanish economy eking out a hell of a lot in the way of growth. Which means if we don't hit those pre-crisis levels soon, which we surely won't, we may never do so -  a more thorough explanation of the justification for this (for many perhaps surprising) assertion can be found in my Secular Stagnation Part 1 - Paul Krugman's Bicycling Problem).

What we need to think about then are not the country's short-term economic dynamics, but its growth potential in the longer term. On this issue the recent report does indeed have something to say (and what it says is backed-up by a deeper analysis in the 2014 edition of Spain Selected Issues). The authors of the Article IV report tell us the following:
"Longer-term potential growth prospects also appear weaker than in the boom years. Growth during 1995–2007 was sustained by large accumulation of capital (the credit-fuelled housing boom) and labor (immigration and rising participation rates) hiding a substantial decline in productivity growth. Demographic trends have now turned negative (emigration and the ageing population) and capital accumulation will likely be lower (given the large rise during the boom and falling population). Spain will also need to tackle the negative effects of very high structural unemployment. In this context, potential growth may only be around 1 percent over the medium term."

They back up the idea that Spain's longer term growth outlook (as opposed to short term recovery-from-the-slump growth) is moving steadily lower with the help of the nice chart I reproduce below.


Over time Spain's growth rate is falling, as it has been in most developed economies. In the Spanish case while the economy grew by an average of 3.5% a year between 1995 and 2007 there was an important structural shift taking place. The rate of per capita GDP growth slump dramatically after 2000 as the employed population surged and much of the growth became labour intensive, a point which is illustrated nicely by another IMF chart:

Before the mid 1990s a significant part of Spain's growth had come from productivity improvements. Even in the second half of the nineties this remained to some extent the case. But between 2000 and 2007 the red markers almost completely disappear from the chart and as can be readily seen from the chart growth was almost entirely explained by increases in the capital stock (the result of construction activity) and higher labour force growth. This is not the direction a country which wishes to raise its living standards by engaging in higher value added work wants to go.

Now, in the wake of the crisis, the country faces an enormous challenge since it has to start raising average productivity at the same time as it tries to put 3 million low skilled workers back to work. We have noted above that Spain has been creating employment on much lower than expected GDP growth, this is only partly good news, since the other side of the coin is that productivity improvements (see the red markers in 2012/13) are now slowing. This is what many feared might happen (current again deficit turn negative, productivity gains weaken) and is a warning signal that the current recovery may not be on such solid ground as some imagine.


But moving beyond the present, the reason we can expect this ongoing fall in trend growth rate to continue  has to do with the composition  of growth and how trend growth is estimated. Basically long term growth potential is a function of working age population dynamics and total factor productivity (TFP) growth, as shown in the diagram below which illustrates the version of the approach used by the EU commission.


Leaving immigration and emigration aside for a moment, Spain's population is now virtually stagnant, fertility is around 1.3 (tfr) and the annual balance will soon turn negative. The annual number of births had been rising before the crisis, but has now started falling again (see chart from statistics office below).



The annual balance between births and deaths also rose to a peak in the boom years only to subsequently fall back (see chart below). In fact the difference between births and deaths was a record low of 36,181 in 2013, and within a few years the balance will surely be negative. But again we need to remember, in economic growth terms it isn't the size of the population that matters, it is the age structure, and Spain's working age population will certainly shrink faster than the overall population will. So even on the best of scenarios Spain's workforce is now facing slow and steady decline and this will undoubtedly bring down the trend growth performance.



But Spain isn't facing the best of scenarios. Where once people were arriving, the dire state of the country's labour market means they are now leaving. And once we factor in immigration, things start to get a bit more dramatic. As the IMF notes (in the 2014 selected issues document):
"Demographics have turned negative. After expanding at a fast pace until 2007, population growth slowed significantly and turned negative in 2012. This is likely to be a new trend, as INE projects working-age population to continue to decline over the next years........Labor dynamics will make a much weaker contribution to potential output. Demographics will be a drag on growth due to declining working-age population (emigration and ageing). The Spanish statistical agency (INE) expects working-age population to fall by 1 percent a year over the medium term."
During the boom years over nearly 6 million immigrants came to live or work in Spain. The population - which as we have seen is nearly stationary in terms of births minus deaths - shot up from 40 to 46 million.


