Scale and the Chinese Policy Challenge
Jun 19, 2006
Stephen Roach (New York)
For the second time in two years, the Chinese economy is overheated. Yet once again, the Chinese authorities are taking an incremental approach in addressing the problem. While this strategy has worked reasonably well in the past, that may no longer be the case. The bigger China becomes and the further down the road of reform it travels, the tougher it will be to use incremental policy adjustments to steer the economy. China needs a new approach to stabilization policy -- before it’s too late.
Scale effects pose an increasingly serious challenge to Chinese macro policy strategy. That wasn’t always the case -- especially when China was a small and largely undeveloped economy. But those days are long gone. While China still accounts for only about 5% of world GDP in 2005 (in dollar-based market exchange rates) -- its overheated sectors now have a much bigger weight in its own economy, as well as in the broader global economy. That’s especially the case for China’s white-hot fixed investment sector. In 2006, fixed asset investment is likely to surpass US$1.3 trillion, or more than 50% of total Chinese GDP. This is astonishing by any standards. Even in their heydays, investment shares in Japan and Korea never rose much above the low 40% range; by contrast, in the United States, the world’s largest economy, fixed investment is likely to be around $2.3 trillion, or 17% of GDP in 2006. In other words, while China’s GDP is only about 18% the size of America’s, Chinese fixed investment outlays are running at nearly 60% of those in the US. Putting it another way, China’s investment "delta" -- the growth in its investment spending -- dwarfs anything the world has seen in recent years. From 2000 to 2005, Chinese fixed investment surged from about $400 billion to $1.1 trillion -- a $680 billion increase that was nearly 70% larger than the US investment delta of about $400 billion realized over the same period. Similar comparisons are evident in China’s export sector -- the other overheated piece of its economy. In 2005, total Chinese manufactured exports hit US$762 billion -- fully 84% of the level of goods exports in the US, the world’s largest trading engine. As a result, goods exports rose to 34% of Chinese GDP in 2005 -- nearly five times the 7% share in the US. Here, again, the growth delta is nothing short of astonishing. Over the 2000 to 2005 period, Chinese goods exports have tripled, whereas those from the US have increased only about 15%. That outsize disparity puts China’s export delta over the most recent five-year period ($512.9 billion) at 4.2 times that of America ($121.3 billion). The repercussions of China’s investment- and export-led growth surge are global in scope. Significantly, it’s not just an export and investment story and the implications on employment and real wages in the developed world. It’s also a story of increasingly powerful impacts on industrial materials and other commodity markets. Driven by commodity-intensive activities such as urbanization, infrastructure, and industrialization, China has emerged as the dominant force in shaping global demand for most strategic materials. As I noted recently, in 2005 alone, China accounted for 50% of total global growth in the consumption of aluminum; for other industrial materials, the comparisons were literally off the charts -- 84% for iron ore, 108% for steel products, 115% for cement, 120% for zinc, 307% for copper, and well in excess of that latter amount for nickel. I have argued that with protectionist pressures mounting and the risks of capacity excesses growing, China is now nearing the end of its "commodity-heavy" industrialization model and is about to embark on a major rebalancing toward consumer-led growth that would lower the commodity content of its GDP (see my 2 June dispatch, "A Commodity-Lite China"). If anything, the investment- and export-led growth blow-out in early 2006 makes such a transition all the more urgent. All this poses an increasingly vexing problem to Chinese policy makers. In a normal market-based economy, fiscal and monetary tools are the primary means by which the authorities temper the excesses of the business cycle. China, however, is far from a normal economy. Despite over a quarter century of impressive reforms, it remains very much a "blended" economy -- a mixture between state- and privately-owned enterprises. While the ownership balance continues to shift dramatically away from the state, the latest statistics put state-owned enterprises at about 35% of Chinese GDP. Moreover, that share undoubtedly understates the degree of state control in the newly privatized -- or "corporatized" in Chinese parlance -- segment of the economy. Even after public offerings, the state still maintains sizable majority ownership stakes in most of its so-called publicly-listed, privately-owned companies. Moreover, there can be no mistaking the limited impact that internal market forces have had in driving China’s two overheated sectors. For example, in 2004, state-owned and collective units still accounted for fully 50% of total fixed asset investment in China. In addition, nearly 60% of total Chinese exports are generated by "foreign-invested enterprises" -- Chinese subsidiaries of foreign multinationals and joint venture partners, who rely on Chinese sourcing as a critical part of their global efficiency solutions. The blended Chinese economy is also supported by a relatively undeveloped financial sector. Despite recent reforms, China is still a long way away from having a fully functioning banking system and capital markets. Two of its "big four" policy banks are now listed companies, but the transition to commercially-based lending practices is only in its infancy. Nor does China have a well-developed corporate bond market that enables newly emerging private businesses to secure funding from capital markets. That means the bulk of China’s credit allocation continues to rest on the shoulders of a still very fragmented banking system -- with decisions made more at the provincial and local level rather than by head offices in Beijing. Moreover, local bank branches are still closely aligned with local communist party politicians, whose main priority is social stability and project-driven employment growth. As such, monetary policy at the central government level -- especially recent adjustments in nationwide lending rates and reserve ratios -- do little to shape Chinese investment spending. Instead, the Chinese authorities have opted for "administrative" controls to fine-tune investment flows on an industry and geographic basis. As a consequence, the modern-day counterpart of China’s central planning bureau -- the National Development and Reform Commission -- has more to say about the allocation of capital than the market or fiscal and monetary authorities. A big risk for China is that it now gets trapped in the inherent contradictions of its blended economy. The excesses of a domestic and global liquidity cycle compound the problem. Not only have Chinese banks been especially aggressive