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-----Original Message-----
From: "Mark Zoff" <markzoff@davidhaleweb.com>
Date: Tue, 1 Jun 2010 19:20:20
To: Mark Zoff<markzoff@davidhaleweb.com>
Subject: David Hale: Will European Fiscal Policy Depress Global Growth?

Dear Colleagues,


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Additionally, please find attached our latest monthly report, “Will European Fiscal Policy Depress Global Growth?” Key points of discussion in the report include:

• The southern European debt crisis illustrates the significant contradictions that are inherent in the monetary union as currently constructed

• The US economy is entering into a period where economic growth leadership will come from exports and capital investment

• Economic recovery has begun in Europe, but significant fiscal drag in 2010 and 2011 throughout the region will limit its growth potential

• Chinese central bank interest rate tightening will likely begin in June, and exchange rate revaluation of 2-5% will take place by the end of the year

• Latin American countries continue to generate positive growth surprises


As always, we welcome any comments or feedback you may have.


Sincerely,

Mark Zoff

Director of Research


DAVID HALE GLOBAL ECONOMICS

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Copyright 2010, David Hale Global Economics. All rights reserved. Please do not forward the attached document to individuals not authorized by David Hale Global Economics to receive it. It contains confidential information and is intended only for the individual named. This document is not for attribution in any publication, and you should not disseminate, distribute or copy this e-mail without the explicit written consent of David Hale Global Economics.


Will European Fiscal Policy Depress Global Growth?

June 1st, 2010 • Volume 08.14

By David Hale


KEY POINTS OF DISCUSSION


• The southern European debt crisis illustrates the significant contradictions that are inherent in the monetary union as currently constructed

• The US economy is entering into a period where economic growth leadership will come from exports and capital investment

• Economic recovery has begun in Europe, but significant fiscal drag in 2010 and 2011 throughout the region will limit its growth potential

• Global growth forecasts for 2010 and 2011 continue to be revised upward

• Chinese central bank interest rate tightening will likely begin in June, and exchange rate revaluation of 2-5% will take place by the end of the year

• Latin American countries continue to generate positive growth surprises

• The concurrent rallies in the dollar and gold price demonstrates the severe decline of investors’ confidence in the euro

• Europe could have a far better fiscal position five years from now than the US or Japan


MARKET CRISIS HIGHLIGHTS CONTRADICTIONS IN MONETARY UNION


The recent turmoil in the financial markets should not arrest the global economic recovery which began nearly twelve months ago. The turmoil merely illustrates the fact that there are still major contradictions in the intermediate-term outlook which will have to be addressed at some point. There are large fiscal deficits in several G-7 countries as well as peripheral countries such as Greece and Spain. The situation in Greece has provoked widespread concern about the issue of national solvency and sovereign debt quality, but these concerns could also apply over time to the United Kingdom, Japan, and the US. Greece is merely the leader in the process because of the magnitude of its imbalances.


The markets also suffered from the political side effects of the Greek situation. The eurozone finance ministers began to discuss a moderate-sized rescue package in February, but they could not move quickly because of German opposition to rescuing southern European countries. There was an election pending in the large state of North Rhine-Westphalia, and German Chancellor Angela Merkel was afraid of offending the voters by offering to help Greece. The delay forced the eurozone finance ministers to expand the aid package from €40 billion to €110 billion. Ms. Merkel then tried to sell the aid package to the German people as a rescue program for the monetary union, not just Greece. The risk of financial contagion led to another large-scale rescue program for the whole of southern Europe one week later. Ms. Merkel accepted the need for the package, but she tried to show her distaste for certain market forces by announcing a ban on short selling. This development startled the markets and led to a further selling of both equities and the European currency. The ban on short selling will be of little consequence because the total stock of credit default swaps on southern European debt is worth only €108 billion, but the action allowed Ms. Merkel to show her contempt for the markets’ impact on the euro. When politicians appear to be panicking, it is difficult for investors to maintain confidence. The rescue programs for southern Europe thus evolved into a comedy of errors which depressed equity markets everywhere.


It is remarkable that the Greek situation could rock stock markets far away from Europe. Greece accounts for only 2.0% of Europe’s GDP. It also has long been an accident waiting to happen. During the past two decades, Greece has run a fiscal deficit averaging 7.8% of GDP. It spends 7% of GDP on public administration compared to a eurozone average of 3%. It has a difficult time collecting income taxes. Its direct tax share of GDP is only 8.1% compared to a eurozone average of 13.6%. The previous government increased public spending from 45.4% of GDP to 50.4% in a vain attempt to obtain votes by creating patronage jobs. The government employs 1.1 million people in a labor force of 5 million.


