AMERICAN FUTURE

“Those who do not remember the past are condemned to repeat it.”

– George Santayana

Few quotes are more frequently mentioned than this one. Keep it in mind while taking a few minutes to read (and ponder) this article from the Economist’s December 10th issue.

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In 2008 the world dodged a second Depression by avoiding the mistakes that led to the first. But there are further lessons to be learned for both Europe and America

“YOU’RE right, we did it,” Ben Bernanke told Milton Friedman in a speech celebrating the Nobel laureate’s 90th birthday in 2002. He was referring to Mr Friedman’s conclusion that central bankers were responsible for much of the suffering in the Depression. “But thanks to you,” the future chairman of the Federal Reserve continued, “we won’t do it again.” Nine years later Mr Bernanke’s peers are congratulating themselves for delivering on that promise. “We prevented a Great Depression,” the Bank of England’s governor, Mervyn King, told the Daily Telegraph in March this year.

The shock that hit the world economy in 2008 was on a par with that which launched the Depression. In the 12 months following the economic peak in 2008, industrial production fell by as much as it did in the first year of the Depression. Equity prices and global trade fell more. Yet this time no depression followed. Although world industrial output dropped by 13% from peak to trough in what was definitely a deep recession, it fell by nearly 40% in the 1930s. American and European unemployment rates rose to barely more than 10% in the recent crisis; they are estimated to have topped 25% in the 1930s. This remarkable difference in outcomes owes a lot to lessons learned from the Depression.

Debate continues as to what made the Depression so long and deep. Some economists emphasise structural factors such as labour costs. Amity Shlaes, an economic historian, argues that “government intervention helped make the Depression Great.” She notes that President Franklin Roosevelt criminalised farmers who sold chickens too cheaply and “generated more paper than the entire legislative output of the federal government since 1789”. Her book, “The Forgotten Man”, is hugely influential among America’s Republicans. Newt Gingrich loves it.

A more common view among economists, however, is that the simultaneous tightening of fiscal and monetary policy turned a tough situation into an awful one. Governments made no such mistake this time round. Where leaders slashed budgets and central banks raised rates in the 1930s, policy was almost uniformly expansionary after the crash of 2008. Where international co-operation fell apart during the Depression, leading to currency wars and protectionism, leaders hung together in 2008 and 2009. Sir Mervyn has a point.

Look closer, however, and the picture is less comforting. For in two important—and related—areas, the rich world could still make mistakes that were also made in the 1930s. It risks repeating the fiscal tightening that produced America’s “recession within a depression” of 1937-38. And the crisis in Europe looks eerily similar to the financial turmoil of the late 1920s and early 1930s, in which economies fell like dominoes under pressure from austerity, tight money and the lack of a lender of last resort. There are, in short, further lessons to be learned.

Riding for a fall

It was far easier to stimulate the economy in the 2000s than in the 1930s. Social safety nets—introduced in the aftermath of the Depression—mean that today’s unemployed have money to spend, providing a cushion against recession without any active intervention. States are more relaxed about running deficits, and control much larger shares of national economies. The package of public works, spending and tax cuts that President Herbert Hoover introduced after the crash of 1929 amounted to less than 0.5% of GDP. President Barack Obama’s stimulus plan, by contrast, was equivalent to 2-3% of GDP in both 2009 and 2010. Hoover’s entire budget covered only about 2.5% of GDP; Mr Obama’s takes 25% of GDP and runs a deficit of 10%.

Roosevelt raised spending to 10.7% of output in 1934, by which point the American economy was growing strongly. By 1936 inflation-adjusted GDP was back to 1929 levels. Just how much the New Deal spending helped the recovery is still debated. Some economists, such as John Cochrane of the University of Chicago and Robert Barro of Harvard, say not at all. Fiscal measures never work, they say.

Those who think that fiscal measures do work nonetheless tend to believe that, in the 1930s, spending was less important than monetary policy, which they see as the prime cause of suffering. In a paper in 1989 Mr Bernanke and Martin Parkinson, now the top civil servant in Australia’s finance ministry, wrote that rather than providing recovery itself “the New Deal is better characterised as having ‘cleared the way’ for a natural recovery.” Others, such as Paul Krugman, would ascribe a more positive role to stimulus spending.

Whatever relative importance is assigned to monetary and fiscal policy, though, there is little doubt that their simultaneous tightening five years into the Depression led to a vicious relapse. Spurred by his treasury secretary, Henry Morgenthau—who worried in 1935 that “we cannot help but be riding for a fall unless we continue to decrease our deficit each year and the budget is balanced”—Roosevelt urged fiscal restraint on Congress in 1937.

By that point the national debt had reached an unheard of 40% of GDP (huge by the standards of the day, but half what Germany’s debt is now). Congress cut spending, increased taxes and wiped out a deficit of 5.5% of GDP between 1936 and 1938. That was a larger consolidation than Greece now faces over two years (see chart 1), but is much smaller than what is planned for it in the longer term. At the same time the Federal Reserve doubled reserve requirements between mid-1936 and mid-1937, encouraging banks to pull money out of the economy. The Treasury began to restrict the money supply in step with the level of gold imports. In 1937 and 1938, the recession within a depression brought a drop in real GDP of 11% and an additional four percentage points of unemployment, which peaked at 13% or 19%, depending on how you count it.

The Snowdens of yesteryear

Today’s monetary policy hasn’t turned contractionary, as America’s did in the 1930s. As The Economist went to press, the European Central Bank (ECB) was expected to announce a further reduction in interest rates. But in many places fiscal policy is moving rapidly in that direction. Mr Obama’s stimulus is winding down; state- and local-government cuts continue. Republican candidates for the presidency echo the arguments of Mr Morgenthau, claiming that deficit-financed stimulus spending has done little but add to the obligations of future taxpayers. Mr Obama, like Roosevelt, has started to stress the need for budget-cutting. If the current payroll-tax cut and emergency unemployment benefits were to lapse, growth over the next year would be reduced by around one percentage point of GDP.

America is not alone. Under David Cameron, Britain’s hugely indebted government introduced a harsh programme of fiscal consolidation in 2010 to avert a loss of confidence in its creditworthiness. The rationale was similar to that for chancellor Philip Snowden’s emergency austerity budget of 1931, with its tax rises and spending cuts. On that occasion confidence was not restored, and Britain was forced to devalue the pound and abandon the gold standard. On this occasion the measures have indeed boosted investor confidence, and thus bond yields; that the country still faces a second recession is in large part due to the euro zone’s woes. That said, the possibility of such shocks should always be a counsel for caution when a government embarks on fiscal tightening.