But now, as the IMF say, this dynamic has turned negative. Quite how many people of working age are leaving Spain every year is hard to say. This, in part, is because while the number of former immigrants leaving is known with a reasonable degree of accuracy, the number of young Spanish nationals who do so is much harder to pin down, in part because you need to go to receiving countries like the UK and Germany to obtain the data since most Spaniards who are working abroad have not registered with the national authorities.


According to the latest estimates (30 June 2014) the net number of emigrants leaving Spain in 2013 was 256,849.  Of these the net number of Spanish nationals leaving was 45,913. But this latter number is confusing since during 2013 some 190,000 former immigrants obtained Spanish nationality and some of these subsequently left for other EU countries. More to the point perhaps, is that these are net numbers. The gross numbers are even more shocking: over half a million people left Spain in 2013 (547,890 to be exact), while some 291,041 new immigrants arrived.


Now I don't want to get into the issue of the enormous tragedy that is taking place daily on Europe's southern borders (and in any event many of the newcomers currently arriving in Spain are doing so as part of family regroupment processes) but the absolute number of people leaving is very large, and those leaving possess a skill set which is vastly superior to that of those arriving, so in the longer run the human capital drain on Spain is massive, again reducing the potential longer term growth rate. As the IMF point out, projections here are pretty risky, but still the Spanish statistics office (INE) have made an attempt, and the result can be seen in the table below.


The impact of this hemorrhage (if it is confirmed over time) on Spain's population pyramid will look something like this.





Basically Spain's population will suddenly have become much smaller and much older. The population will fall by 2.6 million, and the number of people in the  20 to 49 age group will fall by 4.7 million (or 22.7%). This is why it is so important to try to do something more and boost employment rapidly. Otherwise the impact on long term growth will be sizable, and the pressure to reduce pensions constant. This INE population and emigration forecast is, if you like, based on a no policy change assumption, on what will probably happen unless substantially more is done. It is the sense of urgency about this need to do something more that I - and others - do not find encapsulated in the phrase "Spain has turned the corner". If these population projections are realized then quite simply it won't have done so. Pensions, for one thing, will be set on a continuously downward path, which is why I think pensioners could be convinced of the need for them to make sacrifices now, if the situation were better explained to them. For another the debt which is currently accumulating will have fewer and fewer people left to pay it. And lets not even start talking about the impact of this sharp reduction on the value of Spanish property.

The real problem in Spain - and this issue isn't treated in the report - is the complete collapse of civic confidence in many of Spain's institutions, from the Bank of Spain, to market regulator CNMV (the Bankia IPO, Preference Shares), to politicians and political parties (the Barcenas affair, among many others), to the monarchy. It is this crisis of confidence which makes it so difficult to get the consensus to make more sacrifices.

Many say that there can't possibly be 25% unemployment in Spain since if there were there would be a revolution (referring to the existence of the underground economy but conveniently forgetting that the worst years of the 1930s depression were not years of revolution, those came later).

What people are missing about Spain is the way the credibility of the institutional structure is weakening. Voices talking about a constitutional crisis are growing. The economic crisis basically coincided with the moment when the set up established - including the return of the monarchy - during the transition from Franco's dictatorship to democracy was increasingly seen as having "run its course". Many observers recognise that major constitutional reform is needed and some kind of "rebirth" and renovation in the political system. Last months EU elections were the latest warning signal. The two main political parties (the so called institutional parties) for the first time since the transition failed to get over 50% of the popular vote between them, while the Syriza-like Podemos - who hadn't even been listed in the opinion surveys - surged from nowhere to take 5 seats and 9% of the vote. And in Catalonia a large majority of voters voted for parties who are actively campaigning for independence from Spain. A general election is coming next year, but it is hard to see either of the "old" parties getting a majority without a complex set of coalition partners.

So rather than asking whether Spain has now gone round the bend perhaps the Fund would have been better off sticking with "Getting better, but not out of the woods yet, not by a long way".

Thursday, May 29, 2014

Spain: The Land Where Incipient Deflation Becomes Good News For Headline GDP (Updated 29/05/2014).

