Doha Doesn't Matter
Aug 04, 2006
Stephen S. Roach (New York)
Too much has been made of the apparent failure of the Doha Round of trade liberalization. It does not spell the end of globalization. Nor does it signal an imminent threat to the expansion of cross-border trade. Instead, the lessons of Doha bear more on the trust factor - the unwillingness of the world’s body politic to buy into the win-win boosterism of globalization. In the rough and tumble arena of global competition, that may be par for the course -- but hardly the disaster that the breakdown of trade talks was widely made out to be.
The Doha Round was probably doomed from the start. Conceived in the highly emotional aftermath of 9/11 as a politically motivated endorsement of globalization, there was great hope for a major new breakthrough on the world trade front. However, it turns out that the macro climate made concessions exceedingly difficult for rich and poor countries, alike. The seemingly intractable battle over agricultural subsidies -- always a contentious issue under the best of circumstances -- was a foil for much deeper-rooted misgivings. A powerful global labor arbitrage put employment and real wages under intense pressures in the developed world -- causing great resistance to a further lowering of trade barriers in the industrial world. And rapidly growing export-led developing countries resented being cast in the role of scapegoats -- giving them little incentive to offer concessions of their own. For about a year, the handwriting has been on the wall that this round of trade liberalization was going nowhere. By the time the talks finally collapsed, expectations were so low that not all that much was really lost. In the end, the global trade dynamic matters much more than a high-profile media event staged around a breakthrough in multilateral negotiations. Despite repeatedly stiff resistance to the Doha agenda for nearly five years, there can be no mistaking the powerful gains in world trade that have occurred over that same period. Global trade volumes -- calculated as the average of export and import growth -- rose by 6.6% per annum over the 2002-05 period; that pace was about 50% faster than the 4.3% average world GDP growth over the same time frame. As a result, the ratio of exports to world GDP rose by 4.0 percentage points from 24.1% in 2001 to 28.1% in 2005 -- the strongest four-year increase since the early 1970s. Putting it another way, the growth in global exports accounted for fully 40% of the cumulative increase in world GDP over the past four years. In the end, that’s what matters most. Despite the psychological headwinds of a doomed Doha Round, the strength in global trade went well beyond any vigor that can be attributed to the global business cycle. What that means is that global trade barriers may already be low enough to have established a breakthrough threshold for accelerating globalization. I can’t help but think that the hyper-speed of IT-enabled connectivity is an important new catalyst in this equation -- providing multinational corporations with new options to cope with increasingly intense competitive pressures. Not only has the Internet revolutionized the cross-border logistics of price discovery and supply-chain management in manufacturing businesses, but it has also transformed the knowledge-based output of once non-tradable services into tradable activities. A Doha breakthrough -- especially the watered-down agreement that negotiators were aiming for in the end -- would have paled in comparison to these powerful organic developments that are now driving cross-border trade in an IT-enabled global economy. All this is not to say there aren’t serious problems on the global trade front. Suffering from the twin pressures of job and real wage insecurity, rich countries feel increasingly threatened by globalization and are pushing back on free and open trade. The rapid growth of white-collar offshoring is a particularly big deal in the current climate. Even though the absolute number of lost jobs has been small so far, the fear of where this trend is going -- and what it implies for real wage convergence -- are sources of considerable anxiety amongst long-sheltered knowledge workers in the developed world. “No jobs are safe any more,” is the refrain I hear constantly in he developed world. The US and China are lightning rods in this debate. America, with its massive trade deficit, feels more exposed than ever. With a $200 billion bilateral imbalance with China having accounted for 25% of a record $800 billion multilateral US trade deficit in 2005, Washington has fallen into the blame game. Over 20 pieces of China-bashing trade legislation have been introduced in the US Congress in recent years. A multilateral breakthrough in the Doha Round would have done little, in my view, to dissuade Washington from taking dead aim on China. In a narrow sense -- namely, from the point of view of hard-pressed workers --- the politicization of globalization is understandable. Yet in a broader context, protectionism is entirely misplaced and may well be an inappropriate response to unusual macro characteristics of both the US and Chinese economies. For example, as long as the United States runs a “zero” net national saving rate, it is forever doomed also to run large current-account and trade deficits. Like it or not, this is an inherent bias of America’s wealth-dependent, saving-short economy. By going after China, Washington politicians are unwittingly taking aim on the mix of the US trade deficit, while doing absolutely nothing to reduce the magnitude of the overall external imbalance. Similarly, nearly two-thirds of China’s export growth over the past dozen years is attributable to “foreign-invested enterprises” -- Chinese subsidiaries of foreign multinational corporations and joint-venture partners. The very existence of these subsidiaries is an outgrowth of conscious decisions made by Western businesses -- an outgrowth of efficiency solutions implemented in the name of competitive survival. This is a very different development than unfair competition by indigenous Chinese companies. Politicians continue to ignore these macro sources of trade tensions. I guess it’s always easier to find a scapegoat than to look in the mirror. Nor would a Doha breakthrough have cracked this denial either. There is a potentially tragic irony to the juxtaposition between the surging global trade and the political backlash against globalization. There are inherent biases to the macro performance of both the United States and China that are setting up these two nations for trade conflicts. If left unattended, these conflicts pose much greater risks to globalization than the failure of trade talks. A successful completion of the Doha Round would have done next to nothing to diffuse these pressures. From the start, Doha was a sideshow to the main event in the global economy. Nearly five years of disappointing progress in multilateral negotiations didn’t make a dent in an increasingly powerful world trade dynamic. Nor would a breakthrough -- watered down or not -- have done much of anything to temper the mounting bilateral sources of protectionism. A successful completion of the Doha Round of trade liberalization would have been nice. But the benefits would have been fleeting, at best. There are much bigger fish to fry in an increasingly contentious era of globalization.
