Diverse Effects of Expensive Oil
Oct 05, 2005
Andy Xie (Seoul)
Summary and Investment Conclusion
High oil prices are beginning to affect global economic performance, with the negative impact becoming visible in the US, Europe and Southeast Asia. But, contrary to intuition, the effect on manufacturing-intensive Northeast Asia appears to be less. The reason is that the latter benefits more from the increased purchasing power of the oil exporters. The effect on those in Northeast Asia should become apparent when demand from the first group weakens substantially. The increased sophistication of a global financial system has delayed but not eliminated the effects of high oil prices. So far, the negative effects are related to people or economies that do not have access to liquidity. The full effect of high oil prices is only likely to be felt when US property prices stop rising, which is likely over the next 12 months, I believe. Oil Speculation Continues Even though IEA and OPEC have repeatedly downgraded global oil demand this year, oil prices remain high and are now 70% above the average last year. IEA forecasts crude demand in 2005 to rise by 1.4 million barrels/day from last year. The global supply in August 2005 was 2 million barrel/day above last year’s. The OECD industry oil stocks rose by 102 million barrels in June 2005 from last year. In terms of the substitution effect, China’s coal market is key. Ample statistics and anecdotes suggest that China’s coal supply is plentiful again and the forced increase in oil demand due to coal shortages last year is over. The oil and coal data do not support a 70% increase in oil prices from last year, I believe. Instead, the increased liquidity flow into the oil market has shifted the equilibrium prices up, at least temporarily. The oil market is now behaving much more like a bond market. When an event drives up spot prices, the futures also move. As many fund management institutions have raised commodity funds to invest in oil and other commodities, this pool of liquidity is keeping oil prices much higher than they would be otherwise. Oil prices should decline when financial investors pull out of the market. However, this is unlikely to happen unless a shock or serious global economic weakness shakes investors’ confidence. The resilience of the global economy, despite the high oil prices, has encouraged financial speculation. In the following, I discuss the income and liquidity effects of the petro dollars that have temporarily decreased the effect of high oil prices on global demand, and when this might change. Massive Influx of Petro Dollars The income redistribution due to high oil prices is significant. The current oil prices are about US$24/barrel higher than last year’s average. At a production level of 85 million barrels/day, oil producers receive US$2 billion/day extra. If the current prices last until year-end, the average prices for 2005 would be US$17 higher than last year’s, giving oil producers a US$527 billion windfall. The windfall would be US$3.3 billion/day or 3% of global GDP annually at present if we were to use the average prices in 2002 — the year that the global upturn began as a benchmark. The net cross-border trade in crude and refined products is probably around half of this total, the windfall for oil exporters is running at US$1.6 billion/day or an annual rate of 1.5% of global GDP. Income Effects of Petro Dollars The massive income redistribution in the global economy due to rising oil prices is a negative, as the savings rates of oil exporters rises with oil prices. But, their demand also rises with more income. The economies that benefit from their rising demand can mitigate the negative impact of rising oil prices. China’s economic resilience, for example, has much to do with this effect. Its exports to the natural resource exporting economies (Africa, Middle East, Oceania and South America) have increased by 75.5% of the increase of China’s imports from them YTD. This ratio is much higher than the 20–30% range for other industrial economies. No other economies have benefited as much as China from the increasing income of commodity exporters. The main reason for this unique position is the recent relocation of manufacturing to China. Foreign-invested enterprises accounted for 57% of its total exports from Jan.