The Spanish National Statistics Office (INE) today published the first detailed estimate of Spain's Q1 GDP. Basically they confirm the gist of the original Bank of Spain numbers (see my report of 25 March below) although there are some important nuances.

In my earlier report, I stressed that Spain's Q1 surge was as much a statistical artifact as anything else since:

a) Nominal GDP growth was virtually stagnant, and the application of the (negative) GDP price deflator (see explanation in earlier report below) explained most of the annual growth.
b) Spain's strong export drive has stalled, with exports being little changed in March 2014 from September 2013.
c) There was a major input from government spending. An important part of the explanation for the momentum behind Spain's recovery has been the relaxation of austerity, and the strong injection of government funded liquidity into the economy.

All these three trends are confirmed by the latest data, albeit, as I say, with significant nuances.

GDP deflator: Inter-annual real GDP growth was revised to 0.5% from the 0.6% in the INE flash estimate. More importantly we learnt today that nominal GDP fell 0.1% over the year, confirming the impression that despite the recovery people had less money in their pockets (this is what deflation means).

Export recovery: exports fell by less than originally estimated (by 0.4% quarter on quarter rather than by 0.6%) but the big change came in imports which moved from an estimated fall of 1.2% (q-o-q) to a rise of 1.5%. The net trade contribution to the final GDP number thus swang from being 0.2% positive to 0.2% negative. However the impression that this is no longer an export lead recovery was confirmed, as was the fear that as government-stimulus fed domestic demand imports would once more surge. This seems to confirm the idea that the economy is not as internationally competitive as the official sector claim it is.

Government spending: the big shocker in the latest report is the role played by government spending in arriving at the final number. The Bank of Spain only mentioned there had been an increase, giving no estimate for its magnitude. Today we learn that government spending was up 4.4% on a quarterly basis, following a 3.9% decline in the last quarter.This confirms the impression that there was a significant ending-the-budget-year-early effect (see original report below), as spending was transferred from Q4 2013 to Q1 2014. It also confirms the impression obtained from the Q1 labour force survey where we learnt that while private sector employment contracted during the first three months of the year, public sector employment rose by 11,100.  Naturally, if the government is to comply with this years reduced deficit target this momentum cannot be maintained, suggesting we will now see some weakening in the headline GDP number.

In fact in their latest report on the Spanish economy (published May 28) the Bank of Spain confirm this impression, saying that "Los indicadores coyunturales más recientes apuntan, en general, a una prolongación de la fase de recuperación de la actividad, si bien se aprecia distinta intensidad según se trate de información procedente de indicadores cualitativos o cuantitativos". Roughly translated this means that the recoverey phase has continued into the second quarter although the intensity may have reduced according to which indicator you look at (hard and soft). They cite the EU household confidence indicator, which continued to improve in April but less than in the previous three months. Also sales (both of goods and services) by large companies moderated their annual growth rates in March compared with earlier months. To me it looks like Q2 quarterly growth will be weaker than Q1. possibly in the order of 0.2%.
 
Construction activity is an interesting area. The INE Q1 report suggests a quarterly decline in construction activity of 2.6%, yet data supplied by the INE to Eurostat show a 9% rise during the quarter, an improvement that is consistent with other information available. Spain has something like 400,000 unfinished houses and bad bank Sareb and investment funds who have purchased distressed property loans appear to be finishing some of these housing units off in readiness to let.


All in all the argument I am pursuing here is not that Spain's economy isn't recovering - it is - but that the recovery is much weaker and much less well balanced than many think it is. Momentum going forward looks weaker than people expect, employment growth is tepid (except in the public sector), and the fall in unemployment is as much a product of people leaving the country or retiring as of anything else. Spain is already in deflation, house purchases continue to be postponed awaiting a further fall in prices, and the hard won rebalancing of the economy towards external trade is steadily being undermined.


Perhaps just one data point sums this whole problem up. According to seasonally adjusted data, nominal GDP rose by 1.432 billion euros during the quarter, while nominal government spending rose by 2.494 billion euros (or almost double). Not a very impressive bang for the buck. Go figure.



Spain: The Land Where Incipient Deflation Becomes Good News For Headline GDP - 25 April original review
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 According to the bank of Spain, the Spanish economy continued to push forward with its recent expansion in the first quarter, and it do so at an accelerated rate, growing by 0.4% over the previous three months. This is certainly good news for everyone in Spain, and there is no doubt that this is the strongest expansion in economic activity (see PMI chart below) since the crisis started. The economy also grew by 0.5% over a year earlier, the first time it has done this in nine quarters.