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Financial Market Implications of Pension Reform
Aug 04, 2006
Richard Berner (New York)
After nearly two years of debate, Congress has just passed pension reform legislation, and the President likely will sign it. The Pension Protection Act of 2006 improves on current law in several important respects, but together with pending changes in pension accounting, it would expose more fully the economic cost of defined-benefit (DB) plans. As a result, I continue to think that plan sponsors are likely to accelerate the ongoing shift from DB to defined-contribution (DC) plans, and potentially re-allocate portfolios away from equities and towards longer-duration bonds (see for example, “Financial Market Implications of Pension Reform,” Global Economic Forum, January 18, 2005). Indeed, that shift will probably continue even if the reform process bogs down again. But I also think that the resulting market effects could be smaller than I judged two years ago. Here’s why. First, let’s look at the provisions of the new law. It tries to strike a balance between improving the soundness of the pension and retirement saving system and mitigating the resulting increase in costs accruing to plan sponsors. To their credit, the framers embraced some widely-accepted, “best practice” principles for reform. They would require plan sponsors to use more realistic mortality, discount-rate and return assumptions than in current law to calculate funding targets for single-employer plans. For example, the Act requires the IRS to prescribe that most plans use current mortality tables instead of those from 1983 now in use. The Act would require discounting cash flows with a yield curve that matched these flows’ time profile rather than a single corporate yield. It would limit the smoothing of asset values to no more than a 24-month period rather than five years. It would require plans to be 100% funded rather than the 90% currently allowed. The new law would also better define plans at risk, require action to fund them, and increase premiums paid to the pension insurer, the Pension Benefit Guarantee Corporation. It would deem plans at risk if they fell below 70% funded status under worst-case assumptions or 80% under standard assumptions. Plans so designated for two of the past four years would face accelerated funding rules. Such plans could not increase benefits or allow lump-sum distributions. PBGC premiums would rise sharply for riskier plans. The Act would also tighten funding and withdrawal rules for multi-employer plans. The framers of the law understand that the DB system will continue morphing into a DC framework, forcing workers to shoulder more interest-rate, return, and longevity risks. Recognizing that DC plans like 401(k)s also come up short, the new law would improve rules governing such plans as well. It would encourage automatic enrollment with an opt-out provision to increase participation. And it would extend the DC sweeteners enacted in earlier legislation, such as increasing contribution limits, allowing “catch-up” contributions for older workers, and making permanent and indexing the “Savers’ Credit” that allows a tax credit for contributions up to $2000 in 2006 dollars. There’s no mistaking the major compromises and gaps in the Act. While the framers tightened funding rules, opponents of change forced them to accept extended transition periods, especially for some troubled airlines. The delayed start (in 2008) and long phase-in of tougher rules (to 2011 for well-funded plans, to 2013 for those at risk, and to 2023 for airlines that opt for a “hard freeze” of their plans — closing them to new entrants and eliminating further benefit accruals) reduce the proposals’ effectiveness. As I see it, lawmakers would not have needed such compromises had the bill mandated the separation and defeasing of “legacy costs,” or the value of unfunded past promises. That’s because defeasance would wipe the slate clean and thus put consideration of future promises by all sponsors on equal footing (see “Defeasing Legacy Costs,” Global Economic Forum, November 28, 2005). And lawmakers did not sufficiently toughen return and other assumptions. But politically, such radical change is difficult to achieve. That the current effort has won praise from diverse critics such as the United Auto Workers union and the American Benefits Council speaks to the concessions needed to translate reform proposals into reality. Even with long transitions that soften the blow to sponsors of tougher funding rules, the Act would expose more clearly the true economic costs of DB pensions than is apparent under current law. The Financial Accounting Standards Board’s proposal to amend significantly accounting rules for pension and other postretirement benefits — first including the under- or over-funded status of plans in shareholders’ equity and subsequently putting gains or losses in the income statement — would further expose such costs to investor scrutiny. The reality of pension reform thus could accelerate the freezing of DB plans as more CFOs decide that they are simply too expensive. My colleagues and I have argued that the incipient demand for duration resulting from these changes could cap both long-term yields and equity returns in coming years (see “Demand for Duration: Coming Soon? Global Economic Forum, March 10, 2006). But the effects may be small — indeed, smaller than the potential flows out of equities into bonds might imply. The reasons: The transition period for both new pension regulations and accounting rules is long, and some of this is likely already in the price after years of discussion and dozens of plan freezes. That Congress has passed pension reform and will send it to the President for signing is good news, but it isn’t the end of the story. While HR 4 is a tome of 907 pages, the devil is always in the details of complex legislation. Many of the provisions are already laced with exceptions and some are obscure. Talk is already circulating of a “clean-up” bill that would correct, clarify and amend some provisions. The danger from a public policy perspective is that some of the provisions will be further watered down, leaving taxpayers and the pension system still at risk.