in pushing out new loans recently -- RMB lending in the first five months of 2006 was up 80% y-o-y -- but China’s tightly managed currency "float" links its money supply to an explosive build-up in foreign exchange reserves. Last year, Chinese FX reserve accumulation topped $200 billion, and this year, China’s stock of such holdings will easily exceed $1 trillion -- surpassing Japan as the largest reservoir of FX reserves in the world. The problem for China is that its currency regime still requires massive recycling of these reserves into dollar-based assets. Lacking a well-developed domestic debt market, it is difficult for China to "sterilize" all of those dollar purchases, meaning excess liquidity spills over into domestic economy. Not by coincidence, broad M-2 was surging at a 19.1% y-o-y rate in May 2006 -- fully three percentage points above the central bank’s 16% target. Needless to say, this is ultimately quite problematic for inflation control in either goods or asset markets, or both. In my view, China’s investment bubble -- especially the excesses in its coastal property markets -- is undoubtedly linked to the nexus of the global liquidity cycle and its currency policy. Chinese authorities are now scrambling to regain control over a runaway economy. But the response is almost a carbon copy of the approach last used in the overheating of 2004 -- incremental adjustments in monetary policy and administrative measures aimed at controlling industry-by-industry excesses in investment spending. The basic problem with this approach is that it has been overwhelmed by scale -- China’s growth dynamic is now so powerful that its old style of policy management cannot achieve the traction required for effective macro control. Two overheating alerts in two years underscore the pitfalls of the current approach. And the most recent moves to raise bank lending rates by 27 bp (an April 27 action) and required reserve ratios by 0.5 percentage point (a June 16 action) may simply not be enough to contain the domestically-led excesses of its bank lending cycle. Similarly, a continuation of grudging adjustments to its currency policy may not be enough to contain the globally-led excesses of its liquidity cycle. Even though foreign central banks are now tightening, expectations of RMB appreciation continue to drive capital inflows into China. In short, scale effects alone suggest that Chinese policy makers need to do more if they are to succeed in containing the excesses of their overheated economy. In nominal terms, the economy is fully 35% larger than it was in 2004 -- the last time Chinese authorities were faced with a similar problem. The experience of the past two years -- ongoing investment and export excesses, in conjunction with China-led spikes in energy and other industrial commodity prices -- underscores the pitfalls of incrementalism in guiding China’s blended macro policy strategy. Fearful of triggering a boom-bust cycle should policy tighten too much, and concerned about the imbalances that can only mount should policy remain overly-accommodative, Chinese authorities are caught in the middle. Current circumstances in China scream out for a tighter macro policy stance. At the same time, the shift from investment- and export-led growth to a consumer-led growth dynamic has never seemed more urgent. It’s entirely China’s choice in how to proceed -- how to tilt the mix in its macro policies between fiscal, monetary, and currency adjustments, and how fast to push reforms ahead. But the longer China avoids a more meaningful shift to macro policy restraint and the longer it leans on investment and exports at the expense of private consumption, the greater the chance of the dreaded hard landing.
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Globalization and Inflation
Jun 19, 2006
Richard Berner (New York)
It is beguiling to think that globalization, represented by increasing US exposure to low-cost labor, increased market access, cross-border connectivity, and global competition, has capped and will continue to contain US inflation. After all, the US and the rest of the global economy have steadily become more integrated over the past four decades, and recently the pace has accelerated. Given the sharp increase in one key measure of openness — the share of imports in GDP, which tripled since the mid-1960s — both the prima facie evidence and the case seem compelling. Moreover, financial integration, evidenced by burgeoning cross-border capital flows, has financed hitherto-unimagined global imbalances. For all their potential as sources of economic and financial instability, larger imbalances imply more openness, more cross-border integration, and a larger role for global forces in shaping the US inflation outlook. As a result, some observers believe that the recent acceleration in US consumer prices will quickly dissipate on its own. I disagree. While globalization almost surely has reduced US inflation over the past decade, domestic forces still dominate the inflation prognosis. In particular, globalization doesn’t let central banks off the hook from being vigilant about inflation. If anything, globalization cuts both ways: As in the 1970s, US policymakers must now be attentive to the potential for global forces to boost inflation as well as to damp it. The IMF staff and San Francisco Fed President Janet Yellen and Fed Vice-Chair Don Kohn have recently explored thoroughly the debate surrounding the effects of globalization on inflation, so a treatise here isn’t necessary (see, respectively, World Economic Outlook: Globalization and Inflation, April 2006; "Monetary Policy in a Global Environment," May 27, 2006, and "The Effects of Globalization on Inflation and Their Implications for Monetary Policy," June 16, 2006). But it’s important to summarize the channels through which globalization can affect inflation, because some can work in both directions. There are four distinct but related channels through which globalization may have affected US inflation. First and most direct, declines in or slower rates of increase in the prices of imported goods and services could affect overall inflation by shifting the mix to cheaper imported products and by increasing competition, which can depress the prices of domestically-produced goods and services. The empirical evidence suggests that this effect is statistically significant, but not especially large. According to the IMF staff work, from 1997 to 2005, declines in non-oil import prices lowered US inflation by an average of ½ percentage point per year. Federal Reserve Board staff analysis reaches similar empirical conclusions. China, in particular, is commonly viewed as a source of global disinflation, but Fed work suggests that, even the tripling of China’s share in US merchandise imports to about 15% over the past fifteen years might have shaved only 0.1 percentage point from US overall inflation (see Steven Kamin, Mario Marazzi, and John Schindler, "Is China 'Exporting Deflation'?" International Finance Discussion Paper 2004-791). These results, moreover, may actually overstate the influence of declines