Friday, November 27, 2009

Total Eclipse Of The Sun Hits Dubai World

Back in the heady days of 2006 some 30,000 cranes, roughly a quarter of total global capacity, were busy whirring away in Dubai. Today most of these devices have either left to find service in other parts of the globe, or lie silent, unused and unloved. In what is only the latest sign of the ongoing property snarl-up affecting the emirate Nakheel, Dubai World’s property developer subsidiary, asked on Wednesday for a delay in their next debt payment. The move was widely seen by investors as a technical default, raising concerns about investment in risky assets right across the globe. So while their company slogan may well be that the sun never sets over Dubai World, the fact is that Dubai World’s sun not only no longer shines, it is suffering from something more like a total eclipse.

According to the last reckoning, government owned Dubai World has some $59 billion in outstanding liabilities, making the company responsible for the lion’s share of the total $80-100 billion in estimated Dubai state debt. Up to now all maturing government-linked debt has been paid off in full, with government funds making up any shortfall in private funds. But the latest announcement suggests that weaknesses in the global property sector and vulnerability of the emirate’s economic model is leading the government to have second thoughts, and the clear impression is that Nakheel could be a very different story given the government's expressed intention of supporting only viable companies.
More than the scale of the issue, the problem this week in Dubai has been the uncertainty created, the underlying lack of transparency about the state of corporate and national finances and about exactly which debt will be honored, and above all about whether or not other countries – both within and outside the region - will be affected via the process known to financial analysts as contagion.

The consequences of the present payment standstill are wide ranging, as would be the impact of any eventual default. The repayment of Dubai World's $4 billion Nakheel bond was seen by investors as a key test for the emirate's ability to deal with the rest of the $80 billion or so owed by the government and its state-controlled companies. Dubai’s ability and willingness to do just this is what is now in doubt, and the way the process has been handled so far is leading to all manner of investor speculation.

The blow caused by the announcement was initially softened by news earlier the same day that the government had raised $5 billion from Abu Dhabi banks, but this optimism was soon dented as it sank in that the figure was considerably less than what the emirate had been hoping to attract from external investors and the sequencing of the two announcements is interpreted as suggesting that the Abu Dhabi money will not be spent on companies like Nakheel and Dubai World.

Indeed Dubai's growing problems had been evident for some time, with the credit rating agencies sharply downgrading Dubai government-owned corporations over the last year as expectations for the extent of likely government support have declined. Earlier this month Moody’s cut the ratings on Dubai Ports World, and Dubai Electricity and Water to Baa2 (junk status) from A3 and downgraded 4 other government linked companies, with the agency noting in its press release that the debt restructuring plan "highlights the government's intention to strictly adhere to its stated policy of supporting only those companies with viable long-term business prospects”

Aside from the Dubai issue itelf the big worry now is possible contagion to other markets, with Central and Eastern Europe in the forefront of everyone’s mind, given the overlap in bank exposure. The announcement also lead to a sharp a drop in the value of the UK pound on the fear that the Dubai government could be forced into a rapid sale of its international real estate, and since the emirate has extensive UK property holdings which might go under the hammer any such move would clearly have implications for the UK property market, and the banks that have exposure to it.

In total European banks are estimated to have some $40 billion of exposure to Dubai with Standard Chartered leading the group according to research from Credit Suisse. HSBC Holdings, Barclays, Royal Bank of Scotland Group and Lloyds Banking Group also have some, significantly lower, exposure.

Since the decision to halt payments has raised fears of the largest sovereign default since Argentina 2001, most of the attention has been focused on sovereign debt issues, and these, of course, extend far beyond the Middle East itself. In particular European bond market worries grew over the ability of riskier government borrowers from Russia to Greece and Italy to pay back their debts in the longer run. And it is just here that one of the long term consequences of what happened this week in Dubai can be found, since with government after government pressing the accelerator pedal hard to the floor on the stimulus front, and digging ever deeper into the public purse to plug gaps in the bank balance sheets, the perception that paying back all the accumulated debt may be harder than expected, especially with ageing population problems to think about, is now gaining traction among investors. And once sovereign debt default fears really come up over the investor radar, it is going to be very hard work to remove them.

