In Luxembourg today, Latvian Finance Minister Einars Repse told reports: "We will be cutting no less than 10 percent of our GDP over three years but this will bring our imbalances down and pave a very solid basis for recovery,". He means, of course, expenditure equivalent to 10% of GDP - which means 3.3 percent a year. The mystery is, how such cuts will help restore growth. All West European economies are increasing spending, following the normal intuition of supporting an economy in time of weakness. And remember, Latvia has not gotten into this mess by excessive government spending. Back in 2007, before all this started, debt to GDP was around 10%. It's the money lost by the banking sector (with Parex in the forefront) which is causing all this. Oh, I know, I know, they are following the new orthodoxy:
In emerging market countries with debt overhangs, the “Keynesian” effect of fiscal adjustment is likely to be outweighed by “non-Keynesian” effects related to expectations and credibility. Non- Keynesian effects have to do with the offsetting response of private saving to policy-related changes in public saving. In particular, if fiscal adjustment credibly signals improved public sector solvency, a fiscal contraction could turn out to be expansionary, as private consumption rises based on the view that future tax hikes will be smaller than previously envisaged.
IMF - Hungary, Request for Stand-By Arrangement, November 4, 2008
But I still have no idea of the exact mechanics of quite how people imagine all this can work in the current environment, when the private sector is also totally loaded up with debt. Meanwhile exports go down and down, falling from 288 million Lats in March, to 274.2 million in April.
The only saving grace here was that the goods trade deficit was also down, and fell from 124.6 million Lat in March to 96.9 million Lat in April.
Basically I agree with the following from Morgan Stanley's Oliver Weeks:
Which is effectively to say that a move which now has many advantages for Latvia, and few evident disadvantages, is being postponed due to fear of the impact on other countries (and not just Estonia and Lithuania). Latvia is being sacrificed at this point to the "greater good", but the support she is receiving is in the form of loans (to be repaid), not gifts.
We continue to think that devaluation in Latvia is eventually almost inevitable. The timing seems largely to depend now on the EU, but may not be quite as imminent as the market seems now to expect. We believe the IMF is likely to be reluctant to keep funding the peg, but the EU is paying for most of the support programme, and may choose to accelerate disbursement to delay this another few months while Estonia shores itself up, and perhaps agrees on a loan as protection.....
The government and central bank do not appear quite ready to capitulate yet, and technically fx policy is a decision for the central bank alone. We agree with the views of the advisor that helped to trigger the latest panic but would not make too much of his interview since such views are not uncommon and the government has many advisors.....
We think the government will eventually accept the EU s position has not been to Latvia s benefit, encouraging maintaining the peg but also not allowing EUR entry, hence effectively prolonging the pain. There are also signs that politicians are positioning themselves not to be too damaged by devaluation. Note Scandinavian banks are already positioned short local currencies they will be affected by the wave of defaults to follow but these were eventually likely anyway. We think devaluation is inevitable and obviously getting closer, but this is still not an open market where foreign consensus on devaluation is immediately irresistible.
First Mover Advantage?
One additional and highly relevant argument to consider is raised by Variant Perception's Jonathan Tepper:
One final point worth making is that defaulting - for a country on the verge of it - is often, paradoxically, not always a bad idea. If you have two countries, both of whose finances are in a fractious state, and one decides to renege on its debt while the other struggles on and tries to meet its commitments, then the former country is generally able to return to financial health more quickly. They can start again and are able to get their economy back to a situation that nurtures growth, while the non-defaulting country struggles on with the damaging spending cuts and tax rises necessary to pay back their creditors. Markets have short memories, and often misprice the risk of the defaulting country once it starts to borrow again. Argentina, for one example, after its default in 2001/02, had to wait only 3 years for its cost of borrowing to return to a level commensurate with a typical emerging market economy (see chart below - click on image for better viewing).
German Capital Goods Output Falls
Let's start with the story so far. According to GDP data for the first three months of this year, German companies invested 16.2% less in machinery, equipment and vehicles in Q1 than they did in the last quarter of 2008.
But perhaps this fall in investment bottomed out after the first quarter? Well, apparently not, since according to the Economy Ministry in Berlin today, German industrial output declined again in April (over March) with the lead role being taken in the fall by investment goods. Manufacturing output was down 2.9 percent from March (when it rose 0.6 percent), and from a year earlier by 24.2 percent (when adjusted for working day changes).