–Aug. 2005. While the oil exporters may be buying from the same companies with their windfalls, the products come from China instead of Europe, Korea, or Japan. While the revenue balance for China as a whole is not so sensitive to oil prices, there is still a serious internal imbalance, in which the central and local governments can reallocate liquidity to suppress the effects. For example, the prices for refined products are kept low because the refiners are government-owned. Chinese cities keep transportation charges down through redistributing rising revenue from land sales to the affected businesses. China’s low sensitivity to oil prices has benefited its neighbors. China accounted for about 40% of Korea’s export growth this year. It has kept the Korean economy afloat even though it is highly oil-dependent and has not seen much growth in direct exports to oil exporters. Oil-dependent manufacturing economies like China or Korea should be most sensitive to oil prices in theory. However, China’s unique role in globalization has served to shield it, and some of its neighbors, from high oil prices so far. High oil prices have also benefited labor exporters to the Middle East. The Philippines, for example, has seen strong transfers in its current account since 2002. This source of money is probably related to the substantial migrant labor force working in the Middle East, which comes from the Philippines. Without this source of money, the Philippines may well have had a balance of payment crisis by now. South Asian economies, such as Bangladesh, India and Pakistan, have also benefited. The transfer funds in their current accounts have also increased sharply since 2002, similar to that in the Philippines. Without this source of money, these economies would have reacted much more negatively to the high oil prices. However, the demand benefit from the petro dollars for the OECD economies appears limited. This is probably due to globalization. Because of the development in human capital, the increased demand for labor among oil exporters is likely to be met by other developing countries. Similarly, the increased demand for goods from oil exporters is likely to come from other developing countries. Liquidity Effects of the Petro Dollars The South-South trade linkages have made the developing world more resilient against rising oil prices. This makes high oil prices effectively a tax for the OECD economies, and rising oil prices should force a reduction in their living standards. However, the global financial system has allowed them to defend their living standards by recycling petro dollars to finance their consumption. The US consumer leads the world in defending their living standards. When income growth is low, the demand for borrowing in the US is high. The Fed has been accommodating this demand by keeping interest rates low. A rising property market has been the instrument allowing the debt to occur, as US homeowners borrow against their rising home values for consumption expenditure. Hence, the US savings rate has declined and the current account deficits increase with rising oil prices. The US economy is running a US$60 billion/month trade deficit. Australia and the UK are running combined trade deficits of US$7.5 billion/month. Asia is running a US$17 billion/month trade surplus. The common belief that Asia’s surplus mirrors the US’s deficit is clearly incorrect. The massive Western trade deficits are reflected mostly in the surpluses of the oil exporters. The recycling of petro dollars into Western economies is a must to sustain the current equilibrium. It happens directly or indirectly. Asia is experiencing sizable hot money inflow, averaging about US$9 billion per month. Part of that money may be petro dollars, as the oil exporters purchase euro or other assets and the sellers in such transactions choose to put the money into Asia. Petro dollars must also be flowing into the US directly in large quantities. The US dollar has strengthened in the latest surge of oil prices, which may reflect petro dollars flowing directly into the US. The US financial system has been extremely efficient in recycling petro dollars into consumption through financial instruments linked to property appreciation. US householders have been able to defend their lifestyle, despite rising gasoline prices, by tapping into rising home equity value. This appears to have made the US economy less sensitive to the current oil shock than before. The capital inflow into emerging economies has helped some of the most vulnerable economies to keep growing despite high oil prices. The MSCI emerging market index has risen by 120% since 2002 and the capitalization of the emerging markets has increased by about one-third of their GDP. The liquidity inflow from the OECD block has been the main force behind the appreciation. In addition to stocks, liquidity from the OECD block has targeted emerging market currencies, fixed income instruments and properties. The liquidity inflow into emerging economies mirrors the growth of the hedge fund industry, which in turn reflects the rising risk appetite in the OECD economies due to a low interest rate environment. India, for example, received US$22 billion in portfolio investment inflow between 1Q03 and 2Q05, equivalent to 3.4% of India’s current GDP. Korea received US$25 billion in portfolio investment inflow between January 2003 and August 2005, or 3.3% of its GDP. The inflows into emerging markets have far exceeded the increased costs of oil to emerging economies. As long as they can translate such liquidity into demand, they should be able to withstand high oil prices. The instruments for turning liquidity inflow into demand include: 1) government oil subsidies, 2) consumer