[ Update 1 - The news is slowly starting to trickle in; the Spanish statistical office thus posts its first estimate of Q1 figures at 0.3% q-o-q (2.7 y-o-y). While it was not the negative growth rate I was fishing for it does mark a pretty rapid slump in Spain. If you don't believe me, just have a look at the graphs in the initial report from the Spanish statistics authorities]    

Normally, provisional production figures from the national accounts are not that interesting but this time around I do think we should keep more than a weary eye come tomorrow. Basically, governmental agencies, international organizations and others have been busy scything their projections for 2008 GDP growth in the Eurozone (see detailed Q4 07 description here). The most pessimistic was without a doubt the IMF who in their 2008 WEO raised the warning flag for the Eurozone and Eastern Europe.  In this light, Thursday's figures will give an important initial yardstick of what to expect. Of course, Q1 may not turn out as bad as many bears expect but I do think that we might be in for some surprises. In case you might have forgotten the recent figures I produce the visual account below.


As can be readily observed the Eurozone has been steadily slowing down since the advent of 2007. Moreover, we are now witnessing notable growth divergences between the member countries much to the chagrin of the ECB as it makes the policy choice decidedly more delicate on top of a situation of stagflation. Ultimately, of course the Eurozone in its whole entity will tend to slow down albeit the fact that some will definitely fair better than others. In this present context I am consequently looking forward to a couple of things.

• Most commentators are in agreement that Italy slumped into a recession as early as Q4 2007 which would make it the first industrialised economy to tumble into recession (neck and neck with the US) as a result of the turning business cycle ignited by the credit crisis. Yet, we don't have concrete figures for the Italian economy going well into Q2 2008. This is a disgrace and I am wondering whether Italy will once again excel with its absence in the context of reporting statistics to Eurostat.

• How far down the scale will Spain (and Ireland) post their respective growth rates? In the context of the aggregate Eurozone figures Spain is particularly important since the country has been one of the main drivers of the aggregate GDP figure on the margin. It is almost certain that Spain will post a figure significantly below the reported 0.9% in Q4 2007. The question is how much will Spain have slowed down in Q1? Real economic activity has certainly contracted rather rapidly during the first quarter of 2008 but we also know that the Spanish government has been busy with their plans to prop up spending to cushion the economy. However, this is unlikely to have an impact as early as in Q1 which is also why that Spain may in fact quite possibly post a negative growth rate q-o-q come Thursday.

• What will Germany give us? It is important to understand that this is basically all that matters in the context of gauging not only the main trend in the aggregate Eurozone figures but also in the context of the ECB's future course. Evidence suggests that January and February were very good months for Germany where both exports and industrial production expanded at healthy clips. March on the other hand seems to mark a turning point and looking at the data we can be almost certain that the German economy contracted if measured on March alone. This means though that Germany won't publish a negative number come Thursday; far from it. However, the question is how much higher than the previous 0.3% it will be (if at all)? The consensus has it at a heady 0.7% which would clearly open up for a significant backdrop in Q2. We need to understand that at this point Germany is running almost exclusively on external demand but given the fact that the entire European edifice is slowing (Eastern Europe in particular is important here) we cannot expect Germany to continue its hitherto impressive expansion.

[Update added below: Stefan Karlsson responds to the recent data from the Baltics noting that we are now definitely in a recession (although I am not sure that Estonia contracted in Q1 2008 while Latvia and Lithuania certainly did); as for the recession call ... he may very well be right.]

Last Friday Macro Man was looking for pink flamingos or more aptly as he put it:

"(...) what's the next pink flamingo, if any? Where are the remaining high conviction, deeply-positioned trades that might get washed out by the hand of fate (and/or the tap on the shoulder from the market risk manager?)"

 

Consulting the commentary section in MM's post you could easily get the idea that financial markets are awash with pink flamingos. Commodities seem to be taking a center stage at this point in time. However, I have another bid for that pink flamingo. I hardly think that many a hedge fund manager and money mover are exposed to Lithuania but they may be exposed to Eastern Europe in general since this is where some of the highest growth rates have been during the recent global expansion. Most economists have agreed for some time that the Eastern European edifice would slow down significantly and moreover that certain countries harbored a substantial amount of risk with respect to the stability of the existing currency regime. Hungary and its recent abandonment of the Forint's peg to the Euro is a case in point. Yet, the main venue of debate amongst economists and commentators has been whether Eastern Europe and its specific countries would experience a hard or soft landing (see these posts in particular). Here at Alpha.Sources I have had a tendency to lean towards the former scenario. More specifically I have been looking at the Baltics and especially Lithuania as a way to gauge how the economic fundamentals were fairing. In this light, it now seems as if the hard landers are slowly getting the upper hand; at least when it comes to the Baltics.

