United States
Compensation Poised to Accelerate; Will Wages Follow?
Apr 25, 2005

Richard Berner (in Dublin)

Labor markets have firmed noticeably over the past two years, judging by traditional cyclical metrics such as the unemployment rate and the median duration of unemployment.  Together with rising inflation, I think tighter labor markets will soon push up nominal compensation growth in time-honored, cyclical fashion.  But nothing cyclical about this 41-month-old post-bubble expansion seems to have respected time-honored cyclical norms.  That’s certainly true for nominal compensation; so far, Corporate America seems to have held the line on the combination of overall pay and benefits.  Despite soaring energy prices, low inflation and inflation expectations have held back nominal compensation.  More important, wage gains — crucial to sustaining consumer wherewithal — have lagged overall compensation growth more in this expansion than at any time in the past 25 years. 

The chief culprit for that gap, in my view: Soaring healthcare and pension benefits.  To be sure, two other critical factors also matter in the wage-compensation nexus: Labor market slack and outsourcing to cheaper venues.  But inflation expectations and benefits in my opinion are the most important influences by far.  And understanding the benefits-wages dichotomy has important implications for markets and the Fed.  Here’s why.

First, nominal compensation growth is low by historical standards, rising by either 4.2% or 3.7% over 2004, depending on whether measured by compensation per hour or the more reliable Employment Cost Index (ECI), respectively.  Both are above any measure of headline inflation, yet there is a perception that real compensation in this expansion has come up short of past experience.  I think that’s most likely because real compensation (even excluding income from options exercise) jumped in the 1990s.

Surprisingly, however, there’s little difference between the advance in real compensation per hour (which includes both wages and benefits, and calculated either with the PCE chain price index or an adjusted CPI*) to date in this cycle and that in the five most recent recoveries at the same point in cyclical time.  It’s worth noting, however, that real compensation had lagged behind cyclical norms until the past year, that rising energy quotes have recently depressed real compensation once again, and that heavy options exercise distorted the compensation data in the late 1990s.  In addition, I think perceptions of how the productivity pie has been sliced colors the debate: Specifically, productivity gains in this cycle are far above par, and profit margins stand at record levels, but real compensation gains in the ‘50s and high-productivity, early ‘60s outstripped today’s.

In contrast, real wages have lagged slightly behind past experience, and I believe that explosive growth in benefits is a key factor.  Especially lately, growth in compensation and growth in wages (either nominal or real) have significantly diverged; the gap of 1.3 percentage points at the end of 2004 between the 3.7% private compensation and 2.4% private wage growth measured by the Employment Cost Index is the largest in the 26-year history of the data.  Employers and employees alike correctly view healthcare, retirement saving and other noncash benefits as part of total compensation, and both side have bargained to trade off benefits with wage growth.  And benefits measured in the ECI for all civilian workers soared by 6.9% over 2004, the fastest pace in 22 years, other than a short-lived similar rate in 1988. 

That tradeoff is most intense in industries most exposed to global competition or innovation, and in governments that have a history of offering generous healthcare and pension benefits in lieu of pay to a unionized workforce.  Among them: Motor vehicles and parts and other areas of Smokestack America, transportation and telecommunications services, and state and local governments.  Indeed, the experience of General Motors lately illustrates how past, unfunded benefits promises are now squeezing corporate operating income in such industries.  And the pressures from such promises on the budgets of many nonfederal governments are also rising.  Faced with such pressures, employees in many industries and states and municipalities are surrendering wage growth to keep valuable benefits. 

Some think the benefits factor can’t be that compelling; after all, apart from those troubled industries, profit margins are at record levels.  In addition, defined-benefit pensions cover only one in five workers, and as many as 40% of all workers don’t get health insurance on the job.  But that last statistic is misleading, because a variety of studies shows that about 40% of the workers who don’t take up healthcare offers have coverage through a spouse, and another 20% (likely younger workers) decline coverage to save money.  In addition, 7.5 million workers hold two or more jobs, and most often take one healthcare offer.  Workers with families understand the value; in 2004, the Kaiser Family foundation surveys showed that the cost of PPO coverage for a family of four averaged $10,217, and despite increased employee premiums, the employer pays 72% of family coverage, yielding a tax-free benefit worth $8500. 

What about labor market slack?  The overall jobless rate has declined by a percentage point from its peak of 6.3% early in 2003, and the median duration of unemployment has declined by roughly two weeks from its peak of 11.4 weeks two years ago.  But jobless spells remain historically long, suggesting that labor markets may be looser than the jobless rate suggests.  After all, job growth has been subpar and workers who left the labor force in the recession could be too discouraged to return.  But the Bureau of Labor Statistics estimates that including discouraged workers adds only 0.2% to the unemployment rate.  And the decline in the overall labor force participation rate may reflect more than discouraged workers, because it masks two demographic trends: Female participation leveled off five years ago after doubling over the prior five decades.  And male participation has continued its steady 55-year downtrend.  Employment has outpaced labor force growth for two years; if that continues, labor markets will tighten further.

As for outsourcing and offshoring, I believe that they have been factors holding back both US employment and wage gains, especially in certain industries.  But I believe that their influence has been overblown, because cost differentials may not justify the moves, and costs abroad are accelerating.  Indeed, my colleague Jeff Matsu reports that “a just-released Deloitte Consulting survey reveals that 70% of the multinationals they surveyed had significant negative experiences with outsourcing projects and now exercise greater caution in approaching such deals.  Instead of simplifying operations, many companies have found that outsourcing activities can introduce unexpected complexity, add cost and friction into the value chain, and require more senior management attention and deeper management skills than anticipated.”  And courtesy of stronger global growth, cost differentials may not be all they appeared to be a couple of years ago.  For example, Tata, an Indian consulting firm, announced a 34% drop in FY 4Q earnings (ended March 31) to $107.8 million, partly because labor costs are soaring; management expects 13-15% salary increases this year in the Indian consulting industry.

I have no doubt that US compensation gains will increase, but the coming upturn in wage growth may lag behind as companies and governments grapple with still-soaring benefit costs.  Private wages may reaccelerate before government wages, because companies appear to be working hard to bring benefit cost growth down.  For example, growth in the employer portion of private-industry healthcare befits decelerated to 7.3% from a peak of 11.4% early in 2002.  Further reductions may be hard to come by, however.  By comparison, state and local wage growth may lag gains in private industry.  State and local governments seem less likely to be able to control either their unfunded “legacy” costs for healthcare and pensions for current retirees or the growth in healthcare costs for active workers.

Even before wage growth picks up, however, unit labor costs are likely to accelerate as productivity slows and compensation accelerates.  For Corporate America, that will simultaneously add to pressures on margins and prompt them to try to pass those costs increases on to customers.  Although it is far from ubiquitous, pricing power is improving, and those cost increases likely will intensify inflation concerns for market participants and the Fed.  As for consumers, benefits don’t add to spending wherewithal, so either saving or spending may suffer if wages lag.  But keeping valuable and ever-more-expensive benefits for some consumers may be better than pay increases, and may sustain consumer confidence.

