Subject: David Hale: Could There Be a Double Dip in the US?
From: "Mark Zoff" <[email-masked]>
To: "Mark Zoff" <[email-masked]>
Date: Mon, 13 Jun 2011 17:46:05 -0400

Dear Clients,

Please find attached our latest monthly report, “Could There Be a Double Dip in the US?” Key conclusions to the report include:

• Although the US economy’s recent weakness does provide genuine reason for concern, growth, led by autos, should pick up in the second half of this year

• The US could potentially have to endure the most significant amount of fiscal drag in six decades in 2012

• After growing robustly in the first quarter, European growth will slow this quarter, and negotiations on another Greek rescue package are moving slowly

• Chinese growth is moderating as bank lending has slowed and auto property sales decline; power shortages could reduce GDP growth by 0.3% in 2011

• Even though the Japanese economy is starting to recover, the country’s political system is more gridlocked than ever

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Could There Be a Double Dip in the US?

June 13, 2011 • Volume 08.07

MONTHLY REPORT

By David Hale

KEY CONCLUSIONS

• Although the US economy’s recent weakness does provide genuine reason for concern, growth, led by autos, should pick up in the second half of this year

• While residential and commercial buildings investment continues to drag down US growth, equipment and software investment has been a growth leader

• The US could potentially have to endure the most significant amount of fiscal drag in six decades in 2012

• After growing robustly in the first quarter, European growth will slow this quarter, and negotiations on another Greek rescue package are moving slowly

• Chinese growth is moderating as bank lending has slowed and auto property sales decline; power shortages could reduce GDP growth by 0.3% in 2011

• Even though the Japanese economy is starting to recover, the country’s political system is more gridlocked than ever

• East Asian economies recorded strong growth figures in the first quarter, but supply chain interruptions could slow output in the second quarter

• The prospect of increased political meddling in economic affairs, in spite of strong output growth so far in 2011,  is becoming a concern in Latin America

• The likely persistence of loose monetary policy in the US for some time will weaken the US dollar

AS SPRING TURNS TO SUMMER, THE US ECONOMY ENTERS A LULL

The US economy has entered a soft patch which could provoke new concerns about the risk of a double dip recession. Rising gasoline prices have squeezed consumer spending. The housing market remains moribund. The Japanese earthquake has disrupted shipments of auto parts and forced Japanese companies in the US to reduce output by as much as 70%. As a result of these output losses, the economy’s growth rate during this quarter may be only 2.0%.

There have been numerous data reports recently confirming the slowdown in the economy. The ISM purchasing manager index dipped to 53.5 in May from 60.4 in April. The ADP employment report estimated there were only 38,000 private sector jobs created during May. The growth of payroll employment during May dipped to 54,000 from 232,000 in April while there was a downward revision of 39,000 in the two previous months’ figures.

The May employment report was clearly a disappointment. The markets had been expecting a gain well above 100,000 jobs after the three previous months had produced an average employment gain of 220,000. There was broad-based weakness, and the payroll diffusion index fell from 65.0 to 53.6. Retailing shed 8,500 jobs after a gain during April of 64,000. Manufacturing lost 5,000 jobs after several months of gains. There was another small dip in temporary employment after average monthly gains of 13,267 during the first quarter. The most resilient sectors were business services, with a gain of 44,000 jobs, and health services and education, with a gain of 34,000 jobs. The weakest sector was once again state and local governments with a job loss of 30,000 after an average loss of over 23,000 jobs per month during the first quarter.

The household measure of employment gained by 105,000 because of a surge in demand for temporary workers. The household survey of full-time employment declined 142,000. The workweek was revised up to 34.4 hours during April and remained at that level during May. Average hourly earnings also rose by 0.3% after a gain during the past year of 1.8%. As a result, the payroll proxy of private sector labor income is up at a healthy 6.1% annual rate during the second quarter. Aggregate hours worked have risen at a 4.5% annual rate as well compared to 2.0% during the first quarter. The large gains in the April payroll report resulted in part from the fact that the survey period was five weeks. The May survey period was shorter, so the two months should probably be averaged together in order to capture underlying trends. The average gain for April and May was 143,000 jobs.

The economy experienced some transitory shocks during the second quarter which will soon fade. There was severe weather in several southern states as well as typhoon damage. The auto industry is producing at an annualized rate of only 7.8 million cars during the second quarter compared to original plans to produce 8.6 million. The gasoline price rose above $4.00 per gallon during early May, and is now poised to decline $0.25.

HIRING PACE WILL BE KEY TO SECOND HALF OUTPUT GROWTH

The most serious risk to the outlook is the slowdown of private employment growth. Various surveys suggest firms are poised to expand employment by more than they did during 2009 and 2010. The Conference Board conducts a quarterly survey of business CEOs which has turned positive on job creation. The index rose to 67 during the first quarter compared to 62 during the fourth quarter. Half of all CEOs expected to boost employment compared to only 30% one year ago. The percent who expect to reduce hiring fell to 16% from 22% one year ago. GE Capital recently conducted a survey of mid-sized companies’ hiring intentions. It found that 65% have started hiring and that 80% will be hiring in the next twelve months. Monster, the global online employment agency, publishes a monthly index on new hiring. It rose at a 7% annual rate during May, marking the sixteenth consecutive month of gains. The largest gains were in mining, quarrying, and oil extraction. Manufacturing remained at its highest level since 2008 during May.

The GE survey is particularly interesting because the National Federation of Independent Business has been far more pessimistic about job creation in the small business sector. Its confidence index declined during March and April. It found that over the next three months 16% of firms plan to hire while 6% plan to reduce employment, yielding a seasonally adjusted net 2% of owners who plan to create new jobs, which is a very weak reading for a recovery period. The ADP National Employment Report has been far more positive on small business job creation. In April, it reported that employment rose by 84,000 jobs for companies who employ fewer than 50 workers as well as for firms employing 50-499 workers. The job gain for large firms was only 11,000 jobs. In May, employment at small business rose by 27,000 while contracting by 19,000 at large firms.

A few employment indicators have been resilient. The workweek grew longer during April. The Challenger survey reports that layoffs during May were only 37,135, or 4.3% less than one year ago. Announced layoffs fell 21% during the first five months of 2011. Hiring intentions also rose by 117% during the first five months of the year. The employment index in the non-manufacturing PMI rose to 54.0 in May from 51.9 in April. The manufacturing purchasing agent employment index only declined to 58.2 from 62.7 during May despite much larger declines in the indices for production and new orders. This suggests that firms may view the recent pause in industrial production as temporary. Productivity grew 1.8% during the first quarter and 1.3% during the past year. This slowdown suggests that firms are getting all they can from current workers and will have to hire more. In fact, the Philadelphia Fed found in a survey that two-thirds of managers thought their employees were overworked rather than being underutilized.