Some say tightening need not hurt. In 2009 Alberto Alesina and Silvia Ardagna of Harvard published a paper claiming that austerity could be expansionary, particularly if focused on spending cuts, not tax increases. Budget cuts that reduce interest rates stimulate private borrowing and investment, and by changing expectations about future tax burdens governments can also boost growth. Others doubt it. An International Monetary Fund (IMF) study in July this year found that Mr Alesina and Ms Ardagna misidentified episodes of austerity and thus overstated the benefits of budget cuts, which typically bring contraction not expansion.

Roberto Perotti of Bocconi University has studied examples of expansion at times of austerity and showed that it is almost always attributable to rising exports associated with currency depreciation. In the 1930s the contractionary impact of America’s fiscal cuts was mitigated to some extent by an improvement in net exports; America’s trade balance swung from a deficit of 0.2% of GDP to a surplus of 1.1% of GDP between 1936 and 1938. Now, most of the world is cutting budgets and not every economy can reduce the pain by boosting exports.

The importance of monetary policy in the 1930s might suggest that central banks could offset the effects of fiscal cuts. In 2010 the IMF wrote that Britain’s expansionary monetary policy should mitigate the contractionary impact of big budget cuts and “establish the basis for sustainable recovery”. Yet Britain is now close to recession and unemployment is rising, suggesting limits to what a central bank can do.

The move to austerity is most dramatic within the euro zone—which can least afford it. Operating without floating currencies or a lender of last resort, its present predicament carries painful echoes of the gold-standard world of the early 1930s.

In the mid-1920s, after an initially untenable schedule of war reparations payments was revised, French and American creditors struck by the possibility of rapid growth in the battered German economy began to pile in. The massive flow of capital helped fund Germany’s sovereign obligations and led to soaring wages. Germany underwent a credit-driven boom like those seen on the European periphery in the mid-2000s.

In 1928 and 1929 the party ended and the flow of capital reversed. First, investors sent their money to America to bet on its soaring market. Then they yanked it out of Germany in response to financial panic. To defend its gold reserves, Germany’s Reichsbank was forced to raise interest rates. Suddenly deprived of foreign money, and unable to rely on exports for growth as the earlier boom generated an unsustainable rise in wages, Germany turned to austerity to meet its obligations, as Ireland, Portugal, Greece and Spain have done. A country with a floating currency could expect a silver lining to capital outflows: the exchange rate would fall, boosting exports. But Germany’s exchange rate was fixed by the gold standard. Competitiveness could only be restored through a slow decline in wages, which occurred even as unemployment rose.

As the screws tightened, banks came under pressure. The Austrian economy faced troubles like those in Germany, and in 1931 the failure of Austria’s largest bank, Credit Anstalt, triggered a loss of confidence in the banks that quickly spread. As pressure built in Germany, the leaders of the largest economies repeatedly met to discuss the possibility of assistance for the flailing economy. But the French, in particular, would brook no reduction in Germany’s debt and reparations payments.

Recognising that the absence of a lender of last resort was fuelling panic, the governor of the Bank of England, Montagu Norman, proposed the creation of an international lender. He recommended a fund be set up and capitalised with $250m, to be leveraged up by an additional $750m and empowered to lend to governments and banks in need of capital. The plan, probably too modest, went nowhere because France and America, owners of the gold needed for the leveraging, didn’t like it.

So the dominoes fell. Just two months after the Credit Anstalt bankruptcy a big German bank, Danatbank, failed. The government was forced to introduce capital controls and suspend gold payments, in effect unpegging its currency. Germany’s economy collapsed, and the horrors of the 1930s began.

It is all dreadfully familiar (though no European country is about to elect another Hitler). Membership in the euro zone, like adherence to the gold standard, means that uncompetitive countries can’t devalue their currencies to reduce trade deficits. Austerity brings with it a vicious circle of decline, squeezing domestic demand and raising unemployment, thereby hurting revenues, sustaining big deficits and draining away confidence in banks and sovereign debt. As residents of the periphery move their money to safer banks in the core, the money supply declines, just as it did in the 1930s (see chart 2). High-level meetings with creditor nations bring no surcease. There is no lender of last resort. Though the European Financial Stability Facility (EFSF) has got further off the ground than Norman’s scheme, which it chillingly resembles, euro-zone leaders have yet to find a way to leverage its €440 billion up to €2 trillion.

Even if they succeed, that may be too little to end the panic. Investors driven by turmoil in Italian markets are pre-emptively reducing their exposure to banks and sovereign bonds elsewhere in the euro zone. Even countries with relatively robust economies such as France and the Netherlands have not been spared. No matter how secure an economy’s fiscal position, a short-term liquidity crunch driven by panic can drive it into insolvency.

History need not repeat itself. Norman’s Bank of England was created in the 17th century to lend to the government when necessary; central banks have always been obliged to lend to governments when others will not. The ECB could take on this role. It is prohibited by its charter from buying debt directly from governments, but it can purchase debt securities on the secondary market. It has been doing so piecemeal and could declare its intention to do so systematically. Its power to create an unlimited amount of money would allow it credibly to announce its willingness to buy any bonds markets want to sell, thus removing the main cause of panic and contagion.

This week France and Germany proposed the adoption of legally binding budgetary “golden rules” by euro-zone members, ahead of a summit of European leaders in Brussels on December 8th-9th. Mario Draghi, the ECB’s new president, has hinted that were a fiscal pact to be agreed, the ECB might buy bonds on a larger scale. What scale he has in mind, though, is unclear. Jens Weidmann, president of Germany’s Bundesbank and an influential member of the ECB’s governing council, has clearly stated that the ECB “must not be” the euro zone’s lender of last resort.

Where this path leads

On the present course, conditions in developed economies look like getting worse before they get better. Growth in America and Britain will probably be less than 2% in 2012 on current policy, and in both recession is quite possible. A euro-zone recession is likely. The ECB could improve the euro zone’s economic outlook by loosening its monetary policy, but widespread austerity and uncertainty will be difficult to overcome. As in 1931 and 2008, a grave financial crisis may cause a large drop in output. That, in turn, would place more pressure on euro-zone economies struggling to avoid default.

