News from Portugal: Adjustment after all?

Last Friday, Ulrich Fritsche and I presented the results from our analysis of unit labour costs in EMU compared to regional unit labour cost developments at a workshop in Cambridge (see paper here). When we remarked that Portugal had lost roughly 17 percent competitiveness between the start of EMU and 2006, more than has been ever observed in any German Land or US state within any 8-year-period, one discussant remarked that Portugal has actually improved competitiveness in 2007 and is set to do so again in 2008. So, is Portugal actually turning the corner after years in the doldrum?

This question is of utmost importance, not only for Portugal, but also for the question of EMU governance as a whole. Portugal has changed from being one of the fast-growing and applauded economies in the 1990s to a sad example of a country trapped in EMU’s “rotating slump”, with low growth, a record current account deficit of roughly 10 percent of GDP and a clearly overvalued real exchange rate. Since 2002, Portuguese per-capita-GDP relative to EMU has fallen. Convergence achieved earlier has hence reversed.

As Ulrich’s and mine unit labour cost analysis was conducted in 2007, we only used data up to 2006. While I am losely following the EU commission’s forecast, I have to admit that for the Spring 2008 forecast, I did not look in detail at the Portuguese case.

So, later Friday night, I checked the latest forecast of the EU commission on Portugal. The result: Indeed, Portugal has improved its nominal unit labour cost position vis-à-vis the rest of the euro-area in 2007 and is set to improve its competitive position further in 2008 and 2009. While last fall, the EU commission still had predicted Portugal’s unit labour cost increases roughly in line with those in EMU as a whole, it now seems that Portugal is actually starting to correct its unbalanced. Without any doubt, this is good news for Portugal and for the sustainability of EMU. The doubling of the unemployment rate over the past years to 8 percent has finally led to a slow-down in wage increases.

So does this mean that Portugal will soon leave its position at the bottom of European growth tables? Unfortunately, no. According to the EU commission’s data and forecast, Portugal has improved its relative unit labour cost position by 1.1 percent in 2007, will improve its unit labour cost position by 0.7 percent in 2008 and a further 0.3 percent in 2009. From 2007 to 2009, Portugal will hence have improved its competitive position by 2.1 percent, which equals an annual improvement of 0.7 percent. Compared to what has happened in other adjustment candidates, such as Germany over the past decade, this is still quite slow: From 2002 to 2006 alone, Germany improved its competitive position by 1.5 percent per year.

If Portugal continues to improve its competitive position with the speed projected from 2007 to 2009, it will take about 22 years until it has reached the competitive position it used to have before the start of EMU. Of course, Portugal might have entered EMU at an undervalued exchange rate and some of the real appreciation might be due to the Balassa-Samuelson effect. In addition, being a small country means that effects might be earlier to come about than they did in Germany for which it took almost a decade of falling relative unit labour costs before exports picked up enough to provide the country with a decent upswing.

However, as far as we know from Germany, a prolonged period of stagnating real incomes (which a long wage restraint in Portugal would result in), changes consumers’ expectations and behaviour. To get out of this again, Portugal might actually correct the real exchange rate below the equilibrium level to get the economy growing again at a decent speed.

Moreover, with the government deficit still close to 3 percent of GDP the global downturn might again make new expenditure cuts in Portugal necessary, increasing the pain and further slowing economic growth.

Hence, the Portuguese might still have a long way to go before their income convergence sets in again and they might again climb up in the European growth leagues. While adjustment eventually now looks more likely than half a year ago, the time spans involved are still scary.

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The euro economy in 2008

One year ago, we forecast on Eurozone Watch the economic developments in the Euro area for 2007 with a surprising accuracy (see our ex-post analysis here ). As promised, we would like to present now our predictions for 2008, with this first post covering economics and a second post over the coming days covering the politics of the euro area.

Will the credit crisis push the Eurozone into a recession in 2008?

No. The growth momentum in Europe is still strong enough to withstand even a minor recession in the US and keep overall growth in the positive territory. Job creation is still strong and consumption, investment and exports growing. At the same time, in most countries, companies have solid balance sheets so that they can continue their investments.