What are the risks?  A pickup in wage growth, were it to occur sooner than I expect, would add both to income growth and cost pressures.  But there are also downside risks.  Renewed lags in real wage performance — beyond that recently induced by the surge in energy quotes — could menace spending.  And surging state and local benefits that governments finance by raising property taxes, as currently seems to be occurring, might weaken housing values by making housing less affordable. 

* The adjusted CPI in these calculations splices three alternative headline consumer price measures: The published CPI prior to 1977, the “Research Series” CPI (to remove the overstatement in the published data from including financing costs in housing prices) between 1977 and 1999, and the chained CPI (to eliminate substitution bias from the published fixed-weight index) from 1999 on.  The PCE price index, which is also a chain-weighted measure, may understate the cost of out-of-pocket health care expenses and includes some imputed costs for financial services.

 

 

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U.S.
Review and Preview
Apr 25, 2005

Ted Wieseman/David Greenlaw (New York)

Treasury yields ended mixed with the curve significantly flatter over the past week, as the market chose mostly to ignore more signs of rising inflation pressures in another upside surprise in the core Consumer Price Index and in anecdotal reports again in the Beige Book and some possible early signs of an improving trend in the economy coming into April in reports on consumer confidence, jobless claims, and manufacturing activity.  Instead, the market traded in near lock-step with stocks for most of the week.  This trend approached the ludicrous on Wednesday when Treasuries initially gapped lower on the CPI surprise, but then more than rallied back when stocks fell -- in response to the CPI surprise.  So, taking out the middleman, Treasuries rallied Wednesday because of bad inflation news!  Meanwhile, despite a number of additional Fed speakers who all continued to provide the basic message that policymakers, while recognizing recent signs of some energy-induced softening in activity, are not particularly worried about a sustained slowing in the economy, expect to remain on a measured tightening path, and continue to be worried about upside inflation risks, the futures market stubbornly refused to give up on the idea of a near-term pause or even a complete halt in the Fed rate-hiking cycle.  Fed funds and eurodollar futures only slightly scaled back the probability of such an abrupt about-face by the Federal Open Market Committee, putting the front end of the Treasury market under mild pressure.  At this point, many fixed income investors appear to be largely ignoring the incoming data and commentary from Fed officials as too backward looking and instead are closely focusing on recent stock market weakness as a potential real-time indicator of a worsening economic outlook.  Equity portfolio managers have become more pessimistic about the growth outlook, according to our equity strategy team, but for all the recent weakness in stocks, Q1 earnings results have actually come in considerably better than consensus expectations so far.  Strangely, corporate credit now seems to be much less of a concern for interest rate markets relative to stocks, as credit spreads actually had an okay week.  Although the economic calendar is quite active in the coming week, there seems little reason to expect much change in this stock market fixation, as Treasury investors seem more likely to wait for key news in the first week of May -- the FOMC meeting and the employment report, in particular -- to shift focus away from equities and back to economic news.

The Treasury curve experienced a significant flattening move over the past week, as the front end saw modest losses and the back end decent gains.  2’s-30’s ended the week 12 basis points flatter at 97 bp -- just marginally above the prior cycle low hit in late March when yields were about 25 bp higher -- as the 2-year yield rose 7 bp, to 3.605%, and the long bond yield fell 5 bp, to 4.58%.  The belly of the curve put in a relatively strong performance, as mortgage-related buying appeared to be a significant driver at times during the week -- particularly in a solid rally seen Tuesday even as stocks gained -- after the significant recent decline in the duration of the mortgage market moved yield levels into a danger zone for negative convexity hedging needs.   The 5-year yield rose 1 bp on the week, to 3.92%, and the 10-year yield fell 2 bp, to 4.25%.   Benchmark 5- and 10-year swap spreads narrowed about 1 bp on the week and have now reversed a good part of the widening that was seen in the month after General Motors’ initial earnings warning in mid-March raised some fears of systemic risks in corporate credit markets.

There was a very busy roster of Fed speakers in the past week, not one of whom provided any support for the massive repricing of Fed risks seen over the past month in the futures market.   Fed Chairman Greenspan did not address the economic situation much in his testimony on budget issues, but when asked about the risks of stagflation, he unhesitatingly dismissed the idea.   Others were more explicit in continuing to express confidence in the medium-term growth outlook and to forecast contained inflation going forward, but also continuing to warn of upside risks to inflation and to leave little doubt that the FOMC remains ready to respond appropriately if those risks are realized.   Probably most notable in this regard for the second week in a row was Governor Kohn, who said that “the rise in energy prices seems to have taken a toll on consumer confidence and spending most recently,” but noted that “with financial conditions still accommodative, profits and cash flow still healthy, and incomes continuing to increase, most forecasters expect growth to remain solid.”   He also reiterated the “conundrum” theme when he noted that “Treasury yields and risk premiums on private securities are low by historical standards,” that the market believes the “federal funds rate will move up only gradually as the expansion proceeds,” and that the recent rate of home price appreciation has outstripped fundamental explanations enough to “raise questions.”   He wondered, “Are expectations substantially distorted?”   He also made clear that the Fed remains on the tightening path:   “The federal funds rate appears to be below the level that we would expect to be consistent with the maintenance of stable inflation and full employment over the medium run, and, if growth is sustained and inflation remains contained, we are likely to raise rates further at a measured pace.”   Governor Kohn gave similar warnings last week and was ignored by the market; he and the numerous other Fed officials speaking in recent days didn’t have much more success this week.   The July Fed funds contract sold off a half bp, to 3.24%, still pricing in a slight possibility of a pause at the June FOMC meeting.   The October contract was off 4 bp, to 3.55%, pricing in an 80% likelihood of a skipped rate hike by September.   Only marginally more tightening was priced into the second half of the year in eurodollar futures, with the June to December 2005 spread widening 3 bp, to a mere 53 bp, as the June contract dipped 1 bp, to 3.405%, and the December contract fell 4.5 bp, to 3.935%.   The December 2006 contract dropped 3.5 bp, to a yield of 4.35%, continuing to price in little additional Fed tightening next year and a still-easy policy stance.

Economic data released in the past week pointed to rising inflation risks and some early and tentative signs of improvement in the real economy in April after the miserable March results.   The core CPI posted a second straight upside surprise, jumping 0.4% in March on top of a 0.3% rise in February, bringing the year-to-date increase to an elevated 3.3%.   Meanwhile, the Beige Book prepared for the forthcoming FOMC meeting again reported widespread signs of increased business pricing power, allowing more push-through of rising material and labor costs into final goods prices, a trend first noted in the last edition of the Beige Book and since cited as a worrying trend by a number of Fed officials.   Given this second month in a row of worse-than-expected inflation news, we believe the Fed may drop its reference to “measured” rate hikes at the coming FOMC meeting to give it more freedom to step up the pace of tightening if the economy emerges from the spring “soft patch” in the months ahead.   The degree to which the CPI upside is also seen in this Friday’s core PCE price measures will likely be a key consideration in this regard when the Fed meets May 3.   Because much of the upside in the core CPI this month was in hotels, and the weight of hotels in the PCE price index is much smaller than in the CPI, we think the core PCE will probably rise a more benign 0.2% in March, which, depending on rounding, would leave it unchanged at +1.6% year/year or lead to a slight uptick to +1.7%.   Note that this apparently benign outcome would be a base effect more than anything.   A +0.2% core PCE price index in March would leave it up +2.1% annualized in the past six months.   A continued run of +0.2% monthly readings in the months ahead would leave the year/year rate at +1.8% in May (above the Fed’s +1.5% to +1.75% forecast for the year), at +2.1% in July (above the 1% to 2% range several Fed officials have identified as their “comfort zone” for inflation), and at +2.5% by year-end.

