United States
What's the Message in Retail Employment?
Jul 21, 2006

Richard Berner (Oregon) and Ted Wieseman (New York)

Retail employment has declined over the past three months, triggering concerns that it signals economic weakness — or even a recession.  But a broad array of other labor-market indicators tells a different story; indeed, some are signaling boom times in several industries.  Moreover, closer inspection of the retail data suggests that industry consolidation as well as cyclical weakness likely color the retail job picture, so it is hardly the last word on the state of the economy.

There’s no mistaking either the recent decline in retail payrolls or the tepid nature of overall job growth.  Retail payrolls slid by an average 29,000 in each of the past three months, mainly at general merchandise stores, and overall payrolls advanced only by an average 108,000.  Some of the recent retail layoffs may well reflect the sluggish pace of consumer spending. 

However, retail mergers and a bankruptcy and the one-time layoffs associated with them may also have contributed to the less-than-seasonal pickup in spring hiring.  Following its merger with the May Company, Federated Department Stores announced that it would close 82 stores and lay off 6,800 workers.  While many got their pink slips by the end of March, the actual separations may only have occurred in the spring, affecting the overall jobs data.  The Sears-Kmart merger has not yet produced similar consolidation, but some layoffs have occurred.  Following its bankruptcy filing in February 2005, Winn-Dixie announced it would close 326 stores and lay off 22,000 workers; some of these losses may finally be showing up in the spring data.  While these developments hardly evince strength, they are likely one-time events.

To be sure, a slower pace of retail store growth is depressing retail hiring, especially as some of the “big box” retailers focus on boosting revenues per square foot and returns.  A slower pace of retail hiring may also speak to productivity enhancement, especially at the checkout counter or at the gas pump.  The upshot is that while the spring decline in retail hiring likely signals a slower pace of consumer spending, blind cyclical comparisons with past are simply inappropriate.

In contrast, and despite glaring weakness in residential construction activity, a host of labor-market indicators generally paints a more robust picture than do total or retail payrolls.  Self-employed nonfarm employment rose by 245,000 or 2.6% over the past year.  Multiple-job holders (moonlighters) fell to an all-time low as a share of total employment in June, suggesting that workers are increasingly finding satisfactory full-time employment.  The private workweek lately has edged higher, especially in manufacturing, and adjusted for changes in the industry mix of jobs, the overall workweek has steadily crept higher over the past two years.  Initial and continuing claims for unemployment insurance, adjusted for government shutdowns in Puerto Rico and New Jersey and for auto plant maintenance, evince no sign of weakness.  Job opening rates were steady in June at five-year highs of 2.9%, although private opening rates slipped as companies filled open positions.  Manpower’s canvass of employers indicates no change in hiring plans.  The BLS’s tally of mass layoffs hit a ten-year low in the second quarter, and the Challenger survey’s count of planned layoffs is at a six-year low.  And the percentage of respondents saying jobs are “hard to get” in the Conference Board’s consumer confidence survey fell close to a five-year low in June. 

There are some signs of softening, however.  Diffusion indexes of payrolls did show some slippage in June, but most indicate continued expansion (except the manufacturing ISM).  Small-business hiring plans slipped in June, according to NFIB surveys.  It’s worth noting that the top concern among small businesses is the lack of skilled workers to fill open positions.  In that context, the acceleration in hourly pay, especially for several categories of highly-skilled, private service-producing jobs, hints that the mismatch between skills needed and those available could be both driving up pay and limiting hiring.

As a cyclical indicator, changes in retail payrolls are hardly the last word.  Over the past three months, the cumulative drop in such payrolls was 0.6%.  Historically, however, drops of this magnitude have tended to coincide either with an economy already in recession or having just come out of one (see the table below for the history); they have not been a leading indicator.  Since the economy clearly was neither in recession nor emerging from one in the April-June period, in our view the informative value of the recent weakness is questionable.

Historical Three-Month Declines in Retail Payrolls of 0.5% or More

Retail Payroll Decline	Economic Backdrop
March 2003	Just ahead of big acceleration in growth
September 2002	Slow growth 2002Q4-2003Q1, but no recession
December 2001 to February 2002	Recession ended in November 2001
April to June 2001	Recession began in March 2001
January to June 1991	Recession ended March 1991
October 1990	Recession began July 1990
December 1989	Sluggish growth in 1989Q4 but strong rebound in 1990Q1
November 1981 to January 1982	During lengthy 1981-82 recession
May 1980 to June 1980	During the 1980 recession
July 1979	Recession started in January 1980
December 1974 to February 1975	Near the end of long 1973-75 recession
April 1961 and June 1961	Recession ended February 1961
December 1960 to February 1961	Recession ended February 1961
July 1960	Recession began April 1960
February 1958 to June 1958	Recession ended April 1958
June 1956 and September 1956	A year before start of recession in August 1957
July 1954	Recession ended May 1954
January 1954 and March 1954	During 1953-54 recession

Source: Morgan Stanley Research

 

The combination of slower second quarter growth and Fed Chairman Ben Bernanke’s dovish Congressional testimony has convinced market participants that the economy will slow further, that inflation will cool, that the Fed is nearly done, and may well ease during 2007.  In our view, the jury is out on all four counts.

