1/10/2014: IMF's out of Ideas, but still full of Analysis: WEO Chapter 4

IMF WEO October update is steadily creeping toward its main denouement, the release of the database update at the very end of the process that normally starts with releases of analytical chapters of the WEO - bigger thematic pieces dealing with the core topics relating to the global economy.

This week, IMF released its Chapter 4, covering the issue of current accounts imbalances across the world.

Per IMF, "Global current account (“flow”) imbalances have narrowed significantly since their peak in 2006, and their configuration has changed markedly in the process. The imbalances that used to be the main concern—the large deficit in the United States and surpluses in China and Japan—have more than halved. But some surpluses, especially those in some European economies and oil exporters, remain large, and those in some advanced commodity exporters and major emerging market economies have since moved to deficit."

You don't need to say. Just see this post from earlier today: http://trueeconomics.blogspot.ie/2014/10/1102014-that-exports-led-recovery-in.html

But IMF shows some pretty interesting data on composition and levels of imbalances across the globe. Chart below details these:

The IMF argues that "the reduction of large flow imbalances has diminished systemic risks to the global economy." Sounds happy-all-around.

But as usual, there is a kicker, or rather two:
"First, the nature of the flow adjustment—mostly driven by demand compression in deficit economies or growth differentials related to the faster recovery of emerging market economies and commodity exporters after the Great Recession—has meant that in many economies, narrower external imbalances have come at the cost of increased internal imbalances (high unemployment and large output gaps).

This straight into the teeth of the EU, where 'internal devaluations' (beggar thy own consumers and households) policies are all the rage. But it is also a warning to the emerging markets, where the latest stage of economic growth is translating into falling commodities prices, threatening to unravel their own economic 'recoveries' based on beggar-thy-trading-partners economic environment of elevated commodities prices in the past.

"The contraction in these external imbalances is expected to last as the decrease in output due to lowered demand has likely been matched by a decrease in potential output." Which means a Big Boom! Potential output is the stuff economies supposed to produce once the effects of the business cycle (recession-to-expansion) is netted out. In other words, the stuff that is somewhat long-term 'sustainable'. And the above statement says it is down.

"However, there is some uncertainty about the latter, and there is the risk that flow imbalances will
widen again." Which means 'choose your poison' - either risks are materialising in structural growth slowdown or risk will be materialising in current account imbalances returning once again. Rock. Hard place. The world stuck in-between.

"Second, since flow imbalances have shrunk but not reversed, net creditor and debtor positions (“stock imbalances”) have widened further. In addition, weak growth has contributed to increases in the ratio of net external liabilities to GDP in some debtor economies.These two factors make some of these economies more vulnerable to changes in market sentiment. To mitigate these risks, debtor economies
will ultimately need to improve their current account balances and strengthen growth performance."

And here we have the usual bangers-n-mash dish from the IMF. What it says is that debt overhang is not getting better, but might be getting worse. And with that, the IMF runs out of any solutions other than go back to 'internal devaluations'. Which, of course, gets us back to the first kick in teeth. Bigger rock. And an even harder place. And Euro area is now wedged in-between.

"Stronger external demand and more expenditure switching (from foreign to domestic goods and services) would help on both accounts," says IMF. And this is the statement of surrender. Basically IMF says that if more people were to buy stuff from the countries with weak external balances and loads of debt, things will improve. No sh*t Sherlocks. And if money was growing on trees in Sahara Desert, things would improve even more.

IMF's out of idea. But IMF is still full of analysis. QED.

30/6/2014: The Euro Plus Pact: Getting Causality Between Current Account and Competitiveness Backwards

Gabrisch, Hubert and Staehr, Karsten, new paper published by ECB and titled "The Euro Plus Pact: Cost Competitiveness and External Capital Flows in the EU Countries" (February 18, 2014, ECB Working Paper No. 1650. http://ssrn.com/abstract=2397789) looks at the effectiveness of the Euro Plus Pact which was approved by 23 EU countries in March 2011 and came into force shortly afterwards.

Emphasis in bold in the quotes is mine.

"The Pact stipulates a range of quantitative targets meant to strengthen cost competitiveness with the aim of preventing the accumulation of external financial imbalances."

According to the authors: "The rationale behind the Euro Plus Pact is evident in its original name, the Competitiveness Pact, and also in its current subtitle: “Stronger economic policy coordination for competitiveness and convergence” (European Council 2011, p. 13)."