credit, 3) cheap funds for capex, and 4) property speculation. The Tipping Point Oil speculation, hot money into emerging economies and high property prices in the US are all linked to the low interest rate environment. The global financial system has been able to shift funds from the haves to have-nots to mitigate the effects of rising oil prices. The tipping point is reached when the have-nots’ spending is constrained. In Australia and the UK, for example, their consumers were unable to spend more when their property markets stopped rising. The tightening by their central banks led to this tipping point. The Fed is also raising interest rates. Over the next 12 months, the US housing market may hit a tipping point like those in Australia and the UK. When US housing values stop rising, the US household sector will be unable to increase its leverage. The demand for oil is likely to take a serious tumble at this point, I believe. We are already seeing cracks in the story of liquidity holding up demand despite high oil prices. Those that do not have access to liquidity are being affected. Even though their share of global GDP may be small, their plight could still make a big difference. For those who do not own property in the US, high oil prices are squeezing them hard. Some emerging economies are not ‘hot’ and do not receive foreign liquidity inflow and they are also being squeezed. In addition, the financial systems of emerging economies are not as deep or sophisticated as those in the US and cannot translate foreign liquidity inflow into demand as smoothly. This effect is apparent in Southeast Asia. China, after cracking down on property speculation, is also slowing down as one main channel between hot money and demand creation is cut. The unsophisticated financial system in emerging economies and the non-property-owning populace in the OECD block are already slowing oil consumption, but the global economy is yet to be affected. This will require the US housing market to reach its tipping point, in my view.
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Fat Tails Slimming
Oct 05, 2005
Serhan Cevik (London)
The prospect of EU membership is key to internalizing the sense of normalization. Europe’s political leaders have at last decided on a negotiating framework that is acceptable to Turkey. As we have long argued, the start of accession negotiations between Turkey and the European Union is an extraordinary inflection point in Turkey’s institutional and economic transformation. Even though this is just the beginning of a long and demanding endeavour, the prospect of EU membership will continue to guide structural reforms — not just in economic spheres but, more importantly, in judicial affairs — and help to eliminate institutional inertia and to consolidate macroeconomic gains. Leaving the discussion of Turkey’s accession trajectory to a forthcoming report, we now want to focus on the economic and financial implications of this historic event. The start of accession negotiations with the EU will lower macroeconomic and financial volatility. Turkey faces many challenges on the way to becoming a member of the EU and even that is not a universal remedy for structural problems. That said, the accession process will no doubt improve policy predictability, facilitate institutional reforms and reduce macroeconomic and financial volatility. Indeed, ‘fat tail’ political and economic events had long depressed asset valuations in Turkey. Our calculations revealed much fatter tails, fluctuating viciously away from the level implied by a normal distribution (see When the Fat Lady Sings, March 23, 2004). These fat tails, we believe, reflected the country’s underlying vulnerability to ‘exogenous’ shocks. For example, output volatility, measured by the standard deviation of the growth rate of real per capita GDP, increased from an average of 2.43 in the 1970s to 2.53 in the 1980s to 5.02 in the 1990s, and to 5.71 in the last three years. However, political consolidation and policy stability have already led to the normalisation of the macroeconomic landscape, and now the start of accession negotiations with the EU should result in a further reduction in the volatility of macroeconomic variables and financial valuations (see Fat Lady on Diet, December 14, 2004). Turkeywill move towards a stronger, non-inflationary growth path. According to our computations, Turkey can maintain an annual real GDP growth rate of 6.5% and therefore reach an income level in the next 10 years that is reasonably comparable to the European average. As a matter of fact, thanks largely to structural reforms and prudent economic policies, it has already moved away from the infamous boom-bust cycles onto a welfare-enhancing growth trajectory. With total factor productivity growth accelerating from an average of 0.5% in the 1990s to 4.8% in the past four years, the country’s trend rate of real GDP growth jumped from 3.9% to 6.0% and the rate of inflation declined from an average of 77.5% in the 1990s to single-digit