Italy
Times of Change and Good Intentions
Jul 11, 2006

Vladimir Pillonca (London)

The new Italian government on Friday (July 7, 2006) approved the Document of Economic and Financial Planning (DPEF), which anticipates some of the key fiscal measures that will be outlined in more detail in the 2007 Budget later this year.  Here we review some important points that emerged during Friday’s press conference.  (For a discussion of the outlook for fiscal policy in the euro area, see Tightening the Fiscal Belt, by Eric Chaney, Elga Bartsch and Vladimir Pillonca).

Ambitious objectives

Prime Minister Prodi’s new government intends to implement a series of key measures aimed at improving the (dire) state of Italy’s public finances in the 2007 Budget.  According to information so far available, the 2007 Budget is set to announce fiscal consolidation worth a significant EUR 35 billion, or approximately 2.5% of GDP (in addition to this summer’s mini-budget of 0.5% of GDP).  Crucially, the Budget is widely expected to contain several important structural initiatives, as stressed by Italy’s Economics Minister Tommaso Padoa-Schioppa.  He also highlighted that a EUR 14 billion package will be destined for measures to underpin economic growth.  This aims to partly offset the restrictive nature of fiscal consolidation.

One of the (admittedly ambitious) aims of the 2007 Budget will be to reduce Italy’s budget deficit from more than 4% of GDP to under the 3% limit by the end of 2007.  The government also aims to bring the debt/GDP ratio down from an expected 107.5% in 2006 to 99.7% in 2011.  The primary aim of the budget will be to curb spending on four key areas: pensions, healthcare, public employment and local public administrations (‘enti locali’).  Trade unions, however, have been clear to point out that they are strongly opposed to cuts to pensions and social spending more generally.  Some concessions might ultimately need to be made by the government on this front.  Our interest rate strategists have recently discussed some important aspects of fiscal policy in light of an ageing population (see Italy’s Budget, Old Europe and Interest Rates, July 3, 2006).

Decisive structural measures could prevent a further downgrade of Italy’s sovereign debt

Decisive structural measures could prevent a further downgrade of Italy’s sovereign debt from rating agencies (currently S&P has Italy at AA- and on a negative outlook) who are understandably waiting for the Budget’s details before re-assessing Italy’s fiscal outlook.  Also, a rigorous budget would avoid a downgrade of Italy’s sovereign debt and reduce financing costs via lower interest rates on new debt.  A resolute approach would mark a significant policy shift from the previous reliance on one-off measures. 

A statement of intent

A small set of corrective measures or ‘mini-budget’ has already been approved by the new government, worth about 0.5% of GDP (or EUR 7 billion) over the remainder of this year and next.  Though not substantive, this seems a first signal of fiscal commitment.  Good intentions, however, may be curbed by the government’s thin parliamentary majority.

Vincenzo Visco, Italy’s vice-minister for the economy, stated that he does not intend to increase VAT, unless as a last resort to avoid a fiscal disaster.  A series of schemes to curb tax evasion has been announced, but there will need to be a significant degree of restraint and deep-rooted rationalization of government expenditures and benefit levels to place Italy’s debt/GDP ratio on a steady downward trajectory.

The net effect of these measures will inevitably be painful in the near term, and will likely lower GDP growth in 2007.  But this incisive approach is nonetheless a highly desirable strategy for the medium term and beyond, in our view.

Good intentions

We believe that increasing competition in product markets and increasing labour market flexibility will be important challenges to overcome to improve Italy’s longer-term economic performance, after years of underperformance, even relative to the euro area.  There is a lot to do.  But the initial signs are that this government, notwithstanding its small parliamentary majority, has serious intentions.

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Japan
Outward Osmosis
Jul 11, 2006

Robert Alan Feldman (Tokyo)

Visiting European investors last week once again highlighted the large information gap between Japan and the rest of the world. Whether discussing monetary policy, fiscal reform, RoE or geopolitics, the information sets are very different. Moreover, the models used to link information are different. Finally, the priorities set on issues differ as well. No wonder market views differ!

However, the differences are not all adverse for the outlook for equity prices. Indeed, much of the information gap concerns items that are likely to be positive surprises for foreign investors (gaijin). Thus, information osmosis is likely to attract funds back to Japan.