That being said, the credit crisis its taking its toll in Europe and European growth performance in 2008 will be significantly worse than in 2007. Overall, GDP growth in EMU will not be more than 2 percent with much of that growth being a statistical overhang from 2007. There is even the possibility that some of the larger euro countries will come close to stagnation in quarter-on-quarter terms and there that single countries will experience a technical recession (defined as two consecutive quarters of a quarter-on-quarter GDP contraction). Italy might see significant weakness as the country will feel the consequences of the past euro appreciations more strongly than others due to the already weakened competitiveness. Germany is set to experience a weak start into 2008 as the changes in the way how companies can depreciate their fixed assets has been changed and this will depress investment despite the sizable cut in the corporate tax rate (see analysis here ). All this is aggravated by the slowing economic growth in the US and Great Britain and the high oil prices which weigh on consumption.

Will the euro appreciation continue with the speed experienced in the past months?

Probably not. While forecasting exchange rates is a very risky business, there are some factors which actually point towards a stabilization of the euro-dollar-exchange rate. First, the mood in financial markets against the US dollar seems to have moderated somewhat. Traders do not seem to convinced anymore that speculating on a further dollar drop is a save bet. Given the fact that the momentum in foreign exchange market is very important for explaining exchange rates in the short run, there is now muss less reason to expect a further depreciation than a year ago.

In addition, we might soon see some improvement in the US current account deficit. With US growth slowing, imports will grow less while exports will be boosted by the depreciation of the dollar (you need to remember that the US dollar has lately even depreciated against the Chinese renminbi).

Moreover, the depreciation of the US dollar has already significantly improved the net foreign asset position of the US: As the US is mainly indebted abroad in US dollars while US citizens and corporations hold plenty of assets denominated in foreign currency, the depreciation we have seen has improved the net foreign asset position and hence the expected income flows which help to narrow the current account deficit.

Finally, with the euro approaching $1.50, the risk for speculators increases that at some point the ECB actually thinks about limited interventions which makes betting on a falling euro much more risky.

Will the ECB increase interest rates in 2008?

No. Even though the ECB has sounded quite hawkish lately, the further loss in growth momentum in the coming months will provide arguments for the doves in the central bank. However, do not expect an interest rate cut anytime soon by the ECB. The ECB has always proved to be very slow and not very decisive when it comes to cutting interest rates in a crisis. As at the moment the monetarists in Europe are gaining ground who claim that the current US subprime crisis shows that it is dangerous to try to use monetary policy to stabilize the business cycle or provide the economy with a strong stimulus in the crisis. Hence, this inclination of the ECB to linger before cutting rates will probably even increase.

Will Spain finally underperform the rest of EMU in 2008?

Not yet. True, Spain is the most vulnerable country of the euro area to the current credit crisis. Not only have real estate prices risen strongly, the corporate sector has also experienced an impressive increase in its debt level over the past years. Private households by now are heavily indebted as well. Moreover, much of the GDP and employment growth recorded over the past years can be ascribed to the construction boom. Add to this the recent downturn in building permits and you have the necessary conditions for an ugly economic downturn.

Moreover, we already see a significant slowdown in the Spanish growth dynamics as is evident by the recent fall of the Spanish manufacturing PMI below the expansion mark of 50 points. In the course of the year, more cracks in the economic performance will appear and chances are that this is the beginning of a long and painful correction.

However, reported GDP growth in 2008 for Spain will still profit from the strong growth momentum (GDP growth in 2007 will most likely turn out to be in the magnitude of 3.8 perecent) and the resulting statistical overhang as well as some robust consumption growth. Thus, while the Spanish economy will clearly take a turn to the worse, we probably will not see the result fully in the annual GDP figures for 2008 yet.

Will the German consumer finally become the growth engine of the euro area?

No. If you look at the standard German growth forecasts, the story is that in 2008, finally the German consumers will open their wallets. The Kiel Institute for example forecasts a real private consumption growth of 2.2 percent, after a small contraction in 2007. This would also provide a boost to the rest of EMU with higher German imports and a slow correction of German undervaluation. In fact, not a single of the German growth forecasts for 2008 which comes to a growth rate of around (or slightly below) 2 percent does so without pencilling in a strong increase in consumption.