As any mildly astute economist will know it is extremely difficult to call the exact turning point of the cycle and thus the point in time where a recession starts. Usually, such issues are resolved post mortem when the economic data has been firmly revised. Moreover, the actual determination of a slowdown's or a recession's starting point also quickly turns into a battle royal between economists as the alphabet soup of different national account measures easily ties up the discussion as we end up comparing apples and pairs. However, at this point in time I don't think we have the luxury to engage in such a battle among economic gentlemen. I don't think so because the Baltics' (and many of the other Eastern European countries') situation is a bit more complex than your average US type recession where a you clean up the mess with a couple of quarters of negative growth. What we consequently need to understand is that, depending on the turn of events and response from markets, the current slowdown may turn out to have quite far reaching consequences for the region. With these ominous remarks let us turn to the evidence suggesting that the tide is now finally turning in the Baltics. In fact, we can only at this point say something decisive about Latvia and Lithuania since Estonia has not yet posted Q1 08 figures. The pace of growth however has been consistently lower in Estonia throughout 2007 compared to 2006 and in Q4 Estonia posted a growth rate of 0.9% q-o-q which is of course more than respectable but a significant slowdown in relative terms. What remains to be seen now is whether Estonia will kick off 2008 with negative growth rates or just eek out a positive showing. Indicators for retail sales suggest that Estonia may be lagging Latvia so I would not be surprised if Estonian Q1 is positive on a q-o-q basis. In the context of Latvia my colleague Edward Hugh has been keeping a watchful eye. Back in March he asked the question of whether we were heading into a recession in Q4 2007? At the time, strong circumstantial suggested that this was the case and now with the recent flash estimate from Q1 it is safe to say the coffin has now been supplied the final nails;

(...) in constant price terms - Latvian GDP hit a peak at some point between Q2 and Q3 2007 (lets say August 2007) and since that time has been steadily CONTRACTING. Now I know there are probably hundreds of different ways of skinning a chicken, and of course you can read data everywhichway you want to, and there are seasonal factors to take into account, but as far as I am concerned there is no getting away from it, on any reasonable criterion the Latvian economy is now in recession, and has been since the middle of last year.

This leaves us with Lithuania and consequently my little fetish here at Alpha.Sources in looking at this small Baltic economy. Since we just recently got Q1 2008 GDP figures (provisional estimates too I would imagine) we should have a fairly strong picture of what is going on. First, we will have the visual inspection;

As can be observed in the figure above Lithuania stalled sharply from Q3 to Q4 and now posting a contraction in Q1 08 on a q-o-q basis. On a y-o-y basis the economy is still growing but this figure is basically pointless in so far as goes the determination of where the economy is at in the present time. The first graph speaks for itself and in this context the two additional graphs plotting the indexed values of GDP do not really add much to the general picture. I still think they have merit though. Especially the last one is interesting as it shows the 'momentum' of the slowdown. Basically the chart shows the rate of expansion relative to the previous period without saying anything about the level of growth (which is shown in graph number two).

In Summary

I have been very cautious in pulling out the R-word in connection with the Baltics let alone Eastern European in general. I still am. However, what is clear at this point is that we are now observing a hard landing. The rate of the slowdown since it began in the middle of 2007 leaves no other conclusion I think. What happens next then? This question is not at all insignificant. What we now have on our hands in the Baltics is, in macroeconomic terms, quite a predicament. Basically, the economic momentum now seems to be unwinding far too fast relative to the pace by which the inherent imbalances present in these economies can be expected to respond. Large external deficits and pegging currencies here are important since it means that the latter cannot adjust. The only possible alternative if the rout continues is consequently a transition into price and wage deflation. It is still early to say whether this will materialize but it is now a real risk rather than a theoretical possibility. Additionally, we now need to watch all those foreign banks who have set up shop across the Baltics helping to finance all those credit inflows. Will they stay or more specifically can they afford to? This is also now a question which must be considered as more than an academic question.

I am really sorry to start this week on such a nasty note but I do think that the genie is out of the bottle in the context of the Baltics. Now we need to watch carefully where it goes from here. If economic momentum (or lack thereof) continues to linger in the current territory we should be a prepared for a rapid change of fundamentals in the Baltics.

Today's interest rate action was not particularly difficult to call as both the BOE and the ECB moved (Q&A here) in as expected to keep interest rates on hold. Actually, given the BOE's initial response to the credit turmoil á la the Fed with the intention to lower interest rates today's decision has to be seen as somewhat of a u-turn. Obviously, this may turn out to be a wise one (or not) depending on how inflation data pan out in the next couple of months and quarters. Turning to the ECB the decision to keep rates on hold comes in the context of the mother of all dilemmas as the ECB tries to fight the un-fightable in the context of a steadily increasing economic slowdown (with notable divergent trends) and rising headline inflation. I have, on several occasions, been kicking the ECB for not recognizing the downside risks to economic growth and especially for not realizing the unsustainable asymmetries created as a result of the ECB standing its ground in the context of the very aggressively cutting Fed. I still maintain that bias and in this way it is one thing to disagree with Bernanke's policy but quite another to not respond upon how the surrounding world acts. So far however, the ECB has been vindicated in the context of rapidly increasing inflation globally which is also showing up in the Eurozone indices where the y-o-y HICP rate is running far above the threshold deemed comfortable at the ECB. It could thus seem as if the Fed has provided the world with plenty of liquidity to go around and certainly enough for commodities and food to have shot up (although I am far from convinced that all this can be blamed on the central banks).

