Brazil
Apr 20, 2005
Gray Newman (New York)
Seven hikes and 325 basis points later, Brazil’s central bank appears to be ready to end the tightening cycle. At least that seems to be the consensus from the latest surveys of economists and central bank watchers. After arguing for the past two months that the tightening cycle was ending, you might think I’d join in wholeheartedly and argue that the central bank is ready to stop. I’m afraid not.
I suspect that the central bank will hike rates once more on Wednesday, April 20, and seem to be almost alone in expecting a 50-basis-point hike at that. Whether the move is 25 basis points or 50 basis points matters less; I am certainly not interested in trying to build a call with that level of precision. What worries me a bit more, however, is the widespread view that the central bank will leave rates on hold this week. I am concerned how the market will respond if it discovers yet another rate hike this week. I think this week’s move by the central bank will be its last and can only hope that a hike this week does not raise more doubts than it resolves. The problem is that there is still a whiff of “conflation” in the air in Brazil. When doves cry The doves are likely to argue that all trend measures of inflation are showing an improvement. And they are largely right. Few analysts doubt that inflation which fell to 7.6% in 2004 from 9.3% in 2003 will end this year lower still. The uptick seen in month-over-month core measures in the second half of 2004 prompting the tightening appears to have passed. Indeed, the central bank’s own modeling of inflation (assuming that monetary conditions—both the exchange rate and the Selic rate—are held unchanged) now shows inflation for 2006 coming in at 3.8%, well below the 4.5% target the central bank is aiming for next year. And the improvement on the inflation picture is being accompanied by a slowdown in the pace of economic expansion. Trend industrial production growth dipped into negative territory in February; indeed, trend IP has been nearly flat since November. Meanwhile, retail sales slowed to just 1.3% in February – the smallest gain in over a year. Under our calculations, retail sales have declined on a sequential basis for the two months ending in February. And on the trade front, import demand is also showing nascent signs of weakness. Of course, the occasional negative sequential report is hardly reason for alarm. It is consistent with most growth periods in Brazil. What was unusually was the sequential growth in most economic activity indicators month after month after month during the latter part of 2003 and all of 2004. The contrast between April 2005 and September 2004 appears clear. At the start of the tightening cycle, inflation on the margin was moving up; now as the tightening draws to a close, inflation on the margin is showing an improvement. Then growth in activity was accelerating its pace; now the pace is slowing. Why then, you may ask, am I counting on one more rate hike? The hawkish view There is an easy argument to make for another rate hike: the easy answer is also the wrong answer in my view. The easy hawkish answer simply looks at the recent string of disappointing inflation reports. March’s IGP-M came in at 0.85%, well above expectations which had nearly doubled in the weeks leading up to the release. March’s Fipe CPI (0.79%) and IGP-DI (0.99%) also came in above steadily climbing expectations. Furthermore, the pressure from oil prices is building for another hike to gasoline and diesel prices. Neither is factored in to the central bank’s model of zero energy price hikes this year. And finally, inflation expectations appear to once again be on the rise. Not only have 2005 expectations continued to rise—they now stand at 6.10% as of Friday, April 15 for the year-end up from 6.04% the previous week—but twelve-month forward expectations are also beginning to turn up. The April 15 survey showed them moving up to 5.58% from 5.48% in the previous week. As important as expectations are, they tend to be backward looking. The recent upturn in expectations appears to be largely mirroring the recent uptick in prices—largely from adjustments to bus fares and other administered prices over which monetary policy can have no real impact. The notion that the central bank conducts monetary policy by reacting to every uptick or turn in expectations represents a crude misunderstanding of how the monetary authorities work. Monetary policy works with a lag and with an eye towards where inflation pressures are likely to be six to 12 months from now. The legacy issue But the recent upturn in inflation does provide a peculiar challenge for Brazil’s central bank: it raises the issue of the legacy and the credibility of the central bank. Given the central bank’s track record on the inflation targeting front in recent years, the authorities are likely to be very cautious that their actions are not misunderstood as a premature relaxation. It is possible to be on the right inflation path, stop hiking and then discover that economic agents have misinterpreted your actions and pushed you off the desired path. The more credible the central bank and the stronger its track record, the more the monetary authorities can