"In my view … it is impossible to understand this crisis without reference to the global imbalances in trade and capital flows that began in the latter half of the 1990s." Bernanke (2009)

Executive Summary

• Compared with the average quarterly value of GDP in 2007-08, the first two quarters of 2009 are down in nominal terms to the tune of 15.9%, 15.4% and 10.5% in Lithuania, Estonia, and Latvia respectively.

• The average quarterly current account deficit of the Baltics from Q3 2008 to Q2 2009 was mill 500 Euros. This amount to just 18% of the average quarterly current account deficit two years prior to the crisis. Consequently, the Baltics have delevered to the tune of 80% over the course of less than 1 year.

• In the two first quarters of 2009 (relative to Q1-2006 to Q4-2008), imports have contracted 16%, 33% and 11.5% more than exports in Lithuania, Latvia and Estonia respectively.

• In Euro terms, the Baltics have lost external financing to the tune of bn 1.87 Euros in the first half of 2009 compared to the peak of the boom which amounts to 12.6% of the entire region's GDP in the same period.

The quote above from Fed chairman Bernanke is ripped from the introduction of a recent conference paper drafted by international economics icons Kenneth Rogoff and Maurice Obstfeld who suggest that the financial and economic crisis that is currently making its presence felt across the global economy, at least in part, has something to do with the notion of global current account imbalances. Now, and in all modesty, this is something I have argued extensively at this space and in this way I welcome the likes of Messieurs Rogoff and Obstfeld in the fold. I tend to go, of course, for the big prize in my stubborn persistence on the link between global ageing, global imbalances and thus by way of deduction the economic crisis as we have come to know it.

Now, I am not going to treat this link here but merely point to the rather obvious question at this point in time, in the form of whether in fact the crisis itself has been a catalyst of re-balancing? At a first glance this would clearly seem to be the case. In a crisis driven decisively by a violent process of deleveraging, those economies who had hitherto relied on borrowing have now been forced to scale back (and essentially correct either through a debasement of their currency, internal price correction, or a combination of these two) and the nations that had delivered the funding have likewise been forced to accept that their external surpluses have shrunk in a comparative manner.

So far so good then, but what happens when we have to get the patient out of intensive ward; who will run the deficits and surpluses and what size will the imbalances, if any, be. This is a difficult question to answer, but it appears that with the US economy now being effectively forced to correct its external imbalance (be it with Europe, China, Japan et al kicking and screaming or not), we have a situation with a lot of would be exporters and very little importers.

If this is the general set piece, it was with some interest that I read this VOX.eu piece by Mr. Richard Baldwin and Ms Daria Taglioni which dryly submits the thesis that although it may appear that rebalancing is occurring, this is only as a byproduct of the crisis. From ther horse's own mouth;

Global imbalances are shrinking at a fabulous rate. This column argues that these improvements are mostly illusory – the transitory side-effect of the greatest trade collapse the world has ever seen. A global recovery will almost surely return the US, Germany, China and others to their old paths.

Not exactly the prospect we were all hoping for, but in the main I agree with this point except of course the small and important qualifier that the US economy will have to deleverage and reduce the external (and indeed internal) borrowing. Whether Germany, Japan, China will also need to export ... well, this is ultimately a question of finding a customer.

Rebalancing the Baltics?

The obvious question to arise at this point is obviously what all this has to do with the Baltics? Well, in a direct sense not a whole lot since as the Economist so famously put it, the Baltics remain piqsqueaks and whether we observe current account positions, of either negative or positive pedigree, at some 20% of GDP it won't do much to affect the global imbalances. However, in the light of the idea of rebalancing on the back of the economic crisis and whether this is sustainable let alone feasible, the Baltics become very interesting not least since they have chosen (or have been led into) a process of rebalancing through internal price deflation (devaluation) as their currencies, for now, remain fixed to the Euro. In that vein, I thought it interesting to have a look at how the Baltics have faired so far with a specific focus on the external balance.

Beginning however with a general view of the correction so far the picture is definitely one of a hard landing on the back of the economic crisis.

 Most of the readers of this space will be well acquainted with travails of the Baltic economies (and in particular, the near collapse observed in Latvia earlier this year). In all three Baltic economies the Euro value of their GDP peaked in 2007-08 and has since fallen back dramatically. Compared with the average quarterly value of GDP in 2007-08, the first two quarters of 2009 are down in nominal terms to the tune of 15.9%, 15.4% and 10.5% in Lithuania, Estonia, and Latvia respectively. The Baltic economies have lost bn. 2.2 Euros worth of GDP in 2009 from the GDP output observed in 2007-08 which amounts to a loss of some 21% of the average value of the quarterly GDP output for all Baltic economies combined from 1999 to 2009. In short; these economies have taken some blow to the kidneys and even if we can safely say that the levels of nominal GDP observed in 2007-08 were unsustainable the way down is still rough, very rough.

On the price front the correction has indeed begun and the graph above actually underestimates the current bout of price deflation as it smoothes away, as it were, the fact all three Baltic economies are in deflation on a m-o-m basis. Only Estonia registers deflation on my representation with Latvia basically hovering at the 0% line and Lithuania still producing inflation rates at some 2%.

