United States
Betting on Global Growth
Aug 14, 2006

Richard Berner (New York)

Long ago, in another life, a portfolio manager once requested: “Just help me understand the outlook for houses, cars and shopping malls — that’s all I need to know to understand the US economy.”  Of course, that was then: Globalization has taken us far from that parochial and perhaps simplistic perspective of what drives the complex US economy — or has it?  Today, economic doomsayers focus obsessively on housing, expecting that a sharp US housing downturn will soon trigger broader economic retrenchment.  Their logic is simple: Thanks to easy money, strong housing activity and a bubble in housing prices combined to be key drivers for US growth, adding to growth in output and employment and enabling consumers to use their houses like ATM machines to finance spending.  These critics reason the downturn will be even more pronounced than was the boom. 

I disagree on both counts: In my view, other sources of growth likely will be a powerful offset to the unfolding contraction in housing and the coming deceleration in home prices.  Ironically, we project a steeper-than-consensus housing downturn, but we think its ripple effects on consumer spending will probably be smaller than many expect (see “Housing, Mortgages and Consumption: Comparing Australia, the UK and the US,” Global Economic Forum, March 2, 2006). 

Critically, we’re betting that strong global growth, paced by improving overseas domestic demand, will sustainably boost US net exports for the first time in two decades and will contribute to improved US job and income gains.  Moreover, we still think that strong pent-up demand will fuel stepped-up US capital spending.  All three will help promote a moderate second-half acceleration in US economic activity.  And with income growth now rising, I have trouble seeing why housing will collapse.  Here’s why, and an assessment of the implications for financial markets.

If the notion of a second-half reacceleration in US economic activity is far from consensus, the idea that sustained improvement in US net exports will contribute to it is truly heretical.  After all, with the exception of the 1995 mid-cycle slowdown, net exports have been a drag on US growth for twenty years.  Both globalization and the long recovery from the Asian financial crisis seem to have permanently changed the world economy since the 1980s.  And many believe that the US consumer is the only engine of global growth.

To be sure, there are significant challenges to any shrinkage in our massive external imbalance.  Among them:  Daunting deficit arithmetic has locked the gap into a vicious circle that is hard to escape.  With nominal imports of goods and services 54% bigger than exports, exports must grow that much faster than imports just to hold the deficit constant.  Of course, some of the long increase in that ratio reflects the faster rise in import than export prices, especially for petroleum and its products.  But it mostly reflects relatively faster US growth and our presumed loss of market share as we have outsourced and offshored production, especially to China.

There’s thus no mistaking the fact that a sustainable improvement in US net exports requires adjustment on both the export and import sides of the ledger.  On that score, there are several pieces of good news:

First, the improvement in global growth is broadly based, and lately has been driven less by exports and more by domestic demand.  Courtesy of hearty demand growth in Canada and Mexico, which account for 36% of US merchandise exports, merchandise deliveries to North America rose by 12.3% over the past year.  While US real final domestic demand rose by just 3% over the past year, in Canada and Mexico the gains were 4.3% and 7.8%, respectively.  Exports to South/Central America jumped by 17.5% in the year ended in June as domestic demand appears to have accelerated.  Exports to the Pacific Rim region rose by 15.5% in the year ended in June as Asian demand improved.  And shockingly, exports to the 25 countries of the European Union surged by 23.2% over the past year.  The four regions together account for nine of every ten dollars of US merchandise exports.  Sustainable growth in domestic demand appears to have emerged elsewhere as well, although it may depend on increased commodity prices and isn’t immune from recent market declines. 

Second, I think the improvement in overseas domestic demand will continue.  Financial conditions are still supportive of overseas growth; as my colleague Stephen Jen notes, the rise in G-10 country interest rates is a reflection of stronger global growth rather than a barrier to it and hardly makes financial conditions abroad restrictive — at least not yet (see “World Interest Rates Normalizing, Not Restrictive,” Global Economic Forum, August 10, 2006).  As my colleague Gray Newman keeps insisting, rates in many Latin American markets can decline significantly further, reflecting a virtuous circle of fiscal improvement, declining inflation, and rating upgrades.  Improved living standards and pent-up demand for both consumer and capital goods are also key drivers of domestic demand in Asia.  Although second-quarter growth in Japan slowed, my colleague Takehiro Sato believes that strong income growth and rising consumer confidence will continue to unleash pent-up demand (see “Ideal Growth Pattern,” Global Economic Forum, August 11, 2006).

Finally, US-based companies are increasing market share abroad, so faster growth in overseas demand will disproportionately boost US exports.  Their bigger slice of the global growth pie partly reflects the dollar’s real four-year decline.  It also reflects a shift in the mix of global demand, as the overseas recovery in capital spending gathers pace in both the industrial and developing world.  The share of capital goods in US merchandise exports declined during the IT bust, but at 40% it is still the dominant segment in the total, and real capital goods exports are up 14.9% in the past year.  The combination of stronger overseas growth and increased market share is also boosting gains in US exports of services.  Gains in sectors such as financial, legal, engineering, IT, advertising, and research add up to nearly three-fifths of total services, and that aggregate is up 10.3% over the past year. 

Meanwhile, three factors are likely to slow the growth of imports.  The first is slower US domestic demand growth.  Although most of the slowing we expect will be in construction, that deceleration should trim the growth of imported construction materials.  In addition, direct investment in the US affiliates of foreign companies has helped substitute US production for imports in some industries, such as capital goods and motor vehicles.  Finally, it’s worth noting that the decline in energy quotes that we anticipate over the next eighteen months should trim nominal imports by $20–30 billion.  Volumes may also slip: Unlike in 2005, when monster hurricanes disrupted Gulf of Mexico production of crude, refined products, and natural gas, and real petroleum imports accelerated by 700 basis points in the final quarter to fill in the gap, it now appears that this hurricane season will be far more subdued.   Moreover, higher gasoline prices have spurred conservation; US real consumer spending on gasoline fell by 1.2% over the year ended in June. 