Gaijin and the BoJ

At the top of the list of concerns of European investors is monetary policy. While conceding that one rate hike in Japan is inevitable, investors in Europe show a high level of incredulity about the apparent aggressiveness of the BoJ on the need for further rate hikes. The notion of the BoJ returning quickly to a ‘neutral interest rate’ (i.e., a rate equal to long-run growth of 1.5-2.0% plus long-term inflation on 1.0% — that is, a call rate of 2.5-3%) strikes European investors as bizarre. One may argue about the correct approach to monetary policy, but it seems clear that European investors would regard monetary tightening in Japan in line with the current forward curve to be a policy mistake. Thus, foreign investor confidence in Japan would likely be hit more severely by aggressive BoJ rhetoric or policy moves than domestic investor confidence.

Investors are also confused by the debate over liquidity. Did the end to quantitative easing (QE) at the BoJ trigger the global equity sell-off? Or is the end of QE merely coincident but not causal? Academics are likely to debate this matter for many years, but investors agree that the signaling effect was important, especially to foreign investors. (Whether market movements around the world — such as events in Iceland — can be traced to actually liquidity flows remains a mystery.) The implication for now is that the signaling effect of BoJ actions remains extremely important. In particular, statements from BoJ officials that strengthen expectations of rate hikes could have an impact magnified far beyond the extent of any actual hikes.

Finally, European investors seemed far behind the debate inside Japan on the impact of Governor Fukui’s connection to the Murakami Fund. Indeed, most European investors were unaware that a large share of the Japanese population views Fukui’s actions as questionable (although not illegal). Relative to Japanese investors, European investors would be more surprised if Fukui were to resign. Moreover, investors were quite unfamiliar with the backgrounds and monetary policy views of potential successors. Again, I believe that foreign investors are likely to react more negatively than domestic investors in case of a change of BoJ leadership.

Gaijin and post-Koizumi

Foreign investors have consistently been more interested in reform policy than domestic investors. Thus, foreign interest in the post-Koizumi world is higher. However, despite the higher level of interest in policy, foreign investors lag their domestic counterparts on key parts of the policy debate. For example, many had little idea of the large lead that Cabinet Secretary Shinzo Abe has in the race to succeed PM Koizumi. Few have a sense for Abe’s policy views, other than a vague idea from the popular press that he is a ‘hardliner’ on foreign policy. Given the similarities of Abe’s economic philosophy to Koizumi’s, foreign investors are likely to be positively surprised by upcoming statements on economics by Abe. Investors see the other candidates as less market-friendly than Abe, and hence market-friendly statements from them would be even more welcome.

However, investors will likely remain skeptical on reform policy until the next prime minister is in office and the next Cabinet chosen. In this regard, foreign investors frequently ask whether Minister Takenaka will stay in the Cabinet. The working assumption among European investors, based on political pundits and press gossip, is that Abe and Takenaka have drifted apart. Hence, so this view goes, Takenaka is unlikely to be in the next Cabinet, and this is bad for reform. Very few investors are aware of how many insiders (who are rarely sympathetic to Takenaka) Abe needs to be elected this September, and therefore of why temporary silence between the two is beneficial for both. At any rate, most foreign investors are likely to be positively surprised if Takenaka takes a prominent position in the new government, whoever the prime minister is.

Gaijin and fiscal reform

A surprising number of foreign investors showed strong interest in fiscal reform, in contrast to the situation a few months ago when hardly any were interested. Oddly, the state of knowledge about the progress in fiscal adjustment is low. Few investors were aware of the well-reported goal of deficit reduction of Y16.5 trillion, of the heavy reliance on spending cuts, or of the composition of such cuts proposed by the ruling Liberal Democratic Party. Thus, when the significant fiscal progress agreed by the LDP and the government in the July 7 ‘thick bone report’ is better disseminated, foreign investor confidence in fiscal reform is likely to grow.

