Obviously, the discussion which we hope to initiate here comes in two phases. First, there is the question of whether or not the ECB should be considering QE at all? I am sure that there is plenty of people out there disagreeing with the sentiments expressed below. Secondly, there is then the issue of how exactly the ECB would conduct QE. Once again, I should warn you; this is a bugger and, at times, also somewhat technical.

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Most sports coaches - irrespective of whether they work in soccer, baseball, rugby or even American football - have playbooks; small books or pads filled with notes, decision rules and strategies for each and every possible situation they can envision. Of course, in some cases the playbooks are mental rather than physical, but every good coach lives and dies by his ability to adapt and react to new and changing situations and in order to do this effectively what he needs above all is a good playbook.

So what has all this waffle about football, baseball and whatever got to do with the ECB and how it should respond to the Eurozone's "fluid and evolving" economic and financial crisis? Well, the point surely would be that whatever playbook the ECB works with (and it is sometimes pretty hard to see clearly which one it actually is) they do not seem to have included a section on what to do when interest rates finally hit the zero bound (not this month evidently, but maybe, or possibly the one after....as Bank President Trichet said after today's decision to reduce the rate to 1.5%: “We didn’t decide ex-ante that this was the lowest point that we could attain” ). Nor do the ECB seem to have a page which explicitly handles the currently fashionable state of the art set of tools known collectively as quantitative easing. And this omission may, as the zero bound looms and outright deflation threatens, turn out to be a rather large and unfortunate one. The question is, what exactly are we going to do if (or even when) the Eurozone as a whole enters a deflationary rather than a disinflationary dynamic, and even more importantly, what happens if price movements fall into deflation mode and stay there?

 But before we get ahead of ourselves, let's go straight to the horses mouth (as it were), and take a brief look at what it is exactly the ECB has been doing all this time in order to alleviate the credit crunch and reverse that depressing cycle of decline and deterioration which currently seems to hold the Eurozone economies so tightly in its grip. Speaking at the European American Press Club on the 20^th of February ECB President Jean Claude Trichet laid out in some detail the considerable variety of measures the bank has been taking since the crisis broke out in August 2007. Reading through the text of the speech, one major detail immediately strikes the eye, and depending on your point of view the omission is a more or less disturbing one.

The fact of the matter is that at no point in his entire speech does the Central Bank President get to mention (not even once) the effects the crisis has been having on the real economy. His entire attention is focused on measures that the bank has been taking in order to ease the crunch by improving funding conditions in the interbank market, and in particular he enumerates in some considerable detail all the various classes of credit the ECB has been making available to Europe's banks. Now, you could argue that this absence is hardly surprising given that Trichet was not invited to give a talk about the state of the European economy, but rather about the steps the bank was taking to address the impact of the financial crisis and the credit crunch. But this would be precisely the point, since at the present moment in time the two are inextricably intertwined, with the credit crunch driving the real economy down, even as the rising unemployment this produces sends risk sentiment in the banking sector to ever lower levels.

This being said, the more disturbing part of the whole speech is the sense of complacency it conveys, with the impression being given that Trichet by and large believes the ECB has things nicely under control with a nominal interest rate (then) running at 2% and that despite the awkward hurdles which may still lie out there in front of us, no extraordinary measures are needed. If this is the case, maybe someone needs to pick up the phone and give the gentlemen in Frankfurt Ivory Tower a call suggesting they take a long hard look out of their window to see just what is happening in the world that lies beyond.

Possibly some may feel that the dichotomy being made here is a false one since the ECB always held that the measures it was taking to normalize conditions in the interbank market were also de-facto intended to cushion the effects of the credit crunch on the real economy. However, using this argument in the current situation is not only misleading, it is also dangerously complacent. Put in more prosaic fashion; this is all soo pre H2 2008.

The facts of the matter are all now pretty much unequivocal, and really speak for themselves (or at least they should do).

• In the first place the problem in the banking sector and the wholesale money markets was never really the main issue. This, undoubtedly real, problem was merely the outward and evident symptom of a much deeper structural problem concerning how the whole (global) economy needed to deleverage, and how the systemic character of the money market breakdown would ultimately require government and institutional intervention on a large scale.

• Secondly the crisis has now very much become an economic and not simply a financial one. We won't belabour the reader here with all the gory economic details which you are all already so familiar with, but we would like to stress that it is now pretty evident that the global economy is taking a hit on the scale that has not been seen since the first half of the last century, and most specifically, since the years of The Great Depression. So this is not a matter to take lightly, even if some economies are hit worse than others. We should also not fail to take notice of the fact that, despite many early assurances to the contrary, while the United States is certainly busily fighting its own private economic demons, the locus of the crisis has now slowly but surely moved in Europe's direction, first via the Southern and Eastern periphery and then entering into that very bastion of the Eurozone itself - the German economy.


• This is not either the time or the place to examine all the chain-links and mechanisms through which crisis transmission operates, but we should all be aware that the force of the blast we are taking at the present time is such that the very foundations of our common economic edifice - of the Eurozone and even the European Union - are now at risk. When the simple act of transferring deposits from bank accounts in one member state to those in another (in order to speculate on the future stability of a currency) becomes (and by some multiples) a potentially more profitable investment opportunity than building a factory and creating employment then the seeds of financial crisis are well and truly sown, and action needs to be taken to prevent the implicit peril coming to fruition. We simply don’t understand how anyone can deny that this problem exists at the present juncture, and that something needs to be badly and urgently done to secure the foundations of our edifice before the worst is, by omission, allowed to happen. The economies of the EU and, in particular of the eurozone, need to see the return of profitable investment opportunities as an alternative to idle speculation, and the ECB has a key role to play in this process, by returning price stability, by stimulating growth possibilities, and above all by encouraging a return of confidence to our somewhat battered and beaten economic system.

