Sept 29, 2006
Stephen S. Roach (New York)
Long the engine of global consumption, the American consumer should retrench in a post-property-bubble climate. While this could take a cyclical toll on US and global economic growth, it could also provide meaningful relief for a massive US current account deficit — the principal imbalance of an unbalanced world. And if consumers elsewhere in the world finally step up, there might be a powerful and lasting impetus to global rebalancing. Sweet dreams for now, but ultimately the only way out for a US-centric global economy. What would it take to turn those dreams into reality?
The American consumer has slowed. Over the three quarters ending 2Q06, annualized growth in real personal consumption has averaged 2.7%. This is hardly a collapse. It does, however, represent a meaningful deceleration from the 3.7% average growth trend of the past decade — the most prolonged and vigorous burst of consumption in the modern-day history of the US economy. For ten years, spending by increasingly asset-dependent US consumers has exceeded growth in real disposable personal income by 0.5 percentage point per year. I suspect the recent downshift of US consumption growth is only the beginning. As the wealth effect fades in a post-housing-bubble climate and as a meaningful downturn now unfolds in the residential construction sector, I look for the relationship between income and spending to reverse — with consumption growth falling below the underlying pace of income generation for at least a couple of years. For the rational consumer, this is just another way of saying that the sources of saving will shift away from asset appreciation back to labor income. From time to time, growth could well accelerate back above the subdued pace of the past three quarters; that appears to be occurring right now, as real consumption appears to be tracking a 3.5% annualized gain in the current quarter on the back of the sharp recent decline in energy prices. But with the headwinds imparted by negative wealth effects likely to be long lasting and a cumulative contraction in homebuilding activity likely to unfold over a couple of years, it will take steady and sharp further declines in oil prices to keep the US consumption boom going. That is not a bet I am prepared to make.
As the US consumer goes, so goes America’s demand for imports. With goods imports at a record 14% of real GDP and personal consumption still accounting for a record 71% of real GDP, there can be little doubt as to the impetus of America’s seemingly voracious demand for foreign produced goods. And with goods imports fully 77% larger than goods exports, the same excess consumption is obviously central to the gaping US trade and current account deficits. Moreover, if saving shifts back from being asset- to income-based, the national saving rate will also rise. That, in turn, reduces America’s need to import surplus saving in order to grow — and to run massive current account and trade deficits in order to attract the foreign capital. For a rebalancing fanatic like myself, a consolidation by the asset-dependent American consumer — as long as it is orderly and contained — is just what the good doctor ordered.
Yet America can hardly fix global imbalances by itself. The ideal rebalancing scenario has to involve consumers elsewhere in the world. I am actually quite optimistic that day will come. I just don’t think it will happen quickly. For most of the past decade, the American consumer has provided the only real source of consumption dynamism in the world. Europe and Japan have been trapped in structural malaise, and the rapidly growing developing countries have relied much more on export-led growth models than support from internal private consumption. That’s especially the case in emerging Asia, where IMF estimates show consumption shares of GDP falling from around 70% in 1970 to less than 50% in 2005.
The global shortfall of non-US consumption hasn’t occurred in a vacuum. In the developing world, I suspect that consumers are inclined toward what economists call “precautionary saving” — holding back on spending and setting aside funds out of fear. That arises because developing nations are lacking in the “safety nets” that are so essential to instilling consumer cultures. China is an important case in point. While it has a 35% household saving rate, a Gallup tally indicates that the Chinese have become increasingly dissatisfied with their saving positions. With massive layoffs arising from state-owned enterprise reforms — headcount reductions totaling at least 60 million since 1997 — and without social security, pensions, unemployment insurance, and worker training programs, fear-based precautionary saving in China is certainly understandable. The good news is that China’s newly-enacted 11th Five-year Plan makes provisions for funding many of the institutions of a safety net. The bad news is that it will take time for the programs to take hold, and quite possibly even more time for households to trust the security a newly constructed safety net may offer.
In the developed world, a different type of precautionary saving motive may be at work — especially in the restructuring economies of Europe and Japan. Headcount reductions, which are central to corporate cost-cutting strategies, instill a deep sense of job and income insecurity — inhibiting consumption in the process. That was very much the case in the US during the early 1980s and again in the early 1990s when restructuring imparted stiff headwinds to both income generation and personal consumption. Yet when restructuring finally stabilizes and the bulk of the work force comes to the realization that they will be spared, workers breathe a collective sigh of relief and consumption then springs back to life. That also happened in the US around 1983 and again in 1994. Here, as well, the consumption response to the restructuring all-clear signal response takes time — deep-seated insecurities over job loss and income pressures don’t disappear into thin air. As I see it, restructuring constraints are still very much a factor in Europe — continuing to put a damper on any revival in consumer demand. Japan, which is more advanced than Europe in the restructuring sweepstakes, has a somewhat greater structural chance for a sustained pickup in personal consumption.
All this points to an asynchronous global rebalancing over the next couple of years. The post-housing-bubble retrenchment of the US consumer is likely to be far more immediate than any pickup of consumers elsewhere in the world. That, in turn, suggests more relief on the import side of the US trade equation than on the export side. That would limit the magnitude of any US trade and current account improvement and constrain the scope of global rebalancing. But it would be an important cyclical down-payment in any case. The big risk is that the rest of the world draws a false sense of comfort from this temporary reduction in the US external deficit and fails to make progress on its own consumption challenge. If that’s the case, once the ever-resilient US consumer rebounds from a post-housing-bubble consolidation, global imbalances will then start deteriorating all over again.
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Bust, Not Rust?
Sept 29, 2006
Richard Berner (in Ligonier, Pennsylvania)
For several years I’ve argued that the US housing boom had not created a nationwide housing bubble, and that the end of the boom would not promote a housing price bust, meaning nationwide declines in home prices. But the decline from a year ago in two nationwide measures of home prices strongly challenges that view. The median price of new single-family homes sold dipped by 1.3% and that for existing single-family homes sold fell by 1.7% in August from year-ago levels. Moreover, I think the housing recession now underway has further to go. So is this the beginning of a housing price bust, as many argue? Or is it simply the start of stagnation in prices, or “rust,” as I have expected?
