The Pitfalls of Ceteris Paribus
Jul 28, 2006
Stephen S. Roach (New York)
Ceteris paribus may well be the two most dangerous words in the economist’s toolkit. Loosely translated from Latin as “all other things being the same,” this concept has become a foil for partial-equilibrium analysis — an increasingly fruitless and misleading approach in today’s complex and interdependent world. With oil prices rising, the housing cycle turning, and central banks tightening, the pitfalls of ceteris paribus have never been greater.
The US economy is the most obvious and important case in point. There is no lack of rules of thumb to gauge the impacts of shocks. For example, Federal Reserve staff estimates put the impact of a $10 increase in the oil price at -0.2% of forgone GDP growth and +0.2% on the headline CPI — with both impacts spread out over roughly a three-year time period (see D. Reifschneider, R. Tetlow, and J. Williams, “Aggregate Disturbances, Monetary Policy, and the Macroeconomy: The FRB/US Perspective,” Federal Reserve Bulletin, January 1999). At the same time, residential construction activity has risen to a post-1960 record of 6.2% of nominal GDP — well above its longer-term mean of 4.5% (over the 1960 to 1995 period). Under the sugar-coated presumption of asymptotic mean reversion, a post-bubble shakeout of homebuilding could knock at least 1.7 percentage points off overall economic growth. A “non-asymptotic” correction would obviously be a different matter altogether. Meanwhile, the Fed has taken the federal funds rate up from 1% to 5.25% over the past two years — a monetary tightening that the Fed’s own rules of thumb suggest should already be knocking at least one percentage point off aggregate growth in real GDP (see Reifschneider, et al., cited above). In other words, we have a reasonably clear understanding of how to gauge the impacts of any one of these developments. Unfortunately, it is the interplay that matters in the real world.
Our penchant for partial analysis is an outgrowth of the event- and sound-bite-driven culture that shapes the day-to-day debate in the media, financial markets, and political circles. I am as guilty as the rest in that respect. War breaks out in the Middle East and the telephone instantly lights up with requests for impact analysis as seen through the lens of the oil price. New home sales disappoint — as they did once again in the just-released June report (a 3% monthly drop to a level that now stands 11% below the year-earlier pace) — and the calls come in for an assessment of the post-housing bubble carnage in the US economy. Same thing happens every time the Fed tightens — or, more aptly these days, changes its mind on monetary policy. We answer these well-intended questions because they fall within the job description of the economist, market strategist, analyst, or pundit. But in doing so, we compartmentalize our answers in a fashion that does great disservice to the ultimate truth.
Yet “context is key” in going from the partial to the broader answer. That’s especially the case for the American consumer — quite conceivably the most important call in the global economy these days. Energy prices go up and we typically assess the impact of that development by looking at the energy-related portion of personal consumption expenditures. Currently that share stands at 6.2%, well above the 10-year average of 4.9%. Under alternative geopolitical and oil price scenarios, we then typically model different trajectories of the energy portion of total consumption and render the macro verdict accordingly (see Dick Berner’s 17 July essay, “Tipping Point?”). But here’s where the context point is absolutely critical — there is much more going on here than just an increase in oil-related expenditures. The housing market is rolling over, ultimately denying income- and saving-short households the wealth effects they have been aggressively converting into purchasing power and consumption in recent years. Moreover, courtesy of Fed tightening, a resolution of the great bond market conundrum, and “resets” of cut-rate mortgage loans, debt service obligations of overly indebted consumers are also on the rise. In other words, there are a number of other things currently happening to US consumers that render the partial analysis of an oil shock almost meaningless.
And those, of course, are just the first-round implications. If the American consumer finally caves under the weight of this confluence of forces, I suspect business capital spending — the widely presumed next source of recovery — will be quick to follow. I come to that conclusion fully mindful of all the positives that seem to support a much more resilient outlook for this sector — namely, record corporate earnings and cash flows, long-deferred capacity expansion programs, ongoing productivity strategies driven by IT-enabled capital deepening, and the heavy replacement needs of a shorter-lived, increasingly IT-intensive capital stock. Notwithstanding these important considerations, they miss the essence of the capital spending decision: Fixed investment is a “derived demand” highly dependent on expectations of the prospective trajectory of end-market demand. As such, the demand forecast is, itself, an excellent predictor of future pressures on the existing stock of productive capacity — apprising business decision makers of the need to increase the scale of their operations. If demand expectations are marked down in any meaningful fashion —- as could well be the case if the US consumer fades — the investment cycle could quickly shift to the downside. And if capital spending weakens, so, too, will capex-related employment and income generation — putting further pressure on consumers. Yet you won’t reach that conclusion by sticking with the rules of ceteris paribus in analyzing the impacts of higher oil prices.