In order to address the rather urgent task which now faces us we should not, in principal, exclude the use of extraordinary action and recourse to what have come to be known as "unconventional tools" on the part of the ECB. Indeed in the difficult battle which now confronts us, no door should be closed, and no stone left unturned. Yet, all of this still remains on the level of "in principle" and in theory. Since despite all the evidence, indeed the facts on the ground speak for themselves, which strongly suggests that the Eurozone now faces not only a strong disinflation process but the advent of outright deflation (as defined by a sustained period of price declines in the core HICP index, see here and again here) we are still wallowing around in hypothetical discussions with no one actually prepared to strongly push for a very rapid biting of the most badly needed bullet. Furthermore, a new problem now presents itself, since the wreckage which is rapidly piling up in Eastern Europe risks destabilizing the whole system through the deep financial linkages which exist between the banking system in the Eastern countries and those very Western banks which have already been beaten to pulp by equity losses and debt defaults in one corner of the globe after another.

Indeed, some of us would claim that once the wheels of the present train crash were set in motion a year or so ago it was not particularly difficult to see that the lions share of the problem would end up in Southern and Eastern Europe, and in this fashion would arrive beating and hammering at the doors of the ECB in the form of both a severe Eurozone recession and a near-systemic collapse in the economies of Eastern Europe. If there was a danger of a repeat of the 1990s Asian style contagion anywhere it was always going to be in Emerging Europe, as the Bank for International Settlements and those much maligned ratings agencies never ceased to point out.

However, if we come to look at the responses to date from the ECB, we find that these have in no way been either as drastic or as urgent as those initiated by counterparts like the Bank of Japan and the US Federal Reserve (or even, come to that, by the Bank of England and the Swedish Riksbank). In fact, far from reacting rapidly and vigorously, ECB council members have repeatedly voiced concerns about the dangers of letting interest rates drop too low too quickly, and even warned of the dangers of reproducing yet more bubbles. This "conjuring of demons" seems to us to be soo terribly Japan in the 1990s-ish.

In fact the whole crisis reponse and reaction process seems to have revealed more a feeling of confusion and disarray, than one of order and "everything under control". Back in December 2008, the councils self-proclaimed hawk, Axel Weber, was busy worrying us all with his discovery of the "horrifying fact" that lowering interest rates below 2% would have implied the application of negative real interest rates (citing the fact that inflation expectations at that point for the medium-to-short term were themselves hovering at around 2%. He seemed to be blissfully unaware that with economies like the German and Spanish ones registering annual contraction rates in the 5% region, negative interest rates might be just the recipe the doctor was ordering. Just over a month ago Greek council member George Provopoulos added his voice to the chorus, cautioning that there was only limited scope for further rate cuts (towards 1%), citing among other reasons his expectation that the Eurozone economy would begin to recover by the time we reached 2010. Specifically, he noted that while there was room for interest rates to go lower if the economy and inflation expectations were to deteriorate further, this would in no case imply a move towards 0%.

This view was reiterated some weeks later by Luxembourg's representative on the Council, Yves Mersch, when he stated that he was completely opposed to the idea of the ECB adopting a Japanese (or US) type policy of ZIRP (zero interest rates). The reasons normally cited for such continued caution were what one might call the "usual suspects" - namely that while inflation was expected to reach very low levels due to the drop in energy prices it would subsequently rebound in late 2009 (due to the so-called base effects), or that the economic outlook in the Eurozone was fundamentally different that in Japan and the US where the respective central banks had gone much further in the direction of aggressive monetary policy.

Most ECB watchers view the continuing cautious stance over on Kaiserstrasse with a growing sense of unease and bewilderment. In light of the daily slew of incoming bad news it has seemed pretty odd (to say the least) for the ECB to maintain its focus on measures which were clearly lagging the pace of economic development rather than trying to get out in front of the problem and head it off. In fairness, it does now seem that some members at least of the Governing Council may belatedly be moving closer to a recognition of the full scale of what we are up against. Recently, council member Guy Quaden pointed out that it was perfectly possible for the ECB to lower rates well beyond 2% and that, in his view, there were no taboos whatsoever. Such statements certainly constitute a starting point, but still perpetually create the feeling of "too little too late", and in fact have done little to persuade financial markets that the ECB is actually in control of the situation.

This problem was further highlighted at the February meeting when rates were kept on hold and where Trichet, in his usual charming manner, simply noted that ZIRP (and thus QE) had several inappropriate drawbacks, although he did not see fit (at that point) to go further, and elaborate on what he thought these were. The markets responded as might have been expected to such obfuscation, and the yield on two year German bunds was pushed to its lowest level since 1997. Symptomatic of the then prevailing "zeitgeist" was the statement of Austrian council member Ewald Nowotny to the FT that the ECB would not move into ZIRP as this would imply negative real interest rates, apparently not understanding that this may well be precisely what we needed given the strength of the contraction.

As BNP Paribas's senior economist in London, Ken Wattret, said at the time:

“We’re desperately spinning around to get a proper handle on the issue,” (...) “The worst-case scenario is that the ECB is hoping they don’t need to do things like this because the economy will pick up again. If that’s plan A, then that’s rather disturbing.”