in foreign-currency-denominated import prices on US inflation, because in a globalized world, exporters to the United States will "price to market" and typically offset movements in exchange rates with movements — up or down — in import prices. Indeed, the past ten years have witnessed sizable changes in exchange rates vis-à-vis the dollar, and offsetting swings in non-dollar import prices. And while estimates of the "pass-through" of exchange-rate changes into import prices and thus US inflation have declined over that period, it may be that forces other than globalization are responsible. Central banks have reduced both inflation and the volatility of inflation — providing less statistical variability in the data and thus producing lower values for empirically-estimated pass-through coefficients. In addition, the Asian financial crisis of 1997-98 was a globally disinflationary shock whose effects lingered for several years. By widening the gap between desired foreign saving and investment, that shock caused significant dollar appreciation and reduced inflation. Last, the degree of slack in the US and global economy rose during the first half of the 1997-2005 period, and the degree of exchange-rate (or import-price) pass-through depends importantly on the cyclical state of the economy (see "The Dollar and Inflation, Global Economic Forum, May 5, 2006). A second channel through which globalization can affect US inflation is a reduction in the effect of domestic economic slack on pricing dynamics. While it is an important ingredient in the inflation process, the influence of product or labour-market slack on inflation is only one of several determinants, and their interplay can change. Greater economic openness could, by substituting global for domestic capacity, reduce the influence of home-grown slack. Indeed, there seems to be some US evidence of a "flatter Phillips curve" — a Fed study suggests that the sensitivity of US inflation to measures of domestic slack has fallen by about a third since the mid-1980s (see John Roberts, "Monetary Policy and Inflation Dynamics," FEDS Paper 2004-62, 2004). IMF evidence suggests that greater openness explains over half of this reduced sensitivity. And according to a BIS study, global capacity helps explain US inflation. and including it in an equation reduces the effect on inflation of domestic slack. If valid, these effects could be important for monetary policy. But it’s not clear to me that globalization is the biggest part of the story. Disinflationary monetary policies themselves and deregulation in some industrial and many developing countries also helped reduce inflation and likely were more important than globalization. On the surface, moreover, the globalization story seems inconsistent with the record profit margins at US companies; if global competition reduced pricing power, it probably would have pressured margins. Moreover, if the influence of slack on inflation has diminished for whatever reason, the cost of making a monetary policy mistake is higher, because it will increase the "sacrifice ratio" — the cost of bringing inflation down if it goes too high. Likewise, it’s far from clear that globalization is the most important factor influencing the sluggish growth of wages or the strong growth in productivity through the first four years of the current expansion. Some, like my colleague Steve Roach, argue that the low level of wages in newly-emerging outsourcing platforms in China and India has depressed US wages through a "global labor arbitrage" (for example, see his "The End of Labor," Global Economic Forum, January 9, 2006). In my view, however, the rapid growth in employer-paid healthcare insurance premiums and increased pension contributions have played at least an equally important role in reducing take-home pay over much of this expansion (for evidence, see Katherine Baicker and Amitabh Chandra, "The Labor Market Effects of Rising Health Insurance Premiums (NBER Working Paper No. 11160, August 2005). And in my view, the dramatic productivity surge of 2001-2005 was mostly cyclical, partly reflecting the desire of Corporate America to purge the hiring excesses of the 1990s (see "The Coming Productivity Undershoot," Global Economic Forum, March 20, 2006). If anything, the current backdrop of strong global growth and limited capacity expansion argues for globalization now having a positive effect on US inflation, courtesy of strong growth and dwindling slack abroad. As my colleague Eric Chaney notes, in the G-10 countries (the ten most industrialized countries, including South Korea and Taiwan), operating rates are currently rising. For the G-10 as a whole, the manufacturing operating rate stands at 81%, 2.5 percentage points higher than one year ago, and 1.4 p.p. above the long-term average (that is, 0.7 standard deviation) (see "Inflation: Operating Rates Say ‘Yes, but Benign,’" Global Economic Forum, June 16, 2006). And the disinflationary forces in China may be dissipating as the one-time shock from the end of the multi-fiber agreement fades, and the Chinese economic boom continues. Meanwhile, rising domestic inflation expectations, dwindling economic slack, and rising costs are all contributing cyclically to higher US inflation. Gains in several categories — such as apparel, education, communication services, and air fares — recently contributed to the rise in core inflation. However, some believe that the role of owners’ equivalent rent, which jumped 0.6% in May and has been trending noticeably higher for the past six months, is phony, especially because it has turned up just as the housing market is cooling. But I think that even excluding the shelter category entirely, inflation likely will turn slightly higher, reflecting less economic slack and the pass-through of higher energy and other costs to core inflation. Moreover, even though the single-family housing market is cooling, firming apartment rents, higher insurance charges, and higher property taxes seem likely to push the pace of housing costs somewhat higher this year. Although the co-movement in apartment rents and owner’s equivalent rent may reflect statistical sampling problems, rents would not be rising if rental markets were weak. For market participants, this is old news on the whole. Much of our inflation/pricing power story is now in the price, and Fed officials are on high inflation alert. Thus, further inflation surprises likely will be needed to promote a significant rise in break-even inflation. And the combination of recent stability in energy prices and hawkish Fed rhetoric seems to be stabilizing inflation expectations. For example, longer-term inflation expectations in the University of Michigan consumer canvass declined to 3% in June from 3.2% in May. Nonetheless, upside risks to inflation still prevail. A weaker dollar, protectionism, or resurgent growth could intensify those risks. However, I have always thought that the risks were cyclical and likely to be transitory, thanks to an appropriate policy response. That response is well in train, so I see no reason to change our baseline inflation prognosis.