Global considerations also challenge the relevance of partial equilibrium analysis. An unbalanced global economy is still heavily dependent on the American consumer as its major engine on the demand side of the equation. The persistence of a massive US current account deficit — still holding at close to an $800 billion annual rate — underscores the world’s highly unusual state of co-dependence. It implies that any meaningful consolidation by the American consumer has the potential to be a very troubling development for the externally-led remainder of the global economy. Recent signs of cyclical revival in Japan and Germany seem to challenge this conclusion — creating the impression that the world economy has already made meaningful progress on the road to rebalancing and is, therefore, likely to be more resilient in the face of a weaker US consumer. I remain highly suspicious of this view. If the US consumer goes, Mexican and Chinese producers would be quick to follow, as would the rest of China’s supply chain, which now stretches from its neighbors in Asia, to Australia, to South America, and even to Africa. This underscores yet another key pitfall of the ceteris paribus trap — analyzing one economy in isolation from others and failing to appreciate the new linkages that bind these economies together. I guess that’s what globalization is all about.
Modeling in the social sciences is all about assumptions. The applications of our models to real-time developments require an even greater stretch of the imagination — the compulsion to hold certain assumptions constant while tweaking a key aspect of the framework. In the end, this exercise is vacuous — nothing more than a controlled experiment in a highly complex world. The interplay between multiple forces is far important than the partial analysis of any one development — especially in an era of globalization and in a climate where financial markets and real economies have become tightly integrated. On that basis, the interplay between high oil prices, a property market correction, and monetary tightening poses potentially serious downside risks to an unbalanced global economy. That conclusion is not evident from the compartmentalization of ceteris paribus. Instead, it is very much an outgrowth of a broader, or general equilibrium, assessment of macro risks.
Admittedly, this conclusion poses a serious challenge to the more constructive case for global rebalancing that I outlined over three months ago (see my 1 May dispatch, “World in the Mend”). I still believe there are solid grounds for a more benign rebalancing endgame — especially, if G-7 finance ministers, the IMF, and the world’s major central banks remain focused on the perils of mounting imbalances. But the rebalancing fix was something I always felt would take place over time — and, quite possibly, over a long period of time. In the meantime, the world remains highly unbalanced, and, therefore, more vulnerable to a shock than would be the case for a more balanced world. As bad luck would have it, a confluence of three potentially powerful shocks — oil, housing, and Fed tightening -- is now in play. All other things the same, the US or global economy may not have been dealt a lethal blow by any one of these shocks. But that may well be beside the point. This is not the time for ceteris paribus.
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Fairy Tales of the US Bond Market (Tale 2)
Jul 28, 2006
Joachim Fels (London) and Manoj Pradhan (London)
In the first instalment of this three-part piece, we described the backdrop and motivation for our new US bond yield model, which we employ to estimate MS FAYRE, our new proprietary estimate for the fundamental fair value for US 10-year bond yields. Today, we describe the results and discuss whether bonds are still overvalued. The full report is available on Morgan Stanley’s Client Link.
A stable long-run relationship between yields and fundamentals
To estimate the link between the bond yield and our three fundamental variables, we employ a technique called cointegration. This method is especially suited to detect long-run equilibrium relationships between variables. Several different cointegration approaches and various diagnostic checks lead us to conclude that, over the past 25 years, a combination of the three fundamental variables listed above has done well in explaining the broad evolution of the US 10-year yield (again, see the Appendix of the full report for detail).
Some simple rules of thumb derived from MS FAYRE. The estimated coefficients of our three fundamental variables tell us how a given change in the variable affects the bond yield. Specifically, we find that:
· a 100 bp increase in the fed funds rate (assuming that inflation remains unchanged) raises the 10-year bond yield by approximately 25bp;
· a 1 percentage-point increase in 1-year ahead inflation expectations raises the 10-year bond yield by some 1.4 percentage points; and
· a 1-percentage-point increase in the standard deviation of core PCE inflation raises the 10-year bond yield by around 1.4 percentage points.