As panic built in 1931, country after country faced capital flight. The effort to defend against bank and currency runs prompted rounds of austerity and plummeting money supplies in pressured economies, helping generate the collapse in output and employment that turned a nasty downturn into a Depression. It took the end of the gold standard, which freed central banks to expand the money supply and reflate their economies, to spark recovery. Today the ECB has the tools needed to salvage the situation without breaking up the euro. But the fact that the ECB and euro-zone governments have options does not mean that they will take them.

The collapse of the gold standard led to recovery, but caused terrible economic damage as countries erected trade barriers to stem the flood of imports from those that had devalued their currencies. Governments elected to fight unemployment experimented with wage and price controls, cartelisation of industry and other interventions that often impeded the recovery enabled by expansionary monetary and fiscal policies. In the worst-hit countries long-suffering citizens turned to fascism in the false hope of relief.

The world today is better placed to cope with disaster than it was in the 1930s. Then, most large economies were on the gold standard. Today, the euro zone represents less than 15% of world output. In developed countries unemployment, scourge though it is, does not lead to utter destitution as it did in the 1930s. Then, the world lacked a global leader; today, America is probably still up to the job of co-ordinating disaster response in troubled times. International institutions are much stronger, and democracy is more firmly entrenched.

Even so, prolonged economic weakness is contributing to a broad rethinking of the value of liberal capitalism. Countries scrapping for scarce demand are now intervening in currency markets—the Swiss are fed up with their franc appreciating against the euro. America’s Senate has sought to punish China for currency manipulation with tariffs. Within Europe the turmoil of the euro crisis is encouraging ugly nationalists, some of them racist. Their extremism is mild when compared with the continent-wrecking horrors of Nazism, but that hardly makes it welcome.

The situation is not yet beyond repair. But the task of repairing it grows harder the longer it is delayed. The lessons of the 1930s spared the world a lot of economic pain after the shock of the 2008 financial crisis. It is not too late to recall other critical lessons of the Depression. Ignore them, and history may well repeat itself.

“Following the EU Summit on 9-10 December, Fitch has concluded that a ‘comprehensive solution’ to the eurozone crisis is technically and politically beyond reach.”

Fitch Affirms France at ‘AAA’; Outlook Revised to Negative

Fitch Ratings has today affirmed France’s Long-term foreign and local currency Issuer Default Ratings (IDRs) as well as its senior debt at ‘AAA’. Fitch has also simultaneously affirmed France’s Country Ceiling at ‘AAA’ and the Short-term foreign currency rating at ‘F1+’. The rating Outlook on the Long-term rating is revised to Negative from Stable.

The affirmation of France’s ‘AAA’ status is underpinned by its wealthy and diversified economy, effective political, civil and social institutions and its financing flexibility reflecting its status as a large benchmark euro area sovereign issuer. In addition, the French government has adopted several measures to strengthen the creditability of its fiscal consolidation effort. Nonetheless, government debt to GDP is currently projected by Fitch under its baseline scenario to peak in 2014 at around 92%, higher than any other ‘AAA’-rated sovereign with the exception of the UK and US and significantly higher than other ‘AAA’-rated Euro Area peers.

France’s sovereign credit profile benefits from a broad and stable tax base – the volatility of the revenue to GDP ratio is half the ‘AAA’ median – and the interest service burden is moderate and broadly comparable with other ‘AAA’s. Under Fitch’s baseline scenario that does not incorporate the realisation of substantial fiscal liabilities arising from the Eurozone crisis or other adverse shocks, even such an elevated level of government indebtedness is consistent with France retaining its ‘AAA’ status assuming that government debt is firmly placed on a downward path from 2013-14. The Negative Outlook on the French rating reflects Fitch’s view that the likelihood of the realisation of contingent liabilities, although still not our base-case assumption, has materially increased, as has the risk of a much worse than expected economic and consequently fiscal outturn.

Similar to other highly rated peers, France faces medium and long-term challenges to improve the functioning of the labour market and enhance international competitiveness. Fitch recognises that the authorities have adopted measures to address these weaknesses, though a more radical structural reform agenda would underpin greater confidence in the underlying potential growth rate of the French economy. However, corporate and especially household indebtedness is moderate compared to some ‘AAA’ peers, notably the UK and US, while foreign indebtedness remains modest, albeit rising.

The Negative Outlook is prompted by the heightened risk of contingent liabilities to the French state arising from the worsening economic and financial situation across the Eurozone, as reflected in the Rating Watch Negative placed on the sovereign ratings of several Euro Area Member States (EAMS) on 16 December 2011. As Fitch commented in its report on 23 November, ‘French Public Finances’, the fiscal space to absorb further adverse shocks without undermining its ‘AAA’ status has largely been exhausted.

The intensification of the Eurozone crisis since July constitutes a significant negative shock to the region and to France’s economy and the stability of its financial sector. Since May, when Fitch last affirmed France’s ‘AAA’ status, its forecast for economic growth in 2012 has been cut from 2.1% to 0.7% with around one-in-four chance of outright contraction. Despite the additional fiscal measures announced in August and November equivalent to around 1% of GDP, further measures are likely to be required in order to cut the deficit to 3% of GDP by 2013 and stabilise government debt below 90% of GDP in light of the worsening economic and financial outlook.

In Fitch’s opinion, the commitments made by leaders at the EU Summit on 9-10 December and by the ECB were not sufficient to put in place a fully credible financial firewall to prevent a self-fulfilling liquidity and even solvency crisis for some non-AAA euro area sovereigns. In the absence of a ‘comprehensive solution’, the Eurozone crisis will persist and likely be punctuated by episodes of severe financial market volatility.

Relative to other ‘AAA’ Euro Area Member States, France is in Fitch’s judgement the most exposed to a further intensification of the crisis. It has a larger structural budget deficit and higher government debt burden relative to Euro Area ‘AAA’ peers. Moreover, relative to non-Euro Area ‘AAA’ peers, notably the US (‘AAA’/Negative Outlook) and the UK (‘AAA’/Stable Outlook), the risk from contingent liabilities from an intensification of the Eurozone crisis is greater in light of its commitments to the European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM), as well as indirectly from French banks that are less strong than previously assessed as reflected in recent negative rating actions by Fitch.

The Negative Outlook indicates a slightly greater than 50% chance of a downgrade over a two-year horizon. The triggers that would likely prompt a rating downgrade are as follows:

- Increased likelihood that contingent liabilities from an intensification of the Eurozone crisis will be crystallised onto the French state balance sheet.

