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Please find attached our latest monthly report, “Summer Doldrums: Do Safe Havens Still Exist?” Key conclusions to the report include:

• Sectoral divergences abound in the US economy, with weak final demand being partially offset by strength in exports and equipment investment

• A slowdown in growth caused by the most restrictive fiscal policy in six decades remains the biggest risk to the US economy in 2012

• Uncertainty about the risk of a Greek default has pushed bond yields in Spain and Italy to euro-era highs

• While Japan has embarked upon a V-shaped recovery since April, pressure continues to build for Prime Minister Naoto Kan to resign

• Chinese growth remained strong in the second quarter, but local governments’ high debt loads has emerged as a serious risk to the country’s outlook


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MONTHLY REPORT

Summer Doldrums:

Do Safe Havens Still Exist?

July 18, 2011 • Volume 08.10

By David Hale


KEY CONCLUSIONS

• Sectoral divergences abound in the US economy, with weak final demand being partially offset by strength in exports and equipment investment

• A slowdown in growth caused by the most restrictive fiscal policy in six decades remains the biggest risk to the US economy in 2012

• The weakness of employment growth may reflect caution in the small business sector

• There is now an increased risk that the US Congress may pass sanctions against Iranian oil that could cause the oil price to reach all-time highs

• Although the Fed is committed to maintaining an accommodative monetary policy for quite some time, it has only hinted at a third round of QE

• Uncertainty about the risk of a Greek default has pushed bond yields in Spain and Italy to euro-era highs

• While Japan has embarked upon a V-shaped recovery since April, pressure continues to build for Prime Minister Naoto Kan to resign

• Chinese growth remained strong in the second quarter, but local governments’ high debt loads has emerged as a serious risk to the country’s outlook

• The East Asian economies have overcome the headwinds they faced during the second quarter

• Latin American growth is decelerating as anti-inflation efforts take hold

• The outlook for Sub-Saharan growth remains strong in the near term


WEAK EMPLOYMENT NUMBERS CLOUD THE US RECOVERY


The US economy continues to generate contradictory signals. During March and April, final demand lost momentum as rising gasoline prices squeezed household income and the Japanese earthquake reduced the supply of Japanese autos. Employment gains during March and April averaged 205,500. There was a rebound in large department store sales and durable goods orders in June while the manufacturing purchasing agent index rallied to 55.3 from 53.5. Yet, there was a payroll gain of only 18,000 jobs after a disappointing gain of 25,000 during May. The private sector added 57,000 jobs during June compared to 73,000 during May and 241,000 during April, while the government sector shed 39,000 jobs after losing over 100,000 during the previous five months. The auto sector depressed manufacturing hours in June, but the three months rate of change for all hours worked still rose 3.3% during the second quarter. There was a gain of 840,000 jobs on a non-seasonally adjusted basis during June, so seasonal adjustments may have played a role in depressing the payroll gain. If the labor department had used the same seasonal factors last month as in 2010, the job gain in June would have been 221,000. In 2010, there was also a sharp slowdown in job growth during May and June followed by a rebound during the late summer and autumn.


THE US CONSUMER LAGS WHILE NON-BUILDING INVESTMENT SURGES


There continues to be great sectoral divergences in the economy. The strongest sectors are exports and business investment in equipment. Both are growing at double-digit rates. In May, private construction was 1.0% below its level in January and 5.1% below its level one year ago. Public construction, by contrast, was 4.7% below its level in January and 9.3% below its level one year ago. The state and local government squeeze is depressing construction despite attempts by Washington DC to promote infrastructure investment.


Real consumer spending appears to have grown by less than 1% during the second quarter compared to over 2.2% during the first quarter. Retail sales excluding autos and gasoline rose only 0.2% in June. The three-month growth rate has declined to only 2.6% from 9.4% in March. There was a squeeze on household income during the second quarter because of rising oil and food prices. The gasoline price has dropped by $0.30 since early May, so income growth should improve. The decline in gasoline prices has so far failed to boost consumer confidence because of household concerns about the job market and the debt ceiling negotiations in Washington.


The flow of funds data indicates that household balance sheets are getting stronger. In the first quarter household net worth increased by $943 billion to $58 trillion—the level which prevailed in 2005. During the past six years, there has been a significant contraction and expansion of household wealth. It peaked with the housing cycle in the second quarter of 2007 at $65.8 billion, and then plunged to only $49.4 billion by the first quarter of 2009. It has rallied with the stock market during the past two years. Household net worth is now close to its long-term average of five times personal disposable income. It exceeded this level at the stock market peak in 2000 and housing market peak in 2007. Households are also spending less on interest payments. In the first quarter, they spent $803 billion, annualized, on interest payments, or $150 billion below the peak. Sixty percent of the decline comes from reduced debt balances, and 40% comes from lower mortgage interest payments.


The housing market remains moribund. The rate of existing home sales fell 10% between January and May, but pending home sales rebounded 8% during May. New single family home sales have been flat since the end of the homebuyer tax credit last year, and averaging about 310,000 per month so far this year. As new home sales have been weak, construction spending on new homes has fallen 3.7% since January. The Case-Shiller ten city home price index stabilized in April after falling for eight months, and is 3.8% below its level one year ago. The Corelogic house price data reported a 10% seasonally adjusted rate of increase over the three months through May when distressed sales are excluded. When distressed sales are included, the declines in the Corelogic index eased to 0.4% in May.


The market continues to suffer from excess supply, but there are signs that delinquencies are declining. According to an Office of the Comptroller of the Currency survey, seriously delinquent mortgages decreased across all risk categories to 4.8% of the serviced portfolio, which is a 9.4% decrease from the previous quarter and a 25.1% decrease from one year ago. Servicers implemented 557,451 new home retention actions—modifications, trial period plans, and payment plans—during the first quarter of 2011. This was more than three times the 171,618 completed foreclosures, new short sales, and new deed in lieu of foreclosure actions. Newly initiated foreclosures decreased 11.3% from the previous quarter and 15.6% from one year ago because of the continued decline in seriously delinquent loans and increased emphasis on home retention loss mitigation actions.


As developers have very low inventories, there could easily be an uptick of new home starts if sales improve. Mortgage rates have fallen 45 basis points since February, so homes are very affordable. The constraint on sales may be the impact of weak employment growth on new household formations.


