Venting Global Tensions
Jun 26, 2006
Stephen S. Roach (from Shanghai)
I continue to believe that the global economy is now in better shape than financial markets. The stewards of globalization have finally woken up to the perils of ever-mounting global imbalances -- the major macro issue that has concerned me for nearly four years. But the policy requirements of rebalancing are not without risks --especially since they entail a withdrawal of excess liquidity. In my view, the risk aversion trade that began in early May should be seen as a venting of the tension between global rebalancing and a potential shift in the liquidity cycle. Financial markets may not have seen the end of this adjustment.
The linkage between liquidity-driven asset bubbles and global imbalances is at the heart of this venting. Aided and abetted by its bubble-prone central bank, the US has taken the lead in driving this insidious process. By substituting asset-based saving for traditional income-based saving, America has pushed its domestic saving rate down to unprecedentedly low levels; in the second half of 2005, the net national saving rate was essentially “zero.” Lacking in domestic saving, the US then imports record surplus saving from abroad -- which, of course, requires it to run massive current account and trade deficits in order to attract the foreign capital. America’s current account deficit, which soared to a record $791 billion in 2005, was, by far, the largest imbalance in an unbalanced global economy -- absorbing about 70% of all the surplus saving in the world last year. It is a direct outgrowth of bubble-driven dissaving that has taken the personal saving rate into negative territory for the first time since 1933. April was a critical turning point on the global rebalancing watch. After years of denial, the stewards of globalization -- namely, the G-7 finance ministers and the IMF -- finally sounded the alarm over the threat of mounting imbalances. The rebalancing fix that was endorsed has three key ingredients -- the adoption of a multilateral global architecture of surveillance and consultation, general agreement on dollar depreciation, and a global tightening of monetary policies. This latter piece of the rebalancing fix is key to the liquidity withdrawal that now appears to be under way in world financial markets. One by one, all of the world’s major central banks -- in the US, Europe, Japan, and China -- have moved to the tightening side of the monetary policy equation since late April. While there is still considerable disagreement over how far this global tightening may yet run, there can be little doubt over the implications of what has transpired so far. As measured either by price (real interest rates) or quantity (the excess of money over nominal GDP) the global liquidity cycle has now shifted decisively to the downside for the first time since 2000 (see a just-published joint efforts of Morgan Stanley’s global economics team, “Debating the Liquidity Cycle,” 26 June 2006). For liquidity-driven financial markets and the steady stream of asset bubbles they have spawned in recent years, this represents a major about-face. In response to this turn in the global liquidity cycle, the adjustments in world financial markets have been painful but orderly. Developed world equity markets have stayed within the 10% correction band that market historians have long judged to be the norm of most mature bull markets. The biggest moves have occurred in the assets that went furthest to excess -- namely, emerging market equities and commodities. From their early May highs, corrections in these markets have ranged in the 20-30% zone -- significant by any standards but all the more so in light of the extraordinary run-ups of the past several years. Traditionally among the riskiest of assets, emerging markets and commodities had become priced for a veritable absence of risk. I have argued that while there are, indeed, constructive fundamentals in both areas, there are good reasons for investors to remain engaged in an active two-way debate on the macro outcome for risky assets. To the extent that was increasingly less the case, the risks of corrections were high and rising in both commodities and emerging markets. In fact, that’s pretty much the way it has since played out. I don’t think it’s a coincidence that the near parabolic increases in commodity prices in late March and April occurred just when an already vigorous Chinese economy surprised to the upside. Investors and speculators quickly became convinced that China would do little to arrest its “commodity-heavy” growth model that had drawn disproportionate support from fixed investment and exports for the past 27 years. This ignored altogether the possibility that China might tighten its policies to contain another wave of overheating and embark on a major structural transformation of its economy that would see growth shifting away from its commodity-intensive investment and export sectors to more of a commodity-efficient consumer-led outcome. And yet there is now good reason to believe that both such shifts are now under way (see my 2 June 2006 dispatch, “A Commodity-Lite China”). The same can be said for the emerging market debate. As seen from the standpoint of the problems that created the last crisis in the developing world -- the wrenching adjustments of 1997-98 -- today’s fundamentals look nothing short of superb. The outperformance of emerging market equities over the past three years and the extraordinary compression of debt spreads in the developing world suggest investors had become comfortable with the notion that the days of crisis were all but over for this traditionally risky asset class. Here, as well, I have argued that the debate needs to be more even-handed. After all, the proverbial “next” crisis never looks like the last one. While the developing world has, indeed, reduced its external financial vulnerability dramatically over the past nine years, it has done little to reduce the external vulnerability of its real economies. Lacking in support from internal private consumption, a faltering of the long over-extended American consumer could well do serious damage to these still export-led economies. We debate endlessly the fate of the American consumer. But with the US property cycle now turning, it seems foolish to ignore the possibility that there will be a significant consolidation in US consumer demand that would have major implications for externally-dependent developing economies such as China, Mexico, and even Brazil. With liquidity withdrawal now hitting a critical threshold, it seems equally reasonable to price emerging market securities for a more reasonable assessment of such a possibility. And that’s exactly what appears to have happened (see my 16 June dispatch, “Putting the Risk Back into Emerging Markets”). The key question, of course, is whether the risk aversion trade of the past several weeks has gone far enough in pricing in a more realistic assessment of risks. There are three reason why I believe the answer is “no.” First of all, from the standpoint of the recent history of risk-reduction adjustments, the current shift is on the short end of historical experience. This is evident in scanning the record of our proprietary “global risk demand indicator (GDRI).” Since 1997, major downside moves in the GDRI have had an average duration of about 15 weeks; as such, the six-week move in the current cycle is not even halfway there. Second, I believe that the Chinese authorities will have to up the ante on their recent tightening moves in order to slow a white-hot investment sector; so far, this year’s approach has been a carbon copy of the efforts deployed in 2004 -- incremental adjustments in lending rates, a modest increase in reserve requirements, and administrative controls on selected overheated industries. With the Chinese economy overheated for the second time in two years, it is clear that if the incremental approach didn’t work back then, it stands even less chance of working today (see my 19 June dispatch, “Scale and the Chinese Policy Challenge”). I agree with Andy Xie that more Chinese tightening now lies ahead in the not-so-distant future (see his dispatch in today’s Forum, “China: Rate Hikes Ahead”). Third, I think the Fed will continue to surprise the markets with more rather than less monetary tightening; Bernanke has both a credibility problem and the foil of an inflation scare to justify such a policy bias (see my 9 June dispatch, “Tough Love”). And a now-softening housing market will be hit in response -- as will the asset-dependent American consumer. If the US consumer finally capitulates -- a possibility the consensus has all but dismissed out of hand -- commodity markets and the developing world will be the first to feel it. The good news is that none of this speaks of a terribly disruptive endgame for global rebalancing. Had global policy makers ignored the problem, a dollar crisis at some point in the not-so-distant future was a distinct possibility, in my view. But now the combination of architectural reform, currency adjustments, and monetary tightening points toward a more orderly, and hopefully benign strain of global rebalancing. However, it is important to stress that such orderly adjustments in the real economy are no guarantee for orderly adjustments in liquidity-driven markets -- especially those risky assets that have gone to excess. The risk aversion trade is a clear reminder of that possibility. In the end, global rebalancing can’t occur without a shift in the global liquidity cycle -- a withdrawal of the high-octane fuel that has given rise to a multitude of asset bubbles since the late 1990s. If central banks have the wisdom and the courage to stay this course, asset-driven saving imbalances will finally be addressed. Investors have long presumed this day of reckoning would be postponed indefinitely. They had become hooked on the now infamous “Greenspan put” -- the seemingly perpetual willingness of the world’s dominant central bank to bail out disorderly markets. Yet this approach was ultimately destined to fail -- it was a breeding ground for the systemic risks of ever-mounting global imbalances and a moral hazard that could only end in tears. In my view, that’s what this debate is actually all about -- whether the world’s major central banks are finally about to close the book on the Greenspan era. The tension between global rebalancing and the liquidity cycle could well be key to rendering this verdict for world financial markets.
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Has the US Current Account Deficit Peaked?
Jun 26, 2006
Richard Berner (in London)
The US current account deficit declined absolutely and as a share of GDP in the first quarter of 2006, stirring hopes that it may have peaked. At an annual rate of $835 billion, the red ink last quarter eclipsed the 2005 total of $791 billion, but at 6.4% of GDP was little changed from last year and so far is significantly below our forecast of 7.4% for 2006 as a whole. Hopes for a peaking in the external deficit are early, but they are legitimate, in my view. After four years of acknowledging that picking the peak was ill-advised, I’m getting a bit more optimistic on the current account. I think the peak is close, despite daunting arithmetic, the “J-curve,” rising interest rates, and the recent stability in the dollar. Here’s why, what it means for financial markets, and a look at the risks. There’s no mistaking the hurdles to stability in the US current account gap, much less to a narrowing in the