MS FAYRE currently stands around 5.3%. Using the estimated relationship between the bond yield and our three fundamental variables, we can calculate the theoretical level of the bond yield at any point in time, given the prevailing levels of the real funds rate, inflation expectations and inflation volatility at that time. We call this theoretical level of the bond yield the ‘fundamental fair value’, or MS FAYRE. Both the actual bond yield and MS FAYRE have declined over the past 25 years, from extreme highs of around 15% in 1981. The lowest point for MS FAYRE was reached during the deflation scare of 2003, when a negative real fed funds rate and a dip in inflation expectations below 2% pushed the fair value down to 3.4% in the spring of 2003. Since then, MS FAYRE has risen by almost 200bp to 5.3% by the middle of 2006, reflecting a moderate elevation of inflation expectations and a significant increase in the real fed funds rate since mid-1994.
Bond conundrum not unprecedented
The 10-year yield and MS FAYRE have wandered apart at times, but deviations of one from the other tend to be corrected over time (technically speaking, a combination of our fundamental variables and the bond yield are cointegrated). Deviations can and have been corrected through a return of the actual yield to MS FAYRE, through a change in the fundamental variables that brings MS FAYRE closer to the actual yield, or through a combination of the two adjustment mechanisms. The maximum deviations of actual yields from MS FAYRE have amounted to about +/-100bp.
Buy/sell bonds when MS FAYRE is more than 50bp away. It is instructive to look at various past episodes of large deviations of actual yields from MS FAYRE. Actual yields fell significantly below MS FAYRE in 1987, 1989, 1993, 1995, 1998 and 2005, signalling a clear overvaluation of bonds. In each of these cases, a bear market in bonds followed that took actual yields significantly higher towards or through MS FAYRE. Conversely, actual yields stood significantly above MS FAYRE in 1985, 1992, 2000 and 2002, signalling a clear undervaluation of bonds. In each of these cases, a bull market in bonds followed that took actual yields towards and eventually below MS FAYRE. Medium-term buy and sell signals for bonds are typically reached when actual yields trade more than 50bp above or below MS FAYRE.
The conundrum is history now. Looking at the 2005 conundrum episode, it is interesting to note that while bond yields fell some 100bp below MS FAYRE by the late summer of that year, such deviations have occurred several times before during the past 25 years. In other words, a drop of bond yields below their fair value such as the one seen last year did not represent a break with past patterns and, as such, did not require a new paradigm to explain it. In fact, our statistical tests suggest that the relationship between bond yields and our three fundamental factors did not change significantly in recent years. And, as in previous episodes of overvaluation in the bond market, actual bond yields eventually corrected since autumn 2005, rising towards their fundamental fair value. Note that before the very recent bond rally, actual yields rose to 5.25% and thus virtually back towards our present 5.3% estimate for MS FAYRE. With bond yields fairly close to MS FAYRE at the moment, bonds are in the neutral zone from a pure fundamental valuation point of view.
In the third and last instalment of this tale tomorrow, we compare our results to separate estimates of the term premium by the Fed.
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Not Yet Landing
Jul 28, 2006
Eric Chaney (London)
A stronger euro, higher energy prices (not only oil), rising interest rates and shaky equity markets were not sufficient to destabilise Euroland manufacturers. Markets are tempted to translate the correction in headline Ifo and Isae indices as signalling an imminent slowdown; our own reading of the details of July business surveys is more upbeat. Two variables say it all: companies reported a further acceleration in demand and upgraded their production plans for the next three months.
Our Compass is safely in the “Strong and Accelerating” zone
Current production, a coincident indicator, corrected, but mildly enough to leave the Surprise Gap at the border between Acceleration and Neutrality. With production plans significantly upgraded in Germany, France and the Netherlands, the Compass is still “Strong and Accelerating”. Although production expectations apparently peaked out in March and production in June, we do not take for granted that production will slow significantly in the coming months. In fact, our early GDP indicator for 3Q rose one-tenth to 0.7%, a rate significantly above the 0.5%Q trend rate of the last ten years and only two-tenths below the indicator’s estimate for 2Q (0.9%Q). On balance, we think that risks to our above-consensus full-year call, 2.3% GDP growth, are on the upside. Comparing the current business cycle with previous ones, the strength of demand suggests that the economy might have reached a plateau of robust, above-trend growth, rather than passed a peak.