The upshot is that the improvement in net exports seems likely to add about 0.4 percentage point to US growth in the second half of this year, and still more than that in the first half of 2007.  Moreover, and perhaps even more controversially, that improvement will likely bolster job gains in high-wage industries such as manufacturing, transportation, logistics and business services.  Indeed, the 4.2% improvement in factory hours worked over the past year likely reflects the improvement in exports that is already under way.  Such gains, together with accelerating pay, will continue to boost income, which I believe is the most important factor for consumer spending.  While July’s jump in retailing activity got a boost from hot weather, improving income gains likely also played an important role.

For US financial markets that are beginning to discount a recession, stronger second-half growth would come as a surprise.  If it occurs, it will cast doubt on the notion that below-trend growth will quickly damp inflation.  For the Fed, it may suggest both that there is more work to do and that easing is unlikely any time soon.  And the gradual trade improvement may defuse significant dollar weakness and protectionism.

To be sure, there are important risks to this out-of-consensus call.  Supply-induced energy shocks are a threat to both US and global growth.  Terrorism or fear of it could depress global trade and travel, which would hurt tourism in the US.  And protectionism would no doubt stymie the access to global markets critical to the ongoing expansion in US exports.  For now, however, my bet is on global growth.

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United States
Review and Preview
Aug 14, 2006

Ted Wieseman (New York) and David Greenlaw (New York)

The Treasury market posted significant long-end led losses over the past week after incoming growth and inflation data raised a bit of nervousness in a very complacently priced market that the Fed’s widely expected pause bias might have been premature – or at the very least was not supportive of the market’s previous pricing of a quick shift towards rate cuts after October. Futures market pricing still indicates that investors believe the Fed has overdone it and will soon reverse course towards easing. But the FOMC’s continuing tightening bias and the positive incoming growth data – which we see leading to an upward revision to Q2 GDP growth to +2.9% from +2.5% and an acceleration to +3.4% in Q3 – that drew into question the Fed’s forecast that an

extended period of sub-par growth will rein in recently surging core inflation at least forced investors to swing back towards pricing in an even chance of a final rate hike to 5.50%, shift out the timing of expected peak in rates a couple months from October to December – abandoning the quixotic idea that rate cutting could start as early as late this year – and scale back a bit the still significant amount of easing priced in for next year. The key data releases the past week painted a negative backdrop for inflation going forward along with an apparent consumer led acceleration in second half growth. The sharp upward revisions to unit labor costs that followed the big upward adjustments to income growth in the GDP report forced the FOMC to drop altogether its previous reference to contained labor costs as a positive for inflation from its policy statement, while a surge in core retail sales in July suggested that this spike in income growth is prompting a pickup in Q3 consumer spending and thus overall economic growth.

 

Benchmark Treasury yields rose 6 to 10 bp the past week and the curve steepened, though a more significant steepening move in the aftermath of the Fed’s pause was partly reversed by a good-sized front end led sell-off Friday that followed the very strong July retail sales report.   On the week, 2’s-30’s ended up 4 bp steeper and 2’s-10’s 2 bp, with the 2-year yield up 6 bp to 4.965%, the old 10-year yield up 8 bp to 4.98%, and the long bond yield up 10 bp to 5.09%. The old 3-year and the 5-year yields each rose 7 bp to 4.93% and 4.90%, respectively. After a mediocre refunding – weak indirect bidder demand at the 3-year and 10-year legs and a big tail at the bond reopening – all three issues ended the week in the red, with the new 3-year closing Friday at 4.93% after being auctioned Monday at 4.90%, the new 10-year ending at 4.965% after being auctioned Wednesday at 4.93%, and the bond losing a bit relative to its 5.08% reopening level after initially snapping back Thursday afternoon from the poor auction. TIPS continued their recent outperformance, sending breakeven inflation rates to near their highest levels since May. Though coming off a bit from the highs hit in the immediate aftermath of the Fed’s pause when oil and gasoline prices tumbled Thursday, the benchmark 10-year breakeven inflation rate widened 3 bp on the week to 2.64% and the 5-year 6 bp to 2.65%. The 5-year/5-year forward breakeven inflation rate ultimately ended unchanged near 2.63% after peaking Wednesday at 2.67%. This compares with 2.4% at the end of last year, a peak of 2.7% hit in mid-May and a recent low just over 2.5% seen in mid-July.

 

There was surprisingly little initial reaction in the fed funds and eurodollar futures market to the Fed’s pause with a tightening bias, as the small risk of a rate hike that had been priced into the August fed funds contract was uniformly priced out Tuesday afternoon across all contracts, leaving the market still pricing the October FOMC meeting as the cycle peak and showing only about a one-third chance of a hike to 5.50% by then. Rate hikes were still rather inexplicably priced to begin as early as December, and the Dec 06 to Dec 07 eurodollar inversion held unchanged at a record low -34.5 bp. The very strong July retail sales report Friday, however, convinced the market that the Fed might just have to act on its tightening bias after all and was certainly not likely to begin cutting rates any time in the immediate future.

 

By Friday’s close, the peak rate fed funds contract had shifted out from its long-time position in November to January, indicating risks of rate hikes through the December FOMC meeting rather than just October. On the week, the November fed funds contract lost a half bp to 5.355%, putting the odds of a 25 bp rate hike by the October FOMC meeting at around 40%, while the now peak rate January contract lost 7 bp to 5.375%, putting even odds on a move to 5.50% by the December FOMC meeting. Significant easing continues to be priced in next year, but the eurodollar curve inversion eased off a bit Friday, with the Dec 06 to Dec 07 spread ending the week 2 bp steeper at -31.5 bp, with the former off 6.5 bp to 5.485% and the latter 8.5 bp to 5.17%. In the immediate aftermath of the FOMC decision the rate on the Dec 07 contract fell to a several month low of 5.085%, flirting with the possibility of a 4.75% year end 2007 fed funds target, but big losses Friday shifted this back up to pretty cleanly pricing a cut to 5%.

