Sweden
A Potential Change in Government?
Aug 15, 2006

Thomas Gade (London)

We are approaching the next general elections.

Swedish general elections are to be held on September 17. Traditionally, Sweden has been governed by a Social Democratic or centre-left coalition government. Polls are currently indicating a potential change in government. A shift to a centre-right government is likely to be seen as positive for equity markets and the Swedish krona. By contrast, it might be viewed negatively for Swedish government bonds, and 10-year bond yield spreads to the 10-year German Bund could start to widen. The main issues in the election campaign have been employment, income taxes and wealth taxes. The next two weeks will provide more insight as the final election manifests will be published.

Three possible scenarios following the election 
The Swedish parliament contains two political groupings. The centre-left is composed of the largest party in the Swedish Parliament, the Social Democrats (S), supported by the two smaller parties the Greens (Mp) and the Left (V). The Social Democratic Party, the largest political party in Sweden, currently makes up the present minority government. The centre right political parties consist of the moderates (M), the second largest political party in Sweden which recently has surged in popularity, and three smaller political parties, the Liberals (Fp), the Center Party (C) and the Christian Democrats (CD).

There are three possible scenarios for the government formation following the elections.

• A centre left coalition government consisting of the Social Democrats, the Left and the Greens (or one of the latter two parties). 
• A minority government formed by the Social Democratic Party. This would imply that the current government remains in place.
• A centre right majority government consisting of a coalition between the Moderates, the Liberals, the Center Party and the Christian Democrats.

Financial markets are likely to be most positive on the latter government constellation, which is also the one most likely to be able to implement reform proposals, if alliance consensus can be maintained.

A close call in the election run-up
The latest available polls are now indicating a tight race between the bloc of the Social Democratic party and its two left wing support parties and the centre right alliance. Interestingly, the Left and the Greens are borderline parties in terms of voter support. Given the 4% threshold rule to enter Parliament, the possibility of one or both of these political parties not making it into parliament cannot be ruled out. This would favour the centre right opposition and would ease the way for further reform proposals.

Boosting employment through public sector expansion…
The current government’s focus on employment and the labour market already started with the budget bill for 2006. The budget bill aimed at increasing employment through a range of initiatives. The initiatives would affect 55,000 people directly in the labour market through mainly the creation of 20,000 plus jobs and another 35,000 through a combination of internship creation and educational initiatives. The creation of 20,000 plus jobs is aimed at bringing down the level of long-term unemployed, as these job types are provided to those who have been unemployed for two years or more.

…or through lower income taxes
The opposition, on the other hand, is opposing a further public sector expansion. Instead, an increase in employment should come through its main initiative, a lowering of the personal income tax.  The opposition alliance is proposing a two-step tax deduction on employment in the municipal income tax. According to alliance calculations, this should lower the average tax rate by approximately 5 ppt — marginally decreasing as personal income rises. The total cost of the proposal is estimated to be SEK 37 bn in the first step, rising to SEK 45 bn in the second step.  The current government is opposing lowering income taxes, primarily on fears that it will lower the service level of the welfare state. On both political fronts, a proposal to lower the employment payment on new hires has been raised. Furthermore, the alliance opposition has proposed to reform the functions of the Swedish labour market office (AMS) as well as the unemployment insurance scheme.

Property tax initiatives claiming the headlines
Due to annual increases in property prices of about 10% per year for the last 10 years, properties and living expenses in many areas have become increasingly expensive. The increased tax costs from property price appreciation have now turned into a political issue. The aim of the opposition alliance is to completely remove the wealth tax and the property tax. The centre right alliance has initially proposed freezing public property valuations in 2007 and at the same time lowering the tax rate on multi-dwellings from 0.5% to 0.4%. Ultimately, the aim is to completely remove the state property tax and replace it with what has so far been stated as “a low municipal fee”. Statistics Sweden estimated that Swedish residents in 2002 held approximately SEK 500 bn in foreign deposits. A part of these foreign placed deposits can be expected to return as capital inflows should the wealth tax be removed. Hence, a removal of the wealth tax is likely to be positive both for the krona and equities.