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Nonethless many of the old doubts about the durability and sustainability of the Spanish expansion remain. The labour market is still a huge problem, the housing market is gridlocked, credit is scarce and expensive, and the population is shrinking at nearly 1% a year as discouraged workers (both nationals and former migrants) pack their bags and leave. In addition, concerns are mounting that the current government, with low ratings in the polls and elections coming next year, has lost the appetite for reform. Here I will focus on  three issues that strike me in connection with the latest GDP numbers: the stagnation in the export boom, the difficulties being encountered in reducing the deficit and the ongoing deflation issue. The big question still remains: is this a balanced recovery, an export lead one, or simply a government financed one?

Composition of Growth

Here to help think about all this is the Bank of Spain breakdown of recent economic growth.



GDP is a composite, derived by aggregating a number of components. Principal among these are private consumption and investment, public consumption and investment and net trade.  If we look at the composition of growth in Spain in the first three months of this year we find that private consumption grew, but less rapidly (0.3 vs 0.5) than in the preceding three months, government consumption and investment grew (vs contraction at the end of last year) but we don't know by how much because, unfortunately, the BoS don't tell us. Net trade was positive - despite the fact that both exports and imports were down (on a seasonally adjusted basis, by 0.6% and 1.2% respectively). Since imports were down by more than exports, net trade was positive and contributed an estimated 0.2 percentage points (or half) to growth. If imports had fallen by less, by say only 0.6%, then Spanish GDP would only have grown by half (0.2%), such are the quirks of GDP calculations. But it is surely not unequivocally good news if you have had to rely on a slump in imports to get that highest-growth-in-recent-years number.

Lastly Spain is officially in deflation, both of the falling expectations and purchases postponement kind - see this post yesterday - and this is recognised by the presence of a negative GDP deflator, which estimates a fall of 0.4% in GDP price inputs when compared with a year earlier. More on this later.

What is going on with exports?

Spanish exports have been an important part of the country's recovery story, no doubt about that. Services exports (mainly tourism) have been up consistently. But if Spain is to become "the new Germany", and this is what will be needed (current account surplus and all) if the country is to return to stable growth, goods exports need to grow and keep growing at a steady rate, and this is where the evidence we have to hand is a little less than convincing.

 The fact of the  matter is that - according to the latest bank of Spain estimates - goods and services exports ended March at the same level they reached at the end of last September. This is surely a strange result for a country during one of its best moments in an export driven recovery. True Spanish exports are up about 7% over where they were a year ago, but almost all this growth came in the second three months of 2013, just before the impact of Federal Reserve Tapering (which hit in May) was felt in the fast growing emerging markets. Sound familiar?

So in fact while the export story does continue on a modified basis, with growth in the Euro Area picking up some of the slack left by the demise of the EM customer base, it is a long way from being as vibrant as it was. This tendency is clearly revealed in the latest press release from the Economy Ministry covering exports (for February). While in the whole of 2013 export to the Euro Area were only up 0.1%, in January and February of 2014 they were up by 5.5% from a year earlier. Meanwhile exports to non EU destinations were only up by 0.4% over last year even though exports to the US, China and Japan all increased by significant percentages.

Not only are goods exports when compared with six months earlier rather stationary at the moment, the order books suggest the situation won't be improving radically in the coming months as the following chart from the national statistics office illustrates.


Overall new orders were down year on year by 1% in February, with orders from the domestic market - which were down by 2.2% - dragging the aggregate with it. Export orders were positive, but the composition changed, with demand from the Euro Area up 1.6%, while orders from outside the EA were down by 4.8%.

This division between improving export orders and weakening domestic ones is an ongoing story, as the following chart, again from the INE, illustrates. The interesting line is the seasonally adjusted one, and it shows that only in two months in the last two years - December 2013 and August 2012 - have industrial orders been above the level of a year earlier.

This phenomenon is due to the enduring weakness of domestic demand, and even with the recovery the pattern doesn't seem to have been radically altered. Industrial output is up, but only very very marginally, hardly noticeably even in the great scheme of things.