deficit. First, daunting deficit arithmetic has locked the current account gap into a vicious circle that is hard to escape. With nominal imports of goods, services and income now 39% bigger than exports, exports must grow that much faster than imports just to hold the current account constant. And the calculus for merchandise alone is much worse, with imports 82% larger than exports. The faintly good news: The ratio of the broad aggregate of imports to exports has stabilized over the past year, offering hope for future stability in the current account itself. But if that ratio rises again, this hurdle will potentially grow even bigger. Second, and related, import prices are rising twice as fast as those of exports, giving rise to the so-called “J”-curve effect, which means that the current account deficit will widen more in nominal than in volume terms. Obviously, a significant portion of that increase reflects higher oil and energy product quotes. But the dollar’s weakness over the first half of 2006 following a period of a stable-to-rising dollar last year has recently boosted nonfuel import prices. We estimate that the 1.4% rise in nonfuel import prices over the year ended in May increased the nominal merchandise trade gap by roughly $25 billion over that period. A renormalization of US interest rates is a third factor that will widen the current account gap as interest payments to foreign investors and central banks increase. Near term, the effect will be small for two reasons. Rates are now rising globally, so US investors will also benefit from increased investment income receipts. And most of our debt holdings are in UK securities; even though rates in the UK are now lower than US rates, the differential is narrower than elsewhere. Nonetheless, average US-overseas rate differentials have widened. We estimate that, other things equal, renormalizing US interest rates could add about $80 billion (0.6% of GDP) to the current account gap over the next two years. The dollar’s very recent runup is a fourth hurdle to current account adjustment. The Fed’s broad, trade-weighted dollar index has jumped by about 2.6% over the past month as investors bailed out of riskier currencies and sought the dollar’s allure of high, risk-adjusted returns. But the rally must be put in context — it is slight and it is recent. It takes big and persistent exchange rate moves to alter buying and investment patterns, so there is a significant lag between the time currencies move and when they affect trade and income flows. Indeed, I think that the dollar’s real effective 14.8% slide over the past four years has only just begun to have an impact. With those factors as hurdles, what are the sources of my newfound optimism, however faint? I think that four factors have begun to arrest the rise of red ink. First, growth in overseas demand now appears to be outstripping that in the US, boosting US exports and slowing the growth of US imports. Courtesy of hearty growth in Canada and Mexico, US merchandise deliveries to North America rose by 8.4% over the past year. While US real final domestic demand rose by 3.8% over the past year, in Canada and Mexico the gains were 4.3% and 7.8%, respectively. And exports to the Pacific Rim region rose by nearly 10% in the year ended in April as Asian demand improved. The two regions together account for 60% of US merchandise exports. Sustainable growth in domestic demand appears to have emerged elsewhere as well, although it may depend on increased commodity prices, and it isn’t immune from recent market declines. Second, stronger growth abroad has lifted the earnings of and thus receipts from US overseas affiliates just as profits generated in the United States are slowing. Receipts from abroad (balance of payments basis) accelerated to a 21.9% rate in the first quarter of 2006, compared with 8.9% for results of US affiliates of foreign companies, and because the stock of US direct investment abroad is larger than foreign investment here, that growth gap boosted the surplus on direct investment income by about $37 billion over the same quarter in 2005 to $154 billion, both at an annual rate. Indeed, despite growing debt service, America’s surpluses in services and in income received from investments abroad are improving. The combined surplus in 2005 netted to more than $77 billion, and of course, in contrast with deficit arithmetic, ‘surplus’ arithmetic is favorable. Net receipts from services are up 13.2% from a year ago, reflecting the lasting effects of the dollar’s decline over the past several years on foreign travel and tourism to the US (a part of US net exports). Third, US-based companies are increasing market share abroad, so faster growth in overseas demand will disproportionately boost US exports. Their bigger slice of the global growth pie partly reflects the dollar’s just-mentioned real four-year decline. It also reflects a shift in the mix of global demand, as the overseas recovery in capital spending, in both the industrial and developing world gathers pace. The share of capital goods in US merchandise exports declined in the IT bust, but at 40% it is the dominant segment in the total, and is up 9.4% in the past year. In addition, direct investment in the US affiliates of foreign companies has helped substitute US production for imports in some industries, such as capital goods and motor vehicles. Finally, the decline in energy quotes that we anticipate over the next eighteen months will trim nominal imports by $20–30 billion, depending on whether or not hurricanes again disrupt Gulf of Mexico production and on whether the energy conservation that we see beginning to unfold continues. What are the implications of a narrower current account gap for financial markets? Clearly, the context matters. My bet is that the outcome