Financing election proposals is the sore thumb
We have yet to see the final election manifests to judge how the various election proposals will be financed. The opposition alliance claims that, all in all, the total initiatives would result in a net positive of SEK 5 bn for the public finances. So far, the main financing of the proposals (excluding self-financing through increased employment, etc.) is to come through a low municipal fee and a higher degree of self-financing on healthcare and on unemployment insurance. Moreover, the centre right opposition alliance sees further scope for privatizing publicly owned companies. The proceeds from sales are to be used to lower public debt. The alliance expects privatization volumes at around SEK 50 bn per year over the next three years. Nevertheless, financing the election proposals lacks specifics. We hope that the final election manifest will reveal more details of the financing initiatives. Stay tuned! 

Important Disclosure Information at the end of this Forum

Turkey
The Notorious Chicken-and-Egg Problem
Aug 15, 2006

Serhan Cevik (from Istanbul)

Shocks lead to mental confusion and disorientation in expectations. In a country with a long history of breakdowns, even a simple shift might trigger seismic responses in financial markets. However, we thought that the progress Turkey has achieved in the last five years would curtail the effects of exogenous shocks like an increase in global risk aversion. Unfortunately, market expectations are still highly adaptive and fluctuate along with every bit of noise. When the risk of higher interest rates in the world’s leading economies set off a wave of risk reduction across all asset classes, the Turkish lira responded violently, depreciating as much as 28.7% against the currency basket, and the benchmark t-bill rate jumped from 13.5% in April to the recent peak of 22.9% in June. Facing such a financial predicament that destabilised inflation expectations and altered the perception curve, the Central Bank of Turkey has reacted forcefully by raising short-term interest rates from 13.25% to 17.5% and introducing a comprehensive liquidity management plan. And it worked, stabilising the financial system and establishing the sense of calm. However, the problem was not a direct result of Turkey’s own shortcomings, but stemmed mainly from exogenous factors. Now, with the new ‘equilibrium’ in global portfolio allocations, the lira has appreciated by 14% from the worst reading in the midst of the shock, already purging some of the adverse effects on inflation dynamics.

The last rate hike was not necessary and put the central bank into a corner. The whole affair could have been better managed, but here we are facing an unnecessary burden on the real economy that will take at least a year to digest out of the system. Furthermore, the central bank has opted for rebuilding credibility by tightening monetary conditions beyond market expectations. Playing the ‘tough cop’ routine is a part of modern central banking aiming to keep inflation expectations in line with policy objectives. However, that does not mean playing a game of cat-and-mouse with financial markets. In our view, after the first 400 bp increase in short-term interest rates, the Central Bank of Turkey should have remained on hold, disregarding the ‘deterioration’ in adaptive inflation expectations, and focused on judging the effects of higher interest rates and financial volatility on domestic demand. Instead, the authorities decided to open the door for successive rate hikes by fine-tuning the monetary policy stance. Today, following last month’s 25 bp increase in the policy rate, the central bank is in an awkward position: an objective, rational analysis of macroeconomic trends justifies no more hikes, while the notorious chicken-and-egg problem of expectation-driven policymaking demands more and puts the central bank into a corner.

Inflation expectations worsened along with the lira’s weakness, ignoring macro factors. According to the bi-monthly survey of market participants, inflation expectations for the end of 2006 and 12-month ahead worsened from 5.8% and 5.4%, respectively, in April before the global volatility shock to 10.6% and 8.0% in August. Of course, such readings point to a significant divergence from the central bank’s inflation targets (5% in 2006 and 4% in 2007). But are these expectations reliable and, more importantly, rational enough to become the ultimate determinant of monetary policy? We think not. First, our earlier studies showed that survey-based inflation expectations are backward-looking, biased, and irrational, especially in times high volatility (see Wag the Dog, May 8, 2003). Second, together with contemporaneous inflation, currency fluctuations are the main determinant of inflation expectations with a short lag. For example, the volatility shock worsened the average market expectation for TRL/USD at the end of 2006 from 1.39 in April to 1.60 in June. According to the latest survey covering the first half of this month, market participants now expect TRL/USD to be 1.56 at the year-end. Given the strength of the economy and relative normalisation in financial markets, ‘adaptive’ expectations are highly likely to show further improvements.