 

As expected the FOMC held the funds rate unchanged at 5.25% at its meeting Tuesday, breaking a string of 17 consecutive increases stretching back to June 2004. As in June, the statement said growth had “moderated” but acknowledged recent upside in inflation and the risk of more to come – “Readings on core inflation have been elevated in recent months, and the high levels of resource utilization and of the prices of energy and other commodities have the potential to sustain inflation pressures.” But in line with Chairman Bernanke’s recent testimony, the statement predicted that slowing growth (partly as a result of mysterious unnamed “factors”) would reverse this going forward – “inflation pressures seem likely to moderate over time, reflecting contained inflation expectations and the cumulative effects of monetary policy actions and other factors restraining aggregate demand.” As we had expected, the key forward looking language was repeated from June – “the Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.” So clearly, while pausing for now, the Fed retains a tightening bias going forward. We continue to believe that the economy retains a bit more forward momentum than the Fed is factoring in at this point and that core inflation will continue to drift higher. So we look for an additional rate hike – to 5.50% – during the fourth quarter and then expect the Fed to remain on hold for an extended period while core inflation gradually comes under better control over the course of 2007.

 

Recall that in his monetary policy testimony in July, Chairman Bernanke identified four potential risks for the inflation outlook, but argued that none was likely to be a significant problem – growth and corresponding pressures on “resource utilization,” labor costs, inflation expectations, and energy prices. The Fed’s sanguine views on the potential risks from rising labor costs were dashed by huge upward revisions the past week to historical unit labor costs in the past week’s productivity report – and thus a prior reference to contained labor cost pressures was conspicuously omitted from the FOMC’s latest statement. Meanwhile, a very strong retail sales report for July pointed to an acceleration in growth in Q3, while lagging incoming data for Q2 continue to suggest that the advance GDP estimate of +2.5% was too low.

 

So the Fed’s expectation of a sustained slowdown to below trend growth – with no upward adjustment to Q2, second half growth near 2 3/4% would be required for the FOMC’s full year GDP forecast of 3 1/4% to 3 1/2% to be met; with the upward adjustment that now seems likely a deceleration to2 1/2% would be required – is looking questionable at this point. And market based measures of inflation expectations have recently been trending steadily higher, nearly reaching the prior peaks hit in May in the immediate aftermath of the FOMC’s pause before a modest reversal Thursday when gasoline prices tumbled after the foiling of the terrorist plot in London. The University of Michigan’s survey of longer-term inflation expectations has also come off its spring prior highs but in July remained relatively elevated at +2.9%. We’ll see Friday whether the recent move higher in market-based measures is matched by this survey based gauge. So of the four key reasons Fed Chairman Bernanke gave for his sanguine inflation outlook in July, which gave the FOMC the confidence to pause this week in the face of a string of bad inflation readings, only one – the likelihood of a flattening out in energy prices – is looking particularly solid at this point.

 

The most dramatic swing in the wrong direction has been on the labor cost front. In its June statement, the FOMC said that “Ongoing productivity gains have held down the rise in unit labor costs.” This reason for optimism on the inflation outlook was omitted this time, and no wonder given the ugly new picture of recent unit labor cost growth portrayed in the productivity report released just as the FOMC meeting was getting under way. Nonfarm business labor productivity rose at a 1.1% annual rate in the second quarter, as output gained 2.5% and hours worked rose 1.4%. With compensation per hour up 5.4%, unit labor costs surged 4.2%, the largest rise in six quarters. The sharp upward revision to recent growth in employee compensation contained in the recent GDP revisions was reflected in a big upward adjustment to previously benign unit labor cost readings. For all of 2005, ULC was revised up to +1.6% from +0.3%, growth in Q1 was adjusted up to +2.0% from +0.3%, and Q2 reached +3.2%, the highest since 2000Q4. Recent adjustments to productivity growth were relatively small, with Q2 coming in at +2.4% Y/Y, close to what we would estimate to be the long-run sustainable trend, though we expect there will be some cyclical undershooting of this longer-term trend in the medium term as hiring picks up.

 

Meanwhile, growth data released the past week suggested the Fed’s expectation that a sustained moderation to below trend growth that it believes will ease resource pressures and ultimately moderate inflation may be too pessimistic on the economy’s momentum. Data pertaining to Q2 – wholesale inventories, international trade, revised retail sales, and retail inventories – were slightly negative for our expectation for the revision to the advance GDP report. We now expect Q2 GDP growth to be revised up to +2.9% from +2.5% instead of +3.1%. But since most of this adjustment was in inventories – both wholesale and ex auto retail inventories came in a bit lower than BEA assumed in preparing the advance GDP estimate – it had a correspondingly positive impact on our assessment of Q3. And this was magnified by a very strong retail sales report. Retail sales surged 1.4% in July, boosted by a 3.1% jump in auto dealers’ receipts in line with upside in unit motor vehicle sales and a surprisingly robust 1.0% gain in ex auto sales. As expected, gas stations (+2.5%) saw some significant price-related upside, but excluding autos and gas, sales gained a strong 0.7%, and even with the building materials category surging 1.8%, the key “retail control” component that feeds into estimates of consumption jumped 0.9%. Upside was broadly based, with notable gains in electronics and appliances (+1.9%), clothing (+0.7%), and restaurants (+0.6%). With the strong start to the quarter provided by the sharp gains in motor vehicle sales and retail control, Q3 consumption is on track for an acceleration to a growth rate near +4%. Coming into the week, assuming we got the revision to Q2 inventories we had then seen, we saw Q3 growth tracking near +3.0%. With a smaller expected inventory subtraction in Q3 and the

upside in consumer spending, we now see Q3 GDP tracking at +3.4%.