As I see it, there are downside risks, but builders’ aggressive cuts in starts and support from income and job growth still make a bust unlikely. Measured realistically, we expect that inflation-adjusted housing prices will decelerate from a 6.6% rate in 2Q06 to zero over the next 9-12 months, and the deceleration will be sharper in nominal terms if our forecast of declining headline inflation is accurate.
There’s certainly no perfect measure of home prices, but measurement isn’t just a technical issue in the case of home prices, where no two homes are exactly alike. The good news is that all home price measures are telling a similar directional story. But the degree of deceleration or decline varies substantially, and some measures are seriously distorted. Indeed, some of these commonly-cited pricing metrics can be misleading when looked at over periods less than two years.
The Census Bureau’s average and median home prices (in dollars) for both new and existing homes sold each month are cases in point. True, median price composites are superior to average quotes because the upward drift in housing quality biases the average change higher. Yet shifts in the size or value composition of sales will still heavily skew the median price measures for new home sales because these metrics inherently compare apples and oranges — the homes that happen to be sold this year with those sold last year. A shift to sales of more expensive houses will boost the median with no underlying change in the price of comparable units. The index of median prices for sales of existing homes is similarly flawed. That partly explains why the former rose by 3.4% in the year ended in December 2005, while the latter jumped by 10.6% over the same period. And shifts in the mix of houses sold explain why even the median price of new homes has decelerated so rapidly over the past year. The median price stood at $237,000 in August. But sales of new homes priced over $300,000 tumbled between 25% and 36% over the past year, while those priced up to $300,000 declined by 14-19%. The bigger plunge in sales of more expensive houses has depressed the median.
In contrast, the Office of Federal Housing Enterprise Oversight (OFHEO) home price index (HPI) — one of the more reliable home price measures — increased in the second quarter by 10.1% from a year ago. That is the slowest year-on-year pace in two years, and the quarterly gain of 1.2% is the slowest pace since 4Q99. Another relatively reliable measure, the Census Bureau’s constant-quality home price index, increased by only 4.5% from a year ago and just 1.8% in the quarter.
The OFHEO nationwide price index and other so-called ‘matched sample’ popular price gauges are the most reliable price metrics. They track repeat sales of the same single-family properties and thus eliminate most of the mix shift problems inherent to other measures. But even these gauges may overstate ‘pure’ price appreciation in housing, because they don’t take remodeling into account. That is, owners added to the value of the property by investing in additions and alterations, but the index (which is designed for housing intermediaries Fannie Mae and Freddie Mac, not for economic analysis) isn’t adjusted for such increases in ‘quality.’ The difference can be substantial: The Census Bureau’s index of median new home prices rose by 47.3% in the five years ended in 2005, while a similar index adjusted for quality rose by one third less, or 32.4%. In addition, ‘appraisal bias’ may inflate the OFHEO measure; a ‘purchase-only’ version of the OFHEO measure shows that home price appreciation peaked at 11.3% a year ago and ran at 8.3% in the year ended in June.
But measurement issues should not obscure the real debate over the house price outlook. Pessimists argue that the bursting of a putative housing bubble means that prices could decline significantly. There is some risk that prices could decelerate faster or even decline — after all, investor and speculative activity in housing has picked up in the past five years. As evidence, Home Mortgage Disclosure Act (HMDA) data suggest that the investor share of sales (including vacation homes) rose to 13-15% by 2004 or double the proportion from five years previously. Those local markets with extremely high investor shares (Las Vegas 24%, Orlando 19%) seem more susceptible to outright price declines.
In my view, the deceleration in prices has been the product of two factors: Sinking housing affordability that undermined demand and builder exuberance that created an overhang of new supply and inventories of unsold homes. Because housing demand in the short run is relatively insensitive to price changes, a buildup in inventories can produce a sharp deceleration in prices. But that also implies that builders’ aggressive efforts to slash housing starts and cut back inventories will promote a better supply-demand balance and help to stabilize prices. And just as accelerating price changes eventually hobbled demand, I think a sharp deceleration in prices will help stabilize it, perhaps at levels 15% lower than today. Investors thus should not assume that a bust in housing activity will promote more than rusting home prices.
Nonetheless, prices may fall in markets that are affected by a weak economy (e.g., Detroit), by high speculative activity (e.g., some condominium markets), or where there is a preponderance of second homes (e.g., in Florida or the Sunbelt). Ironically, home prices in the Gulf Coast and Florida have fared quite differently in the year following the destructive 2005 hurricanes: The supply shock that reduced the housing stock and caused a scramble for new places to live in the Gulf Coast has led to price hikes of 15-20% in New Orleans-Metairie-Kenner and Baton Rouge, LA and Gulfport-Biloxi, MS. Contrariwise, the sharp escalation in insurance premiums and the difficulty in obtaining homeowners insurance at all has added to downward pressure on Florida home prices. Those disparities underscore the fact that local economic conditions are typically the dominant forces driving home prices.
A comparison of price changes over the four quarters of 2005 with more recent data is instructive. According to OFHEO, four-quarter appreciation rates in 2005 were at record levels in 26 metropolitan areas including Orlando-Kissimmee, FL; El Paso, TX; and Myrtle Beach-Conway-North Myrtle Beach, SC. Phoenix-Mesa-Scottsdale, AZ was the MSA with the greatest appreciation rate of 39.7 percent. By state, Arizona’s appreciation was 34.9 percent, or more than eight percentage points greater than the rate in Florida, the second-fastest appreciating state. As a result, the Mountain Census Division became the fastest-appreciating area of the country.
More recently, Arizona and Florida have shown sharp decelerations in home prices that really began in the spring of 2005. The year-over-year arithmetic masked those changes. Recent monthly changes (unpublished) for both states imply annual increases in the low single digits. Price declines in these states are possible. By contrast, appreciation patterns for the two states with the lowest overall appreciation, Ohio and Michigan, showed minimal deceleration over that period, although the MSAs surrounding Detroit are beginning to show weakness in response to job losses in motor vehicles and auto parts and the exodus from the region.