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Nudging 'Em Higher
Aug 04, 2006
Elga Bartsch (London)
As it was widely expected by financial markets and clearly telegraphed by the European Central Bank (ECB) in advance, the Governing Council decided to hike the main refinancing rate by 25bp to 3% this Thursday. Given that the decision had been widely expected, the more interesting part of the ECB events clearly was the press conference with ECB President Trichet following the meeting, which we view to have been on the hawkish side. In line with our expectations, ECB President Trichet signalled a slightly faster pace of future ECB tightening by saying that the ECB will “continue to monitor the risks to price stability very closely”. Historically, the ECB always went back to “monitoring risks closely” after an upward adjustment in euro area interest rates. By escalating the language compared to the historical norm, the ECB intends to signal that the next rate hike is less than three months away, we think, underscoring our view that the next ECB rate move will likely follow in October. We would therefore expect a further change in the ECB’s chosen language, re-introducing the “strong vigilance” terminology, at the late August meeting. In a new twist to its post-rate hike phraseology, the ECB also deems a “progressive withdrawal of monetary stimulus as being warranted” if its baseline scenario is confirmed by incoming data. At a refi rate of 3% after this week’s upward adjustment, the ECB still views its policy stance as accommodative. In our view, this is a strong hint that rates are going to go up some more unless there are any major downside surprises on growth or inflation. According to the ECB staff projections, the main case scenario is one where real GDP growth comes in at 2.1% for this year and 1.8% for next year. Our reading of recent business cycle indicators, however, is that the risks to these projections are tilting to the upside in the near term (see Euroland Business Cycle Watch: Not Yet Landing, July 28, 2006). We agree with the ECB that the risks are to downside in the medium-to-longer term, but would assign them to a tightening in fiscal and, to a lesser extent, in monetary policy. The ECB Council, by contrast, views the risks to be balanced in the near term and to be to the downside beyond that. On the first count, the near-term risks, the upcoming 2Q GDP reports will be important. Ahead of the Euroland numbers due out on August 14, we will get 2Q GDP reports out of the Netherlands and Italy this coming week. For the Dutch data, we expect a marked pick-up from a meagre 0.1%Q in the first quarter to 0.8%Q in 2Q, while Italian GDP growth has likely slowed from 0.6%Q in the first three months to a reading closer to trend at 0.4%Q. On the second count, the longer-term risks, the ECB is concerned about the downside risks stemming from oil prices, global imbalances and protectionism. The collapse of the Doha round of WTO negotiations and the recent events in the Middle East have reinforced these concerns since the last meeting in early July. According to the ECB President, it is not clear that euro area business surveys have peaked yet. We would probably argue that it is likely — even though not certain — that business sentiment will peak out at current levels. At the time of the late August meeting, the ECB and we will have one more round of business and consumer surveys at hand. In the view of the ECB Council, the upside risks to price stability have increased over the last month. As before, the upside risks are perceived to stem from oil prices and their pass-through into other prices, further indirect tax hikes and potential second-round effects via higher wage inflation. Food prices — which in our view could start to be pushed higher by the unusually hot summer weather that most of Europe enjoyed until recently — were not mentioned as a concern by the bank. At this stage, the ECB Council takes little comfort in the slight slowdown in money and credit growth reported in June. Instead it views the upward trend as still being firmly in place and the dynamics, especially in lending to the private sector, being very strong, therefore requiring careful monitoring by the ECB especially in conjunction with house price dynamics. According to Jean Claude Trichet, it would be premature to take the moderation in M3 growth as an indication that past tightening is starting to take effect. Looking at the money market moves over the last month, the ECB’s attempt to act more pre-emptively seems to be paying off. While money market futures were still pricing in a four handle for three-month Euribor rates at the end of next year, the money market curve has flattened noticeably since and is now pricing in only one more rate hike in the course of next year. We still believe that the market is too bearish on short rates in 2007 and continue to expect the ECB to put its tightening campaign on hold next year.