RESTRICTIVE FISCAL POLICY IS US ECONOMY’S BIGGEST RISK IN 2012


The new challenge for the US economy in 2012 will be the shift to a much tighter fiscal policy than has prevailed during recent years. The Obama budget submitted in February suggests that the tax share of GDP could increase by 2.2% during the new fiscal year, which starts in October, while the spending share is projected to decline 1.7%. The CBO has different assumptions, but still projects fiscal drag of 2.5% of GDP in the next fiscal year.


The major projected changes are as follows:

• Households will lose the 2% reduction in payroll taxes which took effect during January. The president has talked about extending this tax cut, but there has been no enthusiasm among Republicans for the idea. The effect will be to reduce household income by about $120 billion.

• Washington extended unemployment benefits to an unprecedented maximum of ninety-nine weeks in December. This provision will expire in January, which could reduce household income by $50 billion.

• In December Congress gave the corporate sector 100% first year depreciation allowances on new equipment investment. This allowance will drop to only 50% in January. The OMB is projecting this change could increase business taxes by $129 billion in 2012.


• Many components of the Obama stimulus program will unravel during the year ahead. Aid to state and local governments, for example, will fall from $59 billion to only $6 billion. The Republicans are also demanding large spending cuts in their negotiations over increasing the debt ceiling.


The reductions in the federal deficit next year could range from 2.5% of GDP to 3.5% of GDP. If we apply a multiplier of 0.66, the impact on growth could range from -1.7% to -2.3%.


COULD IRAN OIL SANCTIONS SEND THE OIL PRICE TO ALL-TIME HIGHS?


The Obama administration found one novel way to stimulate the economy during June. It persuaded the International Energy Agency to organize a global release of sixty million barrels of oil in order to drive down gasoline prices. The IEA has taken such an action only twice before in response to supply shocks. The action led to an immediate decline in oil prices, and the price of gasoline is down $0.30 from its level in early May. Such a price decline is the equivalent of a $30 billion tax cut.


After the June OPEC meeting broke up in disarray, Saudi Arabia signaled to the markets that it was prepared to boost oil output to 10 million barrels per day. The IEA estimates that Saudi output rose to 9.7 million barrels per day in June. As the oil price rallied in recent days, the IEA is debating whether to release more oil from its reserves. There is no sign that the Libya conflict will end soon, so the market will continue to miss its 1.4 million barrels per day of exports.


There is now legislation pending in Congress which could seriously disrupt oil markets. The bills call for an embargo on Iranian exports of oil and natural gas. As Iran produces 3.6 million barrels per day of oil, such an embargo could drive global oil prices sharply higher.


DEBT CEILING NEGOTIATIONS GROW MORE COMPLEX AS DEADLINE LOOMS


The president is now locked in negotiations with Congressional Republicans over how to increase the federal debt ceiling. He says that he wants a large package, potentially $4 trillion, but the two sides remain far apart on the details. The Democrats want to raise tax revenues as part of a deal, but the Republicans have ruled out any tax increases. Both sides recognize there will have to be changes in the entitlement programs, but the Democrats remain very protective of them.


It would appear five endgames to the debt ceiling negotiations are possible:

1. The two sides reach an agreement on large spending cuts and modest tax increases.

2. They attempt to play for time by allowing only a moderate increase in the debt ceiling while negotiations continue. The president has said that he does not want short-term solutions, but if there is no agreement he may have no other alternative.

3. Senator Mitch McConnell (R-KY) has offered a contingency plan in which Congress would give the president the power to raise the debt ceiling by $700 billion in August and by $900 billion on two future occasions. His proposal would require Democrats to take responsibility for raising the debt ceiling. He believes that this would hurt the Democrats’ political position and increase the odds of Republicans winning control of the Senate next year. What remains unclear is whether House Republicans will want to lose an opportunity to obtain large spending cuts as the price of increasing the debt ceiling.

4. The administration attempts to invoke section four of the 14th Amendment to the Constitution which protects the federal debt. The administration could say that the debt ceiling conflicts with the Constitution and then attempt to sell new debt. The administration has tried to avoid any discussion of such a scenario because of its desire to negotiate, but several legal scholars have said there would be a case for invoking the 14th Amendment if default loomed as a possibility.

5. The final scenario would be the one in which there is no agreement and the Treasury attempts to cope with a cash shortage. The Bipartisan Policy Center estimates that the Treasury will have $172.4 billion of tax revenue during August to meet $306.7 billion of potential spending obligations. The priority spending items would probably be interest on Treasury securities, Social Security benefits, Medicare/Medicaid payments, active-duty military pay ($2.9 billion), and unemployment insurance benefits ($12.8 billion). In the event of such a cash crunch, the Treasury would have to furlough many government employees and suspend spending on a wide variety of programs.


The fifth scenario would be highly disruptive, so both sides want to avoid it. If the gridlock cannot be broken, the second and third scenarios would then become the most likely outcomes. The president is trying to appeal to centrist voters by appealing for modest tax hikes to complement large spending cuts. The potential revenue items on his list are quite diverse. They include:

• Scaling back tax allowances for employer-provided health care benefits, which will cost $117 billion in 2011.

• Limiting itemized deductions for the wealthy, which could bring in $293 billion over ten years

• Repealing tax allowances for large oil companies, which could save $45 billion

• Raising the tax on “carried interest” to 35%, which would be worth $20 billion

• Matching the depreciation schedule for corporate jets to that of commercial airplanes, which would raise $3 billion

• Repealing the “last in, first out” accounting method, which would be worth $70 billion


The Republicans have been adamant that they will not accept any tax increases. They would be prepared to curtail some allowances in return for lowering tax rates, but they rule out any revenue hikes.


The president has suggested that he would be prepared to accept cuts in entitlement programs which would be unpopular among Democratic members of Congress such as raising the age for receiving Medicare benefits to sixty-seven years from sixty-five. The president would also be willing to change the inflation index used to compute transfer payment changes. Under this proposal, the government would use the chained CPI rather than the traditional CPI to adjust transfer payment programs, such as Social Security, and compute inflation adjustments for income taxation. The chained CPI tracks the conventional CPI, but over the last ten years it has increased by 3.6% less than the other measure. The CBO estimates that using the chained CPI would raise federal tax revenues by $72 billion, lower Social Security benefits by $122 billion, and reduce federal pensions by $24 billion over ten years.