 

Along with continued solid gains in consumer spending, driven by the recent sharp acceleration in income growth, and an expected pickup in capital spending, a key driver we expect to offset a significant direct and indirect drag from the sharply declining housing sector and support an acceleration in second half growth to near 3 1/2% is strength in exports. And the June trade report continued to indicate that this forecast is well on track, as the strength in global growth is driving the best gains in exports in many years. The trade deficit narrowed slightly to $64.8 billion in June, but only because May was revised up to $65.0B from $63.3B. Exports surged 2.0%, bringing the year-to-date gain to +15.1% annualized, putting this year on track to be the strongest since 1988. Upside was broadly based across almost all major categories (other than an unusual dip in services) – food, industrial materials, capital goods, autos, and consumer goods. Meanwhile, imports rose 1.2%. This brought the year-to-date increase to +10.1%, but almost all of this has reflected higher prices; real goods imports have only risen 1.8%. In June, sharp increases in autos, consumer goods, and non-energy industrial materials were partly offset by a pullback in energy products from last month’s record high.

 

The economic data calendar is quite busy in the coming week. Main focus will be on the CPI report on Wednesday where we look for some temporary moderation after the ugly run of four straight +0.3% core readings. The “resource utilization” pressures the Fed has expressed some worries about should again be highlighted by another move higher in the

industrial capacity utilization rate to an eight year high in the industrial production report Wednesday. Looking ahead to indications for key initial August data to be released in early September, the early regional manufacturing surveys – Empire State Tuesday and Philly Fed Thursday – will provide some indications of whether the recent strength

in the factory sector has continued, while initial jobless claims this week will cover the survey week for the August employment report. Other reports due out include PPI Tuesday, housing starts Wednesday, leading indicators Thursday, and the University of Michigan survey Friday where the inflation expectations measures will be a major focus:

 

* We expect the producer price index to rise 0.1% overall in July and 0.2% ex food and energy. A modest pullback in food prices following on the heels of a sharp spike in June should help restrain the headline PPI this month. The energy category is expected to be little changed, as increases in quotes for gasoline and electricity should be partially

offset by declines in heating oil and natural gas. Finally, the core is expected to be quite close to the recent trend.

 

* We forecast a 0.4% rise in the consumer price index in July and a 0.2% increase ex food and energy. A rebound in gasoline prices, following a brief respite in June, should lead to an elevated headline result. Meanwhile, the core is expected to be a bit better behaved this month largely as a result of anticipated softness in the key apparel and motor vehicle categories. Although apparel prices have been trending steadily higher of late, a seasonal quirk is expected to provide some restraint this month. And while automakers have not been as aggressive as last year in implementing sales incentives, there did appear to be some step up in July. We see the year/year core CPI holding at +2.6% in July but, given the base effects, some further updrift is likely to reemerge next

month.

 

* We look for housing starts to decline to a 1.80 million unit annual rate in July. The labor market report pointed to some further weakening in residential construction during July. So we look for starts to slip nearly 3%. For the year as a whole, starts are expected to be down about 10% with an even larger drop-off likely in 2007. Still, this cool down

in home construction represents only a modest headwind for the overall economy that is expected to be partially offset by some improvement in nonresidential activity.

 

* We expect industrial production to surge 0.7% in July. Even though the labor market report indicated that manufacturing jobs fell in July, the average work week in the factory sector posted a solid gain. So production appears likely to register another sharp jump on the heels of the 0.8% gain seen in June. The key manufacturing category is expected

to nearly match the 0.7% increase recorded last month with strength evident in the aerospace, machinery and apparel sectors. Also, a spike in electricity output at the end of the month implies another jump in the utility component. Finally, the utilization rate is expected to hit its highest reading in more than eight years.

 

* The index of leading economic indicators should rise 0.1% in July, as a positive contribution from the factory workweek should just barely outweigh the negative impact of the temporary spike in jobless claims and lead to a rise in the overall index for a second consecutive month.

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China
Regional Disparity Constrains Macro Management
Aug 14, 2006

Andy Xie (Hong Kong)

Five provinces along China’s Eastern Seaboard account for one-fifth of the country’s population, two-fifths of its GDP, three-quarters of its exports, and its entire trade surplus.  China’s currency may be undervalued for these provinces but could be overvalued for the rest of the country.  This factor constrains how much China’s currency could react to its trade success.

 

China appears to set its macro parameters for its least competitive provinces, which causes other provinces to overheat.  The decentralization of political power has limited the effectiveness of administrative measures to cool off growth in the competitive provinces.

 

China’s regional disparity and political complexity are likely to keep the economy overheated for much longer than what the central government wants or the market expects.

 

Persistent and Widening Regional Disparity

 

The five coastal provinces that account for one-fifth of the country’s population dominate China’s international competitiveness.  Even though these provinces are experiencing faster increase in costs (e.g., wage, land, etc.), their dominance in the country’s international trade is still increasing.

 

Any large country has substantial regional disparity.  China’s is bigger and more persistent.  For example, according to local government data, per capita income of the three Yangtze Delta provinces was 3.2 times that of Sichuan plus Chongqing at the other end of the Yangtze in 2005 versus 2.8 times in 2000.  Both regions have populations over 100 million and have deep historical roots as distinct regional economies.  Considering that rich provinces are more likely to understate their GDP and poor provinces to overstate, the real gap could be larger.

 

Income Inequality vs. Regional Disparity

 

Regional disparity is a major component of income inequality.  But, local income distribution is even more important.  The differences in the cost of living could offset the regional income disparity.  For example, the ratio of property prices to household income is quite similar across the country.

 

It is a popular perception both within China and abroad that income inequality is mostly due to regional disparity.  This is quite far from the truth, in my view.  If one adjusts for the cost of living difference, local income distribution appears to be a more important factor.  Migration is a major phenomenon and is a force at equalizing the real income of people with similar skills.

 

The estimates for China’s Ginni Co-efficient (which is a measure of social stability based on equality and income distribution) have a wide range of 0.4-.5, which puts China among the economies with the greatest income inequality globally.  As grey income is a substantial proportion of total income, any estimate is likely to understate the true extent of income inequality. 

 

Possible Factors for Regional Disparity

 

Being coastal is certainly one factor but not the only one.  For example, export value per capita for the five provinces along the Eastern Seaboard is 4.1 times that of the four coastal provinces to their north. Such a large gap would suggest that being coastal may not even be the most important factor in explaining China’s regional disparity.