- Material slippage from the fiscal targets that the government has set itself, notably the aim of stabilising the government debt to GDP ratio from 2013 and placing it on a firm downward path towards levels that would increase the ‘fiscal space’ necessary to absorb adverse shocks.

- Weaker than expected economic performance that prompts a re-assessment of France’s medium to long-term growth potential.

Conversely, economic and fiscal performance in line with Fitch’s baseline expectations, as set out in the Special Report, French Public Finances (23 November 2011), along with the resolution of the Eurozone crisis would likely result in the stabilisation of the rating Outlook.

In the absence of a material adverse shock, most likely associated with dramatic worsening of the Eurozone crisis, Fitch would not expect to resolve the Negative Outlook until 2013.

Fitch Places Belgium, Spain, Slovenia, Italy, Ireland and Cyprus on Rating Watch Negative

Fitch Ratings has placed the ratings of all investment grade rated eurozone sovereigns and their debt with Negative Outlook onto Rating Watch Negative (RWN). The euro area country ceiling of ‘AAA’ is unaffected. The rating actions are as follows:

- Belgium ‘AA+’/'RWN from ‘AA+’/Negative Outlook (‘F1+’ Unaffected)
- Spain ‘AA-’/'F1+’/RWN from ‘AA-’/'F1+’/Negative Outlook
- Slovenia ‘AA-’/'F1+’/RWN from ‘AA-’/'F1+’/Negative Outlook
- Italy ‘A+’/'F1′/RWN from ‘A+’/'F1′/Negative Outlook
- Ireland ‘BBB+’/'F2′/RWN from ‘BBB+’/'F2′/Negative Outlook
- Cyprus ‘BBB’/'F3′/RWN from ‘BBB’/'F3′/Negative Outlook

The RWN indicates that the above ratings are under active review and are subject to a heightened probability of downgrade in the near-term. Fitch expects to complete the review by the end of January 2012. If the review concludes that a downgrade is warranted, it is likely be limited to one or two notches.

Following the EU Summit on 9-10 December, Fitch has concluded that a ‘comprehensive solution’ to the eurozone crisis is technically and politically beyond reach. Despite positive commitments by EU leaders at the Summit, notably the decision to accelerate the creation of the European Stability Mechanism (ESM) and to place less emphasis on private sector involvement (PSI), the concerns held by Fitch prior to the Summit remain pressing and have not been materially eased by the Summit outcome (also see, ‘Summit Does Little To Ease Pressure on eurozone Sovereign Debt,’ 12 December). Of particular concern is the absence of a credible financial backstop. In Fitch’s opinion this requires more active and explicit commitment from the ECB to mitigate the risk of self-fulfilling liquidity crises for potentially illiquid but solvent Euro Area Member States (EAMS).

Fitch recognises that the policy authorities in all of the countries with sovereign ratings subject to review have embarked upon significant fiscal consolidation and structural reform and these efforts will be taken into account in the review. However, the systemic nature of the eurozone crisis is having a profoundly adverse effect on economic and financial stability across the region and for some EAMS poses near-term risks that are beginning to dominate the sovereign-specific risk fundamentals. Today’s announcement is focused on those sovereigns that are potentially vulnerable to the worsening external economic and financial environment as indicated by previous negative rating actions and rating Outlooks.

The RWN is prompted by the following risk factors:

- In the absence of greater clarity on the ultimate structure of a fundamentally reformed Economic and Monetary Union and the recognition by political leaders of the potential for an EAMS to leave the eurozone, Fitch will review its assessment of the balance of risks associated with eurozone membership, especially for sovereigns potentially subject to funding stresses.

- While acknowledging the extraordinary measures the ECB has adopted to provide liquidity to the European banking sector, its continued reluctance to countenance a similar degree of support to its sovereign shareholders undermines the efforts by EAMS to put in place a credible financial ‘firewall’ against contagion and self-fulfilling liquidity and even solvency crises.

- The intensification of the eurozone crisis since July constitutes a significant negative shock to the region’s economy and the stability of its financial sector with potentially adverse consequences for sovereign credit profiles across the region, most immediately for those placed on RWN today.

- In the absence of a ‘comprehensive solution’, the crisis will persist and likely be punctuated by episodes of severe financial market volatility that is a particular source of risk to the sovereign governments of those countries with levels of public debt, contingent liabilities and fiscal and financial sector financing needs that are high relative to rating peers.

In light of these heightened risks, Fitch will re-consider the assumptions and analysis that underpin its current sovereign ratings of Belgium, Slovenia, Spain, Italy, Ireland and Cyprus to ensure that the above risk factors are appropriately reflected in its sovereign ratings in accordance with its sovereign rating methodology.

The focus on investment grade rated sovereign governments with Negative Outlooks reflects previous research and analysis that indicates specific weaknesses that render them especially vulnerable to the intensification of the eurozone crisis. However, the outcome of the review will also incorporate Fitch’s current assessment of the strength of their underlying economic and credit fundamentals as reflected in their current sovereign ratings as well as recent policy measures adopted at the national level.

The Telegraph has seen a draft of the EU fiscal agreement, which states that major economic policy reforms within the eurozone will be co-ordinated with all 27 member states. Here is the document in full.

The EFSF’s web address is http://www.efsf.europa.eu

At the rate things are going, there will be a 500th installment of this tragic soap opera — if the euro and my fascination with the death spiral of a critical component of the world’s economic and financial systems last that long.

The pace of events is obviously accelerating. The following comes from articles in the Wall Street Journal (no link) and the Financial Times:

• The euro dropped below $1.30 for the first time since January.
• Rates that banks charge each other for short-term borrowing in dollars continued to climb, hitting their highest level since July 2009. Also since July 2009, the cost of borrowing dollars for three months in the London interbank market reached a new high.
• Foreign-owned banks operating in the US have suffered their largest six month fall in deposits on record in what some analysts have described as a “flight to safety” from European banks to domestic institutions.Cash on deposit at foreign-owned banks fell $291bn, or 25 per cent, to $879bn from the end of May to the start of December, the first time deposits in the sector have fallen for six consecutive months since 2002, according to Federal Reserve data.
• A dozen banks tapped the European Central Bank for one-week dollar loans, the ECB said on Wednesday, borrowing a total of $5.1bn. That is more than the $1.6bn tapped by five banks last week. Demand at the last offering of three-month dollar loans also surged, with 34 banks borrowing $50.7bn from the central bank after it began offering the liquidity at a new and cheaper rate. But, despite the central bank facilities, the cost of obtaining dollar funding in the private market continues to soar, pointing to a dollar funding squeeze as Europe’s banks head into their all-important year-end reporting period.The three-month euro-US dollar basis swap dropped to as low as -150 basis points on Wednesday, meaning banks would have to pay an extra 1.5 per cent premium to swap their euros into dollars for a three-month period. The premium has not been persistently below the -140bps region since late 2008, during the depths of the financial crisis.
• Long-term Italian government bond yields jumped back above 7%, a level that would crimp Italy’s ability to borrow in the future.
• Crédit Agricole SA, France’s third-largest bank, said it will exit 21 of the 53 countries in which it operates to help shore up its finances. In announcing its plans to retreat from various markets, it said it will boost reserves, cut costs and trim its reliance on market borrowing.
• Commerzbank AG, struggling to avoid accepting a bailout by the German government, is in negotiations to transfer suspect assets to a government-owned “bad bank.”
• Fitch Ratings lowered its ratings on five big banks from Denmark, Finland, France and the Netherlands.
• German Chancellor Angela Merkel reiterated that creating such a bond would be no solution to the turmoil.
• Jens Weidmann, president of Germany’s Bundesbank and member of the ECB governing council, said he remained vehemently opposed to the ECB printing money.
• In Sydney, Westpac Banking Corp. warned Wednesday that Europe’s debt woes will impact the price and possibly the availability of credit to Australia’s banks. Westpac Chief Executive Gail Kelly said “term markets around the world are effectivelyclosed.”

If you’re wondering why the euro, and the prices of all other risky assets (i.e., all assets except U.S. Treasuries) are plunging today, here’s your answer:

As reported by the Wall Street Journal (no link):

German Chancellor Angela Merkel, whose positions have shaped the response to the crisis since its inception, restated her position that common euro-zone bonds were no solution to the crisis—and said she opposed lifting the cap on the euro-zone bailout funds beyond €500 billion ($651 billion).

Euro bonds “aren’t suitable as a rescue measure,” she told the German parliament.

Ms. Merkel said the path to fiscal union was irrevocable, but that it could take years to overcome the crisis.

The Chancellor isn’t the only German to blame. From Reuters, here’s Jens Weidmann, President of the German Central Bank:

Weidmann delivered a blow to hopes of more decisive ECB intervention to quell the euro zone crisis, saying his peers at the bank were growing skeptical of its bond-buy program, which he openly opposes.

Weidmann was witheringly critical of appeals for the ECB to do more to help debt-choked governments, comparing them to alcoholics pleading to be given a bottle:

“It is like an alcoholic saying that I need to get a bottle tonight. Starting tomorrow I will be clean and abide by the rules, but I need the bottle tonight. I don’t think it is sensible to give the alcoholic the bottle. He won’t have an incentive to solve the problem.”

He said his Bundesbank would only provide fresh funds for the IMF to help fight the euro zone crisis if countries beyond Europe do so too.

“If, for example, the U.S. and other important donors say they will not participate, then, from our viewpoint, it will be uncomfortably close to state financing … That’s why the conditions we have formulated are so important. If these conditions are not met, then we could not give our approval to these credit lines.”

The cliché of German stubbornness is alive and well.

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Now to my favorite topic: austerity.

From the FT, here’s Nobel Laureate Amartya Sen:

Speaking at the Indian finance ministry’s Delhi Economic Conclave, Mr Sen said the rush to impose austerity plans across Europe was a “spiralling catastrophe,” and was even threatening to drag the US in the same direction.

The Nobel Prize-winning economist said that Europe’s leaders were mistaking the need for greater financial responsibility and accountability in governmental expenditure for more radical, short-term measures that could worsen the current downturn. He warned that large-scale, indiscriminate cutting of government expenditure could “decimate” lives and nip economic recoveries in the bud.

“Many countries in the west seem to be doing their best to go straight into the mouth of a fairly hefty snake. To move from that frying pan of mismanagement to the fire of indiscriminate cuts to satisfy the creditors and to placate the rating agencies has not been helping these countries to move into a responsible forward-looking recovery programme.”

Mr Sen singled out the UK, describing Prime Minister David Cameron’s belt-tightening measures as “oddly confused” and “certainly mistimed”. Many economists have warned that the austerity measures have raised the risks of economic contraction and a double-dip recession.

Mr Sen implored policymakers to study the years after the second world war and during former US President Bill Clinton’s office, when economic growth played a significant role in reducing public debt.

Mr Sen’s views reflect growing misgivings among Indian and, more widely, Asian economists and policymakers about the policy choices in the developed world in the wake of the 2008 global financial crisis. They fear that Europe, which has strong linkages to India, may suffer a decade or more of low growth.

Sen’s worries are widely shared.

Reuters reports:

The austerity zeal risks tipping the continent back into recession and a downward spiral of austerity as pitiful growth prospects undermine budgetary targets and ramp up debt burdens, meaning further austerity is required.

Says Stephen Kinsella, professor of economics at the University of Limerick:

“The expansionary fiscal contraction story says that you cut, you show you are serious about cutting and then the confidence fairy will come along and she will start pulling in private investment. The expansionary fiscal contraction story is a lie. You don’t cut your way to growth.”

With the crisis spreading like wildfire through the currency bloc’s core, pushing up borrowing costs to unsustainable levels, countries are relying more on blunt budget cuts, than time-consuming and difficult structural reforms, to get results. The upshot is ballooning dole queues, shuttered businesses and public services stretched to breaking point.

On the streets of Athens and Dublin poverty has visibly increased with more and more homeless people huddling in doorways. In Spain, emergency wards have been shut and in Italy, retailers are struggling to get by.

Says Attilio Lebole, head of Textura, a mid-range clothing wholesaler based in Florence:

“Consumption has been falling pretty steadily since the winter of 2008. Normally in a crisis, it starts with menswear and goes to womenswear and children. This time, it’s hit them all at once. Demand is falling, there’s no doubt about that. Only foreigners are still shopping.”

Poland: “We want sovereignty, not the euro”

I’ve raised the sovereignty issue several times, most notably, on November 24th:

From the beginning of the “European project,” its opponents have complained about a “democratic deficit” — that unelected Brussels bureaucrats were having a bigger say and more power than elected national representatives. If, as the ECB maintains, crisis resolution requires much-diminished sovereignty, it’s safe to predict that this complaint will be voiced more widely and more stridently than ever before. There will then be a tipping point at which the current economic and financial crisis metastasizes into a political and social crisis. This outcome is avoidable only if the ECB’s analysis, which some will view as a rationale for usurping power, is shown to be unnecessary. That, of course, means that an alternative, at least equally convincing, solution to the crisis involving something less than a “significant” transfer of sovereignty must be conceptualized, offered and widely accepted.