BERNANKE INDICATES QE3 IS POSSIBLE JUST AS QE2 ENDS


The Federal Reserve has ended its quantitative easing program. There was great controversy when Federal Reserve Chairman Ben Bernanke announced the program, but it has been successful in increasing the monetary growth rate, one of the Fed’s most important goals. There has been a recovery in broad measures of US monetary growth during the past six months. The counterpart to this growth has been an increase of $800 billion in bank holdings of cash. Other assets declined. The risk which now exists is that regulatory demands for increased bank capital ratios could retard lending, and thus once again depress money growth.


The Fed remains committed to restraining interest rates for a prolonged period of time as well as maintaining the balance sheet’s current size. As the risk of deflation has faded, Mr. Bernanke will not be anxious to return to quantitative easing, but if fiscal drag seriously depresses output growth during 2012 and unemployment remains close to current levels there will be active discussion about another round of quantitative easing. Mr. Bernanke hinted at such a possibility in recent Congressional testimony.


WHY RENT PRICES ARE DRIVING CORE INFLATION UNCOMFORTABLY HIGH


The CPI inflation rate dipped 0.2% during June because of falling gasoline prices, while the year-on-year inflation rate remained at 3.6%. The big surprise was that the core CPI increased by 0.3% for the second month in a row. The year-on-year increase in the core CPI is now 1.5% compared to a trough of 0.6% last October. The core CPI was driven higher by large increases in prices for apparel, autos, and hotel rooms. One of the factors which could push the core CPI even higher in the year ahead is rent, which accounts for over 30% of the CPI weighting. The rental equivalency index has been increasing at a 1.3% annual rate over the last six months compared to 0.8% in December. The share prices of apartment REITs are suggesting that the inflation rate for rent could increase further during the next few quarters. Since November the share prices of apartment REITs have increased by over 20% compared to just under 11% for the total REIT index. The Fed’s favorite measure of core inflation is the core PCE deflator. It has increased at a 1.8% annual rate over the last six months compared to 2.1% for the core CPI.


AGRICULTURAL COMMODITY PRICES COULD REBOUND THIS FALL


The USDA produced a large decline in agricultural commodity prices during early July by issuing a positive forecast for the potential output of crops this year. The USDA is projecting that farmers will plant 92.3 million acres of corn, which is 5% higher than last year, and 56.4 million acres of wheat, which is also 5% higher than in 2010. The planted area for soybeans is projected to decline 3% to 75.2 million acres because soybean prices have been less robust than those for other commodities. Brazil has also just harvested a record soybean crop of 75 million tonnes. The risk is that adverse weather conditions could produce production declines for wheat in Europe, Canada, and some US states. The International Grains Council also estimates that there could be a corn deficit of 3 million tonnes, and a decline in worldwide stocks to a five-year low because of strong demand. These factors suggest that there is a risk agricultural commodity prices could rebound during the autumn.


HAS COST CUT-DRIVEN PROFIT GROWTH REACHED ITS LIMITS?


Alcoa kicked off the second quarter earnings cycle with a large gain in profits. Other companies have also issued positive reports. Revenue for the S&P 500 has now outpaced the growth of nominal GDP for the past three quarters, so profit growth year on year should be 12-13% during the second quarter. The profit rebound during 2009 and 2010 was driven largely by cost cutting. Profit growth will now require an improvement in top line sales growth. If the economy fails to rebound during the second half, profit growth will also slow.


PRIVATE SECTOR JOB FORECASTS PAINT A SLIGHTLY BRIGHTER PICTURE


There have been other surveys of employment which have been less downbeat than the May and June labor department data. The ADP survey showed job gains of 157,000 last month. The Business Roundtable survey of hiring intentions during June showed that over half of firms plan to expand employment during the second half while only 11% will increase layoffs. The Manpower Employment Outlook Survey projects that 20% of firms will expand employment during the third quarter while 8% will decrease it. When seasonally adjusted, the net employment outlook becomes +8% compared to +6% one year ago. There are more than 18,000 companies in the survey. During the first quarter GE Capital conducted a survey of mid-sized companies’ hiring intentions. It found that 65% of firms have started hiring, and that 80% will be hiring during the next twelve months. Monster, the global online hiring agency, publishes a monthly employment index. In June, it rallied 4% year on year to 146, its highest level since October 2008. The largest year-on-year gains have been in mining, quarrying, and oil and gas. In June, there were robust gains in wholesale and retail trade as well as the media and telecommunications sector. The weakest sector was public administration.


The Conference Board measure of CEO confidence rose to 67 during the first quarter, but slumped back to 55 during the second quarter because of the headwinds which hit the economy after March. Only 33% of CEOs said conditions were better now than six months ago compared to 85% during the first quarter. Despite this new pessimism 70% of the executives continued to predict profit growth in the year ahead. Fifty-seven percent said they would benefit from rising sales while 20% expected to cut costs. The Conference Board’s employment index rose slightly


The only employment survey which has been consistently negative is from the National Federation of Independent Business. Its overall confidence index has been declining since March, and its index in June was only 2.9 points higher than the reading during the trough in July 2009. The small business sector had small job losses in June because of declines in services. The forecast for the next three months is also lackluster. Eleven percent of firms plan to increase hiring while 7% plan to reduce their workforce, yielding a seasonally adjusted 3% of owners planning to create new jobs. The survey said, “these statistics are still at recession levels.”


The US Chamber of Commerce also recently conducted a survey of small businesses which reported widespread pessimism. Sixty-four percent of small business executives said they would not hire in the year ahead while 12% said they would cut jobs. The survey covered 1,409 executives in firms with less than $25 million of sales.


The NFIB survey and the Chamber of Commerce survey are contradicted by the ADP survey. It showed small business job gains of 88,000 during June compared to 27,000 in May and 88,000 during April. Large firms, by contrast, created only 10,000 jobs in June after shedding 21,000 during May. There is not sufficient detail in the BLS payroll survey to distinguish between large and small firms, but there is no doubt that the small business sector is very important. In March 2007, firms employing fewer than 99 workers employed 42.6 million people while firms with over 1,000 workers employed over 54.5 million. During the recession, the small firms lost 4.25 million jobs compared to 3.1 million for the large firms.