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Aftershocks
Aug 04, 2006
Serhan Cevik (London)
Supply-side shocks, not a demand bubble, are behind the rise in inflation. The consumer price index posted a month-on-month increase of 0.8% in July, well above our and consensus estimates. The lira’s weakness and higher energy prices continued to have an overwhelming influence on short-run inflation dynamics, pushing the year-on-year inflation rate from 8.8% in April to 10.1% in June and 11.7% last month. Even though the latest figure remains above the upper bound of the central bank’s uncertainty band, it is likely to be this year’s peak reading, in our view. However, before discussing the outlook for the remainder of the year and its implications for monetary policy, we should look into the ‘black box’ and find out more about the inflation process and the factors driving it. The trouble started two years ago, well before the recent wave of risk reduction in global capital markets, with the rise in oil prices and worsened with an unusual spike in (unprocessed) food prices. This is why we have argued that supply-side shocks, such as higher commodity prices, not an imbalance between domestic demand and supply, are behind the rise in inflation. Of course, global portfolio reallocations out of ‘risky’ assets resulted in an abrupt depreciation of the Turkish lira and consequently led to an increase in import prices and production costs. The pass-through effect accounted for 70% of the rise in inflation in the past three months. Structural changes in the economy and de-dollarisation of residents’ financial holdings have certainly lessened the pass-through effect of currency depreciation on consumer prices, but that does not mean that exchange rate fluctuations have no effect on pricing behaviour. Since the Turkish economy is heavily dependent on imported energy and intermediate goods, the lira’s weakness becomes a source of inflationary pressures. Furthermore, although Turkey achieved disinflation at an extraordinary pace, economic agents are still yet to internalise low inflation and consequently keep inflation expectations exposed to volatility bursts. Judging from the latest data, this is exactly what has happened in recent months. The strongest — and immediate — effect has been unsurprisingly on producer prices, recording a cumulative increase of 7.8% in the past three months and a year-on-year inflation rate of 14.3% in July. Given the extent of the currency shock and soaring energy quotes, the PPI surge is not really a bolt from the blue. Likewise, exchange rate-linked components of the CPI basket have shown an immediate pass-through from the exchange rate’s weakness. The transportation category, for example, jumped 2.9% in July (and 8.4% in the last three months), pushing annual inflation from 7.9% in April to 14.8%, due to higher fuel prices in lira terms. The key components of consumer spending show no sign of a demand bubble. The inertia in rental prices and the pass-through effect from higher commodity prices and the lira’s weakness remain as obvious challenges. However, we need to be careful in analysing post-volatility data and not lose the macro perspective. Once again, the rise in inflation is not a result of demand-driven pressures, and the data provide an unambiguous support for our thesis. For example, clothing and footwear prices dropped by 6.9% month on month in July, lowering the 12-month inflation rate from 7.7% at the end of 2004 to 0.6%. Although a similar adjustment in food prices was underway, it seems (from aggregate figures) that the heat-wave causing problems all around Europe led to a larger-than-expected increase last month. Nevertheless, after increasing by 6.5% in the first five months of this year, the food component posted a cumulative drop of 1.3% in the last two months. As argued in previous reports, the divergence between processed and unprocessed food prices that made a significant contribution to the upsurge in inflation prior to the volatility shock is not an indication of a demand bubble (see The Mysterious Vegetarian Demand Bubble, June 19, 2006). Beyond short-term volatility, it is all about the balance between demand and supply. Market participants and the central bank still focus on volatility and expectations. But beyond short-term considerations, inflation is all about disposable income and demand in relation to supply. As long as there is no policy accommodation, pass-through effects would not become entrenched in pricing decisions. In our view, policy commitment and the state of the economy will limit secondary effects and have, once again, a more pronounced influence over inflation. Even before the burst of volatility, the unemployment rate including ‘discouraged’ workers stood at 20.4% (up from 18.3% last year), against our estimate of about 6.5% for the non-accelerating inflation rate of unemployment. Moreover, with depressed real wages, the labour share of national income showed just a marginal gain from 26.1% in 2003 to 26.6% last year, remaining 410bp lower than the 1999 level (see Marx’s Ghost, July 17, 2006). And now restrictive financial conditions bring a slowdown in domestic demand, as indicated by the marked drop in durable good sales, and create even more slack in the labour market. Given the supply frontier’s shift, these factors will lead to a widening in the output gap and form a ‘ceiling’ on the pass-through from the increase in production costs to consumer prices. As a result, provided that we face no more shocks, we believe that the lira’s depreciation will have a diminishing effect on inflation and fundamentals will bring disinflation back on track.