For the first time in my knowledge, the issue has reached the streets.

The Wall Street Journal reports (no link) that “thousands” of protestors marched through the heart of Warsaw, shouting their opposition to the European Union’s latest plans to rescue the euro zone and demanding that Poland’s government not participate. The protest was organized by the country’s largest opposition party.

The protest . . . spotlights the challenges European leaders face as they try to persuade constituents to back the plans for tighter budget discipline and greater financial backing for indebted countries agreed to at a summit last week.

Under that deal, all 17 countries that use the euro and potentially others in the 27-nation EU such as Poland that still use their own currencies, would face penalties for violating stringent spending limits.

They would also lend up to a combined €200 billion ($261 billion) to bolster the International Monetary Fund, which would strengthen the multilateral lender’s ability to bail out indebted euro-zone nations.

Jaroslaw Kaczynski, the leader of the opposition Law and Justice party, and a former prime minister, addressed the protesters:

“This undermines our status as a sovereign state, our position, our dignity. We can’t agree to this. We can’t, we can’t and we won’t.”

Earlier in the day, his party said that government support for the EU proposals was “an open pursuit of limiting the independence of the Polish state” and that Polish sovereignty, “once threatened by servility toward Soviet authorities,” is now at risk from “servility toward European powers.”

In response, Polish Prime Minister Donald Tusk, defended his government’s support of the EU plan, saying that it didn’t “result from naive internationalism. It’s action directly in the interest of Poland” and that “if the euro zone collapses or gets into turbulence, really, believe me, we’ll feel it more than the French or Germans.”

It isn’t just the Poles who are raising objections to the EU’s latest rescue plan:

On Tuesday, the leaders of Sweden and the Czech Republic said it was too early to count on their countries’ support, which they said was impossible to predict before the particulars of the agreements were finalized. In Hungary, the parliament has yet to consider the matter.

“There are many complicated questions and we must wait for the full details before making a decision,” Czech Prime Minister Petr Necas said Tuesday. Necas added that “I personally am leaning towards not participating” in the contribution of funds to the IMF.

In Sweden, Finance Minister Anders Borg said, “We must continue to evaluate what it is that has been agreed. It is clear that Sweden will not enter this cooperation on the same terms as euro-zone members.”

This is the beginning of the beginning of the contest between saving sovereignty and saving the euro and the EU.

Angela Merkel, speaking to the German parliament earlier today:

Marc Schulman, “A Golden Future?,” (August 2011)

The eurozone standard is the modern day equivalent of the gold standard. Countries that are in economic trouble are forced to implement austerity measures that have ramifications outside their borders. In the 1930s, a crisis in little Austria spread like wildfire to Germany, Great Britain and, finally, to the United States. In our time, a crisis that began in little Greece has spread like wildfire to Portugal, Spain, Italy, and, perhaps France.

Deutsche Bank, “Is the Euro today the Gold Standard of the 1930s for European Economies?,” (December 2011):

The 1930s in Europe was a slow moving game of falling dominoes with countries one by one leaving the narrow confines of the Gold Standard after chronic growth problems that a fixed currency system intensified. There was a definite trend in the 1930s that saw those countries that left the Gold Standard seeing a much quicker recovery from the Depression than those that stayed on for a number of years into the latter half of the decade. Figure 12 shows a case study of six countries currencies relative to Gold in the 1930s. We’ve rebased them to 100 at the start of the series. In order of leaving the Gold Standard, we had the UK (left September 1931), Sweden (also left September 1931), US (April 1933), Belgium (March 1935), France (September 1936) and Italy (October 1936).

Interestingly, by the middle of 1937 all had devalued by at least 40% to Gold except Belgium who had devalued by around 30% in 1935. France, which held on until September 1936, then saw its currency collapse by nearly 70% in the three years up to WWII. Figure 13 then shows the same six countries nominal (left) and real (right) GDP performance over the same period.

The UK and Sweden, which left the Gold Standard earliest (September 1931) in this sample, saw a ‘relatively’ mild negative growth shock compared to the other four. In contrast, France which stuck to Gold until late 1936 saw growth notably under-perform until they left the standard. Interestingly as discussed above, France later saw a dramatic 3 year 70% devaluation to Gold which helped restore nominal GDP close to that of the UK and Sweden by the end of the 1930s. However, in real terms they were still the laggard at this point. The worst slump of all was that seen in the US between 1929 and 1932 where they lost nearly half the value of their economy in nominal terms and nearly 30% in real terms. However, the bottom pretty much corresponded to the end of the Dollar’s gold convertibility and subsequent devaluation. From this point on, the recovery was fairly dramatic until the 1937 recession we’ll discuss below. Overall, Figure 13 does indicate some fairly strong evidence that growth did seem to respond to currency debasement and that countries which left this later ended up with weaker economies for longer and also, in France’s case, a more dramatic end devaluation.

Round 2 of Reactions to the EU Summit (and some other stuff)

The consensus:

The title of the FT’s editorial — “Europe fails to reach summit” — says it all:

It should have been the climax to Europe’s thriller, a summit that would kill off the sovereign debt crisis with a salvo of confidence-restoring measures. But, apart from Britain’sdramatic exit, last week’s European summit was entirely predictable in its inconclusiveness.

To be fair, it is good news that even modest steps were taken towards closer fiscal integration. But the real, comprehensive fiscal union needed to restore faith in the euro, as opposed to a few new rules, remains elusive.

More urgently, the deal that was struck does nothing to resolve the immediate crisis. Moves to bolster the International Monetary Fund and hints of more support next year for Europe’s two bail-out vehicles are neither big enough nor fast enough to deal with the titanic task of funding peripheral countries’ debt until confidence returns.

Hopes in the existence of a big bazooka proved misplaced. Mario Draghi, European Central Bank president, on Thursday quashed hopes that he would launch an unlimited bond-buying programme to help indebted sovereigns, as European rules do not allow this.

Now there is the suggestion that the ECB has a cunning plan to give the bazooka to Europe’s banks, which will be lent bags of cheap money, with which to buy their own countries’ debt.