Meanwhile, even as more negative data for March were reported in the form of an 18% plunge in housing starts, some positive and tentative early signs emerged in the incoming early data for April that provided some hope that the economy has improved recently as energy prices have flattened out.   The weekly ABC/Washington Post consumer confidence poll provided a stark indication of just how tightly sentiment has become tied to gasoline prices.   The index had plunged from -7 in the first week of March to -18 by April 10, moving lower every week as gas prices moved higher.   In the latest week, retail gasoline prices posted their first decline since February, and, right on cue, the ABC index rebounded 2 points, to -16.   Meanwhile, better-than-expected results from the weekly jobless claims and Philadelphia Fed reports led us to set relatively optimistic initial forecasts for April payrolls (+180,000) and the April ISM report (55.0).   Initial jobless claims for the week ended April 16 -- the survey week for the employment report -- plunged 36,000, to 296,000.   The Labor Department attributed some of the swing to faulty seasonal adjustment tied to the unusually early Easter holiday this year.   There is often a good deal of volatility in the claims figures around this time of the year related both to Easter and to eligibility changes at the beginning of new calendar quarters, so it is difficult to untangle the noise from the underlying trend.   But, in examining the seasonal factors and prior years’ patterns in the claims data, it appears to us that only a portion of the latest decline can be explained by faulty seasonal adjustment.   We look for a rebound in next week’s report -- but only to about 310,000.   This would trigger a sizable drop in the four-week average, to 320,000.   Meanwhile, the usually closely correlated Philly Fed and Empire State manufacturing surveys saw an unprecedented divergence in April.   The headline Philly Fed sentiment index surged to 25.3 from 11.4 -- the highest reading since October -- and the underlying details were just as robust.   In contrast, the Empire State headline index (released a week earlier) plunged to 3.1 from 19.6, and the underlying details were just as weak.   For both the Philly and Empire surveys, the headline index is a separate question on sentiment about overall business conditions.   We find a weighted average of the key activity measures to be a much more useful way of looking at these reports than these often volatile sentiment measures.   Applying ISM weights and rebasing to a 50-breakeven scale, the Philly Fed would have jumped to 59.0 in April from 54.8 in March.   In contrast, the Empire State on this basis fell to 50.6 from 55.3.   It’s possible that the later release of the Philly Fed and presumably later collection of survey results point to a significant recent improvement in factory conditions (though it’s hard to imagine such a huge swing in a week).   At this point, we’re going to split the difference between the two surveys and assume the national ISM will be about unchanged at 55.0 in April.

The week ahead is a busy one for economic data releases, but the numbers are generally of secondary importance while we wait for the FOMC meeting, employment report, ISM report, auto sales results, and Treasury refunding in the first week of May.   Certainly, if the market was willing to largely ignore the key inflation reports and heavy calendar of Fed speakers in the past week in favor of a slavish focus on stocks, it seems unlikely that the relatively less important data in the week ahead will divert investors’ attention.   With the Fed moving into its traditional quiet period ahead of the May 3 FOMC meeting, there are few Fed speakers scheduled in coming days, and none on topics related to the current economic situation or monetary policy.   On the supply calendar, Treasury will auction the $9 billion reopening of the 5-year TIPS on Tuesday and announce a 2-year Monday -- we look for an unchanged $24 billion size -- for auction Wednesday.   Data releases due out include existing home sales Monday, Conference Board consumer confidence and new home sales Tuesday, durable goods Wednesday, GDP and claims Thursday, and personal income and spending, ECI, and final Michigan consumer confidence Friday:

* We look for a slight 0.3% rise in March existing home sales, to 6.81 million units, based largely on the new “Pending Home Sales Index” produced by the NAR.   This gauge has had a reasonably good correlation with the existing home sales data one month ahead.

* We expect the Conference Board’s consumer confidence index to fall to 96.0 in April.   The Conference Board sentiment gauge is somewhat more volatile than that produced by the University of Michigan.   Moreover, since this survey is conducted by mail, it tends to capture sentiment during the early part of the month -- when gasoline prices were still near their peak.   So we look for about a 6-point pullback in the index.

* We look for new home sales to be little changed in March at 1.20 million units, reflecting the recent stability in the homebuilders’ survey.   Also, mortgage application volume has held reasonably steady of late.

* We forecast a 0.5% rise in March durable goods orders.   Although survey data point to some underlying moderation in the pace of order activity, the March results are expected to get a boost from the tendency for bookings to rise in the final month of the calendar quarter.   This pattern has been particularly evident in the high tech goods category, where we look for a solid rebound.   Meanwhile, the volatile aircraft category is expected to post a modest decline.   The key core gauge of orders -- nondefense capital goods excluding aircraft -- should show a gain of almost 1.5%.

* The data released over the past couple of weeks -- particularly foreign trade for February and March retail sales -- had a major negative impact on our assessment of Q1 GDP.   We now look for GDP to rise only 3.1%, which would represent the slowest pace of growth since the first quarter of 2003.   Consumption should be up about 3%, while business capital spending is expected to show another solid rise (+12%).   And inventory rebuilding should add about 0.3 percentage point to overall GDP growth.   The main downside contributor is likely to be net exports.   Indeed, we expect a wider trade gap to subtract fully 1.5 percentage points from Q1 GDP.

* Based on the uptick in average hourly earnings and a rebound in vehicle sales, we look for solid 0.5% gains in both nominal income and spending during March.   However, rising prices will eat into these advances, likely leading to flat results for real DPI and real consumption.   Indeed, the headline PCE inflation gauge is expected to be up 0.5%, while the core should show a more modest increase of 0.2%.

* We look for a 0.8% rise in the employment cost index in Q1.   The monthly average hourly earnings data point to another subdued gain in private wage rates.   Meanwhile, cost shifting on the part of businesses is expected to help hold the increase in the benefits category a bit below the elevated readings seen at the start of the past few years.   This should contribute to a further downshift in the year/year growth rate of the ECI, to +3.4%.   Although labor market conditions have been improving for the past year or so, there is still enough slack to prevent any elevation in wage pressures.