The Kauffman Foundation has published a report suggesting that there may be a structural change occurring in small business job creation. Citing data from the US Census Bureau, the report found that the number of employer businesses has fallen 27% since 2006. The study also examined young companies’ size at birth, jobs created, and the survival patterns of new firms. They found that in the past new firms created 3 million new jobs per annum, but the latest cohort produced only 2.3 million jobs during 2009. BLS data indicated that during the 1990s firms started out with 7.5 employees whereas that number today is only 4.9.


Small businesses have suffered from the slump in property values because nearly three-quarters of them have loans secured by commercial real estate. Loans to small business have been weak during the past year relative to total lending. Between the first quarter of 2010 and 2011, small business loans have shrunk 8.6% while overall business loan portfolios have fallen only 0.9%. Small business loans peaked in June 2008 at $711 billion and fell 14.3% to $610 billion by the first quarter of 2011. The declines occurred in all size categories. Loans under $100,000 declined 18.1%. Loans between $100,000 and $250,000 declined 16.8%. Loans between $250,000 and $1 million declined 12.1%.


The Federal Reserve’s Senior Loan Officer Survey suggests that conditions are improving for small business. In the most recent survey, loan officers reporting tighter lending standards for small business dropped to -13.5%. The survey also found that 9.6% of senior loan officers reported increased loan demand from small business, which is only the second uptick since June 2006.


Small firms have expressed concern about the Obama administration’s economic policies. They fear that his desire to hike marginal income tax rates could create an extra burden on firms which file Subchapter S tax returns rather than paying the corporate tax rate. They are also apprehensive about how the Obama health care program could affect their benefit costs.


The June NFIB survey suggests that credit conditions are not a major problem for small business. In June, 91% reported that all their credit demands were met or that they were not interested in borrowing. Nine percent reported that not all of their credit needs were satisfied and three percent said financing was their number one problem. A net nine percent reported that loans were harder to get compared to their last attempt. The NFIB survey suggests that credit access is only a modest constraint on small business, but the fact that small business lending was still shrinking during the first quarter confirms that the sector remains cautious.


EUROPEAN GROWTH SLOWS AS FISCAL DRAG TAKES HOLD


There are numerous signs that the European economy has been slowing after a robust first quarter. The manufacturing purchasing manager index fell to 52.0 in June from 54.6 in May. The services sector PMI fell to 53.7 from 55.4 in May. The manufacturing PMI is now at its lowest level since December 2009. Italy and Spain have dropped below 50. Euro area retail sales fell by 1.1% in May after rising by 0.7% in April. German sales fell 2.8% while French sales declined 0.7%. Spanish sales fell by 1.6% to the lowest level since February 2001. Portuguese retail sales fell 3.1% and are now back at May 2004 levels.


German industrial orders experienced a surprisingly robust gain during May. They rose 1.8%. Domestic orders rose at an 11.3% annual rate while foreign orders contracted 5.8%. The orders data is consistent with further steady growth of industrial production. Euro area manufacturing orders also rose 0.7%. There were robust gains in Germany, Finland, and Ireland, but declines in France and Italy.


The German IFO index surprised the markets by rallying to 114.5 in June from 114.2. German companies remain very positive about current conditions in their nation’s economy, but their long-term expectations index declined for the fourth month in a row.


Ireland’s GDP increased by 1.3% during the first quarter because of a positive swing in the trade account. Exports rose by 3.8% while imports declined by 0.3%. Private and public consumption declined by 1.9%. Ireland has a large tradable goods sector which should help it to recover.


The UK economy lost momentum during the second quarter, and may have a growth rate as low as 0.2% compared to 0.5% during the first quarter. Household real income has declined 2.7% during the past year because of high inflation and stagnant wage growth. The weakness of the pound has helped to produce a 15% year-on-year growth in goods exports, but it cannot compensate for the weakness of domestic demand. The UK purchasing manager index fell to 51.3 in June after having peaked above 60 six months ago. The government had been hoping that the corporate sector would use its large cash balances to boost investment, but weak demand and constraints on credit could dampen capital spending. The markets have ceased to expect that the Bank of England will raise interest rates this year.


The euro area’s growth rate will probably ease to 1.5% at annual rates during the second and third quarters from 3.4% during the first quarter. The first quarter was buoyed by special factors such as good weather boosting construction output. Inventories are not high, but domestic demand has moderated in part because of higher inflation from rising oil and food prices. There is also fiscal drag in several countries. The European Central Bank and the Swedish central bank raised interest rates in early July. The ECB was driven by the robust growth of Germany and the fact that the inflation rate in the euro area is 2.7%. As with Germany, Sweden is enjoying an export boom. German monetary growth has rebounded to the 4-5% range, but monetary growth remains deeply negative in Greece, Ireland, and Portugal.


GREEK BAILOUT TALKS ARE IN FLUX


The debt situation in Greece and other peripheral countries continues to dominate the headlines. The Greek parliament approved a new austerity program in early July in order to achieve its deficit reduction targets and set the stage for privatization of state-owned assets. This action will allow the IMF and the euro area to provide Greece with €12 billion of financial assistance in July.


Greece has so far failed to satisfy the conditions of last year’s aid package. In the first half of 2011, the fiscal deficit remained at 10% of GDP because tax revenues were €3.1 billion lower than planned. The recession in the Greek economy has depressed tax receipts despite the government’s attempts to raise tax rates and improve tax compliance.


The contentious issue has been Germany’s insistence that bankers should share in the rescue program by agreeing to rollover Greek debt. The ECB has said it will oppose such proposals if they lead the credit rating agencies to declare that Greece is in default. The ECB has said it will not allow defaulted debt to be used in the repo funding it has been doing in Greece and other countries.


The issue is highly technical. S&P and Fitch have said they would classify a rescheduling of Greek debt as a default, but they could then reclassify Greece once the country continued to service the debt. Greece is currently rated CCC by S&P as well as Fitch and Caa1 by Moody’s.


Uruguay’s debt restructuring in 2003 could be a precedent for Greece. Uruguay was struggling to finance itself in 2002 because of the Argentine financial crisis and default. In 2003 it convinced investors to swap $3.9 billion of Uruguayan bonds into new securities with longer maturities. S&P cut Uruguay to selective default from CC the day of the swap. It lifted the rating to B- a few weeks later. Fitch did the same thing.