The argument is tempting. Friday’s summit declared that there will be no more haircuts on sovereign debt. So if banks can get three-year ECB money at 1 per cent and buy Italian bonds at 6 per cent, this could help cut debt costs while bringing seemingly risk-free returns. This is not contrary to European rules and it could be in both parties’ interests. If the sovereigns go, Europe’s banks are front line victims.

However, there are many reasons to be wary of such a solution, not least because it fools no one. The ECB would in effect be funding sovereign debt through Europe’s banks. This is hardly in the spirit of the European treaty. Second, shareholders might rightly question why banks, which have been shedding periphery bonds despite having had the arbitrage opportunity for some time now, were suddenly scooping them up. Most importantly, if the current crisis was sparked by the link between sovereign and bank risk, does it make sense to intensify that link? Right now there may be no alternative to save the euro. But it amounts to little more than sleight of hand in a crisis where clarity and resolve would do much more to restore confidence.

Unsurprisingly, the FT’s Wolfgang Munchau agrees:

. . . the decision to set up a fiscal union outside the European treaties will do nothing whatsoever to resolve the eurozone crisis . . . this is not something you would wish to do outside European treaties. The existing treaties form the legal basis for all policy co-ordination of monetary union. It gets very messy when you try to circumvent them.

[...] A fiscal union set up outside the European treaty would face severe legal and practical limitations. Unless a trick is found, it cannot make recourse to the resources and institutions of the EU. Nor can it issue eurozone bonds. The only conceivable counterparty for a eurozone bond is the EU itself.

More important even, a fiscal union created through a legal trapdoor would not help solve the crisis. The eurozone is facing a generalised loss of confidence. Investors no longer trust its crisis management, the solidarity of its citizens, even the ability to conduct sensible economic policies. The EU is not going to restore confidence through legal gimmickry that will face numerous court challenges.

Leaders should have admitted on Friday that the summit had simply failed, or perhaps have given it a few more days. Negotiations might have produced a compromise. With the fake pretence of another treaty, that is no longer possible.

Remember what everybody said a week ago? To solve the crisis, the eurozone requires, in the long run, a fiscal union with a prospect of a eurozone bond and, in the short run, unlimited sovereign bond market support by the European Central Bank. What we now have is no treaty change, no eurozone bond and no increase either in the rescue fund or in ECB support.

Policy changes the ECB announced last week will help banks directly and governments indirectly. But the EU fell short on every element of a comprehensive deal. On Friday, investors reacted positively to what was sold to them as a “fiscal compact”. But once the implications of a separate treaty are understood, I fear disillusionment will set in.

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The rating agencies are equally unimpressed.

In its Weekly Credit Outlook, Moody’s says that “Pressure Remains on Euro Area Sovereigns in Absence of Decisive Initiatives” and “European Bank Recapitalization Plan Is Credit Positive, but Encourages Deleveraging”:

Pressure Remains . . .

. . . the [EU summit] communiqué reflects the continuing tension between euro area leaders’ recognition of the need to increase support for fiscally weaker countries and the significant opposition within stronger countries to doing so. Amid the increasing pressure on euro area authorities to act quickly to restore credit market confidence, the constraints they face are also rising. The longer that remains the case, the greater the risk of adverse economic conditions that would add to the already sizeable challenges facing the authorities’ coordination and debt reduction efforts.

As a result, the communiqué does not change our view that the crisis is in a critical, and volatile, stage, with sovereign and bank debt markets prone to acute dislocation which policymakers will find increasingly hard to contain. While our central scenario remains that the euro area will be preserved without further widespread defaults, shocks likely to materialise even under this ‘positive’ scenario carry negative credit and rating implications in the coming months. And the longer the incremental approach to policy persists, the greater the likelihood of more severe scenarios, including those involving multiple defaults by euro area countries and those additionally involving exits from the euro area.The credit implications of these and further measures likely to be announced in coming weeks require careful consideration against the backdrop of decelerating regional economic activity, fragile banking systems, partly dysfunctional credit markets, and the varying degree of success of country-specific measures aimed at structural change and fiscal consolidation. But in the absence of credit market conditions stabilising, the system remains prone to further shocks which would likely lead to selective rating changes. More broadly, in the absence of any decisive policy initiatives that stabilise credit market conditions effectively, our intention as announced in November is to revisit the level and dispersion of ratings during the first quarter of 2012.

European Bank Recapitalization . . .

Additional capital is credit positive as it enables banks to cope with increased stress. However, there is a risk that tighter capital requirements will encourage further deleveraging, thereby increasing the risk of a credit crunch and additional impairments.

The establishment of a sovereign exposure buffer follows criticism that the EBA’s stress test earlier this year inadequately reflected the true value of, and impairments in, banks’ sovereign exposures. Disclosures in banks’ interim statements also point to inadequate evaluation and provisioning and, in some cases, a failure to comply with international accounting standards.

[...] Supervisors are not simply seeking to achieve higher capital ratios, but also higher capital. Nevertheless, the incentive for banks to deleverage remains high and will only be exacerbated by higher capital requirements. More fundamentally, higher capital buffers cannot address the underlying cause of the disruption to the funding markets which is the sovereign debt crisis.

Fitch says that the “Summit Does Little To Ease Pressure on Eurozone Sovereign Debt”:

After the latest EU crisis meeting it is clear that politicians are responding to the eurozone sovereign debt crisis through incremental improvements. It seems that a “comprehensive solution” to the current crisis is not on offer.

This Summit demonstrated strong political support for the euro, and that its members are putting in place the institutional and policy framework for a more viable eurozone and ultimately greater fiscal union. But taking the gradualist approach imposes additional economic and financial costs compared with an immediate comprehensive solution. It means the crisis will continue at varying levels of intensity throughout 2012 and probably beyond, until the region is able to sustain broad economic recovery.

In the short term we predict a significant economic downturn across the region. The eurozone faces intense market pressure, which is triggering loss of business and consumer confidence, and weak industrial activity and retail sales. Our forecast of 0.4% eurozone GDP growth next year and 1.2% in 2013 would be significantly higher if there was a comprehensive solution to the crisis. The lack of a comprehensive solution has increased short-term pressure on eurozone sovereign credit profiles and ratings.

The latest EU Summit, like others before it, has resulted in some positive developments. There is an extra EUR200bn of funding for the IMF, the ESM has been brought forward, and there has been policy change on private-sector involvement in any future sovereign crisis. As with all Summits there is execution risk.