We disagree with this assessment. While a consumption growth of 2.2 percent does not sound impressive relative to other countries, for Germany it would in fact be the highest increase since 2000 and a fundamental shift in the behaviour of the German consumer.

While it is plausible that at some point the German consumer will react to better job creation and slightly slower wage growth with increased consumption, the question is whether this strong improvement in 2008 is plausible. Given the VAT increase in 2007, the increase in administered prices and the record-high energy prices, real wages are not really growing yet. Even if you read about some quite substantial wage demands in the British FT, you need to keep in mind that those are first demands, not settlements. Actual wage agreements have been much lower so far. A good guess would be that economy-wide, effective nominal wages will grow by 2.5 percent in 2008, not much above the rate of inflation.

Even if employment continues to grow with a rate of slightly above one percent, we should be happy if we see an increase in real private consumption by 1.5 percent in 2008. Given a slow-down in investment, this would leave us with a GDP growth rate of probably around or slightly above 1.5 percent in calendar-adjusted terms (which would translate into around or slightly above 1.8 percent in unadjusted terms as it is reported by the German statistical office), with consumption growing slower than overall GDP. Exports will again grow faster than imports and external trade will again in net terms contribute to German GDP growth (this again is at odds with the consensus view). The rest of EMU cannot yet rely on Germany as a growth engine for their exports.

Predicting 2007: How well did we do?

Almost a year ago, in the first days of the then young year 2007, we posted two contributions on Eurozone Watch making five predictions each on the economics and politics of the Eurozone for this. Before we will present our predictions for 2008 in the first days of the next years, it is time to look back and see how we did in 2007.

As at the time of making our predictions, a number of blogs called them to be implausible in the combination, overly optimistic or just noted our out-of-consensus-calls (see here or here ), we would like to make some evaluation of our economic predictions (we borrow this idea from Nouriel Roubini). What sticks out is that we did surprisingly well – so well that we were ourselves surprised and that we have to credit a significant part of the success to pure luck. But let’s have a look at the details – first at our economic predictions and in a later post over the coming days at our political predictions:

1. We predicted that the upswing in the Eurozone would continue, “albeit at a slower pace” and predicted Eurozone growth at “slightly above two percent, after slightly below three percent in 2006″. When we made this forecast, we were clearly above consensus with this view as most economists did not trust the stability of the European upswing. In fact with everything now pointing at a annual growth rate of about 2.6 percent, our forecast was much better than most for the Euro area.

2. We predicted that the ECB would increase interest rates “to 3.75 percent in the first half of the year by a further 25 basis points later on”. At that time, most economists still did not believe the ECB would see any need to hike that far, with the average forecast for the ECB rate for the end of 2008 standing at 3.75 percent according to the FT Deutschland. In fact, we got it almost right to the point: The ECB hiked up to 4.0 percent, and the last hike came in June, so at the end of the first half of the year, but nevertheless, this call was quite accurate.

3. We predicted that the “euro will most likely further gain in value. There is a significant risk that it rises above 1.40 $ in 2007″. This was against the consensus call that the euro would stabilize around 1.30 $. Well, in fact the euro strongly gained in value and went from 1.30 $ to a new record high of 1.48 $. Even if we did not predict the new record high exactly, we are strongly inclined to count this as a hit as well.

4. We predicted that economic divergences in EMU were set to grow but not to be noticed overly much. This turned out to be true: Unit labour costs in Germany, which has already gained a lot of competitiveness over the past years, again increased much more slowly than in the rest of the euro area (0.8 percent compared to 2.0 percent in Spain, 1.3 percent in Italy or 2.1 percent in France). Germany again recorded the strongest export growth of all EMU countries which the problem country Italy recording the slowest export growth. However, due to the good cyclical development, all this was not a big issue in the Euro area in the past year. We also predicted that growth in Finland and Ireland would moderate – as it in fact did.