On taxes, again the information gap is large. Most foreign investors still fear that a large consumption tax hike will come in 2008, despite the difficulties of debating, legislating and implementing such a hike by then. Most are also surprised by the modest levels of consumption tax hike that are being discussed now, i.e., 2-3 percentage points. This implies that they are also unaware that the LDP is now committed to a fiscal reform that puts 70-80% of the deficit reduction into spending cuts. Moreover, virtually no investor had heard of the LDP’s push in the party tax committee to introduce 100% expensing of business investment. Again, foreign investors are likely to be positively surprised when the vigor and composition of fiscal reform are better understood.

Gaijin, RoE and earnings

In contrast to the low level of knowledge about reform policy, foreign investors are very well aware of the debate on earnings. Indeed, most also agree with Japanese investors that earnings guidance from firms is quite conservative. Thus, foreigners are likely to react positively if, as my colleague Naoki Kamiyama expects, earnings surprises are mostly upward. That said, they are also savvy enough to know that upward revisions of earnings guidance are only likely in October-November, with the announcement of results for the second fiscal quarter of the year. Thus, no rush of foreign equity buying is likely in anticipation of upward earnings revisions. However, such revisions are likely to attract funds once announced.

Gaijin and other matters

A few other matters find foreign investors in full agreement with Japanese investors. (1) Along with the Japanese, foreign investors see a strengthening of the yen as likely. The standard reasoning is that rate hikes by the BoJ are about to start, while rate hikes by the Federal Reserve are about to end. (2) Along with the Japanese, foreign investors worry about the strength of demand in the US and China. (3) Along with the Japanese, foreign investors see both oil prices and the recent tensions in Korea as serious threats.

Conclusion

Overall, my sense is that European investors view Japanese equities positively. They see the economy as fundamentally solid. They see earnings are likely to rise further. They remain fundamentally hopeful about reform policy. Given where sentiment among foreigners is today, upside surprises are more likely than downside ones, despite fears over monetary policy.

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Japan
Preview of This Week's MPM
Jul 11, 2006

Takehiro Sato (Tokyo)

Likely unanimous decision to end ZIRP on Friday

Unless some event risk suddenly emerges between now and Friday, we think that the BoJ will end ZIRP at its July 13-14 meeting. When Governor Fukui’s scandal first came to light, we thought the timing of the policy move would be pushed back about a month. However, since the economy’s fundamentals have been quite close to the BoJ’s expectations, judging from CPI, Tankan and machinery orders data, we think the central bank has little compelling reason to postpone the move. If it were to do so, it would invite idle speculation that it succumbed to political pressure, which in any case is a tailwind for the BoJ, as major economic officials and top ruling party officials have generally indicated their approval, with the main exceptions of top MoF officials such as Minister of Internal Affairs Heizo Takenaka, and Chief Cabinet Secretary Shinzo Abe.

If the BoJ decides to make no policy change on Friday, the second day of the meeting, which starts at 9 am, then the decision should be announced by 1 pm. If there is a policy change, then the announcement would not be until 2 pm or later because of the need to adjust views with government officials and consider the text of the announcement. Given the original intent of holding the policy meeting over two days, however, the announcement could come out as late as 3 pm, the close of the market.

Focal point 1: The official discount rate (Lombard rate) and the applicable period

We expect the policy changes to encompass an increase in the target unsecured overnight call rate from effectively 0% to 0.25%, an increase in the official discount rate (Lombard rate) from 0.10% to 0.50%, a tentative extension of the provisional measure since March 2003 establishing no limit on the number of days for rollover, and a continuation of the current level of outright purchasing operations for long-term JGBs (¥1.2 trillion per month). We predict unanimous decisions on all points. 

If there is some difference of opinion, it is likely to concern the level of the Lombard rate. We could see some market participants wanting to raise the rate to only 0.35% or 0.40% because they consider a hike from 0.10% to 0.50% too drastic. However, we think the BoJ is likely consider a limited rate increase undesirable if the financial institutions would be overly dependent on the system, which would not be good in terms of a recovery in the market mechanism.

There are some concerns that a Lombard rate of 0.50% could mean an unsecured overnight call rate closer to that level, rather than the targeted 0.25%. However, even if the market is likely to be shaken up temporarily, a rise in short-term rates from close to 0% can be expected to gradually result in a more even distribution of funds in the market, as liquidity in the money market recovers. Even if this unfortunately turns out to be the case, the above problem would be eventually resolved. 