In virtual obsession of European policymakers with internal competitiveness expressed in terms of cost of labour and production, "Deteriorating cost or price competitiveness in individual countries is seen as a source of economic and financial instability. This view is directly stated in the conclusions from the European Council meeting at which the Euro Plus Pact was adopted (European Council 2011, p. 5): "The Euro Plus Pact […] will further strengthen the economic pillar of EMU and achieve a new quality of policy coordination, with the objective of improving competitiveness and thereby leading to a higher degree of convergence […].""

The authors use Granger causality tests and vector autoregressive models "to assess the short-term linkages between changes in the relative unit labour cost and changes in the current account balance. The sample consists of annual data for 27 EU countries for the period 1995-2012." This allows them to explore the direction and size of the short term linkages between cost or price competitiveness and external capital flows in the EU countries.

"The analyses are particularly pertinent given the adoption of the Euro Plus Pact… The underlying rationale is that deteriorating cost competitiveness is an important factor behind the accumulation of current account deficits and financial vulnerabilities." Thus, the "participating countries must take measures to improve their cost or price competitiveness and thereby reduce the likelihood of financial imbalances accumulating."

First, authors use Granger causality tests to determine "whether lagged values of one variable help explain the other variable when autocorrelation and country fixed effects are taken into account." The result is: lagged changes in the current account balance help explain changes in unit labour costs, while there is no effect in the opposite direction. The results hold for all 27 EU countries, for the EU15 countries and for 10 EU countries.

Second, vector autoregressive models confirmed "qualitative results are in all cases very similar to those of the Granger causality tests. …"

In other words, "changes in capital flows appear to affect cost competitiveness in the short term, while changes in competitiveness appear to have no effect on capital flows in the short term." This is important, as many policy analysts (e.g. Bruegel) and European policymakers (from Commission to national governments) routinely express the view that external imbalances are the result of poor competitiveness, especially in the periphery and especially in the context of driving the momentum of the financial crisis and the great Recession.

Here is what the authors have to say on this: "Increasing capital flows from the core to the periphery of Europe may partly explain the deteriorating cost competitiveness in many countries in Southern and Central and Eastern Europe as well as the improving cost competitiveness in many countries in Northern Europe [prior to the Crisis]. The reversal of these capital flows after the outbreak of the global financial crisis may lead to ensuring changes in cost competitiveness."

But more crucially, there seems to be no reverse direction of causality: pursuit of greater competitiveness does not seem to be a correct prescription for achieving external balances. "...the measures in the Euro Plus Pact to restrain the growth of unit labour costs may not affect the current account balance in the short term."

Now, wait, that is ECB research paper that says 'restraining growth in unit labour costs' (aka: improving competitiveness) may not do much for external balances… Hmm… did anyone hear that Euro Plus Pact tree fall?

And moving beyond the past: is anyone monitoring flows of 'capital' to the 'periphery' in the form of extremely depressed Government debt yields that are prevailing today? Cause you know, that competitiveness might be falling next time we look…

15/7/2013: Current Account Q1 2013: Extreme Imbalances in the Irish Economy

CSO recently released Balance of Payments stats for Q1 2013 - you can read the main headlines and see underlying data here.

Current account data is of more interest from my point of view. And it shows some changes both at a trend and at shorter-term levels, as well as the extremes of skewness in Irish economic activity in favour of the MNCs-dominated Financial and ICT services.

Let's run through the credit side (exports from Ireland) of the CA first.

Aggregate levels of exports (goods and services):

• Aggregate level (goods and services) exports run at EUR55.657bn in Q1 2013, down on EUR60.295bn in Q4 2012 and down on EUR58.034bn in Q1 2012. This marked the level of exports comparable to Q1 2011 (EUR55.570bn) before we adjust for inflation.
• Aggregate exports were dow 7.69% q/q in Q1 2013, having posted an increase of 1.22% q/q in Q4 2012. The rate of decline was 4.1% y/y compared to 2.19% rise in y/y figure for Q4 2012. 
• Current level of quarterly exports is down 12.03% on peak.
• Cumulated exports of goods and services for last 6 months were down 3.87% on previous 6 months and down 0.93% y/y. Last 12 months cumulated exports (12 months through March 2013) were still up 2.21% y/y. 

Chart above clearly shows the downward shift in the shorter-term trend from the peak of Q2 2012. The chart also shows that prior to the Q2 2012, from Q3 2009, rate of increase in overall exports was slower than in the period of Q1 2005-Q4 2007. This suggests that the 'exports-led recovery' of 2010-2011 was not rapid enough to compare with the previous periods of strong exports growth, such as Q1 1998-Q4 2000, and Q1 2005-Q4 2007. Instead, the rate of growth in exports was closer to that attained in Q1 2003 - Q4 2004 - the period coincident with growth post-collapse of the dot.com bubble.

