IMF Surveillance - From Trusted Advisor to Bully Pulpit
Jul 26, 2006
Robert Alan Feldman (Tokyo)
The IMF’s September 19-20 meetings in Singapore could be a major turning point in global macroeconomic governance. The IMF is likely to propose major changes in its surveillance process. If done right, the changes could improve policy coordination among countries. Better coordination would mean more stable markets and prices, and higher growth.
(b) “Greater candor in staff and management outreach”,
(c) Viewing problems as “the joint outcome of many actors”,
(d) Assessing the consistency of exchange rate and macroeconomic policies with national and international stability,
(e) Expanding the Consultative Group on Exchange Rates to include major emerging market countries,
(f) Developing risk-based scenario analysis, and
(g) Considering “publishing these assessments in the World Economic Outlook”.In my view, the two biggest changes would be items (b) and (g), i.e., candor and publishing. The reason for my view goes back to the economics of the CRIC cycle, my favorite model of how policy is made (see Cobwebs and CRICs, April 4, 2001). Descriptively, the CRIC cycle is a series of phases — Crisis, Response, Improvement and Complacency — though which the interaction of an economy and policy pass. When policy has been Complacent, the inevitable result is Crisis. Due to domestic political incentives, Crisis begets a Response, but the Response may not be constructive, depending on the incentives faced by the government. If not constructive, the Response will lead to only a short period of Improvement. Often, the Improvement reduces the sense of urgency in the economy, and a period of Complacency starts. The inevitable result is another Crisis. However, when the Response is solid, the Improvement is more lasting, and the temptation to Complacency is lower. Of course, the trusted advisor model is perfectly consistent with the CRIC cycle; the problem is whether the trusted advisor model generates (a) support during Crises, (b) constructive ideas during Responses, and (c) effective warnings during Complacencies. Unfortunately, the answer seems to be no. This is where ‘candor’ and ‘publishing’ come in. Given globalization, CRIC cycles among countries are related. Thus, market movements can constitute Crises, and trigger Responses. Where advisors fail, markets can succeed. I am NOT suggesting that the IMF intentionally trigger crises, so that response plans are adopted more quickly. However, I am suggesting that the surveillance process designs and broadcasts misalignment indicators to warn of complacency and also designs multilateral responses to prevent them. The method (I): Misalignment indicators The IMF already — along with many central banks — publishes indices of real effective exchange rates, in many forms. However, these indicators are mostly descriptive. Judgment of whether a particular level of an exchange rate implies misalignment is often avoided. And with good reason. A given level of an exchange rate may be perfectly acceptable, when other policies have to be taken. The same rate may not be acceptable when the other policies are inappropriate. In short, exchange rates must be viewed in the context of other policies of a country. Moreover, exchange rates must be viewed in the context of policies of counterpart countries as well. Finally, the IMF must avoid triggering the crises that it is designed to prevent. For example, it the IMF were to conclude that the current level of the US dollar is inappropriate, given current levels of policy variables in the US and counterpart countries, then the IMF could calculate the combinations of policy changes around the world that would correct the level of the dollar. Nor would the IMF’s scenarios consider exchange rates only. The IMF has a very broad mandate, agreed by members and enshrined in Articles I and IV of the Articles of Agreement. A vector of financial and real variables could be used as the target variable for IMF policy scenarios. In short, the proposal here is for multilateral, multivariable adjustment scenarios. These scenarios would include financial variables, such as exchange rates and interest rates. The IMF would specify and publish which combinations of policies in different countries would lead to what results for key targets such as growth, inflation, interest rates and exchange rates. The method (II): Multilateral adjustment scenarios For this approach to be effective, there are several crucial elements. The first crucial element is quantification. Immediately, problems arise. Econometrics is a risky business. Econometric models are inherently backward-looking, if only because they use relationships among past data. Moreover, modeling techniques are many and diverse, and yield different results. It is easy to criticize quantifications of risk scenarios. A series of models would have to be used. However, one must be practical. Without quantification, scenarios are platitudes. For example, in the April 21 communiqué of the G-7, the finance ministers and central bank governors called on the US to boost national saving with more fiscal consolidation, address