Concerning the applicable period for Lombard lending, we think, perhaps somewhat optimistically, that the BoJ may allow unlimited rollovers for the time being. Otherwise, money market volatility immediately after an end to ZIRP could be exacerbated. Volatility is likely to be exacerbated on July 14, the day after the meeting, because it marks the start for new reserve deposits from July 15 and the initial day of the period falls on a three-day holiday weekend.

Much could depend on the level of the Lombard rate, however. If the rate is not raised that much, the applicable period for the system could be subject to limits. In any case, for the time being, there is likely to be a trade-off between the above and the level of the supplemental lending rate. Finally, if the applicable period is limited to five business days, then the spread versus the unsecured overnight call rate would likely widen to 0.5-1.0 percentage points, as a sort of penalty rate.

We think excess reserves would slowly decline to the level of required reserves after the rate hike, as we have pointed out before, due to the revitalization of the money market function.

Focal point 2: Text of the announcement, press conference

We think, perhaps somewhat optimistically, that the official statement and the governor’s press conference, which should provide important indications for future rate hikes, will have a dovish tone for a mildly hawkish market. The BoJ has been longing to end ZIRP, but if the move leads to a severe stock market correction, then it could end up all for naught. For this reason, the BoJ may be cautious and reiterate the risk factors it mentioned in its April Outlook Report. 

The major risks mentioned in that Report are trends in overseas economies and the possibility of inventory reductions. As the BoJ sees it, with upward price pressures muted worldwide, continued stability in financial conditions has been one contributing factor to sustained economic expansion, and changes to this situation could lead to undesirable changes in global fund flows and the pricing of financial assets for the global economy. The BoJ also noted that stubbornly high prices of oil and other commodities could affect the outlook for the global economy, and that it is particularly monitoring economic developments in the US and China. In this regard, we think a heightened emphasis on US economic trends, which have recently shifted somewhat, would suggest that the BoJ is prepared to raise rates more slowly than the market currently expects.

Concerning inventory reductions, the BoJ forecasts that inventories, particularly of IT goods, will start to be reduced during its forecast period for some reason, on the assumption of a slowdown in growth and despite the current low levels of inventories. This is another risk factor that needs to be watched.

Focal point 3: Pace of future rate hikes

The BoJ is likely to be noncommittal on this point in the official statement and the governor’s press conference. We take at face value the governor’s remarks from before that rate hikes are likely to be slow even if the first one comes soon. We doubt that Fukui will say more or less than that at the July 14 press conference.

The market is currently expecting the next rate hike to come, at the earliest, in October, after the next Tankan comes out, but we do not expect anything on Friday that would reinforce this view. The BoJ’s rate hike scenario could be even weaker if the Fed’s rate hike cycle winds down after the summer and clearer signs of a US economic slowdown emerge. Another key factor, as we have pointed out previously, is a revision to Japan’s CPI statistics, as we think the rise in core inflation could slow gradually toward the end of F2006.

Even so, however, fiscal policy is a tailwind for the BoJ, considering that the recent rise in tax revenues eases the tightening pressures on fiscal policy. In light of the possibility that an increase in the consumption tax will be pushed back beyond F2009, the BoJ’s ‘moratorium period’ may extend naturally. We think the time leeway that the BoJ has to get its policy rate to neutral has increased to this extent.

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China
Rate Hikes Likely on Excessive Loan Growth
Jul 11, 2006

Andy Xie (Hong Kong)

Summary and conclusions

Loan growth in China remains excessive, due largely, I believe, to local governments racing to hoard credit in anticipation of further tightening.  This may force the central government to take additional measures soon.  I expect China to increase both deposit and lending rates by 27bp shortly and by another 27bp before the year-end.

Two years of administrative measures to tighten the economy have failed.  The stated goals of administrative measures to contain excessive capacity and ‘white elephant’ projects have not been met.  The main reason is that local governments drive investment and control local banks.  Moreover, local governments have been successful in attracting foreign capital wherever local funding is insufficient.

I believe that China must address the excess liquidity situation to control the economy.  If credit hoarding by local governments is allowed to continue, the economy could run out of control for a long time.   I expect the central bank to continue to drain liquidity out of the banking system and allow interbank interest rates to rise.