territory. And, now, the convergence with the acquis communautaire, reducing policy uncertainty and improving the business climate, will underpin the shift towards a stronger growth path. Public finances are likely to meet the Maastricht criteria by the end of next year. With the diminishing risk of political fragility and sustained, non-inflationary economic growth, the cost of capital should continue to decline in the coming periods. Of course, this means a significant reduction in the burden of interest payments on the government budget and a dramatic improvement in the quality of public-sector spending. Indeed, according to EU-defined metrics, Turkey’s overall budget deficit already narrowed from 12.3% of GDP in 2002 to 3.9% last year. On the back of soaring privatisation revenues, we estimate that the budget deficit will come down to 2.8% this year and then turn into a small surplus by the end of 2007, allowing the Treasury to borrow less and less from domestic capital markets and even to make early repayments to the IMF. Despite all the remaining difficulties, the accession process justifies asset revaluation. The history of Turkey’s modernisation endeavour goes back to the 18th century but the real push to become a part of the European community started with the association agreement in 1963. Regrettably, political fragmentation and the resulting institutional and economic failures kept the country away from realising its overarching objective. However, now, we believe that with the predictable accession process, Turkey will overhaul archaic institutions, attract greater foreign direct investment, convince residents on the sustainability of change, and also address long-standing historical baggage. It may sound too good to be true, but this is not a Cinderella story. As the experience of other accession countries shows, institutional adjustments and improving policy credibility result in a virtuous circle of expectations and macroeconomic outcomes. Accordingly, the rise in Turkey’s credit quality should — and, in our opinion, will — lead to slimmer tails and an adjustment in asset valuations.
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A Preamble to Larger Cuts
Oct 05, 2005
Gray Newman (New York) and Heloisa Marone (New York)
When Brazil’s central bank cut interest rates last month from 19.75% to 19.50%, after a nine-month 325 basis point hiking cycle, there was little surprise. After all, by mid-September inflation was running at an annualized rate near 2.5%, while expectations had plummeted. Although part of the improvement in recent months had come from a bout of food price deflation (particularly among produce prices), the downturn in inflation could be seen across the consumer price basket. If there was any surprise at all last month, it was the meager size of September’s 25 basis point cut, which stood in contrast with the magnitude of the improvement in inflation. After all, as the central bank noted in its September Copom minutes, inflation under its “current conditions” model was now coming in below the target not only for every quarter in 2006, but even for year-end 2005. Furthermore, the central bank seemed genuinely pleased with the path of inflation. It highlighted in its latest quarterly inflation report that the improvement was not some sort of “transitory development linked to the contribution of positive shocks on a specific sector” but, instead, was the result of a “progressive dissipation of inflationary pressures.” Indeed, the news was even better from the vantage point of the central bank: the slowdown on the inflation front was coming without a downturn in economic activity that many Brazil watchers had predicted. With all of the good news, why then the modest rate cut announced on September 14? And what does the September decision tell us about the pace of monetary easing to come? Perhaps we should be content in getting the trend and the timing of the first rate cut right, but we missed the pace call (see “Brazil: The Case for Rate Cuts” in GEF, June 28, 2005). We expected the central bank to begin the easing cycle with a 50 basis point cut and thought it would up the ante with larger cuts in the months ahead. In light of the central bank’s most recent statements and actions, we are revisiting our call on the rates front. Forecast revisions We now suspect the pace will be more modest this year. We expect rate cuts totaling only 100 basis points through the remainder of 2005 to bring rates to 18.50% by year-end (versus our previous forecast of 16.5%). Nonetheless, we still expect rate cuts to be substantial in 2006 and reiterate our view that rates are likely to fall to 14% by the end of 2006. We have also taken the opportunity to trim our inflation forecasts slightly. We are now looking for inflation to end 2005 at 5.2% versus 5.6% previously. We are leaving 2006 inflation unchanged. Modest today, deeper tomorrow At the core of our view of more modest rate cuts now, but of a longer and more substantial rate reduction cycle next year are three