Demand matches previous all-time record
The trend in demand is a rather lagging indicator of the business cycle. Yet, its level, which correlates the growth rate of order books as seen by companies, matters to gauge the strength of the recovery. In July, the euro-5 (Spanish data are not yet available) demand indicator rose 0.2 points of standard deviation (sda) to 1.6, matching the June 2000 all-time record of a time series starting in 1988. Demand was stable at a record level in Germany and rose in all other countries, as if the strength of the German manufacturing sector was now spilling over into the rest of the euro area. The most spectacular acceleration came from Belgium, a widely open economy particularly sensitive to European demand.
Not all cyclical peaks are equal
We have compared the three main components of euro area business surveys, production plans, production and demand over the last business cycle peaks. The 1995 cycle was a textbook example of a powerful cyclical upswing quickly followed by a slowdown: expectations peaked one month before production, which peaked one month before demand — a logical sequence, since companies have advanced knowledge of demand through their links with customers and suppliers. Back then, the economy was recovering from a deep recession and the post-German unification hangover, and while production had accelerated vividly throughout 1994 as firms rebuilt inventories, demand, although firming up, remained subdued, peaking out significantly below production at 1.1 sda. By contrast, in late 1999/early 2000, demand rose in sync with production and reached 1.6 sda — significantly above trend.
2006 may look more like 2000 than 1995
So far, the 2005-2006 recovery is closer to the 1999-2000 cycle than to the 1995 one. Production seems to have reached a stage of consolidation at a robust, above-trend growth rate, rather than passed a cyclical peak, thanks to strong demand. Which demand? First domestic demand, as euro area countries trade mostly with each other, but also overseas demand, generated by the global capex cycle (another similarity with 1999-2000). Note that, this time, European producers have a comparative advantage, since this cycle is not mainly driven by ICT goods but, rather, by traditional machinery and transportation equipment goods.
Monetary normalisation should not hurt the economy
The view from the bottom, i.e., from businesses themselves, has two important consequences for policy makers and financial markets: first, the Governing Council of the ECB will see no hurdle in its march toward more neutral interest rates: measured against GDP deflator inflation, real rates are still below 1% while the economy is growing at a 2.5% clip. Second, earnings are likely to continue to surprise on the upside in the next few months. As we have often said, 2007 should be quite a different story, but we are not yet there, so enjoy the good times while they last.
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Enduring a Triple Whammy
Jul 28, 2006
Eric Chaney (London)
Unless investors take a negative view on the euro or Euroland policymakers suddenly change their mind about interest rates and public debts, the die is probably cast: a stronger euro, higher interest rates and a significant fiscal tightening will inflict a triple whammy on the euro area recovery next year, not to mention elevated energy prices, in my view. A popular view in the financial markets is that internal demand is so weak in core Europe that policymakers would commit a terrible blunder if they really did what they have announced or implied. I have argued consistently that the recovery that started in 2005 was driven by domestic demand, itself boosted by low real interest rates, rather than exports. Data unambiguously support this view: domestic demand growth reached 2.1%Y in 1Q, versus 0.0% for net exports, but the ‘export-led recovery’ concept is so deeply entrenched in the markets’ subconscious that this was not sufficient. Against this backdrop, it is no surprise that a fiscal and monetary tightening is seen as foolish, since it will unavoidably have a temporary negative impact on domestic demand. The real issue is the magnitude of the triple whammy effect and the real question is whether this could abort the recovery and send Europe back in stagnation for years. Using the coherent quantitative framework of a model, I have investigated these questions and made some interesting findings:
1. This year, the combined impact of the 75bp monetary tightening already done (and we know there is more to come) and higher energy prices has a significant cost in terms of GDP growth — around half a percentage point.
2. If, as we think, the ECB raises short-term rates to 3.5% by the end of this year and Germany and Italy implement the fiscal reforms they have announced, GDP growth would be reduced by 0.9% to 1.3% next year, assuming a stable exchange rate.