Administrative measures have failed

Despite repeated efforts by some central authorities, administrative measures have failed to regulate China’s economy properly.  In 2004, when the overheating began, administrative measures were preferred to a monetary policy approach on the grounds that overheating was restricted to certain pockets, a monetary policy approach would damage the healthy parts of the economy, and administrative measures would be more efficient in targeting the overheated areas.

Two years later, these administrative measures have failed to achieve their stated goals.  Excess capacity has become a bigger problem and more prevalent.  The property market has turned into a nationwide bubble from being concentrated in a few coastal cities.  Wasteful investments have multiplied.

The failure of the administrative approach is due to two factors, in my view.  First, the central government has not been sufficiently determined.  The administrative approach works effectively when it is accompanied by a rigorous anti-corruption campaign.  The anti-corruption campaign has been tepid, however.  Moreover, the potential financial implications for vested interests are much greater in this cycle due to the size of the property market.

Second, as line ministries for industries are no longer effective while state ownership remains dominant in capital-intensive industries, local governments have assumed a dominant role in fixed investment.  Even though local governments have lost some influence over state banks, they control local banks, which are rapidly expanding their market shares.  The local banks have been borrowing funds from state banks in the interbank market to fund their expansion.

China’s political system and economic structure have changed sufficiently to make micro fine-tuning by the central government ineffective.  Such failure of the administrative approach to macro management in this cycle suggests that China must shift towards the global standard approach to macro management via fiscal and monetary policies.

Credit surge poses risks to the financial system

China’s risk management system is still developing.  Rapid credit growth raises the risk of deteriorating credit quality and the rise of non-performing loans.  In particular, a substantial proportion of loans are secured with land and property.  Land prices have skyrocketed in many cities, and hence the potential for a substantial correction appears high, threatening the collateral value of many loans.

When a banking system has immature risk management systems, quantity control over credit expansion is of paramount importance for credit quality.  Historically, rapid credit expansion in immature banking systems has led to bad debt problems without exception.  China’s NPLs peaked at 40% in the previous cycle.  Adjusting for inflation, real credit growth has been faster in the current cycle than in the previous one.  The property market is also much bigger relative to the economy.  We see both facts as warning signs that credit quality could suffer severely when the cycle turns down.

We suspect that credit hoarding is a major force in the current wave of loan growth.  Local governments may be using land to secure loans without immediate construction plans.  This would explain the decoupling of electricity demand and loan growth.  The expectation of further tightening measures provides a motive for credit hoarding, but such hoarding destabilizes macro controls and makes further tightening expectations self-fulfilling.

Excess liquidity is the root cause of macro imbalance

The root cause of China’s excessive credit expansion and the associated ills (e.g., property speculation, overcapacity, etc.) is excessive liquidity in the banking system.  Despite rapid loan growth, the loan/deposit ratio in the financial system has declined to 67% now from 77% in 2002.  Banking reform has made banks more profit-oriented and, hence, more willing to lend when they have funds.

There are many reasons for the excessive liquidity in the banking system.  First, China’s export success is clearly a major factor.  China’s exports have risen three times as fast as global trade since 2002, compared with twice as fast in the previous two decades.  China joining the WTO led to massive relocation of manufacturing to China, and this has resulted in its extraordinary export performance.

Second, speculation over renminbi appreciation has meant that local companies and households are less willing to hold dollars.  Foreign currency deposits in the financial system grew by 3.2% per annum between March 2003 and March 2006, versus 11.2% in the preceding three years.  Further, an unspecified but large amount of capital has flowed into China for the purchase of local currency assets (e.g., property, equities, bonds and bank deposits).

Third, recent reforms have strengthened government and SoE finances, shifted financial burdens to the household sector and increased uncertainties in respect of household expenditure.  Government revenue and SoE profit have been rising about twice as fast as household income.  This has led to less demand for credit from such entities, which has contributed to the excess liquidity in the banking system. 

The household sector has not increased credit demand sufficiently to offset the waning credit demand from the government and SoEs.  This is due largely to a declining share of household income in GDP, rising uncertainties over future expenditures (e.g., education, healthcare) and the lack of a robust pension system.