 

The cluster effect could be the best explanation for rising regional disparity.  While individual businesses may have diminishing economies of scale, a regional economy is likely to exhibit rising economies of scale for a long period of its development.

 

Labor market mobility in China is reasonably good, certainly much better than in Europe.  However, this factor has been insufficient to decrease the regional inequality.  It is possible that labor mobility has exaggerated regional disparity as the brain drain away from the inland provinces makes it more difficult for them to make the jump in competitiveness sufficient to benefit from the cluster effect in economic development.

 

Neither labor mobility nor inter-regional trade could overcome the distinctness and the income gap of the regional economies. The reason is that local governments set the rules for their economies and may change the rules anytime.  As the decisions and wishes of local governments are critical to what economic activities thrive in their domain.  So their economies remain distinct.

 

The increasing economies of scale in development make government effectiveness the most important factor in a region’s success. Interprovincial resource redistribution through the central government fiscal policy and the state-owned banks is substantial.  An effective government could use the resources to accumulate competitiveness until it becomes widespread enough to achieve the cluster effect.  At that point, the region’s economy will reach the take-off stage.

 

The massive investment boom at present is justified on the ground that the inland provinces need to close the gap with the coast.  If the investment does bear fruit, the gap could narrow.  The dominance of property in the current investment boom raises doubts if it would narrow the regional disparity.  Property is not a productive asset.

 

Regional Disparity Limits Macro Management

 

The development gap between the Eastern Seaboard and the rest of the country will probably persist and may continue to widen.  It could limit China’s ability to manage its business cycle.  The government may have to choose interest rates and currency values that are appropriate for the inland provinces rather than their coastal counterparts.

 

For example, financial markets expect China’s currency to appreciate substantially due to its big and widening trade surplus.  However, China’s trade surplus is entirely due to the five provinces along its Eastern Seaboard.  In particular, Guangdong and Zhejiang account for 80% of China’s trade surplus.  The regional nature of the trade surplus would not matter if the economy had no other differentiation factors.  Clearly, this is not the case for China.

 

Despite labor and capital motilities, China remains a collection of distinct regional economies.  First, in a large country, distinct regional economies evolve over time to achieve competitive advantages through differentiation.

 

Second, China’s regional differences have a deep historical background.  The basic shape of the regional disparity today is more or less the same as that five hundred years ago.  Yangtze Delta, for example, may have been the primary source of economic surplus to support the national superstructure for around one millennium.

 

The differences in natural endowment could explain the origin of the regional disparity.   Yangtze Delta has benefited from favorable climate shift over the centuries that has made the region’s agriculture more productive than elsewhere.  The advantage in agriculture evolved into advantages into commerce, industry and technology.

 

The regional disparity severely limits China’s ability to use macro instruments like interest rates and exchange rates to manage its business cycle.  This is why China has a tendency to use administrative measures to manage its business cycle.  But, political decentralization has made administrative measures much less effective than before (see our note Development Model and Tightening Challenges, 8 August 2006).

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Euroland
Closing the Books on 2Q
Aug 14, 2006

Elga Bartsch (London)

In the euro area, we are now almost ready to close the books on the second quarter.  This coming week we will get the last missing data points on headline euro area GDP growth between  April and June with Eurostat’s flash estimate of headline GDP growth.  After several Euroland countries have reported better than expected GDP growth in the course of last week, an upside surprise might be on the cards for area-wide GDP growth.  Even our long-standing, above-consensus estimate of 0.8%Q might turn out to be too conservative. This incidentally had been the message all along of our early GDP indicator, a quantitative model based mostly on business surveys, which yielded a 2Q estimate of 0.9%Q (see Euroland Business Cycle Watch: Not Yet Landing, July 28, 2006).  This would put euro area GDP, at annualised growth rate of 3.6%SAAR, slightly ahead of the growth rate registered in the US over the same period.

 

French, Italian and Dutch 2Q GDP reports all came in stronger than expected -- beating market and our expectations on average by at least 0.2 tenths. Much will now depend on the verdict of German and Spanish statisticians.  On both counts, we are slightly more cautious than the market consensus.  While we are forecasting German GDP growth to have picked-up from 0.4%Q to 0.7%Q, consensus is expecting a whopping 0.9%Q. In Spain, we have assumed a steady growth of 0.8%Q, while the consensus is going for slight acceleration to 0.9%Q. Add to these upside risks the possibility of upward revisions to past data, which is what happened when the government statisticians in Italy, the Netherlands and Belgium had a fresh look at previous GDP reports, even our above-consensus full-year estimate of 2.3% could turn out to be too low. But being already above consensus, we will reserve judgement until we have the detailed 2Q GDP report at hand towards the end of August. Only then will we have insights into the breakdown of headline GDP growth into the various demand components such as consumer spending, corporate investment and construction investment, is known. We expect domestic demand to have been the main driver of the recovery in the second quarter of this year, while foreign trade is no longer making a major growth contribution. 

 

On the last count, consensus estimates and ECB staff projections were for 2.1% for 2006. So, expect them to be brought up in next forecast rounds. At the ECB, this forecasting exercise is already underway and fresh staff projections will be released on August 31.  The stronger than expected GDP data during the first half of this year should also bolster the case for a slightly faster tightening campaign on the part of the ECB in the second half of this year.  We continue to look for two more rate hikes from the ECB before year-end, bringing the refi rate to 3.5% by year-end (see ECB Watch: Trichet’s Trick, July 6, 2006). 

 

This would leave the euro-area policy rate close to the neutral level. However, with a seemingly endless series of one-off inflation shocks hitting euro area headline inflation since the inception of the ECB there is no room for complacency. While not rising any further at the moment inflation expectations remain elevated across the board.  The latest ECB Monthly Bulletin shows at 44% of professional forecasters polled by the ECB see Euroland HICP inflation at or above 2% in five years time.  While this presents a slight drop in long-term inflation forecasts from the 47% in the previous poll, for my taste, it is still too close to a flip of a coin. Especially for a central bank whose official inflation objective is to keep inflation below, but close to, 2% over the medium term.  If these concerns start to take hold in the bond market and current flight-to-safety bid abates bond yields are likely to head higher again.

