Japan
Japan
May 02, 2006

Takehiro Sato (Tokyo)

In the biannual Outlook Report, the BoJ presented a rosy scenario as expected.  Naturally, there was no direct allusion to the timing of the rate hike, but reading between the lines, it looks to us as if the BoJ can hike the rate sometime soon if it chooses.  Therefore, we conclude that the rate hike could be a bit earlier than previously expected, and now attach probabilities of 30% in June, 60% in July and 10% for August or after.

Policy board outlook on economy and prices

The policy board’s F2007 real GDP outlook is a bit more cautious at 2.0% than its F2006 forecast of 2.4%. This is mainly because the BoJ looks for slower capex and the risk of an IT-related inventory adjustment towards the end of F2007, while noting that the downside risk is limited, given the progress made in reducing “excess” in the economy. Meanwhile, the policy board looks for the core CPI rate to be higher at 0.8% in F2007 than in F2006 (+0.6%). The BoJ did not make any reference to its assumptions for oil prices and FX, which is somewhat problematic for an official economic outlook.

But the key is the footnote of the forecast table, in which the BoJ says “Individual policy board members make the above forecasts with reference to market participants’ view regarding the future course of the policy interest rate that is incorporated in market interest rates. Their forecasts made in October 2005 were based on the assumption that there would be no change in monetary policy (our note: namely based on the prolonged ZIRP).” This sentence implies to us that the BoJ is now quite comfortable with the market discounting future rate hikes, and it is looking for an upbeat forecast for the economy and the prices even though it is raising the policy interest rate in line with the pace priced into the market. 

Risk factors

As expected, the BoJ indirectly referred to the risk of the asset bubble, saying that “it can be seen that the stimulus from monetary policy to economic activity and prices may be amplified against the backdrop of improving corporate profitability and a turnaround in price developments.  In this situation, given that the output gap has closed, there is a risk in the medium-to-long term of larger economic swings, resulting in large fluctuations in the rate of inflation”.  So, the upside risk far outweighs the downside, according to the BoJ.

Policy management

The BoJ noted that the accommodative financial conditions ensuing from very low interest rates will be maintained for some time following a period in which the uncollateralized overnight call rate is at effectively 0%.  However, even if the policy rate is 1%, it can be said to be still very low. So, this phrase does not restrict future policy management at all, in our view.

Moreover, the BoJ said that it will adjust the level of interest rates gradually in light of developments in economic activity and prices. This means that it does not assume that the neutral policy rate will be fixed at a certain point, rather that it should be quite flexible in line with the development of the economy and prices. In this sense, the BoJ was quite successful in ensuring that it has a free hand in regard to the terminal point (the targeted level) of the policy rate.

All in all, the ‘degree of hawkishness’ of the BoJ looks to be mostly in line, but we cannot exclude the possibility of the frontloading of the timing of the rate hike, apart from the technical issue of the current account balance held at the BoJ.

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Japan
Japan
May 02, 2006

Takehiro Sato

Increasing chances of a rate hike at the June MPM

The Outlook Report for economic activity and prices in F2006 and F2007 issued by the BoJ at the end of April represents the rosy scenario. The report begins by stating that “the conditions of persistent oversupply have been dispersed and the output gap seems now to have closed”. It goes on to note that for the first perspective, “the outlook deemed most likely by the Bank for economic activity and prices two years into the future” under stable price conditions is for “Japan’s economy to continue expanding with balanced domestic and external demand”. For the second perspective, “the risks that are most relevant to conducting monetary policy, looking over a longer time horizon and taking account of the cost incurred when risks materialize, however improbable they might be”, it notes that “the stimulus from monetary policy to economic activity and prices may be amplified against the backdrop of improving corporate profitability and a turnaround in price developments. In this situation, given that the output gap has closed, there is a risk in the medium-to-long term of larger economic swings, resulting in large fluctuations in the rate of inflation”.  The latter is expressed obliquely, but seems to allude to the risk of an asset bubble. The BoJ also noted that even if its outlook for the economy and prices is not fulfilled, the downside risks are diminishing, and thus it believes that overall risk is on the upside. This amounts to a declaration that the zero interest rate policy (ZIRP) could be abandoned at any time. Naturally, there was no direct reference to the timing of the rate hike, but reading between the lines, it looks as if the BoJ may increase the rate any time it chooses. So although our main scenario for the timing is still the monetary policy meeting on July 13-14, but we think the possibility of this coming earlier at the June 14-15 MPM has risen.