The government is pursuing structural reforms to remedy the situation.  Measures to increase export production costs, cut down healthcare and education costs, cap property prices and improve the pension system are already in the works.  Over time, China should be able to shift towards a more consumption-oriented economy with balanced liquidity.

Dealing with excess liquidity now

While structural reforms should work over time, I believe that their effect will not be fast enough to deal with the current situation — excess liquidity fueling excess credit expansion that may lead to bad debts.  The experience from the tightening of the past two years suggests that administrative measures do not work.  As long as there is excess liquidity in the banking system, local governments will find ways to obtain money for their investment projects.  Further, local governments have incentives to hoard credit in anticipation of further tightening.  The only effective policy is to drain away excess liquidity in the banking system, in my view. 

Recent indications suggest that the central government is prepared for such a policy shift.  The central bank has expressed its intention to issue savings bonds to decrease deposit growth in the banking system.  It is issuing bills to banks to soak up some excess liquidity.  Interbank rates have been rising due to tightening liquidity.

The excessive loan growth in June indicates that the liquidity environment is still too loose.  I believe that China must drain much more out of the banking system to normalize monetary conditions.  While currency appreciation expectations threaten its effectiveness, the rapidly rising US interest rate has created room for China to raise interest rates.  I believe that China could raise interest rates by one percentage point at the current level of renminbi appreciation expectation.  If China introduced a little more currency flexibility, interest rates could rise by much more.

I expect China to raise its deposit and lending rates by 27bp shortly and by another 27bp before the year-end.  In 2007, I think we could see a further 100-200bp of rate raises.

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Mexico
The Slippery (Oil) Slope
Jul 11, 2006

Luis Arcentales (New York) and Daniel Volberg (New York)

With oil prices reaching new highs amid rising geopolitical risks, Mexican fiscal coffers are enjoying an unprecedented bout of abundance.  Mexico’s oil basket has averaged $53.5 per barrel so far in 2006, nearly 50% above the budget estimate of $36.5 per barrel.  In the first five months of this year, oil revenues grew 17.3% in real terms, accounting for 35.1% of total public sector income.  Mexico’s oil abundance, in turn, has allowed the government to spend generously, with total outlays up 12.5% in real terms during January-May. 

When the next administration takes office in December, it will likely find ample resources at its disposal.  Indeed, we estimate that even if crude collapses to around $25 per barrel (WTI) in the second half of the year, Mexico would still manage to meet its budget target.  We suspect that this abundance of oil-related revenues has robbed policy makers of the urgency to do much to wean Mexico’s public sector off of its oil dependence (see Mexico: No Crisis, No Relief, Global Economic Forum, July 4, 2006).  As we await the decision of Mexico’s Electoral Tribunal on who Mexico’s next president will be, we are not too hopeful that much progress will take place on the reform agenda. 

But the source of more than a third of fiscal revenues, namely Mexico’s oil complex, is not in the good shape that soaring oil revenues would suggest.  The most recent figures show proved reserves at just under 16.5 billion barrels as of the end of 2005, down from 17.6 billion in the previous year and just over 20 billion in 2003.  Moreover, for years there has been talk of the imminent decline in Mexico’s oil output due to the limited investment resources available to state-owned monopoly Petróleos Mexicanos (Pemex).  But amid the talk of potentially massive deep-water discoveries, it seems that the future has arrived: Mexico’s oil output is beginning to trend lower. 

The drop in output can be traced to Mexico’s dominant oil field, Cantarell, which accounted for over 60% of total crude production in the past three years.  The peak in Cantarell’s production, which took place in 2004 at 2.1 million barrels per day, and its eventual decline are not new news.  What seems somewhat worrisome to us, however, is Pemex’s inability to diversify its portfolio beyond the aging Cantarell complex.  Whether we look at the past five or ten years, the lion’s share of Mexico’s incremental output has come from Cantarell.  And last year, production from new fields was able to offset only about half of Cantarell’s decline, leaving total output off 1.5% at a time of seemingly insatiable global demand and rising crude prices. 