The central bank should give more weight to the macroeconomic outlook. The global volatility storm, albeit easing, is not over and expectations remain vulnerable to exogenous developments. Thus, the central bank cannot even start contemplating a directional policy change. On the other hand, by giving an unbalanced weight in policymaking to market expectations, the central bank risks merely becoming the executioner of short-sighted expectations developed in the financial markets.  As a market participant, we are well aware of the value of information derived from asset prices, but we can also identify systemic forecast errors. And this is why we argue in favour of a balanced approach to monetary policy focusing on a wide range of indicators. Our own assessment of economic trends (which we have highlighted in previous reports) suggests that there is no need, at this juncture, for further tightening of the monetary policy stance.

Important Disclosure Information at the end of this Forum

Indonesia
2Q GDP Accelerated on Government Spending
Aug 15, 2006

Deyi Tan (Singapore)

GDP growth accelerates in 2Q: Indonesia’s GDP grew by 5.2% YoY in 2Q, accelerating from the upwardly revised 4.7% seen in 1Q and higher than our and market expectations of 4.8% and 4.9%, respectively for 2Q06.

Acceleration due largely to higher government expenditure: Real government expenditure rose 31.4% YoY (compared with 13.0% YoY in 1Q), partly on base effects and partly as government expedited on spending in order to support the economy. This acceleration alone contributed 2.1 percentage points to headline growth.

Worst may be behind us: Although the domestic demand is weak, especially in consumer spending and fixed investment, 2Q data appears to be indicating that Indonesia’s GDP growth trend is bottoming out and the worst may be behind us. 

Upgrading our 2006 & 2007 GDP forecasts: We are revising our 2006 GDP growth marginally to 5.3% (from 5.1% earlier) and 2007 to 5.3% (from 4.9% earlier). We maintain our view that domestic demand (consumption as well fixed investments) should pick up going forward, supported by declines in interest rates and a gradual pickup in government’s capital expenditure.

2Q06 GDP Growth Accelerated to 5.2% YoY

Indonesia’s GDP grew by 5.2% YoY in 2Q, accelerating from the upwardly revised 4.7% seen in 1Q and higher than our and market expectations of 4.8% and 4.9%, respectively, for 2Q06.  For 1H06, the economy expanded 5.0% YoY (vs +5.3% in 2H05). As expected, 2Q data appears to be indicating that Indonesia’s GDP growth trend is bottoming out and the worst may be behind us. 

Government Spending & Inventories Supported 2Q Growth

GDP breakdown indicates that most of the acceleration in growth has been driven by government expenditure and inventory changes.  Specifically, real government consumption rose 31.4% YoY (compared with 13.0% YoY in 1Q), partly on base effects and partly as government expedited on spending in order to support the economy.  This acceleration alone contributed 2.1 percentage points to headline growth compared with 0.8 ppt during 1Q06.  The inventory changes added 0.7 ppt to headline growth, compared to 0.1%-pt in 1Q06.

Private Consumption and Fixed Investment Remained Tepid 1QO6 domestic demand components have all been downwardly revised, and, apart from government spending and inventories, momentum in consumer spending and fixed investment remained mostly tepid in 2Q.   Private consumption rose 3.0% YoY, sustaining the downwardly revised 3.0% YoY pace seen in 1Q06 but marking what we believe could be the gradual petering out of the impact from the removal of fuel subsidies in October last year.  Indeed, consumption indicators are already showing mixed trends with momentum in consumption loans and automobile purchases decelerating, whilst retail sales and consumer import trends seem to have reversed.  Meanwhile, fixed investment contracted 1.0% YoY (vs +0.8% YoY in 1Q) on the back of high interest rates as is reflected in capital goods imports.

External Balance Support Remained Positive

Meanwhile, steady demand on the external front led exports to accelerate to 11.3% YoY from the 10.9% in 1Q.  The detailed breakup we have so far shows healthy performance in crude materials, mineral fuels and manufactured goods exports.  Nonetheless, external balance growth contribution narrowed to 1.8%-pt from 3.2%-pt on the back of also strong imports (+8.3%), where we saw a 23.8% YoY increase in consumer imports from 1Q’s 12.3% and a slight acceleration in raw materials and intermediate goods imports to 3.5% YoY from 1Q’s -6.8%.