focus on inflation trends with little worry that a series of one-off price adjustments are likely to feed into a vicious expectations game derailing progress made. But in the case of Brazil, I suspect that the authorities are still watching the near-term data and are anxious to avoid accumulating enough “short term” disappointments that eventually get strung together and create a “medium term” outcome. Given the legacy issues, I suspect that the central bank will be dissecting the latest inflation uptick and the risks surrounding energy prices and conclude that the risks of contamination from the short term to the medium term warrant another hike in interest rates. In many ways, the central bank is simply acknowledging that it prefers to be one of the last agents in Brazil to recognize the turning point on inflation. Bottom line When the most recent rate tightening cycle is behind us—as I believe it will be after this week’s hike—Brazil’s central bank should be able to argue that monetary policy has proven to be effective. Despite all of the challenges from administered prices to the expansion in credit that served to temper the impact of the current tightening cycle, both activity and inflation appear to have been responsive to monetary policy. Of course there will be nay-sayers who will argue that the recent slowdown in inflation and growth was simply a reflection of global trends. But I am suspicious of many of those critics. The same critics that today argue that monetary policy is ineffectual were warning just one year ago that monetary policy was a dangerously potent weapon which threatened Brazil’s growth path. There appears to be no end to the blame game when it comes to beating up on central banks in the region. That is a shame in many ways. Brazil’s central bank has rightfully proceeded with caution in its effort to prevent domestic demand from getting ahead of itself. Brazil has rarely had difficulties growing; instead, it has had many more difficulties in prolonging and sustaining growth. Brazil’s policy makers seem to have caught on. Some of their critics seem to have confused speed of growth with safety.
Important Disclosure Information at the end of this Forum
Mr. Thaksin Shifting Gear
Apr 20, 2005
Daniel Lian (Singapore)
A Dinner with the Prime Minister On March 28, I had dinner with Prime Minister Mr. Thaksin Shinawatra, Deputy Prime Minister cum Finance Minister Dr. Somkid Jatusripitak and Chief Policy Advisor to the Prime Minister Mr. Pansak Vinyartn. Mr. Thaksin and his two key advisors are clearly re-assessing both cyclical and structural economic prospects given the now more severe economic challenges that are confronting the Kingdom after their recent second term electoral victory in early February. Our policy debate and discussion that evening centered on cyclical economic and longer-term economic restructuring issues. I gave Mr. Thaksin and his two most trusted economic advisors my candid assessment on a range of economic topics. Cyclical Economic Risks Thailand is confronting two inter-dependent economic risks. First, the rapid growth seen since 2002 (one year after Mr. Thaksin commenced his first term in 2001) can no longer be taken for granted (see details below). Second, the assumption that the Kingdom can sustain economic momentum while balancing its current and fiscal accounts over the next few years may no longer be valid. 1. Economic deceleration risk. The Thai economy has decelerated since it peaked in 4Q03. The December 26, 2004 Tsunami has hit Thai tourism hard in the first quarter of 2005. This, coupled with the continued threat of Avian flu, the drought, as well as Southern unrest, has weighed on the Thai economy. Moreover, the deepening energy crisis is putting more upward pressure on general prices and interest rates (the Thai government removed almost 50% of its diesel subsidy on March 23, 2005), weakening business and household confidence and further dampening the cyclical outlook. We believe 1Q05 GDP might slow to only 4% YoY, thus threatening our 5.7% GDP growth forecast for the full year. The economic deceleration could send Thai economic growth to the lower end of the official forecast 5.25-6.25% range unless measures are taken to tackle these cyclical woes. More significantly, the strong growth momentum seen since early 2002 can no longer be taken for granted. The continued deceleration in growth is due to slowing private consumption and net exports (imports pick up steam after Thailand enters a more mature growth cycle with more domestic investment) and the failure of other growth components, notably domestic investment, to pick up the slack vacated by private consumption and net exports. Domestic investment thus holds the key to structural growth in Thailand as neither government consumption nor investment will become major contributors to growth due to the government’s policy of fiscal prudence. 