Part of the problem here, of course and as ever, is that there is far from unanimity on the ECB Governing Council. With the stream of council members lining up to give their own personal views to Bloomberg in recent weeks, one might easily be let to utter that famous "would the real spokesperson for the ECB now stand up"! The latest "dissenter" in the long line who have been queuing up to expound on their "nuanced view" was Athanasios Orphanides, Governor of the Bank of Cyprus, who in a speech the 28th of January made plain his opinion that:

The suggestion that monetary policy becomes ineffective when rates are close to zero is a “dangerous” fallacy.

That this sounds vaguely reminiscent of the message which has long been coming across from the other side of the pond should not surprise us too much, since as Bloomberg reporter Ben Sils has pointed out, he is in fact a former Federal Reserve economist (who made a name for himself, apparently, by telling his superiors they were wrong, go to it Athanasios). Sils suggests that events are now moving rapidly on the Council (although not that rapidly, judging by this week's outcome), and that Orphanides might actually be the one emerging with the upper hand in the near term. And don't for a minute believe Orphanides is merely doing a bit of headline grabbing. There is a real theoretical argument behind his position, one which he, himself, elaborates in this paper which discusses how, in a deflationary situation, the central bank should attempt to steer expectations towards inflation by "promising" very low interest rates for an extended period of time. (For some considerably more wonkish material on all this, try the Lars E. O. Svensson paper from 2001 or Gauti Eggertsson and Jonathan D. Ostry's IMF paper on the importance of communicating clearly when you want to make a "credible threat of irresponsibility").

What are Others Doing Then?

With the ECB being so cautious and unsure about whether or not to engage in what has now become known as Quantitative Easing (QE to its friends, for a pretty detailed discussion of QE in Japan and the US try this post here) why don't we take a look and see just what the rest of them are doing.

Morgan Stanley's Stephen Jen had a very useful piece on the Federal Reserves' entry into QE in late November 2008. In the first place it is important to note that QE comes in two stages (although these will now need to be collapsed into one here in Europe given the looming deflation threat). The first stage is to attack the credit crunch, and when that attack fails (as it evidently has done, virtually everywhere) the second stage is to try to halt the slide into outright price (and then debt) deflation. In fact, for some time we have been operating a kind of modified version of QE in the Eurozone (without, of course, the presence of the "lower bound") based on a division of labour between the bank (which has ballooned its balance sheet in order to provide short term liquidity to the banking sector) and the national governments who (following the Paris meeting of October 12) have worked on the fiscal side with initiatives to try and move credit by guaranteeing bank loans or buying commercial paper. Now we are about to move into the second stage, which involves first and foremost trying to "steer" inflation expectations. According to Jen there are three key elements in any comprehensive system of QE.

• Communication policy is vital, in order to steer expectations and in particular in convincing market participants that short term interest rates will be held low for a prolonged period of time, even as governments print money on the fiscal side, and even at the risk of "monetising" the growing debt. The point here, naturally, is to try to thrust rather than jolt inflation expectations strongly into positive territory. Judging by all the yelps of pain we are hearing from US market participants about looming inflation Bernanke seems to be having some success here (at least for the moment), and it is a pity we are not able to say something similar about their European equivalents, who, it seems to us, are gradually being steered towards reluctantly accepting either deflation, or at the least very low inflation, as now more or less inevitable.


• The central bank can also increase the size of its balance sheet, and this is a tool that the Fed has been using extensively in an attempt to increase the money supply. For a visual illustration of the process, check out this graph . As for the mechanics, this piece by John Kemp is a good starting point. One significant way in which this can work is, as Kemp notes, by matching increased lending to financial institutions with an increase in deposits these same financial institutions hold with the Fed (a bit wonkish, but still).


• A central bank can also alter the composition of its balance sheet by purchasing securities in an attempt to directly affect the prices of financial assets. This measure is of course intimately connected with the previous point, since without the former there is no great likelihood that the latter will work. In fact, the ECB has already doing something like this for some time now, since it is not at all clear just how many of those assets currently parked over in Frankfurt (and which have been exchanged for liquidity) will ever actually get to leave again. In a general sense, there also seems to have been a rather radical change with respect to the kind of assets the central banks have been willing to accept as collateral for liquidity.

One of the basic cornerstones of QE that has so far been implemented both at the Federal Reserve and at the BOJ has been the aggressive expansion in the purchase of unconventional securities. This could for example be corporate debt as well as, in the US' case, agency and mortgage-backed securities (together with a veritable myriad of other assets). All of this marks a considerable evolution of the "traditional" QE measures (as practised during an earlier period in Japan) whereby the central bank engages in heavy purchasing of t-bills in order to "manage" the yield curve on the short end and thus allow the government to conduct fiscal expansion at lower cost. Effectively, what we have at the Fed and the BoJ is both an asset and a liability approach where the former takes the form of the central bank accepting the purchase of an ever broader range of assets while the latter takes the form of expanding excess reserves held by banks at positive interest rates.

So, What should and could the ECB do?

Well the answer to this question clearly depends on where you think the Eurozone's real economy is at right now. In particular, if you are willing to entertain the idea that the bank needs to bring interest rates near to zero and start operating a more aggressive version of QE then you also need to buy the idea that there is a significant and impending risk of deflation in the Eurozone. Basically, M. Trichet's recent comments to the effect that there is no present danger of deflation in the Eurozone seem to fly in the face of everything we have on the table in terms of economic data, and that we are still a long way from doing the necessary.