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Currencies
World Interest Rates Normalizing, Not Restrictive
Aug 14, 2006

Stephen Jen (London)

The ‘world cash rate’ is normalizing, not restrictive

Our proxy for the world real policy/cash interest rate is still around 40bp below the average that prevailed in the 1990s, and the world 10Y interest rate is around 80bp below the 1990s’ average.  There is little evidence that the G10 central banks have over-tightened.  The market’s current expectations suggest that the world policy rate will reach the 1990s’ average by early 2007.  With the bond market conundrum being global rather than local (in the US), it appears that, with global monetary tightening, financial prices may be more vulnerable than the global economy — precisely the opposite view to that of most investors. 

 

Our work on the ‘world interest rates’

In that earlier note, we used the G3 GDP and market cap-weighted average interest rates as the proxies for the world interest rates.  We now broaden our proxy to cover G10.  I make the following observations:

 

• Observation 1.  The world’s policy rate is normalizing, and is far from restrictive.  Measured in real terms, the world’s real cash rate was 1.84% in July 2006, up from a cycle low of 0.07% in June 2004.  If we incorporate the pricing in the futures markets, by end-2006, the world’s real cash rate is expected to rise to 2.20%, just slightly lower than the average of 2.28% that prevailed during the 1990s, which we take, for the time being, as the ‘neutral’ rate.   From this perspective, the world’s central bank policies are not yet in the restrictive zone, but are expected to get there by early 2007. 

 

• Observation 2.  Gingerly global tightening.  While it took eight months for the global real policy rate to be cut from the 1990s’ average to close to zero (from April to December 2001), it will likely take around 28-30 months (from July 2004 to December 2006) for the world real policy rate to return to ‘normal’.  In other words, it will have taken three-and-a-half times as long for the world to normalize rates.  Part of this disparity is due to inflation rising in recent months, forcing the measured global real rates to remain low, but the bulk of the disparity has to do with the global central banks exercising great care in ensuring that the recovery remained on track. 

 

Even though central banks have been careful in their tightening campaign, there is little market indication that the central banks have fallen behind the curve, as in 1994/95. 

I have long argued that a repeat of 1994/95 for the US or for the world is a low-probability event, and that talk that Chairman Bernanke lacked credibility as an inflation fighter is not that compelling.  Back in 1994/95, the persistence in inflation was higher, causing changes in inflation expectations to propagate through a longer horizon.  In contrast, more recently, 1Y forward inflation expectations are much more easily perturbed by changing macro variables, with the very long-term (i.e., 5-10Y) inflation expectations being well anchored.  This persistence in inflation and inflation expectations back in the 1990s was a result of the perceived lack of credibility of the Fed and the other central banks, as well as a hurdle for central banks to impress investors.   At a minimum, the currency market is not likely to care if the Fed falls behind the curve on inflation.  Instead, growth, not inflation, will likely be the more important driver of the dollar. 

 

• Observation 3.  The bond market ‘conundrum’ is global, not local (i.e., only in the US).  The 10Y real world yield is still only 2.42% — about 80bp below the 1990s’ average of 3.2%.  It is also at roughly the same level as in 2002.  In other words, the bond market ‘conundrum’ is still there, for the global economy, not just for the US economy. 

 

As central banks tighten their policy rates toward the ‘neutral’ rate, but with the long bond rate lagging behind, I believe that the global financial markets may be affected more than the global real economy.  This view stands in stark contrast to the market’s view that investors are increasingly concerned about the global economy, while being close to fully invested.  With the global yield curve experiencing a bear flattening, I expect the global economy to remain well-supported, though it is likely to decelerate, but the financial markets to experience more bouts of risk-reduction. 

 

The Fed is not done; USD’s cyclical decline hesitant

Even though I have, since last November, been calling for the dollar to experience a phase of cyclical depreciation centered on a soft-landing in the US housing market, more recently I have voiced my concern that the high cash yield in the US may delay this dollar correction.   Our US economists still believe that the Fed is not yet done, in light of the lingering inflationary pressures and the prospect of the US economy remaining robust in 2H.   If the FFR peaks at 5.50% later this year, as our economists believe it will, the dollar will likely enjoy another surge, for three reasons.  First, the dollar’s cash yield premium will make it difficult for USD-based international investors not to run a high hedge ratio.  Second, it will cost the structural dollar bears that much more just to express their distaste for the dollar.  Third, higher global interest rates could trigger more bouts of risk reduction, which is dollar-positive. 

 

We still look for a soft-landing in the US housing market

There are a number of commentators vocally declaring a US/global recession in 2007 as a near-certainty, primarily because of their bearish view on the prospects for US housing prices.  Even though we agree that the US housing market is likely to weaken in the period ahead, we believe that housing activities will weaken, but it will be difficult for the US nationwide housing prices to fall.  According to the latest OFEHO report, the US’ nationwide property prices rose by 12.5% in 1Q06 (an 8.4% annualized quarterly rate).  It will take a lot for the US to experience outright price declines on a nationwide basis.  This is the primary channel through which the US’ housing wealth could suffer a sharp correction, thereby adversely affecting consumption. 

 

I am not convinced that this will occur, though I see housing activities (home building, transactions, etc.) slowing.  The increasingly popular view about the US falling into a recession due to a softening housing market was precisely the view the market had about the three other economies with buoyant property markets two years ago: the UK, Australia and NZ.  What is remarkable is that the central banks of two of these three countries tightened rates last week.  Property prices in all three economies are still rising and, in the cases of the UK and Australia, have re-accelerated in recent months.  While I am by no means equating these rather disparate economies, I am suggesting that those who have batted ‘0 for 3’ should question the robustness of their analysis of the US housing market and the US economy.