More generally, the OFHEO analysis confirms that the sharpest decelerations are occurring in the MSAs and states that had the biggest run-ups in price. While that strongly hints at the unwinding of local bubbles, it may not be the case everywhere that “the bigger they are the harder they fall.” And rapid home price increases alone aren’t sufficient to conclude that a bubble existed; to create a bubble, in our view, you need rapid price increases that go beyond local economic fundamentals. Metrics for making those judgments, such as home-price-to-rental price or home-price-to-income ratios, offer only limited guidance. In any case, the reality is that prices won’t stop decelerating until the excess inventory of new homes has been mostly worked off and housing affordability begins to turn up.
The dichotomy among financial market participants clearly reflects their views on the outcome of the housing debate. Bonds are priced for a weak outcome — a home price bust and a consequent flattening in growth in consumer spending. In contrast, equities are discounting a much more benign result. The irony is that the sharp downdraft in yields is promoting increases in financial wealth that may be a significant offset.
An extended period of home price stagnation lies ahead. Given the magnitude of the coming inventory adjustment, the near-term risks for home prices are tilted lower. But the faster the builders cut starts, the faster the mismatch between sales and production will be reduced and the pressure on prices will abate.
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Sept 29, 2006
Eric Chaney (Paris)
The July-August softer patch is behind us
Against expectations, Euroland manufacturers have just reported that production accelerated in September, after two months of deceleration. Our favourite index, the assessment on current production taken from monthly tallies such as the Ifo/Insee/Isae surveys, rose by 40bp of standard deviation, only a whisker from the record level reported in June. While the intrinsic volatility of production indicators reported in business surveys calls for caution, the surprising strength of euro area economies is important for policy makers and financial markets. For central bankers, it says that the economy is strong enough to absorb further steps towards monetary policy normalisation. For governments, it says that the times are propitious for fiscal stabilisation: better going for fiscal retrenchment when the economy is robust than when it is weak. For financial markets, it implies that companies’ profits are likely to continue to surprise on the upside in the short term, and that risks regarding short-term interest rates are probably on the upside.
‘It’s demand, stupid’
As we pointed out in the July edition of this Business Cycle Watch, the demand indicator matters in as much as its level correlates well with the growth rate of order books as seen by companies. In September, this indicator regained the ground lost in August to reach 1.5 points of standard deviation (sda), only one-tenth below the June 2000 all-time record of this 30-year old time series. Across sectors, demand for capital goods, followed by consumer goods, is the most buoyant, the former fuelled by a powerful global capex cycle, the latter with the acceleration of consumer spending in some countries of the euro area, starting with France. The strength of demand makes this particular business cycle closer to the 1999-2000 one, which resulted in 4.0% GDP growth on average in 2000, than to the short-lived recovery of 1994-1995. As in 2000, but in contrast to 1995, the demand indicator is significantly higher than the production one. Also, expectations, although having declined significantly below actual production since March, are moving sideways — down in August, up in September — as if companies did not perceive clear signs of acceleration, or deceleration, for the next few months. Since demand is so important, the next question is, how sustainable is the demand trend?
Overseas demand was probably the booster
The other particularity of September surveys is that most of the acceleration was generated by German producers. What is currently happening in Germany is really amazing: on our metric, i.e., indicators taken from the manufacturing section of the Ifo survey, demand and production have never been as strong as they were reported in September. While the production indicator is probably not suitable for long-term comparisons, because German companies have offshored large parts of their producing platforms, thus creating a widening gap between domestic value-added and production (i.e., sales), the same reservation does not hold for demand. Again, the nature of this particular global capex cycle, much less driven by ICT investment than the 1994-2001 one, is particularly favourable to Germany, which remains the largest producer of machinery and equipment in the world. To that extent, the recent acceleration of production in Europe seems to come from overseas demand.
All bets are open for 2007
While the short-term outlook of the euro area economy looks good, I wouldn’t extrapolate it into next year. A combination of tighter fiscal policies in Germany and Italy, higher short-term interest rates and a possible US-generated slowdown of global trade could result into below trend growth next year. This, we will not know before December or January.
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UK and US Housing Markets and the Wider Economy
Sept 29, 2006
David Miles and Melanie Baker (London)
At a time when there is, rightly, a great deal of focus on the implications of a sharp slowdown in the US housing markets on the wider economy, it is important to figure out what can be learned about that from the recent UK experience. We believe that the housing and mortgage markets in the two economies have been sufficiently different to be wary of drawing any clear lessons from what has happened in the UK.
The UK experienced a housing market slowdown between mid-2004 and mid-2005. On the HBOS measure of nominal house prices, UK house price inflation slowed from 22% to 2% year on year over that period. UK real consumer spending slowed down, and by mid-2005 real consumer spending growth was running at 1.1% year on year. While this avoided a ‘consumer recession’, such spending growth rates are below the historical trend of around 3%. Since then, both the housing market and real consumer spending growth have picked up. Some have drawn comfort for the US from this ‘soft landing’ story. However, we would caution about reading too much into the US economic outlook from the UK’s experience.
Before focusing on what is different between US and UK markets, we make a general point. It is that one should be sceptical on the strength of the link between housing markets and consumer spending. Although we agree that there is a degree of linkage (e.g., through changes in housing market activity driving purchases of certain types of household goods and through changes in the available collateral for household borrowing — home equity withdrawal is more than 5% of disposable income in both the US and the UK), this linkage is probably variable over time and may not even be especially strong. Three points are significant: 1) just because house price movements and consumer spending movements may be correlated, this does not imply a causal relationship between them. An observed correlation may simply reflect movement in other factors which affect both house prices and consumer spending, e.g., interest rates, labour market fundamentals and income expectations; 2) Just because housing constitutes the largest part of household wealth (at around 54% in the UK once pension and life insurance assets are included), it does not follow that the value of housing has a very strong influence on consumer spending. Housing is not like other types of wealth. Most people live in the house that they own. If an owner is preparing to trade up, i.e., move to a bigger house (as many throughout the housing market are), then national house price rises do not make that household better off; 3). Those who trade down may gain from house price rises and those who trade up lose; these winners and losers should largely cancel each other out across the aggregate economy.