Greek sovereign debt in particular is attracting a great deal of attention, and this week one historic milestone has been passed, since the cost of insuring Greek debt for the first time equalled that of insuring equivalent Turkish debt. At first sight this is very shocking news, since as recently as 2007, the Turkish CDS spread was trading at about 500 basis points on perceived fiscal risks. The Greek spread, by contrast, was nearer 15bp. The country is, after all, a member of the European Monetary Union, and its euro-denominated bonds were considered effectively protected by other euro states. But over the past year the fiscal position of many emerging markets nations, Turkey among them, has become more favourable, while that of some Eurozone countries, including Ireland and Spain as well as Greece, has steadily deteriorated.

Evidently such comparisons constitute a fairly bitter blow to Greek pride, but there is a much bigger issue here, one which goes straight to the heart of the Dubai saga. Two years ago, global investors generally did not spend much time worrying about the risk that seemingly remote, nasty events might occur. But the financial crisis has changed this perception. Having had their fingers badly burned once, investors are eager not to have it happen a second time, which is why what is happening in Dubai now makes them nervous, and why Europe’s governments would do well to think more about the future, and especially about ensuring that we don’t see Dubai like events starting to happen much nearer to home.

Saturday, November 14, 2009

How Much Of A Eurozone Rebound Was There Really In Q3?

Sorry, and I apologise in advance: in this post I'm going to be a nit-picker. The Eurozone third quarter growth story is all about differences (between countries) and these differences are in many ways all about inventories. So maybe I should have titled the post "all about inventories", following Pedro Almodovar's cinematographic lead in cycling and recycling that old "all about Eve" metaphor - necessity is the mother of invention, and movements in inventories are progenitors of both growth, and of that notorious double dip difficulty. So which one is we have on our hands here?

Indeed, the fact that the devil, as always, lies in the details should not really surprise us since economics isn't that different from other sciences, and isn't such a difficult subject to work with - even if some journalists and lot of bank analysts seem to make it look like it is by managing so frequently to make a dogs dinner out of what should really been an ever so plain, ordinary, and vanilla flavour ice cream. Let me explain.

But first off let's register a very simple plain, evident, and totally undisputed item of fact - the "eurozone sixteen" economy (whatever that rather nebulous concept actually refers to, when you dig down a little below the surface) poked its nose timidly out of recession in the third quarter of this year, with gross domestic product in the 16 countries using the euro rising 0.4 percent from the previous quarter (see chart below). This return to positive headline growth technically brings a recession which lasted five consecutive quarters of shrinking output to a close - even though output was still four percent below that registered in the same period in 2008. So we are out of recession, but are we out of the woods?

Well, basically I think we aren't, and to explain why I think we aren't I'm going to pick (yet one more time) on poor old Frank Atkins of the Financial Times. It almost hurts me to do this, since I am not trying to say that Frank is an especially bad example of economic journalism (far from it - see below) even if he is sometimes very badly served by his headline writers who over the weekend managed to switch Friday's declamatory "Germany powers eurozone recovery" (and here) to Sunday's much more modest "European recession ends with a whimper" but since this is the second time just over as many months that Frank has wheeled out the German economy "powering something or other" word out, I cannot help concluding that either he really likes the expression, or that he must know something I don't about what is actually going on in Germany, since structurally speaking it would seem to me that such "powering" is now completely impossible, given the economy's evident export dependence. Thus far from powering up anything, the German economy is always - in some significant and non-trivial sense - going to be "powered" by someone or somewhere else. The thing about Frank is - in Eurozone economic terms at any rate - he is both geographically very close to where the action is (ie in Frankfurt), and communicational very much in touch with thinking in Brussels and Franckfurt, which is what always makes what he has to say interesting, at the very least. On the other hand, since the journalistic consensus seems to have shifted over the weekend - quite literally from a bang for the buck to a whimper - we might really want to ask ourselves whether we still think the rebound is as strong as it was first claimed to be.

"Germany’s economy expanded by 0.7 per cent in the third quarter", Frank told us (in Friday's version) "marking a sharp acceleration in the pace of recovery in Europe’s largest economy, but the pick-up in France fell short of expectations."