5. We predicted that both Italy and Portugal, the two problem cases of EMU, would not do much better in 2007. According to the latest figures from the EU, Italy should have recorded a GDP growth rate of 1.9 percent in 2007, the same rate as in 2006. Portugal has grown by 1.8 percent after 1.3 percent in 2006. While Portugal’s growth has accelerated marginally, both countries still are the laggards of EMU with their relative per-capita-income falling. We would at least count this as a half point.

So, in total, we got about 4.5 of our 5 economic predictions correct for this year. Given that we do not have much support staff (in contrast to professional financial sector economists), we think we did quite well. The only downside is that we now have laid the bar quite high for the next year. Nevertheless, we will post our forecasts for 2008 in the first days of January.

Read next: How we performed with our political forecasts.

P.S.: Merry Christmas to our readers!

The Euro-area and the subprime mess: taking the temperature

The past week or so has brought a mixed bag of indicators for the euro-zone with both sceptics and optimists finding bits of their likings. Among the most important positive (and surprising) developments were:

• Business climate actually recovered somewhat in November. Both the German ifo index as well as the French INSEE index recorded increases in November. Manufacturing PMIs for the Eurozone also recorded some slight gains, moving for the whole of the area further away from the 50-points-mark a fall below which would mean an outright contraction of the sector. Companies were even reporting renewed growth momentum in export orders.
• Unemployment in Germany continued to fall strongly and employment creation continued at a strong pace in November, even though many firms by now should feel the pain from the strong euro.
• Finally, according to the details of German GDP figures for Q3, consumption picked up and contributed significantly to growth in that quarter. This is even more surprising as the statistics office had not indicated a significant consumption growth in its description of the GDP flash estimate two weeks earlier.

While some optimists are now claiming that this data shows that things might not turn out that bad for Europe after all, and that the data confirms the story that consumption in Germany will finally turn the corner and provide a sizeable growth impetus for all of EMU in 2008, I would rather interpret this data with caution.

Sure, things could have been worse. Nevertheless, in my opinion the euro-economy is coming dangerously close to stall speed at which any further small shock could lead to a new period of stagnation or even a technical recession (being defined as two consequative quarters of negative GDP growth) in some of the larger EMU member states such as Germany, Italy or France.

The first caveat is that exchange rate changes often take a while until they are seen completely in export order data, even though a first effect is usually seen in survey data very quickly. Thus, given the strong appreciation of the euro both against the dollar and (albeit less) in trade-weighted terms, there might be more unpleasant surprises to come in the coming months.

The second caveat is that the pick-up in German consumption (and thus the rather robust EMU consumption growth) still looks extremely shaky. To come to that conclusion, one does not even refer to retail sales data which show a 2.7 percent drop month-on-month in October (surely a shocking figure, but basically worthless given the quality of retail sales data in Germany and its proneness to large revisions already two weeks after initial publication).

More worringly is the underlying fundamental for consumption: Going into 2008, the development of disposable real income does not bode well for a sustained recovery in German consumption. With inflation having risen to almost 3 percent, any expected gain in real wages well be inflated away by higher oil and food prices. True, employment growth is still strong, but even at a rate of a little more of one percent, it does not add much to the wage sum if real wages are stagnating or even continue to fall.

In addition, one has to see the German consumption growth of 0.5 percent quarter-on-quarter in the summer in perspective. Consumption by now is only about 57 percent of GDP. Even if consumption would be growing by 0.5 percent quarter-on-quarter for the coming year, this would only amount to a GDP growth of about 1.1 percent. If exports and investment slumps (as might happen – see this post here), this might not be enough to keep companies to continue hiring. And given that there is no real wage growth, the consumption growth is very unlikely to be sustained if job creation falters.

However, the increasing risks for the German upswing are not enough. While manufacturing in Germany and France seems to have recovered somewhat, the news for Italy and Spain is not encouraging: In Italy, the manufacturing PMI stagnated at 51.3 points, in Spain it rose slightly above the stagnation-mark of 50 points and reached 50.7 points, leaving the indicators for both countries dangerously close to a the stagnation-territory. Judging by experience, these Southern countries are usually much more vulnerable to an euro-appreciation than Germany. So prepare for more bad news there – and a possible new debate on economic divergences in the euro-zone.