In the meantime, the fact that domestic demand is rising has been having a negative impact on the evolution of the goods trade balance, which after hitting a historic surplus high last March has been in deficit territory almost ever since.



Indeed if we look at the trend, after steadily reducing the deficit has once more stabilized well in negative territory. So while Spain's export sector has made considerable progress - more than most, but then the country's problems are greater than most - there is still a long road left to travel. Most importantly a net trade impact based on a sharp fall in imports is not what we should be seeing at a point where the recovery is gathering traction. It does not suggest a broadening out into steadily improving domestic consumer demand, but quite the contrary.

Deficit Difficulties

Spain, as is well known, was given extra time by the EU Commission - 2 additional years - to bring its fiscal deficit down below the 3% of GDP mark. In fact the country has made enormous efforts to reduce the deficit, but the results of such efforts have often been far less than had been hoped for. After hitting a peak of 11.2% of GDP in 2009, the deficit figure has meandered from 9.7% in 2010 to 9.6% in 2011 to 10.8% in 2012, to finally reach 6.6% in 2013. Not surprisingly this deficit record has produced a rather astonishing surge in the government debt level, from 36% of GDP at the onset of the crisis in 2007 to the current level of nearly 100%.

But even this 2013 6.6% number is not everything it seems to be, since the government was forced to draw down some 2% of GDP extra from the pension reserve fund (intended to help get the country through the difficult demographic moment that arrives at the end of the decade) and a further 1% of GDP from the Suppliers Fund (which is to pay suppliers previously unpaid bills). Neither of these liquidity injections affects the EDP deficit, but both certainly help the government square the difference between spending and income. Even so, in order to maintain the 6.6% number (actually it should have been 6.5%) the government was forced to draw the budget year to a close on November 25.

As reported in March in the Bloomberg article - Spanish Government Ended 2013 in November to Reduce Deficit - Spain brought forward the deadline for approving spending in the annual budget for the second straight year in 2013 following a 2012 decision to end the year on December 3. Previously the cut-off date had been the last working day of the year. Hence the enigmatic statement from the Bank of Spain that both government consumption and investment grew in Q1 following "their marked decline in the closing months of 2013". The marked decline was partly due to the cut-off date, so for deficit compliance reasons some of the spending was transferred to Q1 2014, giving a small boost to the headline GDP number.

In fact, the EDP accounting measure is becoming an increasingly blunt instrument for measuring the extent of Spain government spending and the dynamic of its debt obligations. According to Bank of Spain data there were something like 1.35 trillion euros of Spain government debt obligations in circulation at the close of 2013, as compared with the 961 billion euros worth which count as debt under EDP rules. I dealt with this issue at some length a couple of years back, but leaving aside the details - groso modo - it is clear that there is much more Spanish debt out there than many are assuming. Even more surprising is the fact that total debt obligations rose by some 14.5% during 2013, and that 56% of this increase came under headings which don't count towards the EDP measure.

The argument here is not to suggest that Spanish gross sovereign debt is 132% of GDP (which a superficial reading of the headline number would suggest) - the reality is more complicated - but that it is certainly significantly higher than the 93.9% of GDP reported to Brussels under the  EDP criteria. But even more importantly - and this is really the argument I want to get across - in order to achieve a positive GDP quarterly growth figure at this point it is almost impossible to really reduce the scale of the fiscal deficit, whatever Herculean efforts you make. The rest is simply smoke and mirrors.

The Role of the GDP Deflator

Finally we come to what may well be the most important doubt that enters my head when I look at that Bank of Spain table I reproduce above: the role played by the magnitude of the GDP deflator in arriving at the headline GDP number. The GDP deflator is the measure that is used to convert nominal (current prices) GDP into real (comparing apples with apples and not with pears) GDP, since it is an attempt to remove the impact of price movements (inflation or deflation) from the final benchmark GDP reading. Let's take an example. If nominal GDP grows 5% and inflation is 3% then real GDP has grown by 2%. If inflation is then re-estimated at 2% then real GDP growth turns out to have been 3%, and so on. Compensating for deflation is when things start to get more complicated, and doing so when nominal GDP is either stationary or negative is when the world gets really wonky.