From the markets’ standpoint, having priced out inflation and interest-rate risks, we think those now deserve attention again.  And relative to market expectations, the risk that growth will turn out stronger than expected is now much more important.  Indeed, the Fed’s apparent increased tolerance for somewhat higher inflation has increased both sets of risks.

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Currencies
The Global Business Cycle and Currencies
Jul 21, 2006

Stephen Jen (London) and Luca Bindelli (London)

Global growth, asset prices and currencies

There is now a debate emerging on whether the world will fall into a recession in 2007.  While we don’t see this as a likely scenario, we cannot rule it out as a possibility over the next 18 months.  How would various currencies be affected if global growth decelerated sharply and global asset prices fell?  This note revisits a simple quantitative framework that helps us think about how various currencies might perform in different scenarios of global growth. 

Will the world decelerate sharply

With a softening US housing market, global monetary normalization and high oil prices, global growth will likely decelerate in 2007.  Some commentators argue that we will fall into an outright global recession by 2007.  At the same time, with the global liquidity conditions continuing to be tightened, global asset prices could experience further downward pressures.  This bearish outlook for both the global economy and global asset prices is not our central case yet.  However, we need to remind ourselves how various currencies might perform in different growth-asset price scenarios. 

Our framework

We first wrote about this simple framework back in 2001.   The motivation of this exercise was to construct four distinct scenarios, with different combinations of the economic and the equity cycles, and ask how different currencies have tended to perform against the dollar in the past.

We should state at the outset that this is a highly stylized model, one that looks at the most basic relationship between global growth and global asset prices, setting aside issues such as valuation, global liquidity, risk aversion, uncertainty and other considerations.  We suppress these factors to bring into sharper relief the two most important variables we would like to track throughout a global business cycle.  Further, this model does not take into consideration non-linearities between these variables and currencies (for example, our ‘Dollar Smile’ framework).

What history tells us

We examined the historical relationships (correlation based on data from 1995-2005) between the return on selected currencies against the dollar and real growth as well as equity market performance.  We then group the currencies in four different ‘seasons’. Our findings are summarized as follows: 

‘Summer’ currencies.  These are the so-called ‘high-beta’ currencies.  They are the currencies of the countries that are more leveraged to the global economy and the global equity markets.  When the world ‘does really well’, both in terms of real growth and equity market performance, these currencies also tend to perform well.  The three large Asian currencies — the JPY, the KRW and the TWD — are in this camp, as, unsurprisingly, are the commodity currencies — the AUD and the CAD.  These currencies could also be ‘high-beta’ beneficiaries of risk capital, i.e., in ‘good times’, global investors may tend to take more risk by buying into these markets, thereby ‘turbo-charging’ the already solid real economic fundamentals supporting these currencies.   

‘Winter’ currencies.  Historically speaking, CHF and EUR tended to outperform the USD in bad times.  When the world is in a recession and global financial markets are in a slump, the best currency to hold is the CHF.  This makes intuitive sense, as the CHF is commonly seen as a solid safe-haven currency.   The EUR is a good currency to hold if we’re in a bear market for global equities, regardless of whether the global economy is in a recession.   

‘Spring’ currencies.  In our sample, the GBP and the THB are ‘spring’ currencies.  In other words, they tend to do well when the global equity markets are buoyant, but when the global economy is not too strong.  This may suggest that capital flows may be more important for these currencies than net exports or global demand.  For the UK, one could easily imagine why financial flows dominate.  For Thailand, it could be that foreign investors’ risk appetite is more important than how well Thai exports perform.   

‘Fall’ currencies.  No currency in our sample is considered a ‘fall’ currency.  What this also implies is the opposite — the dollar tends to perform well against most currencies when the equity market performance is relatively poor, but the economy performs well.

We have some other thoughts: 

1.    The fate of the AXJ currencies.   We cannot make categorical statements about all the Asian currencies, but if the global environment, measured by global growth and the buoyancy of the global equity markets, has already peaked, which is not yet our central case assumption for 2H06, it might be a struggle for many of the Asian currencies to rally further against the dollar.  Clearly, there are also important caveats we noted above that need to be kept in mind, but from the perspective of the global business cycle, some of these high-beta currencies may have had their best moments already.  In other words, if the global equity markets and risk-taking get a ‘second wind’, with the global economy sustaining its strength in 2H, then these ‘summer’ currencies could still rally further.  Otherwise, we will need to modify our bullish AXJC (Asia ex-Japan ex-China) call, depending on global growth and global equities.   

2.    CAD/CHF, EUR/CAD good hedges against global recessions.  In this framework, CAD/CHF and AUD/CHF seem to be excellent hedges against bad times.     Similarly, we have already argued in the recent past about long-EUR/CAD as a recession hedge.  