Now back to what we might learn about where the US is heading from the recent UK experience. UK and US housing market conditions have actually been rather different in important respects: 1) Year-on-year nominal house price inflation did not turn negative in the UK’s recent housing market slowdown (bottoming out at 1.7% year on year on the HBOS measure, for example). US year-on-year house price inflation has now become negative on some metrics. Nationally, prices never fell in the UK and are now rising at an annual rate of not much short of 10%; 2) The mortgage market structures are also different. A higher proportion of US mortgage loans are fixed-rate loans. This is important for the impact of monetary policy on the consumer and on the housing market and the correlation between the two; 3) Residential construction activity is more important in terms of the size of the population and the economy in the US compared to the UK. In the US, for example, the rate of housing starts per household is around 1.8%. That compares to 0.9% in the UK. In the UK, residential construction activity is also relatively non-responsive to housing market fundamentals, largely due to heavier planning restrictions. The dynamics of any housing market slowdown may therefore play out very differently in the US through the construction channel. US construction activity is larger, more volatile and has recently increased more rapidly than has been the case in the UK. In fact, the rate of housing construction in the UK has been remarkably stable for many years — which may be one reason why prices have been more volatile than in the US, where supply has been more responsive.
All in all, we are wary of inferring much about where the US is heading over the near term from the recent experience in the UK.
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Official Reserves a Source of Stability, Except in 2002
Sept 29, 2006
Stephen Jen (London)
An ongoing debate on the role that reserves play
There has been an ongoing debate on the role that official currency reserves play in foreign exchange markets. Specifically, many believe that reserve managers have been the main driver behind the powerful trends in the currency markets in recent years. In their view, wholesale diversification away from dollars has and will continue to drive the USD lower against other major reserve currencies such as the EUR and GBP.
I continue to challenge this view, and believe that some monetary authorities have indeed caused some downward pressure on the USD through their diversification efforts over the past two years. However, from the perspective of the world as a whole, available evidence suggests that reserve managers, in the aggregate, target the nominal values of their benchmarks. As a result, they tend to be a stabilizing factor rather than a source of mini-runs on the dollar. The exception was in 2002, when there was a one-off 4% shift in the world’s official reserves from USD to EUR. I will prove my point using the latest data on official reserves from the IMF.
Since 2003, the real dollar diversifiers have been US real money managers and not foreign central banks, in my view.
The popular view
It is a deeply entrenched notion among many investors that: (1) large central banks in the Middle East and Asia have been diversifying from dollar assets in the past few years; and (2) this trend will likely accelerate and lead to an eventual downfall of the dollar as the hegemonic reserve currency. This view became popular in late 2004, when some Fed officials (e.g., San Francisco Fed President Janet Yellen), former US government officials (e.g., former Treasury Secretary Larry Summers), well-known scholars (e.g., Ken Rogoff) and many market commentators began to explicitly talk about this theme. (Ironically, this idea became fashionable after the dollar had declined for two-and-a-half years, and EUR/USD’s spot rate today is no different from that of two years ago.)
Several central banks have explicitly announced their intention to diversify away from dollars and toward the euro. For example, on May 25, 2006, Russia announced that the share of foreign exchange reserves invested in euros would be raised from the current 25-30%, without giving details of the new proportion. However, if the reserves are managed in the same way as the Stabilization Fund, the currency composition would be 45% in dollars, 45% in euros and 10% in sterling. United Arab Emirates Central Bank’s Governor announced a change in the composition of foreign exchange reserves, increasing the proportion invested in euro-denominated assets from 2% to 10%. Iran, Venezuela and India have all formally announced their intention to reduce their dollar holdings and increase their non-dollar holdings.
Available evidence continues to contradict this view
Despite these anecdotal announcements, data on global reserves do not corroborate the view that there is a wholesale diversification process going on.
The IMF has the most definitive database on the currency composition of the official reserves. Information on this subject is confidential for most countries, and only the IMF is entrusted with the job of aggregating country-specific data. Even the BIS uses the reserve data compiled by the IMF. We have been tracking the IMF’s quarterly COFER data releases since the beginning, and have made the observation that there has been no sign of wholesale diversification from dollar assets in the last three years, though it is likely that some emerging markets may, on the margin, have been buying incrementally more EUR and GBP and less USD. But this shift is incremental and not close to the order of magnitude that would lead to a trend in the currency markets.
Reserve managers’ target benchmarks
The latest IMF data — released in the Appendix of its 2006 Annual Report (Table I.3, page 131) — provide another perspective, as the IMF separated out its data on the currency composition of official reserves into price and quantity terms. I wrote about this last year when the IMF’s 2005 Annual Report was released, but the key theme — that central banks, in the aggregate, target benchmarks — is even more pronounced this year.
1. 2002 was the only year of USD-EUR diversification. In contrast to popular belief, wholesale USD diversification into EUR occurred only in 2002. The dollar share of total reported official reserves declined from around 72% to around 67-68% in that year. The dollar share has been stable since 2002: 68.1% in 2002, 67.6% in 2005. At the same time, the euro share of total reported official reserves took a commensurate step jump, equivalent to 4-5% of total global reserves, from around 18-19% to 24-25% in that year. Thereafter, the euro share has not changed much. What this means is that genuine wholesale dollar diversification by central banks took place way before the market became alert to this trend, and when the market began to fret about this risk in 2004, there was no discernable diversification.
2. Except for 2002, central banks were a source of stability. The IMF’s data released last week are revealing in that they show a powerful trend: central banks by and large offset the sharp movements in exchange rates by buying currencies that depreciated and selling currencies that appreciated, so as to maintain stable benchmarks. Exhibit 1 shows that, from 1999-2001, the dollar had a positive price effect, i.e., the dollar appreciated. During those years, the world’s incremental dollar buying was only around 50%, substantially below the dollar’s benchmark of around 72%. Far from implying that central banks were already diversifying from USD when the EUR plunged toward 80, this suggests to me that central banks offset the price movements. You can also see the opposite pattern in EUR buying: just as the euro plunged to its low after its launch (a negative price effect shown in the table), the world’s central banks’ incremental buying was quite heavy (49% in 1999, 29% in 2000 and 48% in 2001), almost as much as their purchases of dollars.