3. The growth toll of higher oil quotes is significant this year (-0.3%) but should vanish next year. Unless a supply disruption pushes crude quotes above US$100 for several months, the risk of a quadruple whammy is small.
The analytical framework: oil, euro and interest rates
We use the multipliers derived from a pan-euro area quarterly econometric model (MZE-2003) developed and estimated using aggregated euro area data by Insee economists. Since exogenous variables such as oil prices or the exchange rate have temporary but long-lasting effects on GDP, simulations are sensitive to the starting point. For clarity, we initiate our simulations in 1Q05, so that changes in exogenous variables prior to this date are not taken into account. This point is important for monetary policy (i.e., short-term interest rates): by cutting the refi rate to 2.0% in June 2003 (that is, to practically zero in real terms), the ECB significantly stimulated the real economy in 2004 and 2005, although probably by not enough to close the output gap. Similarly, the 21% rise in crude prices in 2004 had a negative impact on GDP growth in 2005 and has had a positive one in 2006, as oil price shocks do not have lasting effects on GDP levels in the long run.
Fiscal policies: credible or not?
As for fiscal policies, we prefer a simplified framework to the model specifications, again for the sake of clarity. In our first simulation, dubbed the ‘hard case’, we assume that a 1% ex ante fiscal tightening would reduce GDP by the same amount. Taxpayers would neither increase their savings rate (they would do so if they anticipated further tax hikes in the future), nor cut it (as they would do if they felt comfortable about the sustainability of public finances). In our second simulation, the ‘mild case’, we assume that half of the ex ante fiscal tightening would be offset by a drop in the savings rate, as taxpayers anticipate that taxes will decline in the long term. In both cases, the negative impact on GDP is then progressively unwound, as changes in fiscal stances cannot have a long-term effect on the level of GDP.
GDP growth could have been close to 3% this year
All calculations made, we find that already this year, exogenous shocks are hurting GDP growth significantly. Assuming stable exchange rates and oil prices from now on, and a further monetary policy tightening (25bp in August, then two other 25bp hikes in 4Q), we estimate that higher oil prices should cost 0.3% of Euroland’s GDP, monetary tightening 0.2%, and the Italian fiscal tightening (0.5% of GDP, we estimate) 0.1%. On the other hand, the lagged effect of a weaker euro last year would add 0.1%. The combined effect of these exogenous factors is a loss of 0.5% of GDP. Since our full-year GDP growth forecast is 2.3% — and we tend to consider it conservative — the logical conclusion is that, spontaneously, GDP growth would have reached 2.8% this year. This is an important point, because it suggests, first, that the monetary policy stimulus applied to the economy since 2003, which is now being progressively withdrawn, was effective. Second, it suggests that potential GDP (a concept even more elusive than potential GDP growth) might be higher than is commonly assumed. Otherwise, it is hard to see why ‘spontaneous’ growth would be so far above the last ten years’ average GDP growth (exactly 2.0%).
Quantifying the 2007 triple whammy
Turning to 2007, the same methods indicate that monetary tightening in 2006 would cut 0.4% from the euro area GDP, even if, as we think, the ECB becomes more accommodative as GDP growth slows down sharply and the inflation outlook becomes more benign. The lagged effect of the appreciation of the euro since early March would slice another 0.2%, but the really big thing will be the German-Italian fiscal tightening. We assume that the net fiscal tightening will amount to 1% of GDP in Germany and 1.5% in Italy (see Tightening the Fiscal Belt, Eric Chaney, Elga Bartsch and Vladimir Pillonca, July 10, 2006). We also assume neutral fiscal policies in the rest of the euro area. Taken together, the German and Italian fiscal diets might cost between 0.3% and 0.6% of Euroland’s GDP next year, depending on consumers’ saving behaviour. Note that even the ‘hard case’ scenario is not the hardest one could imagine: we have deliberately ignored possible multiplier effects in neighbouring countries through trade links. By contrast, and contrary to conventional wisdom, the impact of past changes in oil prices should be negligible, as long as we assume that there are no threshold or non-linear effects — i.e., that only the change in prices, not the level, matters. In the end, we think the economic cost of the 2007 triple whammy should be between 0.9% and 1.3% of GDP.
