The Coming Rebalancing of the Chinese Economy
Mar 27, 2006
Stephen Roach (New York)
China is sending the world an important message: A key mid-course correction in its development model is coming — a shift away from export- and investment-led growth to more of a consumer-driven dynamic. This change will not be abrupt but it will be an increasingly dominant characteristic of the Chinese growth outcome over the next five years. It is aimed, first and foremost, at providing greater stability to the Chinese economy. It will also have profound implications on the global economy and world financial markets.
I have reached this conclusion largely on the basis of very clear statements made by senior Chinese officials. It is also consistent with my own macro analysis of the Chinese economy. And it’s a conclusion that stood up well to a full-blown debate that I was part of during my recent visit to Beijing (see my 21 March dispatch, “Inside the China Debate”). The essence of the adjustment is actually very simple: A long-standing strategy of resource mobilization — powered by the recycling of a huge reservoir of domestic saving into an export- and investment-led growth dynamic — has now outlived its usefulness. Senior Chinese officials believe that the time is right to shift to more of a self-sustaining internal demand model, driven by private consumption. This rebalancing will not only enable China to deal more effectively with both internal and external imbalances, but it will also enable the reformers to turn their attention to the critically important quality dimensions of the growth experience that are now being actively debated inside of China (see Andy Xie’s 20 March 2006 dispatch, “China: Addressing Backlash Against Reform”). China’s rebalancing imperatives are obvious. The economy has become far too reliant on two sectors — exports and fixed investment. Depending on the metric chosen — due to recent data revisions, a somewhat more ambiguous calculation than in the past — these two sectors now account for between 70% and 80% of overall Chinese GDP. And, as of this point in time, they are still expanding collectively at around a 25% annual rate. If those trends were to continue, the sustainability of the Chinese growth model would be at considerable risk. Years of rapid export growth have already led to serious trade frictions and heightened risks of protectionism. Moreover, a continuation of rapid investment growth could lead to excess capacity and deflation. Meanwhile, there is a clear and increasingly urgent need to boost private consumption, which fell to a record low of just 50.7% of Chinese GDP in 2005 — far below the 65% share that is considered the norm for a more developed economy. Similarly, the mix between capital-intensive manufacturing (47.3% of GDP in 2005) and labor-intensive services (40.3%) reflects yet another layer of distortions in China’s economy that biases its growth dynamic away from job creation — precisely the opposite of what a reform-oriented system requires. In order to rectify these imbalances and avoid their potentially destabilizing implications, a shift in the mix of the Chinese economy must now occur. The Chinese leadership is going out of its way to inform its own citizens, as well as those in the broader global economy, that it will now push for just such a rebalancing. That was certainly the major thrust of the recently approved 11th Five-Year Plan, and it was also the main theme of the just-concluded China Development Forum (CDF) that I participated in last week in Beijing. Over the years, I have found the CDF to be invaluable in providing a window into the China debate. It is timed to take place within days of the completion of the National People’s Congress — the annual gathering of the Chinese legislature. The debate at the CDF is fresh and the message is relevant. It brings the Premier, together with several of the senior ministers and other leaders of the Chinese government, into open and active discussions with both the domestic and the international community. Since its inception in 2000, this relatively small conference has been used by official China to convey many important messages on the Chinese economy. That was the case of the pro-active fiscal stimulus unveiled during the global recession of 2000-01, the cooling down of an overheated Chinese economy in 2004, and the subsequent all-clear issued in 2005. In that context, and on the occasion of the passage of the latest five-year plan, I take the message of the 2006 China Development Forum as one that signals a very important milestone on the road to reform and transition. The Chinese leadership stressed three important aspects of the rebalancing imperative — the first being a moderation of the overall growth objective. The new five-year plan calls for 7.5% average real GDP growth through 2010 — a marked downshift from the 9.5% average pace over the preceding 25 years. This should not be viewed as a worrisome shortfall but, instead, as an effort to raise the quality of China’s growth experience. My own sense is that the Chinese leadership has become increasingly concerned about the pressures that hyper-growth puts on its transitional economy. Bottlenecks in strategic materials have emerged as a serious problem in recent years, as have the related impacts of soaring energy prices. There are also worries that the blistering 10% GDP growth pace of the past three years has led to widening income disparities and environmental damage. These externalities of hyper-growth underscore stability concerns that could ultimately jeopardize reforms. This is where the Chinese leadership draws the line. While Premier Wen left little doubt that the Chinese leadership still placed a high priority on strong growth, he also said most emphatically at the CDF, “China will never backtrack on reforms.” A refocusing of growth objectives from quantity to quality should be viewed as an important means to preserve China’s commitment to reforms. The second leg of the stool is the government’s pronouncement on the intent to rebalance the mix of GDP growth over the next five years. Ma Kai, Chairman of the National Development and Reform Commission, did the heavy lifting on this point — stressing the need to boost both the consumption and the services shares of Chinese GDP at the cost of lowering the portions going to exports and fixed investment. Clear