Similarly, during 2003-2004, the fate of EUR/USD was reversed, with the dollar falling sharply against the euro. Again we witnessed heavy incremental buying of dollars: in 2003, 86¢ of every dollar of incremental increase in global reserves stayed in dollars; this figure was 77¢ in 2004. In other words, just as the dollar was falling at its most rapid rate in 2003 and 2004, and just as the world turned ultra-bearish on the dollar and began to talk about the risk of central bank diversification, central banks were actually doing the opposite: buying a massive amount of dollars to offset the price effect.
Again, looking at the price-volume decomposition, we see that 2002 stands out as the only year where this ‘offsetting’ did not take place and the world, in the aggregate, bought very few dollars (59¢ for every dollar of incremental increase in world reserves) even though the value of the dollar was declining.
US real money investors the true diversifiers
I have made this argument several times before, and will not repeat the details of my point. The problem here is that there are no natural ‘benchmarks’ for these non-dollar securities holdings for US pension funds and mutual funds.
Presumably, one of the main motivations for the general move to diversify away from US equities was the fear of an eventual dollar collapse. Regular readers of my work should know where I stand on this debate: I attach a zero percent probability of that happening in the foreseeable future. The cost of not hedging back into the dollar is so high — currently my measure of the G7 market cap-weighted hedging costs is 250bp, i.e., a dollar-based global equity investors gets paid 250bp for hedging back into dollars their exposures overseas. The longer the dollar defies the doomsday prediction, the harder it will be for US investors to run low hedge ratios on their non-dollar investments.
Further, on a more fundamental level, I am not convinced that US-based investors need to diversify so much to capitalize on globalization. US multinational corporations have been the first wave of pioneers in outsourcing. Many emerging markets are doing well partly because American firms are there. With the US companies being so exposed to the global economy, the need for diversification does not seem to be that urgent, in my opinion. If or when a round of risk reduction like the one we witnessed in May/June is repeated, there could be a powerful wave of repatriation back to the US. In other words, I believe that the US real money accounts are out of balance, and are a source of upside risk for the dollar.
Further one-off adjustments possible, but not inevitable
I have argued that wholesale dollar diversification has not happened, except in 2002. Going forward, whether central banks diversify from dollars again is a real risk, and a function of many considerations. However, nothing is preordained. I see further step divestment from dollar assets as possible, but not inevitable. My best guess is that, if the world’s official reserves evolve into sovereign wealth funds, the real risk is diversification from developed currencies into developing currencies, not a simple dollar-versus-euro proposition.
The latest data from the IMF confirm that there has been no wholesale dollar diversification by foreign central banks, except in 2002, when the EUR share rose by 4-5% of total reserves, at the expense of the USD. In every other year, however, central banks have offset movements in exchange rates by buying currencies that were depreciating and selling those that were appreciating, so as to maintain their nominal benchmarks. In other words, central banks have been a source of stability in the currency markets, except in 2002.
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Why Is the JPY So Weak?
Sept 29, 2006
Stephen Jen and Luca Bindelli (London)
Summary and conclusions
The JPY remains weak, despite the economic recovery in Japan. In REER terms, the JPY is at its weakest level since the period right before the Plaza Accord in 1985. It is widely presumed that the so-called ‘JPY carry trades’ — powered by the net fixed income outflows from Japan — have become even more popular recently as most other central banks have tightened much more than the BoJ has. It has been argued that unless these Japanese capital outflows abate, the JPY will likely remain weak.
In this note, we challenge the notion that the primary reason behind the weak JPY is increased Japanese capital outflows. Instead, we propose three other factors that may have weighed on the JPY: (1) a sharp curtailment of equity inflows into Japan in 2006; (2) changing currency hedging ratios; and (3) the ‘Global Funneling’ process. All these factors may take time to reverse, to push JPY higher.
Questioning the notion of rising Japanese capital outflows
Investors and commentators talk about ‘JPY carry trades’ without properly defining what they are. In a previous note (Don’t Blame the BoJ for the Bloated Global Asset Prices, June 15, 2006), we suggested three types of JPY carry trade. What we find remarkable is that none of the three types of JPY carry trades has actually increased in size in recent months, contrary to popular presumption.
• Type 1 JPY carry trade: net fixed income outflows from Japan. This is the type of JPY carry trade we presume most investors have in mind: net fixed income outflows propelled by interest rate differentials. Despite the popularity of this notion, data do not definitively support this idea. Since 2H05, net bond outflows have actually declined sharply. In fact, in recent months, there have been net bond inflows, contrary to popular presumption. The recent rally in NZD/USD and NZD/JPY has been widely interpreted as a sharp rise in uridashi flows into New Zealand. This may very well have been the case. However, from the perspective of the net aggregate fixed income outflows, the official data don’t corroborate the notion that this type of flow was behind the weakening in the JPY this year.
• Type 2 JPY carry trade: JPY duration trade. There are also JPY-JPY carry trades whereby Japanese investors fund their long JGB positions with short-term credit/loans. This, in fact, was the mechanism through which the BoJ ensured that the yield curve remained contained with quantitative easing (QE). This is an indirect way through which other types of JPY carry trades can be fuelled, as the whole yield curve in Japan is artificially depressed by JGB purchases by banks. Japanese banks have been more involved with this type of JPY carry trade than other institutions. However, Japanese Banks have not increased their holdings of JGBs in recent years. Also, banks’ holdings of foreign securities have not increased either, consistent with the first point we made above.
• Type 3 JPY carry trade: non-Japanese residents borrow in JPY outside Japan. Data on these activities are not definitive. In the BIS Quarterly Review from June 2006, there was a chapter on this issue. However, as we argued in our note from June 15, 2006, the survey data are unclear on whether there has been a large increase in foreign borrowing in JPY. We highlighted that while the stock of outstanding JPY-denominated claims held by both Japanese and non-Japanese banks rose noticeably in 4Q05, JPY loans from Japanese banks were declining in 2005, reaching US$181 billion by year-end.