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Beijing Likely to Shift into Overdrive on the CNY
Aug 04, 2006
Stephen Jen (London)
Beijing will move on RMB I continue to believe that this will be the ‘Year of the CNY’. Using the analogy of shifting gears in a car, I believe that Beijing is about to ‘up-shift’ the pace of crawl in USD/CNY. A faster rate of crawl of USD/CNY should have logical implications for USD/AXJC. This note is not about what China should do. (I think there have been too many research pieces trying to convince China what is good policy.) Rather, this note updates my latest guess as to what Beijing will likely do regarding CNY. We should also remind ourselves that when and what Beijing will do with the CNY is not an economic question, but a joint economic-political question, which is intrinsically less tractable than a pure economic question. My emphasis is not on guessing what date Beijing will do what, but on the key undercurrents that may alter the thinking in Beijing. Busy gear shifts in the past year Let’s first examine the changing evolution of USD/CNY. Since July 21, 2005, Beijing has shifted gears several times. In the initial period, the annualized rate of crawl (ARC) was 1.0% a year (Gear 1). This lasted from July to December 2005. Subsequently, in the first three months of this year, the ARC rose to 2.2% a year (Gear 2). The ARC further accelerated to an interesting 5.0% a year by March/April 2006 (Gear 3). Since President Hu’s visit to the US in mid-April and the G7 meeting on April 21, however, USD/CNY stopped declining, until very recently. Around the time when the impressive but worrying 2Q GDP was released in late July, Beijing reaccelerated the rate of crawl of USD/CNY to a pace close to Gear 2. We believe that Beijing will shift back into Gear 3 and beyond in 2H06. If we are right about this trajectory, USD/CNY is on track to reach 7.70 or below by the end of the year. Implicit in our aggressive year-end target of 7.50 is the assumption that Beijing will go beyond Gear 3. The Year of the CNY On January 6, 2006, I issued The Year of the CNY, in which I argued that “greater flexibility will lead to greater CNY strength, which should help propel USD/AXJC lower”. I supplemented this bullish view on CNY with Beijing in the Driver’s Seat in the Year of the CNY, April 6, 2006. In 2005, China achieved the most orderly currency float in modern history and, with the regulatory changes and institutional reforms in the banking and the financial sectors by the beginning of this year, China was in a position to permit greater CNY flexibility. Further, I argued that the official reserves would soon reach such a high level that the trade-offs between the ‘marginal costs’ and the ‘marginal benefits’ of more foreign reserves were turning. Moreover, I argued that strong global demand would allow China to take this next step from a position of strength, and the risk of protectionist pressures justified using more CNY movement as a form of ‘insurance’ against protectionism. Reasons why Beijing will shift to Gear 3 and beyond In my previous pieces, I already laid out the key macroeconomic arguments supporting my view on USD/CNY, which I will not repeat here. Below, I will emphasize the three key reasons I believe that Beijing will likely ‘up-shift’ its rate of crawl of USD/CNY in 2H. • Reason 1. Foreign reserves reaching a saturation point. At the beginning of the year, I stressed that what would make 2006 different from 2005 and 2004 — the two years during which I refrained from calling USD/Asia to sell off — was that most Asian central banks either had already or would reach ‘saturated’ reserve levels. It is difficult to claim definitively if any country has ‘excessive’ foreign reserves, because there are no clear lines in the sand pin-pointing the optimal level of reserves for each country. However, I am of the view that US$250 billion is a lot of reserves for Taiwan, US$200 billion is enough for Korea, and US$1 trillion is a bit much for China, from both an objective perspective and my best guess of what the respective central banks’ views are. For China, managing more than US$1 trillion of reserves (China’s official reserves reached US$941 billion at end-June, and are on track to breach the US$1 trillion mark by September) would not be easy. The marginal benefits of having a large pool of liquid foreign assets to meet speculative pressures are increasingly overwhelmed by the marginal costs of an official entity being exposed to so much financial and political risk. In other words, assets of this kind, if they are too large, become liabilities in some sense. It is the expected future movements, not the current level, of exchange rates that drive short-term capital flows and reserve movements. Thus, it would still not be clear that if Beijing allows more RMB strength there would not be more short-term inflows. However, I believe this is a risk that Beijing will need to take; the current strategy is not sustainable, as maintaining a managed float that is so ‘sticky’ would certainly lead to very rapid reserve accumulation, in my view. The fact that capital outflows need to be further liberalized for the exchange rate to be a true reflection of genuine underlying demand and supply conditions is well-understood. However, holding USD/CNY