3.    Turns in the business cycle powered by global liquidity.  Our framework is agnostic about the cause of the turn in the global business cycle or the global equity markets.  However, in the current situation, the tightening global liquidity is indeed one of the key factors weighing on the global economy and equity markets.  Given the importance of the nominal cash yield differentials for currencies in general, and for the dollar in particular, the dollar should benefit from continued tightening in the global liquidity and risk reduction.

Bottom line

The emerging debate on the fate of the global economy and the equity markets has great relevance for currencies.  We believe that different currencies perform differently in various scenarios.  As the global economy and equity markets evolve through different scenarios in the coming 18 months, we see good opportunities for cyclical currency trades.   

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Currencies
US Yield Premium to Delay Cyclical Dollar Correction
Jul 21, 2006

Stephen Jen (London) and Charles St-Arnaud (London)

The Fed’s inflation-fighting stance is USD-positive

While since last November we have been expecting the dollar to experience a cyclical correction in 2006 as the economy slows, the biggest development this year that was not a part of our central case assumption eight months ago has been the acute market reaction to inflation in the US.  As the Fed continues to fine-tune its stance through these inflection points for US growth and inflation, the dollar’s prospective cyclical correction is likely to be postponed, relative to our previous expectations.  As long as US inflation remains on an upward trend, and the Fed maintains a vigilant stance, we believe that the dollar is likely to remain well supported against virtually all currencies. 

In this note, we focus on one particular factor:  the yawning US nominal yield premium.  This will (1) raise the cost of outright shorting the dollar by the structural dollar bears, and (2) raise the opportunity cost for the USD-based investors of not hedging their global portfolios back into dollars.  Further, we continue to believe that US real money investors are ‘out-of-balance’ with an overweight position in non-dollar assets.  A further tightening in global liquidity and an upward adjustment in perceived risk and uncertainty will likely trigger further repatriation flows back into the US, in our view. 

While the precise mechanisms through which the dollar may be supported by the US nominal yield premium may be complex and unusual, in the ‘reduced form’ there will be a powerful positive relationship between the nominal yield differentials and the dollar, in our view. 

A shift from a yield-driven currency world to one that is growth-driven will likely materialize when the US starts to show genuine signs of a deceleration.  This is when the dollar is likely to weaken.  In terms of timing, we suspect this may be a 4Q story, rather than a 2H story as we had expected earlier.

Our view on the dollar

We have argued for more than two years now that the dollar is structurally sound, and the market’s fixation on using the dollar as the key tool of C/A adjustment is a fundamentally flawed notion, reflecting a lack of understanding of the effects of globalization.  To us, outsized global imbalances are a logical consequence of globalization of the goods and the assets markets.  We won’t repeat the details of our thesis on the dollar, but only stress that our call this year for the dollar to correct has been based purely on cyclical considerations.  We are not sympathetic to the popular notion that the dollar ‘must’ correct sharply or crash, and that 2005 was a bear market rally in a secular dollar decline.  This is why the changing cyclical outlook of the US and the global economies has such a major impact on the trajectory of the dollar. 

In addition to considerations of valuation and the dollar commanding its safe haven status against heightened geopolitical risks,  we see nominal yield differentials as critical drivers of currencies, particularly the dollar. 

We make the following points.

• Point 1.  It is increasingly expensive for the structural dollar bears to maintain outright short-dollar positions.  This is an obvious but important point.  Our sense is that the majority of investors are structurally bearish on the dollar, and subscribe to the ‘the-unsustainable-C/A deficit-will-force-a-significant-dollar-decline-eventually’ view.  Many of these investors have run opportunistic short-dollar positions in recent years.  With the fed funds rate (FFR) approaching the 5.50-6.00% zone, the cost of running short-dollar positions is close to prohibitive.  Therefore, increasingly, the market spot exchange rate will likely reflect less of the deeply ingrained dollar-bearishness than before.  USD-unfriendly TIC or trade or employment data will have much more muted effects on spot USD exchange rates as the FFR rises. 

• Point 2.  USD-based investors face rising opportunity costs of not hedging their non-USD holdings back into dollars.   Nominal and short-term interest rates will continue to be important for currencies.  We have stressed that it is highly unusual for long-term real rates to become so unimportant for currencies.  The hypothesis we have is that, first, cross-border asset holdings have exploded in recent years, making hedging a much more important factor.  Since most hedges are run on a 0-3M basis, short-term rates have become even more important than long-term rates.  Second, the fact that cross-border asset holdings have risen so rapidly suggests that nominal, rather than real, returns have become more important.  If our hypothesis is correct and the key factor is the secular change in the international investment pattern, then short-term nominal interest rates will remain powerful drivers of exchange rates for some time.

During the last 20 years, relative to the goods market.  Total real money under management in the US has risen from 55% of GDP in 1985 (the year in which we saw the Plaza Accord) to 143% now.  During this period, the US real money accounts’ international investments as a share of total funds under management have also risen.  This has enhanced the importance of the nominal cash yield differentials. 