Moving on to the external balance it is worthwhile splitting up the analysis by having a look at first the import/exports picture and then grinding down to the income level and finish off with a look at the financial accounts and thus the inflows used to finance the deficit (or how the surplus is invested abroad).

This is perhaps the best picture of the Baltic correction there is and nicely illustrates the point emphasised by Baldwin and Taglioni that the correction of imbalances, at this point in time, has been very much forced upon the deficit economies. Consider consequently the average quarterly current account deficit of the Baltics from Q3 2008 to Q2 2009 at mill 500 Euros; i.e. at the point when the crisis made its mark decisively.This amount to just 18% (!) of the average quarterly current account deficit two years prior to the crisis. This means that the Baltics have delevered to the tune of 80% relative to the level of the current account deficit observed up to the crisis. Again and with the benefit of hindsight, we know that these levels were unsustainable, but please do remember that it was only back in the H02 2008 that we were discussion whether the Baltics were going to have a hard or a soft landing. It is remarkable to note the example of Latvia here which has gone from a current account deficit of -17.6% of GDP in the period 2007-08 to a current account surplus of 14% of GDP (mill 681.3 Euros) in Q2 2009 due mainly to the fact that imports and GDP have plunged.

This point in particular is important to emphasize since the extent to which we are able to talk to about a sustainable (or benign if you will) process of rebalancing rather than one entirely driven by a sharp correction in internal demand and thus imports. The intuition tells us that Baltics are currently subject to the latter form of rebalancing and thus it remains to be seen whether there is a virtuous circle of increasing competitiveness and rising export shares (and values) on the back of the current vicious circle. But just how vicious is the current circle then?

The graph to the right attempts to answer this question as it plots the equally weighted average of the evolution of exports and imports in the Baltics. The time series corresponds to the value of exports and imports in million of Euros of the three Baltic economies and is indexed with the average quarterly value between Q1-1999 and Q2-2009 of imports and exports as 100.

The graph easily shows how imports have contracted much more than exports and it is consequently here that we must look for the driver of rebalancing in the Baltics. If we take Q1-2006 to Q4-2008 as the peak of the boom (in terms of the external deficits), exports are down 10.8% in the first half of 2009 whereas imports are down a full 33.4% in the same period. This suggests that more than anything that rebalancing in the Baltics are currently driven by a sharp contraction of domestic demand. Splitting up the result on the three economies and looking exclusively at the second quarter of 2009, imports have contracted 16%, 33% and 11.5% more than exports in Lithuania, Latvia and Estonia respectively.

Another way to look at this is to approach the external deficit from the financing side and consequently have a look at the inflows used to finance the external deficits. In principle, you would normally and in the perfect world mainly look at portfolio and investment flows, but in the case of the Baltics we cannot neglect credit flows which, through all those Euro denominated loans supplied by Scandinavian banks, have been instrumental in driving the external deficits during the peak of the boom. If we begin with the inflows as a share of GDP we observe the drastic way in which the financing have been withdrawn in the context of the crisis.

Observe in particular the Latvian situation where an external surplus has been forced upon the economy, proxied here by "negative" inflows and thus outflows. In Lithuania, the total sum of important inflows had declined, as a share of GDP, to 60% in Q2-2009 relative to value recorded during the peak of the boom (Q1-2006 to Q4-2008). The corresponding figure for Estonia is 23% whereas for Estonia it has changed signs all together due to the fact that financing here has come to a complete standstill. In Euro terms, the Baltics have lost external financing to the tune of bn 1.87 Euros in the first half of 2009 compared to the peak of the boom which amounts to 12.6% of the entire region's GDP in the same period.

As noted extensively above, this process is natural since we can say with some confidence that whatever the level (and flow) of incoming investment and credit during the peak years it was not sustainable. However, when it happens with such force in the context of the global financial crisis and, moreover, in relation to fixed exchange regimes and thus internal devaluation the obvious question that begs is what the risk is of pushing these economies into a hole from which they cannot emerge. One particularly important point here is what kind of general (and domestic!) credit and financing environment we will see as the external funding is ground down and thus, in some sense, what kind of domestic environment the Baltics will have to stage a recovery in.

This last point is perhaps the most important underlying theme to think about when assessing the situation in the Baltics. We could almost say that the extent and pace to which the Baltics' growth path has crumbled is also the extent to which expectations of convergence, Euro membership, underlying growth potential etc have crumbled. Where we go from here is consequently anybody's guess. A lot of unresolved question still clouds the horizon not least the continuing unravelling in Latvia where the IMF has so stuck with the country despite the increasing dire outlook as long as the currency peg remains. What I can tell you however is that the Baltics are going to rebalance, but the key is the extent to which it happens so as to allow the Baltic economies to enter a virtuous circle somewhere down the road.

So far, a preliminary assessment suggests that while the Baltics are indeed rebalancing, they are only doing so because internal demand has caved in. We are yet to see whether the dose of internal devaluation/deflation will bring back competitiveness in due time to turn a vicious cycle into a virtuous one.

As I am preparing for a tournament this weekend in Sweden I only have time for some random shots, but then again; taking random shots seem to be exactly what the markets are all about at the moment. The first such random shot came from today's release of the GDP figures from Europe which showed, with much fanfare, how the Eurzone (and Europe) is now effectively out of recession.

