April 16, 2012 8:31 pm

Europe is distracted by endless firewall talk

Now that the eurozone finance ministers have exhausted themselves with a multilayered package of hundreds of billions of euros, the debate will go global at this week’s spring meetings of the International Monetary Fund and the World Bank. The next preoccupation will be how many more hundreds of billions of euros should be pledged to the IMF. It will be Firewall II: the Sequel.


I beg to differ. Not with firewalls exactly, but with the preoccupation.

The survival of the eurozone now depends on Italy and Spain. They are the countries that are too big to fail – or to rescue. Extraordinary action by the European Central Bank has lowered the interest rates that Italy and Spain pay on their debt, but not solved their problems.

In one sense, the much-badgered Germans are right. The fates of Italy and Spain depend on the steps their governments take to cut spending, reduce debt, strengthen banks and make structural reforms. Firewalls offer reassurance to markets, but the governments’ action, their political support and the ECB’s liquidity will be decisive.

The firewall preoccupation distracts from the fundamental issue: what should the EU do to help Italy and Spain retain political support for reforms? Structural steps are painful for any government. They are devilishly difficult without growth. Reforms can disrupt an economy for a time as investment, business and workers adjust.

In Italy, Mario Monti, prime minister, has begun an exemplary combination of fiscal consolidation and reforms of pensions and labour markets. But unemployment is rising. Will Italy sustain the politics of reform without supportive EU policies? Mariano Rajoy, Spain’s prime minister, has set a similar course, but even modest concessions on the path to reduce the deficit, combined with 23 per cent unemployment and challenges in elections and on the street, have prompted a rise in Spain’s borrowing cost. The economics of adjustment and the politics of reform would be easier if Italy and Spain could be boosted by European growth.

Yet as one European told me, economics is a branch of moral philosophy in Germany, so do not expect expansionary demand policies to trump rectitude, discipline and belt-tightening. There is, however, a supply-side growth alternative: strengthening investment, the single market, and the EU itself.

Instead of quarrelling over firewalls, Europeans should add just a fractionsay €10bn – to the capital of the European Investment Bank. Under current conditions, the EIB may actually have to reduce lending. Instead, the EIB could use more capital to borrow and then invest to support structural reforms, showing Spaniards and Italians that their sacrifices will draw productive investments. The EIB is now even led by a talented German, Werner Hoyer, from the governing coalition. President José Manuel Barroso of the European Commission should also demand disbursement of the billions of euros of structural and cohesion funds that sit on its books while poorer parts of Europe go wanting; find the logjam and break it.

The single market – the very fibre of EU integration – could also come to the rescue. Although goods move freely in the EU, the service sector in many countries – including Germany – could open up more. Labour movement is also far more limited than in a true single market. Whether the cause is language, habits, matching jobs with workers, or cost of relocation, now is the moment to overcome the hurdles and advance the true unification of the EU. Show people who want to work that the EU wants them, too.

The combination of fiscal and structural reforms, EIB and EC investments, the opening of service markets, and easing the movement of workers will pay dividends. Mr Monti has travelled to Beijing to show China’s sovereign investment fund that Italy is becoming a good place to invest. That makes more sense than lobbying the Chinese to add to firewalls, especially if the EU itself invests and makes the single market more attractive.

Firewalls have their purpose. But this debate risks becoming a distraction. Europeans and their partners need to keep their eye on the strategic Schwerpunkt: helping Italy and Spain with growth and the politics of fiscal consolidation and structural reforms that will boost business, competition and jobs. The ECB has done its work. The other institutions of the EU need a burst of activism on investment and strengthening the single market to preserve and secure their union.

The writer is the president of the World Bank Group

Copyright The Financial Times Limited 2012.

Markets Insight

April 17, 2012 1:51 pm

Fed’s doves lose appetite for easing

The Federal Open Market Committee of the Federal Reserve is no longer expected to announce a further round of monetary easing when it concludes its two day meeting in Washington on Wednesday. The fact that the hawks have lost enthusiasm for more quantitative easing is scarcely surprising, given the fall in unemployment, and the stickiness of inflation.