Lets take the case where nominal GDP grows by 2%, and deflation is 1% - then real GDP grows by no less than 3% (you have to add the deflation number, not subtract the inflation one, if in difficulty ask the Japanese for help, they have been doing this for years). Now lets imagine a case where quarterly nominal GDP growth is zero, but the GDP deflator is estimated at minus 0.4% (aha, now you see where I am going). Then in this case real GDP grows on the quarter by 0.4% (precisely the current Spanish result). Supposing that later you revise this estimate to minus 0.2%, then GDP growth is halved at a stroke, since it also becomes 0.2%.

I am not the first person in the world to to think about this issue, and especially not in connection with Spanish GDP data. Back in August last year the UK economist Shaun Richards wrote a blog post - What is happening with the national accounts and GDP of Spain? - which dealt with a number of similar issues. Shaun examines the impact of a series of data revisions carried out at the end of Q2 2013 and draws some thought provoking conclusions.

In particular he examines the impact of a number of statistics office revisions to the GDP deflator estimates. As he tells us,
"we get a new view on Spain by observing that it (the estimated GDP deflator) has been effectively zero since the end of 2008. I am slightly exaggerating as in fact it adds up to 0.17% but I hope that you get the point. The revisions here have been large as the number was previously 1.58%! Now consider GDP numbers which are sometimes poured over for 0.1% and we see one more time that such behaviour is bizarre as they are by no means that accurate. Indeed 2011 seems to be a troubled year for Spain’s accounts as implied deflator inflation was 0.96% and is now 0.02% which is much more like 1% than 0.1%."
 Certainly then the GDP deflator plays a very central role in final Spanish GDP outcomes, and the sensitivity of the early GDP estimates to errors in the deflator value is striking. As I am suggesting here the value attributed for Q1 2014  effectively accounts for 100% of the estimated GDP growth, and the probability of subsequent revision is, going by past experience, large. Indeed in the Spanish context could it be said to be the loop which finally squares any unfortunate circular gaps in the national accounts?

And when I said when nominal GDP is close to zero things get wonky, I meant it. According to data from the Spanish national statistics office, seasonally adjusted nominal quarterly GDP hasn't budged more than a decimal point from 255 billion euros since Q2 2013 (see chart below), and even then the decimal movement has been downwards. We don't have an estimate for the first quarter of this year yet, but if the 0.4% real growth and the minus 0.4% GDP deflator estimates are confirmed, then it should be just about where it was during Q4 2013.


I was surprised to find this, but then maybe I shouldn't have been since shopkeepers have been telling me for months that the takings in their tills hadn't improved. Now we know why. There has been an improvement in output VOLUME and COMPOSITION, since prices have been falling and the economy has reorientated somewhat, but not in overall turnover. Looking at these numbers one of two things are true. Either Spain has been sliding steadily into deflation over the last year, or there has been no recovery. There would seem to be no available third reading. The most probable interpretation of the data we have to date would be the former, that Spain is sinking steadily into deflation. I assume the statisticians at the economy ministry understand GDP calculations sufficiently to get this. In which case the constant denials, and references to early Easter "one offs" etc would seem to be totally irresponsible.


So, the ability of the Bank of Spain to offer an early estimate (normally confirmed by the INE first estimate) of GDP growth - based on the variables included in the economy ministry's synthetic indicator - comes at a price: you need to wait 12 or 18 months to get a much more precise measure of what is going on. As Shaun says:
One of the issues with Gross Domestic Product numbers is that they are revised over time sometimes significantly. This does not fit well with the short attention span of modern media and so leads to an obvious temptation to publish relatively optimistic figures and then revise them later once the hue and cry of the pack has died down.  

Conclusions

As I state at the outset, I have no doubt whatsoever that Spain's economy is undergoing a modest recovery. Even economy minister Luis de Guindos calls it weak, fragile and uneven. Serious doubts exist about the extent to which we are going to see anything resembling a "classic recovery" in Spain, a recovery where solid export growth eventually broadens out into a wider improvement in domestic consumption and investment, even though this is what financial markets increasingly seem to be pricing in. Press headlines have trumpeted the country's new found growth, but when you dig under the surface and find that most of the latest growth is either accounted for by a sharp DROP IN IMPORTS, or by a CALENDAR ADJUSTMENT IN GOVERNMENT ACCOUNTING, or by the ESTIMATED ARRIVAL OF DEFLATION then the conclusions you draw are hardly reassuring ones.