The Greek situation highlights the great contradictions of the European Monetary Union, and has thus forced the eurozone to intervene massively in order to prevent Greece from preventing a wave of financial contagion engulfing the whole of southern Europe. The monetary union has created two major problems for economic policy. First, it lowered interest rates significantly for the countries of southern Europe and allowed them to significantly expand their borrowing. In Greece, this factor helped to finance large fiscal deficits. In Spain and Ireland, it nurtured an upsurge of private lending for property speculation which has now ended in a bust. Secondly, it allowed countries to finance large expansions in their current account deficits without having to worry about their competitiveness as trading nations. In southern Europe, unit labor costs have increased by 30-40% compared to Germany during the past decade. Countries such as Greece, Italy, and Spain will now have to pass through a period of deflation in order to regain external competitiveness. If they still had their own currencies, they could instead devalue, but that is no longer a policy option.


Greece was also a failure in the globalization process even before the monetary union. Its ratio of exports to GDP is only 19%. Its FDI was only $35 billion in 2008 compared to $326 billion for Italy, $597 billion for Spain, $93 billion for Portugal, and $129 billion for Poland. It excels only in tradable services. It has a shipping sector with a value of 5% of GDP while tourism is nearly 17% of GDP.


The eurozone collaborated with the IMF to produce two support packages for containing the contagion resulting from the Greek situation. The first is a €110 billion package specifically for assisting Greece in rolling over its public debt and financing new deficits. The second is a €750 billion package for other eurozone countries which might experience funding problems. The market perceives the second action to be a support package for Portugal, Spain, and possibly even Italy. The European Central Bank has also promised to purchase the government securities of southern European countries that are experiencing upward pressure on their interest rates.


The eurozone intervention initially failed to impress the markets because of investor perceptions that it creates new risks. The markets perceive that Greece has solvency problems, not liquidity problems. Most investors believe that Greece will ultimately have to restructure its debt despite the latest rescue. The markets are now also concerned about the policy implications of the rescue for other countries and the European Central Bank. They fear that the cost of rescuing southern Europe could damage the credit rating of Germany, and that the latest intervention could politicize the ECB and weaken its moral authority. Bundesbank President Axel Weber has criticized the ECB’s plans to purchase southern European debt. There have been op-ed columns from prominent economists such as John Taylor of Stanford University and Thomas Mayer of the Deutsche Bank warning that the new ECB policies could ultimately be inflationary. European Central Bank President Jean-Claude Trichet has rejected such suggestions and had an interview with Der Spiegel in mid-May in which he defended his new policy by stressing how unprecedented the financial situation had become. He said:

We have not relented on our principles (low inflation monetary policy). Price stability is our primary mandate and compass. That being said, it is clear that since September 2008, we have been facing the most difficult situation since the Second World War—perhaps even since the First World War. We have experienced—and are experiencing—truly dramatic times.


Other ECB council members have tried to defend the new policy by saying it is designed to improve the process of financial intermediation by stabilizing markets, and that it is not a policy of quantitative easing comparable to what has occurred during the past two years in the UK and the US. The ECB will intervene in the markets selectively to prevent extreme price movements.


Mr. Trichet’s comments were a reminder to the markets that the recent financial crisis will have legacy consequences. Governments have responded to a collapse of private borrowing by significantly expanding their own borrowing. They have spent hundreds of billions of dollars rescuing banks. If Greece had been allowed to default, European banks could have suffered €100-150 billion of losses. If Spain and Portugal were to default, the losses could have exceeded €1 trillion. Policy makers clearly felt compelled to prevent a Greek default because of concern about both the integrity of the monetary union and the solvency of European banks. They learned from the Lehman Brothers experience that the bankruptcy of medium-sized countries can generate shock waves as great as those from the bankruptcy of a medium-sized investment bank. They will attempt to prevent a Greek default for as long as they possibly can. In fact, there would probably have to be a political revolution in Greece for a default to occur.


As a result of the Greek crisis, there are likely to be major changes in how the countries of Europe coordinate their economic policies. There was always concern that Europe was creating a monetary union without a political union to manage fiscal policy. The European countries did make commitments to contain their fiscal deficits, but there was no way to enforce these promises. The recent recession then led to a sharp upsurge of deficits everywhere. Germany is now demanding that the eurozone create explicit guidelines for fiscal policy and find new ways to make countries comply with targets for deficit reduction. Germany is even suggesting that other countries imitate its recent decision to introduce a constitutional amendment requiring balanced budgets. The Greek crisis is therefore likely to be followed by a period of fiscal austerity in Europe which will constrain growth in the short term, but it could set the stage for economic reforms that would enhance growth in the long term. In 2015, Europe could have the smallest deficits among the large economies in the OECD, excluding Canada and Australia, while the US and Japan could still be confronting deficits in the range of 8-10% of GDP.