Reasons why we think the possibility has grown

Our new subjective distribution of probabilities is 30% for June, 60% for July, and 10% for August or later. What this means is, we have not changed our stance that July 14 is X day, but the BoJ is more inclined to move early than it was. Also, June 15 and July 14 are the final days for the reserve accumulation period for each month, so the chances of a rate increase happening then are higher than the meeting dates for August and September.

Three reasons:

1) US to halt interest hikes soon. The summary of the previous FOMC meeting in March suggested strongly that the rate hike cycle would be ending soon. The FOMC’s meeting schedule through the Jul-Sept quarter is May 10, June 28-29, August 8 and September 20. If the FOMC halts its interest rate increases at any of those dates, the BoJ will want to normalize its policy interest rate as quickly as possible to prevent market disorder from shrinking the US-Japan interest rate gap.

2) BoJ outstanding balance of current accounts to be around JPY 10 trillion toward the end of May. The outstanding current account balance held at the BoJ was JPY 18.9 trillion at the end of April, falling below JPY 20 trillion. The BoJ is trying to reduce its balance to around JPY 15 trillion at a relatively fast pace, so its behaviour so far is just as expected. Judging from the maturity date for fund-supplying operation balances, however, the outstanding balance of current accounts could drop to JPY 10 trillion by the end of May. Since past that point there is a risk of the uncollateralized overnight call rate rising, the pace of reduction would have to slow. If the outstanding balance of current accounts starts approaching required reserves, however, the market will likely become jittery as it sees a rate hike coming, and start to push for such a move.

3) Concerns for the bond market. Inflation concerns have strengthened somewhat on high oil and material prices, and Japan is becoming less of an exception amid destabilizing bond markets worldwide. The JGB market barely withstood the 2% wall, but we can no longer deny the possibility of it breaking out above 2%, depending on how the US bond market behaves. So, policy authorities may believe that hiking the policy rate at an early date will be helpful in stabilizing the bond market.

What could impede this rate hike scenario is an appreciating yen amid rising expectations for the Fed to cease tightening. However, since the yen is still in a very inexpensive range in real effective terms, a high yen/low dollar situation like the current one is not much of a problem, despite the pace of yen appreciation.

Modifying our interest rate outlook

Since there is a possibility that ZIRP may be abandoned sooner than we previous expected, we have revised our interest rate table to project one policy interest rate hike in 2006 and two in 2007 for a total of 75bp. We have accordingly slightly raised our long-term interest rate estimate. We think the rate hike will be smaller than what is being priced in by the market now because, as before, we are keeping in mind that: i) we are more conservative in balancing market consensus and BoJ forecasts for price trends; and ii) after F2007, the harmonization of monetary and fiscal policy will be a more important political agenda, in our view. 

Interest Rate Outlook (%)

 

	2005				2006				2007				2008
	J-M	A-J	J-S	O-D	J-M	A-J(e)	J-S(e)	O-D(e)	J-M(e)	A-J(e)	J-S(e)	O-D(e)	J-M(e)
Call Rate	0.002	0.001	0.004	0.004	0.001	0.01	0.25	0.25	0.50	0.50	0.75	0.75	0.75
3-month LIBOR	0.03	0.04	0.03	0.06	0.13	0.25	0.37	0.50	0.63	0.75	0.88	1.00	0.88
10 Yr. JGB	1.32	1.17	1.48	1.47	1.74	1.80	2.10	2.10	2.00	1.90	1.90	1.80	1.80

e=Morgan Stanley Research forecasts
Source: Nikkei NEEDS, Morgan Stanley Research

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Thailand
Lower Net Services Due to Seasonality Effect
May 02, 2006

Deyi Tan and Denise Yam

Trade balance turns positive; net services lower due to seasonality. March exports rose 16.2% on a balance-of-payments basis, while import growth came in surprisingly low at only 2.0% YoY. The trade surplus consequently turned positive at US$187 million after five months of deficit. However, the net services and transfers surplus dipped to US$298 million in March from US$690 million in February, due to seasonality as we move out of the tourism peak period.  For 1Q06, the net services and transfers surplus (US$1,881 million) recovered to a higher level than the US$1,726 million seen in post-tsunami 1Q05. The current account surplus stood at US$485 million in March.