The European Central Bank cannot cut off funding to the Greek banks because they would immediately become illiquid. The ECB currently has €98 billion of loans to those banks. The ECB will therefore find some way to downplay what the rating agencies do if Greece is able to reschedule some of its debt.


French banks have played a leadership role in trying to draft a proposal for rescheduling the Greek debt. They are prepared to rollover 70% of Greek maturing debt for a thirty year bond that offer a yield of 5.5% and more if the Greek economy grows. Greece must then use 20% of the proceeds for a special purpose vehicle that will buy a triple-A rated security—probably issued by the European Financial Stability Facility. As Athens will only get €50 in disposal funds for each €100 of maturing debt, it will continue to need help from the IMF and the eurozone. European officials have talked about banks agreeing to reschedule €30 billion of debt, but this would be less than a third of the debt maturing in the next three years. Greece is projected to have gross borrowing needs of €204.9 billion between 2012 and 2014, with €168.4 billion for debt amortization.


In recent days the Institute of International Finance and leading banks have offered another proposal. They want the European Financial Stability Facility to purchase Greek bonds at distressed prices and help to lower Greece’s debt stock. In the past, Germany has opposed such proposals, but as a result of the problems with the issue of debt rescheduling there may not be an alternative.


The political factors driving the Greek rescue are the same as they were one year ago. Germany is dedicated to preserving the European Monetary Union because it continues to send nearly half of its exports there. It perceives that a Greek default would not only jeopardize Greek membership, it would trigger a wave of financial contagion which would jeopardize the ability of Portugal, Ireland, Spain, and possibly even Italy to remain in the union. The Greek government prefers more official borrowing to default because a default would make its banking system insolvent and jeopardize the €5 billion of aid Greece receives each year from the European Union. As Greece has a primary fiscal deficit, it cannot afford to rescue its banks or lose European aid. Greece also knows that a default would make it impossible to borrow again for a long time.


German public opinion remains hostile to the idea of the monetary union evolving into a transfer union with financial assistance for peripheral debtor countries or the European Union issuing bonds for its member states. German Chancellor Angela Merkel has tried to contain these sentiments by suggesting that bankers should also make sacrifices, but as a result of opposition from the European Central Bank she has had to retreat from this position.

Handelsblatt reports that Germany will drop its demand for private sector involvement in a new Greek aid package at the forthcoming meeting of European heads of government. If these reports are accurate, the finance ministers should be able to reach an agreement with the European Central Bank about how to go forward. They may, for example, accept proposals to have the European Financial Stability Facility buy Greek bonds at a large discount to par value. Resolution of the disagreements about Greece could also have a calming effect on the markets of Spain and Italy. The disagreements about Greece increased the risk aversion among investors and drove Italian and Spanish bond yields sharply higher.


PORTUGAL DOWNGRADE OVERLOOKS STRENGTH OF NEW GOVERNMENT


Moody’s has downgraded Portugal’s credit rating four notches to Ba2 from Baa1. Moody’s took this action because the country is in the midst of a severe recession, and is finding it difficult to achieve its targets for deficit reduction. The deficit during the first quarter fell to 8.7% of GDP from 9.2%, but is still far short of the 5.9% target. There is also concern about potential liabilities from infrastructure PPPs and state-owned enterprises. Portugal has the advantage of a strong government after the recent election. It is committed to a program of fiscal austerity and economic liberalization. These factors should help Portugal to make progress in reducing the deficit during 2012 and 2013.


CAN TREMONTI’S AUSTERITY PACKAGE SAVE ITALY’S CREDIT RATING?


In mid-June Moody’s placed Italy on review for a possible downgrade. It took this action because of concern about the economy’s performance, market concerns about sovereign debt, and uncertainty about the implementation of Italy’s fiscal stability plan. Italy is unique among the peripheral countries in having a primary surplus of 1.8% of GDP. Finance Minister Giulio Tremonti proposed a €45 billion austerity plan to eliminate the deficit over four years and run a primary surplus of 5% of GDP until 2022 which would reduce the public debt to 85% of GDP. The major risk with the plan is that it is back-loaded. The majority of the spending cuts will occur in 2013 and 2014. The bill passed the lower house of the Italian parliament on July 15th.


In recent days, the situation has been further complicated by rumors that Mr. Tremonti is clashing with Prime Minister Silivio Berlusconi and may resign. Italian bond yields have risen sharply to euro-era highs because of these concerns. The prime minister is sympathetic to proposals from the Northern League for tax cuts that would clash with the Tremonti austerity program. As Italy is both too big to go bust and too big to rescue, the resignation of Mr. Tremonti would generate major shock waves and produce a sharp decline in the euro.


The rise in Italian bond yields has made it clear to Mr. Berlusconi that he cannot afford to lose Mr. Tremonti, so his coalition will rush to pass the austerity package in the next few days. The opposition has also agreed to support the austerity program.


Italy has the second largest debt load in Europe and the third largest among all advanced economies. Its government liabilities are €1.843 trillion compared to €1.591 trillion for France, €1.275 trillion for the United Kingdom, and €639 billion for Spain.


JAPAN’S STRONG RECOVERY WILL NOT SAVE PM NAOTO KAN


Japan has entered a V-shaped recovery from the March earthquake. Industrial production rose 5.7% in May and manufacturers expect a further 5.3% gain in June. Passenger car production rose 5.1% month on month in May. The Tankan survey indicates that firms expect a recovery during the third quarter, and now expect to increase capital spending by 4.1% during the current fiscal year. There was an 8.2% increase in core capital goods shipments during May and their level is now slightly higher than the level prevailing before the earthquake.


The political situation continues to be in flux. The Diet has voted to remain in session until the end of August, but it is still not clear when Prime Minister Naoto Kan will resign. The government is working on plans for a third supplementary budget which could be worth over ¥10 trillion, but it is not clear how it will be financed. The upper house of the Diet has not yet authorized the government to borrow in the bond market. Deputy Chief Cabinet Secretary Yoshito Sengoku has proposed a 10% increase in both income and corporate taxes to help fund reconstruction bonds. As the public appears to be supportive of higher taxes, the odds are high that there will be tax increases next year. The timing of all these actions will depend upon when the prime minister resigns.