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Don't Blame the BoJ for the Bloated Global Asset Prices
Jun 19, 2006
Stephen Jen (London)
Refuting a false notion There is a popular notion among investors that the BoJ’s QE and ZIRP have been the main factor behind the inflated asset prices in the world, and therefore prospective tightening by the BoJ in the coming quarters will have detrimental effects on all financial asset prices. This note is my latest attempt at dispelling this false notion. While I believe that continued tightening of global liquidity will ultimately be bad for risky assets and possibly all financial assets, I am not persuaded by the ‘JPY-carry-trades-holding-up-the-world’ argument. The popular notion I am trying to refute This notion has been embraced by many investors for several months, and is well-articulated in a recent editorial by Mr Anatole Kaletsky (Why Japan Will Keep Rates Ultra Low, The Times, June 12, 2006. According to this thesis, even though the Fed began to tighten two years ago, global liquidity did not diminish because Japan’s ample supply of liquidity ‘substituted’ for the withdrawn liquidity from the US, thereby perpetuating and even exacerbating the asset bubbles in the world. Conversely, when the BoJ starts to tighten, the impact on global asset prices will be more severe than that in response to tightening by the Fed and the ECB. This thesis is seriously flawed While the latest round of risk-reduction coincides with the talk of BoJ tightening, this thesis of ‘JPY-carry-trades-fuelling-global-asset-prices’ is seriously flawed, in my view. We need to understand first how QE worked I apologize if I sound presumptuous; but based on the argument that some of the massive money printing by the BoJ somehow ‘leaked out’ of Japan and found its way to other markets, I suspect that some investors may not understand that all of the excess reserves were bottled up at the BoJ anyway, and were not even available for the Japanese economy, not to mention other markets. The BoJ has guided the CAB lower by allowing the corresponding size of its bills purchased from banks to mature without rolling them over. Both the assets and the liabilities of the BoJ’s B/S as well as the banking systems’ B/S decline in synch. These ‘accounting’ changes have minimal real effects on either the monetary condition or the economy. It is important to understand several features of QE. (1) QE was never true ‘money printing’ in the sense that the expansion in base money meant nothing for broad money or bank credit. With interest rates already at zero, there was no constraint on bank borrowing, and the excess liquidity was ‘trapped’ on the banks’ deposits with the BoJ. (2) The QE regime had primarily a psychological effect that ZIRP will remain in place for a long time, and such an effect may have helped to depress a good portion of the yield curve (up to 5-Y), not just the very short-term rates. (3) The dismantlement of QE, therefore, had zero impact on the amount of ‘money’ or bank credit available for use by Japanese or non-Japanese borrowers. Three types of JPY carry trades Let’s assume that there are three types of ‘JPY carry trades’: (1) Japanese borrowing in JPY and investing in higher-yielding foreign assets; (2) Japanese or foreign investors borrowing in short-term JPY funds and investing in longer-term JPY assets; and (3) foreign investors could have had massive borrowing in JPY from Japanese banks and held foreign securities as a carry trade. · Type 1 carry trades: Capital outflows from Japan. Since the adoption of QE in early 2003, total Japanese portfolio outflows have been around US$170 billion a year. Compared to the US’ gross annual securities inflows of US$7 trillion a year, Japanese outflows should not be so important that they have supported US or global asset prices. However, with cumulative flows since the first introduction of ZIRP in early 1999 totalling close to US$1 trillion, there are reasons to be concerned about the JPY crosses and the prices of smaller markets, if Japanese repatriation were to become an issue. In any case, I believe that the BoJ’s policy per se should not dictate the trend of global asset prices, unless it triggers a wholesale repatriation by Japanese investors, which is unlikely. · Type 2 JPY-carry trades: JPY-JPY carry trade. The biggest investors of this type of carry trades, I suspect, are the Japanese banks: their taking short-term deposits (borrowing short) and holding JGBs (lending long) is the type of JPY carry trade in question. After the introduction of QE in spring 2003, we indeed saw a massive rise in JGB holdings, as Japanese commercial banks not only took maximum advantage of the zero short-term deposit rate, but, more importantly, also reacted acutely to the virtual guarantee by the BoJ that interest rates would remain low for a long time. However, what is more important for our discussion here is that, during the last two years when asset prices in the world really took off, and the Fed began to tighten, there is no indication that Japanese banks bought more JGBs to drive the yield lower so as to offset the liquidity withdrawal by the Fed. · Type 3 JPY carry trades: Foreign investors running JPY carry trades by borrowing from Japanese banks. On further inspection of the scant data I could find, in my view, evidence is not supportive of the claim that there has been an increase in Type 3 JPY carry trades in recent years. In the BIS’ latest quarterly report, it was suggested that there was tentative evidence of JPY carry trades. The BIS reports that the stock of outstanding JPY-denominated claims, held by both Japanese and non-Japanese banks, rose noticeably in 4Q05. However, JPY loans from Japanese banks have declined steadily since 1995. While outstanding overseas loans in JPY rose in 2004, they declined again in 2005, reaching US$181 billion by year-end. Since banks don’t usually take large currency risks, i.e., have large open positions on currencies, non-Japanese banks’ JPY loans should in theory be offset by their liabilities in JPY. In other words, Type 3 JPY carry trades should show up only in JPY-denominated cross-border loans extended by Japanese banks. Furthermore, the total stock of loans in JPY accounts for only 5% of all cross-border bank loans. Also, the total change in the stock of cross-border JPY loans in 2005 was also 5% of all cross-border loans. In other words, there is no indication from these data that large new cross-border JPY loans were extended by Japanese banks in recent quarters at a pace that is out of line with the historical average. Finally, in 2005, there were an additional US$1.2 trillion worth of cross-border USD loans and US$1.3 trillion of cross-border EUR loans extended. Does that mean that there were USD and EUR carry trades? In other words, there are many reasons why cross-border bank loans are extended. What I am not saying I am not arguing that the BoJ policy has no effect on global asset prices. Rather, I am refuting the view that there is something extra special about JPY carry trades. When interest rates rise in Japan, capital outflows from Japan would clearly be adversely affected, ceteris paribus, and some risky assets could be hurt. I do not challenge this point. But it is unreasonable, in my view, to think that BoJ tightening would trigger a collapse in global equities, most commodity prices, etc. Even massive money printing by the BoJ failed to support the Nikkei for years and so I don’t see how money from Japan could have such a big impact on the world. Monetary tightening by the BoJ will have no more and probably less of an effect on asset prices than if the Fed or the ECB tightens. Bottom line There is an increasingly popular view that the BoJ’s QE and ZIRP have played a critical role in supporting the global asset prices, particularly after the Fed began to tighten in June 2004. Conversely, any tightening by the BoJ could severely undermine global asset prices. I strongly challenge this view. Global asset prices will remain vulnerable for many reasons, but not just because of the BoJ’s intention to tighten.