Other reasons why the JPY is weak
We are in no way disputing that there are large short-JPY positions in the market, in search of higher nominal yields outside Japan. What we question is whether this is the dominant factor behind the weak JPY, particularly when data are not unambiguously supportive of this popular notion. Specifically, we believe that three other factors could also be at least as important as the ‘JPY carry trades’. Correctly identifying the factors weighing on the JPY is important, as a prospective rally in the JPY would require a reversal of these factors.
• Factor 1. A collapse in net equity inflows into Japan. We suspect that the change in net equity flows may have been at least as important as ‘JPY carry trades’ in keeping the JPY weak this year. Net equity inflows averaged around ¥0.88 trillion (or around US$7.7 billion) a month during mid-2003 to end-2005. However, so far this year, net equity inflows have averaged only ¥0.48 trillion (or US$4.2 billion). In fact, in July, the 3MMA of the net equity flows actually turned negative.
• Factor 2. Changing currency hedge ratios. Data on currency hedging are scant. However, we believe that the reason why, in general, short-term nominal rates have become so influential for currencies is that cross-border holdings of assets have risen sharply in recent years: countries simply hold much more of each others’ assets than ever. The bloating of the international balance sheets elevates the role of currency hedging. Since the cost of hedging is determined by short-term nominal interest rates, central bank policies have become even more important for exchange rates than before. Further, while tracking capital flows is helpful in thinking about USD/JPY, hedging applies to the entire stock of assets outstanding. In other words, in theory, the adjustments in the hedge ratios by Japanese and non-Japanese investors apply to the entire stock of assets being held, not just the flows. As the nominal cash yield differentials between the US and Japan stay wide, it pays for Japanese investors to reduce their hedge ratios on their USD assets and for non-Japanese investors to raise their hedge ratios on their Japanese assets holdings.
• Factor 3. The ‘Global Funneling Hypothesis’. Back in August, we proposed a structural explanation for why there has been a steady upward bias in EUR/JPY and GBP/JPY. As long as excess savings from oil exporters and Asian exporters continue to be funneled into primarily USD, EUR and GBP assets, there will be a constant upward bias to USD/Asia, EUR/Asia and GBP/Asia. The fact that JPY is now behind GBP as a reserve currency is very telling.
As long as the funds under management by oil-exporting countries (which we estimate to be around US$1.2 trillion: about US$350 billion in the form of official reserves and another US$850 billion on ‘sovereign wealth funds’), and by the Asian central banks (with US$2.6 trillion in reserves, and another US$500 billion in ‘sovereign wealth funds’) continue to rise, this process will remain an important factor depressing the JPY, and prevent it from rallying too hard too fast.
What we are not yet certain about is whether the level of the rate of change of these excess savings affects the strength of this funneling process.
From ‘nominal’ to ‘real’
Nominal variables continue to drive exchange rates. This is problematic, both from a conceptual and a fair value perspective. If a country’s inflation rate is kept low because of productivity growth, its currency would be weak if nominal factors dominate, but the JPY should be strong if real factors dominate. This is precisely what we are witnessing in Japan. According to our calculations, some two-thirds of Japan’s growth in recent years may have come from total factor productivity (TFP) growth. This means that both aggregate supply and aggregate demand have risen in tandem, creating muted inflationary pressures. From a valuation perspective, high TFP growth should lead to a strong currency. But if inflation remains low, the BoJ could afford to be slow in normalizing rates, and the JPY would stay weak as a result. This is perverse, and ultimately a breaking point will be reached where the real fundamentals will start to dominate, in our view.
From ‘bond’ to ‘equity culture’
This distinction between ‘nominal’ and ‘real’ is also related to the distinction between ‘bond’ and ‘equity’ culture. In the example we proposed above, where high TFP growth depresses inflation and therefore interest rates, both equities and bonds should do well in Japan. If ‘bond culture’ dominates, fixed income flows would be more important in driving USD/JPY. But if ‘equity culture’ returns, equity flows would drive USD/JPY lower. Thus, for USD/JPY and EUR/JPY to trade lower, we need to see a return to ‘equity culture’ and a resumption of net equity flows into Japan.
We failed to find definitive proof that ‘JPY carry trades’ have risen this year, keeping the JPY weak, despite the strong real fundamentals of Japan. Instead, we suspect that three other factors have been at least as powerful drivers for the JPY: (1) the collapse in foreign equity inflows; (2) changing currency hedge ratios; and (3) the ‘Global Funneling’ process. Therefore, for the JPY to rally, we need to see a resumption of foreign equity inflows, the BoJ normalizing rates and oil prices staying low. It may take some time for these three factors to turn around. Given the circumstances, the JPY may stay on the weak side for longer than we had expected.
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Sept 29, 2006
Sharon Lam and Andy Xie (Hong Kong)
Healthy growth restored in August: After a terrible month in July, when labor strikes and floods hampered output and sales, the economy rebounded in August, as expected. It proves that the slump in July was only temporary. What is more important is that the rebound in August was again better than expected and certain areas of the economy, such as capex and construction, have even shown some renewed strength. In fact, Korea’s macro data has been beating market expectations for months, and we believe that soon sentiment should improve slightly upon realization that macro fundamentals are solid. Nevertheless, the overall picture of cooling growth is not altered due to global tightening, although we emphasize again that the slowdown in 2H06 will be mild and could be milder than market’s expectations.
Industrial production holding up on exports: Output jumped 10.6% yoy in August after the 4.3% rise in July, restoring the trend of 10.9% growth in June. In fact, August has actually not seen a full recovery yet due to some smaller-scale strikes in the month, while not all backlogged orders in July were completed in August. However, August output still came in strong, indicating that the economy has been more resilient than the market thought, mainly because export growth has not slowed down as feared. Shipments for export climbed 17% in August, while that for domestic market rose 3%. Korea has also become less dependent on the US, as the US is now only the third-largest export market for Korea after China and Europe. Strong export shipments to China and Japan in recent months have helped offset relatively weaker exports to the US. We believe that exports will remain the growth driver in the next three months, though some moderation is expected.