Big enough to cause a recession? Not sure
Taking an average estimate, the growth toll (1.1% of GDP) looks considerable for a region where GDP growth has averaged 1.4% since 2001. Isn’t the euro area going to experience a self-inflicted recession next year? This is not obvious and is not our call. Because of the underlying growth rate of the economy, somewhere between 2.5% and 3.0% according to the estimates for 2006 we have just mentioned, it is probably fair to see the ‘spontaneous’ growth rate of the euro area economy at 2.5% next year, since the output gap is still far from being closed. It also happens that our forecast for next year is 1.4%, based on both bottom-up and country analysis — consistent with our 1.1% average triple whammy estimate and 2.5% spontaneous growth. However, depending on German and Italian savings behaviour and uncertain cross-country multiplier effects, a short recession in the first half of the year cannot be excluded.
2008 — the best year for Euroland since 2000?
We have extended our analysis to 2008, beyond our current set of macro forecasts, assuming stable oil price and exchange rates. We have priced in a significant fiscal tightening in France, worth 1.0% of GDP (see Next on the Fiscal Ultra-Diet List? Eric Chaney, July 17, 2006). While the lagged effects of the 2006 monetary tightening would continue to have a slight negative effect on growth (-0.2%), the stability of oil prices and exchange rates would be positive for GDP growth (+0.3%), as the economy rises back to its underlying trend. And the fiscal relief effect in Germany and Italy would offset the French fiscal tightening. Roughly speaking, the various exogenous factors we quantify would turn neutral if not slightly positive in 2008. Since the underlying momentum seems to be significantly higher than past trend growth, a re-acceleration above 2.0% would not be surprising. Not all leap years are equal: with 4.0% GDP growth, 2000 was a great vintage while 2004 was a petit cru with 1.8% growth. I think that 2008 is likely to be decent vintage, revealing that incremental improvements in the micro structures of euro area economies (more flexible labour markets in Spain, Italy and France, continuous corporate restructuring in Germany) have removed some barriers to growth. Since 2007 is likely to be a lost year, it is time to think about 2008: for once, corporate profit growth would be generated by top-line growth, rather than wage compression.
The risk of a quadruple whammy
Assuming a constant oil price is probably the weakest part of our scenario analysis. Therefore, in our baseline oil price assumption we assume that the price of crude oil reaches US$80/bbl in the later part of this year but then declines to US$60 at the end of 2007 and US$50 at the end of 2008. If this were really to happen, the ‘oil relief’ factor, negligible in 2007, could add another tenth to GDP growth in 2008 — not enough to alter the macro landscape. On the other hand, if the supply of crude oil were disrupted, as in our ‘hot case’ oil scenario — for instance, if Iranian exports were blocked — GDP growth would lose 0.3 percentage points more in 2007, assuming that linear effects continued to dominate. Compounded with the three other headwinds we have looked at (a fiscal and monetary tightening and a stronger exchange rate), the oil shock would result into a full-blown recession that, by itself, it would not have caused. Something would then have to give. In my view, the ECB would be very reluctant to ease monetary policy aggressively, given risks on long-term inflation. On the other hand, I believe that the relevance of fiscal diets, especially by means of higher consumer taxes, would be seriously questioned. Fiscal stabilisation would probably be postponed to better times.
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Currencies and Prospective US Consumption Slowdown
Jul 28, 2006
Stephen Jen (London) and Charles St-Arnaud (London)
Consumption versus capex
While our central case assumption is for US headline GDP to decelerate moderately in 2007, the assumed deceleration in US consumption is sharper, driven by the soft landing in the housing market. In this note, we take a first look at how various currencies may be affected by the disparate trajectories of US consumption and capital expenditures.
If the US slows, Japan, China and AXJC will all suffer; however, a consumption-led slowdown in the US could hurt China more than others, ceteris paribus.
The state of the US economy
We believe that the Fed’s outlook of the economy, as explained by Chairman Bernanke last Wednesday (July 19, 2006) at his Congressional testimony, is sensible. This outlook of a slowdown in domestic demand, propelled by the housing market, with lingering inflationary pressures, was also echoed in the Fed Beige Book yesterday. Whether the fed funds rate (FFR) peaks at 5.25% or 5.75% is still difficult to tell. What is clear is that slowing US consumption and surging capital expenditures will have different effects on the rest of the world and their currencies.