Well, here we have two facts - the Germany economy did grow by 0.7%, and growth in the French economy was below consensus expectations - and one opinion, that the growth represented a sharp acceleration in the German recovery. In fact, in France output expanded by 0.3% in the third quarter, a very similar pace to that seen in the second quarter, but significantly below consensus expectations which were for a 0.6% growth rate.

But really the issue this raises isn't actually one about the French economy at all, but about how the economists in question managed to talk themselves into having such ludicrous expectations, and about what methodology exactly it was they were using to arrive at them. Certainly I am a leading "bull" on the French economy, but I never came anywhere near the quoted number in my estimations, and indeed in my most recent full analysis of the French economy, published 27 October last on A Fistful Of Euros and elsewhere, I actually said this:

"French GDP surprised positively with a 0.3% quarterly gain in the second quarter. Given the data we are seeing, a forecast of 0.2% quarterly growth for both the third and final quarters would not seem to be an unreasonable expectation at this point, which would mean the French economy would shrink by something under 2.5% in 2009, well below the average Eurozone contraction rate."

So you could say, rather than being disappointed I should have been rather surprised on the upside by the outcome, since growth at 0.3% came in higher than my expectation (0.2%). But truth be told, I really wouldn't want to make this claim very strongly, since I was in fact practicing what we Catalans call the ancient art of "trampa" (astute trickery), sin being intentionally excessively prudent in order to outperform, and also trying to shift attention away from the short term headline number issues about this quarters French GDP number to the longer term issue of what happens to monetary policy in a "Eurozone 16" if France recovers significantly more sharply than everyone else.

Before continuing further, I would also make a second point, one which I think is pretty relevant to the whole debate about where the Eurozone actually stands in the here and now, and that is that my most recent piece was actually written about the OCTOBER PMI data, that is I was already looking ahead and talking about prospects for the fourth quarter, whereas Friday's release was actually backward looking, and taking us back in time, in order to revisit not Brideshead, but economic data from the third quarter in an attempt to get a better picture of what was happening back then, even if, as we are now about to see, since Friday's release was only a "flash" one, we still lack most of the detailed breakdown which would enable us to do just that. So in many ways Friday's news was already history (which makes it even more surprising how consensus interpretations have shifted over the weekend) and what really interests us is what is happening now, and where the current so called "recovery" is actually heading. And just to rub our noses right in it, we could remember that a week on Monday (23 November) we will have the Markit Flash PMIs for November (and this will already give us two thirds of the fourth quarter data to play around with, which should help us come up with quite realistic estimates of what eventual GDP will look like).

Thus, despite my openly professed French "bullishness" I do want to stress that I am only expecting modest growth again from France in the fourth quarter, but the important point we should expect this growth to be sustained going forward, and it is this that makes France so different from much of the rest of the Eurozone, since France has the capacity to generate autonomous (endogenously driven) growth in consumer demand and it is precisely this feature that makes the French economy so special (in the Eurozone context) at this point. Anyone looking for dramatic (sustained) surges in the any of the advanced economies at this point is, basically, living on another planet (possibly, I suspect, the one we are all being expected to send our exports to).

Now, after so much palaver, why do I consider this digging for details to be so important? Well, lets look at this from the German Federal Statistics Office:

"In a quarter-on-quarter comparison, when adjusted for price, seasonal and
calendar variations, especially exports as well as capital formation in
machinery and equipment and in construction had a positive impact on growth.
However, a large quarter-on-quarter increase was also recorded for imports
which, among other things, led to a build-up in inventories. Final consumption
expenditure of households, however, was down and slowed down economic growth."

Now if you look at the chart below, you will see that German growth was in the second quarter was, more than anything, a statistical quirk which resulted from a balancing act between strong swings in inventories and in net trade. In the third quarter, as far as we can see (since we don't have that ever so important detailed breakdown), this position has quite literally been inverted, as the earlier trade bonus has been eaten away by growth in imports (largely to stock up on export oriented inventories, not items destined towards domestic consumption) and this part we more or less know, since we do have all the trade data in for the quarter.