recognition was also placed on the establishment of a safety net — especially social security but also rural healthcare and education. This was viewed as necessary to improve income security — thereby reducing the excesses of precautionary saving that continue to inhibit the expansion of private consumption. The math and time lags of the likely shift in the mix of Chinese economic activity are consistent with the announced moderation of the overall growth target over the next five years. That reflects the likelihood that the impetus from rapidly growing exports and investment should fade before the added support from consumption kicks in. Financial reforms are the third leg to China’s macro rebalancing stool. The focus, so far, has largely been on banking reforms. But there are equally strong needs to push into the area of capital markets reforms — especially the development of a corporate bond market. Currency reforms have also been given considerable attention recently — especially in light of mounting bilateral trade tensions with the United States. Senior Chinese financial officials, in particular Governor Zhou Xiaochuan of the People’s Bank of China, have expressed concerns over the excessively rapid accumulation of foreign exchange reserves. The rebalancing of the real economy toward increased domestic consumption should lead to more rapid gains in Chinese imports and a related narrowing of its trade surplus. That will, in turn, reduce China’s current-account surplus, slow the excessive pace of foreign exchange reserve accumulation, and thereby relieve pressures on the currency and trade fronts. Rebalancing on the real side of the economy thus provides China with more leeway to broaden and deepen its financial sector reforms. The implications of this rebalancing are likely to be profound — both for China as well as for the rest of the world. The tilt away from exports and investment toward consumption, along with the moderation of aggregate GDP growth such a rebalancing implies, could challenge many of the perceptions now held in the financial markets about the “China factor.” Three potential impacts strike me as most important: * Commodity markets. A reduction of investment growth is likely to temper China’s impact on the demand side of many industrial commodity markets. In 2005, China accounted for around 25% of worldwide demand for aluminum and about 30-35% of global consumption in copper, iron, steel, and coal. As the pace of Chinese industrial activity slows in the years ahead, pressures on the demand side of industrial materials markets should ease — underscoring the downside risks to commodity prices at just the time when most investors have concluded that there will be no stopping the upside of a “super commodity cycle.” China’s efforts at energy conservation — a targeted 20% reduction in energy content per unit of GDP over the next five years — could well amplify the downside impacts on prices of oil and refined products markets. * Currency and trade tensions. Courtesy of rebalancing, China may be more inclined toward RMB appreciation as a means to promote a shift away from the excesses of export-led growth. The extent of this appreciation will undoubtedly be dependent on the reform and stability of its financial system. Pro-consumption initiatives should also boost Chinese import demand — an outcome that should reduce China’s net-export surplus and thereby provide support for its major Asian trading partners such as Japan, Taiwan, and Korea. The combination of RMB appreciation and reduced external surpluses should play an important role in relieving the anti-China trade tensions now building in the international community. * The Chinese consumer play. The Chinese consumer will not spring to life over night. But this is likely to be a major story over the next 3-5 years. Chairman Ma of the NDRC stressed that the emphasis will initially be placed on China’s labor-intensive tertiary industries involved in distribution and delivery — underscoring not only the opportunities for wholesale, retail, and trans-national shipping but also for e-based trade retail systems. Conditional on the improvement of income and safety-net support — a clear focal point of the new five-year plan — growth in the Chinese consumer products industry should move rapidly up the value chain from soft- to hard-goods over the next several years. Nor is China reluctant to open up its consumer markets to foreign participants; under the terms of WTO accession, foreign multinationals will be allowed increased access to retail trade opportunities within three years. None of this is without risk, and the Chinese leadership is fairly transparent in identifying those risks. It all boils down to concerns over stability. This continues to be the key constraint on reforms and development in China — and it probably always will be. That’s especially the case due to the massive headcount reductions that have arisen from the dismantling of state-owned enterprises (SOEs) — reforms that have resulted in the shedding of over 60 million jobs by the state sector since 1997. Rapid economic growth has long been viewed as the major tool at China’s disposal to offset these massive headcount reductions. In that respect, China’s willingness to tolerate the slower 7.5% GDP growth trajectory over the next five years could be drawn into question. However, with SOE reforms now well advanced and the layoff pace having moderated recently to an annual clip of around 2 million workers per year, there is good reason to believe that China is now better able to withstand the impacts of this mid-course correction. China remains the world’s greatest growth story. But there is far more to its transition and development than the sheer speed of an industrial growth dynamic. An important rebalancing is now at hand that will temper the excesses of the current strain of growth and insure the sustainability of a more balanced and higher-quality economy for years to come. That message came through loud and clear in the 11th Five-Year Plan and in the debate and exchange I witnessed last week in Beijing. Over the years, I have learned not to under-estimate the will and determination of the macro managers who shape the character of the Chinese economy. Time and again, they have made the right moves at the right time. I see no reason to doubt the wisdom or the execution of the coming rebalancing.