The basic idea we have
Countries have quite different compositions of exports. Those that are intensive in exports of consumption goods should, in theory, be more vulnerable to a slowdown in US or global consumption, while those specializing in capital goods exports could be less adversely affected by a consumption-led global slowdown.
According to our measure, Japan, Germany and Korea seem to specialize in capital goods exports, while Spain, ‘Hong Kong’, and Italy appear to be more active in consumption goods exports. ‘Hong Kong’ is in quotes because the trade data used includes trans-shipment from China. Since we don’t have the necessary data for China, this is a reasonable proxy to use. In other words, the more significant observation here is that China is a specialist in consumption goods, consistent with what common sense tells us.
Thus, if the US and the global economy slow mainly through consumption rather than capex, we could tentatively suggest that Spain, China and Italy should, in theory, be adversely affected more than, say, Germany or Japan, which have identical compositions of capital goods and consumption goods in their exports.
However, to get a more accurate read on the true vulnerability of various economies and currencies to a US consumption slowdown, we also need to have a view on: (i) countries’ export-reliance on demand in the US; and (ii) countries’ export-dependence for growth.
• Observation 1. If the US slows, Mexico, Japan, China and AXJC may suffer most. Close to 80% of Mexico’s exports go to the US. If the US slows, the effects on MXN will likely be quite negative. Similarly, Japan, China and AXJC are all quite reliant on US demand. If the US slows sharply, all these currencies could suffer. Here, we should underscore two points.
First, while the currencies of the capital-deficit countries may suffer in periods of risk-aversion, when global or US demand falters, it could be precisely the countries that run large current account surpluses that suffer. In other words, capital-surplus countries tend to be higher-beta economies and should, in principle, be more sensitive to changes in global real demand, while the capital-deficit countries are more sensitive to the nominal factors such as global liquidity. Thus, the popular notion that capital-surplus currencies should outperform capital-deficit currencies should be qualified.
Second, the ‘Dollar Smile’ framework applies here as well. A soft landing in the US may still permit a healthy level of risk-taking, and USD/Asia can still trade lower. This is still our central case. However, if investors start to expect a sharper slowdown in the US and begin to reduce risk, USD/Asia may struggle to trade lower.
• Observation 2. Within Asia, China seems to be most reliant on consumption goods exports. Although all of Asia is rather leveraged to demand from the US, China may be much more sensitive to changes in US consumption, while Japan and Korea might be more resilient to a housing market-centered slowdown in the US, since they export twice as much capital goods as they do consumption goods. This could be one reason to think that Japan may be more resilient to this prospective US slowdown than previous ones.
Also, the fact that China may be more sensitive to US consumption should also have implications for Beijing’s restrictive policies and the CNY policy. Regarding the former, what needs to be reined in is not net exports, but capex and property speculation. If the US slows, Beijing will face the difficult decision of tightening into a slowing global economy. At the same time, however, a hit to China’s net exports could lead to a moderation in pressures on the CNY. Of course, China’s exports may still do well if strong consumption demand within Asia and Euroland offsets any slowdown in US consumption. But the key point here is that, all else equal, the particular type of economic slowdown we have in mind will drive a wedge within Asia.
• Observation 3. Significant disparities within Euroland.Germany is different compared to the rest of Euroland. Germany is much more export-led and much more oriented toward exports of capital goods. Divergent global consumption and capex cycles could further exacerbate the divergence within Euroland, and complicate its policy making.
Our call on USD/Asia
As we have stressed in our recent pieces, our call for USD/Asia to resume their correction is predicated on the growth deceleration in the US being very modest, and that we don’t see more rounds of risk-reduction like the ones we saw in May and June. For USD/Asia to decline, we need: (i) global liquidity to not to tighten too sharply so as to allow more risk-taking in the AXJ equity or currency markets; and (ii) US demand to remain not too weak so that the high-beta Asian exports can remain robust. With the stagflationary bias in the recent data, we remain concerned that the Fed and the other central banks may continue to tighten and global growth decelerates. In this risk scenario, USD/Asia will struggle to go lower.