Yet, the curtain may soon fall for the ECB as economic realities impinge on the objective to maintain price stability. It is pretty obvious that Spain, Italy and Ireland are now all three slowing rapidly. This is not necessarily bad in the context of Spain and Ireland where almost a decade worth of brisk growth had to come to an end but in the context of the former the boom/bust dynamics look set to become very severe indeed. Furthermore, Italy is now set to painfully conform to all those claims heralding the country as the sick man of Europe. I still think that Italy represents a risk to the stability of the global financial system which is wholly unpriced into the general market movements and it is precisely in this context that I have been rather critical of the recent six months' rally in the EUR/USD. However, in terms of cyclical observations it has long been clear that the ECB would not move unless material evidence of a slowdown in Germany emerged. Domestic demand has long been stagnant and declining but that has been countered by an impressive growth in exports and as a derivative industrial production (corporate capex). In this light, the recent news that both exports and industrial production declined in March is not at all insignificant (neither of course is the corresponding news from France).

The ECB is not likely to lower rates come next meeting in June. For this to materialise we would have to see a significant turn for the worse in terms of German data as well inflation also should show signs of abating. On the former account I think we might very well see a considerable deterioration (see also Sebastian Dullien here) although April compared to March is likely to show a pick-up. This is mainly due to the fact that if you add the numbers for March only the PMI for services showed a slight expansion. This means that Germany may have contracted in March. This will of course be verified once we get national accounts for the Eurozone but it is clearly significant in terms of those aiming for a growth rate of 0.75% in Q1. The EUR/USD is now hovering a tad bit lower than its previous highs of 1.59-1.60 currently trading at around 1.54-1.55. The reasons for this slight fall from grace could be many but most prominently has been a discussion about whether foreign central bank reserve managers sold out a bit at 1.60 seeing that the main source of the global economic instability was the falling USD and its contribution to global inflation; much more about this here as well as at Brad Setser and Macro Man.

In summary, the ECB retains its inflationary bias in the face of growing and lingering headline price pressures. The dilemma however has not gotten any smaller in Frankfurt where the ECB is now presiding over a stagflationary economy with notable divergences between the member states. In all likelihood the ECB will stay pat come next meeting in June. A below consensus Q1 GDP reading, a material slowdown in Germany, and abating inflation pressures could pave the way for a cut already in June. This is very unlikely at this point though. Conversely, if inflation picks up considerably pushing the HICP towards the 4% mark and if Germany stays resilient a hike cannot be ruled out. For the record I, as well as most commentators, see a middle position and thus a holding operation.  

So, there you have it; you now know what to watch. Good luck!  

[Update added below as I have corrected some small things below]

I am sorry to paraphrase, arguably, one of Hollywood's better conceptions; but having left the last Fed meeting and looking towards Thursday's corresponding action in London and Frankfurt I cannot help but feel that the tail just might be wagging the dog this time around. One thing is certain; ever since the credit turmoil began and the Fed started to aggressively slash the nominal interest rate to ward off disaster it was assumed ex ante that the ECB and perhaps other of the global central banks would follow as per function of the lack of de-coupling. Now, as investors seem to settle on the notion that the US is in fact in a recession it may be time to turn towards another of the bogey-man out there in the form of inflation. I am still a bit in limbo as regards to where I see things moving. I still see the ECB cutting rates at least once in 2008 on the back of an accelerated slowdown in the Eurozone but that move won't come on Thursday when Trichet and co. are likely to reiterate the chorus that inflation remains the variable to watch. Yet, this was also always going to be the main rub for central bankers in the sense that in a stagflationary environment their main and essentially only weapon of choice becomes increasingly blunt. Quite simply, in a world with free movement of capital, excess liquidity relative to the capacity to absorb it, and lingering structurally inbuilt interest rate differentials it is not at all certain that toggling nominal interest rates higher will have any meaningful effect at all. On the contrary, as we have seen across the global economic edifice many economies, emerging as well as developed, have been hard at work trying to hold off the pressure from capital inflows even in a situation of rather large external balances. Thailand would be a prime example here but more significantly in a global context such heavy weights as India, Brazil, and China on whose shoulders many hopes of recoupling lie have felt the pressure of the international hunt for yield. Obviously, this is not the case everywhere and across the Eastern European region as well as in Iceland external deficits are fast becoming a real issue.

So, what to do for those poor central bankers and more pertinently what does it mean that they don't seem to agree on what to put first in line of priorities assuming that they can see that there are both growth and inflation risks.It is in this light that I am suggesting that the dog is getting wagged rather than, as we have seen, the tail. Consequently, meetings at the BIS which began this Sunday had central bankers worryingly mainly about high and rising inflation. And what is more; they are even waking up to the fact that they stand largely helpless in doing anything about it at least in so far goes as a given central bank trying to quell the inflation bonfire in its respective domestic economy.