However, and in fairness to their point of view, we might start by taking a look at the various reasons which have been offered attempting to argue why it would be inappropriate for the ECB to engage in QE and why some continue to argue that the risk of inflation is still imminent. In order to get to grips with such arguments there is, of course, no better route than by listening to the ECB itself, but since its council members all too often simply offer us their own highly distinct form of newspeak, the following pieces (one by Robert Ophèle Deputy Director at La Banque de France, the other from Sylvester Eijffinger, professor at Tilburg University) are quite useful.

Ophèle rightly tries to highlight the distinction between deflation and disinflation, pointing to the fact that what we are currently experiencing is the latter and not the former. Judging by the recent data it is not certain that this view is entirely correct, but he does highlight an important issue in the sense that the key question here is the extent to which one expects rapid disinflation to turn into deflation.

Ophèle uses two arguments in defence of the idea that what we may currently be experiencing is disinflation and not deflation. The first is the fact that the current sharp drop in price levels mainly comes from energy and food prices, and are thus largely giving back the price gains that were so instrumental in driving global monetary policy only a year ago. The second is a much trickier issue, and concerns the degree to which nominal wage rigidity may actually be a virtue in the context of disinflation since it acts as a structural hedge against a collapse into deflation.

This is an extraordinarily powerful and, as it were, convenient argument for those who would defend the current posture of the ECB. In this context it is perhaps worth going back to all those endless disquisitions we were subjected to about the potential for those horrid second round effects as energy prices shot up ever higher and one might thus assume the argument to be a symmetrical one now that energy prices are dropping sharply. However, the presence of nominal wage and general core price ridigity might mean that wages and prices are not sent on a downward spiral by the negative energy proce shock and if one expects the downtrend in energy prices to be merely temporary then, arguably, the monetary stance should not be changed on this account alone.

However this argument may not be entirely valid in the current context. Firstly, it should by now be pretty obvious to everyone that the current correction will have to be deflationary in its consequences those economies in the Eurozone who have accumulated sizeable imbalances over the last eight years. This would then exactly suggest that whatever the trend in energy prices it is the forward looking trend in the core price index we should be looking at. However, Ophèle has an argument ready to hand even in this case:

We should recall that deflation is not possible while households and enterprises continue to expect price rises. This is incontrovertibly the case at the moment. Business surveys, measures derived from market rates, and forecasting experts surveyed by the ECB all point to five-year inflation expectations remaining anchored around 2% for the euro area as a whole.

Shall we run that one by again: deflation is not possible as long as inflation expectations remain positive? This is evidently wrong, since it is basically circular (since prices can't deflate because households don't expect them to, and households don't expect them to because they are running at x% a year), and it does serve to highlight the care one needs to take when interpreting those dreaded (rational?) expectations models. Basically, just because one expects inflation does not mean that you are going to get it and furthermore, expectations may change over time. It is a question here of which is the leading indicator and which the lagging one. There is much more evidence to support the idea that strong inflation expectations may, in some circumstances, be self fulfilling and fuel future price increases, than there is to support the idea that people always and everywhere don't get deflation because they are expecting inflation. That is, there is a certain asymmetry in the situation. During rapid economic contractions, where excess capacity tends to lead to sharp and unanticipated price reductions, it is far more plausible that expectations follow prices downwards, and this is what we suspect is happening now.

As ever when we have this discussion of expectations the time horizon is the problem. Ophèle is talking about 5 years horizons, and these implicitly embody a high level of uncertainty, especially in an environment like the current one. Quite simply, the key problem for the Eurozone is to keep the edifice together over the next 6 months, not to quibble over some kind of perceived steady state five years from now, and it is this much shorter time perspective which should be in the forefront of ECB thinking right now.

Turning to the case made by Sylvester Eijffinger, an even stronger argument is fielded against the deflation risk in the Eurozone since he not only believes the risk of deflation is slight, he actually thinks the risk of inflation is much higher than that of deflation. Like Ophèle, Eijffinger initially points towards the structural aspects of wage rigidity citing as authority European Union economy and Finance Commissioner Joaquim Almunia who has also advanced the idea that nominal downward wage and price rigidity constitutes a strong line of defense against deflation. This argument would seem to us to be a self defeating one, since if it is valid the future of countries liike Spain, Ireland and Greece within the Eurozone must come under an immediate question mark, since without such downward corrections it is impossible to see how they can ever hope to achieve the competitiveness their economies need in order to grow again. Further, it sees to us to be much more plausible that downward wage rigidity may be much more an issue than downward price rigidity, which means quite simply that as prices fall unemployment simply rises and rises as the recession deepens. In other words the difficulty people have in reducing wages simply means those very same people get sent home rather than working, and thew consequent drop in demand only serves accelerate deflation rather than avoid it. That it, this kind of argument, in a major recession like the one we have now, is totally and thoroughly false.

Basically, the whole problem here boils down to the tricky question of implementing a common monetary policy in the absence of a coordinated fiscal policy not to mention a unified treasury. In this sense and while it is straightforward to see that the Fed should buy US treasuries to conduct QE it is not entirely clear what exactly the ECB either can or should do. For one thing, it is strictly forbidden according to the ECB's own rules for the bank to enter the primary market to directly purchase securities (read print money) in order to finance fiscal deficits in any member country. Moreover, and if we assume that this small niggle could be dealt with; whose bonds should the ECB buy and how many from each country?