But until very recently the hawks have not been in control of the committee. What is more surprising is that the powerful group of doves which includes Ben Bernanke, Bill Dudley and Janet Yellen, and which normally has disproportionate weight on the FOMC, has also taken QE off the agenda.


So is that the end of QE? Not necessarily.

The doves seem to have changed their policy conclusion without changing their basic view of the economy. In recent speeches, they have all repeated that the current unemployment rate of 8.2 per cent will remain two to three percentage points above the level consistent with the Fed’s mandate for some time. This judgment depends on their interpretation of the work of three distinguished economists: Arthur Okun (1928-80), William Beveridge (1879-1963) and John Taylor (who is still very much alive and kicking at Stanford University).

First, Okun’s Law. This describes the relationship between real gross domestic product growth and unemployment, which is reasonably stable over long periods. This stability broke down last year, with unemployment falling much more than it “shouldhave done, given the reported growth of real GDP.

One possible, hawkish, interpretation could be that real GDP growth has been underestimated. But the doves argue that the unexpected drop in unemployment was just a reversal of the abnormally large shake-out of labour by employers in 2009. If this is correct, then unemployment will stop falling soon, unless GDP growth picks up significantly.

Second, the Beveridge Curve. This describes the normally inverse relationship between unemployment and unfilled vacancies in the labour market. Higher vacancies should imply lower unemployment but in the past three years there has been a much larger rise in vacancies than would have been implied by the level of unemployment. The hawkish interpretation of this rise in unfilled jobs is that there is a mismatch between the skills and location of the unemployed, compared with the nature of the new jobs being created in the economy. If so, structural unemployment has risen, leaving less scope for monetary accommodation.

But the doves argue that this is not the case, saying instead that the Beveridge Curve has broken down for temporary reasons. These include the extension in the maximum duration of unemployment benefits and delays between the rise in vacancies and the subsequent decline in unemployment. For these reasons, the doves conclude that the level of structural unemployment has not risen.

Third, the Taylor Rule. This describes the “appropriatepath for short term interest rates, given the behaviour of inflation and unemployment, which are the subjects of the Fed’s twin mandates.

According to Janet Yellen’s speech on April 11 in New York, John Taylor proposed two versions of his famous “rule”, one in 1993 and the second in 1999. The latter includes a larger role for unemployment in determining the appropriate short rate, while the former gives a bigger role to inflation.

Ms Yellen prefers the 1999 rule, which has more dovish implications when unemployment is high, as it is today. She calculates that, on this version of the rule, short rates should stay at zero until the end of 2014, as implied in the Fed’s latest policy announcements. She also reckons that monetary policy has been too tight since 2008, because quantitative easing has not been powerful enough to allow for the fact that short rates could not be reduced below zero. In compensation for this, she argues that monetary policy should be kept easier for longer than the 1999 Taylor Rule implies.

John Taylor has denied Ms Yellen’s claim that he ever proposed the 1999 version of his rule, saying it was an idea that emerged from the Fed itself. And anyway he strongly prefers the 1993 version, which has the hawkish implication that short rates should already be positive and should certainly be rising by 2013. But the doves see things differently.

Given the doves’ determination to interpret these key issues in the direction of highly accommodative policy, it is hard to explain why they have shelved their desire to introduce another bout of QE. To judge from their underlying economic rationale, they are probably just biding their time while inflation is somewhat above target, and will seek to bring easing back on the agenda as soon as they can.


Gavyn Davies is co-founder of Fulcrum Asset Management and Prisma Capital Partners, and writes a regular blog on macroeconomics at FT.com

Copyright The Financial Times Limited 2012

Markets Insight

April 16, 2012 3:46 pm

Don’t let Spain detract from Portugal

The latest news from Spain makes for depressing reading. But despite the growing concerns about the eurozone’s fourth largest economy, Portugal poses a greater threat to the European Union.