2. Current and fiscal accounts risks: Thailand has managed to accelerate growth from late 2001 to late 2003 while retaining a sizeable current account surplus and balancing its fiscal accounts. However, both accounts (surpluses) face the risk of deterioration. On the current account front, rising oil prices, capital imports for the infrastructure build up, and a high probability of weakening global demand means that Thailand’s current account could deteriorate rapidly. In fact, the country’s current account surplus could shrink to just 0.5-1% of GDP in 2005, and become a deficit in 2006. The original government projections of the current account only deteriorating into a small deficit ratio of 0.5-1% in a few years time may now no longer be achievable. On the fiscal account front, fiscal prudence has been a key element of Mr. Thaksin’s economic platform and the attainment of fiscal balance in the latter part of his first term has been a major economic accomplishment. However, the ability to sustain a robust fiscal sector during the second term is somewhat at risk due to the following factors: a) The present robust revenue trend appears to be weakening due to the steady deceleration in economic growth. Hence, continued fiscal balance cannot be taken for granted. b) A big chunk of government revenue continues to be deployed to repay both the principal and interest on the public debt, leaving the government with inadequate fiscal maneuverability. c) The Oil Fund is already saddled with a large deficit of Bt76 billion (US$2.0 billion) and this could rise significantly during the course of this year if oil prices remain firm. d) Although the size of the domestic infrastructure investment program, stretching over the next 7-years (2005-2011, Thai year 2548 to 2554) has been informally reduced from Bt2.4 trillion to Bt1.5 trillion (US$64.2 billion to US$40.1 billion), the sum is still fairly large given the resources of the Thai government. If substantial public financing is required, this would be a further obstacle in terms of efforts to “balance” the fiscal sector. Other Investor Concerns: Privatization and Infrastructure The “intensifying” economic risks elaborated earlier clearly represent a major part of investor concerns. However, most international investors are concerned about whether the government could deliver the “promised” privatization given that this program has lost momentum during the latter part of the first term of the Thaksin administration, as both energy and telecommunication privatization initiatives were delayed due to trade union obstacles and industry design concerns. The other major concern is that, while a grand infrastructure investment program was unveiled about a year ago, investors are still very confused by the various versions of the plans that are floating around. Most importantly, given the intensifying economic risks and pressures on both fiscal and external accounts, investors also want to know whether the Thaksin administration can finally craft the “right size” infrastructure program complete with credible financing details and implementation plans. Shifting Gear Mr. Thaksin’s ongoing economic development strategy has been extensively elaborated and analyzed in some of my earlier pieces (Lowering Risk Premium and Delivering Growth dated March 16, 2005, Mr. Thaksin’s Second Term Policy Priorities dated February 15, 2005, Mr. Thaksin Has a Plan dated September 21, 2004, and Mr. Thaksin’s Third Chapter dated July 21, 2004). I believe the need has arisen for Thailand to shift gear as easy acceleration has come to an end and the Thai economic vehicle needs to abandon its ‘cruising speed’ to prepare to go uphill again. At the dinner with the Prime Minister and his two advisors we discussed several policy options and enjoyed an effective interaction with them on the following subjects: First, enlarge and leverage on the forthcoming supplementary budget to tactically support private consumption in 2005 through building “low import content” local demand. The supplementary budget is projected to be worth around Bt50 billion (US$1.32 billion or some 0.76% of 2004 nominal GDP). I believe the supplementary could double in size to Bt100 billion (US$2.63 billion, or 1.52% of 2004 nominal GDP). This will only strain the fiscal balance slightly, resulting in perhaps a small imbalance. While a Bt100 billion supplementary might finally tilt the fiscal account away from roughly “in balance” to a marginal deficit in the neighborhood of around 0.5% of GDP, the support it offers to the economy at this critical juncture when household and business confidence is faltering is well worth it, in my view. Most importantly, the supplementary budget can be leveraged to generate a high income-expenditure multiplier GDP by targeting the rural-grassroots-SME-new startups-mass housing sectors so to generate a good buffer of support to arrest the declining trend in private consumption, household and business confidence. Second, scale back capital-import intensive “final” infrastructure projects and emphasize productive and high-multiplier intermediate infrastructure. Given the high and rising oil prices, escalating inflationary pressures and deficit pressures on both fiscal and current accounts, “hardware” and final infrastructure ─ those that utilize high imports of capital and technology goods ─ such as the Bangkok mass transit and other bigger scale projects such as highways, ports and new cities should now become lower on the infrastructure priority list. The reason is that this sort of infrastructure tends to have a low multiplier to domestic