If we home in on the ECB who is deciding on interest rates later this week it even seems as if sentiment is solidifying behind the ECB's vigilance against inflation. Solidifying sentiment is of course unequivocally good and in a European context it even prompted Luxembourg Finance Minister Jean-Claude Juncker to exclaim that the ECB had become the inflation fighting machine we all wanted. So far Trichet and his minions have tried hard to live up to this adamant label. On several occasions both in the context of interest rate meetings and beyond have we heard hawkish statements from the ECB much to the chagrin of France's finance minister Christine Lagarde; I would imagine that they are also keeping more than a weary eye in Spain and Italy. As I have noted before the ECB is now faced with a growing divergences between the Eurozone economies. We don't have to look beyond the most recent data snippets to see this. As Edward details over at Global Economy Matters just about everyone save perhaps Germany is now beginning to feel the pinch (although I feel France may fair better than most imagine). Spain and Italy in particular seems to have entered what appear to become very severe corrections. To make matters more complicated the service PMI from Germany actually rose today while the aggregate Eurozone indicator stayed very close to th 50 mark of zero expansion (in fact, it rose a nudge). Thus, I still maintain my view that the ECB will soon have to go for growth rather than inflation. Two issues are however important here. Firstly, I want to reiterate a point I made on an earlier occasion that we will need to see a material slowdown in Germany before the ECB moves. Secondly, the newly found focus by a wide range of observers and investors on inflation relative to downside economic risks mean that the ECB may just have a stronger hand with respect to an adament view on inflation. 

Not everybody agrees though. Over at Morgan Stanley (may 2th GEF) Joachim Fels and Manoj Pradhan continue their ongoing global inflation watch and they seem to share my view (or I theirs if you will). Consequently, Fels et al believe that central banks will soon be inclined to go for growth rather than inflation.

We think breakeven inflation rates are distorted downwards by safe haven buying and collateral concerns, and true inflation expectations in the bond market may thus be higher.  However, even taking this factor into account, we think investors are still too confident in central banks’ ability and willingness to stem higher inflation in the coming years.  Thus, central banks are likely to keep missing their inflation targets in the coming years, and both true inflation expectations and breakeven inflation rates should rise over time.

(...)

(...) we also think investors are still too confident in central banks’ ability and willingness to stem higher inflation in the coming years. Our bottom line: central banks are likely to keep missing their inflation targets in the coming years, and both true inflation expectations and breakeven inflation rates should rise over time.

Behind this quote lies a critical narrative in which central banks falsely choose to neglect inflation risks in an effort to boost growth. As I have argued before I don't tend to see it this way or more specifically I think the current situation is a hell of a lot more complicated than blaming it on the central banks. Recently, I took a swing at precisely Fels and his colleagues for their analysis showing how in fact current interest rates in the Eurozone are accomodative. I think such claims are very hazardous and just as it may be a question of 'missing markets' it is also a question of an unprecedented process of global recoupling (unwinding of population and economic imbalances). Coupled with lingering wide global interest rate differentials this means that no one really knows what 'global capacity' is and much more importantly whether capital is being allocated in an 'efficient' manner. And speaking of which; recent news from the fx markets suggest that the EUR/USD is not as perky as it used to be. 1.60 consequently seem to have been the interim borderline. There can be many reasons for this (see Macro Man here) but more prominently is of course the question of whether those big wallet central banks are beginning lose their fondness for the Euro. In this way, a large part of this boils down to the whole Brad Setser/Macro Man detective work about just what China and the Petroexporters are doing since they are the big price movers and the speculators simply try to go where they go. As Macro Man notes It could seem as if someone with a big pocket sold off some Euros at 1.60 and now that we are hovering at 1.55 it will be interesting to see what happens next. Obviously a hawkish statement come Thursday could take it right back. Most still see the EUR/USD heading lower though but the key is whether we will see more rallies before this happens. Stephen Jen (permalink later) is musing about a EUR/USD at 1.40 at year's end. I fundamentally agree with him but there is also a strange lock-in effect here since who the hell knows what the equilibrium is? My guess is that as re-coupling moves on (and it will, just look at Brazil and their upgrade to IG) the EUR/USD will find a balanced level at some point but as long as strong interests are vested in terms of a fixed currency regime (or not) we could see a lot of volatility.

So, who exactly is wagging who here? 