points all linked to the thinking at Brazil’s central bank. First, there should be little doubt that the 25 basis point cut in September is the beginning of an easing cycle. While it might be possible to argue that the cut was of such a small size as to be little more than a “testing of the water,” the central bank made clear in its September minutes that it was looking towards lower real rates and spoke of the importance that the easing process was “progressive” and took place at a “natural” pace. Second, the central bank does not appear to be concerned that a slow easing in monetary policy is likely to jeopardize the kind of investment spending growth that Brazil needs to keep demand from turning into inflationary pressures. Investment spending, after having experienced an uneven performance last year has long been a major focus of the central bank. After all, after years of a “start-stop” business cycle it was only logical for businesses to be cautious about boosting investment spending as demand rebounded. The tendency instead was to meet stronger demand by running down inventories. That kind of stance, however, increased the risk of an upturn in inflation as demand could easily exceed supply. The weakness in investment spending during the last months of 2004 and the beginning of 2005 raised real questions as to whether it was simply a bout of consolidation (as we argued) or a more worrisome development. As it turned out, investment has regained ground. And much of the weakness early in 2005 appears to have been largely concentrated in the agriculture sector, which had suffered from its own overinvestment cycle. Despite the weakness in capital goods production in July, imports of capital goods continue to soar — trending upward by nearly 20% in the three months through September. And with capacity utilization still tight (although no longer at record levels) and improved macro prospects, investment should gain ground from here. Indeed, from the perspective of the central bank, declining country risk and the prospects of improving consumption thanks to monetary easing should come to the aid of investment spending. There is less sense of urgency from the real economy front. A steady decline in interest rates should be sufficient to keep activity growing at a pace welcomed by the central bank, namely a pace that is “aligned with supply conditions.” With time and as investment improves, the pace of growth consistent with controlled inflation should rise. Finally, do not confuse the disconnect between today’s positive inflation news and the central bank’s modest easing cycle as an unwillingness to cut more substantially in the future. At the core is the central bank’s focus on expectations and the legacy of missed inflation targets. Look, for example, at the hikes in March, April and May as well as the decision to keep policy rates elevated at 19.75% until mid-September. The central bank was not trying to fight administered or quasi-administered hikes nor was it trying to force market prices into some kind of deflationary spiral to offset administered prices. What was driving the central bank was the need to gain a level of credibility to ensure that a string of one-off hikes did not trigger a bout of “copycat” inflation. And now that inflation has fallen, you might be tempted to argue that the central bank should ease commensurately. But from the central bank’s perspective, it would rather ease slowly in an attempt to counterbalance years of missed targets and rebuild its credibility. At some point, the inflation premium (the outgrowth of years of missed targets) should decline. At that point, rates can fall rapidly, even with inflation relatively stable. But from the central bank’s perspective, there is little that it can do except to allow this to take place “naturally” as it rebuilds its track record. (Of course, there are steps that other policymakers could take: the finance ministry could commit to a larger primary surplus or congress could approve central bank independence, but neither measure is in the hands of the central bank). Bottom line The good news is that Brazil’s interest rate easing cycle has begun. The process is likely to be characterized by modest cuts initially. While a rate cut of 50 basis points possible this month or next, we lean towards cuts of 25 basis points in both October and November. We are building in a bit more aggressive cutting in December once the risk of adding further to the seasonal stimulus is lessened. While the next set of economic releases may be a mixed bag, they are likely to be little more than glimpses in the rear view mirror. Unlike the easing cycle of 2000 which quickly ran into a balance of payments constraint, this time Brazil has much greater space to ease. And unlike the easing cycle of 2003, Brazil’s central bank is likely to move more cautiously at first as it strengthens its own track record. A modest pace of cuts today should provide the preamble to larger cuts next year.
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