But what if, instead of directly purchasing individual country bonds the bank were to purchase EU bonds explicitly created for the purpose, and what if the produce of the same of those bonds were to be deployed by the commission across the Union to fulfil pre agreed objectives. But wouldn't those bonds be inflationary in their consequence? Of course, we would answer, that is precisely the objective.

Time to Add More Pages to the Playbook?

We realize that this has been somewhat of a whopper of a blog post and if you have made it this far then congratulations, since you obviously have a good deal more stamina than most. Our argument is fairly modest in its aims, since we are absolutely clear at this point that we do not have all the answers. What we have tried to do here is simply draw an initial tentative sketch of what the ECB might do to move forward towards a process of quantitative easing and we have offered some suggestions about how to do this. Clearly, not everyone will be ready to agree with the initial premise that the ECB should consider QE at all. Looking at the incoming data however this move does seem to be increasingly becoming a foregone conclusion even if the ECB itself is not ready to entertain the idea. As such we hope the ideas here expressed may contribute to a wider ongoing debate about what to do about Europe's present economic and financial crisis, and what kind of measures and tools we have available to deal with it.

Unfortunately, the ECB, and most recently and specifically bank President Jean-Claude Trichet, have been ardently defending a viewpoint based on the non-existence of deflation risk. Today's, decision to cut interest rates by 50 basis points constitutes nothing more than the expected (not even surprising us with a bold move down to 1%) and this on a day when the BoE seems to have accepted the severity of the UK situation as it bit the bullet and moved itself over to QE. We are not arguing here that the ECB should turn itself into some sort of a rubber stamping clone following blindly along a path laid down by its peers, but rather, that the ECB decision makers should reflect very carefully about the arguments which have lead others along the QE path, since quite frankly, at this point in time the ECBs "originality" is beginning to turn into a liability rather than an asset, and one really has to wonder just how much credibility the institution will have left as and when it really decides to jolt itself back into action. In particular, if it has through either inaction or negligence lead the countries in its charge into a negative deflation cycle, will it still have the credibility left to convince market participants that it has the ability to lead us back out of the mire, into the inflation and into the sun.

And now we have the third wave of opposition to open society. It is coming from quasi-totalitarian countries such as Venezuela, Nigeria, Saudi Arabia, Iran, Libya and Russia. They are so wealthy from oil and gas exports that their leaders don't have to worry too much about making good or wise decisions. Like the Melanesian priests, these quasi-totalitarian leaders claim that they -- and not the cursed white people of the West -- have real freedom and a true understanding of peace. And since these regimes are swimming in petrodollars, their leaders make speeches about "true freedoms" while wearing expensive suits that are designed, manufactured and tailored in the West. You won't see them addressing the nation standing barefoot in the sand under a banana tree. In contrast to outright totalitarian regimes, the quasi-totalitarian regimes do not pose a real danger to the free world. That is why nobody worries much if one of their presidents gives an inflammatory speech about deploying Iskander missiles in Kaliningrad. After all, who believes that the leaders of these regimes would ever launch a missile attack against a Western nation in which their luxurious villas and bank accounts are located? Nonetheless, I hope that quasi-totalitarian regimes won't last forever. And I also hope one day to hear a speech by a Russian version of Obama -- a president chosen by the people who will speak the real truth about freedom in our country.

Don’t expect oil prices to remain at these low levels for long, says Byron King. Demand weakness for crude is temporary. And oil-producing nations cannot sustain their own economies unless oil prices are close to $100 a barrel. Byron says it could be time for investors to slowly build up a position in oil service stocks.

This from Whiskey & Gunpowder:

Along with the market decline, the price of oil has fallen. It’s down 50% within three months. Back when oil hit $147 per barrel in July, I said that the price “ought” to be in the range of $100-110, with the possibility of a drop into the $90s. That’s what the fundamentals told me back then.

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Investors remained wary of emerging-market debt as evidence mounted that most of the major major economies - the U.S., the UK, Japan and the Eurozone - are sliding into recession. This realisation has triggered a major exit from commodities, which are a significant source of export revenue for a large number of developing nations. In particular bonds extended losses on the perception that the $700 billion U.S. bank bailout would not work miracles and thus many developed economies will be struggling to digest the impact of the credit blow-out for some time to come.


Until credibility is restored, we will not see people investing in the numbers that emerging economies like India and Brazil badly need to see. But at the same time, we might ask ourselves, at theis moment in time if they don't invest in India and Brazil, then where are they going to invest? The problem is that in the present global environment people are not simply not willing to take assume what is perceived as "risky" without being paid a large - and from the emerging economy point of view - damaging premium. Of course, the situation is also confused since people are no longer clear what constitutes "risky" and what doesn't - the German government, for example, yesterday found itself forced to offer a blanket guarantee of all domestic bank deposits to head off any risk of flight from German bank accounts.

One result of all this nervousness is that the cost of protecting developing nations' bonds against default has been steadily rising. Five-year credit-default swaps based on Argentina's debt climbed 44 basis points to 12.55 percentage points last week, the highest since at least June 2005. That means it costs $1.255 million to protect $10 million of the country's debt from default. Credit-default swaps, contracts conceived to protect bondholders against default, pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements.


Emerging Market Stocks

Emerging-market stocks also fell substantially last week, experiencing their the biggest weekly decline in seven years, led by the banks and energy companies. The MSCI Emerging Markets Index dropped 2.3 percent on Friday to 741.73, following a 3.4 percent decline on Thursday. The index lost 10 percent on theweek, the most since the September 2001 terrorist attacks.