Using the market-cap-weighted G7 3M LIBOR interest rates, we proxy the interest rate cost for USD-based global equity investors of not hedging their non-US investments back into dollars.  During September 2001 and November 2004, investors were paid not to hedge back into dollars.  Incidentally, this was also a period during which the dollar came under particularly severe speculative pressure.  However, since November 2004, this measure of the USD interest rate premium has risen steadily, even though other central banks have also begun to raise rates.  This measure has reached 2.7% recently, on par with that which prevailed in 2000, when the dollar was strong. 

• Point 3.  Tightening global liquidity is good for the dollar.  Even if the ECB tightens in step and in synch with the Fed, we believe that the dollar should benefit.  This is because most of the hedge funds are dollar-based, and almost all the emerging market investors who invest in overseas markets are also dollar-based.  When global liquidity tightens, risk in general is usually curtailed, as money is ‘brought home.’  ‘Home’, to most of these investors, is dollar cash.  At 5.25% and rising, the return on the dollar no longer justifies it being a funding currency, but a genuine high-yield risk-free investment. 

As we have also argued in the past, we believe that the US real money investors have been the true dollar diversifiers, and not the foreign central banks.  The problem with their portfolio holdings is that there are no clear definitions of the benchmark holdings these US real money investors should have on risky assets/foreign assets/emerging market assets.  When push comes to shove, broad-based risk-reduction could really trigger a stampede to repatriate; the dollar would be supported in that event. 

Bottom line

As US inflation trends higher and global interest rates continue to rise, the dollar will be supported.  The nominal short-term cash premium of the USD has reached 2.7%, and is still rising.  We have long warned about the impact of the upside surprise in US inflation on the dollar and how it could alter our currency forecasts.  We now believe that the cyclical dollar correction we had expected to take place in 2H this year may be further postponed to 4Q this year. 

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Nordics
Cross-Country Differences in the Nordics
Jul 21, 2006

Thomas Gade (London) and Elga Bartsch (London)

Recently the Nordic economies have outpaced the euro area economy in terms of real GDP growth. At the same time, consumer price inflation in the region stayed below that of the euro-area block. Although we expect a general economic slowdown in 2007, the outperformance of the Nordics versus the euro area is likely to continue, we think. The strong overall performance of the region masks sizeable country differences in GDP growth ranging from fast-expanding Sweden and Finland to a steadily growing Norway to already slowing Denmark.  In the following article, we provide a brief overview of the macroeconomic and political environment in each of the four Nordic countries and our views.

Sweden — High GDP growth and low interest rates

The economy — GDP is expected to expand by 3.7% in 2006 before slowing slightly to below trend in 2007. Sweden is one of the strongest-performing economies in Europe this year. The labour market is improving. Inflation is low but rising. The Riksbank will likely raise interest rates further.

Politics — Sweden is currently governed by a centre-left coalition. Parliamentary elections will be held on September 17 this year. Polls point to a tight race, which could potentially result in a change in government to a centre-right coalition.  A change could bring lower wealth and income taxes.

Financial markets — The Riksbank raised the repo rate gradually to 2.25%. Like other European bond markets, Swedish 10Y government bond yields have risen to 4.3%. Spreads relative to German Bunds are negative but narrowing. Skr is likely to strengthen further, but remains below fair value.

For the third consecutive year, the Swedish economy is expected to expand at an above-trend rate of 3.7% this year. This makes Sweden one of the strongest-performing economies in Europe in recent years. The labour market has improved during last 12 months with a rising number of jobs and vacancies. Meanwhile, the labour force is also expanding. The unemployment rate is therefore likely to decline at a slower pace. Slack remains present in the labour market and inflation pressures from this side remain limited. In the industry, strong domestic and foreign demand is reflected in elevated business sentiment. Operating rates are high but broadly constant. High productivity growth contains unit labour cost growth and supports the competitive position of the Swedish industry. A continued strengthening of the currency will likely dampen the competitive position of Swedish companies going forward. At 9.2 against the euro, Skr remains below our fair-value estimate of 8.80. Public finances remain in surplus despite an expansionary fiscal policy stance this year. Consumer price inflation is below the Riksbank’s target of 2%, but rising. Subdued by a base effect from energy prices, inflation is likely to be around the 2% inflation target on a two-year horizon, we think. Monetary policy remains accommodative, and the risks of an inflationary overshoot remain on the upside. The Riksbank will likely continue its gradual policy normalisation, in the coming quarters and we expect the refi rate to be 3.50% by mid-2007. Monetary as well as fiscal tightening as well as sensitivity to the projected euro area slowdown will likely slow the Swedish economy next year, we think. Parliamentary elections will be held on September 17. Most recent polls still show a tight race, although the probability of a government change has decreased during recent months. Employment and property taxes are election issues.

Norway — Steady GDP growth but rising inflation risks

The economy — Slightly below trend, we expect the total economy to expand around 2.5% this year and next. The labour market is rapidly improving. Operating rates are high and rising. Slack is declining. Norges Bank will likely continue policy normalization. Credit expansion remains high.

Politics — Elections in September 2005 saw a change in government from a centre-right government to a centre-left coalition. The new government’s policy initiatives focus on employment, pensions, education and healthcare. At present, no corporate tax reform is planned.