If in addition these highly-subject-to-later-revision initial estimates are used by the incumbent government to try to shore up its wobbly position, and also used as an justification for not carrying out deeper reform - especially in the labour market where unemployment remains over 25% - then  beyond not being reassuring they start to become preoccupying.

Sunday, April 20, 2014

Firmly Anchored Expectations, No Postponement of Purchases?

This article from former European Central Bank board member Jürgen Stark (Doomsayers risk a self-fulfilling prophecy) has been occasioning a lot of commentary over the last week or so.
According to Stark, the current deflation debate "lacks three important points: an in-depth analysis of the forces driving inflation down; a clear distinction between “benign disinflation” and “bad deflation”, with a spiral of decreasing prices, wages and output triggered by negative expectations; and a better understanding of the European Central Bank’s approach".

Perhaps the most cited extract is the following:

"It is likely we are living in an extended period of price stability. This is good news. It boosts real disposable income and will eventually support private consumption. Inflation expectations are well anchored, and there is no evidence households and companies are delaying purchases because of negative expectations. Warnings about outright deflation and calls for ECB action are misguided and irresponsible. The longer this discussion continues, and the more intense it becomes, the more likely the risk of a self-fulfilling prophecy".

Two questionable assertions immediately struck me, the idea that inflation expectations are well anchored, and the claim there is no evidence households are delaying purchases because of negative expectations.


Well Anchored Expectations?

The above chart shows implied inflation expectations as derived from the swaps market. As can be seen expectations have been steadily falling for more than a year now, and they are falling right across the 2014 - 2018 term horizon. Indeed, as of the time of writing the implied inflation  rate is still (at  around1.75%) below the ECB 2% inflation objective 10 years from now (see chart below).


If these are well anchored expectations, well, I'd like to see what badly anchored ones looked like..... 


Purchase Postponement Evidence From Spain's Housing Market

The second claim I find questionable is that we have NO evidence for purchase postponement decisions. The phenomenon may not be widespread at this point - first of all prices actually have to start to fall - but let's take a look at what has been happening in Spain. House prices have now been falling steadily since the end of 2007 (I use the real estate valuers TINSA index).


House prices are now down around 40% and continue to fall. There is no reliable estimate of when the slide in house prices will come to an end, and buyers act accordingly. New home sales, despite a massive stock of nearly a million units (between completed and still to be completed), remain near historic lows, and were down in February over 30% from a year earlier.




It's clear that people are delaying purchases in the expectation of lower prices in the future, and they will continue to do so. Why does this matter. Well, let's look at some charts for Japan.


The collapse in land prices was one of the principle underlying elements driving debt deflation in Japan. In Spain we don't have a reliable land price index (to my knowledge) but it might be worth bearing in mind that before he left the Bank of Spain former governor Miguel Angel Fernandez Ordoñez jokingly told journalists that "well, we shouldn't expect these assets to have negative value, now should we?" Not sure he continues to have a smile on his face when he talks about this. These land assets may now be largely provisioned for and valued at virtually zero, but there are a lot of them remaining on bank balance sheets and stored in the "bad bank" Sareb, and it isn't clear what the impact would be of releasing them at market value on  the price of new homes. (Hint, in many urban areas the land cost was roughly 50% of the final house price before the crisis).

To some extent it is the collapse in land prices that has acted as an underlying drag on retail prices in Japan. In the EU HICP housing costs are not included. If they were Spain would already be stuck in entrenched deflation.

Naturally, the Spanish housing market can be discounted by some as an isolated phenomenon, although I would argue it is important enough to make it very difficult to see the ECB being able to raise rates over any foreseeable time horizon due to the pain this would cause to those with mortgages. But how many other examples like this may there be lurking out there? Has Jürgen Stark really run a systematic search, or is he simply repeating - as in the case of well anchored inflation claim - what could be considered to be the official mantra.

Meanwhile we simply watch and wait. Spain EU HICP consumer inflation at minus 0.2% in March over a year earlier.






While Spain's factory gate prices dropped an annual 2.9% in February.