Much has been written about Spain’s deteriorating economic situation. The economy is back in recession and expected to contract by 1.7 per cent this year, and unemployment is nearly 23 per cent. It took less than 100 days for the new government to face its first general strike on March 29, and with further austerity measures planned, more civil unrest is highly likely.


Spanish banks, which are heavily exposed to the deflating real estate bubble, are also likely to need more capital as the economy continues to struggle. Moreover, the poor PR effort surrounding the sequential adjustments of the Spanish deficit objective for 2012 and the disappointing increase in the European bailout facilities did not help calm down market worries over Spanish debt problems.

It is not surprising therefore that the yields on Spanish government 10-year bonds have climbed more than 100 basis points to more than 6 per cent since March 3, their highest levels since early December because investors are becoming increasingly sceptical about the Spanish government’s ability to reach the budget objectives and re-inject some vitality into its sluggish economy.

Despite all of this, we still don’t feel that Spain will need the sort of bailout that Ireland and Portugal required. Indeed, the possible contagion risk from Portugal is greater than that posed by Spain.

The needed adjustment to restore its competitiveness is even greater in Portugal and its long-term growth potential is lower. As a result, relative prices will need to fall more in Portugal than in Spain and the additional run-up in its debt-to-gross domestic product ratio also looks set to increase substantially in that process over the next decade.

In 2013, the country’s bailout runs out and it is expected to start borrowing in the free market again. However, it may struggle to convince investors of its creditworthiness. The economy is entering a second year of recession, and growth is expected to fall by 3.25 per cent this year, following a decline of 1.5 per cent last year. Unemployment continues to rise, hitting 15 per cent in February, and the cost of 10-year borrowing is still above 10 per cent. There is also considerable speculation that the country will need a second bailout. Once the market starts to anticipate this, a self-fulfilling dynamic might develop that pushes Portuguese yields towards Greek levels.

That should not take away from the fact that the country has been applauded for a good implementation programme concerning its fiscal and structural reform targets, and it has broad political and social consensus for this. However, this could be tested as further structural reforms in labour and product markets still seem necessary. Equally important, however, will be the “trust” that the rest of Europe will continue to have in the efforts of the Portuguese government to pursue this path of ongoing structural reform.

The Iberian republic may yet need a new support package from the EU and International Monetary Fund before the year is out. Even so, ongoing Troika support and constructive co-operation with other European stakeholders makes containment of the problems most likely. It would not only minimise the negative impact on the rest of the European economy and its treasury markets, but also create the higher probability that the needed long-term rebalancing objectives are actually achieved.

Looking more short term, the good news is that Portugal has actually become less influential on the Irish, Spanish and Italian treasury markets. Since the beginning of the year, the co-variance in 10-year yields in Portugal and the rest of the peripheral nations has been either negative or close to zero. For nearly all of the two years before that, the co-movement was clearly positive.

This offers some hope that a near-term escalation of the euro crisis and widespread contagion into treasury markets outside of Spain and Portugal is less likely than during stress periods last year. Especially if it continues to be coupled with a recovery in the global economy and much needed external demand for European economies.

Still, the ability of market sentiment to create its own reality in this crisis should never be underestimated, so cautious optimism that market stress will fade in the near term is all that can be offered at this stage.

Valentijn van Nieuwenhuijzen is head of strategy at ING Investment Management

Copyright The Financial Times Limited 2012.

April 17, 2012

There was little news to account for any rally on this Turnaround Tuesday given poor Industrial Production and lower than expected Housing Starts. But, bulls are looking ahead to earnings which have been much lowered and engineered to beat expectations. Goldman Sachs reported a beat ($3.92 vs $3.55 expected) and the stock rallied but now as much as the overall market. The market must smell great earnings news ahead seeing the current global economic softness as buying opportunities.

There could also be some fresh money to funds as investors beat the tax deadline. That money gets invested quickly.