at such a high level now will itself discourage outflows simply because Chinese investors with genuine interest in investing overseas may be concerned about potential capital losses from future CNY appreciation. In short, the more USD/CNY trades toward its fair value, which is less than 10% from the current spot rate, the more likely it is for capital outflows to take place, in my view. • Reason 2. Domestic demand is too strong; China is not that vulnerable to a bit of currency strength. The number one argument against any CNY appreciation is the concern of job losses and stagnant growth. I have (back in 2004 and 2005) argued that maxi-revaluations are dangerous, given the example of Japan in the past two decades, and China’s relatively high trade elasticity with respect to price. However, with the officially reported growth rate running at 10.9% in 1H and 11.3% for 2Q, which are likely to be under-estimations of the actual growth rate in China, and with the PBOC likely to continue to tighten, the fear of modest CNY appreciation is much more difficult to justify now than a short three months ago. Even if the US slows, I believe that another 5% or so appreciation in the CNY will not cause material damage to China’s economy. Unless Beijing keeps USD/CNY supported to make a political point, there are now very few economic reasons why it should intervene so aggressively. • Reason 3. Beijing still has an opportunity to buy an ‘insurance’ against rising protectionist pressures from the US when the US slows. My view is that the economic ‘sticking-point’ between the US and China is trade, not the currencies. However, Beijing should accept that the CNY policy will be politicized in the US. With the US running at above potential growth rate, and the unemployment rate being so low, protectionism has remained a key risk, and a main worry for the US Treasury. If the US slows, it is likely that this risk of protectionism could gain considerable political momentum. In my opinion, China should use the CNY as an ‘insurance’ against this risk of protectionism. As long as USD/CNY is seen by the US to be flexible, and as long as Beijing is not seen to be recalcitrant, with the help of the US Treasury, the political impetus behind protectionism could be muffled. This, to me, is a very small price to pay for China to reduce this risk. Bottom line After the puzzling slowdown in the rate of crawl in USD/CNY between mid-April and late July, I believe that Beijing will significantly re-accelerate the rate of crawl. China cannot continue to accumulate reserves at the current pace; China’s fear of modest CNY strength undermining economic growth is no longer justifiable; and, importantly, Beijing should see modest CNY appreciation as an ‘insurance payment’ against the risk of protectionism in the US, which is likely to rise with a US economic slowdown.
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G10
Aug 04, 2006
Stephen L Jen (London)
Bank of Italy’s (BoI) announcement After some confusion created by a newspaper report, the BoI reconfirmed that it raised the GBP share of its official FX reserves from zero in 2004 to 25% at the end of 2005. During the same period, its dollar holdings were cut from 84% to 63%, while JPY holdings were reduced from 14% to 10%. I have the following thoughts: 1. This has already been done. The conversion of JPY and USD that brought GBP to 25% of the reserve portfolio already occurred over 2005. Given that the BoI announced, and reconfirmed, to the public what it already did in the past, it says very little about whether the other EMU countries have already done, or are in the middle of doing the same. Note, the mid-year report released on August 1 did not elaborate on any further changes in the composition of reserves since the end of 2005. 2. Euro area reserves stood at US$168 billion at end-June 2006. Excluding reserves held by the ECB, the euro area central banks are sitting on US$168 billion worth of foreign currency reserves (Germany = US$38.8 billion, France = US$31.1 billion, Italy = US$23.5 billion) — about 4% of the world's FX reserve holdings of US$4.2 trillion. The BoI’s decision itself is relatively minor, from the perspective of the FX market, as its assets under management are smaller than a small-size real money manager, and equivalent to only 0.5% of the world’s FX reserve holdings. However, if all the euro area central banks did the same, i.e., diversified from USD, then we could see a meaningful (but still not a dramatic) effect on the FX market. 3. The UK is not joining the EMU. The reason why the European central banks had zero GBP holdings in the first place is because of the EMU member countries’ hope and presumption that the UK would, in the not too distant future, join the EMU. To me, the BoI's decision may reflect Italy’s realisation that (i) the UK may never join the EMU and (ii) the BoE is doing a great job being outside the ECB’s reach. The timing (from 2004) is consistent with the UK’s negative verdict on the ‘Five Tests’ in the summer of 2003. In other words, I’m not sure if this decision by the BoI is more negative for the dollar going forward or more negative for the EMU, from a structural perspective. 