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United States
Mar 27, 2006
Richard Berner (New York)
Market participants reasonably believe that the Fed is nearly finished tightening and hope for a clear, confirming signal from the FOMC this week. Specifically, Fed funds futures imply about a 70% chance that the funds rate will reach 5% by May with little, if any, tightening expected thereafter. The economic outlook seems to be consistent with such expectations: While risks remain, core inflation has been relatively stable, and the economy may be slowing to its trend growth rate. Moreover, after this week’s FOMC meeting the Fed will have raised the funds rate by 375 bp in less than two years. At a minimum, therefore, officials could pause to take stock after this meeting or stop after moving in May. Judging by recent Fed commentary, many policymakers might find this an entirely sensible perspective. In contrast, we believe that the Fed will move a bit further to contain future inflation risks. Two assumptions about the outlook are critical. First, while core inflation is currently benign, we believe there are upside risks, given current monetary policy. In addition, we see the economy moving back to above-trend growth in the second half of 2006, reinforcing those upside inflation risks. We think that acceleration is likely despite an expected slide in housing activity and a long-awaited deceleration in home prices. In our view, the trigger for stopping the tightening process will be accumulation of evidence that the economy has slowed enough to balance growth with its potential. But with weakness in housing now glaringly apparent, and with many convinced that housing is the economy’s Achilles heel, the acid test for our view is now at hand. Here’s why. There’s no mistaking the slide in housing demand and its implications for housing activity, for construction employment, and for new and existing home prices. New single-family home sales, at a 1,080 thousand annual rate in February, have tumbled 21% from their August, 2005 peak. Given the slide in housing affordability and our expectations for interest rates, we’ve factored a further 15-20% sales decline into our forecasts of housing activity. Bear in mind that 40% or more of 1-family housing starts are never sold; individuals contract for them directly with a bespoke builder. We assume that such activity will contract in line with the decline in the 60% that developers build “on spec” and sell to the public. A similar decline in sales of existing homes wouldn’t surprise us, although in our view the condominium market is most at risk. That inventories of unsold new homes have already jumped to a decade high indicates a significant mismatch between supply and demand at the current sales rate. The cutback in 1-family housing starts needed to correct that imbalance is consistent with our expectation that starts will, by the end of 2006, plunge by 20-25% from February’s level. Such a plunge might cost 25,000 construction and specialty contractor jobs monthly. What’s more, the decline in housing turnover (sales relative to the housing stock) implied by the coming declines in existing home sales is creating downward pressure on home prices, consistent with our long-standing expectations of a moderation in the growth of home prices from 13% to 2-4% over the next 12-18 months. Other things equal, such a deceleration in housing wealth might trim half a point from growth in consumer spending over 2006. But of course, other things aren’t equal. Indeed, those numbers set in perspective how strong we expect the economy to be apart from the influence of housing activity, reflecting the newfound income generation and appreciable improvement in overseas growth that have emerged over the past year (see “Tweaking the Fed Call,” Global Economic Forum, March 13, 2006). But even if the economy more than weathers the declines in housing activity and deceleration in housing wealth, as we expect, inflation rather than growth risks are the key to the future path of monetary policy. While the initial conditions surrounding the inflation outlook point to upside risks to inflation, policymakers are probably feeling comfortable with the inflation prognosis. Although they have described core inflation at the upper end of the FOMC’s perceived comfort zone, both Fed board members and staffers believe that the post-hurricane runup in energy prices has passed through into core inflation over the past few months. As a result, core inflation could decline when that transitory lift to inflation passes. And although slack in both goods and labor markets has dwindled, several factors might hold inflation in check: Inflation expectations seem relatively well anchored, import prices have decelerated, productivity growth still seems strong, and the full impact of past policy tightening has yet to show up on economic activity. Consequently, a slowing to trend growth or below could ease concerns that tighter labor markets would hike wage and inflation pressures. In contrast, we expect that hearty growth will continue to erode slack in labor and product markets, boosting wage growth further and allowing companies to pass through cost increases into prices. In our forecast, it takes a significant improvement in labor force participation to prevent the jobless rate from declining over the rest of the year. Moreover, while the trend in productivity is still favorable, we believe that productivity will slow to a below-trend 2% pace as job growth catches up with the economy. That will temporarily reinforce the rise in unit labor costs (see “The Coming Productivity Undershoot,” Global Economic Forum, March 20, 2006). Finally, if stronger growth and tighter monetary policies abroad promote a renewed decline in the dollar, a currency depreciation once again could act as an inflation tailwind, perhaps even more than it did in 2003-04. Monetary policy is