entitlement spending, and raise private saving. They asked Europe to implement more structural reforms and encourage domestic demand growth. They asked Japan to do more on fiscal reform and structural reform. However, they did not say how much of anything was needed from anyone, or when. No wonder that skeptics, such as myself, saw little new in this communiqué. Credible surveillance requires numerical targets, time paths, and incentives to achieve the targets. The method (III): Teeth The second key point is sanctions. It is pipedream to think that countries would accept sanctions from an international economic body for failure to hit policy coordination targets. No politician could justify to his constituents sanction-based enforcement of IMF surveillance scenarios. Hence, the IMF surveillance cannot use administrative or judicial sanction. However, markets can provide sanction. This is why publication of IMF scenarios would be so important. As long as the IMF scenarios are credible to investors, deviations of policy from the surveillance scenario path would be an implicit threat to all policymakers that complacency will bring crisis. The deviant country would not be popular with counterparties, and its financial markets are likely to suffer the most. In short, published adjustment scenarios provide not only moral incentives but also market incentives for countries to implement the policies recommended by surveillance. The method (IV): Benchmarks Another area where the IMF could contribute to better surveillance of financial markets would be creating benchmarks for financial markets that discourage herd behavior. One of the greatest problems in monetary policy over the last 20 years has been identifying and deflating bubbles. One of the reasons for such bubbles has been benchmarks that encourage herd behavior. (Otmar Issing discussed this problem in 1998. See his Crisis prevention: IMF Surveillance, need for new teeth? European Central Bank, July 2, 1998. I examined the issued in a simple model in Investors, Automatons, and Healing, August 24, 1999.) Central banks have been reluctant to label asset price movements as bubbles, since the decision on asset prices should ultimately be left to markets. True enough, but the consequences of popped bubbles can be severe. There is a prima facie case that herd behavior constitutes a market failure, and thus should be addressed by policy (so long as the policy does not make things worse).The IMF could develop indicators of ‘irrational exuberance’ or ‘irrational despondency’ and publish them. Again, no single index for irrational market levels should be used. Rather, a broad spectrum of both technical and fundamental-based indicators would be better. Private sector investors already use such indices quite extensively, in order to identify investment opportunities. Policymakers should use similar ones, so long as they are clear about which indicators are used, and how these indicators influence policy. A common set of such indicators among policymakers would enhance their ability to allocate among countries the homework of preventing disruptions. To this end, another set of data could be part of the surveillance process, a data set on capital flows. Investors are constantly searching for reliable information on capital flows, and are constantly disappointed. Even regulatory authorities in major countries express frustration at the lack of accurate data on capital flows. The money: Funding the fund A wholly separate problem with surveillance must also be addressed at the Singapore meeting, in my view. The IMF no longer has a viable business model. As the IMF itself has said, “The current business financing model, of paying for surveillance and capacity building with margins on adjustment lending, is no longer tenable.” (See The Managing Director’s Report on Implementing the Fund’s Medium-Term Strategy, IMF, April 5, 2006, p. 14.) Indeed, the IMF projects shortfalls of SDR57 million, 142 million and 206 million in FY07, FY08 and FY09, respectively under current policies. (As of mid-July, SDR1 = US$1.47.) There can be no viable IMF surveillance without a viable IMF budget. Hence, a key element in the surveillance debate is how the IMF can pay for itself. There is no consensus. Among the ideas are conversion of IMF gold into interest-earning assets and levying an annual fee on members, in proportion to their IMF quotas or other measures. So far, all the IMF has proposed is “to catalyze this process by establishing an external committee, headed by an eminent personality, to make recommendations.” Perhaps the key part of the surveillance mechanism to come out of the Singapore meetings will be a committee to make business model recommendations — with a tight deadline. The need to operate efficiently also brings up the question of how the IMF and other international economic institutions relate to each other. Another sign of progress from Singapore would be an initiative to re-examine the overlaps between the IMF and its cousins such as the IBRD, the OECD and the BIS. If savings are possible, then new surveillance mechanisms would take on new credibility.
