Acceleration in 2006; Mind the Slowdown in 2007
Dec 07, 2005
Eric Chaney and European Economics Team (London)
We are raising our 2005-06 GDP growth forecasts by half a percentage point. On top of a minor upward adjustment for 2005, we now count on above trend growth (2.1%) in 2006, instead of below trend (1.7% previously). On the other hand, we anticipate a sharp slowdown in 2007, on the back of the announced rise in consumer taxes in Germany.
Raising our GDP growth forecast for 2006 to 2.1% There are three main reasons and a contingent one for our more upbeat view for next year: stronger momentum, lower oil prices, expansionary monetary policy, the contingent one being advanced purchases of durable goods in Germany ahead of the announced VAT rate hike in 2007. Stronger momentum. Our reading of business surveys and of GDP data is that domestic demand has picked up in the euro area, mostly corporate and housing investment but also, to some extent, consumer spending, despite the loss of real income resulting from the increase in energy prices. The permanent monetary stimulus applied since 2003 is clearly stimulating the interest sensitive components of domestic demand. We take the sharp acceleration of exports and imports reported by every single euro area country as evidence of a rebound in intra-European trade. In addition, the steady depreciation of the euro, 7% on a trade weighted basis so far this year, is helping exports and our currency team is expecting the euro to stabilise in 2006. Lower oil prices. Our new oil price assumption is 12% lower than previously assumed, most of the change taking place in the winter 2005-06 (see Oil: No Winter Spike, but Still Vulnerable to Shocks, Eric Chaney and Richard Berner, December 5, 2007). By itself, this would add 0.3 p.p. to our 2006 GDP forecast and remove 0.1 from 2007 GDP growth. Consumers are the main beneficiaries of the expected stabilisation of energy prices. Friendly monetary conditions. After having raised the refinancing rate to 2.25% on December 1, we do not think that the ECB will rush to normalize its monetary stance or follow some mysterious hidden agenda. Rather, we think that the central bank will react mostly to inflexions in the real economy and see risks to growth on the downside for some time. The reasons given today — risks of higher oil prices, global imbalances (a code word for currency risks) and weak consumer confidence — are unlikely to vanish any time soon. As a reminder, we see the refinancing rate rising to 2.75% by mid year and 3.25% by year-end, up 25 bp from our previous forecast, because of our more upbeat view on the economy. Advanced purchases of durable goods in Germany. We think that German consumers may wish to break their piggy banks in order to beat the announced three-point VAT rate hike (effective in January 2007). This should boost temporarily sales of durable goods. Of course, there will be a payback in 2007 (see the German section of this note). Too good to last: GDP to decelerate to 1.6% in 2007 Conversely, we are more pessimistic for 2007, despite the decline in oil prices we expect at this time horizon. We take the German government intention to clean up its fiscal imbalances seriously. We assume that the fiscal tightening will be worth 1% of German GDP (or 0.3% of the euro area GDP). In addition, the boomerang effect of advanced purchases of durable goods might subtract another tenth from GDP growth, once multipliers effects are included. Last, we are also discounting the lagged impact of the 100 bp tightening we expect from the ECB, on housing investment in particular. Note that our assumptions regarding fiscal policies in other large European countries (France and Italy) are neutral: not only we have no hints on 2007 budgets but we do not even know which governments will be in charge. Henceforth, there is a risk that other countries could embark in a fiscal tightening by raising consumption taxes, which could result in a slowdown more dramatic than we anticipate. In any case, the ECB is unlikely to continue to raise interest rates against a backdrop of slower domestic demand. We believe that this interest rate cycle should peak out early in 2007 and that the refinancing rate will be around 2.75% at the end of 2007, if our inflation forecasts prove correct. Inflation to drop below the ECB ceiling in 2007 only We are also raising our 2006 core inflation forecast from 1.1% to 1.5%. For that reason, the lower oil prices we now anticipate do not fully materialize in our overall inflation forecast, cut only marginally from 2.2% to 2.1%. First, we now assume that the reform of Dutch healthcare benefits will not affect the measure of inflation while, previously, we thought it would cut euro area inflation by 0.2 pp. In this respect, we follow the hints given by the European Central Bank. Second, the lags associated to the exchange rate and oil price