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Global Global Stability and Imbalances Turkey Oiling Disinflation Indonesia Another 50bp Cut Malaysia August Exports Decelerate View GEF Archive

The IMF has just confirmed “the continued resilience of the global financial system.”  Does that mean that everything is fine and there is no need to worry? 

With a record US current account deficit still holding at 6.6% of US GDP in mid-2006 and with the price differential between risky fixed-income assets (i.e., corporate credit and emerging market debt) and riskless assets (i.e., sovereign bonds) at historical lows, this is hardly a time for complacency.  Overly accommodative central banks have pushed the global liquidity cycle to excess -- in effect, funding the resilience of the global financial system with cheap money.  With central banks now seeking to normalize monetary policies, that excess liquidity will get withdrawn -- posing a much more challenging climate for world financial markets and the global economy.  A turn in the global liquidity cycle is precisely the time when we should be worrying the most.

Are market participants assessing the risks in financial markets adequately, or are they lulling themselves into a false sense of security? 

With the demographic clock ticking louder and louder at just the time when returns on traditional investments have declined, looming unfunded pension and retirement obligations have led to an extraordinary imbalance between assets and liabilities.  Yield-hungry investors have, as a result, moved further and further out on the risk curve -- increasing their allocation to higher-yielding assets such as commodities, emerging markets, and what we have traditionally called “junk bonds.”  In some segments of these traditionally riskier asset classes, the fundamentals have undoubtedly improved.  But I am worried that yield-seeking investors have become indiscriminate in their appetite for yield and assessment of risk -- not differentiating the secure investments from the weak ones in riskier asset classes and, as a result, lulling themselves into a false sense of security. 

What are the biggest risks to global financial market stability?  

The growing drumbeat of protectionism is, by far, the biggest risk.  Economic nationalism is on the rise in Europe, and China-bashing is in full swing in Washington.  Since the beginning of 2005, the US Congress has introduced 27 pieces of legislation that would impose trade sanctions of one sort or another on China.  The recent withdrawal of the so-called Schumer-Graham tariff threat to China does not defuse this broad bipartisan political threat.  If any of the remaining 26 actions are enacted -- a serious possibility in a highly politically-charged climate that is rooted in the persistent near-stagnation of real wages -- China could well reduce its appetite for dollar-denominated securities.  That, in turn, could pose an immediate and serious problem for the funding of America’s massive current account deficit -- an external imbalance that requires fully US$3.5 billion of capital inflows each business day of the year.  Absent Chinese buying of US securities, the dollar could plunge and real US interest rates might soar -- developments which could push the US and global economies quickly into recession. 

The dangers of global imbalances have been stressed for many years.  Nothing has happened.  Aren’t these risks being exaggerated? 

The problem has been serious but the consequences have not been -- at least not so far.  The world has bought time for two reasons: the excesses of the global liquidity cycle and the need for surplus savers to keep their currencies weak in order to maintain export competitiveness.  As noted above, the world’s major central banks are now attempting to withdraw excess liquidity.  At the same time, the world’s major surplus savers -- China, Japan, and Germany are hard at work attempting to stimulate internal demand.  That would tend to absorb their excess saving -- leaving less foreign capital to send to saving-short America.  By drawing comfort from the heretofore-benign consequences of a serious problem, global imbalances are ignored at great peril.  

There are voices, particularly in the US, who do not see a problem in the growing US current account deficit on the one hand and the accumulation of massive foreign exchange reserves in some emerging markets on the other hand.  Do you share that opinion? 

The so-called “global saving glut” theory argues that a consumer-led US economy is doing the rest of the world a favor by absorbing excess saving.  I think this notion is preposterous.  From America’s point of view, the implications are most worrisome -- namely a wealth-dependent consumption model that requires low interest rates to push up asset values and subsidize debt service on equity that is extracted from those assets.  A key risk is that asset appreciation begets an asset bubble that then pops -- putting tremendous pressure on over-extended US consumers.  That is a very real threat today as the US housing bubble now bursts.  From the point of view of America’s creditors -- especially poor developing economies -- the risks are equally disconcerting.  The financiers of the US spending binge subject themselves to dollar over-weights in their foreign exchange reserve portfolios -- leaving them with low-yielding returns, risk of a fiscal hit in the event of dollar depreciation, and excess liquidity for those countries like China who cannot effectively sterilize all their purchases of dollars.  And, of course, the large bilateral trade imbalances that are an outgrowth of these imbalances raise the politically-inspired risks of protectionism.  There is no “new paradigm” explanation that adequately explains away these growing risks. 