So we need to see the MAGNITUDE of the German inventory shift, and then we can get an idea of how much this could unwind in Q4. The current position reminds me very much of Q1 2008, when Germany put in a record annualised growth rate (1.7% q-o-q, 7.2% annually) only then to slouch off into recession and four consecutive quarters of GDP contraction. One reason for this surge in GDP, then, was that the huge growth registered was a by product of a massive inventory pile-up (see chart), a pile up which was precisely the result of an anticipated continuation in demand, demand which, as it happened, never materialised.

Now the current position is not as bad as Q1 2008, since the size of the distortion is not so great, and the general external environment may be more supportive in Q4 2009, but still I think the general structural point holds. Indeed the October PMI suggests inventories are coming down again, with Markit reporting that "companies remained cautious regarding input buying and stock levels" and that the "October data showed that both inventories of purchases and finished goods fell sharply over the month". Finally, we should not let this last point from the German Federal Statistics Office Report escape our notice, since at the end of the day it holds the key:

"Final consumption expenditure of households, however, was down and slowed down economic growth."

So now, by way of comparison, let's turn our attention to France, and see what was actually happening there. Now, according to the quarterly report from analysts at Nomura:

"France is the only country to publish a components breakdown and the details are disappointing, with domestic private demand still very depressed. Most of the growth came from public spending and net trade; private consumption was flat, while fixed investment from firms and even more from households retrenched heavily. Inventories continued to decline."

Well, as Nomura say, France has published a table showing the breakdown, and just for the record, here it is:

Now the Nomura people say "with domestic private demand still very depressed", but, I'm sorry, if you take a look at line three in the table, which shows quarter on quarter household consumption, you will see this is stable, and up. In fact France has not shown one single quarter of quarter over quarter contraction in household spending during the whole crisis. This is what I mean when I say robust. Now you could say that this is all about cash for clunkers, and to some extent you would be right, but other countries have had cash for clunkers programmes, and domestic consumption hasn't held up anything like as well, so the outstanding issue for economic theory, and for eurozone monetary and fiscal policy, is why, why does the French economy and none other exhibit this profile?

Now you might want to argue that French household consumption was stationary in the third quarter (and this is what many of the analysts point to), but I would respond by pointing out it is still well up on consumption in the third quarter of 2008 due to the earlier quarters of growth. OK, so we don't exactly have a consumption boom (yet), but is anyone really expecting one at this point? Even in Norway? All I am saying, and saying almost boorishly, to the point that it irritates, is that French consumption has the potential to rise in the coming quarters, while German consumption doesn't, and this is going to be the key FACT about the Eurozone in the months and quarters ahead. And if you find economic at times a boring and tedious subject, then I'm sorry, sometime things are just like that.

And please, please, note this: "Inventories continued to decline."

Look at the next to last line in the table. French inventories fell by 1.5% quarter over quarter. So, to put things plainly, the real difference between those headline GDP numbers for Germany and France is that Germany increased inventories while France ran them down, and government spending in both cases played a large part in the growth. The thing is, in the fourth quarter it is quite likely that Germany will have to run down some of those inventories, while France may start to increase them. Either way, I repeat, at this point French growth (even if at a tortoise pace) looks a lot more robust and a lot more sustainable than growth in any other Eurozone country, and if things turn out as they appear to be, then we will one more time need to be asking ourselves just what it is that is wrong with "convergence theory", since whatever the actual reason behind the present Eurozone divergences, the plain fact of the matter is that they exist.


The third quarter GDP data suggest that the region has exited recession, but the move was hardly a decisive one. Despite a 12%ar gain in industrial production across the region, GDP managed to increase by only 1.5%ar. Clearly, there was a lot of weakness in construction and services. These data will reinforce the perceptions of the consensus: that the upswing will be lackluster and bumpy. And, they present a major challenge to our more upbeat forecast of growth over the coming year. Indeed, if GDP can only increase by 1.5%ar when IP grows at a double digit pace, the largest gain since 1984, one can only worry about the future.

Ah well.

The GDP rise, incidentally, means that Greece, Spain and possibly Ireland are the only major Eurozone countries still in recession.