Prime Minister Kan says that he wants to accomplish three things before he goes: pass another budget for fiscal 2011 to help finance reconstruction, pass a bill to promote the use of renewable energy, and get approval for the government to sell bonds to finance the budget. He has also launched a campaign against nuclear power which could jeopardize electricity supplies. Japan requires its nuclear plants to shut down for inspections every thirteen months. As a result of the recent problems at Fukushima, only seventeen of the country’s fifty-four nuclear reactors were operating in early July, and more will eventually be shut down for maintenance. If none are restarted, forty reactors will be out of service this summer, and all fifty-four will be out of service one year from now. Before March 11th, Japan got 30% of its electricity from nuclear power.


HOW BIG A RISK TO CHINESE GROWTH ARE HIGH LEVELS OF LOCAL DEBT?


China continues to be focused on the issue of inflation. The People’s Bank announced on July 6th that it would raise the one-year benchmark deposit and lending rate by 25 basis points. The action was in anticipation of a high inflation rate for June, which ended up being 6.4%, and a desire to bolster bank profit margins. The rate hike was the third this year and the fifth since last autumn.


The Chinese government reports that real GDP grew by 9.5% during the second quarter compared to 9.7% during the first quarter. The quarter-on-quarter growth rate was 8.8%. Industrial production contributed to the resilience of output by rising 1.5% in June compared to 1.1% in May. The dominant growth sector continues to be fixed asset investment. Its year-on-year growth rate remained steady at 25.6%. Retail sales also rose 17.7% in June, but real demand has suffered from the recent upsurge in inflation.


There are signs that Chinese growth could slow. The June purchasing manager index eased 1.1 points to 50.9, which is its lowest level since February 2009. The new orders index fell 1.3 points to 50.8. Export orders eased 0.6 points to 50.5. Output dropped 1.8 points to 53.1. The good news was that PMI input prices fell 3.6 points to 56.7, suggesting that inflationary pressures are abating.


The greatest risk in the Chinese economy today is a credit crunch afflicting small- and medium-sized enterprises. The Chinese press is full of stories about small firms curtailing output or going bankrupt because they cannot obtain credit. Statistics from the Wenzhou Economic and Trade Commission show that the city’s commercial banks reduced lending by 33.5% during the first quarter. They surveyed local companies about financial conditions, and 42.9% said they faced a shortage of funds. One-fourth of the companies in another survey said they are suffering losses. There is an underground lending market to help companies who cannot obtain bank loans, but interest rates can range as high as 96%. As SMEs account for 60% of industrial output and 80% of total employment, these signs of financial distress are a clear danger for the economy.


The Chinese National Audit Office (NAO) has recently published its estimates of the local government debt that was amassed during the recent infrastructure spending boom. It reported that the total debt of local governments and their loan financing vehicles was 10.72 trillion renminbi (RMB). Seventy-nine percent of this debt was in the form of bank loans. The sectoral breakdown of the loans was as follows: urban construction (36.7%), transportation (24.9%), land reserves (10.6%), science/education/public housing (9.5%), and agriculture and water supply (4.8%). Local governments have the responsibility to repay 59% of the 8.47 trillion RMB of bank loans, they have guaranteed 23% of the loans, and there is no guarantee on the final 18%.


Moody’s has published a report which suggests that the National Audit Office is understating local government liabilities. Moody’s said that the audit office failed to account for 3.5 trillion RMB of loans to local governments because they did not feel governments should be responsible for them. The loans in question are poorly documented. The Moody’s numbers are closer to an earlier estimate of loans made by the People’s Bank of China that local governments might have loans as large as 14.37 trillion RMB. If the Moody’s numbers are correct, local government loans could be equal to 37% of GDP. Some officials have suggested that as much as 25-30% of this debt could go bad, but the NAO did not offer any estimates. The central bank has discouraged banks from increasing local government loans during the past year, but the central government has not yet explained how it will deal with any future upsurge of non-performing loans.


There are precedents for the central government to rescue local governments that are experiencing revenue shortfalls, but the magnitude of the loans now at risk is much larger this year. Local governments account for about 83% of public spending, but they rely upon central government transfers for 44% of their revenue. They also obtain about 37% of their revenue from land sales. In the late 1990s, the cost of rescuing China’s banks was nearly 50% of GDP. The cost of local government bad debt is likely to be 8-10% of GDP, so the problem is manageable for a country with a growth rate as high as China’s. What remains unclear is when the Ministry of Finance will articulate a policy for repaying the loans. China’s bank stocks are likely to remain weak until there is more visibility on this issue.


The National People’s Congress Standing Committee has approved a change in the income tax law which will take effect in September. The new law raises the minimum threshold for paying income tax to 3,500 RMB per month from 2,000 RMB. The tax rate for the lowest bracket is also reduced from 5% to 3%. The new law will reduce the number of people paying income tax to 24 million from 84 million. It could boost the incomes of people earning 5,000-10,000 RMB per month by 18-27%. The lower tax payments should boost consumption after inflation squeezed demand during recent months.


The ASEAN+3 countries recently had a finance ministers’ meeting in Hanoi which made two decisions. First, they agreed to double the size of the Chiang Mai liquidity facility to $240 billion. This facility had been launched after the East Asian financial crisis to lessen the risk that any member country would ever again experience a liquidity crisis. Secondly, they agreed to appoint a Chinese official as the inaugural director of the group’s new research office. The official is Wei Benhua, former deputy administrator of the State Administration of Foreign Exchange. The new research office will be responsible for monitoring countries in the region and determining if they will have any financing needs.


The Japanese had hoped to place one of their people in the research director’s job, but as a result of China’s new financial power it won the position. The compromise is that Mr. Benhua will serve only one year and then be replaced by a Japanese official, Yoichi Nemoto. The ASEAN+3 countries have always stressed working with the IMF, but China wants to increase the share of loans made independently of the IMF to 30-40% from 20%. China wants the ASEAN+3 group to loosen its dependence upon the IMF. As the East Asian countries currently have large forex reserves they are unlikely to need any loans in the near future, but as a result of the crisis in 1997-98 they have established an institution to protect themselves which could ultimately evolve into an Asian IMF.