THE US ECONOMY IS EXPECTED TO GROW SOLIDLY IN SECOND QUARTER


The US economy appears likely to expand at a 3.5-4.0% annual rate during the second quarter compared to 3.0% during the first quarter. The upturn in retail sales continued during April. Consumer confidence has rallied because of falling gasoline prices. Network TV advertising is expected to grow by 13% in 2010 after declining by 10% in 2009. Capital goods orders are resilient, and business spending on equipment should grow at double-digit rates in the second quarter. Homebuilding could stall temporarily because of the end of the tax credit for home purchases, but home sales should benefit over time from the fact that prices are cheap, and the recent financial turmoil has reduced mortgage rates to only 4.84%. The sector which still has the potential to create large job losses is state and local governments. They reduced spending by $31.3 billion in 2009, and are planning at least another $55.7 billion of cuts in the year ahead. But the Congress is currently debating Medicaid and education assistance programs worth $48 billion which could protect thousands of jobs.


There has been concern that the Greek crisis could slow growth in Europe and have an adverse impact on both US exports and corporate profits. As the Greek economy is only 2.0% of eurozone GDP, it is unlikely to have any major consequences for the large European economies. The great risk would be if financial problems forced Spain into a more severe recession, but Spain has already had a major downturn and unemployment is currently 20%.


The largest markets for US exports are in northern Europe, and those countries are currently experiencing a recovery. Europe currently consumes about 23% of US exports compared to 26% for Asia and 32% for NAFTA trading partners. Europe, the Middle East, and Africa account for 9.14% of sales among companies in the S&P 500. The shares vary greatly by sector. Europe accounts for 30.3% of sales for auto companies, 19% for food and beverage companies, 18% for consumer durable companies, 18% for capital goods companies, 17% for household and personal product companies, 16% for consumer service companies, and 16% for insurance companies. It accounts for 5.7% of sales for technology equipment and hardware companies as well as 2.4% for health care equipment companies.


EXPORTS AND CAPITAL INVESTMENT WILL DRIVE US GROWTH IN 2010


The dominant theme of the current recovery is that the US is now headed for a prolonged period in which growth leadership will come from exports and capital investment while consumption lags. The outlook for exports and capital investment is positive because of the corporate sector’s success during the recent recession in slashing costs so dramatically. The US had an output decline of 3.8%, but it reduced private sector employment by 7.5%. Other industrial countries could not respond as aggressively. There were output declines of 6-8% in Germany and Japan, but job losses were only 2-3% of employment. As a result, US productivity during the past year has exceeded 6% while it has declined by nearly as much in Europe and Japan. The US is now highly competitive. The productivity rebound is also setting the stage for profits to grow by 50% this year compared to their trough last year. In the first quarter, domestic corporate profits already had increased by 40% compared to their level one year ago. There was a 26% gain in non-financial profits and a 77% gain in financial profits. Foreign profits also rose by 24%. Such rapid profit growth has created a record level of free cash flow in the corporate sector which is fueling a rebound in capital spending. It is the resilience of the corporate sector which explains the economy’s recovery this year, not government stimulus. The government helped to prop up final demand last year, but it cannot create the circumstances in which employers will want to create jobs. The private sector will now want to create jobs because it perceives opportunities to improve profits as the recovery continues. As employment expands and bolsters personal income, the growth process will become self-reinforcing.


RECENT US HOUSING DATA PROVIDES PROMISING, BUT MIXED SIGNALS


New home sales rose by 14.8% during April, or by 47.8% compared to their level one year ago. The surge in sales reduced the supply of homes to 211,000 compared to 300,000 one year ago and 458,000 two years ago. This number is equal to only five months of supply, or the lowest level since the housing downturn began four years ago. It suggests that homebuilders will have to add to supply when sales resume growing later this year.


Sales of existing homes rose 7.6% during April to a seasonally adjusted annual rate of 5.77 million. The number of homes for sale also rose by 11.5% to 4.04 million as sellers attempted to take advantage of the expiring tax credit for first time home buyers. As a result of the credit, first time buyers accounted for 49% of all purchases last month compared to 44% in March. Investors, by contrast, accounted for 15% of transactions in April compared to 19% in March. Home sales are likely to slacken during the next few months because of the expiration of the tax credit, but buying conditions for homes are still favorable. The European financial crisis has boosted the dollar and helped to nudge mortgage rates down to 4.84%. They could easily drop another 20-30 basis points during the next few months. Home prices are also 30% below their peak of four years ago in the country as a whole, and as much as 50% in formerly hot markets such as California, Arizona, Florida, and Nevada.