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Renewed Restructuring Momentum
Jul 26, 2006
Elga Bartsch (London)
This is the first of a two-part analysis of the German restructuring story. Today we are looking at how the coming slowdown will likely affect the restructuring momentum in Germany. We argue that a slowdown to a below-consensus 0.7% GDP growth next year, on our forecasts, will likely create headwinds for German stocks. But it should also create tailwinds for corporate restructuring. Contrary to macro reforms, micro reforms show no sign of slowing. Year-to-date, German companies have announced job cuts of 73,700 compared to a total of 107,000 in 2005. Net job losses are running at 81.6% of those registered last year. Slower profit growth in the coming quarters will likely give new impetus to corporate restructuring, in my view. The coming economic slowdown In this note we are revisiting German structural reforms, where — contrary to macro reforms — micro reforms show no sign of slowing (see Macro Reforms Meet Micro Restructuring, August 25, 2005, for our earlier assessment). Compared to the consensus, we are looking for a more pronounced slowdown in German real GDP growth next year. Our full-year GDP forecast of only 0.7% compares to a consensus estimate of 1.1% for 2007. This constitutes a noticeable deceleration from an above-trend rate of 1.8% this year. The slowdown will likely create headwinds for the more cyclical German stock market. But it will likely also create tailwinds for further corporate restructuring, we think. Revisiting the restructuring theme A renewed underperformance of the German stock market should not come as a surprise, I believe. Ronan Carr of Morgan Stanley’s European equity strategy team points out that the relative performance of the German stock market seems to be closely connected to the direction in which the Ifo business survey is heading. In the coming months, these cyclical negatives will likely offset the structural positives. While still being attractively valued relative to Europe, according to our European Equity Strategy team, valuations aren’t as attractive as they used to be. The coming slowdown will reinforce the need for further reforms in Germany, I think, especially at the corporate level. So, get your score cards out: We are revisiting the German restructuring story and assess it in a G3 perspective so that we know what to do when the Ifo bottoms out. Cyclical pressures to reform will intensify The pressures to reform are likely to rise further as economic growth slows back below trend and companies need to trim their cost base, in my view. The slowdown is due to tighter fiscal policy, higher ECB interest rates and probably a stronger euro next year. On our estimate, a three-point VAT hike will likely push consumer spending and possibly overall GDP growth into negative territory in early 2007. The VAT hike is part of an ambitious fiscal consolidation package, which will likely cause the structural budget deficit to shrink by almost 1% of GDP, on our estimates (see Budget Blues and Beyond, June 28, 2006). Chances of meaningful macro reforms are remote The chances to see meaningful macro reforms implemented by the grand coalition are slim, in my view. If anything, the legislation pushed through so far seems to have concentrated on raising taxes and social security contributions, introducing a far-reaching anti-discrimination law and a piecemeal reform of federal relations. The outline of a planned healthcare reform seems to be an awkward compromise between both parties’ reform proposals. A potentially very detrimental introduction of minimum wages is on the agenda this autumn (see Putting a Floor Below Wages, April 14, 2005). A yet-to-be drafted corporate tax reform aims at cutting the corporate tax rate from 25% to 12.5% in 2008. But the lower corporate tax rate will probably be financed by taxing half of the interest, the rents, the leasing rates and the licence fees paid. Alternatively, rules on shareholder loans could be tightened, a real estate tax on corporate assets could be introduced or local payroll taxes be revived. The net impact of such a reform would likely vary from company to company, depending on its profitability and its capital structure (see Cutting Corporate Taxes, July 14, 2006). Micro restructuring still in full swing Contrary to macro reforms, micro restructuring at the corporate level shows no signs of slowing. In other words, German companies are ahead of the German economy in embracing the need for structural reforms. In the second half of the 1990s, when companies left the increasingly rigid industry-wide wage contracts and instead negotiated wages and working conditions with workers at the company level, a wave of micro restructuring was witnessed. It caused many industry-wide wage contracts to become more flexible and allowed companies to pay lower wages or have staff work longer hours in so-called opening clauses. More recently, we have seen a number of high-profile cases in which workers agreed to pay-cuts or to working extended hours (see Reforms Reach the Grass Roots, July 7, 2004). In addition, many companies — including several high-profile large caps — have started to trim staffing levels. Despite the cyclical up-tick in overall hiring on the back of the cyclical upswing, corporate restructuring, if anything, seems to be gaining momentum. Year-to-date, German companies have announced further job cuts of 73,700 compared to a total 107,000 cuts announced in the whole of 2005. As a result, gross job reductions announced in the first six months of 2006 already amount to 68.5% of last year’s total. Meanwhile, announced new jobs created are trailing at 42.8% of last year’s payroll expansion, bringing the net job losses up to a considerable 81.6% of those registered last year. There is also a rising trend in the size of the restructuring programme announced. This year, an average number of 1,053 workers are going to be laid off per announced restructuring case compared to 513 per case counted last year. About 40% of this year’s announced job cuts are taking place in the telecommunications sector. Last year’s leaders, the auto sector, and to a lesser extent financial services, remain active too. We expect micro restructuring to gain more momentum in the coming 12 months. The coming pressure on profit margins Slower global growth, a stronger euro, higher input prices and rising interest rates as well as expanding investment have already started to put pressure on profit margins in Germany. This and the margin pressure still to come will likely give new impetus to corporate restructuring in Germany. In addition, tough locational competition from the new EU member states in Central and Eastern Europe continues (see Merging Europe, October 3, 2003). Looking at the mark-up over unit labour costs, captured by the price-cost ratio, which tracks the relative movements of the GDP deflator versus unit labour costs, we project a sharp slowdown over the course of next year. The cyclical deterioration in profit margins will likely be aggravated by the VAT hike. Last but not least, unit labour costs should start to stabilise again, in my view. Having dropped a cumulative 2.3% since late 2003, a resumption of hiring and a slight pick-up in wage inflation will likely result in unit labour costs to stabilise this year.