4. But if the UK joins the EMU one day, EUR/USD should sell off. We need to be consistent. If we think that a generalized move away from USD into GBP by the European central banks is negative for the dollar, then if and when the UK does join the EMU, all these central banks will need to sell GBP and buy something else, and the BoE (with US$38.7 billion in FX reserves) will also need to sell its EUR holdings and buy something else, because these foreign reserves have to stay ‘foreign’. But this is a risk for later, not now. 5. Anecdotal observations versus aggregate data. There are many anecdotal observations suggesting that central banks have been diversifying away from USD. But, the most definitive data on this subject (the COFER database from the IMF) still do not suggest any meaningful move away from USD. I’ve recently written about this, using the latest IMF data, which showed that the world’s holdings of official reserves in USD were 66.3% as of end-1Q06, compared to 67.4% two years earlier (a very small decline). For industrial countries, the ratios were 73.8% now, compared to 73.6% in 1Q04. Further, if we consider the valuation effect, i.e., the fact that EUR/USD is substantially stronger now than in 2004, then there has actually been net USD buying in real terms! 6. I like GBP, from a structural perspective. The market has been overly fixated on the cyclical outlook of the UK, in thinking about GBP/USD or EUR/USD. Until very recently, for example, the market had been overwhelmingly negative on GBP. From a structural perspective, I think GBP has a number of advantages, which I have written about, that more than offset the cyclical problems it might have. Bottom line This is clearly an important issue for us. But I continue to believe that what is commonly believed to be true (wholesale dollar diversification) is a gross exaggeration of what has actually happened. Also, so much fixation on what central banks may or may not have done has distracted us from monitoring what the private funds have been doing. I personally suspect that the US real money accounts (with US$18.6 trillion under management) have done more USD diversification in the last three years than anyone else. The dollar is in fine shape, from a structural perspective, because the private sector is more underweight the dollar than the central banks are overweight the dollar. The market’s fixation on the latter is not a balanced view.
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Warning from Hawkish Policy Board Members
Aug 04, 2006
Takehiro Sato (Tokyo)
The yen interest-rate market has run out of bad news for the time being. BoJ Governor Fukui ruled out the possibility of consecutive rate hikes and also rejected the option of just raising the Lombard rate (supplemental loan rate) at the press conference after the BoJ lifted ZIRP on July 14. These comments pushed back consensus expectations for an additional rate hike from October to sometime in 2007 and eliminated chances of a surprise hike of the Lombard rate this summer. The call market converged surprisingly quickly to the 0.25% target rate in one week from the reversal, and longer-term rates are declining with lower expectations for an additional rate hike and lower US long-term rate. Hawkish members on the BoJ policy board have reacted to this sentiment in recent speeches, openly expressing discomfort with the market consensus that the BoJ will not raise the policy rate again in 2006. Investors should only interpret Mr. Fukui’s comment that the BoJ “will not conduct consecutive rate hikes” as saying that it will not follow the US pattern of rate hikes at every policy meeting. We hence think investors should take these comments seriously as a warning from authorities. However, these assertions are not convincing right now amid heightened investor concerns about a slowdown in US economic momentum and negative repercussions for Japan (regardless of the actual state of the economy). Where is the market headed? The main risk for recent market optimism about the policy rate path is domestic and overseas economic momentum remaining firm in contrast to slowdown worries. While we maintain our bullish outlook, the recent decline in market rates needs to be closely monitored within this context. There is still no sign of domestic and overseas economic momentum easing, despite the risks of deceleration. In the US, corporate activity is relatively strong, led by capital investments, even though growth has slowed for the household sector. Corporate finances should withstand negative demand shocks thanks to steady margin expansion, reducing the likelihood of capital investment and job cutbacks even if personal consumption slows. We also expect rich margins to help companies absorb higher input costs from the upswing in energy and raw material prices to some extent with improved productivity. This diminishes the prospect of inflation pressure despite widespread concerns. The Japanese economy is also experiencing weaker momentum in the household sector as poor weather hurts personal consumption. However, the BoJ Tankan Survey from June reports solid capital investment activity exceeding expectations. IT and materials industries have replaced the automotive industry, which was the primary driver in 2005, as leading forces in manufacturing industries, and domestic-demand areas are setting double-digit expansion plans in non-manufacturing industries. The most