Capex also held up despite earnings concerns: Facility investment jumped 11.7% in August, up from 4.2% growth in January-July. Although this monthly series fluctuates a lot, the trend is positive. Korea’s capex growth has been holding up longer during this cycle despite concerns over oil prices and exchange rates, which hurt corporate profitability. This implies, in our view, what we have been emphasizing as a genuine need for more capex in Korea. Our argument for sustained capex growth is based on tight capacity. Korea’s manufacturing utilization rate has hovered above 80% since the beginning of this year, and output has been rising faster than capacity in the last two years. While capex growth is in positive territory, it is still not enough to support the need for greater production today; capex has been suppressed since the financial crisis. As a result, we think further downside to capex is limited, which is another factor that leads us to believe there will not be any major correction, since we have not seen excesses created in the economy.
Additional data provide evidence of a rebound in capex: There was a pick-up in private sector machinery orders (excluding vessels), which grew 16% in August, up from 6% in July. Strong machinery orders were seen by the petroleum industry and mining, as well as stable orders from the electronics sector. In the non-manufacturing space, wholesale and retail also contributed to the increase in machinery orders.
Construction sector likely bottomed in 2Q06: There has been rebound in new construction orders, especially from the private sector, after the lull in 2Q. Total construction orders rose 15% in August, the highest level in six months. Orders by the private sector have registered two months of positive growth after falling since the end of last year, while the decline in public orders has narrowed. Construction investment has been discouraged by the government’s anti-speculation policies and rising interest rates. With growth cooling and next year’s presidential election, we do not expect further anti-speculation policy, especially as the property market appears to have stabilized. Meanwhile, we also expect the central bank to be done with the rate hike cycle, and banks have started trimming mortgage rates recently. We expect more moderate downside to property prices in the coming year as liquidity growth is slowing, but we also think all the bad news that has hampered construction investment before is priced in.
The peak of consumption has passed, but no drastic downturn expected: Sales of consumer goods also rebounded in August after labor strikes dampened automobile sales in July. Overall sales grew 3.4% in August, reversing a 1.3% drop in July, although growth was still weaker than the 5% gain recorded in 1H06. With weak consumer sentiment, it is not surprising that consumption growth is losing steam, but the slowdown has been mild so far. Korea’s consumer sentiment is very sensitive to external conditions. With the major external uncertainties fading, such as US Fed rate hikes and oil prices, we believe that sentiment started to improve in September. While a rebound in sentiment could cap downside in terms of spending, we believe that further upside on consumption is rather limited due to declining wealth gains from both stock and property markets. Nevertheless, we do not foresee any significant correction in consumption growth in the coming downturn, as the peak of this consumption recovery has been low.
In fact, we had predicted that Korea’s consumption recovery would be mild due to a structurally difficult labor market and aging population, which raises the savings rate but suppresses consumption. The peak of Korea’s consumption growth reached 4.8% in real terms in 1Q06, in line with our expectations but lower than the 6-7% the market was hoping for. The good news is that, since there was no overspending in this cycle compared to wealth gains, we are not worried about any significant adjustment needed when the cycle turns down. This is just yet another reason why we believe that the coming downturn will be mild.
An orderly slowdown, no need to panic: We have been stressing solid fundamentals in Korea despite weakened sentiment. We believe that growth is only normalizing rather than correcting. Many had called for a slowdown in Korea since the beginning of this year, although we have not yet seen any noticeable deterioration in the Korean economy, except in July when strikes dampened production. While the peak is behind us, the economy has been holding up better than market expectations. Export growth has not slowed, capex strength has remained, construction investment has bottomed, and the slowdown in consumption has been milder than that suggested by consumer confidence.
Macro data in recent months have not surprised us, but have beaten market expectations. Korea has always been a rather volatile economy, and this is why common perception remains that any downturn could be severe. However, volatility has been smoothed out by the lack of fiscal and credit stimulus in this cycle. We believe that the coming downturn will be driven primarily by slower global growth rather than by any domestic crisis. Korea did not have excessive capex growth, loan growth or consumption growth during the past economic boom, and therefore we do not think that any major correction is needed to adjust the economy. We see growth remaining above trend in 3Q06, then slowing to trend average in 4Q, and bottoming in 2Q07, but we do not sense any recession scenario in Korea unless China collapses. A too pessimistic view of Korea is unwarranted right now, in our view.
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New Administration Is Market-Friendly
Sept 29, 2006
Takehiro Sato (Tokyo)
Hidenao Nakagawa the real architect for economic policy
The media commended the line-up of the new Abe administration as a cabinet of technocrats. We doubt this really is the case, however.
The new Financial Minister is Koji Omi, who of course is famous (or infamous) for falsely predicting that “the economy will recover before the cherry blossoms bloom” when he was the minister of the Economic Planning Agency (EPA) back in 1997, when Japan was on the verge of entering a deflation spiral as a result of a financial crisis. His economic outlook was way off target and he failed to propose appropriate and necessary measures for the economy. Many may still feel apprehensive on Mr. Omi, given this track record.
Economic and Financial Minister Hiroko Ota is the former Cabinet Director-General for Policy Planning, who is basically a loyal successor to Heizo Takenaka. This may not necessarily seem like bad news to market participants, but we wonder whether the Council on Fiscal and Economic Policy will function properly under her leadership. Heizo Takenaka had shown remarkable strength when it came to defending his own opinion, for better or for worse. We are concerned on this regard whether Ms. Ota will show such strong leadership. The Council may be watered down, which could limit its effectiveness.
The other main economic cabinet ministers, including the Minister of Economy, Trade and Industry and the Financial Services Minister, only give weak impressions. This seems to have given more authority to the LDP leadership by assigning the ‘lightweights’ to cabinet posts. More precisely, one could even call it a concentration of power to the LDP leadership. Reigning at the top is Chief Secretary Hidenao Nakagawa, who I personally view as the shadow Prime Minister for economic policies.