 

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Currencies
Private Sector Financing Is Still Key for the USD
Apr 25, 2005

Stephen L. Jen (Brussels)

Excess savings of the rest of the world, particularly in Asia, continue to make it easy for the US to fill its external financing needs.  This is, in my view, likely to persist for some time longer (12-18 months).  The sense of urgency expressed in the latest G7 communiqué needs to be backed up by concrete policy action, especially from the US.  After all, in the long run, it is not enough that the Asian central banks keep propping up the dollar; private investors have to find US policies credible to prevent another significant sell off in the dollar. 

My thesis on the dollar

Rather ironically, it is precisely because of this yawning growth premium that the US enjoys that the dollar has recently found some support, through yield differentials.  Private sector capital continues to flow into the US, contrary to the expectations of the USD-bears.  Structural excess savings as well as the US cyclical growth premium have helped sustain these massive private inflows into the US. 

While I continue to firmly hold the view that the rest of the world will give the US ample time to raise its low savings rate, there is a growing danger that the US may squander this opportunity by not acting firmly or urgently enough.  What the US needs to do is clear:  fiscal and monetary tightening.  This is, in many ways, a race against the clock.  The US may not need to actually reduce the C/A deficit by half or even the fiscal deficit by half.  What it needs to do is to establish credibility with the market that their policy trajectory is convincingly heading in the right direction. 

I am assuming this will happen.   The Fed is doing its job.  But I feel increasingly uncomfortable with the fact that no concrete action on the fiscal front has been taken.  In any case, the key audience here for the policy makers is the private sector, not the Asian central banks, even though the latter has attracted a great deal of market attention. 

I make three points.

·       Point 1.   Private sector inflows are much more important than official inflows.  Some commentators have argued that the US has been reliant on foreign official inflows, and have been citing figures like ‘more than 50% of the US C/A deficit in 2004 was financed by interventions by foreign banks.’  This statement is misleading, as it exaggerates the importance of the role of foreign official financing.  Exhibit 1 shows gross capital inflows to the US, separated out by private and official flows.  It is clear that the official flows are dwarfed by private flows.  It is evident, also, that private inflows into the US are, by themselves, more than enough to fully finance the US C/A deficit.  Gross official inflows are, historically, roughly one third of the private flows, though we’ve witnessed some increase in the official flows in 2004.  (The reason why some commentators argue that more than half of the external financing comes from official sources is because they are referring to the net flows.)  Official inflows were needed to stabilise the dollar mainly because US-based investors have been diversifying into foreign assets, mostly equities.  The key point here is that, at the end of the day, private flows are much more important than official flows.  The notion that the USD was propped up by official flows is misleading and policy makers had better exercise care in conveying the right messages to the private investors, both US and foreign. 

·       Point 2.   TIC flows remain strong, for now.  The currency markets have been trading as if the global investment community has already lost faith in USD assets.  This is simply not seen in the data we have.  The balance has been quite favourable to the USD throughout the last decade.  Until the world finds new uses for its savings (i.e., a rise in investment in Asia) or it finds other places to divert the savings to (Europe), capital flows should continue to support the USD.  Again, this is why I stress the importance of good, credible policies pursued by the US.  They are critical in ensuring that private capital flows continue to come to the US. 

·       Point 3.   One should have a considered view on the nature of the Asian central banks’ interventions.  There is also a lot of talk about Asian central banks (in particular the MOF of Japan and PBoC of China) artificially propping up the dollar and ‘manipulating’ their exchange rates.  This topic is quite current, as the US Treasury is in fact preparing its semi-annual report on currency manipulators. 

I make two comments.   First, Japan has not intervened in the market since March 16, 2004.  The fact is, USD/JPY drifted back up toward 105 long after the MoF ceased intervention.  In retrospect, evidence seems to support the ‘market smoothing’ interpretation over the ‘manipulation’ interpretation.  Once sentiment on USD/JPY was stabilised by massive interventions by the MoF, USD/JPY behaviour stabilised. 

Second, the example of China is illustrative of how we should be careful about calling a country a currency manipulator.  The bulk of the dollars bought by the PBoC reflect net capital inflows, not China’s C/A surplus.  Much of the capital flows into China are ‘speculative’ in nature.  When commentators/politicians label China as a ‘currency manipulator’, they usually have in mind China keeping their currency artificially low to gain unfair advantages over trade in goods.  However, the reality is that the bulk of the interventions are related to capital flows.  This point circles back to my earlier point that official interventions are more of a ‘reaction’ to these private flows.

Bottom line

Private capital flows dominate official flows.  For the dollar to avert a collapse, US policy makers will need to convince the market with specific measures to raise the savings rate.  A sense of urgency should be conveyed through policy action, not just through a communiqué.

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Currencies
China's Pre-Funding of Future Private Outflows
Apr 25, 2005

Stephen L. Jen (Brussels)

While Japan and Korea may be approaching saturation points with the size of their official reserve holdings, China can still justify accumulating more reserves.   China stands out as a unique case as its private sector holdings of overseas investment are extraordinarily low.  The official reserves, therefore, could be considered as ‘pre-funding’ of the private sector outflows expected in the coming years if China’s private sector is to achieve similar levels of foreign asset holdings relative to the size of GDP, as other major Asian economies. 

I propose some back-of-the-envelope calculations to support the case that China’s private overseas portfolio and FDI holdings are so low that the official reserves of US$660 billion China now possesses can in theory be run down by private demand for dollars for investment purposes − not a panic run on the RMB but a steady stream of benign outflows.   What this means is that China can continue to intervene to keep USD/RMB from gapping lower now, so that it can keep USD/RMB from gapping higher in the coming years. 

The basic idea.   As countries develop and grow, they naturally accumulate domestic and foreign assets.  Home bias, per capita income, and wealth are some of the important determinants of the level of gross foreign asset holdings of a nation.  I use Japan and Korea as comparators, in thinking about China.  For China, as of 2003, total gross holdings of overseas investment were some 6.9% of GDP.  This is quite low, compared to 12.5% in Korea and 53.4% in Japan. 

Simulations.   How much more foreign assets would China need to acquire if it were to raise its foreign asset holdings as a share of GDP?  There are three key ‘degrees of freedom’ in this back-of-the-envelope exercise.  First, the rate of increase in nominal GDP is a variable.  However, in all my scenarios, I make the innocuous and conservative assumption that it increases by 10% annually.  Of course, the higher the growth rate of the economy, the larger the size of the foreign asset purchases would be to achieve a particular target on foreign asset holdings in percent of GDP.  Second, the assumption on the annual rate of appreciation of the RMB is important, as it dictates how rapidly China’s USD GDP grows.  Third, I vary the targeted foreign asset holding ratios, from the current rate of roughly 7.0% of GDP to 10% and 15%.  I arbitrarily chose the year 2010 as the target year by which the new investment target will need to be met. 

The results of my simulations

There are six scenarios.