The latest Case-Shiller house price data indicates that a recovery in home prices has begun in many cities. The largest gain during the past year has been 16.3% in San Francisco. The largest decline has been 12% in Las Vegas. Prices have also increased by 6.7% in Cleveland, 5.7% in Washington DC, 4.1% in Denver, 3.9% in Boston, and 3.0% in Dallas. Prices have declined by 3.9% in Charlotte, 3.5% in Seattle, 3.5% in Tampa, and 2.7% in Portland.


The delinquency rate for mortgage loans rose to 10.06% at the end of the first quarter from 9.47% during the fourth quarter. The percentage of loans that are seriously delinquent (ninety days or more past due) was 9.54%, or 0.13% less than at the end of the fourth quarter. The percentage of loans in the foreclosure process was 4.63% at the end of the first quarter, or a level that is 78 basis points higher than one year ago.


The delinquency problems are greatest in the states which once had the hottest property markets. While the delinquency rate is still high, there are signs that it is peaking and could now ebb lower. The share of mortgages that have always been current but became delinquent in the last month has dropped from 3.3% in late 2008 to 1.3% last month. The rate of new foreclosures is also declining. In California, it has dropped from 2.1% in the first quarter of 2009 to 1.34% during the last quarter. In Florida, it has dipped from 2.79% to 2.41%. The Nevada number has eased to 3.23% from 3.35%. The Arizona number has declined from 2.52% to 2.24%.


US FINANCIAL SECTOR IS FACING A PERIOD OF UNCERTAINTY


The Senate has passed Senator Christopher Dodd’s (D-CT) financial regulatory reform bill, and the legislation will now move to conference committee so that it can be reconciled with the House financial regulatory reform bill. There has been great media focus on the issue of derivatives regulation and attempts by banks to reverse Congressional attempts to curtail their ability to operate in those markets. There is another provision in the legislation, however, which could also have important economic consequences. Senator Susan Collins (R-ME) persuaded the Senate to amend its bill to include a provision which would prevent banks from using trust preferred securities in their Tier 1 capital. According to the American Bankers Association, this provision could penalize 644 bank holding companies. As they have $129 billion of trust preferred securities in their Tier 1 capital, they could conceivably reduce their lending by $1 trillion unless the law is modified. As the economy is just emerging from a severe credit squeeze, Ms. Collins’ amendment is very poorly timed for an economy that is trying to revive bank lending. It is a further confirmation of how politicians fail to grasp the consequences of financial regulation for the economy’s performance.


It has been revealed that three Federal Reserve districts requested discount rate hikes during April. The requests came from Kansas City, St. Louis, and Dallas; all of them wanted to hike the discount rate to 1.0%. The Fed said that its discount rate hike during February was not an exercise in monetary tightening. As borrowings from the discount window are currently very low, a rate hike at the current time would not have had a major impact. But it would have been a psychological jolt, and would probably have contributed to the recent slump in equity markets which resulted from policy turmoil in Europe.

The FDIC reports that banks increased their profits by $18 billion during the first quarter, or the largest gain since the first quarter of 2008. Banks set aside $51.3 billion for loan losses during the first quarter compared to $60.9 billion one year ago. Many small banks experienced increased loan losses, but large banks significantly improved their figures. Loans and leases 30-89 days past due rose to $144.1 billion during the first quarter from $144.1 billion during the fourth quarter, but they were down from $158.7 billion one year ago. The total value of earning assets on bank balance sheets was $11.552 trillion during the first quarter compared to $11.587 trillion one year ago. The FDIC increased its estimate of problem banks to 775 from 702. The problem banks have $431 billion of assets.


The Federal Reserve continues to say that it will restrain interest rates until there is more evidence of a sustained recovery in employment. The Fed’s policy actions have helped to stabilize markets during the past year, but they have not yet succeeded in producing positive growth of the money supply. The annualized growth rate of M3 during recent months has been a negative 10%. Two factors explain the weakness of money growth. The corporate sector has been able to reduce borrowing because of a profit boom and the household sector is deleveraging because of wealth losses on real estate. These factors have made it difficult for the Fed to revive money and credit growth. Policy makers no longer pay much attention to the monetary data, but the weak growth of M3 is a reminder that monetary policy has been more stimulative in its intent than in its actual impact. There is unlikely to be a revival of money growth until credit growth resumes.


The low growth rate of money supply has been accompanied by a further deceleration of the US inflation rate. The year-on-year growth of the core CPI has declined to 0.9% from 1.8% in December 2009. The twelve month core inflation rate is the lowest in forty-five years. The inflation rate has declined because of the impact of high unemployment on wages and low capacity utilization rates on the ability of firms to raise prices. The high vacancy rate for apartments is also playing an important role. The index for shelter, which has a weight of 32.3% in the CPI, declined by an annual rate of 1.4% during the past six months. Inflation will accelerate in 2012 when rents stabilize and lower unemployment starts to boost wage costs.