Is the current boom of mergers and acquisitions a sound development -- especially since it doesn’t lead to job creation?

To the extent that rising M&A activity is a proxy for an accelerated pace of corporate restructuring, that is good news for productivity change.  That was the case in the US in the early 1980s and especially in the early 1990s.  It has also been the case in Japan in recent years and now seems to be bearing fruit in Germany.  German M & A activity could top US$160 billion per year in 2005-06 -- double the pace of the three preceding years.  Meanwhile German productivity has increased at a 1.7% average annual rate in the five quarters ending in mid-2006 -- a stunning acceleration from the anemic 0.7% trend from 1998 to 2004.  Yes, the cost-cutting tactics of restructuring initially put pressure on employment and real wages.  But as the productivity dividends are realized, labor has a much better chance in sharing the benefits.

Are private households so heavily indebted that they could become a destabilizing factor if interest rates should continue to rise?.

Overly indebted, saving-short American households pose a major risk to the US and global economy.  Household sector debt service hit a record 13.9% of disposable personal income in early 2006.  The fact that debt burdens are so high in an historically low interest rate climate is all the more disconcerting. It reflects the voracious appetite for consumption and the willingness of US consumers to lever their favorite asset -- their home -- in order to fund consumption in an income-short environment.  It may not even take further increases in interest rates to push debt service into the danger zone.  After all, borrowing costs of about US$2 trillion in adjustable rate mortgages (ARMs) will be reset over the 2006-08 period.  Inasmuch as a large proportion of such indebtedness was initially taken on at sub-market “teaser rates,” the reset mechanism that takes such ARMs to market rates will boost household debt service even if interest rates don’t rise further from current levels.  Moreover, any shortfall of income growth -- a distinct possibility as the US now enters a homebuilding recession -- could exacerbate the pressures likely to bear down on overly-indebted American consumers.  

Have the risks to global financial stability changed over time?  

There is nothing static about the risks to global financial stability.   As disparities between current account deficits and surpluses widen -- a disparity that is currently in excess of a record 6% of world GDP -- the risks associated with global imbalances undoubtedly mount as well.  To the extent that the world relies increasingly on one asset-dependent consumer -- namely the American consumer -- to prop up the demand side of the global economy, the risks of a post-bubble consolidation of wealth-dependent consumption become increasingly serious.  And to the extent that the excesses of the global liquidity cycle have led to a distortion of the price of risky assets -- namely emerging market debt and high-yield corporates -- a normalization of liquidity poses risks to many of the more popular investments in the world today.  In general, to the extent an accelerated pace of globalization in the real economy and in global financial markets has been accompanied by mounting imbalances, the risks to financial stability change dramatically over time -- and in the current instance, I’m afraid for the worse.

Are the institutional precautions like the Financial Stability Forum sufficient to guarantee global financial stability?

The existence of the Financial Stability Forum, under the auspices of the IMF, is a necessary but hardly sufficient condition for the insurance of global financial stability.  It has done a very good job in the area of surveillance.  The semi-annual Global Financial Stability Report published under the auspices of the IMF is a very helpful review of the stresses and strains in world financial markets bearing down on both developing and developed economies.  But the Forum has nothing in the way of an enforcement mechanism that would put teeth into the review process.  I would like to see the frequency of the report increase from semi-annual to monthly and I would also like to see the development of new and more sophisticated metrics for measuring financial market stresses and strains.  If “stability thresholds” are breached, the Forum should be more explicit in stating that.  A reluctance of officials to sound the alarm out of fear of investor “herding” has created a new moral hazard in world financial markets. 