(quote Bloomberg)

The euro-area economy emerged from its worst recession since World War II in the third quarter as exports from Germany and France helped compensate for households’ reluctance to increase spending Gross domestic product in the economy of the 16 nations using the euro rose 0.4 percent from the second quarter, when it fell 0.2 percent, the European Union’s statistics office in Luxembourg said today. Economists had forecast the economy to grow 0.5 percent, according to the median of 34 estimates in a Bloomberg survey.

Europe’s economy is gathering strength after governments stepped up stimulus measures and the European Central Bank injected billions of euros into markets to encourage lending. While confidence in the economic outlook is at a 13-month high, rising unemployment, the expiration of stimulus plans and a surging euro are threatening to undermine a recovery. “The euro-zone economy has officially turned the corner and that is cause for relief, but not celebration,” said Martin van Vliet, a senior economist at ING Bank in Amsterdam. “The economy remains in a fragile state and is recovering mainly because of government stimulus and temporary inventory effects.”

Now, before we get ahead of ourselves, the comments by Mr. van Vliet should, as I would assume the comments from any other proper economist, alert us to the fact the current impressive figure, while not a figment of imagination, is indeed driven by decidedly imaginative factors in so far as goes the idea of a sustained recovery. In this way, one off government spending which, by nature, cannot be sustained indefinitely as well as a less severe bout of inventory reduction by part of companies (which may of course be a forward looking indicator) do not in themselves make a recovery.

Add to this that behind the headline figure for EU16 and EU27 of 0.4% and 0.2% GDP growth qoq respectively lies a decidedly murkier picture. Consequently, Greece and the UK continued to spend the third quarter in recession (-0.3 and -0.4 qoq respectively) and then we have poor Spain of course where the horror show of a recession continues without showing any signs (-0.3 qoq), whatsoever, of abating. It is noteworhty in this respect to consider the stark contrast between the European economies in the context of the latest aggregate confidence reading conducted by Bloomberg;

Bloomberg users in Spain remained the most pessimistic in Europe as that nation stayed mired in recession, with unemployment soaring toward 20 percent and the economy struggling to recover from a construction-industry collapse. The Spain confidence index was 17.7 this month from 10 in October.

So, the divergences are growing inside Europe and already they must be hard at work in Frankfurt to try to knit to together a strategy to suit all the individual economies of the Eurozone. The point is of course that they can't and it will indeed be interesting to see how they manage this particular challenge in the future. Before we get to that though and, one would assume, any talk of lifting nominal interest rates from their current low levels we need to get over the hurdle of when and how to pull back "extraordinary measures" of monetary policy.

And here, this is not only about the ECB.

Consequently, and with the small exception of the BOE where Mervyn King recently left it an open question of whether the BOE would buy additional gilts, the three major central banks have all upped their discourse on the winding down of asset purchases in the context of the Fed and BOJ and "enhanced credit support" in relation to the ECB.

In Frankfurt and elsewhere, the outlook on these exit strategies remain opaque except to say that with the continuing emphasis by part of central banks most market commentators expect these measures to be withdrawn some time in Q1-Q2 2010 with the notable exception that the ECB seems to have indicated that the liquidity offering (12 month) coming in December will be the last.

Without going too much into detail [1] it appears to me that central bankers may end up in trouble on account of those exit strategies and how to instigate them into a 2010 "post stimulus" slowdown. This is not so much because I cannot see the impetus to exit in itself, but rather because if now is not the time to exit, how can you argue in the first half of 2010 that it is? 

Surely, on this account I would give them an A+ in so far as goes the attempt to prepare markets, but I am more uncertain as to which they will also be able to actually deliver the exit strategy to the tune of the same grade. We will see I guess; for now, I hope that they are not taking, what will turn out to be, random shots at volatile asset prices and premature signs of non-materialising recoveries.  

---

[1] This will have to wait for another time.

Update 2: Mr Singh has left a comment below in response to my piece. Go check it out.

Update: Mr. Singh posts the third and, as far as I know, last installment in the series on Asia's outlook written on the basis of the Regional Economic Outlook for the Asian and Pacific Region. The topic is perhaps the most interesting of all aspects of Asia's aggregate economy, the high prevalence of savings and its excess over investment which produces a corresponding external surplus which, I'd might add, is structural at this point. See below for more comments.

---

In case you had not noticed, the IMF is blogging and it is not "merely" the garden variety IMF staffers they are rolling out to fill the pages; nope here we are treated to the likes of Blanchard, Atkinson, Lipsky, Cottarelli and a host of other of the Fund's A-listers. Consequently, it would seem that in an already (over)crowded world of econblogging, the IMFdirect blog merits more than a little bit attention.

In the past week, the dual post coverage by Mr. Anoop Singh of the recent Regional Economic Outlook for the Asian and Pacific Region caught my attention in particular. In the first, Mr. Singh invokes among other things the puzzle of Asia's relatively sharp recovery given the notion that the region is largely dependent on exports to grow. Two reasons especially are important here. One is the simple fact that as these economies moved into the crisis with bulging coffers (especially on the reserves vis-a-vis the rest of the world), the room for fiscal manoeuvre was greater and it was used decisively. According to calculations by the IMF, the collective stimulus programs in the Asia-Pacific region added 1.75% to GDP growth in the first half of 2009 and it makes the programs even more generous than those observed in the OECD and other emerging markets. Secondly, Asian economies has benefited from the, so far, V-shaped comeback by part of the global economy and key regions who are likely to grow smartly in h02-2009.