HIGH INFLATION RATES REMAIN A CHALLENGE THROUGHOUT ASIA


The East Asian economies have been buffeted by a variety of headwinds during the second quarter, including rising oil prices, slower import demand from China, and the Japanese earthquake. During April, industrial production declined in Thailand, Singapore, and Malaysia. In June, MAP scores recovered everywhere except Malaysia and Korea. Exports remained firm while domestic demand has been steady. Many Asian central banks have raised interest rates during the past six months because of rising inflation, but they have not been aggressive. There is no country in which interest rates have risen back to their pre-crisis level despite the fact that output gaps have closed. As a result, credit growth remains robust and could soon approach the peak set before the 1997-98 financial crisis.


One of the countries which will need to raise interest rates the most this year is Thailand. Yingluck Shinawatra and the Puea Thai Party won a clear victory in the recent national election on a populist platform. It is committed to large increases in the minimum wage and more public spending on education. When Thailand had a major increase in the minimum wage in 2005, there was a surge of core inflation which forced the central bank to raise interest rates to 5%. In 2011, the central bank will probably have to increase interest rates another 75 basis points to hold inflation close to 4.0%. It raised interest rates 25 basis points in mid-July.


India has had one of the most serious inflation problems, and the Reserve Bank has hiked interest rates ten times since March 2010. The economy’s growth rate slowed to 7.8% during the first quarter from 8.3% in the fourth quarter, but the inflation rate was still 8.7%. There has also been a sharp downturn in the level of investment spending. It grew by a mere 0.4% during the first quarter compared to nearly 20% eighteen months ago. The downturn appears to reflect policy inertia resulting from scandals involving the Commonwealth Games and telecom licenses. There has been an increase in regulatory bottlenecks—from land acquisition to environmental approvals—which has dampened spending. The monetary environment is likely to become more restrictive during the next six months, but the government could still boost investment by addressing its own bottlenecks. Prime Minister Manmohan Singh may have given investment a boost by removing the environment minister in mid-July. He had been blocking many large projects. The stickiness of inflation and the government’s administrative problems suggest that Indian growth is likely to slow to 7.5% during both 2011 and 2012. The goal of outperforming China will have to wait for Chinese growth to slow further.


HOW MUCH WILL A CARBON TAX IMPACT THE AUSTRALIAN ECONOMY?


The Australian economy has been sending mixed signals. Surveys of both business and household confidence have been subdued. There was a surprise decline of 0.6% in May retail sales as households remained cautious and held their savings rate at 11.5%—the highest level since the early 1980s. The employment data for June, by contrast, was a positive surprise. There was a gain of 23,400 jobs and the unemployment rate ticked down to 4.9%. Full-time employment rose to 59,000 during June after a contraction of 84,000 during the two previous months. The total gain for the first half was 50,300 jobs. The mining industry has been driving the employment gains despite the fact that it accounts for only 2% of total employment. In the three months through May, mining sector employment rose by 6% compared to a 2% decline in manufacturing and a 1% decline in retailing. Australia is benefitting from the fact that its terms of trade are at a 140-year high. The Treasury’s forecasting model is projecting that over the next nine years mining and construction will create 280,000 new jobs while manufacturing employment could decline by 170,000.


Strong commodity prices are generating a capital spending boom without precedent in Australian history. As the table indicates, the value of mining and energy related capital spending is now over 13% of GDP compared to 2% nine years ago. The Australian boom should be viewed as a byproduct of China’s high rate of economic growth. China has created a tremendous demand for Australian iron ore, coal, and liquefied natural gas, which has increased the Chinese share of Australian exports to over 24%.


Australia has announced plans to introduce a tax on carbon starting at $23 per tonne on July 1st, 2012. The tax will then shift to an emissions-trading scheme in 2015. As Australia obtains 80% of its power from coal, the tax will increase business costs and raise the inflation rate moderately. The Treasury estimates that the CPI could increase annually by 0.7% in 2012-13 and another 0.2% in 2015. The carbon tax will be paid by the five hundred largest polluters. There will be no tax on agriculture or on fuel used by autos and light commercial vehicles. The tax will raise $27.3 billion during the first four years. More than half of the revenue will be used to assist households with tax cuts and direct payments. The coal mining industry is warning the carbon tax could cost jobs while Qantas has said it will have to raise prices. Europe has had an emissions-trading scheme for nearly five years. The Obama administration tired to introduce one in the US during 2009, but the Senate rejected it. Australia will be the first country to impose a carbon tax. Australia feels it should introduce such a tax because it has high per capita carbon emissions due to the economy’s dependence upon coal. The Green Party also performed very well in recent elections, and is a strong supporter of curbing carbon emissions.


DESPITE HIGH INFLATION, CANADIAN MONETARY POLICY STILL ON HOLD


The Canadian economy continues to outperform the US economy. It experienced job gains of 28,400 during June. Canada’s employment-to-population ratio now stands at 62%, or 3.8% more than the US level. This is the widest gap in thirty-five years. There was also a 6.9% rise in auto sales during June and 20.9% rebound in building permits. The residential investment share of GDP is just under 7.0% compared to 2.4% in the US. Industrial production fell 0.7% during April as a result of a sharp fall in auto production resulting from shortages of Japanese components. The CPI inflation rate surged to 3.7% year on year in May, which is the largest gain since March 2003. The Bank of Canada’s May policy statement said that some of the monetary stimulus currently in place would be withdrawn, but Governor Mark Carney has been talking about headwinds confronting Canada from its strong dollar and the US slowdown. The markets are interpreting these comments to suggest there will be no interest rate hikes until late this year or next year.


WHY POLITICAL CHANGE IS IN MEXICO’S, BUT NOT ARGENTINA’S, FUTURE


The Latin American economies are now slowing in response to tighter monetary policy and weaker exports. Real GDP growth was 5.4% during the first quarter compared to 6.1% last year. Growth rates remained at high levels in Chile (10% year on year), Peru (9%), and Argentina (9.6%), while Brazil slowed to 4.2%. Monetary tightening in Brazil has boosted the interest rate on consumer loans to 47% from 41%. The consumer debt service burden, which stood at 24% of disposable income in 2010, is projected to rise to 28% in 2011. Debt delinquencies have also increased from 7.8% in December to 9.1% in May. The largest gains in delinquencies have been for auto loans. The household debt burden in relation to disposable income has risen to 26% from 24.2% during 2009 and 2010, but mortgage debt is still only 4% of GDP. The unemployment rate is an all-time low of 6.4%, but wage gains have been modest. The tighter credit conditions and modest wage gains have dampened retail sales. In 2012, there will be a 13-14% increase in the minimum wage while wage bargainers will seek compensation for the uptick of inflation to 6.4% this year. Brazil is likely to achieve a growth rate modestly above 4.0% this year compared to 7.5% in 2010.