demand at least in the initial years of construction due to its reliance on foreign capital goods and know how. In my view, these projects should become smaller and be built over a longer period unless there are signs the Thai economy will pick up growth momentum without triggering overheating and external imbalances. Instead, Mr. Thaksin should emphasize intermediate infrastructure, in my view. Intermediate infrastructure such as the improvement of rural-grassroots-agriculture infrastructure as well as other “software” (low capital-import content) infrastructure for SMEs and new startups would be the key to the value creation strategy. In addition, this type of infrastructure spending also tends to generate a stronger multiplier effect, ensuring that money spent goes towards creating stronger domestic demand, akin to the 2001-2002 “second track” experience when the first term Thaksin government successfully rejuvenated rural demand and salvaged sluggish domestic demand inherited from the previous administration of 1997-2000. Third, the market and the global investment community want to know the precise status of the domestic infrastructure investment program. They can appreciate a scaling back of “hardware” infrastructure with high capital and import content. Once the government takes into account the current fiscal and economic constraints, as well as the economic effectiveness of various infrastructure programs, the government should clearly outline and communicate the revised domestic infrastructure investment program with details of financing means as well as execution timetable to the public. This, in my view, will go a long way in boosting market and international confidence in the Thaksin administration and the Thai economy. Fourth, the market and the global investment community want to see an effective acceleration in privatization as this signals the administration’s commitment to economic restructuring. The rationale to kick-start privatization is well understood by both investor and the Thaksin administration. Privatization will bring in proceeds to help fund Mr. Thaksin’s Third Chapter, but in my view, Mr. Thaksin should assign top priority to privatization not because Thailand needs the proceeds but rather because privatization is likely to instill greater corporate discipline in state enterprises, thus helping to improve the overall efficiency of the public sector. Privatization should also help deepen the Thai financial market, making Thailand more attractive to international investors. Fifth, the Thai government needs to effectively communicate its economic strategy and ambitions. The world is quite skeptical on whether Mr. Thaksin will be able to deliver economic prosperity in his second term. It is thus important, in my view, for Mr. Thaksin to set a goal for Thailand and every Thai citizen. The value creation strategy should become a rallying point for the whole country. The dual track strategy has been a successful slogan and economic program during the first term. Value creation, a natural extension of the dual track, should become the economic goal and rallying point for the country in Mr. Thaksin’s second term. While predominantly an economic development strategy, the value creation principle could also stretch to other non-economic social realms such as the civil service, education, law and order etc. Bottom Line: Mr. Thaksin Should Shift Gear to Preserve Growth and Confidence To conclude, in our view, apart from the cyclical economic and structural risks, investors are also concerned about whether Mr Thaksin will be able to restart the privatization programme. In addition, they are also looking for further insights into the infrastructure plans and whether, given the intensifying economic risks and fiscal pressures, Mr Thaksin is able to craft an appropriate program complete with financing and implementation details. I believe that investors’ concerns and the “tough” and potentially “deteriorating” cyclical economic environment means that Mr. Thaksin has to prioritize his economic objectives and programs for 2005 as well as his second term. I believe the following strategy would be appropriate given the current environment. The administration should tactically support private consumption in 2005 through building “low import content” local demand by leveraging on the supplementary budget. The investment program should also be prioritized to emphasize intermediate infrastructure, which I believe holds the key to the value creation strategy, at the same time, scaling back on “hardware” infrastructure. To gain investor confidence, the government should also communicate a revised infrastructure investment program with detailed financing and execution plans to the market, as these would boost confidence in the government, in my view. In addition, a renewed momentum in the privatization process would signal a commitment to economic restructuring as well as instill greater corporate discipline. Last but not least, I believe Mr. Thaksin should formally adopt a value-creation economic blueprint in his second term, both as an extension as well as an enlargement of the successful dual track strategy. This, I believe, would encourage the whole country to work towards a common goal.