In general, Mr. Singh's analysis appears cautiously tied to the great unknown of 2010 where it appears that we will see whether all those battered economies of the world will be able to hold their own in a world where quantitative easing from central banks and lax fiscal policies are withdrawn rather than enacted. Here, Singh's remarks echo the general discourse where the the underlying tone is one of skepticism. A long period of risky asset buoyancy coupled with upbeat economic data releases have proved before to be crying wolf of an impending recovery and policy makers are advised to take this into account.

It is hard for me to disagree with Mr. Singh that the green shoots observed in the Spring of 2009 seem way too shaky a foundation on which to build a narrative of recovery. Yet, this is exactly what has happened and the famous inflection point will be reached when we discover that the recovery observed thus has been because of and not despite monetary and fiscal stimulus which makes the enforcement of exit strategies going into 2010 a very interesting experiment in the making. Some will make it, some won't and some will inevitably fall back into recession (not just in Asia).

However, the most important part of Singh's argument and indeed the most important part of IMF's analysis in general is the question of whether Asia's economic trajectory, in a post stimulus/recovery context, will be driven by domestic demand or not? To put it in the most reductionist form. Will Asia be a provider of net capacity to the global or economy or not? If yes, it would mean that a post crisis Asia had truly emerged as something new in the form of a force of a real addition to total demand. If not, it would mean that Asia would revert to old tricks and habits of relying on exports and foreign asset income to propel growth in national income.

Now, leaving the question of the number of export dependent economies the world economy can muster neatly to the side, I am not so optimistic here on Asia's contribution to the rebalancing of global imbalances through a net expansion of domestic demand. Yet, let me also immediately qualify here that I am not very comfortable with talking about Asia/Pacific in one both because of the obvious heterogeneity amongst the economies, but more importantly; also because I am not really an expert here. I have done the analysis on Japan though and on this I can say with unequivocal certainty that we won't we seeing any provision of excess domestic demand from this side.

Ultimately of course, Japan is of little real importance here and so is the rest of Asia really. What really matters on this topic is China and all the hopes currently pinned on her shoulders in the form of the ability of the economy to pull the global economy out of the mire. Traditionally, this has boiled down to a rather technical discussion about the RMB and an almost perennial Becketian wait for the shackles to break and an appreciating RMB to solve all problems. While I concede that the RMB should rise, it won't solve any of the underlying problems inherent in China's investment driven economy. Basically, chalk it down to culture and institutional specificity in the origin, but the simple fact remains I believe that just as China may evolve to become the economy we all hope and believe her to become (say in a 2020 context) the one child policy will have done its work so to speak and China will be sporting an OECD like age structure and is likely to even surpass many of OECD's economies.

This is no recipe for an axis of rebalancing and although China will be the main story to follow for the immediate future I think we should look elsewhere to find the potential rebalancing candidates. This may indeed involve other parts of Asia (India for instance and Indonesia), but in the current discourse the likes of China, Japan (and Korea) hold little promise in terms of providing a decisive engine for rebalancing through sustainable growth in domestic demand which exceed the investment rate.

In this sense I remain cautious on the overall sustainability of the recovery in Asia mainly because of my skepticism towards the sustainability of overall global momentum where I acknowledge that I may be very wrong. Watch out for 2010 and all those exit strategies is what I say and particularly for the "post fiscal stimulus" world. This also means that I am more than a little bit skeptical on the prospects of a sustained recovery across Asia driven by domestic demand, especially in relation to Japan and China.

At least, this would be my humble argument here a murky Monday morning in Copenhagen. In any case, you might want to punch the IMFdirect blog into your RSS reader, just to make sure that you know what the IMF is up on a daily "research" basis.

(click on pictures for better viewing)

It is indeed an old adage that while goods things are to be preferred over bad things it is possible to get too much of the former. Looking at recent comments from the governor of the Reserve Bank of Australia it is not difficult to imagine how these, albeit old and worn, pearls of wisdom may well have inspired Mr. Stevens in his effort to tiptoe the thigthrope between signalling the intention to raise rates into an expected economic recovery on the one side and trying to prevent the Aussie shoot of on helium into the sun with wings of wax on the other.

(quote Bloomberg)

Australia’s central bank Governor Glenn Stevens signaled a surge in the nation’s currency to near parity with the U.S. dollar has given him scope to slow the pace of future interest-rate increases.

Stevens, who yesterday became the first central banker in the world to raise borrowing costs twice in 2009, said the 28 percent gain in the currency this year may hurt exports and cool inflation, allowing him to “gradually” raise borrowing costs. Just last month, he warned it may be “imprudent” to keep rates at “emergency levels.” The local currency and bond yields fell as traders slashed bets on another quarter-point boost next month, after Stevens raised the overnight cash rate target to 3.5 percent from 3.25 percent. Investors have been driving the Australian dollar toward parity with the greenback, betting China’s economic growth will boost exports from Australia, the biggest shipper of iron ore used in making steel.