•   Scenarios 1 & 2.  I hold the investment ratio unchanged at the current level of around 7.0%, but vary the rate of RMB appreciation.  In Scenario 1, if USD/RMB is held constant and GDP grows at 10% a year, to keep the foreign investment ratio unchanged, China would need to buy US$204 billion worth of additional foreign assets by 2010.  And in 10 years’ time, China’s total new purchases of foreign assets would breach US$300 billion.  In scenario 2, I assume that USD/RMB declines by 5% a year.  This would raise the total new foreign asset acquisitions to US$264 billion by 2010, and would breach the US$300 billion mark six years from now. 

•   Scenarios 3 & 4.  Here, I assume that China’s foreign investment rate will gradually rise from the current 7% of GDP to 10% of GDP by 2010.  With no RMB appreciation, additional acquisitions of foreign assets would total US$292 billion by 2010, and by US$377 billion with a 5% annual RMB appreciation.

•   Scenarios 5 & 6.  Here, I assume that China’s foreign investment rate will rise to 15% by 2010.  With no RMB appreciation, additional acquisitions of foreign assets would total US$438 billion by 2010, and US$566 billion with a 5% annual RMB appreciation. 

Chinadoes not have too much reserves.   In my simulations, I have made very innocuous and conservative assumptions, on growth, on RMB appreciation, and on the foreign investment target.  I have demonstrated that China’s private sector could easily buy another half a trillion worth of foreign assets in the next five years.  When the private sector fully takes advantage of a more liberalised capital market and starts to accumulate foreign assets in earnest, a good part of China’s official reserves will change hands and be sold back to the private sector.  Thus, low private sector foreign asset holdings is a feature that is unique to China, and is a powerful justification for accumulating more official reserves today, so as to prevent USD/RMB from rising when the private demand for dollars accelerates.  Further, due to this ‘pent up’ demand for foreign assets, there are doubts about USD/RMB following the path of USD/JPY post-1973.  Moreover, limited downside risks to USD/RMB would also limit the potential valuation loss China could sustain on its reserve holdings from a stronger RMB. 

Bottom line.   In contrast to Japan and Korea, China, in my view, does not have ‘too much’ official reserves.  China needs to continue to accumulate official reserves to ‘pre-fund’ the private sector outflows expected in the years ahead.  US$1 trillion in official reserves in the coming years may not be unreasonable. 

 

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China
Renminbi Speculation, Over-investment and BoP Surplus
Apr 25, 2005

Denise Yam (Hong Kong)

2004 balance of payments released amid renewed speculation on revaluation

The State Administration of Foreign Exchange released China’s 2004 balance of payments (BoP) data.  In line with the huge jump in forex reserves, the overall BoP surplus came to US$206.4 bn in 2004, up 76% from 2003.  The current account surplus expanded 50% to US$68.7 bn, while the financial account saw US$111 bn in inflows (US$53 bn in 2003).  The bulk of the surpluses were realized in 2H as RMB speculation intensified.  Errors and omissions jumped to a US$34.3 bn net inflow in 2H04, bringing the year total to US$27 bn, another record after 2003’s US$18.4 bn.

Current account surplus reached 4.2% of GDP

The BoP goods surplus (FOB exports - FOB imports) came to a record US$59 bn, reaching 4.2% of GDP and beating the US$45 bn in 2003.  Service exports grew at the strongest pace since 1994 at 33.6% to US$62.4 bn, while service imports rose 30.4% to US$72.1 bn, yielding a services deficit of US$9.7 bn, up 13% from 2003.  Though becoming a larger net exporter of tourism-related services (US$6.6 bn, tripled YoY), China remained a net and larger importer of transport (US$12.5 bn, +21% YoY), insurance (US$5.7 bn, +35%), and patents and royalties (US$4.3 bn, +24%).

Financial account surplus more than doubles to US$110.7 bn

Inflows associated with renminbi optimism is most evident in the “other investment” account, which saw a US$29.3 bn surplus in 2H04 (US$37.9 bn in 2004).  Net repatri-ation of foreign portfolio assets (US$6.5 bn) added to foreign investment in Chinese securities (US$13.2 bn) to give a US$19.7 bn surplus in the portfolio investment balance.  Gross FDI exceeded US$60 bn for the first time in 2004.  The overall financial account surplus more than doubled that in 2003 to US$110.7 bn.  We suspect that China’s exporters may have overstated shipments in recent months to bring in forex for speculation, and, if this is the case, part of the recorded current account surplus should in fact be included under the financial account.

Large BoP surplus adds to international pressure for a stronger renminbi

China’s BoP surplus has always been quoted by the US and China’s other trading partners as evidence that the RMB is undervalued.  Until we see tougher tightening measures by the government to curb growth and dampen speculation in asset markets, including a firmer stance on the currency regime, large BoP inflows could be sustained in the short term.  Forex reserves increased by a further US$49 bn in 1Q05.  While we agree that the FX regime should be reformed eventually, we remain skeptical about a premature shift ahead of establishing a robust and commercialized banking system.

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Japan
Economic Future -- Outline of Opportunity (Part I)
Apr 25, 2005

Robert Alan Feldman (Tokyo)

(This is the first of a two-part series on the new government outline for Japan’s economic future.   Part I deals with the outline of the strategy and specific sectors that will benefit.   Part II will discuss several surprises in the report, and some warts in the paper.)

Economics Minister Takenaka’s new report is different.    Typically, government reports about the long-term future start with flowery platitudes and sentimental optimism.   In contrast, the title of the first section of the executive summary is a threat: “Face the Crisis: A Scenario to Avoid.”   The main text goes on to say, “If Japan continues to drag its feet on reform and to lag the trends of the era, a crisis will surface, and Japan will tread a path of slow but certain decline.”   The report then advocates a “constructive sense of crisis,” and outlines the measures that Japan must take to stabilize its future.

The content of the measures has been clear for some time (see “Next Steps -- the Post-Postal Reform Agenda,” Morgan Stanley, January 11, 2005).    What are different in this reform are a) the specificity of policies, b) the urgency of the time line, and c) the identification of sectors that will grow if the country makes the right decisions.   There are many hints for investors on where to invest over the long term.

Outline of the Long-Term Economic Strategy

Faced with bad demographics, accelerating globalization, and resource constraints, the Takenaka team had to develop an economic strategy for Japan with very little room for maneuver.   The new strategy focuses on three components: productivity, globalization, and fiscal reform.   Social policy is part of the report, of course.   However, the core is economic, because none of the social goals can be achieved without good performance of the economy.

On productivity, the key elements are: a) investment in technology, human capital, and labor-saving machinery; b) development of superior management; c) deregulation and transfer of resources away from low-productivity to high-productivity sectors; d) better corporate governance along international standards; e) protection of intellectual property, and f) public sector reforms to enhance productivity in government services.

On globalization, the key elements are: a) liberalization of trade through more Free Trade Agreements and Economic Partnership Agreements, especially in agriculture; b) increased education of Japanese abroad; c) aggressive promotion of immigration to Japan; d) technology development aimed at solving global problems such as energy shortages and environmental threats, and e) a special focus on Asian economic development, even while maintaining ties with the US.