will be relatively benign and orderly. That’s partly because I think a tighter monetary policy will promote what amounts to a US soft landing and slow turn in the current account, and that likely will be associated with stable-to-gradually declining US interest rates and US dollar and eventual rallies in risky assets. In contrast, a US recession — even a mild one — would more rapidly “fix” the current account but only up to a point, because it would menace growth abroad. And it would be bad news for the greenback and US equities. But there are other risks besides that of a US hard landing. The narrowing in the US current account gap will be a long process under the best of circumstances. Shocks to overseas growth and/or rising protectionism would stymie the process. Beyond rate differentials, investor confidence and certainty about policies have been critical supports for the dollar. By comparison, a loss of confidence in US policies would undermine the dollar and US markets (for further elaboration, see “America’s Twin Deficits: Implications for the Dollar and Interest Rates,” Global Economic Forum, December 16, 2006)
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Entering Knock-Out Stage
Jun 26, 2006
Elga Bartsch (London)
As the excitement about the World Cup, which is entering its knock-out stages this weekend, mounts and a quiet week in terms of the data and the news flow in Europe draws to a close, the June business survey compiled by the Belgian National Bank still staged a stunning surprise. Defying market expectations for a small correction, the widely watched synthetic indicator surged to an all-time high of 10.1 in June. The sharp rise from a reading of 2.0 recorded in May was driven by both manufacturing and trade. This trend could well be echoed by other business surveys this coming week. Contrary to the investor community, which seems to have become much more bearish on the euro area growth outlook according to the June ZEW investor survey, the business community still seems to be in high spirits. As a result, this coming week might hold a few surprises — not just for football fans, but also for financial markets. The European traditional business surveys tend to garner considerable financial market attention as they come out before the Purchasing Managers’ Indices, including the US ISM survey. They are one of the very few data points where European statisticians crunch the numbers faster than their US colleagues. Belgian manufacturers reported a stunning surge in production during June, a sharp rise in new orders, especially foreign ones, and swelling order books. If confirmed by so-called hard activity data in Belgium and elsewhere, this would underpin our call for a smart acceleration in euro area GDP growth during 2Q. Our GDP indicator currently gives a 2Q estimate of 0.9%Q at present, up from 0.6%Q reported in 1Q. At the same time, forward-looking indicators — notably output expectations, hiring intentions and the assessment of inventories — all corrected mildly in June, according to the BNB survey. This would point to a moderation in GDP growth in the second half of the year — in line with our forecasts. Prior to the Belgian business survey, we had expected most of the heavy hitters — the likes of the German Ifo business climate, the French INSEE gauge and the Italian ISAE survey — to have posted small corrections or stable readings. If the Belgian BNB survey is anything to go by, this might turn out to be an unduly pessimistic view. This probably holds most acutely for our below-consensus forecast for the German Ifo business climate, where we have pencilled in a drop to 104.2 in June from 105.6 in May, while the consensus is looking for a reading of 105.0. Ours is not the lowest forecast in the market, but one of the lowest. With forecasts for the headline Ifo business climate ranging from 103.9 to 107.6, there are even some out there who see the indicator bouncing higher in June. And they might be proven right. So might the market consensus on the French INSEE survey, which contrary to my colleague Eric Chaney, foresees a small gain. At the current juncture, business sentiment looks to be affected by two opposing factors. On the one hand, forward-looking components are likely moderate. On the other hand, coincident components are likely climb higher. A priori, it is difficult to say which of the two effects will gain the upper hand, making forecasting the synthetic headline indices more difficult than usual. When the data are released, we will be watching our surprise gap index closely for any signs of a turnaround in the euro area business cycle. In May, the surprise gap index eased back into the neutral zone after having spent several months in the acceleration zone. In Belgium, where the data tend to be a lot more volatile than in the euro area as whole, it jumped back into the acceleration zone in June. So, what if the June business surveys this coming week were making new highs? In isolation, a single monthly data point is unlikely to completely change the ECB’s policy stance. Many ECB watchers including yours truly burned their fingers forecasting a May rate hike after a strong March Ifo business climate and further rise in February M3 money supply. But together with what could be another rise in headline HICP inflation to 2.6%Y in June, the data flow this coming week could underscore again that an acceleration of the ECB tightening campaign ahead of its summer recess might have been warranted. At this stage, however, the ECB President has not prepared markets for an imminent rate hike. Other ECB Council members, e.g., Axel Weber, are less reluctant to voice the need to be vigilant, a terminology that in the past has been used by the ECB to signal a rate increase. Eyes on the screens, ears to the ground!