Financial markets — Norges Bank’s rate hikes have pushed short-term interest rates up to 3.0%, while 10Y government bond yields are trading at 4.4% with a positive noticeable spread over Bunds. Equity markets corrected since May, but are in positive territory year to date. The Nkr appears overvalued against the euro but continues to range-trade.

Slightly below trend, the Norwegian economy is expected to grow at 2.6% this year, followed by 2.5% next year. But stripping out oil-related activities, mainland GDP is expected to grow above trend at 3.3% this year. Growth is expected to be driven by fixed investments and private household consumption. The labour market is improving rapidly. Despite an increase in the labour force, unemployment continues to fall. In the industry, operating rates of 83% are now above their long-term average and still rising. Although unit labour cost growth is still contained, the continued appreciation of Nkr is hampering international competitiveness in industry. Fiscal policy is expansionary. However, the non-oil structural public deficit is in overshoot of fiscal rules and a consolidation is widely expected. Consumer price inflation is rising, but remains below the Norges Bank’s target of 2.5%. Still, Norges Bank is like to keep normalizing monetary policy in “small and less frequent steps”. The total tightening to date amounts to 100bp, bringing the policy rate to 2.75%. Monetary policy remains accommodative and markets expect another 50bp of tightening this year. 10Y government bond yields trade at 4.4% and spreads relative to Bunds remain positive in a range of 20-30bp. Nkr continues to range trade against theeuro between 7.8-8.0 €/Nkr. Our fair value estimate of 8.2 suggests that Nkr is slightly overvalued against the euro. On the political front, the September 2005 elections brought in a new centre-left coalition. Pension reform, employment, healthcare and education are focus points for the new government.

Denmark — Growth slowing to trend and below

The economy — The Danish economy is expected to slow to the trend rate of 2.5% this year and further to 1.7% next year. The labour market is showing signs of shortages. So far, inflation has remained contained. With the Dkr pegged to the euro, Danish monetary policy shadows the ECB’s.

Politics — The current centre-right coalition government was elected for a second term in February 2005. Implementing further welfare reforms have been key policy issues. The next key policy issue will likely be to lower personal income taxes. There is no corporate tax reform on the agenda.

Financial markets — The ECB’s monetary policy normalisation has also pushed Danish short rates up to 3.1% and 10Y government bond yields to 4.0%. Spreads relative to Bunds are now close to zero. The Danish equity market corrected in May and June and is now in negative territory year-to-date

Contrary to the pick-up in growth expected in the euro area, we forecast the Danish economy to slow back to trend this year. Next year, the Danish economy is expected to slow down further to 1.7%. Thus far, household consumption has been the main driver of economic growth, but fixed investments have also risen sharply during recent years. Low financing costs, surging house prices and strong income dynamics have been the main drivers of domestic demand. The labour market has improved markedly recently and is now showing signs of labour shortage, especially in the construction industry. Operating rates are above their long-term average and have risen continuously during the last two years. While a tighter labour market has implied rising wage pressure, high productivity growth has limited unit labour cost dynamics and, for now, contained inflationary pressures along the production chain. As the Dkr is pegged to the euro, Danish monetary policy shadows the decisions of the ECB. Monetary policy thus remains very expansionary in Denmark. The ECB’s gradual normalisation of interest rates has pushed up short rates to 3.1% and the ten-year government bond yield to 4.0%. We expect the ECB to continue normalising rates to 3.50% by year-end and then pause from there. Politically, the centre-right coalition government was elected for a second term in February 2005. Recently, welfare reforms related to the retirement age and pension system have been implemented. Lowering personal income taxes is likely to be the next big policy issue. No corporate tax reform is currently on the agenda.

Finland— Strong growth but contained inflation

The economy — At 3.8%, on our forecasts, Finland will likely be one of the fastest-growing economies in the euro area.  The recovery is helped by a favourable base effect from last year’s strike, which shut the country’s paper industry down for seven weeks. Next year, we expect Finnish GDP growth to return to a growth rate that is slightly above the long-term trend of 2.3%.

Politics — Ahead of the next general election in March 2007, it seems that Finland could see a change in government from a left-of-centre coalition between Centre Party, the Social Democratic Party (SDP) and the smaller Swedish People’s Party to a conservative-led coalition.

Financial markets — Being the only Nordic country that joined the euro, Finland has seen three rate hikes from the ECB since December 2005. This brought policy rates up to 2.75%.  We expect three more rate hikes before year-end and unchanged interest rates thereafter. Along with German Bunds, Finnish bond yields have risen recently and currently trade at a small spread over Germany.