Turkey's benchmark index fell the most in three weeks, losing 4.2 percent to 34,553 in the first trading day since Sept. 29. Russia's Micex Index slumped 5.3 percent, extending its annual loss to 51 percent. India's Sensex index slid 4.1 percent to 12,526.32. Reliance Industries Ltd., India's biggest company by market value, slumped 7.6 percent, to its lowest in a year.

Inflation Falls

But while India's financial system has been taking a beating, Indian inflation, almost un-noticed -slipped back to a 13-week low in late September, giving the central bank some breathing space to keep interest rates unchanged and lossen the liquidity strings when it next meets at the end of this month. Wholesale prices rose 11.99 percent in the week to Sept. 20 from a year earlier after gaining 12.14 percent in the previous week, the commerce ministry said in a statement in New Delhi on Thursday.



Reserve Bank of India Governor Duvvuri Subbarao is under pressure to boost money supply as a local stock sell-off triggered by the global credit crunch has drained funds from the banking system, increasing borrowing costs. Subbarao will undoubtedly seek to steer a middle course, since, given that inflation is still double the central bank's target he will not want to seem to be "soft", while on the other hand he will want to be prudent and will try to head off an excessively rapid credit tightening on the back of the global crunch. In addition, the peak of global inflation has now undoubtedly past, and we are now likely to see growing deflationary (rather than inflationary) headwinds as capacity levels exceed demand across the whole global economy and commodity prices tumble, as Claus Vistesen explains in this excellent and timely post.

The Indian central bank had been busy tightening, and had raised the cash reserve ratio, or the proportion of deposits that lenders maintain with it as reserves, by 400 basis points to 9 percent during the period between December 2006 and July 2008 in an ongoing battle to contain inflation. The bank will make the outcome of its next meeting in Mumbai known on Oct. 24, but we can be pretty sure that the "bias" will now have shifted towards loosening liquidity conditions rather than tightening them, as the priorities have changed, and the big priority now is to avoid any systemic bank problems, to keep the cost of borrowing for Indian companies down, and to prevent consumer credit slowing too dramatically.

The Indian banking system has been under increasing strain in recent days, and one symptom of this is that the rate at which Indian banks lend to each other reached an 18-month high of 17.5 percent on Oct. 1. Indian banks borrowed an average 413 billion rupees a day from the central bank in September, almost twice the amount in August, further indicating a shortage of funds in the banking system.


Commodities Down

Commodities, as measured by the Reuters/Jefferies CRB Index of 19 raw materials, tumbled 9.9 percent last week, the most since at least 1956.

Crude oil has lost 12 percent during the week, the most since 2004. The contract for November delivery traded at $94.47 a barrel, up 0.5 percent, as of 12:11 p.m. London time. Copper fell as much as 3.1 percent to $5,670 a ton on the London Metal Exchange, the lowest since February 2007 and was down 12% on the week.

Such downward movement in commodity prices has a double-edged impact on emerging economies. On the one hand inflation, which has in large part been driven up by rising commodity prices, will reduce significantly, but on the other hand many emerging economies are dependent on revenue from commodity sales to finance growth and development. Really this is a situation which will sort the "men" from the "boys", since those emerging economies which are really going to emerge will be in a position to switch the driving force of growth from commodity and agricultural dependence to industrialisation and domestic investment and consumer demand. It is my firm belief that India is now decidedly inside the group which is in the process of making this transition.


Stocks Down

Indian stocks fell during the week, with the benchmark Sensex stock index declining to its lowest in 18 months. The Bombay Stock Exchange's Sensitive Index, dropped 529.35, or 4.1 percent, to 12,526.32, its lowest since April 2, 2007. The index posted its second weekly decline, falling 4.4 percent. The S&P CNX Nifty Index on the National Stock Exchange fell 3.4 percent to 3,818.30. The BSE 200 Index declined 3.8 percent to 1,515.29. Nifty futures for October delivery fell 2.9 percent to 3,853.


Overseas investors bought a net 845 billion rupees ($18 million) of Indian stocks on Sept. 30, trimming their net outflow this year from equities to $9.1 billion, the nation's stock market regulator said.


Forex Reserves

India's foreign exchange reserves fell marginally by USD 153 million to USD 291.819billion for the week ended September 26 from USD 291.972 billion in the previous week. Reserves had jumped by USD 2.511 billion in the previous week. Foreign currency assets (FCA), during the week, dropped to USD 282.652 billion from USD 282.811 billion a week ago, according to data issued by the RBI on Friday.

Rupee

India's rupee slumped to the lowest since 2003, adding to speculation investors will take continue taking money out of the currency. The currency completed its eighth weekly loss, the longest drop since December 2005. The rupee was down 1 percent on the day to 47.085 per dollar, the lowest since June 2003, as of the 5 p.m. close in Mumbai on Friday. The currency lost 1.15 percent this week.

September Global Manufacturing PMI Shows Sharp Contraction

September seems to have been the ultimate "mensis horribilis" for industrial output internationally - and thus it is only natural to assume that Indian industry was also adversly affected - with global manufacturing activity contracting for the fourth consecutive month, and output falling to its weakest level in over seven years according to the JP Morgan Global Manufacturing PMI, which at 44.2 hit its strongest rate of contraction since November 2001, down from 48.6 in August (Please see the end of this post for some information about countries included and the JP Morgan methodology).


According to the JP Morgan report the retrenchment of the manufacturing sector mainly reflected marked deteriorations in the trends for production, new orders and employment. The declines in output and new work received were the second most severe in the survey history, while staffing levels fell at the fastest pace for over six-and-a-half years. The Global Manufacturing Output Index registered 42.7 in September, well below the 48.5 posted for August.