neither stimulative nor restrictive, so the outlook and the data shaping it will clearly drive policy going forward. In those circumstances, officials likely will need a good deal of flexibility to adapt to any surprises. Moreover, Fed officials are acutely aware that markets may overreact to any change in language describing the policy outlook. In our view, the language contained in the January statement — “further policy firming may be needed” — provides latitude for the FOMC either to hold steady or move again in May. Thus, significant changes in the post-meeting statement seem unlikely. To be sure, new Fed Chairman Ben Bernanke has promised more transparency in the communication of policy intent. While he was a Fed Governor, that meant pushing for more detailed analysis of the issues confronting policymakers, plain talk about policy options, and more timely disclosure of the minutes of FOMC meetings. As Fed Chair, that means working towards a numerical objective for price stability, more frequent and timely publication of numerical forecasts, and more nuanced discussion of policy responses to changes in the outlook. Discussion about some of these issues may be the subject of this two-day FOMC meeting. But as listeners to Chairman Bernanke’s first two speeches learned, in these circumstances transparency does not mean offering clues about the future policy path unless they are conditioned on the outlook. As has been the case since the January FOMC meeting, therefore, Fed guidance may become less clear and markets will be increasingly sensitive to incoming data and the way they shape the prognosis. In my view, with market participants beginning to anticipate an end to policy tightening, financial markets are again somewhat vulnerable to upside inflation and growth surprises. But there is a strong market conviction that the trigger for stopping will be further declines in housing activity and/or a deceleration in home prices. And we still expect only a leisurely rise in core inflation and a temporary spring deceleration in growth. Consequently, it may take some time before those vulnerabilities are apparent.
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Review and Preview
Mar 27, 2006
Ted Wieseman (New York) and David Greenlaw (New York)
Treasury yields ended mixed the past week with the curve significantly flatter, after a big rally Friday following weaker than expected new home sales and durable goods reports partly reversed significant losses that had been seen through Thursday. This followed comments from Fed Chairman Bernanke that were balanced, rather than overtly dovish as the market apparently expected, and upside surprises in the PPI and existing home sales reports. Fed pricing in the futures market saw a similar whipsaw. After having come into the latest week after the big rally the prior week expecting that 5% and possibly even 4.75% would mark the peak in the fed funds target, the lack of any particular signal from Chairman Bernanke suggesting the FOMC would suggest such a scenario after Tuesday’s meeting coupled with the worse than expected PPI inflation and upside surprise in existing home sales had the market again contemplating the possibility of a 5.25% peak. This was in large part reversed following the new home sales report on Friday, however, and the net change in Fed pricing on the week was only to a slightly more hawkish profile in the futures market. Despite this back and forth volatility — which was mostly confined to a big sell-off Tuesday after the PPI report and a big rally Friday after the new home sales data — overall it was a quiet week for the market, with a heavy corporate issuance calendar the main focus much of the time, as investors were largely biding their time ahead of Tuesday’s FOMC announcement. For the week, 2’s-10’s flattened 6 bp and 2’s-30’s 8 bp, as, following a 5 to 6 bp rally to end the week Friday, the 2-year yield rose 6 bp to 4.71%, the 10-year yield was unchanged at 4.67%, and the 30-year yield fell 2 bp to 4.70%. The 3-year and 5-year yields each rose 4 bp, to 4.67% and 4.66%, respectively. Market pricing of the Fed in the futures market ended the week slightly more hawkish after pulling back significantly from a more substantial move through Thursday, most of which occurred Tuesday in response to Fed Chairman Bernanke’s Monday evening remarks and the upside surprise in core PPI. For the week, the May fed funds contract was off a half bp to 4.885%, pricing in a roughly 70% to 75% chance of a hike in the funds target to 5% at the May 10 FOMC meeting following the fully priced in move to 4.75% on Tuesday. The July contract was off 2.5 bp to 4.985% and the September contract 3 bp to 5.02%. So on net the market now again sees the risks around its central case of a 5% peak in the funds target as slightly more tilted to 5.25% than the 4.75% it came into the week favoring. There was also a small reduction in the inversion in eurodollar futures on the week, with the September 2006 to September 2007 spread rising 3.5 bp to -14 bp, with the former losing 2.5 bp to 5.11% and the latter 6 bp to 4.97%. Real rates in the TIPS market resumed their recent move towards their highest levels in a couple years. The current 5-year TIPS hit an all-time high yield since being auctioned in October 2004 (with a now preposterous looking 7/8% coupon) of 2.16% Thursday before rallying to close Friday at 2.12%, up 11 bp on the week, reducing the breakeven inflation rate versus the current nominal 5-year by 7 bp to 2.54%, a cumulative 23 bp decline in the past three weeks. Economic news the past week was sparse and generally mixed for the market, with upside in core producer inflation but some softness in the growth side data that led us to cut our Q1 GDP estimate to +4.2% from +4.6%. The week’s main item of interest, however, was Fed Chairman Bernanke’s first speech as Chairman on the topic “Reflections on the Yield Curve