The employment outlook is critical because it will influence the growth of personal income. After a blip in January resulting from tax cuts, personal income has been increasing at a 0.4% monthly rate. The income growth has sustained modest gains in personal consumer expenditures despite an upsurge of inflation. If employment now dips back to only 100,000 jobs or less per month, the growth rate of income and consumption will also decline.

INVESTMENT HAS BEEN US ECONOMY’S BIG STRENGTH AND WEAKNESS

The economy’s strongest growth locomotives have so far been exports and business investment. Since the expansion started in the third quarter of 2009, real exports of goods and services have increased by over 20%. Merchandise exports have jumped 28%, or the largest gain since the late 1980s. During this period, the surge in exports accounted for half of real GDP growth compared to a traditional 10% during the early stages of past recoveries. Consumer-related industries have led the export recovery, including a 86% gain for exports of motor vehicles and parts. Capital goods exports—a category which accounts for one-third of exports—increased by 27%. As aircraft shipments have been sluggish, the capital goods upturn reflected strong demand for industrial machinery, construction and agricultural machinery, semi-conductors, and telecom equipment. Domestic equipment and software investment increased by 15.3% last year and by 11.6% at annual rates during the first quarter. It has been driven by a strong recovery in profits and the introduction of 100% first-year depreciation allowances during 2011.

The housing sector continues to be a drag on the economy because of excess supply resulting from foreclosures. Pending home sales fell 11.6% during April, leaving the index at its lowest level in seven months. Sales of existing homes fell 0.8% in April to 5.05 million compared to 5.8 million one year ago when there was a tax credit for first time homebuyers. First time homebuyers accounted for 36% of sales in April compared to 49% one year ago. All cash transactions accounted for 31% of sales in April while investors accounted for another 20%. This demand shows that there are bargain hunters looking for opportunities because of falling prices.

The rate of mortgage delinquencies declined to 7.97% in April from 9.29% in October according to Lender Processing Services. The rate of foreclosures fell to 4.14% from a peak of 4.21% in March, but is well above its level of 3.67% one year ago. At the current time there are 2,184,075 homes in foreclosure and 1,960,972 homes delinquent more than ninety days. Banks have taken possession of 872,000 homes, or twice as many as in 2007, according to Realtytrac. The highest ratios of foreclosure and seriously delinquent loans are in Florida (22.7%) and Nevada (18.6%). The lowest are in North Dakota (4.0%) and South Dakota (5.0%). Seriously delinquent loans that were current six months ago have fallen to 1.28% from a peak of 1.86% last October. The seasonally adjusted delinquency rate stood at 4.59% for prime fixed rate loans, 11.25% for prime ARM loans, 22.04% for subprime fixed rate loans, 26.31% for subprime ARM loans, 12.03% for FHA loans, and 6.93% for VA loans according to the Mortgage Bankers Association. As 22.7% of all homeowners have negative equity according to Corelogic, there is a risk that more defaults could occur if prices continue to fall. The stock of existing homes for sale during April was 3.87 million units, or 9.2 months of supply at the current sales pace. If we add a shadow inventory of 2.0 million units because of foreclosures, there is fourteen months of supply.

The excess supply caused the Case-Shiller Home Price Index to decline 4.2% during the first quarter of 2011 after a 3.6% decline during the fourth quarter. Nineteen of the twenty cities in the survey posted year-on-year price declines in March while twelve posted new record lows. The only city to experience rising prices was Washington DC (4.3%). The largest year-on-year price declines were in Minneapolis (10%), Phoenix (8.4%), Chicago (7.6%), and Portland (7.6%). The Chicago futures market for house prices is projecting there could be another 4.2% price decline by February 2012, and then a 5% price recovery by May 2013.

The Federal Housing Finance Agency publishes another home price survey. It fell at a 9.97% annual rate during the first quarter and is 5.5% below levels one year ago. The average price decline in the US since the housing peak in the first quarter of 2007 has been 19.8%. The largest price declines have been in Nevada (56.3%), Arizona (45.9%), Florida (45.6%), California (42.3%), and Idaho (33.5%). Falling house prices have produced a $6.6 trillion wealth loss since the third quarter of 2006, or a decline equal to 9% of total wealth.

The homeowner vacancy rate during the first quarter was 2.6% compared to a peak of 2.9% during late 2008. The rental vacancy rate was 9.7% during the first quarter compared to a previous peak of 11.1% during the third quarter of 2009. The supply of new homes for sale in April was only 175,000, or 6.5 months of supply at current sales rates. This low level of inventory suggests there could be a modest uptick of new construction if home sales can recover further because of low mortgage rates and attractive prices. The homeownership rate fell to 66.5% during the first quarter from over 69% seven years ago and is now back at the level of 1998. New home sales rose 7.3% during April to 323,000, but they are still below their 2010 peak of over 400,000.

The housing share of real GDP has fallen to only 2.4% from a peak of 6.2% five years ago, so housing is unlikely to subtract from output growth. But the fact that over 2.2 million construction jobs were lost between April 2006 and January 2011, and only 51,000 gained since the trough, has definitely restrained the economy’s recovery. The declining vacancy rate for rental units should encourage an uptick of multifamily starts during the next few quarters. The National Multi Housing Council publishes a quarterly index of market tightness in the rental market. It rose to 90 in April compared to a trough of 11 in early 2009, and is now above its peak in 2006. The Council attributes the upturn in demand to the large number of young people entering the market as the employment situation improves. The single family sector will lag, but with inventories at record lows, starts will gain modestly if home sales improve. It is encouraging that the Conference Board’s latest survey of consumer confidence reading of the number of respondents who plan to buy a home during the next six months stayed at 5%. This number is well above the 3.8% reading that was recorded last July.

STATE AND LOCAL GOVERNMENTS CONTINUE TO SHED JOBS IN 2011

The state and local government sector continues to suffer from fiscal deficits. They are projected to be $112 billion in the next fiscal year compared to $130 billion in the current fiscal year and $191 billion in 2010. As a result of these deficits, state and local governments have shed 528,000 jobs since August 2008 and 116,000 this year. The new challenge will be to cope with a substantial reduction of assistance from Washington. Since the Obama stimulus program was enacted in February 2009, the federal government has given the states $158 billion of assistance. In the new fiscal year starting July, this aid will decline to only $6 billion.

The Rockefeller Institute reports that state government tax receipts rose by 9.1% during the first quarter on the basis of preliminary data from forty-seven states. Tax collections have been rising for five quarters, but are still 3.1% below their level three years ago. The problem is that state and local government spending on social benefits has been soaring. In the first quarter, it rose 10.5% to an annualized rate of $562.9 billion and is now 26.1% of total state and local spending. The fiscal drag from state and local governments was 0.5% of GDP in fiscal 2009 and 1.2% during fiscal 2010. It declined to 0.7% of GDP in fiscal 2011, but could now rebound to 1.0%.