Policy makers “are probably glad for the parity talk as it reduces the amount of work they need to do with monetary policy,” said Matthew Johnson, an interest-rate strategist at UBS AG in Sydney. “A December move is a 50-50 proposition.” Traders are betting there is a 50 percent chance Stevens will increase the key rate by another quarter point on Dec. 1, according to Bloomberg calculations based on interbank futures on the Sydney Futures Exchange at 12:22 p.m. today. Prior to Stevens’s comments, they had a 96 percent bet on such a gain.

Mr. Stevens' comments follows in the heels of the recent push by part of the Aussie towards parity with the US dollar reflected primarily in the fact that the RBA has already raised twice in 2009 (from 3.00 to 3.5%) as well as a growing risk sentiment which is a fundamental prerequistie, in the current market, for observing investors react to (growing) yield differences. In so many words, this is all about carry trade and more specifically about the fact that in a world where the G3 and others are still fiddling with quasi- or outright QE it takes a brave sould to initiate a hiking process since it will mean an immediate reaction in the currency market. This is especially the case when the liquidity anchor effectively constitutes the US and thus; while the US pump priming keeps a floor under risky assets and volatility at low levels it becomes a veritable turkey shoot to gun for those currencies whose central banks are on the hike (see more here).

Following Mr. Stevens' comments, the Aussie did lose a bit of its steam even if many currency punters still see it racing towards parity over the course of the coming year.

For example David Forrester who is currency economist at Barclays Capital expects the Aussie to test the parity level in 2010, a call based on the idea that the RBA will have hiked rates to a full 5.5% by the end of next year. Needless to say, in a world where risky assets continue to fly and risk aversion is kept in check this will provide a juicy interest rate differential vis-a-vis the G3 and thus the carry trade flows (be they actual carry trades or simply spot market piggy backing) will be plentiful. 

The question is of course; can you blame the RBA for wanting to raise rates?

As it turns out, not really and particularly not in light of global central banks' new found focus on asset prices in setting the policy rate. You know, it was all Greenspan's fault and all that jazz. Still, for those worried about a too rapid V-shaped recovery, Australian house prices seem to offer plenty of things to worry about.

From Q3-08 to Q1-09 the house price index (weighted for the 8 biggest cities) fell a modest 5.6%, a drop which has been decisively paired in Q2/Q3-09 with the index rising a cumulative 8%. This picture is repeated if we look at a general gauge for consumer spending in the form of a sector break down of retail sales.

Consequently, the annual as well as monthly flow of retail trade turnover never really went decisively into negative in the context of the financial crisis which has no doubt contributed to the fact that the RBA never really contemplated a move into ZIRP and QE.

What happens next then?

Well as I noted recently, the burden of rebalancing may be tough to carry for those economies who have central banks brave enough to raise interest rates. Ironically of course and if it is really asset prices you are worried about, the risk is naturally that you just end up sucking in liquidity as you which in itself defeats the purpose of the hiking campaign (see Edward's recent piece on Norway for a Scandinavian perspective on this). Naturally, you can retort to Brazil like capital controls, but in a world where capital flows freely and where the global economies are largely interdependent, this is like trying to stop a freight train with a VW Polo. Also, allow me to finish with a small quibble of mine in relation to the sudden urge by part of central bankers to target asset prices. I mean, this is fine and all and for those who know a little bit about monetary policy this is not something completely new. The problem is merely that targeting asset prices may not only be counterproductive in a world where asymmetric liquidity conditions and carry flows are the norm, by targeting asset prices also entail targeting a price which is considerable more volatile than traditional prices (because I assume that forecasting long term asset prices is not as easy as many believe). In this way, a steady gaze at asset prices may also conflict with central banks' general propensity to favor incremental and gradual moves.

Whether this is the case in Australia, only time will tell. Yet, from the lovely fjords of Oslo, to the beaches of Rio, and on to the Great Barrier Reef policy makers may soon learn that you can indeed get too much of a good thing.

(click on pictures for better viewing)

Last week, we learned that industrial production rose yet again in Japan clocking in at 1.4% month-on-month in September after having increased by 1.6% in August.

Companies said they planned to increase production in October and November as well, indicating the recovery from a record export collapse in the first quarter is holding up. Growth in China is generating sales for manufacturers including Hitachi Construction Machinery Co., which this week said it has worked off stockpiles that piled up during the recession.

“The pace of the recovery is faster than expected,” said Hiroshi Miyazaki, chief economist at Shinkin Asset Management Co. in Tokyo. Withdrawal of stimulus in the U.S. and Europe may cause output and exports to slow down this quarter, Miyazaki said, “but so far, today’s production report showed few signs of that.”

This is good news for Japan's economy even if it seems that Japan may simply be re-deploying old tricks in which companies are leveraging external demand but the domestic economy remains unable to pick up on the momentum. As ever, the disconnect between the level and flow of domestic activity (and price pressure) created by the domestic economy and the additional boost from external demand and asset income remains one the main perspective through which to look at the Japanese economy.