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Monetary Response to Military Shocks
Jul 26, 2006
Serhan Cevik (from Istanbul)
The escalation of tensions creates new challenges for the central bank. Israel has always been a small country with big shocks. Over the course of the last 60 years, the country has faced numerous conventional wars with its Arab neighbours and struggled with the unresolved conflicts in occupied territories that fuel popular resentment and terrorist activities. Therefore, the ‘sudden’ eruption of violence in the Gaza Strip that abruptly proliferated to Lebanon is not really an ‘unexpected’ shock, in our view. As long as the Palestinian conflict remains unresolved, Israel will remain exposed to, as well as a source of, geopolitical risks in the Middle East. Then, the question is whether the economy and the financial system can withstand such threats without experiencing a deep recession and devaluation of asset prices. Even though the Israeli economy is, in our opinion, strong and flexible enough to absorb military shocks, the economic policy mix is crucial for limiting the fallout from the escalation of hostilities. The government is committed to prudent fiscal policies; and the Bank of Israel has an advantageous position to manage adverse effects of heightened uncertainty on expectations and economic behaviour. Nevertheless, we argue that there is a valid case for further tightening of the monetary policy stance, not because of a threat of currency depreciation-inflation spiral, but based on the state of the domestic economy and underlying inflation. The rise in inflation is not just a result of higher energy prices and seasonal variations. The consumer price index posted a month-on-month increase of 0.1% in June — an above-consensus reading that brought the cumulative inflation rate to 1.6% in the first half of the year. Even though the annual inflation rate remained unchanged at 3.5% — pointing to a deceleration from the recent peak of 3.8% in April, it is still above the upper bound of the central bank’s target range. Furthermore, the most important factor lowering inflation was the shekel’s appreciation against the US dollar, pushing domestic prices lower in exchange rate-indexed sectors. For example, the housing component of the CPI basket (which is directly linked to the dollar) posted a monthly drop of 0.5% in June and a drop of 2.9% in the first half of this year. As a result, consumer prices excluding the housing category increased by 0.3% month on month in June, following a 2.4% rise in the first five months of the year. This is why we have argued that the pressure of increasing domestic prices is not just a result of higher energy prices and seasonal adjustments. Indeed, the ‘core’ rate of consumer inflation, which excludes volatile food and energy prices and currency-indexed rents, accelerated from an annual rate of 1.5% at the end of last year to 2.5% last month. In other words, the shekel’s strength is not enough to curb inflationary pressures stemming from the sustained rise in domestic demand. The Israeli economy is expanding at an above-trend pace for the third consecutive year. The Central Bureau of Statistics recently revised national accounts, lowering the annualised real GDP growth rate from 6.6% to 6.0% in the first quarter of this year. More importantly for inflation dynamics and the monetary policy stance, the latest revisions lowered the growth rate of business-sector GDP from 10.6% to 7.7%, which is now in line with our own real GDP growth projection of 4.8% compared to the Ministry of Finance’s estimate of 5.3% this year. However, these downward revisions — and geopolitical risks — do not change the fact that the Israeli economy is growing at an above-trend pace for the third consecutive year. As the detailed national accounts show, domestic demand continues to expand at a pace that has led to an unambiguous narrowing of the output gap. For example, the annualised growth rate of private consumption increased from 2.0% in the fourth quarter of last year to 9.2% in the first quarter of this year. And forward-looking indicators, such as the state-of-the-economy index, suggest a similar performance, if not stronger, in the second quarter. Of course, the escalation of violence in the region has introduced downside risks to the growth outlook. Nevertheless, even with our conservative assumptions, domestic demand growth will continue adding to upward pressures on inflation. In our view, upside risks to inflation outweigh downside risks to growth. Against consensus expectations, the Bank of Israel decided to raise short-term interest rates by 25bp to 5.5%, in line with our own thinking about the state of the economy. However, we do not see geopolitical threats as the overwhelming factor for monetary tightening. According to our estimates, the monetary policy stance is just above the ‘neutral’ level for the Israeli economy and therefore macroeconomic trends justify, regardless of what happens to the shekel’s valuation, higher interest rates. Indeed, the reason for the central bank’s pause in the last three months was the shekel’s appreciation against the dollar that lowered inflation in currency-linked sectors of the economy. Of course, today, even if the shekel remains stable, the pass-through from higher energy (and other import) prices and the narrowing output gap require the normalisation of monetary conditions. As a result, we are revising our short-term interest rate forecast from 5.75% to 6% by the end of this year, with further upside depending on the extent of the military shock.
