The New Cabinet - Good, but Not Quite Great
Sept 27, 2006
Robert A Feldman (Tokyo)
Specific appointments
Cabinet Secretary Shiozaki is an expert on many aspects of economic and financial policy. A former BoJ official, he has been active in debate on reforming the financial system, on foreign policy issues (as Vice Foreign Minister in the last cabinet), and on corporate governance. Economics Minister Ota has worked closely with former minister Takenaka over the years, and has been one of the architects of both fiscal reform and reform of government administrative structure. If monetary policy becomes an issue, Ota should be able to debate ably with Governor Fukui. Other appointments suggest that PM Abe wants to impose fiscal discipline on the areas of the government where reform is needed. In the Ministry of Welfare, frank veteran Hakuo Yanagisawa should lend great expertise to the many pending reform issues, especially pension and medical reform. The issues are not only those of policy (e.g., how to impose better cost control) but also of implementation (e.g., how to outsource more of the implementation work to the private sector). A major issue will be introduction of a taxpayer ID system. Heretofore, the Welfare Ministry has adamantly opposed the use of the social security number for this purpose. It will be interesting to see if Yanagisawa takes a stand on this issue. At the Ministry of Education, Bunmei Ibuki brings formidable talents. A former MoF bureaucrat who spent four years in London, he has a number of books to his credit, and has a broad range of experience in the party. Ironically, Ibuki was a doubter on Koizumi reforms, but Abe has put him into a post where his ideas are aligned with those of PM Abe himself. At the Ministry of Finance, veteran Koji Omi will oversee the fiscal reform policies already determined by Hidenao Nakagawa and other LDP leaders over the summer. Some key elements still open to debate include tax policy, especially the tax treatment of triangle mergers. Rules to permit such mergers go into effect from this coming May, but the rules are meaningless without tax treatment that brings such international transactions onto par with domestic transactions — which are exempt from taxation at the time of the merger. Omi may have to take leadership on this issue. A major question mark concerns the Financial Services Agency. The new minister, Yuji Yamamoto, appears to have little expertise in the financial area. His home page discusses that financial sector issues are a matter of focus on small business. Practically, this appointment likely means that financial sector policy will be run mostly by the FSA bureaucrats, with intervention from Cabinet Secretary Shiozaki (who is a genuine expert on financial sector policy) when necessary. Minister Yamamoto is likely to focus on the Second Chance agenda, which PM Abe has made a key component of his political strategy. One fascinating appointment is that of the Komeito’s Fuyushiba to the Land and Construction post. The Komeito, the LDP’s coalition partner, is an urban-welfare oriented party. The message from this appointment is that the budget for roads and bridges and for rural construction will be constrained. Dynamics Another key aspect of the Cabinet is how well the ministers work together. This will be unclear until a few weeks of Cabinet meetings and agenda sorting has occurred. In the end, the level of cooperation among Cabinet members depends largely on signals from the PM. If PM Abe enforces cooperation, then it will happen. If he allows disunity, then investors could well have an unfavorable impression. Some other aspects of the new government will be key, in my view. PM Abe has appointed five assistants, including some former Cabinet ministers, for various policy initiatives. The relationship between these assistants and the respective ministers (e.g., in education policy) remains to be clarified. In addition, the Council on Economic and Fiscal Policy, the nation’s highest policy body for economic affairs, will require new appointments of all its private sector members. Since Minister Ota has been close to former minister Takenaka over the years, she is likely to insist on strong appointments. Indeed, I see PM Abe’s appointment of Ota as a signal that he intends to use the CEFP actively. The specific appointments, however, are extremely important. Next steps In my view, the next major developments will be PM Abe’s Basic Policy speech, expected on September 29, and the subsequent debate between PM Abe and Democratic Party head Ichiro Ozawa, expected on October 2-3. These events should help to clarify the policy agenda and the priorities among the policies. In addition, it will be necessary for the new ministers and the new assistants to the PM to establish a set of task forces, to make proposals on reform. These proposals will be the core of the LDP’s election strategy for the Upper House election next July, in my view. This election is a must-win for Abe and the LDP, and so I expect vigorous action from the task forces.