The Economic Policy Institute has estimated that every $1 million of state and local spending cuts generates 18.2 job losses, with 30% being for private suppliers. During the past two-and-one-half years, state and local government workers have received compensation increases of 5.2%. The cost of their salaries is about $967 billion. If their pay could be frozen rather than increasing 2%, state and local governments would be able to save $19 billion. Such savings could help to protect 380,000 jobs. The Republican takeover of several state governments last year has led to more efforts to restrain state and local pay. Connecticut Democratic Governor Daniel Malloy also did a deal to save 4,700 jobs in return for $1.6 billion of wage, pension, and health benefit givebacks. The success of these efforts will determine how many jobs the state and local governments give up during the year ahead.

US CONSUMERS HESITANT TO RESUME PAST FREE-SPENDING WAYS

Real personal consumer expenditures grew by 2.2% during the first quarter compared to 4.0% during the fourth quarter. Retail sales rose by 0.5% during April because of rising gasoline prices. Sales excluding gasoline, automobiles, and building materials rose 0.2% in the month, and are up a robust 7.8% at annual rates since December. Retailers reported moderate gains in retail sales during May. The twenty-four retailers tracked by Thomson Reuters reported a gain of 4.9% for stores open one year or more. Up-market retailers such as Saks and Neiman Marcus reported much stronger results than down-market retailers such as Target and Kohl’s. This pattern suggests that affluent consumers are less restrained by rising gasoline prices than people with lower incomes. Real consumer spending will probably increase 1.6% during the second quarter.

The Federal Reserve reports that household net worth increased by 1.2% during the first quarter to $58.1 trillion. The value of financial assets, including equities, savings deposits, and money market funds rose 2.4% to $48.9 trillion. The value of real estate assets fell 1.9% to $18.1 trillion. Total household debt fell 0.9% to $13.3 trillion. Household debt is now equal to 114% of after-tax income compared to a peak of 130% in 2007. As this ratio averaged 85% during the 1990s, there is room for further deleveraging in the household sector.

The Conference Board Consumer Confidence Index fell to 60.8 in May from 66.0 in April. The expectations sub-index for consumers’ six month outlook fell to 75.2 from 83.2. The present situation sub-index dipped to 39.3 from 40.2. Consumers reporting jobs are plentiful increased 0.5%, but those reporting jobs are hard to get increased 1.5%. This data suggests consumers are more apprehensive about the outlook because of rising energy prices and uncertainty about employment.

The Federal Reserve Bank of New York reports that aggregate consumer debt held steady during the first quarter after nine quarters of decline. As of March 2011, total consumer debt was $11.5 trillion, a reduction of $1.03 trillion from its peak during the third quarter of 2008. There was a small increase in mortgage balances during the first quarter, but they are still 8.2% below their peak.

Aggregate credit card limits rose slightly during the first quarter, reversing a long series of declines which began during mid-2008. About 195 million credit card accounts were closed during the past four quarters while 166 million new accounts were opened during this period. There are now 379 million credit cards outstanding, which is down 24% from its peak in the second quarter of 2008. The stock of consumer credit rose by $7.2 billion in April. The uptick in April was driven by the demand for school and auto loans.

As a result of declining debt, the ratio of household financial obligations to disposable income fell to 16.6% during the fourth quarter of 2010 from 18.8% at the end of 2007. The ratio probably fell to 16.2% during the first quarter based on declining mortgage payments and increasing personal income. The costs savings from this declining ratio are probably worth about $115 billion.

WILL A DEBT CEILING DEAL BE REACHED BEFORE A CRISIS ERUPTS?

Congressional Republicans are continuing negotiations with the White House and Senate Democrats over requests to increase the federal debt ceiling. The Republicans are demanding large multi-year spending cuts as a precondition for increasing the debt ceiling. It is unclear how the two sides will be able to achieve large spending reductions without touching core entitlement programs such as Social Security, Medicaid, and Medicare, which account for 56% of federal spending. Representative Paul Ryan (R-WI) has introduced proposals to convert Medicare into a voucher system, but his ideas have recently suffered a setback. There was a by-election in upstate New York in late May in which the Democratic candidate scored an upset victory by campaigning against Rep. Ryan’s proposals. The victory has strengthened Democratic resistance to Rep. Ryan while making the Republicans nervous about their ability to sell the program.

It is possible that the two sides will agree to a modest increase in the size of the debt ceiling in order to ensure that the government will meet its short-term funding needs while continuing to negotiate more far reaching policy changes. They could also focus on a process bill which would guarantee long-term reductions in government spending without making large short-term cuts. One bill which could fit this formula was a proposal from Senators Bob Corker (R-TN) and Claire McCaskill (D-MO) to reduce the federal government’s share of GDP to 20.6% in 2022.

Wall Street is concerned that if the debt ceiling is not increased the Treasury Department might default on its debt. As the government still funds itself 60% from tax receipts, the Treasury should be able to avoid default, but without new funding it would have to choose between such unpopular alternatives as suspending Social Security payments or not paying the Army.

Rep. Ryan does not believe the two sides can reach a deal before late July. He has also taken heart from an interview which Stan Druckenmiller had in the Wall Street Journal suggesting that markets could cope with a short-term default if the White House agreed to large spending cuts. Moody’s has announced that it is placing the US under review for a possible downgrade because of uncertainty about the budget negotiations and the risk that they might not prevent a further upward spiral of the public debt. As the Republicans and Democrats reached an agreement in April on a continuing resolution for the current fiscal year, the markets have so far been complacent about the debt ceiling. They could become more apprehensive during July if there is no progress in the negotiations.

THE US WILL FACE SIGNIFICANT FISCAL DRAG IN 2012

The Obama fiscal policy outlined by the Office of Management and Budget (OMB) three months ago has the potential to be quite restrictive in 2012 even if the Republicans do not amend it with new spending cuts. The Obama budget projects the tax share of GDP will rise by 2.2% next year and that the spending share will fall by 1.7%. The tax increases will result from the expiration of tax cuts enacted by Congress in December, including a 2% reduction in the Social Security tax and the introduction of 100% first-year depreciation allowances for new equipment spending. There will be large spending declines as various elements of the Obama stimulus program enacted during 2009 unravel. One of the biggest items is a $54 billion reduction in aid to state and local governments.

The financial counterpart to the US government deficit has been a large swing in the private savings rate. It has risen from a negative 4.1% of GDP in 2006 to a positive 7.1% of GDP today. Domestic private savings has been able to finance 36% of the fiscal deficit in 2008, 85% in 2009, and 77% in 2010. The residual has come from foreign borrowing. It is the large rise in private savings which has allowed the US to run large deficits without driving bond yields sharply higher.

MONETARY POLICY WILL REMAIN LOOSE FOR QUITE SOME TIME

The Federal Reserve has begun to discuss an exit strategy from its highly accommodative monetary policy, but the only policy change which will occur during the next few months is the end of quantitative easing. The Fed will complete its purchase of Treasury securities in June. As a result of the recent weakness of economic data and declines in commodity prices, there is no pressure for the Fed to start shrinking its balance sheet or raise interest rates. Fed Chairman Ben Bernanke is confident that inflation will soon peak. He admits that the Fed’s forecast for moderate growth during the year ahead could be vulnerable to fiscal drag from both tax increases and spending cuts.