Core economic policies unchanged
So how will economic policies change ahead? Basically, not by much. On the fiscal policy side, Mr. Nakagawa sparkled as LDP Policy Committee Chairman by putting together the so-called ‘big-bone policy framework for 2006’. The framework for steep spending cuts over the next five years has been decided upon, and the role assigned to the finance minister is only to steadily incorporate these cuts in drawing up the budget ahead. This essentially nullifies the importance of the finance minister position. Also, the new minister of agriculture, forestry and fisheries is a diehard expansionist, but lacks the authority to override basic policies. Although the true test for the new administration will be in drawing up the initial budget for F2007 towards the end of the year, a return to pork-barrel politics would likely spell fewer votes in urban areas in the Upper House elections, in my view. As a result, although the keys to the fiscal budget were essentially passed on to the ruling coalition, it has few options in terms of expenditure.
New administration not necessarily hostile to the BoJ
In terms of the tax system, Mr. Nakagawa is aiming for reflation of sorts with the ‘rising-tide’ economic policy, and wants to put off genuine tax increases as far as possible and instead boost tax revenue by speeding up nominal growth. To achieve this, he is calling on the BoJ to maintain an accommodative stance in monetary policy. There also seems to be a strong body of opinion that policy outcomes will be affected to a degree by Kaoru Yosano’s — a man with a good understanding of the BoJ — dropping out of the ministerial race. However, we do not entirely agree with the proposition that a BoJ rate hike is likely to be put back because of the creation of this new cabinet and the LDP executive line-up. Even under Mr. Nakagawa’s former chairmanship of the LDP Policy Committee, the BoJ went ahead and lifted quantitative easing back in March, followed by ZIRP in July. Essentially, as long as the economy is sound, rate hikes are of benefit to both the government/ruling party and the BoJ, and it is not going too far to say that how policy pans out will ultimately depend on the economy. Also, with all of the personal consumption and manufacturing data currently pointing to weakening, if the economy were to slide back into deflation and recession, the BoJ’s credibility would inevitably be rocked. No doubt the BoJ executives are also aware that to lean towards a hawkish stance now would not be politically wise.
Ultimately, if the economic outlook remains sound, we think the BoJ can continue with measured rate hikes, and if the outlook dims, the interval of the rate hikes is likely to be protracted. Also, such a path should not change, even if the core inflationary rate nears 0% due to a decline in oil prices. With regards to the impact of the core inflation rate on policy, we have been prone to slight misinterpretations, having been so used to the backward-looking policy framework during ZIRP. What matters is that the BoJ has shifted to a forward-looking policy framework based on ‘two pillars (two perspectives)’, when it lifted ZIRP. In this regard, it is crucial to note that the current inflation rate has lost some of the conclusiveness of the past. We think a key will be how the BoJ views the future inflation rate and asset price trends ahead from the medium/long-term perspective.
Timetable for a consumption tax hike
What is the outlook for the consumption tax hike? The consensus seems to target a hike in F2009, but we think F2010 or F2011 is more plausible, depending on the outcome of the Upper House elections. Actually, if the LDP faces an uphill battle in the Upper House election next year and if the next general election is set for the summer of 2009 as a result, a consumption tax hike from April 2009 will be even more unrealistic. So events would give the BoJ more latitude.
Don’t jump to conclusions, however. Indeed, much of the administration’s work ahead will hinge on the result of next year’s Upper House election, and at this point we advise against underestimating the merits of the new administration. Moreover, although the bulk of economic policies have already been decided on, we also look forward to seeing Mr. Abe’s work his magic in foreign diplomacy. There is a chance that the divine winds could blow for Abe again before the next elections, just as the North Korean missile tests provided a great opportunity for him back in July.
Finally, what are the implications for the markets? In simple black-and-white terms, Mr. Nakagawa’s reflationary policies are likely positive for the stock market and negative for the yen. Although successful reflationary polices would bring higher rates for JGBs in the event of higher stock prices, aggressive spending cuts would limit risk premiums. To sum, with stocks rising modestly, we continue to look for a ‘Goldilocks scenario’ in asset markets, with long-term rates trending stably in a tight range, and the yen weakening contrary to the consensus.
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CBC Hikes Again, Unmoved by Recent Events
Sept 29, 2006
Denise Yam (Hong Kong)
Another 12.5bp: The Central Bank of China went ahead with the ninth consecutive rate hike today at its quarterly monetary policy meeting. The rediscount rate was lifted by 12.5bp to 2.625%, the highest level in five years. We see this policy decision as a very close call, torn between the recent ease in inflation and the preference to further normalize the monetary policy stance. For our detailed analysis on the considerations behind today’s decision, please refer to Is the CBC Done with Rate Hikes? September 26, 2006.
Staying the course of monetary policy normalization: CBC’s statement recognizes weak domestic demand and tame inflation, but stresses that rates remain “below neutral”, hence the hike. On the other hand, we believe that capital outflows (evidenced in the financial account deficit of US$6.4 billion in 2Q06 and US$19.5 billion over 3Q05-2Q06) and recent currency weakness also contributed to the decision.
Money market conditions remain loose: Heavily managed by the CBC through open market operations of NCDs, money market interest rates have remained low, and further below the policy rate over the past two years. Continued foreign investor inflows into the Taiwanese stock market (NT$76.9 billion over Sept 1-27) have supported the CBC’s liquidity buffer, with the stock of NCDs totaling NT$3.67 trillion today, up from NT$3.33 trillion in late June. In other words, monetary conditions have tightened less in reality than suggested by the hike in the rediscount rate. 90-day money market rates have risen only 70bp since mid-2004, against the 125bp rise in the rediscount rate.
One more hike possible in December, but aggressive tightening is limited by benign inflation and weak domestic demand: Depending on the pace of the slowdown in exports and the recovery in domestic demand, the CBC could still see room to hike again in December, in our view. Nevertheless, benign inflation and the ongoing weakness in domestic demand make it difficult to justify a more aggressive tightening path.
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