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Leading the Elephant
Jun 26, 2006
Serhan Cevik (from New York)
Liquidity-driven capital flows are like an elephant in a china shop. Central banks around the world lowered interest rates to unprecedented levels against the risk of a recession-deflation spiral in the post-September 11 period. That was a prudent decision, but also set the stage for the most powerful liquidity cycle of our times. With cheap money, investors embarked on a buying spree across all asset classes. But nothing lasts forever, and the accumulated effect of monetary tightening, especially in the US, in the past two years has triggered a wave of global risk reduction and turned liquidity-driven capital flows into an elephant in a china shop. To be honest, we initially thought that countries, like Turkey, that have behaved responsibly throughout the global liquidity cycle would not get battered as much as imprudent ones (see Positive Discrimination, March 15, 2006). We could not have been more wrong, as indiscriminate risk reduction has made Turkey one of the worst performers in the down-cycle. Even though we still believe that there is no fundamental reason — yes, even considering the current account deficit and political speculations — for the intensity of the sell-off in Turkey’s financial markets, the authorities cannot ignore the risk of an exogenous shock evolving into an endogenous problem. The central bank has raised interest rates and introduced liquidity measures. Facing the threat of contagion from global volatility, the Central Bank of Turkey has raised interest rates by 225bp to 17.25% and, more importantly, introduced measures to address the liquidity squeeze in the foreign exchange market. After a five-year-long easing cycle that brought down interest rates from 65% in 2001 to 13.25% in April, this is the second time in a month that the central bank tightened the policy stance in an attempt to keep inflation expectations and pricing behaviour in line with its multi-year inflation targets. Although this is arguably a necessary move to curtail the secondary effects of global risk aversion, interest rate increases are not the solution to what is effectively a liquidity crunch caused by capital outflows and technical conditions in the banking and corporate sectors. Turkey’s financial system used to be one of the most liquid among emerging markets, but has suddenly become shallow, creating a perfect setting for speculative movements that weaken the lira and distort inflation dynamics. This is why liquidity management is far more important for smoothing out portfolio adjustments and preventing a vicious cycle. When investors lose the sense of direction, anything can be an excuse for a sell-off. Tighter monetary conditions in developed countries are the main driver of risk reduction. In particular, with rising inflation in the US and the prospect of higher interest rates — reaching 5.25% this month and then 5.50% in August with the possibility of 5.75% in October — investors now have a shrinking appetite for risk. However, we are at the peak of the business cycle and receive conflicting information about economic growth and inflation that heighten uncertainty surrounding the direction of monetary policy. Of course, this creates a fertile environment for the ‘blame game’ in which anything can be an excuse — like South Africa’s current account or, as one columnist put it, Somalia’s unemployment — for more pressure on asset prices. The monetary authority is aiming to bring an end to exaggerated currency movements. There is a prevalent view that the Central Bank of Turkey is ‘behind the curve’ and must raise interest rates aggressively to gain credibility. In our opinion, this is, to say the least, an unjustifiable suggestion. Even if Turkey had Alan Greenspan as the governor, the result would not have been materially different. Despite Turkey’s own shortcomings, risk reduction is not a Turkey-specific event and higher interest rates would not stem capital outflows when investors embrace a higher degree of home bias. Nevertheless, the central bank has already tightened the monetary policy stance by 400bp — more than the 201bp worsening in inflation expectations in the past two months. Meanwhile, apart from speculations, we have no post-volatility data on inflation and other economic variables. Although the recent rise in inflation is a result of supply-side shocks, such as higher energy and unprocessed food prices, the lira’s depreciation to a three-year low is bound to increase inflation in the near future. As a result, since the pass-through effect is not linear and intensifies along with the rate of currency depreciation, the central bank has taken steps to bring order to the foreign exchange market. Blindly following adaptive expectations would heighten uncertainty and damage credibility. Central banks should not ignore the information contained in asset prices, but they must be careful in utilising such extractions. This is especially challenging in the case of Turkey, where market expectations are adaptive and have short time horizons. Therefore, blindly following market expectations would only increase uncertainty and damage policy credibility in the longer run. Although global risk aversion is unlikely to moderate in the near future and Turkey will keep having a significant exposure to liquidity-driven flows, the country’s macroeconomic achievements are not an illusion created by favourable global conditions. Hence, as long as the government maintains its commitment to prudent policies and structural reforms, the central bank should be able to lead the elephant, not run after it.
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Thirteen Questions the PM Will Face
Jun 26, 2006
Robert Alan Feldman (Tokyo)
What’s new