Import growth slowed on oil intake; manufacturing and machinery exports remained strong. The customs-based trade data breakdown shows that the import growth slowdown was due primarily to slower mineral fuels and lubricants intake (+8.6% YoY in March versus +89.1% in February) as crude oil imports slowed.  This is likely a blip, in our view.  On an end-use basis, consumer imports — one indicator to gauge consumption strength — was the only category that showed acceleration (+18.1% YoY in March versus +16.3% in February). Meanwhile, on the export front, manufactured goods (up 18.5% YoY) and machinery (up 15.4% YoY) still registered strong momentum.

Oil import volume contained; high oil price impact on trade balance likely to be cushioned. Although Thailand’s oil dependency has been due to structural factors rather than inefficiency issues, mandatory conservation efforts and oil import checks at refineries have worked well to quell speculative hoarding and contain oil import volumes in the last two quarters (-7.5% YoY in 1Q06 and +2.0% YoY in 2Q06 versus double-digit growth in 1-3Q05).  In our view, this should help cushion some of the impact on the trade balance of higher forecast oil prices going forward.

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Mexico
Mexico
May 02, 2006

Luis Arcentales

Mexico’s economy is booming once again, with real GDP in the first quarter likely growing at its strongest pace in more than six years.  Indeed, the news from the real economy has been overwhelmingly positive: courtesy of a revival in the auto sector and solid US demand, manufacturing is on a sharp upswing.  Meanwhile, supported mainly by booming credit, consumer spending hasn’t missed a beat: Mexico’s largest chamber of retailers reported total sales among its members up 10.5% in the first quarter; unemployment is hovering near three-year lows; and the strong showing in investment spending of late — up 13.4% in January — bodes well for consumers as upturns in investment spending tend to signal better job growth ahead. 

But with all the good news on the real economy front, there is one missing piece: formal job creation.  In the 22 quarters since the Mexican economy peaked in late 2000, formal employment stands just 6% higher.  At that same point in the previous two business cycles during the second halves of the 1980s and 1990s, formal employment stood over 30% higher. 

To be fair, the shallow 2001 recession — when GDP fell just shy of 1.5% over three quarters — pales in comparison to the 15% cumulative contraction during the preceding two major downturns in 1986 and 1995.  With intense competition from China, and lacking any structural changes such as the introduction of NAFTA over a decade ago, it is not surprising to see more modest formal employment growth in Mexico today.  However, a magnitude of the current formal employment shortfall has been nothing short of dramatic.

There is a second important characteristic in today’s job market: a clear tendency to favour contract temps over permanent workers.  This type of business outsourcing of services ranging from janitorial to accounting has occurred at a pace and magnitude that is unprecedented by historical standards.  Data on permanent workers show that the current cycle has been in essence a jobless one.  By contrast, 22 quarters into the past two cycles, gains in permanent positions exceeded 30%.  The flipside of lacklustre demand for permanent workers has been a surge in temporary positions, accounting for almost 90% of cumulative growth since the third quarter of 2000.  The upshot is that temps today account for 17% of urban formal jobs compared to just 7% a decade ago.  In past cycles, by contrast, demand for contract temps was fairly insipient.

What has motivated the remarkable shift in the composition of jobs?  Most likely it has occurred in response to global competition and to Mexico’s fairly inflexible labour markets.  China has been slowly eroding Mexico’s market share in its principal export market, the US.  More recently, Mexico’s share of manufacturing exports excluding autos has stabilised just above 8% of the US market; however, the forces of globalisation, epitomised by competition from China, represent a secular long-term challenge to Mexico.  We suspect that part of the ongoing shift towards temporary workers — which has not been limited to export-linked sectors — has come from the need to rationalise cost structures.  By some accounts, the hiring, benefit and taxes involved in keeping a permanent employee on payroll in Mexico could be as high as two times that of workers under temporary contracts.