The British Petroleum oil spill in the Gulf of Mexico has the potential to boost oil prices. The Gulf of Mexico accounts for 31% of US oil production and 11% of natural gas production. It also is a major center of new drilling activity. At the current time, the Gulf accounts for 12% of the world’s active jack-up rigs and 16% of active floating rigs. President Obama has imposed a moratorium on new drilling activity until the government has a better understanding of what caused the BP disaster. This moratorium could reduce US oil output by 15¬0,000-200,000 barrels per day next year and 300,000-400,000 barrels per day in four years. The BP disaster will probably also make it difficult to lift the ban on offshore drilling in other coastal regions of the US. Such a ban will make it impossible for the oil industry to develop the billions of barrels of oil which could exist on the East Coast and in the eastern regions of the Gulf of Mexico near Florida. Such negative supply shocks will not prevent new oil development offshore in Brazil and West Africa, but they will force the US to become more dependent upon oil imports.


EUROPEAN RECOVERY WILL BE LIMITED DUE TO FISCAL TIGHTENING


The European economy has begun a recovery that is being led by German exports and French consumption. Total real GDP grew by 0.2% during the first quarter despite severe winter weather. The great concern of investors now centers on how moves towards fiscal austerity could dampen final demand in southern Europe and depress growth in the continent as a whole.


There will be significant fiscal tightening this year in Greece, Spain, Portugal, and Ireland. The value of the tightening is equal to 5.0% of GDP in Greece, 2.0% in Spain, 1.8% in Portugal, and 2.5% in Ireland. Italy has also just announced a fiscal restraint package worth €24 billion over two years. It will freeze public sector wages and reduce aid to regional governments. Germany will offset some of this fiscal drag with a tax cut during 2010, and thus reduce total fiscal tightening in Europe to only 0.2% of GDP.


In 2011, fiscal policy will become tighter in both northern and southern Europe. There will be fiscal drag equal to 3.0% of GDP in Greece, 2.5% in Spain, 2.8% in Portugal, and 1.4% in Italy. There will also be fiscal tightening equal to 1.1% of GDP in Germany and 1.0% in France. The total value of this fiscal drag could be nearly €120 billion, or 1.2% of GDP. The public spending cuts in Europe are painful, but they are essential to restoring confidence in the bond markets of several countries. The good news is that the cuts have begun to work. Spain reports that its deficit for the first four months of this year fell to €5.66 billion from €6.91 billion, which is an 18% reduction. Greece should soon be reporting similar declines in its deficit. As the markets see the deficit numbers actually contract, there will be a gradual recovery of confidence in the troubled economies.


The total value of bank claims against southern Europe varies with the size of the economy. They are $1.418 trillion for Italy, $1.145 trillion for Spain, $286 billion for Portugal, and $263 billion for Greece. The biggest lenders to Greece are France ($75 billion) and Germany’s ($45 billion). The US has only $17 billion of exposure to Greece. The biggest lenders to Spain are Germany ($238 billion), France ($220 billion), the Netherlands ($120 billion), and the UK ($114 billion). The biggest lenders to Portugal are Spain ($86 billion), Germany ($47 billion), France ($45 billion), and the UK ($24 billion). The biggest lenders to Italy are France ($511 billion) and Germany ($190 billion).


It has been suggested that Germany and France were anxious to protect Greece because of their banking exposure there. There can be little doubt that such concerns existed, but the primary consideration of policy makers was the survival of the monetary union itself. European politicians have made such a large investment in the monetary union that they are unprepared to countenance any event which might call it into question. They were therefore prepared to rescue Greece despite the fact that there is a compelling case for Greece to restructure its debt. Greece has a much higher ratio of debt to GDP than Latin American countries which have defaulted in the past. But other European countries were unprepared to accept a Greek default because they felt that it would undermine confidence in the monetary union, if not the European Union itself. This political commitment suggests that the Greek rescue package will not suddenly end in 2012 when current commitments run out. It will probably be extended to ensure that Greece can fund itself at modest levels of interest rates, not the double-digit yields which would prevail in a free marketplace.


The recent crisis has not dimmed enthusiasm for the monetary union in Eastern Europe. It now appears that the European Commission will grant Estonia admission into the monetary union next year. Estonia has held its budget deficit to 1.7% of GDP despite a 14% contraction in real GDP last year. The deficit has exceeded 3% of GDP only once in the past fifteen years—the year of the Russian crisis in 1999. Estonia’s admission to the union comes after many years in which it pursued a currency board relationship with the deutschemark and then the euro. It is a further confirmation that Estonia has probably been the most successful country to emerge from the former Soviet Union by pursuing highly orthodox free market policies and a firm commitment to low inflation through exchange rate targets.