IBM just announced earnings that missed top line revenue estimates and stock falls. Intel (INTC) beats lowered estimates but stock is lower in after-hours trading. Yahoo (YHOO) earnings beat estimates and the stock is nearly 2% higher. Of many others, Cree Inc (CREE) shares were lower by almost 8% after its report.

There wasn’t much news out of Europe today so stock bears there could take the day off while bulls could play. And, drum roll pleaseApple (AAPL) shares rebounded nicely to close above $600 once again.

Bonds were only slightly weaker as stocks rose sharply. The dollar was slightly weaker with eurozone calm and commodity prices (GLD, DBC, USO and JJC) were more or less unchanged. This is a tip that investors are doing some last minute funding of their retirement accounts and commodities aren’t front and center.

The Argentines know firsthand the rewards of defaulting and rationalizing doing so as the other guys fault. The country defaulted 10 years ago on $94 billion in debt after refusing to enact austerity measures dictated by the IMF. (Sound familiar?)

Fast forward 10 years and now with Moral Hazard issues shrugged-off and enabled the country has now seized YPF a subsidiary oil and gas production company of Spain’s (as if they didn’t have enough problems) Repsol.

"You can have my answer now Senator, if you like. My final offer is this: nothing. Not even the fee for the gambling license, which I would appreciate if you would put up personally."
Godfather Michael Corleone adapted especially for Argentina’s Kirchner reply to Repsol.

I guess doing business south of the border particularly in Buenos Aires other than skipping out on your hotel bill, is out of the question now. But corporations have short memories as do other investors.

Volume Tuesday was about average, which is to say light, for recent periods. Breadth per the WSJ was quite positive.

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April 16, 2012 11:01 pm

LME eyes renminbi move for metals

The London Metal Exchange is considering offering traders the chance to settle its contracts in the Chinese renminbi, a move that could lead to its dropping sterling after 135 years.

The move, still at an early stage of discussion, would highlight the shift in power in global metals markets.


When the LME was established in 1877, Britain was one of the world’s most important manufacturing powerhouses, and the LME’s benchmark contracts for delivery in three months were designed to mirror the length of time needed to reach British ports for shipments of copper from Chile and tin from Malaysia.

But now China is the dominant force in the market, accounting for more than 40 per cent of global demand for most metals and a rapidly increasing share of trading in LME futures.

While LME contracts – which serve as global benchmarks for metals from aluminium to zinc – are denominated in dollars, the exchange offers companies the option of settling and clearing their trades in euro, yen and sterling.

The LME is asking its members as part of a survey to help the exchange design its planned new clearing house whether they would like the renminbi to be added to the roster of currencies on offer for settling and clearing, and sterling dropped. The LME plans to maintain its benchmark denominated in US dollars. “We are always looking at new ways to help the market,” the exchange said.

The move would be a final blow to sterling’s role in metals trading. The LME’s flagship copper contract was denominated in sterling until 1993, when it switched to dollars in the wake of the Black Wednesday sterling crisis.

The use of the UK currency to settle and clear LME contracts has dwindled to negligible levels in recent years, brokers say. “I haven’t traded a contract in sterling for five years,” said the head of one large LME brokerage.

The use of the renminbi in commodities markets is, on the other hand, slowly increasing as China moves to internationalise its currency. Hong Kong Exchanges & Clearing (HKEx) has announced plans for a range of renminbi-denominated commodity futures, while the Hong Kong Mercantile Exchange (HKMEx) is planning to launch renminbi gold and copper contracts.

.The Chinese currency would need to become more freely tradable before it could be used for LME trading and settlement. Over the weekend Beijing announced the latest step in the internationalisation of the renminbi, widening its daily trading band.

The discussion at the LME reflects the growing involvement of Chinese companies on the exchange. The LME announced this month that Bank of China had applied to become its first Chinese member.


It opened an office in Asia in 2010 and members of staff now have business cards printed in both English and Mandarin.

Moreover, HKEx is seen as a frontrunner to acquire the LME, with final bids due to be submitted by May 7. CME Group, ICE and NYSE Euronext are also bidding.

Copyright The Financial Times Limited 2012