and Monetary Policy.” The significantly negative market reaction to the speech said a lot more about the market’s having gotten itself out of position the prior week by becoming far too bulled up about the prospect of an imminent Fed pause than it did about the actual content of the speech itself. The Chairman advanced a number of theories, some contradictory, for possible causes and consequences of the low level of longer-term rates without drawing any firm conclusions. Indeed, given the uncertainty he laid out surrounding the causes and consequences of unusually low long-term rates, his main conclusion was merely to reinforce the data dependency of monetary policy — “policymakers should monitor bond yields carefully in judging the current state of the economy, but only in tandem with the signals from other important financial variables; direct readings on spending, production, and prices; and a goodly helping of qualitative information. Ultimately, a robust approach to policymaking requires the use of multiple sources of information and multiple methods of analysis, combined with frequent reality checks.” For some reason, investors had apparently been expecting Bernanke to give an advance warning that the FOMC was preparing to signal an end to the rate hiking cycle, but his carefully balanced remarks (which we expect to be followed up with a largely unchanged FOMC statement Tuesday) helped spark a big market sell-off Tuesday and reassessment of whether risks were more tilted towards a 4.75% or 5.25% peak in the funds target relative to the 5% central case embedded in futures pricing. Market weakness through Thursday was also added to by worse-than-expected core PPI inflation and a stronger-than-expected existing home sales report. The headline producer price index plunged 1.4% in February, one of the largest declines ever, on sharp falls in both food (-2.7%) and energy (-4.7%). In contrast, the core rose 0.3%, a second straight above-trend gain after a 0.4% jump in January. Modest elevation in a number of categories, including drugs, tobacco, and aircraft contributed to the upside in the core. Often volatile motor vehicle prices were little changed overall, with a drop in cars offset by a rise in light trucks. News at earlier stages of production also reflected a divergence between food and energy driven headline weakness and core elevation. The core intermediate gauge gained 0.5% on upside in paper, chemicals, and building materials, while the core crude index surged 3.3% on big gains in scrap metal prices. Looking down the pipeline, the core crude index is now up 11.9% year/year, core intermediate +4.8%, core finished goods +1.7%, and core goods CPI 0.0%. So there are a lot of potential pipeline materials costs pressures to be passed through if strong demand growth and rising operating rates continue to boost business pricing power. News on the housing market was mixed, mostly it seemed as a result of different methodologies in counting new and existing home sales and the big weather swings experienced in January and February, and as a result greatly whipsawed the market. A common element of both reports, however, was just how bloated home inventories are becoming, which is likely eventually to start exerting significant pressure on pricing and new construction. Existing home sales rose 5.1% in February to 6.91 million units annualized, reversing most of the drop seen over the prior three months and interrupting a previously steady decline since record levels were hit last summer. Because existing home sales are mostly counted at closing they generally reflect transactions initiated a month or two earlier, and the warm weather in January appeared to provide a boost. This was seen in the regional breakdown, with very strong gains in the Northeast and Midwest, a smaller rise in the West, and decline in the South. Homes available for sale surged 30% year/year, and even with the rise in the selling rate the month’s supply held steady at 5.3%, the high since 1998, though not especially elevated from a long-term perspective. Meanwhile, more timely (and more volatile) new home sales which are counted at contract signing, even if, in many cases, construction hasn’t even begun, plunged 10.5% in February to 1.080 million units annualized, nearly a three-year low. The swing in the weather after the record warm January probably hurt activity but this was clearly not the only reason, as sales were weakest in the West (-29%). With sales down sharply and new construction still elevated, new home inventories are also becoming increasingly bloated. The number of new homes available for sales rose 23% Y/Y in February, and the month’s supply jumped from 5.3% to 6.3%, the highest level since January 1996. The net impact of the two home sales reports was marginally positive for Q1 growth because of the much larger magnitude of existing home sales in calculating the brokers’ commission component of residential investment. But this was more than offset by a disappointing durable goods report. Overall durable goods orders jumped 2.6% in February, but all of the upside came from the volatile civilian aircraft (+52.5%) and defense capital goods (+104.1%) categories. The key core gauge, nondefense capital goods ex aircraft orders, fell 2.3%, mostly as a result of a 6.3% drop in machinery bookings, which have corrected significantly the past couple months after surging late last year. Nondefense capital goods shipments fell rose 0.6% after a downwardly revised 4.4% plunge in January; excluding aircraft they fell 1.1% in February after being flat in January. This surprisingly weak outcome pointed to a less robust gain in business investment in Q1 than we previously estimated. We cut our forecast for equipment and software investment by about 5 percentage points to +12.5%. Assuming a decent rebound in capital goods shipments in March, and incorporating the unusually volatile but