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The Erosion Has Halted
Jul 26, 2006
Luis Arcentales (New York) and ray Newman (New York)
After watching its market share in its largest export destination steadily decline for the past three-and-a-half years, a remarkable thing has happened lately — Mexico appears to be regaining share in the US. Or at the very least, the deterioration in market share appears to have stopped. While part of the upturn in Mexico’s export performance is simply a function of higher oil prices, the change appears to be much deeper than that. Indeed, even after stripping out Mexico’s two high-profile exports, oil and automobiles, the most recent data suggest that the erosion of Mexico’s market share in the US has halted. While many currency watchers are closely monitoring the political arena for clues over where the Mexican peso will go next, we would argue not to overlook the signs of improving Mexican market share. It’s not just oil… The headline market share numbers have been positive for nearly a year now, although signs of a turnaround in underlying data have been more recent. After topping out with a market share of just over 12.2% of all US imports at the end of 2001, Mexico watched its share of total imports drift downward until the second half of last year — falling below 10% of total US imports during the third quarter of 2005. Since then, the rebound has been substantial, with Mexico’s market share gaining to just over 10.6% of all US imports. But part of the turnaround in market share has come from oil. Oil has contributed to the improvement thanks to an upturn in oil prices, instead of an uptick in Mexican oil production. But even though Mexico’s most closely watched Asia competitors are in no position to become oil exporters, we would shy away from touting Mexico’s uptick in US market share as a sign that it is gaining competitiveness if there were not more behind the improvement. After all, a turnaround based on an oil windfall could turn out to be temporary. …or autos But the turnaround in Mexico’s market share appears to be deeper. Part of it can be explained by the auto sector. Mexico’s upturn is not limited to gains in its market share of total US imports, but also shows up in gains in Mexico’s market share of US imports of manufactured goods. Mexico’s manufactured goods share presented a slightly more dramatic fall from the end of 2001 through 2005 than did Mexico’s overall market share, but has rebounded since then. The upturn in Mexico’s market share comes as Mexico appears to be gaining ground against Canada’s auto exports to the US. The upturn is also taking place as a broader shift towards greater Mexican market share of vehicles produced in the NAFTA area is unfolding. In the first five months of 2006, Mexican-made vehicles gained market share and jumped to 7.6% of all vehicles bought in the US, up from 5.1% in the same time period from last year. The increase in market share was greater than that of Asian producers in the US during the same period. And Mexico’s gain in market share came even as sales in the US of NAFTA-based produced cars fell and as total sales of imports and domestics also fell. Mexico sold just over 169,000 more cars in the first five months of this year than it did in 2005, even as overall sales of NAFTA-based assemblers fell by nearly 272,000 and total car sales (the sum of NAFTA-based assemblers as well as non-NAFTA imports) fell by nearly 25,000. We aren’t arguing that, faced with shrinking demand in the US, Mexico can continue to gain not only market share, but also boost its absolute production. But that is precisely what has been happening so far in the auto sector. There is a limit in extrapolating from Mexico’s positive experience in dealing with a mild downturn in US auto demand to a situation of a more pronounced downturn in US consumer demand. But the experience so far suggests that a simple link between US consumer demand and Mexico’s productive cycle runs the risk of getting it wrong. Peso implications Even if we exclude oil, as well as automobiles, from the mix of products that Mexico is selling to the US, the market share deterioration of recent years appears to have reverted in recent months. We believe that this is particularly relevant as we try to think through issues related to the competitiveness of the Mexican economy and the exchange rate. After all, some might argue that the auto industry is a special case and that, given the significant entry costs, might not act as a leading indicator of a loss of competitiveness. China, which has nearly doubled its market share of US imports during the past six years, has hardly made a dent in the US auto sector. Hence, the importance of the fact that Mexico’s non-auto manufacturing market share has stabilized with some signs of an uptick after declining for the better part of four years. It cannot be explained away based on oil prices or the special qualities of the auto industry. Perhaps most interesting is that the fact that the erosion ended in a period in which the currency has gained and lost almost equal ground in real terms. The first signs that Mexico’s non-auto manufacturing sector was gaining ground came in the last months of 2005 and the beginning of 2006, even as the currency rallied in both nominal and real terms. Without entering into a more detailed review of the currency at this time, we would at least argue that it is difficult to make the case that the peso being at levels near where it was seen late last year — when it approached our 10.50 end-year target — is somehow far out of line with fair value. The link is alive, but which link? We have long been proponents of the view that the link between the US and Mexican economies is alive. The link is alive and strongest when comparing US industrial output with Mexican industrial production as well as Mexican manufactured exports. In contrast, the link between US consumer demand and Mexican output is fairly weak. The recent experience from the auto sector might be instructive: a softening in demand may lead NAFTA-based producers to be even more vigilant in reducing costs and may lead to an increase in lower-cost Mexican production even as overall demand is falling. Of course, in a more pronounced cyclical downturn, such a strategic or even structural shift may get overwhelmed. There may be another angle worth pursuing that might explain the improvement of the US market share of Mexico. Because Mexican production is often an integral part of the US manufacturing process — after all, nearly 54% of Mexican exports are intermediate goods while its Asian competitors tend to sell more finished goods — Mexico may be in a better position to benefit from an uptick in US industrial production while US consumer demand is moderating. Bottom line We have long argued that Mexico needs to do more to improve its competitive standing. Much of the inflows of recent years that have boosted the economy have come from extraordinary oil prices as well as worker remittances: the former flows suggest nothing about Mexico’s competitive standing and what the latter flows suggest is discouraging. Hence, when we see some positive news that challenges our view, we want to make sure that we are the first to examine it and present it as such. The improvement in Mexico’s non-oil, non-auto export sector’s market share in the US may ultimately say more about the strength of Mexico’s link to a robust US industrial plant than to anything else. The improvement certainly is not strong enough to stop us from warning Mexican policymakers that more time needs to be spent focusing on how to boost public investment and create the conditions for stronger private investment. But it does suggest that the link may be creating a degree of resilience that is allowing Mexico to better compete against its global challengers.