In this note, we focus on the impact of a consumption-led slowdown in the US. If the US slows, Japan, China and AXJC will all suffer; however, a consumption-led slowdown in the US could hurt China more than others, ceteris paribus. Such a consumption-led slowdown could also drive a wedge within Euroland, as Germany is a capital goods-intensive exporter, while France, Italy and Spain are all consumer goods-intensive exporters.
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Jul 28, 2006
Serhan Cevik (from Istanbul)
Should we celebrate the openings of Harvey Nichols and Saks Fifth Avenue in Turkey? Turkey has enjoyed an extraordinary period of economic stability, raising per capita income from US$2,146 in 2001 to above US$5,000 this year. Even so, the level of purchasing power of an average Turk is still less than one-third of the European level. This is why it is a curious development to see the giants of luxury retailing, like Harvey Nichols and Saks Fifth Avenue, opening stores in Turkey. These department stores for the super-rich rarely invest outside of their homelands, building franchises only in the Gulf region and Hong Kong. So why are they interested in the Turkish market when there are so many countries with higher purchasing power? The answer is not hidden in demographics or national accounts. We need to look beyond averages and aggregates to see the reality attracting luxury brands. Turkey’s per capita income may be a mere 31% of what an ordinary European takes home in a year, but there is a sub-group of the population that is as rich as the richest of rich countries. In other words, the socio-economic structure encompasses several income groups including the super-rich, the middle-income and the poor, which remains almost at par with sub-Saharan countries. Therefore, luxury fever is simply a manifestation of inequality in income distribution and consumption patterns, not a reason for jubilation, in our view.
Income distribution has improved in recent years, but is still the worst in Europe. Measured by the Gini coefficient, the income gap between the rich and the poor narrowed from 0.49 in 1994 to 0.40 in 2004. The share of income received by the bottom quintile of Turkish households increased from 4.9% in 1994 to 6.0% in 2004, while the income share of the most affluent quintile dropped from 54.9% to 46.2% of all income. Moreover, the combined income share of third- and fourth-quintile households increased from 31.6% in 1994 to 47.8% in 2004. Although these are certainly encouraging results, Turkey still has the worst income distribution in Europe where the Gini coefficient stands at 0.30 on average. And if we analyse income distribution according to 5% segments instead of quintiles, social disparities look even worse — the poorest 5% of the population getting 0.9% of national income versus 20.9% received by the richest 5% of households. Furthermore, even though official figures do not allow a percentile-level analysis, our calculations suggest that the richest 1% of households enjoys approximately 260 times more income than what the poorest 1% earns in a year. It is this super-rich group with an increasing propensity for ‘conspicuous consumption’ that attracts retailers like Harvey Nichols and restaurants like Hakkasan to Turkey.
Income inequality is a result of the unequal distribution of real estate and financial wealth. The problem of income inequality in Turkey is mainly a result of income concentration among the super-rich, rather than the income share of the poor, which is reasonably comparable to the share of the poorest quintile in Europe. This is why we need to explore the functional income distribution and effective collection of taxes on income and capital gains. While labour earnings are the most important source of income for the poor, high-income households receive the majority of real estate and financial income. For example, using the distribution of deposits as a proxy for the concentration of financial wealth, we find that 0.8% of the depositors hold 65% of bank deposits. Similarly, the top 100 equity investors account for 40% of total portfolio valuation. As a result, the richest quintile receives 80% of all financial income and 70% of real estate earnings, compared to the lowest quintile getting a mere 1% of non-labour income. This is why the distribution of financial income explains more than 50% of income inequality, and therefore we need to focus on structural factors limiting socio-economic progress.
The archaic tax system contributes to the unequal distribution of income. There are several reasons ranging from macroeconomic instability to family size and educational attainments that have contributed the unequal distribution of wealth and income in Turkey. However, even though it would take generations to address some of these underlying factors limiting the access to economic opportunities, there is one area the authorities can, and should, start tackling today, in our view. That is the archaic tax system, which creates a haven for those evading and/or avoiding income and capital gain taxes and thereby worsens the after-tax distribution of income. In our view, the failure to develop a better taxation system would not only increase the cost of ‘subsidising’ the posh at the expense of the poor, but also delay the country’s income convergence.
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