On fiscal reform, the key elements are: a) prompt action on pension and medical reform; b) a shift in the balance of fiscal spending away from the old and toward the young; c) widespread outsourcing of public sector functions, and d) decentralization of government and taxation.

For Investors:    Who Will Benefit?

For investors, the key issue raised by the report is how to channel investment for highest returns in the new world.   Fortunately, the Takenaka report itself gives a number of hints.   These hints are sprinkled through the report, but, once gathered, present a compelling set of long-term themes.

One investment theme is pervasive: the need for huge investments in information technology systems development and integration.    The most obvious needs are in healthcare.   Despite significant sums spent on IT connectivity within hospitals, connectivity among hospitals and clinics in Japan remains low.   The lack of clear privacy rules constrains the sharing of medical records.   Moreover, some doctors and hospitals have resisted increased disclosure, for fear of legal consequences.   Surprisingly, even medical terminology is not standardized within the country, so that information sharing could create mistakes.   A national project on healthcare information sharing is an obvious way to address these problems.

But the need for system integration goes far beyond healthcare.    Japan still lacks a taxpayer identification system.   This makes tax evasion easier, and hinders implementation of financial sector reforms, such as the cap on deposit insurance.   Financial institutions still require major spending on systems integration.   As immigration grows, the nation will need a more efficient means for monitoring the status of guest workers.   Increased international trade will require better tracking of product origins (e.g., through RFID tags).   Growing numbers of single-person elderly households will require systems for monitoring their health and safety.   Product development is already under way in some of these areas, such as the hot-water dispensers that automatically send an email message to a guardian when the elderly user draws water.

There are several related fields.    One is robotics.   Already, Japanese factories rely heavily on robots, and the next phase of this factory development is under way.   Home robotics, however, are in their infancy.   The new report cites this area as a key sector where capital could substitute for labor.   Another related field is encryption.   Japanese firms stand at the forefront of encryption technology, which will only become more important as information exchange increases.

Yet another pervasive theme will be energy, both development and conservation.    The demand for energy will only rise over coming decades, as China and India develop.   Moreover, should events in the Middle East continue toward democratization, conflicts are likely to wane.   Yet another region of rapid economic development may emerge.   On the supply side, both high prices and the slowdown in identification of new sources of energy imply that oil supply may indeed be constrained, as suggested by some recent accounts (see Kenneth Deffeyes, “Beyond Oil: The View from Hubbert’s Peak,” Hill and Wang, 2005, and “Hubbert’s Peak,” Princeton University Press, 2001).   The world will need new sources of energy, such as natural gas, coal, tar sands, heavy oil, uranium, and hydrogen fuel cells.   Moreover, efficient engines will be even more important.

Japanese companies already have strong positions.    Japanese firms provide key products used in delivery of oil and gas, such as seamless pipe.   Japanese plant engineering firms remain industry leaders in many areas, and have strong technology advantages in some areas of energy transportation, such as LNG carriers.   In conservation, Japanese firms are world leaders in many areas.   Indeed, Japan uses only about half the energy per unit of GDP that the US does.   Japan’s lead in hybrid cars is well known, but technology in this area continues to develop, such as new types of batteries that may increase engine efficiency sharply.

Housing will be another key sector.    As Japan ages, there is likely to be a further concentration of population.   Indeed, the new report from Minister Takenaka suggests that the next 25 years will bring reductions of 20% in the populations of towns with fewer than 30,000 inhabitants and in areas more that one hour away from regional cities.   (The overall population is forecast to shrink by about 8%.)   Hence, the housing stock will have to be reconfigured.   Moreover, even within large cities, the need for accessibility will rise.   As business activity concentrates and moves to high-rise buildings in the core areas, residential communities will likely move into formerly commercial but less central areas.

Surprises and Warts

In addition to the sector focuses described above, there were several surprises in the report.    Moreover, there are some problems with the report that need attention.   The surprises and warts are the subject of Part II of this series, which will appear subsequently.

 

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India
Three Concerns on the Central Bank's Mind
Apr 25, 2005

Chetan Ahya (Mumbai)

Summary

The Reserve Bank of India (RBI) is due to present its bi-annual monetary policy statement on April 28th.    After three years of dealing with excess liquidity, the Central Bank is now facing the challenges related to the after-effects of excess liquidity.   Although the Finance Ministry appears to be less keen to take up a hike in interest rates, the RBI has continued with a tighter monetary policy.   While the RBI has left the official short rates steady over the last six months, it has been curtailing real money supply growth over this period.   Not surprisingly, the market-determined 10-year government bond rate, commercial banks’ deposit rates, and lending rates are rising.   We believe that the RBI is unlikely to change its tight monetary policy in the short term.

Credit Deposit Ratio Close to All-Time High

Although demand for money has been high, the RBI has kept money supply growth in the low range.    The real money supply has ranged between 7% and 8% over the last 10 months, from the peak of 14% in April 2004.   The most important measure for assessing liquidity conditions would be the commercial banks’ incremental credit deposit ratio, which measures deposit growth in the context of credit demand.   The incremental credit deposit ratio reached 110% as of this month, close to the highest-ever level over the last 34 years for which we have data on Indian banking sector liquidity.   The last time commercial bank liquidity was in a similar condition was in 1996, when Dr. Manmohan Singh, then Finance Minister, mandated a tight monetary policy to control inflation driven by domestic demand right before the 1996 general elections.   While the credit cycle in 1996 was due to corporate investment, the current cycle appears to have been influenced to a large extent by a pickup in retail loans.   According to the latest banking sector data as of April 2005, deposit growth has decelerated to 13.6%, while the credit growth rate is at 26.8%.   Although the RBI could unwind some of the sterilized liquidity into the system to match the increased credit requirement, it appears to be less inclined to do so.

What Concerns the RBI?

We believe there are three concerns currently preoccupying monetary policymakers.    These are potential inflationary pressures, a widening current-account deficit, and consumer credit risk.

1) Potential Inflationary Pressure

India’s democratic political setup gives the Central Bank little leeway to let inflation rise above 5%.    Although the inflation rate has decelerated to 5.5% recently after reaching a peak of 8.7% in August 2004, concerns on inflation persist.   The government has managed to suppress headline inflation by controlling domestic oil product prices, transferring the burden onto the oil companies and the budget deficit.   We believe that about 1 percentage point of inflation has been bottled up just on account of the delay in domestic oil product price hikes.   The cascading effect of input price increases is now likely to show up in select finished goods prices as producers try to protect their margins.   We believe inflation is unlikely to slip below 5% in the short term for the Central Bank to ignore this risk.

2) Sharp Widening in the Current-Account Deficit

With India having cut its import tariffs over the last few years to very low levels, inflation pressures tend to be temporary.   Indeed, the government has resorted to aggressive import tariff cuts since the last quarter of 2003 to ward off inflationary pressure.   The policymakers have also allowed the rupee to appreciate on a trade-weighted basis to help reduce inflationary pressure.   The trade-weighted exchange rate adjusted for inflation (REER) has appreciated by 6.5%.   Due to global trade integration, a pickup in domestic demand when capacity utilization is running high and import protection is low is resulting in a higher trade deficit rather than adding to inflationary pressure.   In other words, with the investment cycle (i.e., new capacity creation) remaining weak, a higher consumption-oriented growth push supported by low real interest rates has been a key factor pushing the trade deficit to an all-time high of US$11.8 billion (6.8% of GDP, annualized) during the quarter ended December 2004.