pass-through seem much longer than we had previously assumed, as shown by the research performed by the ECB sponsored “Inflation Persistence Network”. It appears that retail prices are changed once every six months on average in the euro area, vs. once every four months in the US, for instance. We have then re-calibrated the impact of the depreciation of the euro in 2005 in our 2006 profile. Last, stronger growth in 2006 is likely to reduce the output gap. In opposition, we see the euro area inflation rate declining in 2007, despite the German VAT rate hike, because of a widening output gap and lower oil prices. We do not anticipate full blown second round effects, that is, cost pushed inflation leading to wage inflation. Germany: Recovering on Borrowed Time (by Elga Bartsch) The combination of a stronger-than-expected recovery in the second half of this year, a lower profile assumed for crude oil prices, and the prospects of a three-point VAT hike in January 2007 causes us to revise up our 2006 forecasts to 1.8% from 1.3% previously. On a calendar-adjusted like-for-like basis, our (non-calendar adjusted) forecast of 1.8% is equivalent to 2.0%, thus putting Germany very close to the calendar-adjusted euro area average. This would be the strongest rate of expansion for the German economy since the heydays of the year 2000. Unfortunately, however, this period of smart growth (by German standards where an average 1.3% rate GDP growth is the historical norm) will be short-lived. A three-point VAT hike planned to be implemented in January 2007 will likely push the German economy close to a technical recession in early 2007 as consumer spending, notably on durables, is likely to slump at least temporarily. While we would expect companies to largely look through this temporary bump, investment spending should slow in response to slower profit growth and rising interest rates. At the same time, the planned reduction in non-wage labour costs should boost cost-competitiveness of the German exporters while the higher VAT, which also applies to imported goods, should dent German import demand, thus helping German companies to absorb the lagged impact of a stronger euro. At an average GDP growth rate of only 0.8% in 2007, on our forecasts, the slowdown will be noticeable nonetheless. As a result, concerns about German economic underperformance will likely resurface a year from now when investors start to peer into 2007. Much will depend on whether the grand coalition is willing to pay such a high price to bring the Maastricht budget deficit back below 3.0% of GDP. France: Soft landing in the housing sector (by Eric Chaney) In 2004 and 2005, French economic growth was driven mostly by internal demand, up 2.2% on average. The household sector was the main driver of demand, for both housing investment and consumer spending. Rapidly rising property prices were positive not only for housing investment but also for sales of home equipment goods. Looking forward, early signs of a slowdown of the property market growth have already appeared. In the Paris region, a leading indicator for the whole country, sales of existing flats and houses have recently come to a standstill in volume terms. Unit prices are still rising, albeit at a slower pace: 10.4% in Q2 (quarterly annualised rate) vs. 12.5% from one year ago. Looking forward, the moderate pace of monetary tightening we envisage should result in a soft landing of the housing market, we think. The most speculative and expensive part of the market is likely to cool down, while the overall market should continue to grow faster than GDP. Although lenders will probably become more cautious regarding borrowers’ solvability, we think that financing conditions will remain attractive. In addition, other fundamental factors, such as demography and real income growth will continue to support the market. Corporate investment should recover at a relatively subdued pace, supported by profits and demand, but also dented by the growing share of offshore investment. In terms of economic policy, the 2006 budget is broadly neutral, stabilisation efforts from the central government being offset by growing deficits in welfare funds. At this stage, we do not make assumptions for the 2007 budget, nor do we price the tax reform which should widen the tax base and reduce marginal tax rates in 2007. We think that the elections due in May and June 2007 may lead to either a deepening of the reform or, on the contrary, its cancellation, depending on the result of the presidential election. Italy: Cyclical turnaround amidst structural hurdles (by Vincenzo Guzzo) The third quarter GDP results have shown Italy growing a modest 0.3%Q after a strong rebound in the second quarter. Business surveys and hard data point to a gradual recovery in manufacturing activity accompanied by a moderate pick-up in domestic demand. A more upbeat economic environment