Output of investment goods such as machines slumped 6.4 percent in April from the previous month, and by 29.6 percent year on year (following a 23.9 percent drop in March). Production of intermediate goods fell 1 percent and manufacturing output slipped 2.9 percent from March. Output of consumer goods rose 0.5 percent in April from the previous month. Energy production was up 5.8 percent and construction output rose 0.5 percent.
And despite the fact that many were putting a brave face on yesterday's April industrial orders data, orders for investment good were down month on month by 4.4 percent in April (following a 5.6 percent rise in March over February.
German industrial orders, a key indicator in Europe's biggest economy, were stable in April compared with the previous month, the economy ministry said on Monday. Orders had risen strongly in March, their first rise in six months, and the ministry said the latest reading, a change of exactly zero percent, showed a "noticeable improvement in the medium-term perspective" for German industries. The March figure was revised slightly higher moreover to a gain of 3.7 percent from a previous estimate of 3.3 percent. Analysts were divided on what the steady result meant, but most saw the glass as half-full as Germany struggles to pull out of its worst post-war slump.
Export orders for investment goods were down 5.1 percent following a 9.1 percent increase in March. Year on year, export orders for investment goods were down no less than 46 percent (down from only a 34.9 percent annual drop in March). Anyone who can see signs of a developing recovery here - the German Technology Ministry said they saw signs of a "noticeable improvement in the medium-term perspective" (see citation above) - might like to explain to me how, since I certainly can't see it.
Similar results were found in a survey by Frankfurt-based trade association VDMA. German plant and machinery orders dropped an annual 58 percent, the most since data collection started in 1950, after falling an annual 35 percent in March, according to the association. Export orders were down 60 percent while domestic demand dropped 52 percent. The VDMA is forecasting a decline in orders of between 10 percent and 20 percent for the year as a whole.
“Signs of a trough aren’t recognizable yet,” according to VDMA Chief Economist Ralph Wiechers.
Japan A Similar Picture
Japan’s economy - just to remind ourselves - shrank at a record rate in the first quarter as exports collapsed and businesses drastically cut back on investment spending (an almost identical picture to the German one). Gross domestic product fell by an annualized 15.2 percent in the three months ended March 31, following a revised fourth- quarter drop of 14.4 percent. The economy contracted 3.5 percent in the year ended March 31, the most since records began in 1955.
As in Germany, employment and consumer spending held up reasonably well - only dropped by 1.1 percent year on year. But business investment was down a record annual 10.4 percent, and a massive 35.5% over the last quarter. And companies are likely to keep cutting spending because the decline in external demand has left factories operating well below capacity level, and semi idle workforces can only be retained for so long.
While industrial output bounced back a bit in April, general machinery products continued to fall, and were down 14.5 percent month on month, a sign that managers remain wary of upgrading factories and equipment before they are convinced an economic recovery has taken hold. If you look at the chart below (click on image for better viewing) you will see that the year on year drops (indicated by black triangle) in machine output continued to be massive in April, with production of general machinery down almost 50 percent on the year.
And the future continues to look very bleak. Japanese companies plan to slash capital-investment spending by 16% in 2009 according to the business daily Nikkei, the steepest drop in the history of their survey. Companies suggested they expect to spend 22.7 trillion yen ($230 billion) on capital investments in fiscal year 2009, a 4.28 trillion yen decrease from a year ago, according to the survey which covered 1,475 firms.
Previously the steepest cut in spending was a 12% decline in 1993. This year's decline marks the second year in a row that capital-investment spending dropped.The Nikkei reported that with 15 of 17 manufacturing sectors planning capital-investment cuts, spending by manufacturers overall is expected to drop a record 24% to a total of 11.7 trillion yen.
According to the survey, electronics firms will spend 3 trillion yen, a 29% drop from a year ago, and automakers said they'd spend 2.3 trillion yen, a 33% decrease. Among manufacturers, only the food and pharmaceutical industries intend to increase spending.
And the conclusion of all this? Well it is clear that there will be no recovery lead by export dependent economies like Japan and Germany. But this is not the big problem. The big problem is who is actually going to lead the world forward with a new round of import growth? At the present time this is a question without an answer.
And talking of which, I can only agree with this sentiment from Brad Setser:
"Like everyone else, I am curious to see what China’s May trade data tells us. If China truly is going to lead the global recovery, China needs to import more – and not just import more commodities for its (growing) strategic stockpiles."
Brad, you will find if you follow the link over, has been busy digging for green shoots over in the Korean trade data, but he had a hard time finding them.