It is obvious that growth divergence dilemma persists for the ECB. If anything, it has now grown worse with the recent abysmal data from Spain and Italy at the same time as Germany continues to run on the last legs of strong external demand. At the same time inflation continues to linger at levels far above the formal ECB target even though we actually saw signs of abating pressures recently. In this context, it may seem as if the market discourse has changed a bit in favor for the ECB's strong inflation stance as rampant food and energy prices are beginning to pop up on the agenda. I tend to agree with Fels et al. however when they say that the ECB ultimately will lower rates in 2008. I don't agree with the whole 'inflationist central banks' narrative however since I think the situation is a whole lot more complicated than as such. As for concrete calls it is pretty obvious that the ECB is going to stay pat this Thursday. Coupled with today's devastating news from the US housing sector (Fannie Mae's trip to the pillory is covered by Felix here) and the subsequent ripple effect in the debt markets a hawkish statement could take the EUR/USD back towards hitherto record levels of 1.60.   

[This note is also posted at Japan Economy Watch and Global Economy Matters] 

I am finally back and not much different from the proverbial Phoenix so have the scribe at this space emerged from a rather tough patch of exam hardship. And this is none too late it seems as financial markets and economic data streams have served up an interesting set of new information. In this note, we are taking a trip to Japan and the recent slew of economic data for the month of March as well as other relevant information. Last time I did my monthly review of Japan the data had not budged much. This time is different. As per usual my analysis will progress by looking at Japan's economy from five angles which should subsequently yield a full picture of the current important yardsticks for assessing just where Japan might be heading. Consequently, I will have a look at price developments, domestic demand (also the labour market), domestic investment (and as a derivative here external demand) as well as the Yen. Immediately, there are two important questions which should be stated up front. One is whether I still see the BOJ cutting in Q2? I don't think so. As we shall see below derivatives trading implying future rate movements by the BOJ have, during the past month, moved from a dovish to hawkish and now back to a medium position where most investors and observers expect the BOJ to stay pat for the rest of 2008. The second question is whether Japan is heading for a recession. Upbeat data in the beginning of this month and the (most welcome) reluctance of the data to turn decidedly for the worse recently prompted Morgan Stanley's Takehiro Sato to somewhat retreat from his call that the global economy would see a dual-recession with the second unlucky economy being the US in this case. Since I have also been musing ominously about a potential recession in Japan am I about to retreat to? Not exactly, but I do concede that we are far, at this point, from an actual contraction in Japan. However, this also quickly turns into a alphabetic soup of just what kind of national accounts we are looking and how we 'deflate' the numbers. In Japan's case it e.g. depends on how we treat production vs. income. Basically, the current environment of stagflation means that traditional headline activity numbers need to be taken with a pinch of salt.

A lot of ground to cover then it seems. Let us commence.

If we begin with the development in prices the biggest news from the data was without a doubt how inflation has now returned to the shores of Japan. This was epitomized in the fact that even the price index stripped from food and energy managed to wring out a slight increase in prices at 0.1% y-o-y.


Yet, this is a far cry from the kind of 'escape' that was originally expected in the context of interest rate normalization in Japan and a positive spill-over effect as activity in the corporate sector as well as a tight labour market would lead to a recovery in Japan's hitherto slumbering domestic economy. Of course, the return of positive figures for Japanese inflation has prompted all kinds of knee-jerk reactions from commentators. Even the normally cool David Pilling from the FT was  carried away I think as he featured a story noting how Japan may now finally have 'shaken' off more than a decade of deflation. I remain very skeptical of this and I completely agree with Edward when he says that the argument of Japan escaping deflation would carry much more weight if we were standing on the brink of a recovery rather than in the middle of the worst global financial crisis for many years, a subsequent slowdown in global trade, and a resulting slowdown in Japan's economic edifice. The fact consequently remains that the domestic economy is still slumbering and in this light the passage of strong headline inflation to core prices has not have been an easy one. Most commentators and observers are now beginning to latch on to the narrative I, among others, have been pushing in the context of how Japanese inflation is driven by cost-push rather than demand-pull inflation. Reports are thus coming in about how rising raw materials now represent a paramount risk to the Japanese economy. Ken Worsley furthermore has a timely analysis on the recent data from the inflation front reiterating the point that inflation is coming from all the 'wrong' sources. Japanese consumers are thus still very pessimistic on future income expectations and obviously the current bout of inflation naturally weighs heavily here since it erodes real income. We should also understand that the passage of prices down through the value chain is not occurring without collateral damage. This is the whole point about cost-push inflation without the subsequent demand effect. A significant sign of this came with the reports that the amount of small-cap companies, who constitute 70% of the Japanese workforce, filing for bankruptcies rose 18% in the year ending March. To be slain by the sword or the axe seems to be the nasty dilemma for many companies as they are finding themselves in a double bind with no real ability to pass on the rising costs over to their customers. The inflation figures above thus suggest that inflation is now finding its way to consumers in other goods than energy and food. This could in principle be a good sign in the sense that if inflation expectations were to persistently move upward it could pave the way for that much allured interest rate normalisation in Japan. Moreover, recent news that wages were climbing on the back of changing regulation prompting companies to regularize part time workers is a very welcome structural change in terms of labour market dynamics. Yet, I think it is unlikely that this constitutes a lingering trend or at least I remain skeptical that what we have now is the beginning of a virtuous circle. On the contrary it seems as if the current price dynamics in Japan could now constitute more of a vicious circle.