ultimately, relative to our prior assumptions, about neutral durable goods inventories figures (a significantly upwardly revised 1.0% surge in January followed by a 0.5% drop in February), we cut our Q1 GDP forecast to +4.2% from +4.6%. The FOMC meets Monday and Tuesday. Another 25 bp rate hike in the funds target to 4.75% seems assured, so the main focus will once again be on the language contained in the official statement. Clearly, monetary policy is becoming increasingly data driven and the Fed needs a good deal of flexibility in such an environment. In our view, the language contained in the January statement, specifically, the reference to “further policy firming may be needed”, provides sufficient maneuvering room, allowing the FOMC to either hold steady or trigger an additional rate hike in May. Thus, we don’t see the need for wholesale changes to the message at this point. From our standpoint, it might actually be risky for policymakers to alter the wording too much at this point given the tendency for markets to overreact. Current futures market pricing of a 70-75% hike in the funds target to 5% in May, and if not in May then almost certainly in June, seems quite reasonable to us and probably also to the Fed. However we (and certainly, we suspect, the Fed also) continue to believe that the pricing of a quick shift towards rate cuts from September is off base. While we don’t look for any significant change to the policy and risk assessment portion of the statement, the description of current economic conditions may be a bit more upbeat than last time around. In January there was reference to recent data having been “uneven.” This description was appropriate after the then just released disappointing Q4 GDP report. The latest weather-related swings in some of the incoming data may justify maintaining the “uneven” phrase. But clearly labor market conditions have been quite robust in the past couple months, and incoming data have made it increasingly likely that Q1 growth will see a significant rebound from the disappointing Q4 results. With upside in growth, tightening labor markets, and rising industrial capacity utilization rates, the warning that “possible increases in resource utilization as well as elevated energy prices have the potential to add to inflation pressures” remains appropriate. However, recent benign underlying consumer inflation results certainly justify the description of core inflation as having “stayed relatively low in recent months” and inflation expectations “contained.” Note that the new Fed Chairman has added an extra day to the March meeting — the announcement is still due at around 2:15 p.m. on Tuesday, but the session will kick off on Monday. The press release announcing this change indicated it was made to “allow additional time at Chairman Bernanke's initial meeting with the Committee.” Of course, this follows the January meeting having been shortened from its usual two days to one to allow it to end within Chairman Greenspan’s term. But the additional day in March is not merely a substitute — there is no need to compile the official economic forecast produced by the FOMC as part of the Monetary Policy Report to Congress. That’s a large part of what the extra day in January (and in June) is needed for. Instead, it seems likely that Bernanke intends to lead a Committee discussion on issues such as inflation targeting and communications strategy. While the manner in which the Fed communicates in its post FOMC meeting statements will probably be discussed and some significant changes may be made down the road, it seems too early to expect any meaningful adjustments at this meeting. In addition to the FOMC meeting, Treasury supply — a $22 billion 2-year Monday and $14 billion 5-year Wednesday, both unchanged in size ahead of likely further modest increases in the months ahead — and some economic releases are scheduled for the coming week. The data calendar is light, with notable releases including consumer confidence Tuesday, revised GDP Thursday, and personal income and spending and factory orders Friday: * We forecast a rise in the Conference Board’s measure of consumer confidence to 103.5 in March. Other sentiment gauges have been mixed in early March, with the ABC News/Washington Post poll showing solid improvement, but the University of Michigan index unchanged. We look for the Conference Board gauge to post a modest rebound following the pullback seen in February, with the lagged impact of the drop in gasoline prices in February providing a boost. * The final revision to Q4 GDP is expected to show a slight upward adjustment to +1.8% from the +1.6% reported last time around. Higher net exports and inventories account for just about all of the expected revision. In the current quarter, we see GDP tracking at +4.6%. * We forecast a 0.4% gain in February personal income and a flat reading for spending. Gains in employment and wage rates should more than offset a slight dip in the length of the workweek, leading to a modest rise in personal income. Meanwhile, a slower pace of motor vehicle buying and an outright decline in retail control imply a flat result for consumption even after factoring in an expected weather-related rebound in outlays for utilities. Despite the sluggishness of February spending, real consumption appears likely to post about a 4.8% gain for the quarter as a whole. On the price front, we look for the core PCE price index to match the 0.1% rise seen in the core CPI. Finally, note that the expected combination of income and spending in February is likely to lead to a rare uptick in the personal saving rate. * We look for a 1.2% rise in February factory orders. A rebound in bookings for durable goods — largely related to the volatile aircraft category — points to a partial bounceback in overall factory orders. Meanwhile, both shipments and inventories are expected by the market to be little changed.