What else would be necessary?

Global financial stability is very much linked to the state of balance on the real side of the global economy.  In that regard, the world has a very serious problem with a striking imbalance in the mix of global saving -- the United States does none of it (at least insofar as net national saving is concerned) and several developing and developed economies do too much of it (especially China, Japan, and Germany).  At the root of this disparity are equally profound imbalances in the mix of global consumption -- too much in America and too little in export-led surplus economies elsewhere in the world.  The world needs a saving agenda: The US needs to save more and the surplus savers need to save less.  In the US, that spells serious government budget deficit reduction and some form of a consumption tax.  Elsewhere in the world, there is an increasingly urgent need for structural reforms of labor markets and for efforts to fund the safety-net institutions (i.e., public sector social security and private sector pensions) -- both of which are essential to instill thriving consumer cultures.  The world needs more than one consumer and it also needs fewer surplus savers.

Turkey
Oiling Disinflation
Oct 05, 2006

Serhan Cevik (from Istanbul)

Seasonal and Ramadan-related factors should keep inflation in a tight range for a couple of months. The consumer price index posted a monthly increase of 1.3% in September, coming right in line with our own projection but higher than the consensus estimate. As a result, the year-on-year inflation rate increased marginally from 10.3% in August to 10.5% last month. Even though the drop in commodity prices provided a relief, seasonal and Ramadan-related increases in certain components of the CPI were enough to push the headline inflation rate higher. In our view, this is neither a surprise nor a disappointment. Indeed, we are likely to see a similar monthly reading — around 1.5% — in October, simply because of the continuing seasonal adjustments in food and clothing prices. However, these transitory movements are not a threat to the disinflation outlook; and inflation will start declining, once again, toward the single-digit territory by the end of the year, in our view. But before discussing disinflation dynamics in the future, let’s analyse the latest inflation figures.

The Ramadan effect is an important factor for pricing behaviour in certain sectors. The third quarter is usually the peak in business cycle, leading to more pronounced seasonal price changes in some categories like food, clothing and education. However, this year, in addition to usual seasonal price adjustments, the start of Ramadan (which moves forward every year according to the lunar calendar) has become an additional factor leading to higher prices in certain sectors of the economy. For example, food prices increased at a monthly rate of 2.9% in September (up from 1.3% last year), raising the 12-month inflation rate to 12.4% from 10.8% in August. Likewise, clothing prices posted a month-on-month increase of 2.4%, after declining by 13.4% in the previous two months, and with the start of the new school year, the education category registered a 3.7% increase last month. Although domestic demand has not collapsed as many feared after the May shock, the pace of growth in consumer spending is still not a threat to the disinflation outlook. In our opinion, the economy will remain on a non-inflationary growth trajectory, and the most critical factor determining the inflation trend in the near future will be the behaviour of commodity prices and its effect on the lira.

The decline in commodity prices could accelerate the pace of disinflation. After suffering from the global commodity bubble that limited disinflation in the past couple of years, Turkey now stands to benefit from the correction in commodity prices. If sustained, such a positive terms-of-trade shock would ease the burden on external accounts and inflation dynamics. According to our calculations, a sustained US$10 correction in the price of crude oil would lower Turkey’s current account deficit by about US$3.5 billion on an annualised basis and thereby have a favourable influence on the lira’s valuation (see Commodity Correction and the Lira, September 20, 2006). Indeed, as oil prices have fallen from US$78.5 a barrel to below US$60 in recent weeks, domestic fuel prices declined by 14.5% in the past two months, lowering the annual inflation rate from 18.9% in July to -5% in September. As a result, transportation prices in the CPI basket posted a monthly decline of 1.8%, with the year-on-year inflation rate easing from this year’s peak of 14.8% in July to 9.3% in September. If the commodity correction becomes a sustainable phenomenon, we may see even faster disinflation in the final months of the year.