Important Disclosure Information at the end of this Forum
Technological Sclerosis and Productivity Divergence
Apr 20, 2005
Serhan Cevik (from New York)
Turkey enjoys a productivity surge, but the sectoral breakdown highlights micro problems. According to our computations, the underlying trend rate of real GDP growth increased from an average of 3% in the second half of the 1990s to a very strong 7.8% last year. In our opinion, structural reforms and prudent policies that have facilitated the normalization of the macroeconomic landscape also encourage Turkish firms to focus on productivity growth in order to improve profitability ratios in the low inflation environment. Indeed, the trend growth rate of labour productivity in the business sector increased from an average of 2.4% in the 1990s to 5.7% in the last three years and to 6.6% in 2004. Nonetheless, even though almost every sector of the economy has enjoyed an increase in labour productivity, industry-level data reveal significant productivity divergences across industries due to organizational inefficiencies and technological sclerosis. Declining unit labour costs strengthened Turkey’s industrial cost competitiveness. The average real wage in the manufacturing sector increased by 2.5% last year, following a cumulative drop of 25.2% in the preceding three years. This unusual combination of rising productivity and declining real wages lowered unit labour costs by an unprecedented 40% in the last four years. Furthermore, Turkey’s average unit labour cost declined from 143.5% of the average level of the EU countries in the 1990s to 65.7% in the past three years (and to 61.6% at the end of 2004). Likewise, the ratio of unit labour costs in Turkey to those in the US improved from an average of 131.0% in the last decade to 67.2% in the post-crisis period. As we have long argued, the compression of unit labour costs is one of the key drivers of Turkey’s impressive export performance, especially, against an appreciating currency. Of course, even with a slow recovery in the labour market, real wages will no longer decline across the board, and unit labour costs will depend even more on productivity trends. Technological sclerosis and politically-driven decisions result in wage pressures in traditional sectors. The average real unit labour cost in the manufacturing sector declined by 4.6% last year, but stopped contracting in the second half of the year. Moreover, disaggregated manufacturing data show a wide divergence in sectoral labour productivity performance and wage adjustments. Real wage growth is much higher in traditional sectors employing low-skilled workers, compared with capital-intensive sectors. For example, food and clothing sectors recorded real wage increases of 5.4% and 11.3%, respectively, last year, owing to a 24.3% rise in the national minimum wage. On the other hand, higher value-added sectors, like machinery, electronics and automotives, experienced a further contraction of real wages (by 5.5%, 2.2% and 7.8%, respectively). Therefore, traditional sectors that have lower productivity growth, compared with technology-intensives industries, suffer disproportionately from politically-driven wage increases. Technology-intensive sectors are benefiting from higher productivity growth rates. On average, Turkish firms lack technological capability to move up on the value chain. Only 29.4% of manufacturing companies made technology-intensive capital investment in the 1998-2000 period, up from 24.6% between 1995 and 1997. Even the remarkable investment boom that we have witnessed in the last two years may not be enough to catch up with international levels of technology spending. As a result, some sectors (dominated by small firms suffering from the problem of technological backwardness) have a significantly lower productivity level. For example, output per hour-worked in the textile sector increased by 19.1% in the last four years, whereas the machinery industry enjoyed a 55.9% surge in labour productivity. We have long argued that institutional obstacles limit firms’ capacity to achieve economies of scale and thereby lead to technological sclerosis. Microeconomic reforms can open the door to technological innovation. The normalisation of macroeconomic dynamics and productivity-enhancing capital spending have been the key to maintain an above-trend growth performance in the last three years, but the future of (total factor) productivity growth will increasingly depend on microeconomic adjustments. Indeed, an economy cannot be ‘competitive’ unless companies are competitive. However, the sophistication of companies is inextricably interconnected to the quality of the business environment. Furthermore, an educated workforce and technological progress, not relative unit labour costs, are the key for improving a country’s international competitiveness and income growth in the long run. Therefore, Turkey now needs a modern institutional matrix that would support competition and innovation, not the rent-seeking structure that has limited the emergence of an entrepreneurial society.