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Monetary Policy
Jun 19, 2006
Thomas Gade (London) and Elga Bartsch (London)
Conclusion. The Executive Board of the Riksbank in Sweden will meet again this Tuesday to decide on monetary policy. The most likely outcome according to markets and our own beliefs is another 25bp rate increase. Despite our baseline call, we see risks skewed to the upside and would not rule out a 50bp rate hike as an outside possibility. What’s new. Another monetary policy decision in Sweden is due this coming Tuesday. The Riksbank is facing a closing window of opportunity to normalize interest rates. Real short rates are still hovering around 0%, while capacity utilization is rising and the economy could expand by as much as 4% this year — more than a full percentage point above the historical trend rate. Further, asset prices and financial quantities appear to have gained a more prominent role in the latest memorandum on the monetary policy strategy of the Riksbank. Contrary to the ECB, the Riksbank does not seem overly worried about the upside risks to medium-term price stability from a surging money supply. As much of the recent acceleration in the expansion in money supply has been driven by lending to non-financial corporations for primarily investment purposes, the subdued concern of the Riksbank is reasonable, we think. Instead, the Riksbank is concerned about the continued high expansion rate in household lending as well as house prices — a concern that is warranted, in our view. The next inflation report may perhaps show how great this concern indeed is. Implications. Although we have not changed our monetary policy forecast of 25bp per quarter this year, we see increased risks of the Riksbank bringing forward further monetary tightening, with potential negative implications for the short end of the rate curve. Another step in monetary normalisation Once again the Executive Board of the Swedish central bank, the Riksbank, will meet this Tuesday to decide on monetary policy. According to market expectations and our own beliefs, the most likely outcome is another 25bp rate hike. This would bring the main monetary policy instrument, the repo rate, to 2.25%. A closing window of opportunity The risks to our baseline forecast of another 25bp rate increase are skewed to the upside. Given the continued strengthening of the krona as well as, in our perception, rising risks of a global slowdown next year, the Riksbank may be facing a window of opportunity to normalise monetary policy that is closing already. With monetary policy rates at 2.0% and real interest rates continuing to hover just above zero, while the economy could grow close to 4% during this year, monetary policy remains very expansionary on our numbers, and we see the scope for a faster pace of monetary normalisation perhaps more present now than ever. Of course, the appreciation of the krona is perceived by many as a tightening of monetary conditions. However, this is likely only to have a dampening effect on activity and less so on house price appreciation and debt build-up. Had it not been for the recent signals from the Riksbank that another gradual increase is imminent, we would have placed as much as a 50/50 chance of a 25bp rate hike versus a 50bp rate hike. Nevertheless, despite lowering the probability, we would still not rule out a 50bp rate hike next week as an outside possibility. Raising rates to raise inflation — a monetary paradox? As the Riksbank most likely continues its gradual monetary tightening this Tuesday, it will engage in what appears to be a monetary paradox. It will raise interest rates to secure a continued gradual rise in inflation. Of course, it is not as much the paradox as it might appear. At the current stage of the monetary tightening, the Riksbank is performing a balancing act between upside inflationary pressure and the financial risks evolving from a continued expansionary of monetary policy and a very strong performance of the real economy. On the one hand, the Riksbank wants to bring inflation back towards the 2% target from the levels below the lower range of the tolerance zone observed through most of the last two years. No doubt, the strong economic performance this year, rising capacity utilisation rates and improving labour markets amid a still expansionary monetary policy will do the trick of bringing inflation up. One could even argue that, at the current speed of rising inflation, the Riksbank may get more than it bargained for. On the other hand, the strong performance of the economy and expansionary monetary policy has induced a rapid expansion both in the level and the rate of house price appreciation and household indebtedness. Contrary to the ECB, the Riksbank does not have targets for financial quantities such as monetary aggregates. Nor does it have targets for changes and levels of different asset prices, similar to the ECB. Although the Riksbank does not have an official target for monetary growth, changes in asset prices and in other financial variables nevertheless gained a more prominent role in the recently published memorandum on the Riksbank’s monetary policy strategy (Sveriges Riksbank: Monetary Policy in Sweden, May 18, 2006). In the euro area, broad money is rising at an annual rate of close to 9%Y and the ECB has for some time now expressed concerns with regards to medium-term price stability — in accordance with its two-pillar strategy. In Sweden, the rate of money growth is surging by 18%Y, dwarfing the already high 9%Y in the euro area. One could reasonably argue that the medium-term growth rate in broad money consistent with medium-term price stability should be higher in Sweden, given the higher trend growth rate and slightly higher inflation target. However, the difference from the 4.5%Y in the euro area should only be as much as perhaps a percentage point and nothing that would support 18%Y monetary growth. Contrary to the ECB, the Riksbank appears more concerned about the rapid expansion in household debt and house price appreciation than the risks to medium-term price stability. This may be a legitimate focus of concern. Although the rise in bank lending to households is high and has been rising at double-digit rates for the last two years, much of the more recent acceleration in money supply has been driven by lending to non-financial corporations. Lending to non-financial corporations was running at 19%Y during the first quarter and has continued to rise into the second quarter. A large part of this corporate borrowing is being directed towards increased corporate investment. As such, non-financial borrowing is at least partially being invested in increased capacity, which should limit the upside risks to price stability over the medium term. The Riksbank’s concerns with regards to the rapid increase in house prices and household indebtedness are more warranted, we think. The concern is that the continued double-digit expansion in house prices and household indebtedness increase the risk of a more abrupt correction in house prices. A more abrupt correction is likely to have destabilising repercussions in the real economy, again affecting inflation. Hence, the Riksbank is raising interest rates and withdrawing liquidity from the economy in order to secure a softer slowdown in house price appreciation and a continued gradual rise in inflation. Sounds like a monetary paradox, but we see it as a balancing act — nothing more than that. Bottom line The Riksbank is facing a closing window of opportunity to normalise monetary policy, in our view. Real short rates continue to hover around zero in an already very strong-performing economy. Should household borrowing continue to rise at double-digit rates and inflation continue to develop above expectations in the coming months, we see increased risks that the Riksbank may bring forward further monetary normalisation before the window of opportunity is closed completely. Such a move would be likely to have negative effects on, but limited to, the short end of the rate curve.