Within this context, the notion of Japan being dependent on exports to grow has emerged; initially as a strong market discourse and since in a more formal theoretical light in the form of the humble contribution of yours truly. It still represents a powerful market discourse and in fact, the idea of export dependency or reliance on external demand has been propelled to the main scene of the current economic turmoil as it has slowly but surely dawned on market participants and policy makers that the extent to which global imbalances need to be resolved, we have to find someone to run the deficits. And although this may seem a simple task, it has proved decidedly difficult to make the puzzles match in a world where deleveraging remains a key driving force on both the microeconomic and macroeconomic level.

In this entry I thought it would be interesting to look at a topic which combines the two perspectives above, that is; both the theoretical and the more market oriented narrative. On the former, this analysis would seek to move the analytical perspective down a notch from the pure macroeconomic level to a microeconomic level linking data on the company level (company accounts) with macroeconomic data (national accounts). On the latter, the analysis would provide some empirical foundation for the often cited relationship between a positive reading on industrial production/capex and a pick up in external demand, or more precisely the link between corporate activity and exports.

The analysis will be based on data from the Japanese trade ministry (METI) and OECD and will cover the period 1960Q1-2008Q4 (mail me for the excel sheet). On the company side, I will use data on sales (topline) and as well as profits (operating and ordinary). I will also distinguish between the manufacturing and non-manufacturing sector since one might expect, in Japan's case, the accounts of the former to be considerably more sensitive to external demand than in the case of the latter. With respect to national accounts I am using the OECD CARSA methodology which essentially signifies that we have current prices at annual levels with seasonal adjustment.

In line with the spin traditionally served here at Alpha.Sources, I will be looking at an increase in the connection between corporate sales and profits and external demand as an implicit function of age. This is to say, that this disconnect between domestic momentum and the ability of Japanese companies to generate revenues and thus growth based on external demand is a function of the increase in Japan's median age.

The main results of the analysis can be summarized in the following points.

• The positive relationship between the change in Japanese companies' profits/topline and the change in exports or the current account has increased markedly in a post 1990 and specifically post 1998-2000 context. This effect is predominantly a phenomenon observed amongst manufacturing companies.

• The empirical analysis suggest that Japanese manufacturing companies are now highly reliant on external demand to generate sales, profits and thus in some sense investment activity. 

• The sensitivity of the sales of manufacturers to the volume of exports has increased by a factor of 60% from 0.25% to 0.4% around the period where Japan breaches a median age of 40 years.

• The sensitivity of the ordinary profits of manufacturers to the current account has equally increased markedly in the period where Japan has moved to a median age above 40. In the period after 1997 results indicates that a 1 unit (JPY) increase in the change of the current account has led to a 0.23 unit (JPY) increase in the ordinary profits of Japanese manufacturers which compares with a corresponding non-significant relationship in a pre 1998 context.

A Look at Company Performance, the Current Account and Correlation

Regardless of whether one squares the outlook on the Japanese economy, there is no doubt that the dent which the corporates have taken as a result of the economic turmoil is unprecedented.

Notice that I have indexed the charts with 1995 as a base year and then realize that current nominal value of company revenues has dropped to a level comparative to the one observed in 1993-1994 in relative terms. In absolute terms, the aggregate value of sales of Japanese manufacturers stood at some tn 84 and 82 JPY in Q1-09 and Q2-09 respectively which is value not observed since 1989 in nominal terms. This should give us a clear picture of drop in activity and then also the difficulty with which Japan will have in restoring productive activities back to normal whatever this might mean as we move forward.

With respect to Japan's external balance it is a bit more complicated, but there are some important points to remember as we move through the charts. Japan has been running an external surplus since the beginning of the 1980s, but as I have spent an entire academic paper explaining, it is only in the latter part of the 1990s and into the 2000s that this external surplus seems to be connected strongly with output growth. Moreover, it is important to distinguish between net exports and the income balance since the latter has been particularly important driving Japan's external balance in a from the 1990s and onwards

In light of the graph above, we can say that given the sharp decline in domestic growth in a post 1990 context external demand has take over, so to speak, both in terms of keeping national savings higher as well as contributing to headline growth. It is along the same axis that we would then expect the relationship between Japanese companies and external demand to have increased.

Moving on to some simple correlation analysis the following two charts which show the correlation between company sales and exports as well as the trade surplus/GDP will give us a nice initial overview of the data in question.

The representation is in changes (which is not unimportant) and smoothed by taking the correlation as a 4 year moving average (i.e. 16 quarters). The y-axis is ending period which means that a correlation for e.g. 1997 means correlation between 1993-1997.

Simply eye balling these charts does not seem to provide decisive evidence of the hypothesis of export dependency. Sure, we can easily see that the period 1997-2008 has seen a sharp increase in the relationship between company sales and the flow of exports as well as the share of external demand and GDP, but the key point to take away from these graphs is that they appear to be mean reverting (with a very weak positive time trend in the case of the second). This would mean then that the connection currently observed between exports and corporate sales is not unique. However, if we focus the attention on the second graph, it is also pretty clear that it is only in a post 1980 context that we have observed periods in which the correlation between sales and the trade surplus has been consistently and strongly positive. This would then seem to lend some evidence to the idea of export dependency and how this may be a distinct characteristic of contemporary Japan.

Moreover it would seem that it is not possible (except in the case of the correlation between sales and the trade surplus) to distinguish decisively between manufacturing and non-manufacturing. In later sections and using simple ordinary least squares analysis, it is however possible to differentiate this statement considerably.