for the euro area as a whole, well-behaved energy prices and a weaker currency support the case for further expansion in 2006, in our view. In our new set of forecasts, we have raised our prognosis for 2006 to 1.3% from a previous 1.0%, but remain cautious about medium-term prospects. Our first cut at 2007 exhibits GDP growing another mild 1.0%. Unfavourable product specialization, loss of competitiveness on tradable goods markets, and high non-wage costs and services prices lie behind Italy’s structural underperformance. In addition, a deficit running close to 5% of GDP and a debt ratio back on a rising trend will likely require some form of fiscal correction in the course of 2006, which should also weigh adversely on the economy. In the absence of significant currency adjustments, the country will try to regain ground through more aggressive deregulation in services leading to a period of competitive disinflation, we think. Our 2007 inflation forecast stands at 1.2%, below euro area average. Spain: It is not all about construction (by Vincenzo Guzzo) Spain has now exhibited eight consecutive quarters of above 3% growth in quarterly annualized terms and no signs of slowdown have surfaced yet. A solid pick-up in disposable income, currently running at annual rates in excess of 6%, is behind the broad-based growth in domestic demand. As a result, we now see GDP growing at a steady 3.3% in 2006, followed by only a slight slowdown to 2.9% in 2007. We think that loss of competitiveness and private over-indebtedness, two of the commonly cited risks leading to a possible hard landing in the Spanish economy, are overblown. High negative net export contribution to GDP growth is a by-product of Spain’s wide outperformance within the monetary union and productivity stagnation is the cost associated to the recent labour market transformation. While there is a well-documented case for overvaluation in house prices, we do think that gradually higher interest rates will likely lead to a desirable rebalancing among the various components of demand rather than killing the current robust phase of economic expansion.
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GDP and the Coming Adjustment
Dec 07, 2005
Gerard Minack (Sydney)
The slowdown in domestic demand growth from Q2 to Q3 overstates the loss of economic momentum. However, we do think that the domestic economy is slowing: residential activity is now a drag on growth; business investment will stay strong, but is unlikely to maintain its current growth (17% real four-quarter growth for equipment investment, 28% for engineering work); and the consumer is likely to remain under pressure. Today’s report fits with our view that there are growing risks for profits. The domestic corporate sector faces the loss of top-line growth as well as rising costs. The most important cost is labour, and the pressure there is partly coming from the worsening productivity trend. GDP per hour worked in the market sector is now running 0.8% below year ago levels, having fallen in 5 of the past 6 quarters. The big picture adjustment on consumer finances has started, but has so far been very gentle. But there is a lot further to go. As a result, we do not expect that the current consumer pause will be one that refreshes – rather we think that the consumer will weaken further in 2006. The two factors that have moderated the adjustment this year – the terms of trade windfall and the buoyancy in housing sentiment (outside Sydney) – are likely to fade as supports next year. I will review all my forecasts next week. But there’s nothing in today's report to suggest that I need to make major changes. In particular, I still think a recession is likely in 2006-07. The market implications of that view are clear: weaker equities, a falling A$, and expect the RBA to cut rates. The following comments focus on the big-picture adjustment in household finances. A few observations: First, the household sector has only made the first baby-step of a big adjustment. The household saving rate rose to -2.1% of income in Q3, compared to -3.5% in the prior two quarters. But don't lose sight of how far there is to go. We expect that the adjustment will require a return to a positive saving rate (in our forecasts, to the late 1990s level); it will also require an end to negative net lending by the sector. (The principal difference between net saving and net lending is that net lending takes account of capital spending – in other words, it’s a truer reflection of the sector's net cash flow.) Both net savings and net lending hit all-time lows in this cycle. Remember the two important implications of this adjustment. First, just as a falling saving rate turbo-charges domestic demand, a rising saving rate is a drag. Exhibit 2 shows an estimate of the GDP impact of saving rate changes. Through most of the past 15 years the saving rate has fallen, boosting