 

What if the FFR has indeed peaked?

If, however, we are wrong on the Fed in our belief that the pause on Tuesday marks the end of the Fed’s tightening cycle, I believe that the USD will indeed enter a cyclical soft-landing, probably against most currencies (Asian as well as European) at first.  However, I believe that EUR/USD and cable will eventually sell off, while the Asian currencies’ prospective appreciation will be more durable. 

 

Bottom line

The world’s real cash rate is 40bp below its long-term average, and is not yet in the ‘restrictive zone’.  At the same time, the world’s 10Y real interest rate is still some 80bp below its long-run average.  This global bond market ‘conundrum’ is likely to have a bigger impact on the global financial markets than on the global real economy.

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Currencies
Uniformity of Treatment
Aug 14, 2006

Stephen Jen (London)

Not as different as some may think

 

While there are obvious differences between China and the GCC (Gulf Cooperative Council) countries, there are also important similarities.  Just as it would not be reasonable, in light of their large C/A surpluses, to demand the GCC countries to revaluate their currencies significantly against the dollar, officials and commentators should not demand China to do the same.  There are subtle but very important constraints that both China and the GCC countries face that would prevent them from allowing their currencies to appreciate sharply.  Conversely, if these commentators and officials insist on pressuring China to ‘revalue’, they should do the same to the GCC countries. 

 

While I believe that the CNY is 10% or so under-valued, that it is in China’s interest to permit greater currency flexibility, and that economic and political conditions are now ripe for the CNY to appreciate somewhat against the dollar, the claim that China has been manipulating its currency is as unconvincing as the notion that oil-exporting countries have been manipulating their currencies. 

 

My main point

 

In thinking about whether the Chinese RMB is grossly under-valued and whether China needs to permit a massive appreciation in its currency, it is useful, as a ‘robustness test’ of the logic of the argument, to apply the same thought process to the oil-exporting countries, many of which have even larger C/A surpluses than China.  The ‘obvious’ differences between China and the GCC, that somehow the latter’s C/A surpluses are more ‘forgivable’ than the former’s, are not very convincing, in my view. 

 

Further, the oil price stabilization funds that many of these GCC countries have may, conceptually, not be that different from China’s official reserves.  These oil funds were originally set up to stabilize the shocks changing oil prices have on the budget, monetary policy and the economy. However, to the extent that the oil price increases in the last two years were ‘permanent’, the massive asset holdings in these oil funds are not very different from China’s official reserves.  If China had been ‘manipulating’ the RMB, as many US scholars and politicians believe is the case, then the GCC countries are guilty of worse: their currencies are actually de facto pegged to the dollar, while China’s RMB regime is, at least, a heavily managed float. 

 

I should clarify that I believe China should permit greater currency flexibility as soon as possible, and the CNY will likely strengthen if Beijing utilizes the ±0.3% daily trading band more fully.   The point of this note, however, is to separate myself from the structural dollar bears, most of whom also strongly believe that Beijing has been manipulating a massively under-valued RMB.  Even though at this juncture, we may have a similar call on the CNY, the reasoning behind my call is fundamentally different from theirs.

 

China’s C/A surplus has attracted too much attention

 

Looking at actual 2005 C/A surpluses in percentage of GDP of selected countries, China does not even rank among the top quartile in the sample.  Also, many of the countries with the largest C/A surpluses (as a percentage of GDP) are the oil-exporting countries.  For example, Qatar, Kuwait, and Libya have surpluses greater than 40% of GDP, and Saudi Arabia, UAE, Algeria, Venezuela and Norway all have surpluses equal to 20% of GDP or more.  China’s surplus was 7.1% in 2005.   I make the following points.

 

• Point 1.  A currency is not necessarily under-valued if the country has a large C/A surplus.  Similarly, a currency is not necessarily over-valued if it has a C/A deficit.  Nobody genuinely believes that the SGD is massively under-valued.  Yet, there has been a popular presumption that there is a positive relationship between the C/A balance and the fair value of the currency in question.  I have commented regularly on the subjective nature of currency valuation calculations.  In particular, I have cautioned that FEER (fundamental equilibrium exchange rate) based methods are highly problematic in this globalized world:  the assumed equilibrium conditions and the assumed elasticity conditions — both of which have high margins of error — often dictate the results of the fair value calculations.   These FEER-based models invariably find the CNY significantly under-valued and the USD significantly over-valued.  If we were to also apply the FEER approach to the currencies of the oil-exporting countries (which collectively are expected to run as large a C/A surplus as all of Asia put together this year! ), I would not be surprised if all of them were found to be massively over-valued, and urgent revaluation would be considered necessary by those who rely on these misleading models. 

 

I will not go further on this line of argument, but note that, based on the FEER approach to valuation, the Saudi Arabian riyal and the Singapore dollar are likely to be more under-valued than the Chinese RMB. 

 

• Point 2.  The main cause of large external surpluses in China and in the GCC countries is one and the same —globalization.  There are obvious differences between a balance of payments (BoP) surplus arising from a sharp rise in the price of a non-renewable resource, on the one hand, and a BoP surplus arising from a large manufacturing trade surplus on the other hand.  Nevertheless, I argue that the root cause of these external surpluses in Saudi Arabia and China is the same: globalization.  Globalization has allowed the US and China to specialize in what they are good at.  The accentuated comparative advantages within this ‘de facto dollar zone’ led to a gradual atrophy of the manufacturing sector in the US, but also strengthening in the US services industry and the financial markets.  I have used the analogy that it’s as if the US has suffered from a form of the ‘Dutch Disease’, with the US’ superior institutional framework to intermediate capital leading to a dollar that crowded out the manufacturing sector.  The sharp rise in China’s trade surplus was not really due to a fundamental acceleration in productivity.  Rather, it was a result of globalization, which permitted the inclusion of China’s labour force in the global economy.  This is a ‘quantity’ effect, not a ‘productivity’ effect. 