notable feature of Japan’s current prolonged economic recovery is the support from steady replacement of momentum drivers from IT to materials, materials to automotive, and automotive to IT and materials. We anticipate the next shift going to domestic-demand industries. Yet we are still cautious about the direction of Japanese prices. The core inflation rate has been rising moderately, reflecting higher energy and raw material prices, in line with the BoJ scenario. While oil prices and yen rates will naturally continue to affect the price path, upward pressure from energy prices should gradually recede toward the end of F2006 if oil stays at the current level. Productivity gains are unlikely to slow as much as feared by the BoJ, considering the surprisingly low rate of wage growth. There is also substantial room for productivity improvement in the Japanese economy, given ample slack (labor force and other resources) in regional economies. We hence expect healthy productivity growth to continue keeping a lid on prices. We have an optimistic outlook for the policy rate path, despite warnings from policy board hawks, while still being somewhat concerned about the recent decline in market rates. The main event risk that might overturn our optimistic view is a smaller-than-expected impact from revision of the CPI benchmark figures on August 25 that reinforces the outlook for minimal price decline. Miyako Suda mentioned a specific revision margin in her July 26 speech, noting the “possibility of a retroactive revision of just under -0.3pp”. While this comment has generated a variety of investor speculation, we think she simply restated the retroactive revision margin covered in April’s Outlook Report. We currently expect a -0.2pp revision with some variation due to uncertainty surrounding imputed rents. However, the market outlook toward prices could change if the actual revision is less than the -0.3pp cited in this speech. We see the following type of risk. Price growth typically declines from revision of the price standard that defines a new basket from a substitution effect since households are constantly shifting to cheaper goods and services. Yet the substitution effect might be positive this time, based on detailed analysis of the Household Survey used in defining the price basket since the proliferation of PCs has reduced the consumption weight of the item with the steepest price decline. Our estimate of the overall impact from the revision remains negative since other price effects are likely to exert downward pressure, including the selection effect for new products with steep price declines such as flat-panel TVs and mobile phones, the index resetting effect from changing the benchmark year from 2000 to 2005, and the outlet effect. Market expectations for a rate hike might move forward into 2006 again if speculation heightens in the fall that the BoJ is likely to present a more bullish economic and price outlook in the end-October Outlook Report as suggested by board member Atsushi Mizuno in a speech on August 2. Prerequisites are surprisingly robust earnings and capital investment plans in the September Tankan (scheduled for release on October 2) despite coming just ahead interim results and an early return-reversal effect for stock prices during the fall on enthusiasm for upward revision of earnings plans. However, we think the next rate hike will occur after the BoJ confirms upward post-1H revisions of earnings and capital investment plans in the December Tankan.
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June Trade Decelerated Slightly
Aug 04, 2006
Deyi Tan (Singapore)
June trade momentum decelerated slightly from May, with exports and imports expanding 11.4% (versus +13.1% and +11.8% in May). Consequently, the trade balance stood at RM8.6 billion in June (versus RM8.0 billion in May). Quarterly trade momentum decelerated. Compared to 1Q, both export and import momentum decelerated to 9.8% YoY and 11.5%, respectively (versus +11.5% and +13.7% in 1Q). Meanwhile, the trade surplus narrowed to RM23.2 billion from RM25.8 billion in 1Q, implying that the GDP growth contribution from the external balance is likely to come off in 2Q. Key trends in export segments. Electrical and electronic products was slightly more subdued than the pace seen in May (+8.0% YoY) at 7.1% YoY (+3.7%-pt). Meanwhile, we see oil exports such as crude petroleum (+29.4% YoY and 1.4%-pt) and petroleum products (+22.8% YoY and +0.8%-pt) held up by firm prices while iron and steel exports continued at a blistering pace (+82.5% YoY), contributing a full 1.0%-pt to headline growth despite it being a small segment. In terms of market destinations, exports to EU15 held up at 15.8%YoY (+20.4% in May), likely on the back of machinery and transport equipment. Meanwhile, exports to Japan contracted slightly (-1.9%YoY vs -4.3% in May) and exports to US rose 6.1%YoY (vs +7.5%). Import momentum mixed across categories. Consumer goods imports are still expanding at a healthy pace of 14.2% YoY (versus +12.1% in May). Meanwhile, capital goods imports rebounded from negative territory to 21.3% YoY. Intermediate imports were comparatively weaker at 6.3% YoY in terms of growth. However, they contribute the most to import growth at 4.4%-pt.
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