The new UK government has begun to outline its plans for fiscal retrenchment. It plans £6 billion of spending cuts immediately, and will announce more cuts in the budget speech on June 22nd. The British press has carried stories about as many as 300,000 civil service jobs being cut. There was a consensus before the election in both the Liberal and Conservative Parties that there would have to be spending cuts and tax increases. The great challenge for the two parties will now be to agree on the details. The Liberals have some proposals which could be negative for the UK economy and equity markets, such as hiking the tax rate on capital gains to 40%. The Tories should resist such suggestions, but there may be a compromise that takes the tax rate to levels in excess of 20%.


Financial conditions in Europe are deteriorating. The LIBOR rate has increased to just over 0.53 basis points from 0.25 in March. There is concern about the impact of southern Europe’s problems on credit quality and bank balance sheets. These concerns were magnified during recent days by the decision of the Bank of Spain to seize a Catholic regional savings bank and force a merger of four others. The regional caja banks account for over 55% of all mortgage loans in the Spanish financial system. The weekly volume of bond issuance has dropped from $29.9 billion during early April to only $1.1 billion in mid-May. The appetite of investors for new securities was dampened by Germany’s decision to suddenly ban short sales. The ECB’s euro liabilities to the euro area credit institutions, through current account and deposit facilities, have risen to €526.3 billion from €387.3 billion in late January. The ECB is again offering liquidity through six month refinancing operations. The Federal Reserve has reactivated a reciprocal currency arrangement with the ECB, and so far provided $9.2 billion to the markets.


GLOBAL GROWTH FORECASTS ARE REVISED UPWARDS BY LEADING NGOs


The OECD has published a new forecast of its members which is much more positive than the November forecast. The OECD is now projecting that it will grow by 2.7% this year and 2.8% in 2011 compared to earlier forecasts of 1.9% in 2010 and 2.0% in 2011. The OECD now projects US growth of 3.2% in both 2010 and 2011 compared to 2.5% and 2.8% previously. The European growth forecast has been revised upward to 1.2% in 2010 and 1.8% in 2011. It also has revised its Chinese growth forecast to 11.1% for 2010 from 10.2% while 2011 growth is set at 9.7%.


As positive as the new OECD forecast appears compared to earlier estimates, it still leaves the eurozone economies far below their previous peaks. The UK, for example, would still be 2% below its 2008 peak at the end of 2011. The German economy will also be 2% below its 2008 peak at the end of 2011. Italy will be even further behind. Only France appears likely to regain its previous output peak well before the end of 2011. The magnitude of the output gap in Europe, coupled with the fiscal drag occurring in southern Europe, will make it difficult for the European Central Bank to consider any interest rate hikes this year and during the first half of next year. The US will return to its previous output peak in the second or third quarter of this year.


The IMF has also published new estimates of growth for all the countries of the world. In 2010, the IMF projects that eighteen countries will have negative growth rates and that seventy-eight will have growth rates exceeding 4%. Six countries will even exceed 8%. In 2007, there were only three countries with negative growth rates while 121 had growth rates that exceeded 4%, and forty had growth rates that exceeded 8%. The world will probably require another two years before 120 countries can once again achieve growth rates exceeding 4%.


CHINESE MONETARY TIGHTENING CAN BE SEEN ON THE HORIZON


There is growing concern in the financial markets about the danger of inflationary overheating in the Chinese economy and government actions to clamp down on property speculation. The Chinese stock market has fallen. Commodity prices have declined. The exchange rates of countries that are sensitive to the Chinese economy, such as Australia, have fallen sharply.


During April, the Chinese government announced a variety of policy initiatives to curtail real estate inflation. It increased the down payment required for second home purchases. The government instructed many large state-owned companies to cease speculating in commercial property. There was a further hike in reserve requirements to dampen bank lending.


These policy actions have begun to dampen the property market in China. Sales of flats fell 52% in Beijing during the first two weeks of May, 64% in Shanghai, and 79% in Nanjing. The Chinese press is now carrying stories warning that property prices in Beijing could fall by 30% after double-digit gains during the past year.


Residential construction accounts for approximately 30% of all Chinese fixed asset investment (FAI), so a housing downturn will have macroeconomic consequences. Chinese economists estimate that a 20% decline in home sales will depress FAI growth by 7%, construction by 6.4%, and steel consumption by 3.5%. The government wants to curtail property speculation because house prices are a sensitive social issue. Practically all Chinese citizens now aspire to homeownership, so the government wants to ensure that prices do not rise to levels which crowd out middle class families.


The Chinese central bank is likely to raise interest rates in June because real yields on bank deposits will turn negative with inflation likely to soon exceed 3.0%. The fact that the government is relying so heavily on administrative guidance over bank lending lessens the risk that there will be several interest rate hikes, though. The Chinese government is carrying on the Japanese tradition of using non-market instruments to manage monetary policy and bank lending.