To be fair, the magnitude of the deteriorating output figures has been very modest so far.  Moreover, the brutal 2005 hurricane season added some noise to the data.  Still, output is again off during the first five months of this year, albeit marginally, and is undershooting Pemex’s 3.40 billion barrel per day target by nearly 2%. 

And what we are seeing today is likely to be only the beginning of Pemex’s uphill battle to keep output at least flat in coming years.  Based on Pemex’s own estimates, the decline of Cantarell will accelerate and is projected to stop producing some 500,000 barrels per day by 2008 from today’s levels.  Not only has output growth stalled, but it is also becoming increasingly costly to get oil out of the ground.  We will defer the technical aspects of advanced recovery technologies, three-dimensional seismic processing and deep-water drilling to our Energy Team, but their research makes clear that upstream costs have risen significantly in recent years; moreover, finding, development and operating costs are expected to trend even higher from here (see Douglas Terronson’s Raising Crude Oil, R&M Forecast; Raising Estimates, May 24, 2006). 

Rising upstream costs are a global trend that is particularly important for Pemex’s future.  Just days before Mexico celebrated the anniversary of Oil Expropriation Day on March 18, authorities announced the discovery of a possible giant new field in the deep waters of the Gulf of Mexico.  Three months later in mid-June, Pemex recorded some early success in tests indicating the deep-water potential, which could provide a major boost to Mexico’s dwindling proved crude reserves.  But the production timing is not on Pemex’s side: with the low-hanging fruit from Cantarell becoming increasingly scarce, the operationally difficult and costly deep-water hydrocarbon production stands as Pemex’s next (and possibly only) frontier.  Given Pemex’s lack of deep-water experience and limited financial resources, Mexico is unlikely to see production from these new reservoirs anytime soon.

If Mexico fails to make up for the expected lost output from its prolific Cantarell field, then the public sector will face an inevitable round of belt tightening.  Last week we presented some preliminary findings from our work on an oil-adjusted fiscal balance, which suggested that if oil prices fell from their current levels to the average of the last decade (through December 2005), Mexico’s spending would have to be cut by some 5% of GDP (see Mexico: No Crisis, No Relief, Global Economic Forum, July 4, 2006).  Borrowing from that same work, if we assume our Economic team’s oil outlook and constant oil production (see Eric Chaney’s and Richard Berner’s Oil Alert: No Relief on Supply, April 21, 2006), Mexico’s fiscal house would remain in surplus territory until late 2007, at which time some adjustment would be necessary to prevent any red ink.  If we assume, by contrast, that the output lost from Cantarell in 2006 and 2007 is not offset by other fields, Mexico’s public sector could show a deficit as early the first months of 2007.  By the end of 2007, the fiscal balance deterioration would be to the tune of 0.8% of GDP relative to the constant oil output scenario.

Though time seems decidedly against Pemex, some positive, albeit modest, steps in the right direction have taken place.  Capital expenditures have averaged more than $10 billion a year since 2003 — more than triple Pemex’s investment budget in the 1990s — with the vast majority going to exploration and production.  Moreover, Pemex’s new fiscal regime should allow it, in theory, to keep a little more resources to fund further investment and improve its financial health.  However, given the public sector’s oil addiction and the constitutional impediments to private investment in the energy sector, Pemex will continue to face what appears to be an unsustainably heavy tax burden even under the new fiscal regime.

Bottom line

Focusing on whether Mexico can manage to keep up oil output or not risks missing the forest for the trees.  The inability to boost oil output and proved reserves is no more than the result of the public sector’s addiction to oil, reflected in the oil sector’s role as the provider of 32% of fiscal revenues during the past two decades.   Instead, the real challenge for Mexico’s policy makers is to avoid the complacency caused by the ongoing abundance of inflows, which we suspect has reduced the political will to move forward on the reform front. 

An eventual decline in oil output, however, could act as the wake-up call that the political class needs to begin the difficult process of reversing the public sector’s heavy dependence on volatile oil revenues.  Given Mexico’s experience on the oil front, however, we remain skeptical.