The RBI would not have been concerned with the widening trade deficit if a rise in capital goods imports had been the key driver.    However, unlike China, which has used global liquidity for creating capacity that has allowed it to increase market share in global exports and sustain a higher growth trend, India has used the external monetary stimulus for consumption.   Our analysis shows that a large part of the sharp widening in the trade deficit since the quarter ended March 2004 was driven by consumption.   Out of the total increase in imports to GDP since March 2004, only about 7% is due to capital goods, 33% is due to higher oil imports, and the balance of 60% has been due to a rise in non-oil non-capital goods (read: consumption).   This is corroborated by the trend in private corporate sector and public sector investment, which has recently picked up but remains close to 30-year lows.   Government and household debt (primarily used for consumption) combined has increased by 19.6 percentage points of GDP, to 85.5%, over the last five years compared with an increase of 3.3 points in the preceding five-year period ended F2000.

A higher trade deficit has, in turn, pushed the current account for the quarter ended December 2004 into a deficit of US$5.5 billion (3.2% of GDP, annualized).    This is the worst quarterly current-account deficit that India has witnessed since June 1991.   Indeed, during the quarter ended March 1991, when the current-account deficit reached a peak of 3.8% of GDP, it caused a serious balance of payments crisis.   India’s macroeconomic fundamentals are very different today, with US$141 billion in foreign exchange reserves, which would ensure financial stability.   However, the current account’s turning into deficit at a time when the consolidated fiscal deficit is at 9.5% of GDP (close to the all-time peak of 9.9%) is likely to put pressure on interest rates.   Indeed, apart from higher capital inflows over the last two years due to a rise in global risk appetite, the current-account surplus was a key reason for the higher balance of payments surplus and the sharp fall in the cost of capital between 2001 and 2004.   A reversal in the current-account balance, we believe, is a major inflexion point for the trend in cost of capital.

3) Credit Risk Is Rising in the Banking System

Loose monetary policy over the last four years is also showing up in aggressive credit lending approaches of the commercial banks.    While the Indian banking system has traditionally been completely averse to retail lending, in recent times it has become extremely liberal.   Retail loans now account for one-third of the banking sector’s incremental commercial credit flow.   According to our Asia Pacific Financial Services analyst, Amit Rajpal, India’s consumer credit penetration exceeds the level justified by current income.   He argues that India’s consumer penetration at 6.8% of GDP as of March 2004 has exceeded the fair levels by about 25%.   He has based his estimate for fair level by regressing the retail loan to GDP to per capita income for other emerging and developed economies.   Retail loans are growing at 30-35% currently compared with nominal GDP growth of 13%.

Many investors have argued that India’s current retail loan penetration is very low and should not be a concern.    While we agree that the systemic risk arising from this area is low, incrementally, the trend appears to be worrying.   This is reflected in the fact that currently many large commercial banks provide loans for automobile purchases at almost the same rate as that for mortgage lending.   Until recently, banks had been providing 5-year fixed rate auto loans at just 50 to 75 basis points over the government bond rate for similar maturity.   These spreads are clearly not enough to cover the underlying credit risk and the operating costs incurred for managing these assets.

More importantly, in October 2004, the RBI itself issued a caution to commercial banks against the breakneck pace at which these banks had been chasing retail loan assets.    The RBI has raised the risk weightings for loans awarded for mortgages and other consumer loans.   However, despite this measure, there appears to be little slowdown in retail loan growth trends.

Unfavorable US Yield Curve Dynamics Will Add to Liquidity Pressure

Over the last two years, India and most other emerging markets have benefited from the rise in global risk appetite (carry trade) as the US yield curve (US 10-year government bond rate less Federal funds rate) steepened, with short rates remaining low while confidence in growth picked up.   During this two-year period, we estimate, India has received cumulative capital flows of US$58 billion, or two and a half times the level received in the preceding two years.   Indeed, less stable sources of capital inflows, including portfolio equity investments and debt inflows, have accounted for about 70-80% of the capital.   At the peak of this carry trade in April 2004, Indian government-issued 10-year bond real yields were lower than those in the US, implying that the US government-issued bonds had a higher risk profile than Indian bonds.   However, the rise in US short rates and the flattening of the US yield curve since mid-2004 have resulted in lower capital inflows and a correction in Indian bond prices.   Even after this correction, the real 10-year Indian government bond yield is almost the same as the US, despite the Indian government’s fiscal deficit and public debt to GDP being almost three times and one and a half times, respectively, that in the US.   We believe changes in the US yield curve dynamics and waning risk appetite will ensure the right risk pricing of Indian government bond rates (see our dispatch entitled Second Round of Rate Rises on the Way, dated March 29, 2005).

Bottom Line: Normalization of Cost of Capital Is Inevitable

We believe that domestic liquidity trends are influenced by two major factors: the balance of payments surplus and the system’s ability to absorb this external monetary stimulus without posing a risk to macroeconomic stability.   Both of these factors have turned adverse.   The balance of payments surplus is narrowing and will likely slow further.   More importantly, the Central Bank has been forced to tighten due to rising concerns about potential inflationary pressure, the widening current-account deficit, and credit risk emanating from the consumption-oriented growth push.   We believe that political pressure may prevent the RBI from hiking benchmark short-term rates (reverse repo rate), currently at 4.75%, in the next monetary policy announcement due on April 28.   However, slowing capital flows and money supply tightening by the RBI will keep pushing market-oriented interest rates including commercial banks’ deposit rates, lending rates, and government bond yields.   We maintain our view that the 10-year government bond yield will likely reach 8% by the end of 2005, up from the current 7% level, assuming that the capital spending cycle remains weak.

 

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United Kingdom
Three Key Data, but Still No Move
Apr 25, 2005

Melanie Baker and David Miles (London)

The past week has seen important, and mixed, new UK data.  Many perceive the Bank of England’s Monetary Policy Committee (MPC) as close to raising rates, and several commentators now expect them to raise rates in May.  With CPI inflation at a seven-year high, this is not all that surprising.  We, however, continue to believe that data do not yet support such a move and expect interest rates to remain at 4.75% throughout 2005. 

The MPC again voted 7-2 in favour of leaving interest rates unchanged at the 6/7 April meeting, with Deputy Governor Andrew Large and Paul Tucker again preferring a 25bp rate rise.   It was clear from the Minutes that the data coming out in the two weeks after that meeting on output and consumption could be very significant in shifting the balance of opinion on the Committee.  Recent signals from the data, however, have been rather mixed.  After strong inflation data (March annual CPI inflation rose to 1.9%, from 1.6%), rather weak retail sales data (volumes fell 0.1% on the month in March) and a small deceleration in GDP growth (to around trend in Q1), there is fuel for both sides of the interest rate debate among the Committee members. 