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Turkey - Politicising the Central Bank
Mar 27, 2006
Serhan Cevik (London)
The appointment of a new central bank governor has turned into a political tug of war. President Ahmet Sezer vetoed the government’s proposal to appoint Adnan Buyukdeniz, CEO of Al Baraka Turk, as the new governor of the Central Bank of Turkey. The appointment process is harming the central bank’s institutional credibility as well as raising doubts about the government’s commitment to the central bank’s formal and de facto independence, in our view. Even though everybody knew that the previous governor’s term would expire on March 14, the authorities in charge of the appointment procedure waited until the last moment, leaving no room for any margin of error, to present the new management team. And now, with the presidential veto and the resignation of vice governors, Turkey’s central bank — the most important economic institution, and the ‘last resort’ of prudence and stability safeguarding the economy and financial markets — has a tarnished record of independence and transparency, and appears to be in an administrative limbo. Politicising the central bank would result in a loss of policy credibility. Though all governments have a democratic right to make bureaucratic appointments, the governor of an independent central bank is no ordinary bureaucrat. The ‘distance’ between politicians and the governor should not be narrowly defined, especially in a country that still lacks institutional credibility and transparency. This is why appointing a governor who might be perceived as ‘too close’ to the ruling party could actually hurt the government’s own performance on the economic front by distorting market expectations away from the targets of the macroeconomic framework, in our view. Although the new management is unlikely to introduce significant policy changes, politicising the central bank would likely still result in a loss of policy credibility and delay the reduction in interest rates. For example, the reaction of market participants to the government’s attempt at damage control by withholding the announcement of the presidential veto for two days will probably be adverse and impede the central bank’s ability to conduct monetary policy in the future. A truly independent central bank is necessary to achieve price stability on a sustainable basis. An autonomous central bank, protected from political intervention by law and by tradition, is a building block of economic stabilisation. Indeed, Turkey could not have enjoyed the opposite of stagflation — strong output growth and rapid disinflation towards single-digit territory — without an independent and transparent central bank. We believe it has been a crucial factor in accelerating the pace of disinflation and in lowering the output costs of disinflation. As the Central Bank of Turkey has moved away from control by the government, the disinflation programme has gained credibility and anchored inflation expectations to the official targets. Therefore, we believe that any attempt to re-politicise monetary policy would upset the delicate balance in financial markets, particularly in today’s increasingly risk-averse environment, and would likely result in higher real interest rates. This is why we believe it is in the government’s own best interest to strengthen the central bank’s formal, as well as de facto, independence and to uphold the primacy of price stability. Enhancing policy credibility improves the quality of economic growth. The Turkish authorities have made considerable progress in fostering policy credibility both on the fiscal and monetary fronts by following a transparent set of rules and objectives. Thus, exposing the central bank to politics would seem injudicious, not only stressing financial markets, but also likely putting a damper on economic growth over the longer run. A truly independent central bank with an exclusive mandate to focus on price stability, and supported by prudent fiscal policies and structural reforms, would be much more likely to be successful in lowering inflation and the volatility of inflation. That would, in turn, boost the business sector’s investment appetite and thereby increase the economy’s potential growth rate and labour absorption capacity. In other words, the most populist step the government could take is essentially maintaining fiscal discipline and bolstering the credibility of monetary policy.