Nudging up our 2006 and 2007 GDP forecasts

Better-than-expected 2Q06 growth leads us to revise upwards our 2006 GDP forecast from 5.1% YoY to 5.3%.  However, given that the better-than-expected 2Q06 growth was not due to upside surprises from consumer spending or fixed investment but mostly due to government expenditure, we are keeping our 2H06 forecasts unchanged and adjusting the headline merely to fit in the stronger 1H06.

Our broad macro view remains intact.  We continue to look for a 2H06 re-acceleration with the improvement in private consumption as consumer spending normalizes post one-time adjustment due to the hike in oil prices and declining interest rates.  In addition, we believe that, with declining interest rates as well a gradual pickup in government’s development expenditure, private investment should recover from 2H06 onwards.

We are also concurrently revising our 2007 GDP forecast from 4.9% to 5.3% as we see improved macro stability allowing the government to further shift its policy bias from stability to pro-growth.  While we maintain our outlook for reducing support from external demand in 2007, we are building in a stronger pickup in domestic demand.  Specifically, we expect domestic demand to pick up pace from 4.5% YoY in 2006 to 5.9% in 2007.

Important Disclosure Information at the end of this Forum

Latin America
Rethinking Country Risk
Aug 15, 2006

Gray Newman (New York) and Daniel Volberg (New York)

Mexico’s announcement last week that it had cut its external debt by more than $12 billion in a matter of weeks is just the latest sign that external debt appears to be on the verge of extinction in emerging markets.  Indeed, if you put together a who’s who of the 15 most prominent emerging markets---from Brazil to Venezuela with the Czech Republic, Thailand and Turkey in between--you will find that they have cut their external debt to GDP ratios on average nearly in half in the past five years.

And in the past 12 months we have seen an unprecedented number of countries spending reserves to buy back external debt and swap instead into domestic debt.  Indeed, when you look at the trading volumes of the emerging markets lead trade association, EMTA, local debt is now replacing external debt as the instrument of choice.

Perhaps claiming that external debt is approaching extinction is a bit too strong, but look at the record of the past 12 months.  Not only did Argentina and Brazil rush to announce that they were repaying the IMF in full late last year, to the tune of $9.5 and $15.5 billion respectively, but the buyback fever soared in recent months.  Since the beginning of the year, Brazil has announced plans to buy back up to $20 billion of its external debt and that it was calling its Par bonds.  Meanwhile Venezuela used a $3.9 billion buyback to take out virtually all of its Brady bonds in April. Mexico’s move to pay off over $9 billion of Inter-American Development Bank and World Bank loans this week, as well as retiring another $3.4 billion in external bonds came less than six months after its announcement earlier this year of another $3 billion in bonded debt that was taken out.  In the month of August alone, Mexico’s external debt to GDP is set to fall to 5.4% from 7% as the transactions are registered.

The result of the buyback of external debt is that we are now faced with countries such as Brazil, which just three years ago was viewed by many as being on the brink of debt default and capital controls, now having its net public external debt at zero.  With external debt on the decline, it seems logical that more rating upgrades will follow.  But therein lies the quandary: what do country ratings tell us in an era in which external debt is disappearing?

As emerging market external debt disappears, it is time to rethink country risk.  During the past decade, when asked about country risk, most emerging market practitioners would answer by referencing the sovereign’s credit rating.   While a sovereign’s credit risk is not the same as country risk, the reference was germane.  After all, for most holders of external bonds the component of country risk that was most relevant was the sovereign’s ability and willingness to honour its external obligations to pay.  As external bonded debt issuance exploded in the 1990s, particularly among emerging market economies, country risk and the country ratings from the largest rating agencies seemed almost synonymous.

But now as external debt is losing ground to local issuance and to increased equity stakes by direct foreign investors, the traditional sovereign credit ratings are likely to be less relevant.  The coming upgrades as external debt is extinguished tell us a great deal about the sovereign’s ability and willingness to service its limited external debt, but very less and less about broader country risk. 