As for the immediate future the current momentum seems likely to keep all three inflation indices in the positive for the next couple of months. However, core prices in Tokyo for April actually moved from a 0.1% increase to a flat reading of 0%. Given that this figure is a leading indicator for the price indices above (to some extent at least) I would not be surprised to see a return to deflation for April in core prices.

If we move over to the development in domestic demand the situation is obviously closely related to the analysis of prices above. The first months of 2008 saw a surprisingly strong showing from Japanese consumers but as I also noted there might be a distortionary bias in the numbers. Quite simply, with a situation resembling stagflation (driven by price increases in food and energy) consumers cannot but take on the increase in prices in the context of consumption of 'non-luxury' goods (i.e. for which demand elasticity is low.)

The first figure above shows, as per usual, the main data as reported by the media. As can be observed the decline in y-o-y consumption of -1.6% means that the initial strong showing at the end of 2007 and in the beginning of 2008 now has been somewhat paired . In fact, the average of the last four months slots in nicely with my general rule of thumb that we should not expect domestic consumption to grow by more than 1% in a Japanese context. For a fuller analysis of this headline consumption figure Ken Worsley provides the relevant information. Especially, the sharp decline in durable goods (i.e. the lacking demand effect again) seems to be a decisive factor in explaining the March figure. A look at the more long term tendencies for the recent two months indicates that we are moving on nicely around reversion to a declining mean over time. The reason as to why we have a mean with 'trend' here as we put it in econometric lingo is, I think, to be found in the context of Japan's demographic profile where an ever declining size of the working and income earning cohorts relative to the total population coupled with endogenous changes in life cycle behaviour (at least I think so) exert a structural pressure on domestic consumption. The future cyclical tendencies in domestic consumption are very difficult to gauge I think. One thing which casts a cloud over the next months' reading is the flurry over the gasoline tax which was not re-approved by the DPJ and may thus be reinstated which would increase gasoline prices and thus potentially push up consumption expenditures (or even divert resources consequently pushing down consumption). The main point is that monthly consumption figures tend to be clouded in a stagflationary environment. What would perhaps be more pertinent, and Ken Worsley's analyses are usually very much to the point, is to look at traditional strong demand components such as durable goods, semi-durables, furniture etc (household investment), auto sales, etc. in order to gauge what the real domestic demand effect is.

In this way, and as I have recently emphasised it would serve us more to look at tendencies in corporate capex (e.g. industrial production) and its connection with export growth if we want to assess the Japanese business cycle.


As we see in the figure above it could seems as if the curve is starting to dip. Obviously, the interpretation for cyclical analysis is not straightforward since we are talking about an index but I still think it is beginning to look as a turning point. As Edward notes here industrial production also nudged back on a monthly basis which suggests that economic activity is now clearly firming down. Not surprisingly the relative poor showing from industrial production comes in conjunction with a marked slowdown in the increase of exports. The semantics here are not insignificant since what we need to understand is that absent a recovery in domestic demand Japan needs a high increase in the growth rate in both exports and as a derivative corporate capex in order to keep the economy floating. If this rate of increase slows down significantly (even if it may not dissipate entirely) it also effectively means an erosion of Japan's only shield against a severe slump. In this light specifically, IMF's and WTO's recent warnings of a significant slowdown in global trade are especially worrying from Japan's point of view since she so desperately depends on being able to leverage external hotpots of economic growth in order to keep growth at a minimum sustainable level*. If the slowdown stabilises on the current level of increase which is a bit lower than the high levels seen in the summer/autumn 2007 I think Japan can weather the storm without experiencing a contraction. However, if the slowdown in capex and exports intensify I am unsure as to how much we can expect domestic demand to take up the slack and in any case growth will have to come down to much lower levels.

Finally, I should mention FX markets where the Yen as ever remains an important canary in the coal mine for gauging the overall risk sentiment in the market place. For a more thorough operationalization of this argument I invite you visit my post on the USD/JPY and its correlation with equity markets.

As we can see the Yen has weakened across the board since last time we looked at this chart and even though we are not nearing the soothing pre credit turmoil carry trading days (save in the context of the EUR/JPY cross maybe) it does seem as if risky behavior is returning to the market. Now, as Macro Man notes in the comment section here he finds that this past week has been rather puzzling. This may be so. However, I don't think that our good MM's compass is completely off and in our immediate context he asked this Thursday whether in fact risky assets and carry trade were once again, if perhaps temporary, the game to play.

The SPX broke 1400 just before and after the FOMC announcement, but there was little appetite to follow through; the close must have been disappointing to bulls. Similarly, USD/JPY flirted heavily with resistance around 105 earlier in the day but failed to breach it, thanks in part to reported Golden Week offers from exporters. Watching these two charts in tandem is probably not a bad idea; if both break and hold, it should suggest that the risk trade is "on, baby." However, if they both continue to jiggly about without showing much inclination to break through, it will send a powerful signal that all is not well in Denmark.....or make that risky financial assets.