DOMESTIC PROFITABILITY TEMPERED AT THE BEGINNING OF 2011

The FDIC has published its first quarter data on the performance of the US banking system. Net income rose to $29 billion from $17.4 billion during the first quarter of 2010, which is the best quarterly result since the second quarter of 2007. Provisions for loan losses fell to $20.7 billion during the first quarter from $51.6 billion one year earlier. This marks the sixth quarter in a row that loan loss provisions have had a year-on-year decline. Net operating revenue (net interest income plus total non-interest income) was $5.5 billion, or 3.2%, lower than a year ago. This was only the second time in the twenty-seven years for which the data are available that the industry has reported a year-over-year decline in quarterly net operating income. Much of the reduction in net operating income was concentrated at larger institutions; more than half of all institutions (59.5%) reported year-over-year gains in net operating revenue. But among the ten largest institutions, six reported year-over-year declines in net operating revenue. The number of institutions on the FDIC’s problem list increased to 888 from 884. These institutions had assets of $397 billion.

Business credit rose at a 4% annual rate during the first quarter, the largest gain since the third quarter of 2008. Debt owed by large companies rose by 7.1% because of their easy access to the credit markets. In the five months of 2011 through May 18th, companies with investment grade ratings issued $392 billion of bonds, up 30% from the same period one year ago. Worldwide sales of junk bonds also totaled a record $56 billion in May. Google took advantage of the low yields in the marketplace to raise $3.2 billion during May despite the fact that it has $37 billion in cash on its balance sheet. Google says it will use the bond proceeds to reduce its issuance of commercial paper.

Federal Reserve Governor Dan Tarullo recently made a speech suggesting that the government may demand much higher capital ratios from systemically important financial institutions (SIFI). Under the new Basel rules, capital ratios are supposed to increase to 7%. The Dodd-Frank bill defines banks with more than $50 billion in assets as systemically risky. There are thirty-five banks that fit this criterion. The government is now considering increasing the ratios for large institutions by 3-7%. Switzerland has already announced that it wants to impose a ratio of 19% on its two largest banks. The US government is considering higher capital ratios because US loan losses during the recent financial crisis were equal to 7% of bank assets.

As both the Treasury Secretary and Fed Chairman have expressed concerns about the potential for SIFI standards to compromise the competitive position of US banks versus foreign banks, they will probably attempt to introduce any new rules over several years. They must also determine which non-bank financial institutions are systemically risky. The Fed has said that it wants a short list, so any new rules may apply to only four insurance companies as well as a few other large institutions such as GE Capital. The Fed will probably try to conclude the debate on these proposals early next year. There is a risk that higher capital ratios could encourage large banks to reduce their lending, so the Fed will have to proceed carefully.

Corporate profits rose by 5.2% at annual rates during the first quarter and are 8.5% above levels one year ago. Domestic non-financial profits grew at a 5.2% annual rate while financial profits fell 16.5%. Foreign profits rose at a 12.5% annual rate. Operating profits have now posted a 44% cumulative increase since the recovery began. The profit rebound has resulted from large gains in productivity while wage growth has remained subdued. Foreign profits have benefitted from the performance of foreign economies as well as a weak dollar. As a result of the rise of emerging market countries, global GDP growth excluding the US has averaged 6.0% since 1995 while US growth has averaged 4.7%. Some of the best profit results during the first quarter came from companies which are benefitting from the performance of the global economy such as Caterpillar. Its 57% gain in sales was led by a 90% increase in sales to Latin America, followed by 72% in North America, and 67% in Europe, the Middle East, and Africa.

The US economy has grown by 4.9% since the recession ended two years ago, whereas the average post-war recovery has generated a growth rate of 9.4% at this stage of the expansion. The US economy began another slowdown during the second quarter of 2011 which is provoking concern about the risk of a double dip recession. The recent slowdown has resulted from specific shocks, such as disruptions of Japanese auto supplies and rising gasoline prices, which should be transient. The odds are therefore high that output growth will rebound to 3.0% of higher during the third quarter. Auto production is scheduled to increase from annualized rates of 7.9 million units to 9.25 million units in the third quarter, and could easily add 1% to the economy’s growth rate.  The risk of a slowdown will then increase again at the start of 2012 because of tax increases and cuts in government spending.

EUROZONE GROWTH STRONG, BUT ARE FAULT LINES EMERGING?

The growth rate of real GDP in the euro area accelerated to 3.2% during the first quarter of 2011 compared to 1.2% in the fourth quarter. The year-on-year growth rate was 2.5%. Lithuania and Estonia led with growth rates of 14% and 8.4%. Germany had a growth rate of 6.0%. France followed with a growth rate of 4.0%. Austria also had a 4.0% growth rate. Spain eked out a growth rate of 1.2%. Although Eurostat initially reported a gain of 3.2% for Greece, it has since been revised down to 0.8%, and the year-on-year decline was 5.5%.

Purchasing agent surveys indicate that European growth has slowed considerably during the second quarter. The eurozone PMI fell to 54.6 from 58.0 in April. The output index fell 4.9 points to 55.2. The new orders index fell 4.0 points to 53.3. The German index fell 4.2 points to 57.7. Spain’s index fell to 48.2 from 50.6, or its lowest level since January 2010. Greece remained in recessionary territory with its index falling 2.2 points to 44.5. Ireland also had a sharp fall from 56.0 to 51.8 as a result of weakness in new orders and employment.

The great surprise in the May data was the fact that Germany’s IFO index remained unchanged at 114.2 despite widespread expectations of a decline. The IFO survey indicates that German firms remain optimistic despite recent concerns about inflation, the Japanese earthquake, and sovereign debt on the European periphery. This optimism reflects the strength of both exports and investment in the German economy. In March, export orders rose 7.3% above levels in February, although a correction did occur in April. The president of the German Industry Association said that his group expects exports to rise 11% this year.

The Bundesbank has issued a positive forecast for the economy. It now expects growth of 3.1% this year compared to 2.5% previously. After a robust first quarter led by investment and exports, it expects that domestic demand could benefit from further gains in employment. German employment rose by 28,000 in April after gains of 38,000 in March and 37,000 in February. The German unemployment rate fell to 7.0% in May from 7.1% in April, and the Bundesbank believes it could fall to 6.5%. The euro area unemployment rate in May was 9.9% compared to a peak of 10.2% in April 2010.

The euro area inflation rate eased to 2.7% in May from 2.8% in April because of lower oil prices. The core inflation rate appears to have remained at 1.5%. Wage growth during the first quarter increased at a diverse rate because of different national policies for wage indexation. German wages rose at a 1.8% annual rate compared to 1.5% during the fourth quarter. The growth rate of wages in Spain rose to 3.1% from 1.3% because 54% of firms automatically index wages for inflation. Belgian wage growth also accelerated to 2.4% from 1.1% because 98% of firms index wages for inflation. The ECB has begun to raise interest rates because it is very concerned about the recent uptick of CPI inflation influencing wage negotiations.