demand – most spectacularly in 2002, which is what gave Australia its economic resilience through the global recession. Now, however, the saving rate is rising, which is starting to detract from growth. The second benefit from a falling saving rate is to boost earnings, because corporates see top-line growth that they don't have to 'pay' for via increasing labour costs. We show how total household spending (on consumption and capital) has stayed high as a share of GDP, even as income has fallen. Narrowing that gap will be bad for corporates. The flip-side of this spending strength — and the net cash flow deficit — has been the need to take on debt. Most of that was done via home equity extraction. That extraction continues, but at a rapidly shrinking pace. Even so, household finances remain stretched, with the debt-service ratio making a new high, despite the low level of rates. This stretch is likely to cause a lot of pain if employment growth weakens. That’s what we expect next year. Two final, corporate-related points: First, the squeeze remains on domestic non-financial firms. Finally, profit share of GDP hit a new all-time high in Q3. But the top-down PE (based on top-down earnings relative to market capitalisation), is also very near all-time highs. In other words, valuations are very high with earnings very high. There’s not much fat in the Aussie market.
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Big Picture
Dec 07, 2005
Serhan Cevik (from Frankfurt)
The real roots of the current account deficit lie beyond the headlines. Turkey’s current account deficit reached a record $16.4 billion in the first nine months of this year, implying an annual deficit of 6.5% of GDP. With such a significant deviation from the average deficit of 1.4% in the 1990-2004 period, some observers make predictions with dreadful consequences for the Turkish economy. Even though there is nothing fundamentally wrong with running a current account deficit, especially when a country becomes more closely integrated with the global economy, we want to look beyond the headlines in search of the real roots of Turkey’s current account deficit. Along with external factors, such as the slowdown in foreign demand and the rise in commodity prices, fundamental shifts in the domestic economy, such as the behaviour of savings, the surge in business investment spending and the acceleration of productivity growth, have played significant roles in reshaping Turkey’s external accounts. The current account balance is the difference between savings and investment rates. According to national income accounting, the current account balance is linked to domestic savings and investment spending. Therefore, we need to investigate the savings gap — the difference between domestic saving and investment rates — to discover whether Turkey’s current account deficit is a result of declining savings or increasing investment spending. We must also consider the sectoral source of such changes in aggregate figures, since a decline in private savings, or an increase in business investment spending, may have different causes and implications than a widening in the government budget. Moreover, such shifts in the behaviour of saving and investment spending provide important clues about the sustainability of the current account deficit. For example, a current account deficit caused by an increase in net domestic investment suggests that the inflow of ‘foreign’ savings finances an expansion of the country’s capital stock and promotes a higher level of productivity. In such a case, servicing and ultimately paying off foreign debt would not entail a decrease in per capita income in the future, since higher output growth generates not just higher consumption and investment spending but also an increase in savings. On the other hand, a current account deficit caused by a drop in national savings suggests that ‘foreign’ savings finance higher levels of domestic consumption and government spending. In such a situation, servicing international debt eventually requires a reduction in consumption towards a level that is well below the trend. Turkey’s current account deficit is not a result of a drop in the national savings rate. The sudden loss of income during the crisis lowered the Turkish savings rate from an average of 21.5% of GDP in the 1990s to 17.5% in 2001. But the gross savings rate recovered back to 21.9% in 2004 and then to 23.0% this year, which is indeed well above the long-term average of 19.7% recorded in the 1950-2003 period. A momentous swing in the position of the public sector, reducing government dissavings, has contributed to the rise in the national savings rate. With the narrowing of the fiscal deficit from 15.2% of GDP in 2001 to 7.1% last year and to 2.8% this year, the negative savings rate of the public sector has improved dramatically from 9.1% of GDP in 2001 to 