We think it is the right time to look at a new set of indicators--ones that look at the micro issues facing emerging markets.  Indicators that will help us understand how strong are institutions and the regulatory framework across emerging markets?  While the literature linking institutions to growth had difficulties in quantifying the precise relationship, there is general agreement that institutions play a major role in long-term growth. 

Introducing the micro radars

We have created our first set of “micro” radar chart designed to complement the longstanding series of radar charts that Morgan Stanley has used to summarize a country’s key credit statistics relative to benchmark values appropriate to the country’s level of credit risk.  We’ve kept the traditional radar charts, but have added the micro radars along side.  (The complete set, containing 45 emerging market countries, will be available upon request).

Fortunately, the task of analyzing micro conditions has been simplified thanks to the work of the World Bank which for three years now has published a database of business regulations, publicly available at www.doingbusiness.org.  The database provides indicators of the cost of doing business by identifying specific regulations that enhance or constrain business investment, productivity, and growth. 

Unlike other measures of country risk that rely on subjective ratings of the quality of institutions or the business climate, the World Bank data is based on a set of common assumptions used across 155 countries.  For example, to measure taxes, the World Bank contacts law firms and accountants for each country and asks them to calculate tax treatment of a medium-sized company of 60 employees, which started operations on January 1, 2003, had a loss in the first year of operation and distributed 50% of its profits as dividends to the owners at the end of its second year.  For trading across borders, the World Bank uses a 100 employee company which exports a mix of textiles, apparel, coffee and spices.

We have taken 11 of the indicators including starting a business, employing workers, credit information and rights, shareholder suits, tax costs and time involved in filing as well as bankruptcy recovery rates and contract enforcement costs.  Among our key finding are:

First, Eastern Europe is the region with the best institutional and regulatory environment among emerging markets.   In particular, Eastern Europe has business friendly contract enforcement institutions as well as a better than average regulatory process for starting a business.  The only category where Eastern Europe underperforms is on institutions relating to credit information.  The high marks for the region are not entirely surprising as a number of countries are current or prospective EU members and have had to adopt its institutional framework.

Second, Latin America ranks as the worst institutional and regulatory environment. The region’s major problem is the high tax burden and the bureaucratic challenges to contract enforcement and entrepreneurial activity.

Third, although it is instructive to look at regional aggregates, it can easily mask significant heterogeneity within the groupings.  In Latin America, for example, Chile has major advantages relative to the emerging markets average on virtually every indicator, while Brazil ranks near the bottom in most indicators with significant short fallings due to large tax burden, low bankruptcy recovery rate, a legal framework that makes it difficult to start a business or access credit and a rigid labour force. 

Despite all of the talk about Mexico being set for another credit upgrade, the micro radar chart suggests that the new administration should focus on the costs involved in starting a business, labour reform and investor protection.  Peru, where hopes are also on the rise for an upgrade, the micro radars suggest that starting a business, contractual enforcement and credit legal rights should also be high on the list of the authorities which have just recently took office. 

Caveats

Neither our traditional radars which measure solvency and liquidity risks nor the new micro radars provide a full picture of country risk.  But the micro radars are an additional facet of country risk that we think is increasingly important to focus on, especially as emerging markets have made important strides in many of the traditional areas of macro concern.  Nonetheless, the micro radars have their limitations as well. 

The efficiency of application or enforcement of the law is poorly measured, if at all.  Corruption remains a major problem in emerging markets and is not taken into account in our first set of micro radars.  Nor is the issue of security. High crime rates and difficult security situations pose a significant cost on doing business, as does widespread informality.  Still, the micro radars should serve to provide investors with another measure of country risk to complement the better known ratios of external debt and current account to GDP, reserve adequacy ratios and inflation, investment and growth.

Bottom line

As external debt continues to be extinguished, look for more upgrades to come as the ability and willingness of sovereigns to service their external debt obligations improve.  But don’t mistake the improving sovereign credit rating with an improvement in country risk.  Country risk is much broader than sovereign credit risk and includes a valuation of the regulatory and institutional framework in each country.  For countries that have made important macro strides, we would argue that there are a whole host of micro reforms that need to be taken up.  The costs associated with doing business in emerging markets remain a significant obstacle to growth.