The ECB Survey of Professional Forecasters is projecting that eurozone inflation will be 2.5% this year and decline to 1.9% next year. It continues to project that the five-year inflation rate will be 1.96%. The European Central Bank monitors this survey very carefully, so it will reinforce the current bias to raise interest rates in July. The Federal Reserve has ignored the recent uptick in CPI inflation and focuses much more heavily on the core inflation. One of the members of the ECB board, Mr. Lorenzo Bini Smaghi, wrote an op-ed column for the Financial Times in early June asserting that it is unwise for central banks to ignore commodity prices and focus on core inflation. He argues that the rise of the emerging market countries has produced a permanent increase in commodity prices which cannot be overlooked.

Portugal has reached an agreement with the IMF and the EU on a €78 billion rescue package, including €12 billion for bank recapitalization. The rescue package came after the Portuguese parliament defeated a fiscal program which would have reduced the deficit to 4.6% of GDP this year, 3% next year, and 2% in 2013. The deficit was 9.1% of GDP last year instead of the government’s target of 7.3%. The new Portuguese government elected in last week’s election has promised to implement the program while accelerating labor market reforms. Portugal has so far had more success than the other peripheral European countries in reducing its fiscal deficit. Tax receipts rose sharply during the first four months of the year while spending fell slightly. Spain and Ireland have achieved some deficit reduction, but less than they had planned. The deficits of Greece and Italy have been increasing. S&P has cut its outlook for Italy from “stable” to “negative” because of concerns that Italy’s weak recovery may make it difficult to achieve its deficit reduction targets.

Spain is struggling to achieve its deficit reduction targets for 2011. In the first four months of the year, the deficit was reduced by €3 billion, or a number far short of the government’s goal of reducing the deficit by 3.2% of GDP. It is also uncertain how the regional governments are performing in their attempts to control public spending. Eight of the seventeen regions had deficits exceeding 3% of regional GNP last year. Spain achieved a growth rate of 1.2% during the first quarter because of exports. They contributed 1.4% to output growth while domestic demand fell by 0.6%. Spain’s real retail sales have fallen at a 4.8% rate so far this year. Spanish consumers have been retrenching because they have a high debt burden and unemployment now exceeds 20%.

The odds continue to diminish that the Bank of England will raise interest rates in the near future. The consumer sector continues to suffer from the fact that the inflation rate is in the 4.0-4.5% range while wage growth is only about 2%. House prices have fallen during the first four months of the year and could decline 1.4% during the year as a whole. The most vociferous proponent of monetary tightening, Andrew Sentance, has left the monetary policy council. His replacement, Ben Broadbent, does not appear to share his views. In recent testimony before parliament, he expressed concerns about downside risks in the UK economy while downplaying the risks of rising inflation expectations. Bank of England Governor Mervyn King has opposed monetary tightening because of the growth risks in the economy and his support for the government’s policy of fiscal restraint. His views are likely to prevail because of the weakness in retail spending and the fiscal drag from the government’s tax and spending policies.

IS THERE A GOOD SOLUTION TO THE GREEK DEBT CRISIS?

There has been much discussion over the past month about how to manage Greece’s financial problems. Some European ministers have introduced a new term called “debt reprofiling” to suggest that the maturity of Greek debt should be extended. Greece has fallen behind in achieving its deficit reduction targets because of the impact of its recession on tax receipts. They fell 7.1% during the first four months of the year compared to forecasts of a 3.7% gain. S&P has downgraded the country’s debt rating to CCC. It is now obvious that Greece will be unable to return to the financial markets during 2012 to seek new borrowing or rollover its existing debt.

Some officials have suggested that Greece should restructure its debt or at least reprofile it with longer debt maturities. German Finance Minister Wolfgang Schaeuble has proposed a voluntary extension of the maturity of Greek debt by seven years. The European Central Bank initially opposed any discussion about either debt restructuring or debt reprofiling. It said that it would cease to accept Greek debt as collateral for loans to Greek banks, a development which would create an immediate liquidity crisis for the banks. What remains unclear is whether the eurozone finance ministers can organize a debt reprofiling which both the ECB and credit rating agencies would regard as truly voluntary. Mr. Trichet has hinted that he could accept a truly voluntary restructuring, but it is not clear how to define such an event. The ECB is concerned about a Greek default because it has only €11 billion of capital while the European monetary system as a whole has €81 billion of capital. French banks have indicated that they would be prepared to subscribe to new issues of Greek sovereign debt to replace bonds which are maturing.

The alternative plan now emerging is to duplicate the agreement which major banks had with Eastern European countries during the global financial crisis. In 2009, the banks pursued a policy called the Vienna Initiative in which they pledged to maintain their lending at year-end 2008 levels to five countries so that any new loans from the IMF could be used to assist the sovereigns in making fiscal adjustments. The IMF regards the Vienna Initiative as one of the most successful voluntary loan rollover agreements ever undertaken. It was possible because the number of banks involved was small and they had large exposures (€225 billion) to the vulnerable countries. The ownership of Greek debt is also relatively concentrated. The top five Greek banks own 15% of it. The largest fifteen European banks own 15%. French banks own $57 billion of Greek debt and German banks own $34 billion. The ECB now owns about 20%. As twenty-one banks own half of Greece’s public debt, it should be possible to work out a program for them to voluntarily rollover their bonds when they come due. What remains unclear is whether they will seek any sweeteners such as higher coupons or collateral. Nor is it clear how the rating agencies will classify a voluntary debt reprofiling. Korea also had a debt rollover during the Asian financial crisis. In this case, the IMF and the US threatened a default unless private sector players made a contribution. Their informal rollover agreement quickly evolved into a formal maturity extension with loans extended one to three years and guaranteed by the Korean government.

If the disagreements about debt reprofiling can be resolved, it now appears that the IMF and EU will offer new funding in return for strict conditions on reducing the deficit and privatizing state-owned assets. The Greek government is set to announce a new austerity program which envisions €6.4 billion of spending cuts and tax increases as well as plans to privatize €50 billion of government-owned assets. The government will also create a new agency to preside over the privatization program. There was initially strong opposition to privatizations from the trade union, but opinion polls show that 75% of Greeks now support the idea.

Under the rescue program launched last year, Greece was supposed to achieve a debt-to-GDP ratio of 133% at the end of 2010 and 149% in 2012-13. The latest data shows that the debt-to-GDP ratio hit 142% at the end of last year and will rise to 157% in 2012. As a result of the new aid program, the IMF and the EU will own €129 billion of Greek government debt. The European Central Bank also appears to have bought over €100 billion of Greek debt either directly or through collateralized loans to Greek banks (€86 billion). The ECB is concerned about the potential losses from any restructuring because the equity of the eurozone central banks is only €81 billion.