Breakdown between goods and services exports:

• Credit on goods side (exports) shrunk 3.82% q/q in Q4 2012 and this was followed by the decline of 4.83% in Q1 2013. Y/y exports of goods were down 9.21% in Q1 2013, after posting a y/y increase of 0.52% in Q4 2012. Credit on goods side of the Current Account was down 18.16% on peak in Q1 2013. 
• Longer term series for credit on goods side were down 7.12% in current 6 months cumulative basis compared to previous 6 months period and y/y last 6 months cumulated credit on goods side was down 4.47%. Over the last 12 months (through March 2013) cumulated credit on merchandise side was down 1.74%.
• On services side of credit in current account, q/q rise of 4.65% in Q4 2012 was followed by a decline of 8.66% q/q in Q1 2013. Y/y changes are more solid: +8.90% in Q4 2012, slower at +2.68% in Q1 2013. Current levels are 8.66% below peak.
• Longer term trend for Services shows current 6 months cumulated services credits down 0.74% on previous 6 months - bad news. Good news, current 6 months cumulated credit up 5.84% y/y. 12 months cumulated credit through March 2013 is still solidly up 8.75% y/y.

On trends side: chart above shows worrying shorter-term changes downward in merchandise credit, from a gently up-sloping trend established in and contraction in Q4 2009, and a sharp short-term decline on robustly upward trend in services.

Breakdown in the core MNCs-driven services credits is in the following chart:

Balance side:

• Merchandise balance has deteriorated at an accelerated rate in Q1 2013. Net balance in Q1 2013 stood at EUR7.458 billion surplus, down from EUR8.616 billion in Q4 2012 and EUR8.401 billion in Q1 2012. Overall, this is the lowest Q1 balance on merchandise side since the disastrous Q1 2008.
• On Services, side, balance rose to EUR754 million in Q1 2013 from EUR238 million in Q4 2012 and is up on EUR178 million recorded in Q1 2012. Q1 2013 balance marked the third highest balance in the series, but the balance is rather sluggish compared to previous two top performing quarters (Q2 and Q3 2012).

• Overall balance is at EUR1.197 billion in Q1 2013, down on EUR2.895 billion in Q4 2012 and up on deficit of EUR704 million in Q1 2012. Good news is: Q1 2013 marked the 7th strongest quarterly balance on current account side of all quarters since Q1 1998, and the strongest first quarter of any year since Q1 1998.

 Chart below shows breakdown in balance contributions by key MNCs-driven services sector:

The chart above underpins the extremely skewed distribution of source of the current account balance. Taking three sources of the balance attributable to MNCs-driven trade in services: Financial Services, Computer Services, net of Royalties and licenses payments, the three sources of balance accounted for 21.5% of all credits recorded on the credit side of the Current Account, but 190% of the total balance. In other words, even when we factor out net outflows of funds to cover licenses and royalties, the resulting balance on two sub-sectors of ICT and financial services stood at EUR2.271 billion which is almost double the total current account surplus of EUR1.197billion recorded across the entire economy.

07/11/2011: Don't blame 'Johnny the Foreigner' for Western markets collapse

Global current account imbalances have been at the forefront of policy blame game going on across the EU and the US. In particular, the argument goes, savings glut in net exporting (mostly Asian) economies was the driving force behind low cost of investment flows around the world, producing a credit creation bubble via low interest rates. The deficit countries - the US, EU etc - have thus seen easing of lending conditions and world interest rates fell. The credit boom, therefore, was fueled by these savings surpluses, increasing risk loading on investment books of banks and other lenders and investors in the advanced economies.

Much of this orthodoxy is rarely challenged, so convenient is the premise that it is the Chinese and Indians, etc are to be blamed for what has transpired in the West. The mechanics of the process appear to be straight forward with current account imbalances going the same way as the causality argument - from surpluses in the East to deficits in the West.

A recent paper from the Bank for International Settlements, authored by Claudio Borio and Piti Disyatat and titled "Global imbalances and the financial crisis: Link or no link?" (BIS WP 346, May 2011), however, presents a very robust counter point to the orthodox view.