I completely agree with MM when he notes that we should be watching the USD/JPY in conjunction with the SP500. As such, it could seem as if the bulls were exiting their pens to scour the planes once again. Surely, those with a knack for risky assets could use the recent employment data from the US to underpin their views. Moreover, the USD seems to be staging somewhat of a come back against the Euro as the economy of the latter fiat currency now decisively seems to be heading for choppy waters. On the Yen, it remains calibrated as a very fine thermometer measuring the degree of risk aversion in financial markets. I urge investors in this context to remember that the fundamentals of Japan's economy are next to useless in plotting the path of the Yen and if anything exerts the opposite effect of what the textbooks would claim. Personally, I am surprised to see that the EUR/JPY is back in the +160 territory and from a short term tactical point of view I think that a sell could be warranted here. The USD/JPY is now firmly back in the 100s and we consequently never really got to stay for long in the <100s for the MOF's patience to be tested. One part of the fundamentals which may actually be important here is how the Fed has now signalled, after cutting to 2%, that this will be the last cut due to upside risks for inflation. In summary on the Yen recent movements reflect a return of risk appetite to the market place ... whether this will linger is still quite unlikely I think so be careful out there.

In Conclusion

How should we connect the threads there then? A good place to start would be to revisit the two questions stated in the beginning. Is Japan heading for a recession and pending that question what I am expecting from the BOJ? As regards the first question it is pretty difficult to say I think but what is not difficult to see is that Japan is now set to slow down significantly. Recently, the BOJ noted (see a detailed analysis here) how the economic outlook had worsened in eight out of nine regions. This change in outlook was chiefly driven by the adverse effect of high headline inflation as well as a decline in corporate profit. On the latter the BOJ is expecting that capex will trend down not least seen in the light of a general slowdown in global trade. The charts above support this analysis. The MOF (ministry of finance) also recently reiterated the general point that economic momentum is fading on the back of declining business activity and investment. I don't think this is surprising. However, what comes next will be a big test of what the idea of a recovery actually means in a Japanese context. Many observers have voiced the expectation that as the external economic edifice slows domestic demand would be able to take over the baton providing a cushion for the low levels of business investment as well as consumption would provide a buffer. I remain very skeptical with respect to these claims. At the very least I expect that whatever change of baton we will see the receiving athlete in the form of the Japanese consumer will be moving at a considerably slower pace than we have seen in the past 18 months. In that vein I think that industrial production need to be watched closely from here on, especially in connection with the slowdown in global trade. One important brigth spot in this regard is the reports indicating that companies are beginning to take on more full time employees as per function of recent legislation. We even learned from the data that unemployment declined in March. This could in theory give a structural boost to wages and thus domestic consumption. However, the chains of economic fundamentals have not been broken. A large bout of economic research suggests that the increase in part time jobs in connection with an ageing workforce is driven by productivity effects as well as ageing workers' preference for supplying their labor exclusively in a part time context. As such, wages should not be expected to increase above and beyond labour productivity I think since this is not possible in the context of many Japanese firms exposed to external competition.

Finally, we have the future course of the BOJ. The new governor Masaaki Shirakawa started out on a hawkish note which even had investors expecting a raise in interest rates at some point during the past month. Such expectations have now been paired and at this point we are back to "normal" so to speak with the BOJ in a perpetual holding position. In my mind there is no doubt that the proverbial statement paving the way for a cut in the event of a rapid deterioration of economic fundamentals is made . However, the market discourse has also changed so as to make a weary eye on climbing inflation a higher priority relative to the initial response of massive damage control to counter the effects of the credit turmoil. In this light I want to hammer down that Japan's exposure to the credit turmoil does not come from the liquidity issue itself but rather from the potential adverse effects of a general slowdown in global activity and trade. For the immediate future I am moving in behind the market consensus pointing towards a holding BOJ for the next three months. This position is subject to a revisit should industrial production show further signs of an accelerated slowdown.

 
*Where of course "sustainable" in the long run here is virtually impossible but if the end point can be postponed it can buy us time to perhaps turn the ship around

As my regular readers will know a part of my analysis on Eastern Europe and the Baltics has been to look at the Eastern European edifice through the lens of Lithuania. Last time I did that I showed an update in terms of the labour market as well as I did a more thorough analysis of Lithuania's external position. At this point I probably should move in with a lot of updated graphs on the labour market and economic activity. However, I won't since we have not gotten a lot of new data and what we have got confirms what we already knows. Inflation continued its upward increase in the first months of 2008 where the HICP index touched nearly 12% y-o-y. This is not at all good news. As we can currently observe across a wide range of Eastern European countries inflation is lingering even as economic growth slows down considerably. Meanwhile of course Lithuania's capacity to work its way out of this seems quite shaky since unemployment is at all times low which means that the structural pressures for wage increases and productivity eroding inflation is now a fundamental part of the economic structure. A combination of rapid economic growth as per expected on the basis of the convergence hypothesis and a structurally broken population pyramid and net outward migration is now taking its visible toll. Provisional estimates for Q1 GDP suggests that Lithuania expanded at 8% y-o-y which is still way too fast given the underlying capacity constraints. Official authorities in Lithuania narrate this as if the economy is on track towards a soft landing. I can only hope they are right but I am not confident. Signs of a slowdown are beginning to emerge ever so slightly in the labour market where unemployment has risen a tad going into 2008. Obviously, as Lithuania slows further this development should increase. As ever though, the risk is of a rapid reversal of economic conditions loom on the horizon in the context of the global financial and now also food crisis thundering along with all the increased risks that such events bring with it in the context of a small emerging market such as Lithuania.