The latest figures give no reason for further tightening of the monetary policy stance. The Turkish economy may be flexible and adapt quickly to new conditions imposed by exogenous developments, but the effects of what happened this summer will continue influencing economic behaviour, in our view. The tightening of financial conditions, for example, is still coming through the economy, and will help contain inflationary pressures stemming from the lira’s weakness and deteriorating expectations. Nevertheless, given the divergence from the target path, the central bank still needs to maintain its cautious stance. However, that does not mean that there is a need for further monetary tightening. As we have long argued, inflation expectations are based on exaggerated, biased risk assessments and thus have a limited value for policymaking. In our view, not only do downside inflation risks outweigh the risk of surprises on the upside, but short-term interest rates also stand almost 800bp above the neutral interest rate.

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Indonesia
Another 50bp Cut
Oct 05, 2006

Deyi Tan (Singapore)

BI cuts rate by 50bp: Bank Indonesia cut the benchmark rate by 50bp to 10.75% in its meeting today.  This is the third consecutive 50bp rate cut following the one last month.

Inflation decelerating … In our view, monetary policy likely takes into account two factors: inflation and currency.  Data on the two fronts are slightly mixed.  On the inflation front, the latest September data continue to show a deceleration (14.6% versus +14.9% in August), in line with expectations.  Indeed, we expect inflation to fall to around 6% by year-end, which is below the central bank’s forecast range of 7-9%, and October inflation to dip into single-digit territory from double-digits in September.  

… but currency slightly volatile; net foreign equity buying decreasing: While the currency has remained broadly stable/appreciated in between monetary policy meetings for the last two meetings, the rupiah has depreciated by 1.4% since the last meeting on  September 5, likely on the back of a decline in net foreign equity flows (15-day trailing sum).  Nonetheless, this currency movement is still in line with other currencies in the region.

We expect BI rate to come to 10.0% by year-end: We had originally expected the central bank to calibrate rate cuts (i.e., 25bp) to lessen currency volatility despite the benign inflation data.  However, in its monetary policy statement, the central bank stated that the financial stability is maintained and the economy continues to improve.  Hence, we are taking down our year-end BI rate forecast to 10.0% from 10.5%.  With the central bank trying to boost domestic demand through aggressive rate cuts, the trade-off is that there could be volatility on the currency front, and we see the risk that the currency could weaken to 9,500, which is in the upper range of the comfort zone for the central bank.

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Malaysia
August Exports Decelerate
Oct 05, 2006

Deyi Tan (Singapore)

Trade balance widens: Exports slowed to 14.8% YoY in August (versus +15.9% in July), while imports accelerated to 17.7% (versus +10.2% in July). Consequently, the trade balance stood at RM10.1 billion in August (versus RM9.0 billion in July).

Export momentum decelerated: Electrical and electronic products rose 11.4% YoY, adding +5.6%-pt (versus 8.9% and 4.5-pt in July) — the highest increase since the start of 2005. A sharp pick-up in exports of machinery appliances (+19.6% YoY versus +10.3% in July) and wood products (+36.3% YoY versus +14.4%) was also observed. However, exports of crude petroleum (-10.4% YoY and -0.6-pt) and petroleum products (+15.8% YoY and 0.6-pt) saw slower growth in August amid declining crude oil prices.

In terms of market destinations, exports to the US rebounded to 10% YoY (versus -0.7% in July) and to Japan to 23.5% YoY (versus -1.1% in July). On the other hand, exports to the EU remained robust, with the latest August reading at 33.5% YoY (versus +25.6% YoY). However, exports to ASEAN and Hong Kong registered a deceleration/contraction at 13.3% and -3.2% YoY, respectively (versus 22.5% and -7.4% in July).

Imports momentum buoyed by consumer and intermediate goods: By end-use classification, imports in August accelerated across all categories when compared with July data. Noticeably, imports of consumer goods expanded 24.3% YoY in August (versus 13% YoY in July), an all-time high since October 2005. Imports of intermediate goods also rose at a handsome pace of 17.4% YoY (versus 7.6% in July). However, capital goods imports remained lackluster, increasing by only 5% YoY in August (versus 0% in July).

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