With average GDP growth of slightly below 4% this year and 3% next year, the Finnish economy is clearly expanding at an above-trend growth rate, helped by expansionary monetary and fiscal policy fuelling domestic demand.  Job growth has started to surge and wage pressures will likely increase when the current multi-year wage agreement expires in September 2007.  Strong productivity gains should limit the increase in unit labour costs though. We therefore expect Finnish consumer price inflation to keep trailing the euro area average of 2.25% by a considerable margin.  As a result, the competitiveness of Finnish companies versus their euro area counterparts should improve further in coming quarters.  With a revival of demand elsewhere, we expect this to translate into stronger export demand too.  Despite a three-year tax cut plan, which will reduce taxes by €7 billion, the budget balance remains firmly in surplus. However, most of the surplus stems from the country’s pension funds. Yet, unemployment remains relatively high in Finland and further welfare reforms seem warranted. On the political front, the next elections will be in March 2007 at the latest. Internal tensions between the current centre-left government parties raise the probability of a shift to a centre-right government in the coming year.

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Turkey
Treatments for Oil Addiction
Jul 21, 2006

Serhan Cevik (from Istanbul)

The energy shock is a late wake-up call to deal with the world’s oil addiction. The sharp rise in oil prices — from $10 a barrel in 1998 to $78 of late — is a challenge as well as an incentive to deal with the world’s fossil-fuel addiction, in our view. The global oil demand has expanded at an unprecedented rate from 70 million barrels a day in 1995 to 85 million barrels today, outpacing the increase in production capacity and thereby leading to a sustained rise in energy prices. The International Energy Agency expects the global demand for crude oil and natural gas to remain high, mainly because of the insatiable appetite of fast-growing, energy-inefficient countries. Even though this alone is enough to keep energy quotes at a higher plateau and to create a drag on oil-importing economies, the emergence of new geopolitical supply risks is changing the nature of the energy shock and setting the stage for fear-driven pricing behaviour in the commodity markets. Indeed, the Middle East crisis has already pushed the price of oil to a new peak and awakened stagflation fears in the global economy. We still think that the risk of a full-blown regional war is low, but the tight balance of global oil demand and supply will keep prices extremely sensitive to geopolitical developments.

Fossil-fuel dependency makes Turkey more vulnerable to geopolitical risks. Since domestic oil production covers barely 8% of demand and electricity generation is overly dependent on fossil fuels, Turkey imports 72% of its total energy demand. As a result, the country’s fossil-fuel imports already increased from 2.7% of GDP in 1999 to 6.2% last year, and with the latest spike in oil prices, this figure likely to exceed 7% this year. Of course, this growing dependence on energy imports widens the trade deficit, becomes a serious drag on the economy, and creates inflationary pressures. And now with a weaker currency, the latest figures and projections point to further increases in production costs and consumer prices. Unfortunately, if the authorities fail to introduce a comprehensive energy strategy, Turkey will become even more dependent on imported sources of energy, with 95% of oil imports coming from the Middle East and 82% of natural gas from Russia and Iran. Even if recent hostilities in the Middle East get resolved peacefully, the growing scarcity of fossil fuels will keep the Turkish economy vulnerable to price increases and supply disruptions, in our view.

Turkey needs to improve conservation and efficiency and develop new energy technologies. Oil addiction is a global threat, but the impact of record-high oil prices on oil-importing developing countries like Turkey is even more challenging. This is why the authorities must give priority to better conservation guidelines and alternative energy systems. Of course, developing alternative energy technologies would take considerable time, and therefore the most feasible option for increasing energy security in the short run is demand management focusing on conservation and efficiency. And Turkey has a lot of ‘potential’ in this area, given its high degree of energy intensity in domestic production and its transmission loss ratio of 23%, compared to an average of 7% in other OECD countries. However, with the doubling of global energy demand almost every decade, Turkey also needs supply-side solutions to overcome the energy crisis. As a matter of fact, only new technologies can reduce overdependence on fossil fuels and also help address the threat of climate change.

Diversification out of fossil fuels is key for energy security and economic development. With the opening of the new pipeline from the Caspian Sea that will pump 1 million barrels of oil a day to the West, Turkey has indeed become a secure bridge for energy sources. Unfortunately, that is no consolation when high energy prices hurt the economy on multiple fronts. This is why we have long called for the development of alternative energy systems, including nuclear power and biofuel programmes, which would also have positive externalities, like technology transfer, improved research capabilities and productivity gains in the agriculture sector. Today, Turkey has no nuclear facility, while atomic energy accounts for 15% of total electricity generation in the EU and as much as 75% in France and 45% in Sweden. Therefore, Turkey should build a network of nuclear power plants, which are now commercially viable and produce no greenhouse gas emissions. Furthermore, it has an extraordinary potential to develop biofuel capacity and renewable forms of energy (which presently account for a mere 3% of total electricity generation). All in all, even beyond geo-political factors, Turkey needs greater diversity in energy sources to meet the rising energy demand and to improve energy security in an uncertain world.

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Slovakia
Committed to 2009?
Jul 21, 2006

Oliver Weeks (London)

We remain sceptical of the new Slovak government’s new-found commitment to the 2009 euro entry target.  Even given an unlikely level of fiscal restraint, there seems likely to be enough ammunition for the EC and ECB to keep a politically unwelcome government out on the inflation and now on the FX criteria.  With oil prices rising, inflation pressure is likely to resume and the current account deficit looks likely to rise above 10.0% of GDP in the next few months.  While car exports will eventually bring the deficit down, in the short term we believe that pressure on the informal 39.32 EURSKK band looks likely to resume.  