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Israel - Peace, Poverty and Politics
Mar 27, 2006
Serhan Cevik (London)
The peace process and socio-economic conditions are at the centre of the campaign. Every election is important, but the one on March 28 represents, in our view, a critical turning point in Israel’s political history. With far-reaching changes in the Middle East and, especially, after Israel’s withdrawal from the Gaza Strip and northern Samaria and the decisive victory of Hamas in the Palestinian legislative elections, Israeli voters will not only elect the country’s next government, but will also determine the general direction of the peace process and economic policies. In the past six months, we have already witnessed significant shifts, such as Prime Minister Ariel Sharon’s bold decisions to disengage from the Palestinian territories and the Likud Party, which have altered political dynamics in a revolutionary fashion and may well now bring ‘surprising’ results in the forthcoming elections. In our opinion, the peace process and the state of the economy are the two main centres of the campaign where Israel’s new political enterprise, Kadima, enjoys an advantageous position. Opinion polls confirm realignment towards the centre in Israel’s political landscape. Kadima’s centrist position, drawn from the left of Likud and right of Labour, responds to Israeli voters’ pursuit of peace and prosperity. With improving economic conditions and a growing consensus on unilateralism, Kadima has become an ‘umbrella’ party for centrist politicians and voters, and, contrary to the discouraging history of centrist parties in Israel, could be heading for a victory in the forthcoming elections. Despite some erosion in the polls from 43 seats, on average, in January to 41 seats in February and 37 seats this month, Kadima, now led by Ehud Olmert, remains well ahead of Amir Peretz’s Labour, receiving 19 seats, and Likud, led by Benjamin Netanyahu, getting 16 seats in the Knesset. We believe that Kadima’s attractiveness reflects a continuing political realignment in Israeli society towards the centre and the public’s desire for a strong centrist leadership that could resolve the Israeli-Palestinian conflict and keep economic growth on track. Unilateralism, despite its obvious shortcomings, has become a national consensus. Given the country’s electoral regime, we are unlikely to see full consolidation of the fragmented political landscape. Nevertheless, the expected changes in voting behaviour should be enough, we think, to produce a stable coalition government with a centrist mandate. It seems that the key driver of political consolidation is Mr. Sharon’s unilateralist strategy, which has become a national consensus, at least, for the near future. About 75% of Israelis support the unilateralist approach and, indeed, 60% of voters are in favour of withdrawing from the West Bank in exchange for a lasting peace agreement with the Palestinians. This is an encouraging change, in our view, since the ‘greater Israel’ project, creating frustration not only in the Palestinian territories but also across the Middle East, has been the most significant obstacle to a resolution of the conflict. However, unilateral decisions concerning the West Bank would not ensure economic and political viability of an independent Palestinian state and therefore fail to guarantee the sustainability of peace. This is why, regardless of the election outcome, I believe only a comprehensive strategy, empowering Palestinians, would bring a sustainable resolution. Socio-economic developments, as much as the security situation, shape the national psyche. The state of the economy is always an important factor in political cycles. Take, for example, what happened in the Palestinian elections. With nearly half of Palestinians living below the poverty line, the sweeping victory of Hamas was not a surprise. In the case of Israel, however, we do not expect economic conditions to lead to unexpected election results. Though output growth initially failed to create jobs, the latest figures highlight notable gains in the labour market. The unemployment rate improved from the peak of 10.9% in 2003 to 8.7% at the beginning of this year, while real wages, after contracting by 6.2% in 2002 and 3.0% in 2003, increased by 2.5% in 2004 and 1.4% last year. It may still be too early for extensive improvements in socio-economic conditions, but the outlook certainly appears much more encouraging. Having said that, we also realise that Israel’s two-track growth trajectory — favouring technology-intensive industries more than traditional sectors — implies political risks stemming from the voting behaviour of the poor-favouring sectorial parties. Israelneeds peace to alleviate poverty and to improve income distribution. Politicians propose numerous schemes to alleviate poverty and to improve the distribution of income. Some of these suggestions, like negative income tax, may indeed be useful; while others, like increasing entitlements or raising the minimum wage, would not be effective at all, in our view. The income gap also reflects a mismatch between educational attainments and the needs of Israel’s high-tech companies. Finally, a faster rate of employment growth requires higher investment spending that in turn depends on the country’s economic prospects. Therefore, we believe that the ultimate requirement for fulfilling economic potential and improving socio-economic conditions is a sustainable peace deal.
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Singapore Economics
Mar 27, 2006
Deyi Tan (Singapore) and Denise Yam (Hong Kong)
Rebound on LNY effect: Manufacturing output rose 37.2%YoY in February (vs 2.4%YoY in January). The sharp jump was aided by a low base effect, as LNY fell in February last year, as well as favourable momentum in the biomedical segment (+199.7%). On average, manufacturing output rose 17.4%YoY in Jan-Feb, accelerating from the 14.1% in 4Q05. On a seasonally-adjusted sequential basis, the 17.6%MoM was the fastest growth seen since Jan 2004. Broad-based momentum in all segments, including pharmaceuticals: All segments registered healthy momentum. The electronics segment saw 21.1% expansion (vs 20.2%YoY in Jan-Feb). All electronic sub-segments saw reasonable growth, with the exception of data storage (-6.8%YoY), which mirrors the decline in disk drive exports that we are seeing. Meanwhile, growth in chemicals (+4.8%YoY), precision engineering (+22.7%YoY), transport engineering (+35.1%YoY), general manufacturing industries (+10.8%YoY) was respectable. Notably, biomedical manufacturing rebounded to 199.7%YoY following two consecutive months of contraction as pharmaceuticals came in at 312.6%YoY on a different product mix. Strong manufacturing to help 1Q06 GDP growth: The latest number provides corroboration that demand is on the rising part of the growth trajectory, which should continue for 1H06 at least, in our view. March production growth is unlikely to reach the high we saw in February, but, barring any extreme volatility in pharmaceuticals, we think growth in the manufacturing segment (which constitutes about 25% of GDP) should average around 17% in 1Q06; this alone should add 4.5ppt to GDP growth, on our estimates.
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