 

At the same time, globalization has enhanced the ability of the world to run at a faster pace without as much manufacturing goods price inflation.  Commodity price inflation, as a result, became a necessary by-product of the effective doubling of the global labour force. 

 

In short, the cause of the large BoP surpluses in Asia and in the oil-exporting countries is the same: globalization availed itself in the form of a significant increase in the volume of net exports (volume) for China but a positive terms of trade shock (price) for the GCC countries.  The argument that this distinction between a volume-shock and a price-shock has relevance for the currency discussion is not compelling to me.  This is also why I have long argued that global imbalances are a natural consequence of globalization.  The fundamental issue that is relevant here is trade, not exchange rates. 

 

• Point 3.  The policies to deal with the surpluses in China and the GCC countries are equally difficult to implement.  Many investors and policy makers have the view that the oil-exporting countries do not have the capacity to spend their windfall, and so they could be ‘forgiven’ for running such large C/A surpluses and for possessing bloated oil stabilization funds.  In my opinion, it is just as difficult to induce a compression in the savings-investment (S-I) balance in China.  I won’t repeat in detail what I have argued before, but simply note that China’s high savings rate reflects genuine structural issues in China.  The demographic trend and the repercussions of the transition from a socialist regime to a capitalist regime have powerful effects on the savings pattern that cannot be offset by a stronger CNY. 

 

Further, some may argue that what makes the GCC countries different is that they are exporters of a commodity.  I would suggest that ‘cheap labor’ is also a commodity, and most of the low-value-added, labor-intensive goods that China exports now are also commodities.  Oil and almost all of China’s exports are dollar-based.  It is not clear why it makes more sense for the GCC countries to stay with their dollar pegs than it is for China to have a currency that is relatively stable vis-à-vis the dollar. 

 

In short, a currency-based solution to the oil-exporting countries’ surpluses and China’s surpluses is equally inappropriate.  This is why both the PBoC and the US Treasury have long stressed that they support greater currency flexibility, not maxi-revaluation. 

 

• Point 4.  The nature of China’s official reserves is not that different from that of the GCC countries’ oil funds.   First, many of these oil funds were originally established as ‘stabilization’ funds,  because of the mean-reverting nature of oil prices in the past.  However, since oil prices are likely to have experienced a permanent increase in the past couple of years, these price stabilization funds have become more like ‘savings’ funds.  China’s foreign reserves experienced a similar evolution.  On the eve of the Asian Financial Crisis in mid-1997, China’s reserves stood at only US$120 billion.  The accumulation in reserves in the subsequent half a decade was primarily motivated by ‘liquidity’ considerations’ — a ‘self-insurance’ motivation, just like the oil funds.  However, with reserves approaching the US$1 trillion mark now, China’s ‘financial stabilization’ fund that was meant to stave off speculative flows has turned into a wealth-accumulation fund.  In any case, the evolutions of the foreign currency funds in both China and the GCC countries are very similar; China’s official reserves are really not that different from the oil exporters’ oil funds. 

 

Second, there is also an ‘ownership’ issue.  Much of the oil receipts in the oil-exporting countries belong to state enterprises.  These foreign currency holdings did not need to pass through the currency market: oil receipts in dollars could be directly invested in USD assets.  In the case of China, however, much of the foreign currency earnings belong to private enterprises, which then have to sell their foreign currency receipts in the currency market.  The PBoC then soaks up this foreign currency liquidity.  In other words, the main reason why there is heavy ‘intervention’ in the case of China and no intervention in the case of the GCC countries or Norway is because of the ‘ownership change’ in the foreign currency holdings.  However, the underlying nature of the BOP surplus is very similar.  The irony here is that had China remained totally communist with all activities owned by the public sector, the PBoC would not need to intervene at all. 

 

This ‘ownership’ issue is important.  I have previously pointed out, in China’s Pre-Funding of Future Private Outflows, April 21, 2005, that China’s private holdings of foreign assets are extremely low, relative to the public holdings of foreign assets.  If, in the next five years, China’s private-public shares of holdings of foreign assets are to approach those of Korea and Japan several years ago, the PBoC may need to sell more than US$550 billion worth of its reserves to the private sector.  In a way, much of China’s reserve accumulation can be considered as ‘pre-funding’ of expected future private capital outflows.  Rebalancing this private-public share of foreign asset holdings is very much on the minds of the Chinese policy makers.  In its 2Q monetary report, the PBoC commented, “(The country) should push forward the policy shift from stockpiling foreign exchange reserves in state coffers to letting businesses and residents hold more foreign currency and encourage the shift from state-led overseas investment to private overseas investment.”

 

Third, in both the GCC countries and China, the policy preference has been to choose ‘future national wealth’ over ‘current purchasing power’.  The philosophical motivation behind the reserve/oil fund accumulations is very similar. 

 

Chinais more liberal than the GCC countries

 

The choice between ‘fix’ and ‘float’ is not a straightforward one.  But there is an odd presumption that it is okay for the GCC countries to stay with dollar pegs while China has not done enough to help resolve global imbalances through a maxi-revaluation, when the underlying cause of the burgeoning surpluses in both countries is the same.  Unlike the GCC countries, China has declared its intention to move to an increasingly flexible exchange rate regime.  Unlike the GCC countries, China has declared its desire to adopt a more independent monetary policy.  Unlike the GCC countries, China has worked hard to build up its financial institutions to allow a flexible CNY price to be meaningful. 

 

China’s primary motivation to allow greater currency flexibility has little to do with global imbalances but much to do with its desire for greater monetary independence.  Indeed, it is as clear now as ever that China’s business cycle could diverge from that of the US, and therefore China needs its monetary policy to be more independent from the Fed. 

 

Bottom line

 

While I believe that Beijing will likely permit greater currency flexibility, and therefore CNY strength, later this year, I challenge the view — intensely held in some circles — that the CNY is grossly under-valued and that China has blatantly violated the international code of conduct and trading partners’ trust by ‘manipulating’ the CNY.  I suggest that applying the arguments made about China to the GCC countries may serve as a good test of the robustness of the logic behind these arguments.

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