PM Koizumi will visit the US and Canada from June 27-July 1. He will face a number of questions about the economy and politics. Conclusions Since he will leave office in September, the PM is not likely to break new ground on his visit. However, there could be surprise statements. Topics may include the economic upswing, financial regulatory policy, the BoJ, post-Koizumi politics, or Japan-China relations. Market implications Deviations from expected statements (see text) could move markets. Risks The largest potential for unexpected statements lies in financial regulatory policy, BoJ matters, tax policy and post-Koizumi politics. PM Koizumi travels to the US and Canada this week, and he will face many questions about the economy. I give a list of potential questions, and the answers that I expect him to give. To the extent that my expectations reflect the market consensus on his views, differences from the following responses would be important. Is the Japanese economic upswing sustainable? Yes. The inventory cycle is fundamentally smaller than in earlier years. Moreover, firms now use production to control inventories, quite contrary to both economic textbooks and actual history. Regarding the latter, high costs of production adjustment meant it was cheaper to let inventories be volatile, while production was kept smooth. Now, it is cheaper for firms to make smaller, more frequent adjustments of production. So now, production is more volatile than inventories. This reversal happened because of structural reform in labor and capital markets, globalization of production chains, IT improvements, and active M&A that allowed firms to be more rational in the use of resources. Why is the FSA being so aggressive in enforcement? The FSA has become aggressive in many areas, with enforcement actions taken recently in consumer finance, accounting, trust banks, internet companies and investment funds. The increase of staffing in financial regulatory agencies is paying off, since now we are catching more questionable practices. Tough cops make good markets, so investor confidence should rise. That is why my minister of economics and financial reform, Minister Yosano, used the phrase ‘ichibatu hyakkai’. This means that a small number of tough actions deter a great deal of questionable activity. Japan will continue to be aggressive in enforcement, but simultaneously needs to keep redesigning the financial regulatory system to meet new needs. Will corporate profits keep rising? The key is productivity growth. If firms can raise productivity faster than wages rise (as labor markets tighten with the aging of the population), then profits will keep rising too. The whole purpose of structural reform policies has been to raise productivity, by allowing freer movement of resources and reducing barriers to business. That said, the private sector must make decisions on its own. There should not be any increase of government intervention. Quite the contrary. When will Japan rely on domestic demand for recovery, instead of foreign demand? Actually, Japanese recovery has not relied on domestic demand. Since the start of the recovery in 4Q02, the average real growth rate has been 2.7% annualized, of which 0.7 percentage points have come from net foreign demand. Domestic demand is strong, so slowdowns in either the US or China will not pose huge problems for Japan. Will BoJ rate hikes kill the recovery? Interest rate policy extent and policy is decided by the BoJ. The government believes that rate hikes in line with real growth and with the abatement of deflation will not be a problem. Many large companies have a lot of cash and few borrowings, so they will benefit from higher rates. Some market participants fear a potential problem in the bond market. They say that this problem stems from ambiguity about policy in the BoJ’s ‘understanding’ of price stability lying in the 0-2% range. The BoJ’s March 9 policy framework was a big step forward, but the BoJ needs to be clearer about how it will use this range. Will fiscal policy and monetary policy remain balanced? Yes. The BoJ has been aggressive in its statements, but the BoJ law and public opinion are constraints. As long as fiscal reform remains on track and prices remain stable, the BoJ is not likely to take an aggressive hiking policy. What has been and will be done in the important reform areas? Laws have been passed or new policies taken within the last two years in most of the key areas, such as medical reform, government financial institution reform, government property use, public service outsourcing, public works reductions and agriculture. All of these areas remain under scrutiny. The LDP is now working on a fiscal reform plan, which will encompass both taxes and spending, and which will suggest further steps in many reform areas. In addition, we have begun more aggressive work on immigration and fertility policy. Will the government actively intervene to promote industrial reorganization? No. The Industrial Revitalization Corporation of Japan (IRCJ) was a success, but it was a one-off effort. It will shut down in about a year, and will not be revived. Now that the government has set new rules on corporate activity with the new 2005 Corporation Law, we will leave industrial reorganization matters like M&A in the hands of the private sector. What will happen to tax reform? Until now, the LDP tax committee, the MoF tax commission, and the Council on Economic and Fiscal Policy (CEFP) have fought about taxes. Since last October, however, the LDP committee and the CEFP have worked much more closely, so that developing new policies is easier. Burdens on companies should be lightened, in order for Japan to keep global competitiveness. What will happen after the Koizumi Administration ends? Will Takenaka stay in the Cabinet? The thrust of policy will remain the same, regardless of who becomes PM next. The policy needs are clear, and the popular will is clear. The difference — if any — will derive from the passion and focus of the new PM. A huge amount depends on who the new PM appoints to Cabinet and other important posts. We should judge by the policies announced and enforced by the new PM. I am not endorsing anyone. Minister Takenaka is an excellent public servant. However, whether he stays in the Cabinet is a decision to be made by the next PM. Can the Japan-China relationship switch from a backward- to a forward-looking orientation? There are many forward-looking aspects in the Japan-China relationship already, and we are cooperating well in many areas, such as energy, environment, etc. The coolness in political relations has not hurt our economic relationship. On the history issue, I will not stop visiting the Yasukuni Shrine. Period. As for timing of my visit, I will make an appropriate judgment. The next prime minister will make his own judgment. What Governor Fukui’s investment in a mutual fund now accused of insider trading? The governor has testified about the matter in the Diet, and has discussed the matter directly with senior members of the government. We think that the BoJ will review its rules over investments of BoJ staff, but this is a matter for the BoJ to decide, not the government. The BoJ is an honorable institution, and Governor Fukui is an honorable man. The BoJ and he will make responsible decisions. Why are Japanese stocks so weak? Global risk aversion has risen. Look at stock markets around the world. Investors are worried about a lot of things, like where global interest rates will go, where US and Chinese economies will go (they seem less worried about Japan), global inflation fears, oil markets, and domino effects among investors. Japanese companies also seem conservative in their earnings forecasts. However, Japanese economic fundamentals have not really changed since March, when the Nikkei Average was in the 17,000 range.