Is Europe really that sclerotic? Lessons from IMF statistics

The general perception about the relative merits of the US economy on the one hand and the continental European economies on the other hand is simple: The US is a very dynamic economy which has been growing briskly over the past decade while Europe is sclerotic and always lagging behind. While markets in the US are free to allow for a swift process of innovation and growth, overregulation and a large government sector in Europe keeps growth down.

Against these stereotypes, the latest statistics from the International Monetary Fund’s latest World Economic Outlook are highly interesting (see the whole publication here or the tables referred to in this post here): After a number of downward revisions of the US GDP data over the past years by the Bureau of Economic Analysis, the data just does not support this impression anymore. If it comes to growth in real GDP per capita, arguably the single most important indicator if one wants to measure how well an economic systems manages to improve the welfare of its citizens, the US has been growing more slowly than the Eurozone economy over the past decade.

According to the IMF figures (table B1), the US economy has produced a real per capita GDP growth of an average of 1.6 percent per year over the period 1999 to 2008 while the Euro economy has produced a real per capita GDP growth of an average of 1.8 percent per year. Interestingly, even Germany which hovered around stagnation for several years at the beginning of the decade, has reached a per-capita-growth rate of 1.5 percent per year, only slightly below that of the US.

But where do these surprising figures come from? Did not the US economy outperform the European one in most of the years in question? The first reason is that European population is growing much slower than the American one. German population is stagnating, so a headline economic growth of 2 percent at once translates into a per-capita-growth rate of 2 percent. The US population is growing, so part of the economic growth is just needed to keep per-capita incomes from falling.

A second reason is that American statisticians tend to overestimate growth in their first estimations while European (and especially German) statisticians have a clear tendency to underestimate growth in the first publications of GDP data. The later revisions are often not given as much coverage in the news as the first publications.

But the data holds a wider lesson as well: Obviously, capitalism is a much more resilient system than some of the critics of the European economies implicitly suggest. Even with distortions, regulations and frictions as they exist in Europe, a free-market system can still produce decent rates of growth. And, yes, there seem to be different varieties of capitalism that work. Not everyone has to chose the same variety, and it might not be as clear as some people think which variety suits a country best.

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ECB fights crisis only half-heartedly

Roughly six weeks ago when the turbulences in the financial markets came to the attention of the general public and the ECB pumped the money market with special overnight tender of roughly € 100 bn, we highly praised the ECB’s reaction. Looking at the ECB now for its latest management of the tensions in the money market, it unfortunately deserves much less praise.

Not only run tensions still high in the EMU money market which becomes obvious by the fact that the three-months EURIBOR interest rate now stands at almost 4.80 percent (see the figure taken from the Bundesbank’s website), roughly 80 basis points above the main refinancing rate officially stated by the ECB. The ECB has also done a much poorer job in managing the money market than the Bank of England or the US Fed.

In the US, the Fed had intervened in the federal funds market to an extent that the effective interest rate fell below the target rate even before the official rate cut (see graph) from 5.25 to 4.75 percent on September 18 while the BoE managed to bring LIBOR rates back down significantly closer to its overnight target rate.

It is not that the ECB could not have acted more boldly. Both the long-term and the short-term tender this week ended with average refinancing rates far above the minimum bid rate of 4.0 percent: In the weekly tender, banks had to pay an average of 4.29 percent, for the three-months tender, they were charged an weighted average of 4.63 percent. In the weekly tender, banks which bid below 4.20 percent were not alloted any liquidity. In the three-months-tender, the marginal rate reached 4.5 percent. If the ECB were serious about tensions in the money market, it would have alloted more liquidity to a lower interest rate.

The fact that the ECB does not really act that boldly raises the suspicion that it is not really serious about fighting the tensions in the money market. Parts of the governing council still want to increase interest rates and seem to be content to have the interest rate increase through the back door. After all, for the banking sector as well as the economy, it is not the stated minimum bid rate for weekly tenders (which is the key interest rate decided on by the governing council) that matters, but the effective interest rate the banks have to pay. This rate is now already significantly higher than the 4.0 percent officially stated, thus already acting as a brake on economic activity.