What risks we should watch out for is what I will investigate further here.

Better late than never an old adage goes. In this way, IMF's recent World Economic Outlook as well as its Global Financial Stability Report comes with a timely warning in the context of the current financial and food/energy related crisis (the latter point which I will deal with later and where you, in the meantime, could do a lot worse than read Macro Man's recent tale of the 800 lb gorilla). As per usual, IMF's center piece publications are littered with information but the part of it I most noticeably latched on to was the chapter about emerging markets and their resilience. More specifically, I took note of the part dealing with the resilience of the CEE and Baltic economies' external position. Now, this story has already been well summarised by RGE's Mary Stokes in her excellent investigation of foreign banks' presence and exposure to the Eastern European markets and thus, by derivative, Eastern's Europe dependence on credit inflows to finance external borrowing (often done in foreign currency just to make it a bit more complicated). Since I have also sketched this situation many times before I am going to quote myself from a previous note in which the stylised facts are laid out ...

The past years' expansion and subsequent build-up of large negative external positions in the Baltics have mainly been driven by consumer and mortgage credit supplied by foreign (most notably Scandinavian) banks and credit institutions. In this way, the Baltic economies are very dependent on this link not only to keep the external position from not correcting too quickly which would happen if the foreign banks suddenly closed shop and retreated their fangs but also in order to keep and restore confidence in their economies and most importantly the currency boards tying their currencies to the Euro. Quite simply, the Baltics need these banks to now follow them down into whatever the current slowdown will bring. Will the banks be ready for this?

Especially, the last question is important to be aware off and essentially this is also at the heart of the inquiry Mary and IMF are making. In the context of Lithuania the dependence on foreign loans reveals itself on two accounts. Firstly, we have the composition of the external balance where we can see how the liabilities (i.e. the break up of the negative net investment position) is made up disproportionately much of bank loans compared to the more traditional components of portfolio flows and direct investments. Secondly, we have also seen how, as a result of the pegged Litas to the Euro, many of these loans are denominated in Euros. This is about balance sheet risks then in the context of translation risk which basically arise in connection with loans denominated in Euros and cash-flow/deposits where an overweight is in Litas. Obviously, this works well as long as the peg holds but in light of the discussion sketched above the risk is of course that the foreign banks suddenly retreat and/or that the Lithuanian currency is subjected to a pressure to depreciate as the external position becomes unsustainable. Quite clearly, any kind of market moves here would require the ECB to shield the peg since the currency board itself cannot be expected to keep the peg if the unwind really begins.

The main question I am asking here is what actually provided the build-up of foreign denominated loans in the first place and what the main driver is? Well, we are finally getting to the visual part of this note. As the first set of of graphs we have the formal illustration of what translation risk potentially means. Note that the graphs are updated with the latter part of 2007, a rather important point for the rest of the analysis (click on the pictures for better viewing).

Quite simply, translation risk can be measured by the extent to which these two figures are not alike. As we can see the loan composition does not match domestic deposit composition thus making the servicing of the debt vulnerable to potential currency movements. Moreover, these figures tend to underestimate the real translation risk since one thing is deposits another thing is the cash flow itself used to service the loans. In this light, one of the questions that has haunted me a bit lately when I looked at the charts is what exactly drives the fluctuations and general discrepancy between these charts.. One obvious explanation is that, per function of the strong foreign bank presence, the liquidity of the Euro credit market is a lot deeper than the corresponding market for Litas denominated loans. And as we shall see below this seems to correspond to reality since a deeper more liquid market quite simply translates into lower funding costs.

The three graphs above tell an important story about the market for credit in Lithuania and thus I imagine in the Baltics. As can be immediately observed borrowing in Euros is substantially cheaper than borrowing in Litas. Over the sample period in question the average interest rate spread in favor of Euro denominated loans has been 123 basis points (sd: 35 basis points) which should be more than enough to induce a considerable cross-price demand effect. Another interesting observation is that the trend in loan taking now seem to be parting ways with respect to currency denomination. In this way, the volume of outstanding loans denominated in LTL is beginning to decline where as it seems as if steam is still left in the Euro credit flows. Obviously, there may be both stock and flow effects where the latter would be how Litas loans were simply rolled over into Euro loans or, in the context of flows, simpl