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Inflation
Jun 19, 2006
Eric Chaney (London)
As the debate over global inflation risks intensifies, I have revisited an old-fashioned instrument, the manufacturing capacity utilisation rate, or operating rate. Back in the 1980s, the predicting power of operating rates, or of their more sophisticated version, the ‘output gap’, was widely recognised among macro practitioners. The underlying economic model was easy to grasp: an excess of demand relative to supply was likely to generate inflation and vice versa. Then, the relationship broke down in the mid-1990s and operating rates moved out of economists’ radar screens. It is, I think, time to dust these tools off and try to read their message. Before entering into the details, let me start with the conclusion: at the aggregate G-10 level, the operating rate is rising above the long-term average, signalling some cyclical inflation risks. However, these risks are benign, even if operating rates were as reliable as they were in the 1980s. In addition, low-cost economies such as China continue to squeeze prices and will do so as long as their global market share increases. No doubt, operating rates are rising In every single country of our sample (the ten most industrialised countries, including South Korea and Taiwan), operating rates are currently rising. Over the last three quarters, Korea, Germany and the US reported the strongest increases, while France and Canada had the lowest. For the G-10 as a whole, the manufacturing operating rate stands at 81%, 2.5 percentage points higher than one year ago, and 1.4 percentage points above the long-term average (that is, 0.7 standard deviations). If production continued to accelerate and grow faster than capacity, the operating rate would move one standard deviation or more above the long-term average before the end of this year, a sign of tension seen only three times since 1980: in 1988, 1994 and 1997. In the current context of capital discipline, where companies do not easily decide to expand production capacities, only a significant demand slowdown would prevent this from happening. Is the link between operating rates and inflation restored? When operating rates were reliable predictors of inflation trends, they typically had a 4-6 quarter time lead, depending on the regions: the typical lead was ‘only’ four quarters in the US, versus six quarters in Europe. So far, core inflation in the G-7 has been remarkably stable, fluctuating between 0.8% and 1.5% since the end of 1998. However, core inflation has recently accelerated in the US, and this might be an early indicator of global inflation. If the link between operating rates and inflation was even partially restored, the rise of the former since late 2003 would fit well with the six-quarter lead it used to have. I see two reasons why this link might be partially restored. First, the acceleration in trend productivity in the US seems over, while the acceleration of productivity in Europe and Japan is not yet convincing, to say the least. Second, the deflationist influence of Chinese exports is likely to be less intense after the climax reached when restrictions to textile exports were partially lifted in 2004. Even so, cyclical inflation risks are benign Since old models do not work anymore, it is difficult to rely only on operating rates to predict inflation. However, it is possible to use these old links to estimate a ceiling for the cyclical inflation generated by higher operating rates. On our estimates, core inflation in the G-10, currently 1.3%, would not rise above 2.5% in the worst case scenario (sharp productivity slowdown, no Chinese exports), i.e., if the old relationship were fully restored. Because productivity seems to accelerate somewhat in Japan and in Europe but also because Chinese exports, which currently take only 10% of global trade, will continue to grow faster than global trade, the worst case scenario is a very remote possibility: in my view, core inflation is more likely to rise to 2% and hover there for some time. Yet, central banks must do their job Note that this is not a sufficient condition to declare that the risk of inflation has gone: cyclical inflation may turn into a structural acceleration if inflation expectations followed the same path. At this juncture, with a robust global economy (probably slowing, but not much) and some measures of inflation expectations on the rise, G-10 central banks should not take a benign stance vis-à-vis inflation risks. What operating rates cannot predict is precisely the dynamics of inflation expectations.
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Until the Pips Squeak
Jun 19, 2006
Oliver Weeks (London)
Hungary’s long-awaited fiscal package so far looks close in structure to what we expected but slightly larger in size. The tax and price hike side of the adjustment is highly aggressive in the short term, though there are as yet few convincing measures on the spending side, with PM Gyurcsany explicitly ruling out a Slovak-style ‘socially merciless’ welfare reform — or indeed any welfare reform as far as we can see. In coming weeks, we expect more details of spending adjustments and a privatization programme. Nevertheless, we remain doubtful that this type of tightening can be sustained politically, even with a weaker HUF and higher inflation. Although growth will slow sharply, interest rate hikes continue to look likely in the near term, and euro entry still looks remote. Even more in tax than we expected. The initially poor bond market reception for the package may have been influenced by the government’s extensive efforts to talk it up before its announcement, but also by the global environment and the PM Gyurcsany’s accompanying comments on the currency. On the revenue side, the package looks stronger than we expected, though we cannot quite see the HUF 1 trillion claimed for 2007, with 2008 and beyond looking even less certain. On top of the hike in the middle VAT rate from 15% to 20% and the extra 4 pp rate of corporate profit tax, the most important source of revenue will be a two-stage hike in employees’ health fund contributions, from 4% to 6% in September and to 7% in January. With a range of smaller new taxes and enforcement measures also confirmed, we expect a total revenue gain of around HUF 750 billion in 2007. As expected, measures on the spending side look much less aggressive (see Hungary: Taxing Times Ahead, June 6, 2006). The government will freeze HUF 111 billion of ministerial spending and reserves, and lay off 7,000 central government workers (10% of the total) by the end of 2006. We still expect severance, outsourcing and welfare costs to consume much of the initial saving here. Price hikes for energy, transport and pharmaceuticals are likely to limit but not reverse the overshoot in price subsidy spending. We continue to see little prospect of local government reform passing. We expect further announcements on administrative savings and on cost recovery in the health and education sectors. While these are clearly welcome — Hungary’s expenditure to GDP ratio, at 50.9%, is currently third-highest in the EU — the scope for short-term savings from measures suggested in these areas so far seems limited. Long-term path still looks questionable. At the same time, the government has begun to come clean on the state of the 2006 deficit. After a 1.6% of GDP of assumed adjustment in 2006, it puts the ESA deficit at 8.0% of GDP, excluding