The sharpest decline in production was recorded for Spain, followed by the US, Japan and then the UK. Although the Eurozone Output Index sank to its second-lowest reading in the survey history, it was above the global average for the first time in four months. Within the euro area, France and Spain saw output fall at survey record rates, while in Italy and Ireland the contractions were the second and third most marked in their respective series. Germany, which until recently was the main growth engine of the Eurozone, saw production fall for the second month running and to the greatest extent for six years. Manufacturing activity in Japan fell to the lowest in over 6- years with the Nomura/JMMA Japan Purchasing Managers Index declining to a seasonally adjusted 44.3 in September from 46.9 in August.

At 40.8 in September, the Global Manufacturing New Orders Index posted a reading well below the neutral 50.0 mark. JP Morgan noted that the trends in new work received were especially weak in Spain, the UK, France and the US, with the all bar the latter seeing new orders fall at a series record pace (for the US it was the strongest drop since January 2001). The downturn of the sector led to further job losses in September, with the rate of reduction in employment the fastest since February 2002. Conditions in the Spanish, the UK and the US manufacturing labour markets were especially weak.

Russian manufacturing shrank for a second month in September, and in so doing registered its first back-to-back contraction since November 1998, as companies cut jobs and growth in new orders slowed, according to the latest VTB Bank Europe Purchasing Managers Report. The PMI came in at a seasonally adjusted 49.8, compared with 49.4 in August. The August reading was the lowest figure in three and a half years, according to the bank statement. On such indexes a figure above 50 indicates growth while one below 50 indicates a contraction.

Manufacturing in China contracted for a second month in August, underscoring the risk of a slump in the world's fourth-biggest economy. The Purchasing Managers' Index was a seasonally adjusted 48.4, unchanged from July, the China Federation of Logistics and Purchasing said today in an e-mailed statement.




Brazil's industrial output fell a seasonally-adjusted 1.3 percent in August, the largest monthly drop this year, bolstering expectations the central bank will ease monetary tightening in response to slowing economic growth. On an annual basis, output rose 2 percent, the slowest pace since March, according to data from the national statistics agency in Rio de Janeiro.

And the situation seems to have deteriorated further in August, since the headline seasonally adjusted Banco Real Purchasing Managers’ Index (PMI) registered a 25-month low of 50.4, down from 51.1 in August.

So basically this is where we get to learn what a global credit crunch means in terms of output and economic growth.

India's Industrial Output Weakens Too

India's industrial output growth bounced back again in July (the last month for which we have official data), reaching a five-month year on year expansion rate high of 7.1%. This follows a noted slowdown where output only rose by 5.4 percent gain in June, and 4.1% in May, according to data from the Central Statistical Organisation.


But if we come to look at the manufacturing PMI we will see that India's manufacturing output has also slowed somewhat, and expanded at its slowest pace in 14 months in September according to the ABN AMRO Bank purchasing managers' index. The PMI reading - which is based on a survey of 500 companies operating in India - fell to a seasonally adjusted 57.3 in September from 57.9 in August. This reading was the lowest since July 2007. Still 57.3 still suggests Indian industry continues to grow quite vigoursly, although the report did highlight the fact that the drop in the index was mainly the result of a decline in growth of new orders, and implied a deterioration in demand conditions, both locally as well as in export markets.


Current Account and Trade Deficit

The Rupee has also been dropping in reaction to India's deteriorating current account situation. The current account deficit rocketed to $10.7 billion in the three months from April to June, up from a $1.04 billion gap in the previous quarter,according to data from the Reserve Bank of India last week.

India's trade deficit almost doubled to a record in August as a surge in crude oil prices increased the import bill and overseas sales of goods slowed. The trade deficit widened to $13.9 billion from $7.2 billion a year earlier, according to data from the Ministry of Commerce and Industry. Imports grew 51 percent, the fastest gain in seven months, to $29.9 billion, while exports expanded 27 percent to $16 billion.

A near doubling of oil prices has boosted import costs, since India relies on overseas purchases for three-quarters of its energy needs. India paid an average $8 billion a month this year for oil imports, up from $5.5 billion in 2007, as crude oil costs surged to a record $147 a barrel on July 11. In India's case the 35 percent drop in oil prices we have seen since July has been partially offset by the decline in the rupee to a five-year low.

India's oil imports in August rose 77 percent to $10.9 billion as refiners paid more for crude oil purchased overseas. Non-oil imports gained 40 percent to $18.9 billion. Imports in the five months ended August 31 rose 38 percent to $130.3 billion from $94.6 billion a year ago. That took the trade deficit to $49.2 billion, compared with $34.5 billion in the same period a year earlier. Overseas sales of Indian goods in the five months to August 31 grew 35 percent to $81.2 billion, compared with $60.1 billion, the statement said.

India and Brazil Critical Weathervanes

What I have been arguing in this post is not that everything about India's economy is perfect - far from it, but neither is it the "perfect storm" disaster which current knee jerk reactions among international investors would seem to suggest. The problems which are hitting the Indian economy at the moment, from the rapid rise in inflation to the sudden withdrawal of sentiment have a common origin: the dynamics of the global economy, and it is to these we must now look if we are to be able to sort the wood from the trees about what happens next. Basically, when the dust settles, I think it will be apparent that there are few economies left sufficiently well standing (not Russia certainly, and probably not China, given the export dependence on the developed economies) and with sufficient energy to bounce back. Many may be sceptical that Brazil and India are going to lead the coming charge (this recession cannot, after all, last forever), but I ask you, if it isn't Brazil and India, who is it going to be?