Political commitment may prove fragile.  After questioning the 2009 target date before and immediately after the elections, PM Fico has promised to coordinate policy with the National Bank to ensure that 2009 euro entry is achieved.   Policy details to back this up are unlikely to be released until August 1, but Mr Fico has also since repeated that electoral spending promises will be met and earlier reforms rolled back.  While Finance Minister Pociatek committed to 2009 immediately after his appointment, assurances on tax policy he made at the same time have already been reversed by the PM.  Mr Fico’s decision to join with the extreme-right SNS and nationalist HZDS seems to suggest that he was unwilling to accept the financial constraints on delivering his pre-election programme that a coalition with more moderate parties would have required.  Already his threats to introduce petrol price caps point to a readiness to unsettle the market.  Meanwhile his partners in the Coalition Council, SNS leader Slota and HZDS leader Meciar, may not remain as accommodating as they currently seem for long.  Mr Slota has made his doubts about 2009 clear, while Mr Meciar’s assurances of a new friendliness to Brussels are not reciprocated (see Koruna to the Slota?, June 23).  While there are no explicit political criteria for euro entry, the scope for discretion in interpretation of the existing criteria may yet make the presence of perceived extremists in government decisive. 

Significant fiscal tightening still needed.  We currently expect the new government’s programme to include VAT cuts, new housing subsidies, the abolition of healthcare fees and hikes in the minimum wage, pensions and family benefits.  In the short term, the deficit impact may be partly countered by higher corporate tax on banks and utilities.  Given an underlying fiscal deficit likely to be around 2.5% of GDP this year, there may appear to be some room for manoeuvre.  However, with SNS and HZDS in charge of spending ministries such as regional development, agriculture and environment, gradual pressure for more spending looks likely.  Mr Pociatek does not yet appear to have the political weight to run the sort of independent line held by Brigita Schmognerova in the 1998-2002 left wing administration.  While an official real GDP growth forecast of 5.4% for 2006 is clearly conservative, next year’s 6.1% is already more aggressive, and higher interest rates will further reduce the scope for discretionary spending increases.  Also important will be the interpretation of transfers to private pension funds, not recorded in the current ESA deficit estimates but likely to amount to 1.3% of GDP in 2006 and 1.4% in 2007.  To bring the wider deficit to 3.0% of GDP by 2007 would imply a need for an underlying deficit around 1.6% of GDP, a tightening of 0.9% of GDP.  The revised Stability and Growth Pact provides for temporary allowance to be made for pension transfers, but only if the deficit is “close to the reference value”.  Given likely doubts about the political sustainability of fiscal tightening in the Slovak case, and the risk of setting a loose precedent, we would expect this requirement to be interpreted strictly, to mean at most a 0.1-0.2% of GDP overshoot and a deficit continuing to head downwards.  The ambiguity may indeed inspire misplaced complacency. 

Inflation criterion also still a risk.  Lithuania’s case has already made it very clear that there will be no concessions offered on the inflation criterion.  We continue to see this as a risk for Slovakia.  While HICP inflation slowed to 4.5% year on year in June, we expect a rise to around 5.0%Y in the next few months.  Tobacco excise hikes are likely to begin to feed through, while fuel prices are set to rise again.  Given Slovakia’s relatively late price liberalisation, energy prices still account for over 18.0% of the consumer price basket.  Industrial PPI growth is at a six-year high of 9.9%Y.  Real retail sales growth, averaging 9.3%Y in March to May, points to a risk of rising demand pressure.  Unemployment has fallen rapidly to 10.4% from 16.6% at the beginning of 2004.  Real wage growth was 4.2%Y in May, while union involvement in drawing up the government programme suggests further upside risks.  The initial assessment period for the Maastricht inflation criterion will begin in March 2007, at which point we expect HICP still above 3.5%, against a Maastricht reference level currently at 2.8%, and National Bank target ceilings of 2.5% for end-2006 and 2.0% for end-2007.  Any attempt to restrict local energy prices downwards is likely to be seen by the ECB as grounds for questioning sustainable compliance with the inflation criterion.  The National Bank’s odd reluctance to raise interest rates more rapidly may be explained by optimism on the prospects for FX strength, but continues to look like an expensive mistake to us. 

Current account deficit still widening for now.  Indeed, with the current account deficit currently standing at 9.8% of GDP (in the year to March), the short-term case for FX strength looks weak to us.  The impact of higher oil prices on the deficit is non-linear, given Slovnaft’s capacity to raise exports of refined products, but we do not think the deficit has yet peaked.  The trade deficit on fuel products amounted to 9.0% of GDP in 1Q and, at current prices, could add another 1.0% of GDP to the deficit.  Meanwhile, imports of investment goods are likely to slow slightly, but we expect consumer imports to pick up.  An increase in Audi production and the beginning of Peugeot shipments also look unlikely to turn the deficit around this year.  Body parts for the Audi Q7 are so far still supplied from Germany while engines come from Hungary.  The import content of new car exports may still be as high as 80%.  Peugeot’s 2006 plan to ship 60,000 207s may be worth less than 1.0% of GDP net on our estimates.  Net inward FDI covers 51% of the deficit to date but may begin to slow, given a partial reversal of liberalisation and a likely halt to foreign privatisations.  With Peugeot exports planned to rise to 450,000 units by 2010 and Kia planning to produce 300,000 mid-sized cars a year by 2008, the long-term export outlook remains highly impressive, even with an investor-unfriendly government.  However, for 2006 we expect a full-year current account deficit of around 10.5% of GDP, falling to around 7.5% of GDP by the end of 2007.  The car export boom will still come, but may be too late for 2009 euro entry. 