transfers to private pension funds and the PPP road programme (around 1.4% and 0.5% of GDP, respectively) and possible bailouts of the railway and metro companies (2-3% of GDP, which may be distributed over the 2003-6 deficits). Transfers to pension funds will have to be reported to Eurostat as spending from 2007 and the off-budget status of the PPP programme continues to look questionable to us. Even after tightening, the all-in 2006 deficit including one-off items still looks close to our original 11.0% of GDP estimate. Given the expiry of one-off items and a 3.5% of GDP adjustment, it looks feasible now to cut the deficit to 6.0% of GDP in 2007 in the government’s terms including pension spending, or around 7.0% of GDP including road spending. However, cutting the deficit any further will be more challenging. The scope for further tax rises is clearly very limited. Even before the latest hikes, the total labour tax wedge (sum of income tax and social security contributions) on a worker one-third above average income levels was 53.7%, the highest in the OECD after Belgium. The government’s political honeymoon period is fading fast, with Fidesz already ahead in a recent opinion poll only weeks after its election humiliation. Given an inevitable sharp slowdown in domestic demand growth in 2007, the political appetite for more cuts may also evaporate quickly. The government’s hopes for the jump in EU transfers due in 2007 to compensate may place too much faith in short-term disbursement capacity. Worryingly, the government also still appears to aspire to tax cuts ahead of the next election. Higher inflation, weaker FX may help spending cuts. Among the most interesting aspects of the fiscal announcement was PM Gyurcsany’s accompanying call for a weaker HUF, the first time the government has talked the HUF down for several years. The Finance Ministry subsequently played down the PM’s comments but he has since repeated them. It is natural that the government should hope for looser monetary policy during a period of fiscal tightening — the 1995 Bokros tightening package was preceded by a 9% HUF devaluation and the subsequent surge in inflation played an important role in allowing real terms spending cuts. The Finance Ministry’s apparently optimistic inflation projections may point to a deliberate underestimating of 2007 inflation, a frequent technique for restraining spending demands in the past. We expect administered price hikes to take headline inflation to around 6.0% by end-2006 and to around 7.0% in 1Q07. The National Bank is even more pessimistic, seeing annual average inflation at 6.0-7.0% in 2007. Meanwhile risks to the HUF do indeed seem to remain on the downside to us. While GDP growth may slow to around 2.0% in 2007, we expect the current account deficit to decline only to around 7% of GDP as German import demand also slows (the NBH currently assumes 5-6% of GDP). Meanwhile, household FX borrowing is likely to slow more sharply as households face a combination of higher tax rates, higher inflation, rising unemployment and higher global interest rates. At the same time, we continue to expect net inward direct investment to weaken as outward FDI accelerates and a rising tax burden and a temporary period of stagflation make inward investors wary. With Moody’s downgrades still overdue and emerging market fund outflows continuing, the scope for portfolio inflows to compensate seems limited. Limited rate hikes still likely in medium term. In the short term, the coming macro environment is likely to intensify the current splits on the Monetary Council. We believe that the NBH’s analysis suggests that current underlying inflationary pressure remains weak (around 1-2% once the impact of the food price surge and tax effects is taken out), and that the longer-term risks from the VAT hike are negligible, particularly as government layoffs will weaken the labor market. However, prolonged administrative price adjustments and the social security hikes pose a greater risk, as do the government’s efforts to weaken the currency. Wages may still react more quickly to currency-driven inflation than they did in 1995. We currently expect only a minority vote for a 50bp hike on Monday, but continue to expect 100bp of interest rate rises later this year as the HUF weakens to around 280 to the euro. The NBH may hold off from further rises despite the surge in headline inflation, as growth slows next year, ECB rates peak and new appointments make the Council more government-friendly.
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The Mysterious Vegetarian Demand Bubble
Jun 19, 2006
Serhan Cevik (from Vancouver, BC)
A demand-driven increase in inflation is just an urban myth, in our view. Turkey is a fascinating country, with views as diverse as the people of Anatolia. And it is not just the variety of opinions, but also emotional swings that make monitoring the country challenging as well as entertaining. Last year, for example, we witnessed a curious line of reasoning that effectively implied an impending recession. In the end, however, the Turkish economy grew by an amazing 7.4% in real terms, on top of a cumulative increase of 24.3% in the previous three years. Then, suddenly, those who were projecting the economy’s downfall have started arguing that it is in fact overheating because of an imbalance between domestic demand and potential supply and that price indices provide unambiguous evidence for such demand-driven inflationary pressures. Consumer price inflation, after declining from 73.2% at the beginning of 2002 to 7.1% in June 2004, has indeed stuck in a narrow range and subsequently started increasing in the last couple of months. The ‘fact’ may seem clear, but finding what lies behind it is far more important for policy responses and asset prices. Hence, we want to take another look into Turkey’s disinflation process, which we have long believed to be a secular phenomenon. We need to look beyond the headline figure to see what factors have driven inflation higher. The consumer price index increased at an annual rate of 9.9% in May, up from 8.8% in April and 7.7% at the end of last year. And, now, the lira’s sharp depreciation is likely to push import prices and production costs higher in the coming months. Keeping in mind the effect of volatility on forecast errors, our rough estimates point to a year-on-year inflation rate of 11.2% this month and 12.8% in July — the highest reading since the end of 2003. Though we expect a deceleration after August, the year-end rate is destined to remain above the central bank’s target. So is this the end of disinflation in Turkey? Certainly not, in our view. As the decline in the inflation diffusion index shows, the inertia and, more recently, rise in inflation are a result of certain categories that have largely remained under the influence of supply shocks and seasonal fluctuations. Turkey is suffering from supply-side shocks like higher commodity prices. The Turkish economy is heavily dependent on imported energy sources, and the doubling of oil prices pushed its energy import bill to around 6.5% of GDP in the last year. This supply shock contributed significantly to the widening of the current account deficit as well as to the acceleration in headline inflation (see More Turm(oil), April 26, 2006). But inflationary consequences of the global commodity bubble go beyond the oil factor in Turkey’s case. Curiously, gold is included in the CPI, with a 1.4% weight. As a