Against this backdrop, Mexico has failed to reduce the rigidities that plague its labour market, which include relatively high severance and hiring costs.  For example, the most recent Doing Business survey by the World Bank puts Mexico in a disappointing 125th spot out of 155 countries in terms of the ease involved in hiring and dismissing workers.  The lack of legal flexibility in job markets has been detrimental to Mexico and the region, encouraging growth in the informal sector, with adverse effects on both productivity and fiscal receipts.

Lastly, some of the recent growth in formal jobs appears to have been exaggerated.  Temporary positions rose 27% in the first quarter of the year — the fastest pace since mid-1999 — while permanent positions grew a more modest 2%.  Efforts by fiscal authorities to improve corporate oversight have likely meant a reduction in the numbers of workers that businesses kept ‘off the books’.  Though difficult to quantify, the result has been some exaggeration in the actual pace of formal employment growth.

More jobs, but how good?

Lurking behind headlines of expanding jobs and relatively low unemployment is the inability of Mexico to deliver good-quality jobs.  Based on the quarterly employment survey from Mexico’s Statistical Institute — which dates back to 2005 under a new methodology — in the nine months ending December 2005, Mexico generated 1.4 million new jobs, which represented a net expansion of nearly 300,000 positions once the growth in the labour force is factored in.  But that seems to be where the good news stops.  The devil is in the detail, and the evidence is not encouraging.  Around 700,000 or half of the total jobs created over this period took place in the informal sector, which by the end of last year accounted for 29% of the labour force.  Moreover, nearly 40% of non-agricultural jobs created in the nine months to December were in ‘micro-business’, a euphemism for a significant part of the informal economy.  Once we exclude government jobs, this figure increases to 45%.  And at the end of 2005, nearly one of every seven workers belonged in the ‘critical conditions’ group, which includes, among other categories, those working full time making less than one minimum salary.

The inability of Mexico to create formal sector jobs is even more disappointing, given the current context of solid economic growth and abundant inflows.  Since the results from the new employment report are not readily comparable to the previous survey, it is useful to review the data available in the four years ending 2004.  Not surprisingly, the picture is again far from encouraging.  In this period, Mexico’s labour force grew by just over 700,000 new entrants on average per year, yet formal employment contracted by nearly 40,000 positions over the entire period.  On average, 470,000 new jobs were created since the end of 2000 in ‘micro-business’.  More worrisome still, the average number of new jobs created in ‘micro-business’ without a locale (essentially street vendors) averaged 240,000 per annum.  Even in the two years ending 2004 when the formal sector generated nearly 300,000 new positions, the growth in the number of street vendors roughly doubled the total creation of jobs in Mexico’s formal economy.

The failure to produce formal employment poses serious questions for Mexico’s political, social and fiscal institutions and is likely to maintain a worrisome level of political discontent.  Unfortunately, progress on the reform agenda is unlikely, given the abundance of convergence inflows from oil, worker remittances, foreign direct investment and tourism, which have robbed the political class of the urgency to tackle Mexico’s competitive challenges.

Bottom line

While the economy has rebounded and is producing some of the strongest growth in more than six years, the quality of the growth on the jobs front still leaves much to be desired.  The widespread reliance on temporary workers and the uneven performance when comparing growth in the formal and informal job markets suggest that Mexico still faces significant micro challenges.  Low inflation and credit growth are transforming Mexico’s consumer dynamics, but the poor jobs picture suggests that despite the abundance of late, Mexico’s consumer will need more than simply good growth.  Mexico needs the kind of comprehensive reforms to help boost job creation.

The shortfall on the employment front also raises serious questions about the resilience of Mexico’s credit-driven consumer story if the economy were to slow.   During a downturn, credit can contract quickly and job losses are all but inevitable.  But the difference today is that the overwhelming tendency to favour temporary positions — which are presumably easier to eliminate during lean times — could prompt a more rapid adjustment and leave consumers more vulnerable than in past cycles.

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