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Korea Will Normalize, but No Significant Slowdown
Jul 26, 2006
Sharon Lam (Hong Kong) and Andy Xie (Hong Kong)
2Q economy has not slowed as market feared. Headline GDP data for 2Q came in weaker than expected, at 5.3% YoY (versus consensus at 5.8%), down from 6.1% growth in 1Q. However, the slowdown came only from lower construction spending and statistical discrepancy. Statistical discrepancy alone (which represents differences arising from the use of different GDP accounting methods and is therefore not exactly a real indication of economic performance) has shaved GDP growth by 0.7 ppt. In other words, without statistical discrepancy, GDP growth in 2Q would have been almost as strong as in 1Q. Indeed, capex and export growth continued to surprise on upside in 2Q. On the back of our recent China GDP upgrade, we are raising our 2006 GDP estimate for Korea to 5.1%. Nevertheless, we expect growth to begin to normalize in 2H, but no drastic downturn. Not everyone will pay attention to the detailed GDP breakdown, and so today’s seemingly weak number may still put pressure on sentiment. Coupled with lingering external uncertainties on oil prices and North Korea, we see limited potential for further upside in the Korean economy. However, a drastic downturn is also unlikely. Exports will be supported by prolonged China resilience in the near term, which will also help Korea’s capex maintain momentum, due to tight capacity. At the same time, government spending should inject some stimulus in 2H, as budget spending is targeted to rise by 30% YoY. Moreover, construction activity could rebound in 2H from the lull in 2Q. As a result, the downturn we envisage in 2H is likely to be just a normalization of growth rates rather than a real slowdown. More rate hikes to come. The Bank of Korea (BOK) has been pre-empting inflationary risks, but should not be seen as hawkish since the rate hikes so far have been only mild and gradual. The current rate is still below neutral levels. We expect a further 25-50bp of rate hikes for the rest of this year. A rate increase in August (which we believe depends on July CPI data due to August 1) would raise the chance of one more hike in 4Q, we feel. 2Q GDP not as bad as it looks Korea reported preliminary 2Q06 GDP growth of 5.3% YoY, down from +6.1% in 1Q, and below expectations (Morgan Stanley: 6%, consensus: 5.8%). On a seasonally adjusted QoQ basis, 2Q GDP also slowed to 0.8% from 1.2% in 1Q. The headline growth reported today looks disappointing on the surface, but a look at the growth breakdown tells us that the Korean economy is actually still very solid, with strong exports and sustained domestic demand recovery. The downside to the 2Q GDP number came from construction activity and statistical discrepancy. The slowdown in construction investment can be attributed to a drop in private sector investment due to the government’s real estate policies and also a delay in some government projects. Meanwhile, statistical discrepancy alone has shaved real GDP growth by 0.7 ppt. Without statistical discrepancy, Korea’s GDP growth would have been 6% in 2Q, implying no real slowdown in the economy. On the other hand, capex and exports continued to surprise on the upside in 2Q, indicating strong macro fundamentals. Meanwhile, private consumption came in better than expected, maintaining above-trend growth despite weakened sentiment, suggesting that consumption is not as vulnerable as the market has feared. Construction activity is also likely to rebound in 2H as the government is stepping up infrastructure spending (particularly in replacing facilities destroyed by the recent floods) and increasing home supply. On the back of solid fundamentals and our recent upgrade of China’s GDP outlook, we are raising our 2006 GDP estimate for Korea from +4.5% to +5.1% In terms of monetary policy, we believe that the BOK will continue to raise interest rates as inflation is picking up, while the current rate at 4.25% is still below neutral. However, we think the BOK should not be regarded as hawkish — in fact, it is far from hawkish. The BOK is pre-empting inflationary risks, but it has been raising interest rates at a measured and mild pace. We believe that the BOK’s objective is to bring rates back to a neutral level of at