Important Disclosure Information at the end of this Forum
Disclosure Statement
The information and opinions in this report were prepared or are disseminated by Morgan Stanley & Co. Incorporated and/or Morgan Stanley & Co. International Limited and/or Morgan Stanley Japan Securities Co., Ltd. and/or Morgan Stanley Dean Witter Asia Limited and/or Morgan Stanley Dean Witter Asia (Singapore) Pte. (Registration number 199206298Z) and/or Morgan Stanley Asia (Singapore) Securities Pte Ltd (Registration number 200008434H) and/or Morgan Stanley & Co. International Limited, Taipei Branch and/or Morgan Stanley & Co International Limited, Seoul Branch, and/or Morgan Stanley Dean Witter Australia Limited (A.B.N. 67 003 734 576, holder of Australian financial services licence No. 233742, which accepts responsibility for its contents), and/or JM Morgan Stanley Securities Private Limited and their affiliates (collectively, "Morgan Stanley").
Global Research
Conflict Management Policy
This research observes our conflict management policy, available at www.morganstanley.com/institutional/research/conflictpolicies.
Important Disclosures
This report does not provide individually tailored investment advice. It has been prepared without regard to the circumstances and objectives of those who receive it. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages them to seek a financial adviser's advice. The appropriateness of an investment or strategy will depend on an investor's circumstances and objectives. This report is not an offer to buy or sell any security or to participate in any trading strategy. The value of and income from your investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized.
With the exception of information regarding Morgan Stanley, reports prepared by Morgan Stanley research personnel are based on public information. Morgan Stanley makes every effort to use reliable, comprehensive information, but we do not represent that it is accurate or complete. We have no obligation to tell you when opinions or information in this report change apart from when we intend to discontinue research coverage of a company. Facts and views in this report have not been reviewed by, and may not reflect information known to, professionals in other Morgan Stanley business areas, including investment banking personnel.
To our readers in Taiwan: This publication is distributed by Morgan Stanley & Co. International Limited, Taipei Branch; it may not be distributed to or quoted or used by the public media without the express written consent of Morgan Stanley. To our readers in Hong Kong: Information is distributed in Hong Kong by and on behalf of, and is attributable to, Morgan Stanley Dean Witter Asia Limited as part of its regulated activities in Hong Kong; if you have any queries concerning it, contact our Hong Kong sales representatives.
This publication is disseminated in Japan by Morgan Stanley Japan Securities Co., Ltd.; in Canada by Morgan Stanley Canada Limited, which has approved of, and has agreed to take responsibility for, the contents of this publication in Canada; in Germany by Morgan Stanley Bank AG, Frankfurt am Main, regulated by Bundesanstalt fuer Finanzdienstleistungsaufsicht (BaFin); in Spain by Morgan Stanley, S.V., S.A., a Morgan Stanley group company, which is supervised by the Spanish Securities Markets Commission (CNMV) and states that this document has been written and distributed in accordance with the rules of conduct applicable to financial research as established under Spanish regulations; in the United States by Morgan Stanley & Co. Incorporated and Morgan Stanley DW Inc., which accept responsibility for its contents. Morgan Stanley & Co. International Limited, authorized and regulated by Financial Services Authority, disseminates in the UK research that it has prepared, and approves solely for the purposes of section 21 of the Financial Services and Markets Act 2000, research which has been prepared by any of its affiliates. Private U.K. investors should obtain the advice of their Morgan Stanley & Co. International Limited representative about the investments concerned. In Australia, this report, and any access to it, is intended only for "wholesale clients" within the meaning of the Australian Corporations Act.
Trademarks and service marks herein are their owners' property. Third-party data providers make no warranties or representations of the accuracy, completeness, or timeliness of their data and shall not have liability for any damages relating to such data. The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of MSCI and S&P. Morgan Stanley bases projections, opinions, forecasts and trading strategies regarding the MSCI Country Index Series solely on public information. MSCI has not reviewed, approved or endorsed these projections, opinions, forecasts and trading strategies. Morgan Stanley has no influence on or control over MSCI's index compilation decisions. This report or portions of it may not be reprinted, sold or redistributed without the written consent of Morgan Stanley. Morgan Stanley research is disseminated and available primarily electronically, and, in some cases, in printed form. Additional information on recommended securities is available on request.
|