Many investors continue to believe that Greece will ultimately have to restructure its debt. In fact, the German bank NordLB has announced that it will write down the value of its Greek bonds because of its belief that there is a 20% probability of a restructuring occurring before 2013 and 40% thereafter because it is still running a primary budget deficit. Greece projects that this year’s primary deficit of €2 billion will turn into a surplus of €8.3 billion in 2013. Greece could conceivably consider a restructuring once it has a large primary balance. But three factors suggest it will not.

First, the European Central Bank will continue to argue that a Greek default will produce contagion effects on other troubled European countries such as Ireland, Portugal, and Spain. If those countries could regain market confidence through economic recoveries and significant deficit reduction, the contagion risk would diminish, but they are unlikely to achieve such a benign outcome before 2015.

Secondly, if Greece defaulted, it would create large losses for the Greek banks, which have over €58 billion of the securities. The government would have to help recapitalize the banks at a time when its own ability to borrow would be compromised. Greeks are themselves aware of the risks to the banks. During the past eighteen months, Greek banks have lost over 17% of their deposits.

Thirdly, the Germans continue to fear that a default by Greece or other troubled countries could jeopardize the survival of the European Monetary Union. They will take any action necessary to guarantee its survival.

As Greece has a long history of defaulting, it is natural for investors to be skeptical about its ability to avoid default this time. But the fact that Greece belongs to a monetary union with strong creditor countries has changed the political dynamics of the situation profoundly. If Greece did not belong to the monetary union, it would have already defaulted, but its membership has created a variety of policy options which do not exist for other troubled debtors. There is still a risk that the economic situation in Greece will become so desperate that the government will lose its ability to impose further fiscal austerity. But as the survival of the Greek banking system will be at risk, any government will have a strong incentive to continue cooperating with the IMF and the EU.

A EUROPEAN WILL MOST LIKELY CONTINUE TO HOLD THE TOP IMF JOB

The IMF is now searching for a new managing director. Since it was established in 1946, there have been ten directors. Of these, four have been from France, two from Sweden, and one each from Belgium, the Netherlands, Germany, and Spain. There is now great controversy over whether another European should receive the job. Many say it is time for a candidate from a developing country. The only serious candidate to emerge so far from the developing countries is Agustin Carstens, the governor of the Bank of Mexico. He launched his candidacy last week, but so far he has received no endorsements from other countries. The European candidate is Christine Lagarde, the French finance minister. She has already received the endorsements of France, Germany, and the United Kingdom. She is now traveling to Brazil, China, and other developing countries to seek their support.

As the Europeans have 35% of the votes at the IMF, their candidate has a clear advantage unless there is a compelling alternative. The US has 17% of the votes, but has so far tried to be neutral. If a European gets the top job, there could be an attempt to give the number two job to someone from the emerging markets rather than continuing the tradition of appointing an American. It is unclear, however, if the US would be willing to make such a sacrifice. It could jeopardize the support for the IMF and the World Bank on Capitol Hill. At present, the odds favor Ms. Lagarde getting the job.

CHINA’S EFFORTS TO MODERATE ECONOMY’S GROWTH RATE TAKE HOLD

There are more signs that China’s policy of monetary restraint is slowing the economy. The central bank has increased interest rates 100 basis points since last October. It has hiked bank reserve requirements five times. The growth rate of bank lending has slowed from 34% in 2009 to 17.5%. The cost of borrowing in the underground money market has reportedly increased to 60%.

Some key indicators have started to decline. In April, auto sales declined for the first time in two years. Nationwide property sales, in terms of floor area, dropped 10% from a year earlier. Sales volume in nine major cities was down 45% year on year. There is contradictory data on house prices, but some surveys are starting to show year-on-year price declines or much smaller rates of gain.

There are also signs of weakness ahead in foreign trade. The recent China Trade Fair is reported to have achieved $36.8 billion of export orders, up only 5.8% from the previous one and the weakest growth rate since the second half of 2009. Export orders from the US increased 12.4% while those from Europe were up 14.1%, but orders from Hong Kong were down 16.8%, orders from Japan fell 19.1%, and orders from ASEAN fell 3.7%. Analysts were also concerned by the fact that 90% of orders were short term compared to a normal ratio of 40-50%.

The purchasing manager index for May fell 0.9 points to 52. The new orders index fell 1.7 points to 52.1. The output index fell 0.4 points to 54.9. The index for export orders dipped 0.2 points to 51.1. This data confirms that China’s industrial production is gradually losing momentum and could slow to the 10-11% range this summer from 13.4% in April.

The economy’s strongest sector continues to be fixed asset investment. Real estate investment led the sector with a 35% year-on-year gain while manufacturing investment rose by 29%. Manufacturing should remain robust, but private real estate is likely to slow while the government will try to bolster social housing. The major constraint on social housing is that several cities have recently experienced large declines in land sales. The drop in land sales will reduce the funds available for local governments to finance social housing projects.

China has been experiencing power shortages since March. Twenty provinces and regions have had to introduce power rationing. The State Grid Corp of China predicts that China will face a thirty gigawatt power shortage this summer compared to a ten gigawatt shortage during 2006-07. There have been droughts in some inland provinces which has reduced the supplies of hydropower. Some power companies have reduced supplies because of large increases in the price of coal. The government decided to raise power tariffs for industrial and agricultural users by 4-5% recently. These price increases should help to alleviate the supply situation by reducing the number of power companies losing money. Chinese economists estimate that the power shortages could reduce output growth by 0.3% compared to 0.6% during the power shortages of 2004.

There has been an upsurge of concern during recent weeks about the health of China’s small- and medium-sized enterprises. Rising labor and raw material costs are squeezing their profit margins. The central bank’s monetary tightening has made it more difficult for them to obtain loans while increasing the cost of credit they can obtain. An index of business conditions published by the China Association of Small and Medium Enterprises declined 2.2 points to 104.1 during the first quarter.

The central bank hiked reserve requirements again during mid-May to show its concern about the fact that the inflation rate is 5.3%. There has recently been a decline in vegetable prices which should reduce pressure on the inflation rate this summer, but there continues to be pressure on service prices from rising wages. Concern about inflation has helped to produce further strong demand for gold in China. During the first quarter, Chinese investors bought 93.5 tonnes of gold in the form of coins, bars, and medallions, a 55% increase from the previous quarter and more than double levels from one year ago. At this level of sales, China appears likely to overtake India as the world’s largest gold market this year.

China is about to make a change in its income tax system which will bolster personal incomes. The plan is to raise the income threshold at which people pay income tax from 2,000 yuan per month to 3,000 yuan per month. The plan would also reduce the number of tax brackets from nine to seven and change the tax rates from 15-40% to 5%, 10%, and 45%. At present, 28% of Chinese pay income tax. The proposed reform would reduce this number to 12%.