Before we come to that though, it would be apt to use the initial conclusion above and have a closer look at the post 1980 period. Moreover, and courtesy of a more richer dataset on the macroeconomic level we can now augment the analysis with the income balance and thus the current account. This may seem trivial, but is very important in Japan's case since the income balance in particular has driven the external balance in recent years. From a company point of view and in order to be consistent, I will correct for the importance of the income balance by including company profits as the main gauge for company performance.

This chart (in level form and only for manufacturers) seems to be more supportive of the evidence of export dependency at least if we allow ourself the luxury to look only at the period from 1980s. The chart shows however that the strong positive relationship between the current account and the profits of companies is a relatively recent phenomenon which took off somewhere around 2000. Consequently, in the period from 1983 to 2000 the correlation between the current account and company profits in the manufacturing sector has been negative and in some cases strongly negative.  

From this brief look at correlations, we should be satisfied that when it comes to the period post 1998 (more or less) the performance of Japanese companies have been strongly linked to external demand and income derived from external assets. Yet, this does not provides decisive evidence for export dependency measured as a strong and growing link between the performance of companies and external demand. In order to show this we must turn our attention to a bit more sophisticated statistical techniques although I can promise you that it won't be very fancy.

Some Models to Go With That?

The analysis which proceeds will center on the two following simple models which take the first difference or percentage change as a linear function of the change in either the value of exports or the current account.

The first regression will also be run with the sales of non-manufacturers as dependent variable in order to check the initial conclusion above that it is really not possible to distinguish between manufacturers and non-manufacturers[1].

Now, if you don't care about statistical analysis, you may stop here and move straight to the conclusion or go back to the summary in the beginning where the main results are reported. If you decide however to move on, rest assured that, following the models above, I never move beyond univariate OLS, so things should not get too complicated if you are a little bit familiar with statistical analysis.

Note that throughout the results presented below, the full period will be Q1 1960 to Q4 2008, period 1 signifies the period where Japan had a median age below 40 and period 2 is consequently defined as the period in which Japan had a median age above 40.

If we begin with the first model that plots sales of manufacturers as a linear function of the volume in exports (both in % changes), the results for the full period, period 1, and period 2 regressions return the following results [2].

For those of you who are familiar with the results presented in my earlier work on Japan, these results should be well known. In this way, it appears that the relationship between the sales of manufacturers and the volume of exports has increased markedly, both in terms of the marginal effect as well as in the context of the overall fit of the model. Since this model is a log-log model, we can interpret the coefficient in percentages and in this way, the estimation indicate that the sensitivity of the sales of manufacturers to the volume of exports has increased by a factor of 60% from 0.25% to 0.4%. In words, it means that in the second period the estimation suggests that a 1% increase in exports will lead to a 0.4% increase in the sales of manufacturers whereas the corresponding number is 0.25% in period 1.

Looking at the overall fit of the relationship, the results clearly indicate that this representation leaves out a considerable source of the variation in the sales of manufacturers which is entirely to be expected. As always, it is essentially a qualitative and theoretical question whether the increase in the sensitivity as well as the goodness of fit (from 0.08 to 0.13) represents de-facto export dependency or simply indicates an increased reliance over and above other more important factors.

In relation to the second model which plots operating profits as a linear function of the change in the current account, it is important to note that this model is estimated in the first difference (and thus not log-log) because the current account in some cases has been negative. Moreover, the sample period is shorter than for the first model (1980-2008) since OECD does not have data for the income balance prior to 1980.

On an overall basis these results underpin those from the first estimation although they seem to confirm the hypothesis to a much higher degree. Abstracting from the full period result which serves as an anchor for the overall significance of the relationship, the difference between the model estimated for period 1 and period 2 is striking. Consequently, the first period estimation signifying the period where the median age of Japan is below 40 shows no significant relationship whatsoever, in this sense it appears that the apparent negative relationship implied above from the correlation charts do not pass the simple causality test which OLS represents. The second period regression on the other hand returns a strong and significant relationship which indicates that a 1 unit (JPY) increase in the change of the current account will lead to a 0.23 unit (JPY) increase in the ordinary profits of Japanese manufacturers. On the goodness of fit measure the only thing we can say is that it has increased considerably to signify the increase in relationship between the profits of manufacturers and the current account. However, whether a goodness of fit of 0.15 is high in an absolute sense here is difficult to say without a more thorough and comparative study. But since we have a univariate framework, I believe this result to be quite extraordinary.

Conclusion

I hope by now that I will have either convinced you or scared you off in terms of the importance of whether Japan is dependent on exports to grow or not. I would also hope that the connection to events closer to the market is not too difficult to see. For example, Bloomberg is running the story today that the BOJ, like most other central banks, is either willingly or, dragged kicking and screaming by market sentiment, moving towards the formulation and near execution of the famed exit strategy from extraordinary monetary policy measures. Clearly, interest rates are to remain low for as far as the eye can see, but it is interesting to ponder whether the decision by the BOJ scale back corporate debt purchases is related to optimism on the companies ability to leverage domestic growth or whether it is because they see export markets reving back up in which case it would be back to the same old growth strategy. Another example would be the latest inflation reading which suggests, more than anything, the extent to which the domestic economy in Japan is not able to provide an environment in which companies can operate profitably as well as it indicates how overall domestic momentum is essentially contractory.