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Carried Away
Sept 27, 2006
Serhan Cevik (from Rome)
The ultra-low cost of capital in developed countries set the stage for the carry-trade boom. We all know that global imbalances are behind the wild gyrations in financial markets and increasing risks to economic prospects. But do not indiscriminately blame ‘irresponsible’ policymakers in developing countries this time, because the origin of today’s challenges is in the developed part of the world. For one reason or another, central banks in advanced countries lowered interest rates, whether measured in nominal or in real terms, to their lowest level in the last five decades. Such extraordinarily expansive monetary conditions spawned an overpowering flood of liquidity and encouraged international investors to reduce risk aversion. The unsurprising result was asset bubbles, popping up almost in a self-fulfilling fashion, all around the world. Of course, nothing lasts forever. Rising interest rates and growing unease about global imbalances altered the risk/reward balance in financial markets and raised the opportunity cost of capital, especially for leveraged investors. And with the shrinking supply of global liquidity, we have started witnessing abrupt fluctuations in risk appetite and sporadic bursts of volatility. With global imbalances, unfortunately, anything — political noise or ‘disappointing’ data for a month — can be an excuse for across-the-board sell-offs in financial markets. A tsunami of super-hot money created bubbles, and now leads to market corrections. Today we live in an unbalanced world in which the real systemic risk is not some macroeconomic problem per se, but liquidity-driven capital movements crashing around like bulls in a china shop and all together looking for the next correlation trade in inherently shallow ‘emerging’ markets (see The Contagion of Mutual Imitation, June 13, 2006). This is a serious threat to developing countries where domestic institutional investors are simply too small to play a stabilising role. Even though emerging markets as a whole have in fact become net exporters of capital, private capital flows to debt and equity markets in developing countries still reached US$314 billion in 2004 and US$336 billion last year, exceeding the previous record of US$316 billion in 1997 before the Asian and Russian crises. But we must be careful in analysing the spillover effects of global asset reallocations, especially on capital-importing emerging markets. Take, for example, the much-debated case of Turkey. Between the beginning of 2002 and May 2006, the current account deficit amounted to US$64.5 billion on a cumulative basis, while capital inflows (excluding IMF loans) reached US$140.6 billion. In other words, Turkey received twice as much in foreign capital inflows compared with its external funding need. This has been an unprecedented, incredible wave of capital movements, but not really a big surprise. When interest rates are unusually low, investors rush to generate alpha through greater exposure to higher-yielding markets. Though Turkey, like some other emerging economies, has maintained prudent macroeconomic policies and persevered with structural reforms throughout the liquidity cycle, no country (even with an advanced financial system) can absorb such global excesses. The unwinding of carry trades has contributed to the recent bursts of financial volatility. The first wave of risk reduction may have emerged from an inflation scare and the pressure of higher interest rates in developed countries, but it also triggered tectonic shifts in financial markets and reached a state of extreme sensitivity to every bit of noise ranging from growth to geopolitics. In our view, this is simply an indication of the underlying fragilities of risky investment strategies. The overlap of abundant global liquidity and the rise of hedge funds (as well as greater risk appetite among institutional investors, commercial banks and the proprietary trading desks of investment banks) is no coincidence. Thanks to low interest rates and petro-dollars, the number of hedge funds increased from less than 1,000 in 1995 to approximately 10,000, with assets under management rising from US$100 billion to about US$1.5 trillion. It may still be small compared to the rest of the investment community, but hedge funds already account for more than half of the global trading volume. And when higher interest rates and the perceived risks to the growth outlook diminished the attractiveness of carry trades, the unwinding of leveraged positions has resulted in sharp reversals of capital inflows and thereby contributed to the rise in volatility. Losses realised in one market induce investors to reduce positions in other markets. Developing countries have never been as strong as they are today, but that is unfortunately not enough, especially for those with fully liberalised capital accounts, to purge vulnerabilities to sudden changes in global liquidity conditions and contagious herding behaviour in financial markets. Indeed, even as the share of direct investments increased from 15.5% in the first half of the 1980s to 50.2% last year, liquidity-driven portfolio flows into emerging markets are still substantial enough to result in distortionary bursts of volatility. This is why the usual advice of ‘strengthen economic policies and pursue structural reforms’ is not really a long-term solution to what is effectively a chronic problem. Without doubt, emerging economies must accelerate institutional convergence and maintain macroeconomic stability, but ignoring the responsibility of developed countries would only delay the adjustment of global imbalances.
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Rates Likely on Hold for Rest of Year
Sept 27, 2006
Deyi Tan (Singapore)
Rates left unchanged. The central bank (BNM) kept the overnight policy rate unchanged at 3.50% today, making this the fourth consecutive time it has kept rates on hold. This was in line with our and market expectations. August inflation continues to support a pause. Neither demand-induced inflation nor second-round effects (MoM inflation at -0.1%), factors that the BNM cited as calling for a monetary policy response, were evident in the August inflation data. While it is not possible to calculate core inflation, as data on more specific sub-components have not been released yet, what are available do not suggest a major change in the underlying core inflation trend. July core inflation was tracking at 1.0% YoY, and we expect August core inflation to come in at similar levels, with real policy rates tracking at about 2.5%. Base effects from the August 2005 fuel price hikes of 3.6% to 18.5% contributed as much as 0.6 ppt to the deceleration in headline inflation, as transport price inflation dipped from 12.3% YoY to 8.8% YoY. Rates likely on hold for the rest of the year. In its monetary policy statement, the BNM said it believed that inflationary pressures are likely to remain contained in the near term, underpinned by moderation in global oil prices while growth remains steady. Indeed, the BNM expects inflation to decelerate further until year-end and come in below 3% next year. This is in line with our expectations. However, its 2007 GDP growth expectations are relatively optimistic compared with ours (+6.0% versus +5.0%). Comments by the BNM hint that rates are likely to be kept on hold for the rest of the year, with policy change unlikely unless there is a change in outlook.
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