The arguments made at the 6/7 April meeting by the seven members who voted to keep rates on hold, went like this.   They argued that: 1) the data suggested that the balance of risks was still to the downside around their central inflation forecast; 2) an interest rate rise would be a surprise and difficult to explain given the above; 3) more data were needed to assess the apparent slowdown in consumer spending; 4) more data were needed to assess whether other sources of demand would grow fast enough to maintain output growth around trend. 

Recent data, in our view, are unlikely to convince these MPC members that the balance of medium term inflation risks is now to the upside of the Bank’s forecasts:  a) March annual CPI inflation, although higher than expected, was affected by the timing of Easter.  Further, after rather sluggish retail sales, the Committee may not be convinced that the strength of prices seen in clothing and footwear or furniture and furnishings in March is sustainable; b) Retail sales volumes fell by 0.1%M in March.  Although retail sales are volatile on a month-on-month basis, smoother series also suggest a subdued pace of household spending; c) Although headline GDP growth was broadly in line with Bank expectations and although this release did not give us an expenditure-side breakdown, the composition of growth (including output in the ‘distribution, hotels and catering’ sector falling 0.1%Q, although there was a positive contribution from personal services) may not eliminate worries among some members about the weak outlook for the consumer.

In the Minutes to their April meeting, the Committee highlighted a number of current ‘puzzles’, including a problem reconciling Q4 GDP growth at 0.7%Q with the expenditure components of GDP, and said that there might ultimately be upward revisions to some components of final demand.   However, they suggested that consumption was not the most likely candidate for such a revision.  Hence, some Committee members’ worries on downside risks to the outlook may not be soothed by this possibility. 

Our central case forecast for unchanged rates over the balance of 2005 is of course data dependent.   We have been looking for a slowdown in the UK economy and sluggish consumer spending growth in the first half of this year.  We are seeing rather sluggish consumer spending, but GDP growth in Q1 was somewhat above our forecast.  Although at this stage we maintain our central case forecast that the Bank of England will keep interest rates on hold at the May meeting, the probability of a rate rise is clearly significant. 

 

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Central Europe
Still Room for Rate Cuts
Apr 25, 2005

Oliver Weeks (London)

External factors, notably US inflation and France’s EU constitution referendum, continue to alarm central European markets.  While higher interest rates in core markets are clearly a risk, as Joachim Fels has highlighted, the more direct risks to central Europe look overplayed to us.  The implications of failure of the EU constitution may sometimes be exaggerated in the cause of pressing for a yes vote, and do not yet look likely to include changing the criteria for EMU accession.  The local inflation outlook remains largely benign.  Political and foreign exchange risks notwithstanding, we continue to see room for further rate cuts in both Poland and Hungary. 

A soft patch for growth in Poland   The most significant room for rate cuts remains in Poland, where we see output growth entering a temporary soft patch.  March’s negative year-on-year industrial production growth is likely to be repeated in April, though is strongly influenced by high base effects from last year.  More surprisingly, an incipient surge in construction output also appeared to weaken in March.  There is clearly a risk that political uncertainty ahead of the parliamentary elections further delays an overdue recovery in fixed investment.  Consumer confidence is also weakening, reflecting both politics and still negative real wage growth, restrained by still high unemployment.  We see real GDP growth just below 3.0% in 1Q, and slight downside risks to our 3.8% full-year forecast.  Despite supply side risks from fuel and seasonal food, we still see no demand pressure on inflation and think the longer-term food price outlook remains benign.  We expect headline inflation to continue to weaken, ending the year just below the National Bank’s 1.5-3.5% target range. 

Local political risks, but rate cuts still justified  Of risks to the rate outlook, the most significant seems that of further PLN weakness.  We continue to expect the current account deficit to widen from its currently very low levels, driven by weaker export growth and repatriation of recently high corporate profits.  Nevertheless, weak wage growth means current zloty levels already look relatively comfortable for exporters.  On the fiscal side, weak nominal GDP growth and pre-electoral deadlock on spending cuts and privatisation will halt recent progress, but a significant loosening still looks unlikely under the current technocratic team.  On the political side, the current proposals to alter the electoral system to boost smaller parties slightly reduce the chance of forming a two-party reformist coalition at elections likely in September.  In the period after the Pope’s death, allegiances may be fluid, but still there seems little sign of a shift to the radical Catholic LPR, and still little risk, in our view, of populists entering a governing coalition.  We continue to see room for 150 basis points of rate cuts in the rest of this year. 

Hungary’s imbalances looming again   In Hungary, the fragile credibility of the Ministry of Finance continues to suffer.  The first fiscal release under the new Minister was an April forecast implying a January-April deficit at 71% of the annual target, even worse than our 65% expectation.  Revenue adjustments to compensate for an acknowledged HUF 62 billion shortfall in VAT revenue, notably another HUF 45 billion hike in revenues from budget institutions, look unconvincing.  The Ministry argues that HUF 249 billion of spending so far this year (including wage and pension bonuses, agricultural spending, and debt servicing) is front-loaded, and drives the apparent overshoot.  However, HUF 125 billion of revenue from the sale of motorways is also clearly not repeatable.  Payment of last year’s VAT refunds is still not complete.  The Ministry will be able to count these (HUF 127 billion so far) and HUF 47 billion of agricultural spending as 2004 spending under the ESA definition, pointing to further upside risks to the 2004 and even 2003 deficits, but a 2005 deficit overshoot still looks inevitable to us, even without counting off-budget spending.  At the same time, slower Euroland growth, rising gas prices, and higher real wages will also slow any correction in the current account deficit. 

But still some room for cautious cuts   Nevertheless, we continue to see the inflation outlook as quite benign.  In the short term, headline inflation may tick up further on vegetable and energy prices, but core inflation remains below the year-end target range, at 2.8% year on year.  FX moves so far do not pose any serious threat to the 4.0% end-year target, we think.  Fiscal policy will continue to leave the market vulnerable, but we do not think the political outlook yet justifies Mr Veres's risking a 2002-style boost to consumption spending.  The tension between the governing Socialists and Free Democrats over the Presidency nomination is a risk -- the latter are both a significant pillar of government support and a force for fiscal constraint -- but a split still looks highly unlikely to us.  The government’s short-term plan for funding off-budget motorway spending now looks less ambitious than the EUR 3 billion in six months initially proposed, but we continue to expect around 60% of the official deficit and most of the off-budget spending to be financed in EUR.  Planned net issuance of HUF bonds is only 39% of 2004’s total.  This would already cover a budget deficit overshoot of around HUF 200 billion, but with a larger overshoot, the Ministry still has discretion to raise FX funding further.  We expect further widening in external debt spreads but still think pressure on the local market is likely to stay relatively limited for now, and that there is room for three more 25 bp rate cuts in the short term.  Slight and gradual FX depreciation looks more likely to us than a crisis.

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