Important Disclosure Information at the end of this Forum

Disclosure Statement

The information and opinions in this report were prepared or are disseminated by Morgan Stanley & Co. Incorporated and/or Morgan Stanley & Co. International Limited and/or Morgan Stanley Japan Securities Co., Ltd. and/or Morgan Stanley Dean Witter Asia Limited and/or Morgan Stanley Dean Witter Asia (Singapore) Pte. (Registration number 199206298Z) and/or Morgan Stanley Asia (Singapore) Securities Pte Ltd (Registration number 200008434H) and/or Morgan Stanley & Co. International Limited, Taipei Branch and/or Morgan Stanley & Co International Limited, Seoul Branch, and/or Morgan Stanley Dean Witter Australia Limited (A.B.N. 67 003 734 576, holder of Australian financial services licence No. 233742, which accepts responsibility for its contents), and/or JM Morgan Stanley Securities Private Limited and their affiliates (collectively, "Morgan Stanley").

Global Research Conflict Management Policy

This research observes our conflict management policy, available at www.morganstanley.com/institutional/research/conflictpolicies.

Important Disclosures

This report does not provide individually tailored investment advice. It has been prepared without regard to the circumstances and objectives of those who receive it. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages them to seek a financial adviser's advice. The appropriateness of an investment or strategy will depend on an investor's circumstances and objectives. This report is not an offer to buy or sell any security or to participate in any trading strategy. The value of and income from your investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized.

With the exception of information regarding Morgan Stanley, reports prepared by Morgan Stanley research personnel are based on public information. Morgan Stanley makes every effort to use reliable, comprehensive information, but we do not represent that it is accurate or complete. We have no obligation to tell you when opinions or information in this report change apart from when we intend to discontinue research coverage of a company. Facts and views in this report have not been reviewed by, and may not reflect information known to, professionals in other Morgan Stanley business areas, including investment banking personnel.

To our readers in Taiwan: This publication is distributed by Morgan Stanley & Co. International Limited, Taipei Branch; it may not be distributed to or quoted or used by the public media without the express written consent of Morgan Stanley. To our readers in Hong Kong: Information is distributed in Hong Kong by and on behalf of, and is attributable to, Morgan Stanley Dean Witter Asia Limited as part of its regulated activities in Hong Kong; if you have any queries concerning it, contact our Hong Kong sales representatives.

This publication is disseminated in Japan by Morgan Stanley Japan Securities Co., Ltd.; in Canada by Morgan Stanley Canada Limited, which has approved of, and has agreed to take responsibility for, the contents of this publication in Canada; in Germany by Morgan Stanley Bank AG, Frankfurt am Main, regulated by Bundesanstalt fuer Finanzdienstleistungsaufsicht (BaFin); in Spain by Morgan Stanley, S.V., S.A., a Morgan Stanley group company, which is supervised by the Spanish Securities Markets Commission (CNMV) and states that this document has been written and distributed in accordance with the rules of conduct applicable to financial research as established under Spanish regulations; in the United States by Morgan Stanley & Co. Incorporated and Morgan Stanley DW Inc., which accept responsibility for its contents. Morgan Stanley & Co. International Limited, authorized and regulated by Financial Services Authority, disseminates in the UK research that it has prepared, and approves solely for the purposes of section 21 of the Financial Services and Markets Act 2000, research which has been prepared by any of its affiliates. Private U.K. investors should obtain the advice of their Morgan Stanley & Co. International Limited representative about the investments concerned. In Australia, this report, and any access to it, is intended only for "wholesale clients" within the meaning of the Australian Corporations Act.

Trademarks and service marks herein are their owners' property. Third-party data providers make no warranties or representations of the accuracy, completeness, or timeliness of their data and shall not have liability for any damages relating to such data. The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of MSCI and S&P. Morgan Stanley bases projections, opinions, forecasts and trading strategies regarding the MSCI Country Index Series solely on public information. MSCI has not reviewed, approved or endorsed these projections, opinions, forecasts and trading strategies. Morgan Stanley has no influence on or control over MSCI's index compilation decisions. This report or portions of it may not be reprinted, sold or redistributed without the written consent of Morgan Stanley. Morgan Stanley research is disseminated and available primarily electronically, and, in some cases, in printed form. Additional information on recommended securities is available on request.