There have been widespread expectations that China will allow its currency to rally during the second half of this year because of rising inflation, resurgent export growth, and international pressure. The US has been lobbying hard for a revaluation. India and Brazil recently called on China to revalue as well. Their exchange rates appreciated last year while the renminbi was pegged to the dollar, so their manufacturing sectors are complaining about lost competitiveness.


The major new constraint on Chinese exchange rate policy is the European crisis. The euro has fallen by as much as 10% against the dollar and renminbi since March. As Europe takes 22% of China’s exports compared to 19% for the US market, Beijing is naturally concerned about the renminbi appreciating excessively against the European currency. As a result of growing inflation pressures in China, there is still a good case for currency revaluation, but it is possible that the European crisis will encourage China to procrastinate for a few months. The fact that President Hu Jintao told the recent US-China economic summit that China will reform its exchange rate policy makes some appreciation inevitable this year. The question now is whether it will be 2-3% or 5%.


ASIAN ECONOMIES CONTINUE TO GENERATE STRONG GROWTH


Economic news from other Asian countries has been positive during recent weeks. Thailand, Taiwan, and Singapore have reported large double-digit gains in first quarter real GDP growth. Malaysia has raised interest rates for a second time because of 10.1% first quarter real GDP growth as well as concern about robust asset markets.


Japan posted a fourth straight quarter of real growth during the first quarter. Real GDP grew at a 4.9% annual rate. Domestic demand grew at a 2.3% annual rate while exports grew at a 3.6% annual rate as imports shrank. Private capital spending grew at a 4.0% annual rate while housing grew at a 1.2% rate. Consumption also grew at a 1.2% annual rate. Corporate profits are improving as well. In the most recent reporting period, 70% of companies beat analyst forecasts compared to 45% one year ago.


In its latest Fiscal Monitor, the IMF is projecting that Japan’s public debt could rise to 250% of GDP by 2015. The UK has achieved such a high level twice in its history—1945 and after the Napoleonic Wars in 1821 when the ratio briefly hit 288% of GDP. Germany’s government liabilities also reached 400% of GDP in 1921 after the victorious allies imposed reparations. The British public debt had little impact on interest rates. The German reparation payments set the stage for a hyperinflation. As Japan’s debt is owned primarily by local investors, it is doubtful that the central bank will resort to hyperinflation to extinguish real claims on the public sector. But there will be a need at some point for a fiscal consolidation package to stabilize the debt-to-GDP ratio. The problem is that the new DPJ government has become so unpopular that it will be difficult to impose any unpopular tax or spending changes during 2010 and 2011. Japan will instead be adrift while waiting for new leadership.


AUSTRALASIAN BUDGETS CONTAIN SURPRISING PROPOSALS


Australia’s Labour government delivered its third budget in mid-May. The budget projects that the government will return to surplus in 2012-13, which is three years sooner than was expected in 2009. The government’s revenues have benefitted from the fact that Australia avoided a recession last year as well as higher excise taxes on tobacco. There has also been a 2% cap on spending in real terms until a surplus returns. The new budget expects greater revenues from a 40% Resource Super Profits Tax as well. This proposed tax is generating tremendous controversy, so there may be attempts to modify it before it is enacted. The government asserts that effective tax rates on the mining sector declined during the recent boom, and it wants to ensure that it shares in the profits of future booms. During the period 1999-2004, royalties and resource taxes were equal to 32% of Australia’s mining profits. In 2008-09, the tax share fell to 14%. The mining industry contends that the tax will make Australia a less competitive country in which to do business and thus depress investment. Some big mining groups are deferring a few projects.


It is not surprising that the government is tempted to go after the resource sector. ABARE reports that capital expenditure in the Australian mining industry reached AU$41.3 billion in the 2009-10 fiscal year, which was a record high. ABARE also reports that capital spending could rise to AU$49 billion this year. At the end of April, the value of advanced minerals and energy projects was AU$109.6 billion, which is the second highest on record. There were forty-one energy projects, twenty-eight mining projects, and six processing plants. Western Australia accounted for 79% of capex on advanced projects while Queensland accounted for 10%.


The major risk posed by the government’s new tax policy is not merely that it could dampen the boom. It could also produce a change in the composition of Australia’s inward investment. There could be a slump in new capital spending by North American, European, Latin American, and African mining houses while China could continue to spend without hesitation. The Chinese are focused on Australian raw materials for strategic reasons, not just short-term profits. They will therefore be less sensitive to profit factors than companies based elsewhere. The political risk will come if Australians someday perceive that their mining industry is Chinese dominated. Such perceptions could trigger a nationalist backlash.