FX stability already questionable.  In this context, the case for the National Bank continuing to defend the unwritten 2.5% band on the weak side of the koruna’s central parity looks unconvincing to us.  We believe that a breach of 39.32 will weaken Slovakia’s chances of being assessed as meeting the FX stability criterion for Maastricht, but these are already fading, in our view.  On the FX side, the Maastricht treaty (Article 121) requires: “The observance of the normal fluctuation margins provided by the exchange-rate mechanism of the European Monetary System, for at least two years, without devaluing against the currency of any other member state”.  The Treaty’s protocol on convergence criteria (Article 3) implies a slightly longer requirement for membership: “The criterion on … ERM… shall mean that a member state has respected the normal fluctuation margins provided for by the exchange rate mechanism of the EMS without severe tensions for at least the two years before the examination”.   However, the ECB’s interpretation of the application of treaty provisions is both more subjective and stricter still:  “The examination of exchange rate stability […] focuses on the exchange rate being close to the ERM 2 central rate while also taking into account factors that may have led to an appreciation […]  In this respect the width of the fluctuation band within ERM 2 does not prejudice the examination of the exchange rate stability criterion.  Moreover, the issue of the absence of ‘severe tension’ is generally addressed by 1. Examining the degree of deviation of exchange rates from the ERM 2 central rates against the euro, 2. Using indicators such as exchange rate volatility vis-à-vis the euro and its trend, as well as short-term interest rate differentials vis-à-vis the euro area and their development; and 3. Considering the role played by foreign exchange interventions”.  Extensive intra-band FX intervention could thus already be grounds for questioning Slovakia’s qualification in 2009. 

Intervention to continue, but may prove in vain.   Given the interdependence of the Maastricht requirements, we believe that the National Bank will still be reluctant to be the first to let its side slip, and given the Prime Minister’s current public position it will have to continue FX intervention for now, while belatedly raising the pace of rate hikes.  The National Bank may suspect, as we do, that if 2009 is missed, the next opportunity will not be for several years.  At slightly over USD 13.0 billion on our estimates — around 3.8 months of import cover — FX reserve levels remain comfortable for now.  Recent intervention is so far still less than the EUR 3.6 billion the National Bank bought to weaken the SKK between December 2004 and March 2005.  The National Bank also highlights that the high degree of reprocessing in Slovak imports, implying three months of import cover, may be unnecessarily conservative in the Slovak case.  The Board will at least be hoping to wait for the 2007 budget, which has to be submitted to parliament by October 15, but will be circulated to the NBS earlier.  Nevertheless, the case for pressure on the intervention level to resume in the meantime looks strong to us.  With fiscal support likely to prove lacking and the inflation picture likely to worsen, a move to full fluctuation within the existing 15% bands continues to look probable to us in the next few months. 

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Japan
On Track Toward a Summer Rally
Jul 21, 2006

Takehiro Sato (Tokyo)

The BoJ ended ZIRP without incident, and Fed Chairman Ben Bernanke’s mention of policy flexibility in his testimony to Congress was well received. We believe that the stage is being set for mini-summer rallies in stock and bond markets both in domestic and overseas markets, now that some events are out of the way. At the risk of being criticized for a rose-tinted vision, we outline the reasons for our view below.

Market-friendly central banks

First, we think the market-friendly policy stances of the BoJ and the Fed apparently favor buying.

The BoJ managed to smoothly bring an end to ZIRP, quite ironically partly supported by the investment scandal surrounding Governor Fukui. While he refrained from making assertive comments on policy management in the midst of the scandal, the market naturally discounted an end to ZIRP at the July meeting after the June Tankan showed the momentum of the domestic demand to be stronger than expected, resulting in the BoJ’s policy decision itself being almost a non-event. There was some upset that the BoJ only raised the ODR (the Lombard rate) to 0.4%, rather than to 0.5%, perhaps because of the MoF’s pressure. However, we do not see this as a vital issue because the central bank went beyond the ODR to the heart of the matter, ending ZIRP. At the press conference, Governor Fukui ruled out the possibility of successive rate hikes and sealed the possibility of raising only the Lombard rate. We accordingly think the likelihood of a surprise Lombard rate hike in August and September has almost disappeared, and that most of the negatives concerning Japan’s monetary policy are already out for the time being.

Meanwhile, Fed Chairman Bernanke appears to be struggling to be friend