HOW BADLY WILL JAPAN’S FRACTURED POLITICS IMPEDE THE RECOVERY?

Japan’s economy contracted at a 3.7% annual rate during the first quarter because of the impact of the earthquake on both output and consumption. There were declines in consumption, investment, and inventories because of the earthquake. Industrial production rose 1.0% in April after falling over 15% in March. There are estimates that it could increase by 7-8% during May and June. If these numbers are correct, industrial production will recover to 95% of pre-quake levels of output during June. New auto sales surged 23.9% month on month in May.

The Japanese political system is deeply divided. Prime Minister Naoto Kan survived a vote of no-confidence last week by promising to resign, but he gave no firm date for his departure. He said that he wanted to preside over more of the recovery from the earthquake. There are deep divisions within the Democratic Party about his status, not just between the parties. Former Prime Minister Yukio Hatoyama has said that Mr. Kan should step down at the end of June, but that will not leave adequate time to prepare the next supplementary budget. The prime minister has also said that he wants to remain until the Fukushima nuclear power plant problems are resolved. In such a scenario, he could remain until the end of the year. The opposition parties may use their control of the upper house of the Diet to block the approval of the bill to issue deficit financing bonds. As Mr. Kan’s own party is divided about his status, it is far from clear that he will be able to survive the summer.

The government’s advisory committee on reforming the social security system issued its report last week. The report covered a wide range of topics, including child care support, employment measures for the young, medical and nursing reforms, pensions, and anti-poverty measures. The committee proposed hiking the consumption tax from 5% to 10% by 2015. The committee believes that the government can achieve its goal of reducing the primary deficit by half in 2015 if such a tax increase occurs. Japan will need strong political leadership to sell such a program to the public because many blame the consumption tax hike from 3% to 5% in 1997 for the recession which occurred at that time. Mr. Kan obviously does not have the political capital to obtain a tax increase. What remains unclear is whether his successor will have the ability to enact legislation or whether the Democrats will be forced to seek a coalition with the LDP.

STRONG GROWTH PERSISTS AT THE START OF 2011 THROUGHOUT ASIA

India’s economy dipped to a growth rate of 7.8% year on year during the first quarter from 8.3% in the fourth quarter of 2010. Domestic demand was weak and the growth rate of investment slumped to only 0.4% year on year. Investment has suffered from slow approval of infrastructure projects and a large increase in the level of interest rates. The strongest sector of the Indian economy is foreign trade. During the past year, export growth has been 34.4% while import growth has been 14%. Engineering exports grew a blistering 109% while petroleum product exports rose 53%. The merchandise trade deficit in the last fiscal year fell to $104 billion from $119 billion in fiscal year 2009. India has never been considered a big exporter. Merchandise exports are only 16% of GDP. But recent growth rates suggest that its manufacturing sector is becoming highly competitive, and the Ministry of Commerce and Industry is now setting a target of $500 billion for exports in 2014. The export surge reflects a changing mix of markets. In 1999-2000, India sent half of its export to the US (23%), the UK (6%), Germany (5%), Japan (5%), and the United Arab Emirates (6%). Asia now receives 55% of India’s exports while the EU takes 21% and North America 12%. India is pursuing new trade agreements to promote exports. It has signed deals with Malaysia, Sri Lanka, and Canada, while continuing to negotiate with Japan, South Africa, Turkey, and the EU.

Singapore’s GDP overtook Hong Kong’s during the first quarter. Its quarterly GDP rose to $63.9 billion compared to Hong Kong’s $57.9 billion. Ten years ago, Singapore’s GDP was only 55% of Hong Kong’s. Singapore has allowed its currency to appreciate 21.3% against the Hong Kong dollar since 2006. Singapore’s population has also grown at a 3.5% rate during the past five years compared to 0.75% for Hong Kong. As a result of these differences, Singapore’s real GDP growth rate has averaged 6.5% since 2005 compared to 4.0% for Hong Kong. Singapore has also benefitted from attracting more high value-added manufacturing industries than Hong Kong. Manufacturing still accounts for 21% of Singapore’s GDP compared to 2% for Hong Kong. Hong Kong’s major advantage is the large size of its financial sector ($36.9 billion) compared to Singapore ($25.1 billion).

The East Asian economies had generally high growth rates during the first quarter. Singapore, Hong Kong, and Taiwan had double-digit growth rates, with Singapore exceeding 22%. Malaysia grew 6.5% and the Philippines’ growth exceeded 7%. Korea accelerated to 5.6% from 2.0%. Indonesia slowed to 4.0% from 10.8%. The Japanese earthquake will disrupt supply chains to East Asia during the second quarter. Thailand will be especially vulnerable because of its large exposure to the Japanese auto industry. Korean industrial production also suffered during April from disruptions of Japanese supplies in its audio, video, and telecom equipment sectors. As a result of the resilience of the East Asian economies and the impact of food prices on inflation, the odds are high that most central banks in the region will raise interest rates further during the second half of the year.

AUSTRALIAN AND CANADIAN ECONOMIES FACE DISPARATE CHALLENGES

Australia’s real GDP contracted 1.2% during the first quarter because of the floods in Queensland. They reduced output by 2.4%. Domestic demand grew at a 3.1% rate year on year. Australia has a multispeed economy. Retail spending has increased only 4.5% during the past year because of households raising their savings rate. Capital spending, by contrast, is booming because of the resource sector. The government’s latest capital spending survey indicates that firms plan to boost investment in fiscal year 2012 by 30% to $140 billion.

This growth is almost entirely driven by the mining sector whose investment share of GDP now exceeds 4%. The Australian Bureau of Agriculture and Resource Economics tracks spending in this sector. Its latest reports indicate that there are ninety-four projects at an advanced stage of development with a combined value of $173.5 billion, or 13% of GDP. This sum is dominated by energy projects (67%) with the largest being the Gorgon LNG project. The bulk of the projects are in Western Australia and Queensland with the other states a distant third. The government’s latest budget projects that it will return to surplus in 2012-13 because of revenues from the mining boom. The structural deficit would be 2% of GDP in 2012-13 without cyclical revenues from the resource boom. The Reserve Bank has signaled that it expects inflation to rise to 3% later this year because of low unemployment and rising wages. The odds are therefore high that it will raise interest rates during the third quarter.

Canada’s real GDP grew at a 3.9% annual rate during the first quarter. Investment was robust, but consumption was flat. Canadian firms are boosting their capital spending because they have enjoyed good profit growth and the strong Canadian dollar is lowering the cost of capital goods imports. The consumer pause reflects a high level of borrowing during recent years and a slowdown in the housing market. The Canadian central bank raised interest rates three times last year, but it is cautious at the current time despite rising commodity prices because of concern about the US economy. Exports to the US account for 17% of Canada’s GDP.