New Zealand also presented a budget in mid-May. The thrust of the budget was the need to raise the national savings rate. It boosted the value-added tax while reducing income taxes. New Zealand is concerned about the low savings rate because of its history of running large current account deficits and the fact that its personal income has been slipping compared to Australia. New Zealand incomes are now on average 35% below Australia’s compared to virtual parity before the 1960s. Australia’s system of superannuation has helped to bolster savings and create robust capital markets. New Zealand’s markets, by contrast, are much smaller, and the country has a capital shortage for funding new enterprises.


LATIN AMERICAN ECONOMIES CONTINUE TO REBOUND STRONGLY


There have been many positive surprises in Latin America this year. Brazilian forecasters now believe that their country’s growth rate could exceed 6.0%. Argentine economists have boosted estimates of their country’s growth rate to over 5.0% from only 2.0-3.0%. Both countries are benefitting from large export gains and higher commodity prices. Brazilian exports could grow by 32% this year and Argentine exports could grow by 19%. The upturn in commodity markets should also produce a growth rate of 6% or higher in Peru. Chilean growth should rebound to 4.5% this year from -1.5% last year as capital investment rebounds to growth rates exceeding 30% while consumption grows by nearly 6.0%. Mexico had a real GDP contraction of 6.5% last year as exports to the US slumped, but growth should rebound to nearly 4.0% this year as exports grow 16% and investment grows by 4% compared to a 15.4% decline. Latin America is always vulnerable to the global business cycle, but it has been outperforming recently because it does not have the current account imbalances, nor is it dependent upon short-term capital flows which created financial crises in the past.


IMF BECOMES MORE OPTIMISTIC ABOUT GLOBAL BANK LOSSES


The IMF is now scaling back its estimates of the losses which banks will experience as a result of the recent financial crisis. In April 2009, the IMF projected that the banks would lose $2.47 trillion on a global basis. They projected losses in the US of $1.6 trillion, losses in Europe of $1.193 trillion, and losses in Japan of $129 billion. The new data projects total global losses of $2.276 trillion. It expects losses of $885 billion in the US, $455 billion in the UK, $665 billion in Europe, $156 billion for European banks that are outside of the monetary union, and $115 billion for Asian banks. While US banks have recognized most of their losses, European banks have lagged. It is also unclear if the IMF estimates make allowances for the severity of the recession in southern Europe resulting from the move towards greater fiscal austerity.


EUROPE COULD BE IN A STRONG FISCAL POSITION BY 2014


The eurozone crisis has produced a sharp rally in the value of the US dollar this year. It also has produced ripple effects that are depressing the value of many emerging market currencies such as the Korean won. The Australian and Canadian dollars have slumped as well because of concern about declining estimates of Chinese growth. The Canadian dollar should benefit from the central bank’s recent decision to hike its interest rate, but Australia’s Reserve Bank is likely to place monetary policy on hold for the next few months. The OECD is projecting that Canada will have the highest growth rate in the G-7, but the currency is still sensitive to commodity prices.


The slump in the value of the euro will be positive for European growth because the OECD estimates that every 10% depreciation of the currency bolsters output growth by 1.0%. Germany was already experiencing an upturn of exports before the devaluation. The new round of currency weakness will be a positive for southern Europe’s less productive economies. It should also boost Greek tourism, which accounts for 17% of GDP.


The unique feature of the dollar’s recent rally is that it has been accompanied by a further rally in the gold price. It is unusual for gold to be so resilient when the dollar is strong. The fact that the dollar is rallying with gold demonstrates the magnitude of the confidence problems now gripping the European currency. The markets increasingly fear that the Bundesbank traditions of the ECB are being eclipsed by the financial problems of southern Europe. The ECB will soon open a new billion dollar office tower in Frankfurt, but many investors perceive that the ECB really should be in Rome or Brussels. The greatest loss of confidence appears to be in Germany. The financial media is now full of stories about Germans rushing out to buy gold coins and bars. If this trend continues, it could create the risk of the German people themselves deciding to abandon the monetary union and demanding the restoration of the deutschemark. German politicians are currently asking for sacrifices to protect the monetary union, and no party is proposing an alternative strategy. But as popular resentment against the euro builds, some politician could spot an opportunity and seek to exploit it.


The current fiscal austerity programs in Europe will dampen growth during the next two years and increase pessimism about Europe’s future. In 2013 and 2014, Europe could have a far better fiscal position than the US and Japan. If the US political system proves incapable of addressing the nation’s fiscal challenges, there could be a loss of confidence which could jeopardize both the dollar and the US bond market. In such a scenario, there could be a rally in the European currency because Europe took the pain to cure its fiscal imbalances three or four years before the US.

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©2010 David Hale Global Economics.

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