It is within this general economic context that the notion of export dependency becomes important and specifically how this might relate to the ageing of Japan's population. In this entry I have tried to take this idea down a notch from the strict macroeconomic level in the form of an analysis of the relationship between external demand measured through national accounts and aggregate corporate accounts. The results, I believe, speak for themselves and strongly suggest I think that Japan indeed is becoming increasingly dependent on external demand to create the growth and income the economy needs to maintain economic growth. Following from this, a number of questions present themselves, not least the most crucial general question relating the issue of export dependency to ageing in a general sense and then on to the discourse on global macroeconomic imbalances. But for now, I will let you digest the data at described and analysed above.

---

[1] - Results of this regression is not formally reported in the text; please mail me if you want my excel sheet and results.

[2] - In order to be really rigorous I would have to formally test for the difference between the two periods (e.g. through a Chow Test or related method), but here it will suffice to look at the change over the period without putting a label of statistical significance on it.

As a puny yet honest attempt to show you that I actually read other things than plain economics I thought that I would share this piece with you on declining nomadism amongst Americans; it is written for Newsweek by author Joel Kotkin. I am not quite sure whether he believes the ageing of the population to be the decisive factor contributing to the rise of localism which he speaks about or just a factor among many. I would presume that sociologists and historians could find an explanation for this development in their distinct theoretical tool kits too without invoking the demographic evolution. Although, it is tempting to go for a nostalgic narrative here I don't think this is appropriate. To me, an increase in physical localism could go well hand in hand with an ever greater degree of global integration and social mobility in the non-physical sense.

On almost any night of the week, Churchill's Restaurant is hopping. The 10-year-old hot spot in Rockville Centre, Long Island, is packed with locals drinking beer and eating burgers, with some customers spilling over onto the street. "We have lots of regulars—people who are recognized when they come in," says co-owner Kevin Culhane. In fact, regulars make up more than 80 percent of the restaurant's customers. "People feel comfortable and safe here," Culhane says. "This is their place."

Thriving neighborhood restaurants are one small data point in a larger trend I call the new localism. The basic premise: the longer people stay in their homes and communities, the more they identify with those places, and the greater their commitment to helping local businesses and institutions thrive, even in a downturn. Several factors are driving this process, including an aging population, suburbanization, the Internet, and an increased focus on family life. And even as the recession has begun to yield to recovery, our commitment to our local roots is only going to grow more profound. Evident before the recession, the new localism will shape how we live and work in the coming decades, and may even influence the course of our future politics.

Perhaps nothing will be as surprising about 21st-century America as its settledness. For more than a generation Americans have believed that "spatial mobility" would increase, and, as it did, feed an inexorable trend toward rootlessness and anomie. This vision of social disintegration was perhaps best epitomized in Vance Packard's 1972 bestseller A Nation of Strangers, with its vision of America becoming "a society coming apart at the seams." In 2000, Harvard's Robert Putnam made a similar point, albeit less hyperbolically, in Bowling Alone, in which he wrote about the "civic malaise" he saw gripping the country. In Putnam's view, society was being undermined, largely due to suburbanization and what he called "the growth of mobility."

Yet in reality Americans actually are becoming less nomadic. As recently as the 1970s as many as one in five people moved annually; by 2006, long before the current recession took hold, that number was 14 percent, the lowest rate since the census starting following movement in 1940. Since then tougher times have accelerated these trends, in large part because opportunities to sell houses and find new employment have dried up. In 2008, the total number of people changing residences was less than those who did so in 1962, when the country had 120 million fewer people. The stay-at-home trend appears particularly strong among aging boomers, who are largely eschewing Sunbelt retirement condos to stay tethered to their suburban homes—close to family, friends, clubs, churches, and familiar surroundings.

(...)

After decades of frantic mobility and homogenization, we are seeing a return to placeness, along with more choices for individuals, families, and communities. For entrepreneurs like Kevin Culhane and his workers at Churchill's, it's a phenomenon that may also offer a lease on years of new profits. "We're holding our own in these times because we appeal to the people around here," Culhane says. And as places like Long Island become less bedroom community and more round-the-clock locale for work and play, he's likely to have plenty of hungry customers.

Well worth a read and a closer reflection.

... at least not yet that is. Let us see how the rest in Europe will fair.

(From Bloomberg)

U.K. gross domestic product unexpectedly dropped in the third quarter as enduring slumps in services, manufacturing and construction kept the economy mired in its longest recession on record.

Gross domestic product dropped 0.4 percent from the previous three months, the Office for National Statistics said today in London. Economists predicted a 0.2 percent increase, according to the median of 33 forecasts in a Bloomberg News survey. The economy has now contracted in six quarters, the most since records began in 1955.

Chancellor of the Exchequer Alistair Darling said this week he will focus on spurring economic growth as he struggles to cement a recovery in time for a general election due by June. Today’s data may add to pressure on Bank of England officials to expand bond purchases at their Nov. 5 decision after completing a plan to buy 175 billion pounds ($291 billion) in assets.

Where goes Sterling on this?