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Rate Hikes Ahead
Jun 26, 2006
Andy Xie (Hong Kong)
*China may increase interest rates by 54bp before year-end. The accelerated pace of the Fed’s rate hikes is creating room for China to hike interest rates despite the expectation of renminbi appreciation. China’s deposit rates could rise by 27bp before August and another 27bp before year-end. *China may raise interest rates further in 2007 as the US interest rate stays high due to inflationary pressure. The renminbi appreciation expectation could ease in 2007, which would allow China to raise interest rates more aggressively. *Receding global liquidity could normalize China’s monetary policy. Renminbi appreciation expectation and the trade surplus have led to excess liquidity in the banking system and complicated China’s monetary policy. As global liquidity recedes and the US economy turns down, the excess liquidity is likely to decline to restore normalcy to China’s monetary policy. *Credit rationing may be coming. Interest rate policy alone may not dent the demand for credit as borrowers may be local government-related and thus not rate-sensitive. China may have to resort to credit rationing temporarily to contain excessive credit creation. Summary and conclusions China could raise its deposit interest rate by 27bp before August and another 27bp before year-end. The Fed is raising interest rates fast and high enough to create room for China to raise its interest rate, despite the expectation that the renminbi will appreciate. However, tightening measures to date, and the additional measure of raising interest rates may not be sufficient to contain credit growth, as the credit demand stems primarily from local government-related projects or businesses that are not interest rate-sensitive. The government may have to resort to credit rationing temporarily to rein in excessive credit growth. Global liquidity downturn and a weakening US economy should help restore normalcy to China’s monetary policy. China has struggled to control its economy amid massive excess liquidity due to the renminbi appreciation expectation and export boom. Higher US interest rates should soon begin to suck liquidity out of China’s banking system, and the weakening US economy should lower China’s trade surplus. China’s interest rate is abnormally low compared to its GDP growth rate due to excess liquidity. As China’s excess liquidity dissipates in a tightening global liquidity environment, China’s interest rate should normalize also. Its deposit rate could rise to 5% from about 2% now within 24 months. Raising deposit rates promotes consumption in China. The income effect from a rising deposit rate is much bigger than the inter-temporal substitution effect on consumption, as China’s household sector has low debt and low wealth. Room for rate hikes emerges As the Fed shifts into inflation-fighting mode, the potential is emerging for China to raise interest rates to rein in its credit expansion. Since 2003, the renminbi appreciation expectation has exceeded the gap in interest rates between the US and China, and this has prevented China’s central bank from raising rates. The Fed is likely to raise interest rates to 5.25% in June and 5.5% in August. China’s six-month deposit rate is 2.07% and, after discounting for 20% interest income tax, is 1.66% effectively. The renminbi appreciation expectation is running at about 3% per annum. If the six-month deposit rate were raised to 3.1%, the spread between the fed funds rate and China’s deposit rate would still be consistent with the 3% renminbi appreciation expectation. The expectation for renminbi appreciation has prevented China from raising interest rates appropriately to stop overheating. As the potential for raising rates emerges, China is likely to seize this opportunity to tighten monetary policy, especially as lending is still substantially above the government’s target. I believe that China could raise its deposit rate by 27bp before August and a further 27bp before year-end. Lending rates will likely rise in line with deposit rates but could be less, given that China only raised lending rates, not deposit rates, last time. A decrease in the banking system’s excess liquidity may be necessary to support further rate hikes. The interbank rate should be equal to the deposit rate plus deposit collecting costs in equilibrium. For example, the 1-month deposit rate is 1.71% and the deposit collection cost is about 60bp, so the equilibrium 1M interbank rate should be 2.31%. However, its average in the first five months of 2006 was 1.79%. The 1M interbank rate spiked by 100bp to 3% in the past two weeks. The spike may partly reflect a tightening international liquidity environment. If it sticks, it would support rate hikes. Raising deposit rates could slow property speculation, which is a primary government objective. Despite double-digit GDP growth in recent years, China’s savers have not benefited as the government has kept deposit rates low. That is one driver for property speculation. Rising deposit rates encourage consumption There is a popular view that low deposit rates encourage consumption. This is an erroneous application of an economic theory, in my view. Low interest rates stimulate consumption by (1) making consumer credit easier to obtain and (2) creating a wealth effect through the appreciation of financial assets. China’s consumption is income-driven. The wealth level of the household sector is quite low, probably around two times GDP and substantially below the equilibrium level of 3-4 times that is necessary for the wealth effect to play a meaningful role in consumption. The Chinese government owns assets worth over 100% of GDP that do not play a role in supporting consumption at all. Further, household wealth is highly concentrated among a small number of households that are not constrained in consumption power by either availability of credit or wealth. Low interest rates would not make a difference to them. Instead, the income effect from higher interest rates could boost consumption. More importantly, as the household sector is in a catch-up phase in achieving a wealth level of 3-4 times GDP, higher deposit rates make the household sector more optimistic about future wealth accumulation. This effect could decrease their savings rate and boost consumption further. China should remove