1.9% last year and then moved into the positive territory (0.7 of GDP) this year. On the other hand, private savings declined from the peak of 25.5% of GDP in 2001 to 23.8% in 2004 and to about 22.0% this year. In other words, despite the significant correction in public savings, the drop in the private-sector savings rate seems responsible for the widening in Turkey’s current account deficit. But, once again, the headline figure may be misleading in analysing the underlying changes in the behaviour of savings. Private saving and investment decisions reflect an improving economic outlook. Both the household and corporate sectors, expecting higher output growth in the future, have increased their current consumption and investment spending. In fact, the household savings rate has simply returned from the crisis peak of 28.2% of GDP to its normalised level — 26.5% in the 2002-2004 period — and then declined marginally to 25.8% this year. Hence, the real ‘culprit’ is the corporate sector, increasing its investment spending by an astonishing 100% in real terms in the past four years. That has, of course, exceeded the increase in the gross savings rate and consequently led to a wider current account deficit. But is this really a threat to macroeconomic stability? We believe that a current account deficit caused by a combination of higher business investment spending and lower corporate savings does not represent a systemic risk at this stage. Contrary to a current account deficit caused by a fall in public-sector savings, the recent decline in private savings is likely to be a transitory phase in Turkey’s transformation towards a higher growth trajectory. The decline in the corporate sector’s net savings is the cause of the current account deficit. As the data clearly show, Turkey’s current account deficit is result of a sharp increase in investment, not a fall in national savings rate. Domestic investment spending surged from the post-crisis low of 18.9% of GDP in 2002 to 24.3% in 2004 and 25.6% this year. Just like the trend in national savings, we have also witnessed a structural shift in investment behaviour, moving well above the average of 21.3% in the 1950-2003 period. Of course, by definition, the resulting gap between Turkey’s saving and domestic investment rates has led to a bigger current account deficit. A closer look into aggregate figures reveals that the decline in the private sector’s net savings rate — from 15.6% in 2001 to 1.3% in 2004 and 0.5% this year — is the most important factor driving the widening in the current account deficit. However, as highlighted above, the so-called ‘deterioration’ in net private savings is a result of higher investment spending and lower savings in the corporate sector. In our opinion, this is a healthy, rational response to Turkey’s increasing attractiveness for new investment projects. Future investment profitability determines aggregate investment rates. Coupled with political and economic normalisation, productivity gains have triggered capital inflows and higher investment spending in the post-crisis period. The astonishing acceleration of Turkey’s total factor productivity growth — from an average of 0.5% per annum in the 1990s to 4.8% in the past four years — has raised the rate of return on domestic investments and the country’s potential growth rate. Even though the marked increase in the country’s capital stock has resulted in a widening in the current account deficit, we believe that these productive investments bring in higher export revenues and thereby improve the sustainability of the current account deficit. Furthermore, with the continuing improvement in Turkey’s credit quality, ‘foreign’ investors will intensify their involvement in the economy — an important issue which we will investigate in a forthcoming report. Increasing public savings is the most effective way to deal with the current account deficit. A reduction in the government budget deficit should theoretically bring about an increase in net savings of the economy and thereby lead to a reduction in the current account deficit. However, the effect of fiscal tightening on the current account deficit depends on the extent to which increases in public-sector savings are offset by declines in private saving. These counteracting effects may work through a variety of channels, including the ‘crowding in’ effect whereby fiscal tightening lowers real interest rates that in turn induces a decline in the private saving rate or an increase in private investment spending. Indeed, fiscal consolidation has had such expansionary effects the past four years. Nonetheless, since measures aiming to raise private saving have little success, the most effective method to reduce the current account deficit is still an increase in domestic savings through a reduction in public-sector borrowing.
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