least 4.5%. Since the beginning of 2006, we have been calling for a 75bp rate hike in Korea this year. We have seen 50bp of rate hikes, but there has been increasing noise from the market in the past couple of months regarding the end of this rate hike cycle. We feel convinced that more rate hikes will come, despite normalizing growth rates. We expect 25-50bp more rate hikes for the rest of this year (the market is pricing in 25bp only). If the BOK raises rates in August, which we believe depends on July’s CPI data, another hike in 4Q is likely, in our view. Yet, we do not see high inflationary risk in Korea due to a strong currency and low wage growth. Moreover, the property market appears to have been brought under control by the government’s tax measures. Hence, we expect rate hikes to remain measured and are not concerned about restrictive monetary conditions emerging in Korea. Fundamentals are solid; growth to normalize, but no drastic slowdown Global demand for Korean products is holding up well, as illustrated in the strong export data. Export strength also appears to have extended beyond World Cup-driven demand. Korea’s export resilience again demonstrated the country’s structural improvement in competitiveness, which is helping it remain immune from exchange rate issues. Meanwhile, the Chinese economy, Korea’s biggest export market, has delivered surprisingly strong performance despite government tightening measures. Our team has recently raised its 2006 GDP growth forecast for China from 9.5% to 10.5%. While we believe that a correction in the Chinese economy is unavoidable, the adjustment may well be delayed once again, and so downside to Korea’s exports could be limited in the near term. On the domestic demand side, we believe that consumption growth will remain stable due to resilient export earnings, but further upside may now be capped as the wealth effect from the stock and property markets is fading. Structurally, we see income inequality and relatively sluggish income growth as the biggest obstacles to Korea’s consumption growth over the medium term. Sentiment has become a major determinant of Korea’s consumption strength over the short term. Meanwhile, the capex recovery in this cycle looks more sustainable than any of the previous cycles since the 1998 financial crisis. This is because, as we have argued repeatedly, Korea has a genuine need for capex due to tight capacity. Demand for Korean products, and hence production, keeps increasing, but there has been no meaningful capital expansion since the financial crisis, which has led to today’s factories running at high utilization ratios. As a result, Korea corporates kept increasing capex even though their profitability was under pressure from oil and exchange rates in 1H. Since export growth is holding up, we believe that companies will continue to add more capex in the next three to six months. On top of the cyclical strength from both exports and domestic demand, government spending may also help support the economy in 2H. The government has planned a 30% YoY increase in budget spending in 2H. Spending will focus on helping SMEs and low- to middle-income households by extending tax exemptions and creating jobs. Meanwhile, to promote construction growth, the government plans to push for construction of large-scale enterprise cities and innovation cities and to speed up the ‘build-and-lease’ private-financed infrastructure projects. As part of its package to cool down property prices, the government also vows to increase home supply. In addition, facilities destroyed by the recent floods need to be replaced. As a result, we believe that construction investment will pick up in 2H from the lull in 2Q. On the back of robust exports, stable domestic demand and government spending, the downturn we envisage in 2H is likely to be just a normalization of growth rates rather than a real slowdown. The outlook for 2007, however, is more challenging as inflation risks and tightening from global central banks could start to have an impact on demand, while China will be weighed down by overcapacity problems and government policies. In a tougher external environment, we believe that not only will Korea’s export outlook be affected, but also its domestic demand, which is often susceptible to the economy’s export earnings.