The extra resources for the IMF are welcome but it is not clear how and under what circumstances they would be deployed. The move away from requiring private-sector involvement (PSI) as a condition for ESM programmes is clearly positive for bondholders. The European Commission said it will “strictly adhere to the well established IMF principles and practices.” PSI has been a feature of past IMF programmes, but the Fund sets out to attract private capital to sovereigns and can be expected to use PSI as a last rather than a first resort.

Separately, the ECB also announced changes to its repo schemes that will aid bank liquidity, such as three-year liquidity lines and looser collateral requirements for structured finance. This could be positive for eurozone sovereigns if it eases pressure on them to introduce or re-activate bank debt guarantee schemes.

The Summit’s conclusions show a longer-term desire to move towards some form of fiscal integration in return for enforced fiscal prudence. We believe that most of the vulnerable eurozone countries are already implementing aggressive austerity programmes, and some are already changing their national constitutions. It is too early to judge how effective the fiscal compact will be due to the uncertainty regarding how it will be implemented.

We still believe the ECB, either directly through its sovereign bond purchase programme or indirectly by allowing the EFSF/ESM to access its balance sheet, is the only truly credible “firewall” against liquidity and even solvency crises in Europe.

Hopes that the ECB would step up its actions in support of its sovereign shareholders as a quid pro quo for institutional and legal changes that gave the ECB greater confidence in the long-run commitment of eurozone governments to fiscal discipline appear to have been misplaced.

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Lurking in the background, according to the Wall Street Journal, is an old nemesis: credit default swaps, which have been used in copious quantities by European banks:

Dozens of banks across Europe have sold large quantities of insurance to other banks and investors that protects against the risk of ailing countries defaulting on their debts, the latest illustration of the extensive financial entanglements among the continent’s banks and governments.

New data released last week by European banking regulators suggest the risks of banks suffering losses tied to European government bonds could be higher and more widespread than previously realized.

The numbers show European banks have sold a total of €178 billion ($238 billion) worth of insurance policies, in the form of financial derivatives known as credit-default swaps, on bonds issued by the financially struggling Greek, Irish, Italian, Portuguese and Spanish governments. If those bonds default, as some investors fear they might, banks could be on the hook for making large payments to the holders of the swaps.

The banks have at least partly insulated themselves from such potential losses by buying large quantities—roughly €169 billion worth—of credit-default swaps tied to the same bonds, apparently in large part from other European banks, according to European Banking Authority data.

Some analysts and investors say they had assumed that sovereign credit-default swaps, known as CDS, were primarily sold by giant global investment banks in the U.K., France and Germany, as well as in the U.S. Those banks sell the swaps to big corporate clients and other banks and institutions.

But the new EBA data show a surprising breadth of large and small European banks—at least 38 of them—have sold instruments that protect against potential losses on Greek, Irish, Italian, Portuguese and Spanish government bonds.

Of the total protection that European banks have written on government bonds in Europe’s five most-stressed countries, nearly one-third originated from German banks.

The diverse array of banks in the sovereign CDS market means that risks can spread more quickly through the financial system. It also means it is harder to predict how losses would ricochet among institutions and countries, analysts say.

The banks and some analysts argue that the industry’s actual exposure is far less than the €178 billion of swaps they have sold because the banks have purchased €169 billion in similar protection from other sources, which can offset the exposure. Many of Deutsche Bank’s purchases and sales of CDSs, for example, are with the same counterparties, with whom the German bank has legally enforceable netting agreements in place.

But some experts say it is risky to assume that all banks’ CDS transactions neatly cancel each other out.

“Netting is all very well provided that you trust your counterparty,” said Jon Peace, a Nomura Securities banking analyst. But in a crisis situation, “what you thought was net could tend toward your gross exposures” because certain sellers of the default insurance could themselves go bust.

For example, two of Italy’s biggest banks, UniCredit SpA and Banca Monte dei Paschi di Siena SpA, have sold a total of about €5.3 billion of protection against the risk of an Italian sovereign default, according to the new EBA data. The problem is that, in a default scenario, both banks likely would be in trouble themselves due to their huge holdings of Italian government bonds and the fact that their businesses are largely concentrated in Italy.

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While the Organisation for Economic Co-operation and Development (OECD) hasn’t issued a statement setting forth its view of the results of the EU summit, the Financial Times reports that it “will warn in its latest borrowing outlook, due to be published this month, that financial stresses are likely to continue with the “animal spirits” of the markets – their unpredictable nature – a threat to the stability of many governments that need to refinance debt.”

For the foreseeable future it will be a “great challenge” for a wide range of OECD countries to raise large volumes in the private markets, with so-called rollover risk a big problem for the stability of many governments and economies.

Rollover risk is the threat of a country not being able to refinance or rollover its debt, forcing it either to turn to the European Central Bank in the case of eurozone countries or to seek emergency bail-outs, which happened to Greece, Ireland and Portugal. The OECD says the gross borrowing needs of OECD governments is expected to reach $10.4tr in 2011 and will increase to $10.5tr next year – a $1tr increase on 2007 and almost twice as much as in 2005. This highlights the risks for even the most advanced economies that in many cases, such as Italy and Spain, are close to being shut out of the private markets.

While borrowing was higher in 2009 and 2010, the risks are greater than ever because of rising borrowing costs in turbulent, unpredictable markets.

The OECD says that the share of short-term debt issuance in the OECD area remains at 44 per cent, much higher than before the global financial crisis in 2007. This, according to some investors, is a problem as it means governments have to refinance, sometimes as often as every month, rather than being able to lock in more debt for the longer term that helps stabilise public finances.

The OECD also warns that a big problem is the loss of the so-called risk-free status of many sovereigns, such as Italy and Spain, and possibly even France and Austria. The latter two have triple A credit ratings but investors no longer consider them risk-free.

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Contagion from the eurozone crisis appears to be spreading to emerging markets: Indian industrial production dropped by 5.1 percent in October. From the Financial Times:

“The data are way worse than we were expecting,” said A Prasanna, economist at ICICI securities in Mumbai. “Usually output is lower during the months of October and November as there are fewer working days due to the festival season but a 5.1 per cent drop is significantly more than we predicted,” he added.

Manufacturing output, which represents about 76 per cent of industrial production, dropped 6 per cent in October, compared with a year ago and capital goods production, which is considered to be a key barometer of investment sentiment in the country, fell 25.5 per cent. Meanwhile, mining production was down 7.2 per cent, as a series of scandals in the sector and continued uncertainty over the outcome of a long-awaited mining bill hurt the industry.