the 20% tax on interest rate income, in my view. The tax was imposed in the belief that low interest rates would discourage savings and improve consumption. It hasn’t worked. Further monetary normalization ahead Most central banks are behind the curve, in my view. They were misled by low inflation due to deflation shocks in the past decade, kept monetary policy too loose for long-term price stability, and allowed non-financial sector debt to rise much faster than income. The debt boom has led to global asset inflation. IT, property, emerging markets and commodities have all taken turns. Asset inflation has exaggerated global demand growth, which many investors viewed as the justification for asset inflation. Deflation shocks have receded. Indeed, some have turned into inflation shocks. Emerging economies that devalued to earn more hard currency now run current account surpluses and increasingly shift their policies to support domestic demand, which is inflationary for the global economy. The current stock of money in the global economy, in the absence of deflation shocks, is not consistent with price stability. Inflation, like many other economic variables, has become global. Its global nature has made it stickier both on the way up and on the way down. Major central banks are likely to raise interest rates more than expected for a long time. The tightening of the global liquidity environment could fundamentally change China’s monetary conditions. The global asset bubble has exaggerated China’s trade surplus and amplified the renminbi appreciation expectation. Both are likely to reverse in 2007, which would allow China to normalize its monetary conditions. China’s nominal GDP has been growing at a double-digit rate for three years. However, its bank deposit rates have remained at about 2%. The gap between the GDP growth rate and interest rates is unprecedented. Monetary normalization requires more rate hikes going forward. China’s deposit rate could rise to 5% in two years. Credit rationing may return temporarily Local government-sponsored companies or projects drive China’s credit demand. In response to the central government’s tightening stance, local governments appear to be hoarding credit in anticipation of further tightening measures. As local governments are not sensitive to interest rates in their credit demand, market-based measures may not be able to control credit expansion. China has been reforming its financial system to migrate towards a market-based financial system. Partial deregulation of lending rates, elimination of the quantity-based credit policy, listing state-owned banks and improving currency flexibility are recent steps taken towards a market-based financial system. However, as government-related entities drive credit demand, reforms on credit supply alone cannot achieve the desired levels of effectiveness. Indeed, it may make some of the problems worse. More flexibility for financial institutions like local banks leads to more control of local governments on credit allocation. The property market, for example, has become an instrument for local governments to convert bank credit into fiscal revenue. That is a powerful incentive to sustain credit growth. If credit growth continues to surge, China may have to bring back credit rationing temporarily. This sounds like a step backwards. However, the alternative could be worse. The primary objective for China is to control the extent of non-performing loans as the global economic cycle turns down. Urgent need for reforming local government finance The final solution is to reform local government finances. I view the lack of transparency in this area as the biggest threat to China’s long-term financial stability. Local governments are not allowed to run fiscal deficits but are essentially in charge of most development projects. The contradiction has incentivized local governments to create numerous ‘commercial’ vehicles to borrow against specific development projects. Lately, property has been the instrument to turn bank credit into revenue. China must introduce transparency to local government finance, in my view. Local governments should make public their revenues and/or expenditures directly or indirectly, including local, government-controlled companies. China should also introduce a bond market for local government finance. Without opening a channel for funding development projects, reforming local government finance would be an uphill battle, in my view. The advantage of a bond market is that it is transparent. The market prices of these bonds send instant signals about the financial health of government.
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May Production Rebound
Jun 26, 2006
Deyi Tan (Singapore) and Chetan Ahya (Singapore)
May production rebound. Manufacturing production rebounded from the 2.8% YoY seen in April to 10.6% YoY in May. This is on the back of stronger performance in both non-biomedical (+12.7% YoY) and biomedical (+0.3% YoY) manufacturing amid weaker base effects. Year-to-date, manufacturing production rose 14.7% YoY. Industrial data points to moderation in 2Q06 GDP growth. For the first two months of 2Q06, industrial production rose 6.7% YoY. This compares to 20.2% in 1Q06 and 14.5% in 4Q05 and underpins the moderation in GDP we will likely see in 2Q06, in our view. Electronics performance moderated slightly... In terms of the breakdown, momentum in the electronics segment faltered slightly to 8.6% YoY in May (versus +9.0% YoY in April). Specifically, the infocoms and consumer electronics sub-segment reversed from a 12.5% YoY contraction to +7.0% YoY in May. Semiconductors was sustained at 38.9% YoY. However, computer peripherals (-4.2% YoY in May versus +5.5% YoY in April), data storage (-37.6% YoY versus -30.4% YoY) and other electronic modules (+10.8% versus +12.8%) were a shade paler compared to the previous month. …while other segments accelerated. Meanwhile, the chemicals segment expanded 8.4% as petrochemicals production rose 18.7% YoY (versus +10.4% in April). The transport engineering segment also accelerated to 35.5% YoY (versus +23.6% YoY in April). In terms of growth momentum, the biomedical segment was almost flat (+0.3% YoY versus -29.6% YoY in May), likely representing a moderation from the strong 59.3% YoY in the first four months of the year.
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