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RBI Stays Concerned on Stability Factors
Jul 26, 2006
Chetan Ahya (Mumbai) and Mihir Sheth (Mumbai)
Policy rates hiked by 25bp In the first quarter review of the monetary policy, the Reserve Bank of India (RBI) announced another 25bp hike in short-term policy rates, moving the reverse repo rate (the rate at which the RBI absorbs excess liquidity) to 6% and the repo rate (the rate at which the RBI infuses liquidity) to 7%. This was in line with our and consensus expectations. Indeed, all 12 economists surveyed by Bloomberg had expected a 25bp hike in policy rates. We believe that the hike in policy rates has been prompted by rising concerns that are threatening macroeconomic and price stability. Maintaining concern on macroeconomic stability The text of the monetary statement has at various points highlighted the macroeconomic stability issues concerning the RBI. We believe that the RBI is increasingly tilting the policy bias towards maintaining stability, even if that implies paying the necessary price of lower growth. The three key concerns highlighted in the monetary policy are as follows: 1) Potential inflationary pressures. With domestic demand (as reflected in credit growth) continuing to be strong, the RBI remains particularly concerned about potential inflationary pressures. In addition, the RBI has highlighted its concern about the potential inflation pressures arising from the full pass-through of rises in global oil prices “which is largely being regarded now as containing a significant permanent component”. We believe that while potential inflation pressure has been a concern for some time, current global financial market conditions and concerns on runaway credit growth are the two more important factors influencing the RBI’s decision to continue with interest rate hikes. 2) Credit quality concerns. In the annual monetary policy statement announced in April 2006, the RBI indicated a target of 20% YoY for total commercial bank credit (including non-food bank credit, investments in bonds/debentures/shares of public sector undertakings and private corporate sector and commercial paper) in F2007 (YE March 2007). However, total commercial credit (bank credit plus corporate bonds) growth has stayed strong at 29.5% as of July 7 as compared with 29.6% in April. Indeed, the current credit cycle has continued to be one of the longest that India has witnessed in the past 35 years. The RBI has already taken a number of measures to slow credit growth over the past two years, including a 125bp hike in policy rates. Despite these measures in the past, not only have banks continued to pursue credit growth beyond sustainable levels (incremental credit deposit ratio being at 100%), but they have also been mis-pricing credit, raising the risk of a credit quality problem in the coming months. The issue of mis-pricing is evident from the fact that banks have created over 50% of their current loan book during the past three years, a period during which the banks’ lending rate pricing risk curve has been flattening. We believe that public sector banks have not been pricing credit risk adequately, and many of them are also not fully equipped with the correct risk management systems to match the aggressive retail loan growth pursued. Credit quality concerns are only likely to rise in the coming months as economic growth slows further. 3) Global developments and re-pricing of risk. India’s credit cycle has been dependent on low real interest rates supported by large foreign capital inflows, particularly portfolio equity flows (driven by global risk appetite). With global interest rates continuing to move up and the risk reduction trade underway, the RBI needs to keep taking rates higher to avoid a disruptive rate rise at a later date. Indeed, the RBI clearly mentioned in the monetary policy statement that India has been a beneficiary of the decline in price of risk and has recently suffered as the price of risk is rising. In this context, the policy statement highlights, “the two important questions in assessing the outlook are: whether the process of re-pricing of risks, in general, is complete; and whether corrections are incomplete in the economies which benefited from lower-priced risks in the past. The overall macroeconomic and geopolitical global environment is admittedly indicative of marked downside risks”. Slowdown in credit will result in further deceleration in corporate revenue growth We believe that the RBI will likely make two more rate hikes of 25bp each over the next six months in line with the 50bp hike in the US Fed rate as expected by our US economics team. We believe that debt-funded consumption growth, which has been at the heart of the above-trend GDP growth over the past three years, will be hit by the rise in the cost of capital and the consequent soft landing of the credit growth cycle (see The Coming Credit Cycle Slowdown, June 13, 2006). Indeed, we believe that the first round of macro slowdown is already evident in the deceleration from the peak in the corporate revenue growth largely to due to supply constraints. We believe that slowdown in credit growth will cause a further deceleration in corporate revenue growth, in line with consumption slowdown over the next 12 months.
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A High CPI - But Don't Get Carried Away
Jul 26, 2006
Gerard Minack (Sydney) and Mark Skocic (Sydney) and Toby Walker (Sydney)
Today’s higher-than-expected CPI report adds to the already-strong case for another RBA rate hike. The market is now fully pricing a 25bp increase, taking the cash rate target to 6%, on Wednesday, August 2. The market has also increased the prospect of an additional rate increase beyond that (in fact, a move to 6.25% cash is almost fully priced for early next year). I agree — there obviously is the chance of further rate increases beyond August. But don’t get carried away: monetary policy is now fairly restrictive, in my view, and it won’t take many signs of deceleration in forward-looking growth indicators for the RBA to stop tightening. In fact, the Conference Board today reported that its Australian leading index fell in May, the second consecutive monthly fall. In addition, the RBA will have one eye on global growth — certainly it pointed to the strength in global growth as a factor behind the last rate increase — which now seems to have passed an inflection point, particularly in the US. I believe that the key point for equity investors is this: the RBA has either tightened policy enough to ensure slower growth next year, or it will continue to tighten until growth does slow. What’s at issue is how much further the RBA has to tighten, what’s not at issue is that growth will be slower — which is the critical point for equity investors. In fact, I think growth will slow substantially next year, even without further rate increases. To the extent that the RBA does keep on increasing, it simply strengthens my confidence in the view that it will have to cut rates next year. I’m expecting the first cut in the first half of next year. One final, gratuitous point: After today’s data, some in the press have reported inflation “breaching the central bank’s inflation target” (Bloomberg). Remember that the RBA’s inflation target is to keep inflation in a 2-3% band through the cycle. There’s nothing wrong with inflation occasionally rising above 3% (or, indeed, falling below 2%). Put another way, the RBA won’t be panicked by today’s data.
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