According to authors, "The central theme of the Excess Savings (ES) story hinges on two hypotheses: 

(i) net capital flows from current account surplus countries to deficit ones helped to finance credit booms in the latter; and 

(ii) a rise in ex ante global saving relative to ex ante investment in surplus countries depressed world interest rates, particularly those on US dollar assets, in which much of the surpluses are seen to have been invested. 

Authors' objection to the first hypothesis is that "by construction, current accounts and net capital flows reveal little about financing. They capture changes in net claims on a country arising from trade in real goods and services and hence net resource flows. But they exclude the underlying changes in gross flows and their contributions to existing stocks, including all the transactions involving only trade in financial assets, which make up the bulk of cross-border financial activity. As such, current accounts tell us little about the role a country plays in international borrowing, lending and financial intermediation, about the degree to which its real investments are financed from abroad, and about the impact of cross-border capital flows on domestic financial conditions." In other words, looking at current account deficits and surpluses, tell us little, in authors' view, about the financial flows that are allegedly being caused by these very current account imbalances.

This kinda makes sense. Imagine a MNC producing goods in country A, selling them to country B. Current account will record surplus to A and deficit to B. But the MNC might invest proceedings in country C via a fourth location, country D. Net current account position becomes indeterminate by these flows. Thus, per authors, "in assessing global financing patterns, it is sometimes helpful to move away from the residency principle, which underlies the balance- of-payments statistics, to a perspective that consolidates operations of individual firms across borders. By looking at gross capital flows and at the salient trends in international banking activity, we document how financial vulnerabilities were largely unrelated to – or, at the least, not captured by – global current account imbalances."

The problem arises because in traditional economics framework, savings (income or output not consumed in the economy) is investment. But in the real world, investment is not saving, but rather financing - a "cash flow concept… including through borrowing". Thus, per authors', "the financial crisis reflected disruptions in financing channels, in borrowing and lending patterns, about which saving and investment flows are largely silent." So ignoring the difference between the savings and investment financing, the current account hypothesis ignores the very nature of imbalances it is trying to model.

With respect to the second hypothesis, "the balance between ex ante saving and ex ante investment is best regarded as determining the natural, not the market, interest rate. The interest rate that prevails in the market at any given point in time is fundamentally a monetary phenomenon. It reflects the interplay between the policy rate set by central banks, market expectations about future policy rates and risk premia, as affected by the relative supply of financial assets and the risk perceptions and preferences of economic agents. It is thus closely related to the markets where financing, borrowing and lending take place. By contrast, the natural interest rate is an unobservable variable commonly assumed to reflect only real factors, including the balance between ex ante saving and ex ante investment, and to deliver equilibrium in the goods market. Saving and investment affect the market interest rate only indirectly, through the interplay between central bank policies and economic agents’ portfolio choices. While it is still possible for that interplay to guide the market rate towards the natural rate over any given period, we argue that this was not the case before the financial crisis. We see the unsustainable expansion in credit and asset prices (“financial imbalances”) that preceded the crisis as a sign of a significant and persistent gap between the two rates. Moreover, since by definition the natural rate is an equilibrium phenomenon, it is hard to see how market rates roughly in line with it could have been at the origin of the financial crisis."

In other words, the second hypothesis above confuses the observed market cost of capital - interest rates charged in the market - for the equilibrium natural rates that prevail in theory of balanced goods and services flows. The latter do not really exist in the market and cannot be referenced in investment decisions, but are useful only as benchmarks for long term analysis. Natural rates are "better suited to barter economies with frictionless trades" while the market rates are best suited to analyzing "a monetary economy, especially one in which credit creation takes place". And the market rates are driven by largely domestic (investment domicile) regulation, monetary policies, market structure, etc. In other words, market rates are caused by the US, EU etc policies and environments and not by Chinese trade surpluses.

The main conclusion from the study is that while current accounts do matter in economic sustainability analysis, "in promoting global financial stability, policies to address current account imbalances cannot be the priority. Addressing directly weaknesses in the international monetary and financial system is more important. The roots of the recent financial crisis can be traced to a global credit and asset price boom on the back of aggressive risk-taking. Our key hypothesis is that the international monetary and financial system lacks sufficiently strong anchors to prevent such unsustainable booms, resulting in what we call “excess elasticity”."

The former means, frankly speaking, that bashing China et al is not a good path to achieving investment markets stability and sustainability. The latter means that hammering out a new, more robust risk pricing infrastructure back at home, in the advanced economies, is a good path to delivering more resilient investment markets in the future. No easy "Johnny the Foreigner made me do it" way out for the West, folks.