MANUFACTURING SECTOR LEADS SOUTH AFRICAN ECONOMY IN 2011

South Africa’s real GDP grew by 4.8% during the first quarter. The manufacturing sector led the economy with an output gain of 14.5%. The gains were broad-based, encompassing chemicals, iron and steel, non-ferrous metals, rubber and plastic products, machinery, and furniture. The mining and quarrying sector grew by only 1.8% compared to 17.1% during the fourth quarter of 2010 and 33.7% during the third quarter. The sector continues to be vulnerable to power shortages. The construction sector remained lackluster with no growth during the first quarter after a paltry 0.2% gain during the fourth quarter. Retail sales grew at a 5.6% rate during the first quarter compared to 7.6% during the fourth quarter. This sector should benefit from further gains of employment and wages. The housing market has recently experienced some gains in prices, but it is following a choppy path because of uncertainty about employment growth. The Reserve Bank has not yet talked about raising interest rates despite recent commodity price increases, but it could act late this year if the CPI inflation rate appears to be moving higher on a sustained basis. The Reserve Bank is projecting output growth of 3.6% this year.

POTENTIAL POLITICAL MEDDLING EMERGES IN LATIN AMERICA

The Latin American economies remained strong during the first quarter. Brazil’s growth rate remained robust at 5.2% because of investment and consumption. Peru’s real GDP grew 6.4% while Chile grew 5.2%. Mexico, however, grew at just a 2.1% rate in the first quarter. As a result of the recent correction of commodity prices, there is now concern about how a deterioration in the terms of trade could affect the Latin American economies. Oil, mining, and agriculture products account for 64.5% of exports in Argentina, 58.6% in Brazil, 68.4% in Chile, 75.7% in Colombia, 77.1% in Peru, and 98% in Venezuela. Only Mexico has an economy in which manufactured products account for over 82% of exports. The recent decline in commodity prices has been too modest to threaten Latin America’s outlook this year, but it will remain a vulnerability if there is a downturn in China or the US unexpectedly slides back into recession. Inflation has become a challenge for the central banks in the region. It is running at or above target in Brazil and Peru. It is hovering in the middle of the target band in Mexico, Chile, and Colombia. It is running at high levels without any central bank target in Argentina and Venezuela. Brazil appears likely to hike interest rates two more times. Peru and Chile will tighten again as well. Mexico appears to be on hold because of official perceptions there is slack in the economy and sudden concerns about the resilience of the US economy.

Brazil has announced plans to impose new trade barriers on auto parts and a variety of other products. The strong Brazilian real is boosting imports and putting pressure on the profit margins of Brazilian firms. Brazil overtook Germany last year as the fourth largest car market in the world. In 2010, Brazilian auto sales were 3.5 million, a 12% gain from 2009 and 140% from 2002. Brazil has over five hundred auto parts companies with total sales of $32 billion in 2009 and exports of $6.6 billion. Brazil’s imports of auto parts come from Germany (20%), Japan (14.5%), the US (12%), Argentina (10%), France (7%), Italy (7%), and China (5%). As the Brazilian real has appreciated by nearly 40% against the US dollar since 2009, domestic manufacturers have suffered from a loss of competitiveness. The Brazilian finance minister has talked about the danger of a currency war. It is not clear if Brazil’s new policies will be approved by the WTO, but they are a sign that exchange rates are a challenge for exporters in countries with appreciating currencies.

It appears that Ollanta Humala has won the Peruvian presidential election over Keiko Fujimori. Mr. Humala ran as an ally of Venezuela’s Hugo Chavez in the last election, but this time he tried to appear more moderate by saying his role model is Brazil’s Lula. He also won the endorsement of former President Alejandro Toledo after Mr. Toledo’s defeat in the first round of the election. Peru has recently enjoyed an economic boom because of growth in the mining sector, and there are a large number of projects still under development. Mr. Humala has said that he will raise taxes on mining companies, but not attempt to nationalize them. His victory reflects a traditional divide in Latin American economies. There can be a boom which enriches people in the urban centers, but leaves many rural people behind. Mr. Humala’s victory will be a blow to investor confidence in Peru, but if he pursues moderate policies, Peru still has the opportunity to enjoy a high growth rate.

Mr. Humala’s party, Gana Peru, has only 47 of the 130 seats in the congress. He could achieve a majority of sixty-eight votes by forming an alliance with the party of the former president Mr. Toledo. As Mr. Toledo endorsed Mr. Humala in the run-off election, it is possible to imagine a scenario in which Mr. Humala recruits former officials from the Toledo administration for key cabinet appointments. They would lessen the risk of Humala pursuing left-wing policies that would undermine the boom.

WHAT CAUSED THE RECENT COMMODITY PRICE CORRECTION?

The Chicago Mercantile Exchange punctured a rally in the silver price by hiking margin requirements five times in early May. The silver price collapsed and triggered a correction in many other commodity prices. The Brent oil price plummeted more than $16 per barrel to $109.13 after rising $8 per barrel in April. There were also corrections in the price of base metals and some agricultural commodities. As a result of the oil price increase since December, the International Energy Agency is now forecasting that global oil demand will increase by 1.5% this year to 89.2 million barrels per day compared to a 3.3% gain last year. OECD oil demand in March was 2.8% below levels one year ago while Asian demand led by China was 6.4% higher. Global oil supply has dipped to 87.45 million barrels per day (mb/d) as a result of lost output from Libya. Total OPEC output in April was 28.75 mb/d, or an estimated 1.3 mb/d below the January output level of 30.04 mb/d.

Saudi Arabia increased its oil output by 200,000 barrels per day in May, and appears prepared to increase it another 200,000-300,000 barrels per day in June, which would take its output above nine million barrels per day for the first time since 2008. The June OPEC meeting failed to reach an agreement on increasing output, but Saudi Arabia can still act unilaterally in order to lessen the upward pressure on oil prices. As a result of its large increase in social spending, it will probably target an oil price closer to $90 per barrel rather than the $70-$80 per barrel level which prevailed one year ago.

HOW LONG CAN THE US DOLLAR STAY THE DOMINANT RESERVE CURRENCY?

It appears that emerging market foreign exchange reserves increased by $100 billion during April. At the end of February, the world had $9.611 trillion of foreign exchange reserves. The developed countries had $1.986 trillion and the emerging market countries had $7.624 trillion. China had the largest reserves at just under $3 trillion. At the current rate of accumulation, global reserves could reach $11 trillion by early next year. According to IMF data, about 62% of reserves have been invested in the US dollar since mid-2009. The euro’s share at the end of 2010 was 26.3%. Emerging market central banks reduced their dollar purchases late last year and during early 2011 because of concern about the Fed’s quantitative easing program. They resumed buying dollars during April because of concern about exchange rate appreciation. The dollar will remain vulnerable to weakness because the Federal Reserve has clearly signaled that any change in its monetary policy is many months away while the European Central Bank could raise interest rates again in July. The recent weakness of US economic data will magnify market concerns about Federal Reserve policy while resolution of Greece’s debt problems could bolster confidence in the euro.

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©2011 David Hale Global Economics, Inc

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