JP Morgan Global Manufacturing PMI Methodology


The Global Report on Manufacturing is compiled by Markit Economics based on the results of surveys covering over 7,500 purchasing executives in 26 countries. Together these countries account for an estimated 83% of global manufacturing output. Questions are asked about real events and are not opinion based. Data are presented in the form of diffusion indices, where an index reading above 50.0 indicates an increase in the variable since the previous month and below 50.0 a decrease.

The countries included are listed below by size of global GDP share, and the figures in brackets are the % og global GDP in each case (World Bank Data).

United States (30.5), Eurozone (18.7), Japan (13.9), Germany (5.6), China (4.9),United Kingdom (4.5), France (4.0), Italy (3.2), Spain(1.9), Brazil (1.9),India (1.7), Australia (1.3), Netherlands (1.1), Russia (0.9), Switzerland (0.7), Turkey (0.7), Austria (0.6), Poland (0.5), Denmark (0.5), South Africa (0.4), Greece (0.4), Israel (0.3), Ireland (0.3), Singapore (0.3), Czech Republic (0.2), New Zealand (0.2), Hungary 0.2.

For example, AIG (AIG) is paying a very steep interest rate for its bridge loan and for the privileged taxpayers who get most of the equity in the firm. However, the decision was made that they had to get ahead of the whole problem and deal with it on a systemic basis after the markets started to seriously unravel.

The credit market comes to a screeching halt.  So a week before Congress is set to adjourn, he recognizes the crisis and comes out with a bare-bones proposal (2 ½ pages), which pretty much says, "Give me $700 billion to buy just about any asset from anybody I choose, at any price I choose (assuming the seller is willing) and then sell it off to anybody I choose at any price I choose.  Oh and there shall be no oversight of this by any other agency or court of law." 

Congress is outraged and the public is overwhelmingly against the proposal.  Chris Dodd makes very substantial revisions to the plan, including lots of oversight proposals, equity participation for the taxpayers for firms that participate in the program, caps on CEO pay to ensure that the capital being supplied to these institutions is not siphoned off to their bank accounts, and doing the deal in installments so Congress has a chance to evaluate how things are going before the whole wad is blown.  The Administration was very receptive to most of these changes, and it looked like a bi-partisan agreement was about to be reached.  Within the first hour of the first Senate Hearing it was clear that the Paulson plan was dead and the discussion was really about the Dodd Plan. 

The Dodd plan was far from perfect.  It looked like the deal was going to leave out changes to the bankruptcy law that would allow homeowners some relief if they were willing to go through the very onerous procedure of declaring bankruptcy.  It was also flawed in that it overly focused on addressing the problem of too much leverage from the asset side of the equation rather than the equity side. 

However, it is clear that something had to be done.  There was a meeting at the White House to try to hammer out some of the final details.  The meeting quickly broke down after the head of the House GOP, John Boehner, announces that he is going to oppose the deal, and at the last minute drops a brand new proposal on the table.  These proposals were not mentioned at all in any of the hearings that have been going on this week.  The Boehner plan, as best I understand it, calls for the elimination of even more regulations, cutting capital gains taxes and insuring these assets rather than buying them. 

We got into this mess because of a lack of regulation.  Insurance is available on these assets privately in the form of the ABX indices.  They are one of the canaries in the coal mines that have been warning about the problem.  The cost to insure has gone through the roof as risks have risen. 

Hank Paulson is right on this -- the Boehner plan will not work.  We need to act quickly and we need to get it right.  Congress needs to be kept in session to hammer out a plan, and it should be based on modifying the existing Dodd plan, most notable by directing more of the money into the equity side of the equation.  The House GOP has just made sure that nothing will be done soon. 

The end of the quarter is coming up, and that will allow people to withdraw cash from hedge funds, causing them to have to sell and deleverage.  That has been exacerbated since in the middle of all this, the SEC has made the fundamental investment strategy of almost every "true hedge fund" illegal by banning short-selling.  After all, they are called hedge funds because they hedge overall market risk by buying some stocks and selling short others.

The market is going to tank today, but do not try to bottom-fish it.  Right now, TIPS look like a safe place to hide.  High grade Muni bonds look good, but make sure that the credit rating is based on the underlying credit, not because it is insured -- insurers MBIA (MBI) and Ambac (ABK) could be strained further.  On a tax-adjusted basis they look very cheap. 

On the equity side, look at the gold miners.  There is a very good chance that the only card left to play is monetization of debt by the Fed, which will lead to much higher inflation.  Gold miners like Barrick Gold (ABX), Harmony Gold (HMY) Kinross Gold (KGC) and Newmont Mining (NEM) would be the natural beneficiaries of this.

Read the full analyst report on MBI

Read the full analyst report on ABK

Read the full analyst report on ABX

Read the full analyst report on HMY

Read the full analyst report on KGC

Read the full analyst report on NEM

The Russian government’s reluctance to occupy Tbilisi shows that there is still a debate going on in Moscow about how much international opprobrium the country can afford. Half a trillion dollars was wiped off the value of the Moscow stock exchange in the aftermath of the invasion of Georgia. The wealthy, Kremlin-connected elite would like to retain the privilege of having bank accounts in Switzerland, houses in London and tanks in neighbouring countries. It should not be too hard to suggest that there is a choice to be made. A crackdown on visas for Russian businessmen would be a good signal.