The Mexican economy will also slow to a growth rate slightly above 4.0% this year from 5.4% last year. The growth rate of exports slowed to 7.5% year on year in April, the lowest since November 2009. Higher oil prices have boosted export revenue, but export volumes have been suffering from weaker output and the impact of subsidies on Mexican domestic demand for gasoline. During April oil export volumes rose back to 1.3 million barrels per day in May, but these levels are still well below the previous peak in the early 2000s. The peso has rallied to 11.6 against the dollar from 15.4 in March 2009. The Mexican central bank has not intervened aggressively, but foreign exchange reserves have increased to $130 billion. As the inflation rate fell from 4.4% in December to 3.2% in June, there is no possibility of the central bank raising interest rates.


The PRI won three Mexican state elections on July 3rd. The most significant victory was in the state of Mexico, which has 15.2 million people and is the largest state. The PRI candidate, Eruviel Ávila, won 64.9% of the vote compared to 22.0% for the PRD candidate and 12.5% for the PAN candidate. The victory has confirmed that former Governor Enrique Peña Nieto is the clear front-runner for the presidential election in 2012. He is a young and charismatic leader who is identified with some of the PRI’s traditional conservative factions. As the economy is performing well, the major issue in next year’s election is likely to be the government’s battle with the drug cartels.


Argentinean President Cristina Kirchner has announced that she will seek reelection in this October’s presidential election. As Argentine consumption could increase by 11% this year, she is regarded as the overwhelming favorite despite an unofficial inflation rate of 25%. The robust consumption is likely to produce a current account deficit this year for the first time since 2001. The currency has been declining gradually, but is still appreciating in real terms. The strength of the Brazilian real has helped to protect Argentine exports in the Mercosur trade zone, but there will ultimately have to be a significant decline in the inflation rate or a larger devaluation of the peso in order to sustain the country’s competitive position. Growth could slow to 5.0% next year from 8.0% this year.


AFRICAN GROWTH PROSPECTS REMAIN VERY BRIGHT


The South African purchasing agent index dropped for the third month in a row to 53.9 in June. The sub index for new sales orders fell 3 points to 58. The sub index for employment dropped for the fourth month in a row to below 48. The good news in the report was a decline in the prices sub index to 76.0 in May from 88.0 in March. There is a risk that strike activity could disrupt output during the third quarter. The metal and engineering unions are demanding a 13% wage increase while the employers say the most that they can afford is 7%. The Centre for Development and Enterprise (CDE) has produced a report on South Africa’s unemployment problem which could encourage a debate about the country’s burdensome labor regulation. The report notes that whereas during the 1970s each percentage point of GDP growth boosted employment by 1%, this ratio has now fallen to only 0.4%. Many businesses have become more capital intensive and less labor intensive because of problems with unions and government regulation.


The CDE report calls for a dramatic increase in exports of labor-intensive products. The problem is that South Africa has higher wage costs than many other emerging market economies. The report notes that centralized wage bargaining imposes the same costs on all firms regardless of firm-specific circumstances, thereby undermining the link between productivity and pay. There is also a high cost for terminating employees which discourages recruitment. As a result of its links to trade unions, the ANC has long sought to avoid addressing rigidities in the country’s labor market. But it will not be able to achieve its goal of producing five million new jobs without a new labor market policy.


The African Development Bank, in conjunction with the OECD and the United Nations, has issued a new forecast for the African economy. It projects 5.5% growth in Sub-Saharan Africa this year compared to 4.9% last year. The report says that growth will benefit from both the strong commodity cycle and rising domestic demand. It projects only 3.6% output growth in South Africa and a 7.3% contraction in the Ivory Coast because of recent political turmoil, but it expects robust growth in many other countries, including Ghana (12%), Ethiopia (10%), the Democratic Republic of the Congo (8.4%), Zimbabwe (7.8%), Mozambique (7.7%), Angola (7.3%), Liberia (7.3%), Tanzania (6.9%), Nigeria (6.9%), and Botswana (6.9%).


US DOLLAR’S FOREX RESERVE DOMINANCE CONTINUES TO WANE


The IMF has published updated estimates of global foreign exchange reserves. They rose to $9.694 trillion at the end of the first quarter from $9.258 trillion at the end of the fourth quarter and $8.287 trillion one year ago. The 17% year-on-year growth in reserves greatly exceeds the growth rate of nominal GDP, but has tracked the 22% growth in global trade. During the past ten years, global GDP has doubled while forex reserves have risen fivefold. Emerging market countries now account for 67% of global forex reserves compared to 39% in 2001.


The share of global reserves held in the US dollar eased to 60.7% during the first quarter from 61.8% during the fourth quarter. This decline probably reflected reduced purchases from China. Standard Chartered Bank recently produced a report comparing the growth of China’s forex reserves with US government reports on Treasury note purchases by China as well as banks in Hong Kong and London which often act as intermediaries for China. The report noted a particularly large drop in Chinese purchases of US securities during the first four months of this year. Between January and April of 2008-10, net purchases of Treasury securities from China, Hong Kong, and London equaled 52% of the growth in China’s forex reserves. In 2011 net purchases from these markets fell to only $46 billion, or 24% of the growth in China’s forex reserves. China appears to have been a large buyer of euros as well as a sprinkling of other currencies such as the Australian dollar and the British pound.


Emerging market countries now hold 57.8% of their reserves in the US dollar compared to 27.7% in the euro, 2.9% in the yen, 5.7% in the British pound, and 5.7% in a variety of other currencies such as the Australian and Canadian dollars. The IMF has formal data on reserve allocations for only 39% of emerging market reserves compared to 87% for the developed countries. As China does not share its data with the IMF, the euro’s share is probably larger than the number available from the countries which do provide the data. Emerging market central banks were often critical of the Fed’s quantitative easing policy last year. Now that the policy has ended they may buy more dollar securities during the second half of 2011.

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©2011 David Hale Global Economics, Inc

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