result, soaring gold prices led to an 11.7% increase in the miscellaneous category of the CPI basket in the first five months of this year. In other words, exogenous factors (like higher commodity prices) that actually have nothing to do with domestic demand in Turkey have created headwinds for the disinflation process in the last 18 months. Food price increases have made the most significant contribution to inflation. The food component (accounting for 27.7% of the CPI basket) increased by 6.5% in the first five months and posted a year-on-year surge of 10.4% in May. This is a momentous acceleration from 5.0% in May 2005 and the low of 3.7% last October, contributing 39.8% of the rise in headline inflation so far this year. According to some analysts, the rise in food prices is a clear indication of a ‘demand bubble’ in Turkey. Interesting assertion, but do price indices really support such a point of view? Let’s dig into the data. The food component consists of two main sub-categories — processed and unprocessed food — with the respective weights of 13.5% and 14.2% in the CPI basket. So if there is such a ‘demand bubble’, we should catch at least a glimpse of it in food prices across the board. Indeed, unprocessed food prices increased by a staggering 11.4% in the first five months of the year. Moreover, the annual inflation rate in this category surged from -2.7% in June 2004 to 6.3% at the end of last year and then to a shocking 18.9% in May, due largely to a sharp increase in fresh fruit and vegetable prices. But this must be a mysterious vegetarian demand bubble, because the rest of the food component — that is, processed food — shows no sign of demand-driven pressures. Processed food prices increased by a modest 2.3%, on a cumulative basis, so far this year, and the annual rate of change declined from 7.6% in June 2004 to 4.3% last month. Supply constraints, not a mysterious demand, have driven up food prices. The divergence between processed and unprocessed food prices suggests that the increase in unprocessed food prices is a supply-side shock, not a sign of the so-called ‘demand bubble’ in Turkey. And this is certainly not the first time we are witnessing such a deviation (see, for example, Aubergines, Cauliflowers and Asymmetric Signals, April 17, 2003). Supply constraints — arising from adverse weather conditions earlier in the year — have moved fruit and vegetable prices beyond the usual seasonal pattern in Turkey, as well as in other countries in the region. These uncharacteristic fluctuations make it difficult to forecast food price inflation, but it should, in all probability, decelerate in the coming months. Likewise, clothing prices, in spite of a 21.1% seasonal increase in the last two months, actually show no sign of a demand-triggered burst of inflation. The annual rate of change in clothing and footwear prices declined from 7.7% at the end of 2004 to -0.1% last year and then stood at 0% last month. All in all, the two major categories of consumer spending provide no support for the ‘demand bubble’ hypothesis and confirm our view that higher inflation is a result of supply shocks and seasonal fluctuations. Headline inflation may be higher, but the underlying inflation rate is still declining. Although the recent rise in headline inflation is not an indication of a trend shift, it would be misleading to suggest that there are no inflationary imbalances in the Turkish economy. As a matter of fact, even before the commodity shock and abnormal seasonal oscillations, the disinflation process has faced the challenge of inertia in the housing sector. Rental price increases, still running at an annual rate of around 20%, resulted in, for example, a year-on-year increase of 11.4% in the housing component of the CPI last month, up from 6.2% in May 2004. Coupled with institutional bottlenecks, the housing boom has led to an imbalance between demand and supply in this sector. In our view, the relative price adjustment in non-tradables is likely to persist, but the recent tightening in financial conditions should make it more manageable, especially considering housing supply in the pipeline. Besides, even with the distortionary effect of rental price increases, the core CPI excluding gold remains — at 5.5% — in line with the central bank’s year-end target. The volatility shock weakening the lira will no doubt lead to higher inflation. As if all the above factors have not caused enough trouble, Turkey is now experiencing yet another shock — risk reduction in the global financial markets. The resulting depreciation of the lira is pushing import prices and production costs higher. Of course, this pass-through effect, however limited, will lead to an increase in inflation in the next couple of months. According to the central bank’s estimates, the lira’s fall already contributed 0.7% to the 1.9% increase in the CPI last month. Though painful, this is not surprising. Turkey has not yet internalised low inflation, and higher uncertainty still distorts inflation expectations and keeps price-setting behaviour sensitive to a weaker currency. Nevertheless, structural changes and financial de-dollarisation have reduced the pass-through effect of a one percentage point depreciation of the exchange rate on consumer prices from 45bp to 24bp in the post-float period. The weak state of the labour market will limit excessive price adjustments. The volatility shock may bring abrupt price movements in the short run, but indirect effects depend on the state of the economy. With an unemployment rate of 12% and almost no real wage growth, productivity gains will surely mitigate inflation pressures. As long as the government does not steer the incomes policy away from the multi-year targets, the increase in the degree of competition should keep unit labour costs muted and price increases at minimum. Indeed, structural shifts in pricing behaviour have already delivered secular disinflation, especially in sectors open to competition. For example, the annual rate of change in furniture prices declined from 8.9% at the beginning of 2004 to 2.1% last month — a trend shift similar to that seen in clothing prices (see The IKEA Factor, October 9, 2003). Furthermore, our calculations show that the non-accelerating inflation rate of unemployment stands around 6% (compared to the current reading of 11.9%) and the economy is still operating with an output gap. Therefore, the recent tightening in financial conditions — the average monthly interest rate on housing loans increased from 1% to 1.6% in a matter of weeks — will slow the pace of demand growth and curb inflation pressures. An excessive focus on contemporaneous inflation could aggravate the slowdown. The Central Bank of Turkey could not have dismissed the effects of global volatility on inflation expectations and pricing behaviour and responded audaciously by raising interest rates. This pre-emptive approach should help to prevent inflation from being built into people’s planning, but Turkey is ultimately experiencing supply shocks that cause price increases independent of the monetary policy stance. Therefore, an excessive focus on contemporaneous inflation could aggravate the economic slowdown. In our view, prudent policies and structural reforms that have so far raised the potential growth rate and paved the way for secular disinflation are the best guarantee for keeping the rise in inflation just a temporary breach of the target.
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