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Middle East and North Africa
Slum Farms
Jul 11, 2006

Serhan Cevik (London)

Urban poverty is not just a result of failed economic policies but also unfair trading rules. The world is urbanising at an unparalleled pace. After increasing by 40% in the last 20 years to 3.2 billion people out of a total of 6.5 billion, the global urban population will reach 5 billion (or 60% of the total population) by 2030. And developing countries will account for 95% of sprawling urban settlements and become home to 80% of the world’s urban populace. It may sound exciting, but we fear the fact that 45% of the urban population in all developing nations and 80% in the least developed countries already live in slums. With rising unemployment, especially in rural areas, the world’s slum population will grow by about 27 million people a year and bring the number of people living in poverty to 2 billion over the next three decades (see The Slum Challenge, June 27, 2006). This is a complicated problem, and putting all the blame for over-urbanisation and spiralling poverty on failed economic policies in developing countries would be misleading. In our view, protectionist and unfair trading rules of the developed world are also responsible for the global poverty challenge.

The rural poor, trying to get out of poverty by moving to cities, become the urban poor. Poverty has become an urban phenomenon, but the underlying problem is partly a consequence of the lack of rural development. Indeed, rural poverty still accounts for 60% of poverty in the world, contributing mass migration to urban areas. In other words, the rural poor, trying to get out of poverty by moving to the cities, become the urban poor. Turkey’s experience is a case in point. While urban poverty declined from 22.3% of the population in 2003 to 16.6% in 2004, rural poverty worsened from 34.5% to 40% (see Urban Recovery, Rural Poverty, February 16, 2006). And sooner or later, this will become a nationwide problem for two key reasons: the share of agriculture in GDP and employment has been on declining trend, and structural rigidities have limited the labour absorption capacity of industry and services. As a result, with rising rural unemployment, impoverished farmers migrate in search of better opportunities but usually end up becoming urban poor living in slums. Although distorted policies and structural weaknesses have certainly been major contributors to poverty, overlooking the role of exogenous factors would lead to an unfair assessment and futile policy recommendations.

Subsidised agricultural products in rich countries undercut farmers in developing countries. In our view, massive farm subsidies in the world’s rich nations ruin rural incomes in developing countries and push people into urban slums. For example, OECD governments provided $279.8 billion in subsidies to the agriculture sector last year, accounting for 29% of all farm receipts. Even if we exclude ‘emerging’ members like Korea, Mexico and Turkey, the ‘subsidy superpowers’ of the world still increased agricultural support spending from $230 billion a year in the 1990s to $238.8 billion in 2005. To put this in context, the EU, for instance, effectively provides $2.50 a day in subsidies for every cow in Europe by keeping milk prices artificially high — against the less than $2 a day half of the world’s population lives on. Likewise, thanks to the US government’s generous subsidy scheme, inefficient cotton producers of the Mississippi Delta dump surplus cotton on world markets at prices far below the cost of production. Of course, such a trade-distorting subsidy gives no chance to West African farmers producing at one-fifth the cost of US cotton. And it is not just that the average agricultural tariff is 60% against 5% for manufactured goods, but also developed countries practise a complex system of tariff escalation that traps poor nations in low value-added segments of the global economy.

The Doha round of global trade negotiations is key to a more balanced global economy. Even though open markets have become the world’s engine of growth and lifted hundreds of millions out of poverty, the global economy needs further liberalisation of trading regimes to alleviate persistent poverty in developing countries, in our view. Unfortunately, the Doha round of trade talks, launched in 2001 with its promising ‘Development Agenda’, is on the verge of collapse. Even if there is a compromise, it would generate, according to the World Bank’s latest projections, economic gains of only $96 billion, with $80 billion of the benefit going to the developed world. That would be a disappointing outcome, considering the possibility of significant revenue losses in low-income countries. Not surprisingly, the main stumbling block is agricultural protectionism of the developed world, and both the EU and the US are still refusing to make deep subsidy cuts and to give market access. While preaching the advantages of free trade to the developing world, rich countries keep building trade barriers. This is of course a self-defeating protection of narrow commercial interests and will make the situation even worse in years to come. The elimination of farm subsidies in rich countries, combined with greater market access for poor countries, would not only help to reduce poverty, but also create a more balanced global economy. Needless to say, trade liberalisation alone is no panacea, and developing countries must achieve economic stability and improve institutional capabilities to maximise trade gains.

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