The Great Chinese Profits Debate
Oct 06, 2006
Stephen S. Roach (New York)
The profitability of Chinese businesses has suddenly become a cause célèbre. One group -- led by the World Bank -- argues that enterprise profitability has soared in recent years, playing an increasingly important role in boosting China’s already high national saving rate and current account surplus. The other side -- spearheaded by Weijian Shan of TPG Newbridge and long one of Asia’s most successful investors -- maintains that China’s national income accounts bias conventional measures of profitability to the upside, masking a decidedly subpar return on equity and a potentially serious bank-directed misallocation of capital. The debate is technical and it takes forensic analytics to wade through it. But it has very important implications for investors, China’s macro policies, and the Chinese economy.
In a series of recent research papers, World Bank economists came to the very important conclusion that a significant portion of China’s sharply elevated national saving rate -- estimated to be close to 50% of GDP in 2005 -- is due to sharply rising levels of enterprise saving and profitability. If correct, the resulting windfall of retained earnings implies that China’s investment boom has been increasingly self-financed -- drawing into serious question the widespread presumption that investment projects have, instead, been funded more by directed lending of a highly fragmented Chinese banking system. Specifically, World Bank economists estimate that after-tax enterprise saving from retained earnings rose to more than 20% of GDP in 2005 -- leading them to conclude that Chinese banks funded only about one-third of enterprise fixed investment while more than 50% of the financing came from internally-generated profits. The World bank’s findings, which were based on one of the first analyses of China’s so-called flow of funds accounts, portray China’s business sector as surprisingly sound and robust -- increasingly capable of standing on its own in providing the sustenance for future expansion (see Louis Kuijs, “Investment and Saving in China,” World Bank Policy Research Working paper 3633, June 2005, and an unpublished September 2006 note by Bert Hoffman and Louis Kuijs of the World Bank Office Beijing, “Profits and Investment of China’s Enterprises”). In the other corner is Weijian Shan of TPG Newbridge, a former Wharton professor and principal in some of Asia’s most important investment transactions of the past decade. In a recent article, Shan took the World Bank economists to task, arguing that their analysis was based on a flawed interpretation and analysis of aggregate data (see Weijian Shan’s, “The World Bank’s China Delusions,” Far Eastern Economic Review, September 2006). Basically, Shan underscores the critical distinction between national-income based measures of saving and business profitability and metrics used by businesses and investors. He not only makes the point that national-income accounts often go astray in estimating profits, but he also argues that in the case of China, the World Bank calculations fail to net out income taxes and government subsidies. He goes further to derive the leverage and return characteristics of the Chinese economy that can be imputed from the World Bank scenario -- namely that debt-to-equity ratios would need to be declining steadily over time and that return on equity would have to be increasing sharply. As an investor and businessman who has evaluated countless potential transactions in China, Shan speaks from an experience that is completely at odds with the macro imputations of the World Bank. There are three reasons why this debate is such a big deal: First, China is having a serious problem controlling an overheated investment sector. It make a huge difference if investments are funded internally through surging profits and retained earnings, as the World Bank argues, or if this is a bank-sponsored investment binge. In the former instance, an investment slowdown can best be engineered by policies that crimp internal funding. Alternatively, if runaway bank lending were the culprit, monetary tightening and/ or administrative edicts would be more appropriate. Interestingly enough, the World Bank’s conclusions appear to have found sympathy in some quarters of official China: recently, a proposal was floated for the State to begin collecting dividends from state-owned holding companies -- an action designed to crimp an internally-funded investment binge. Second, rate of return results are obviously of critical importance to investors in Chinese securities markets -- both onshore and offshore. Profitless prosperity has long been a major concern of equity investors with respect to Chinese companies. If the World Bank calculations are correct, those fears may be overblown. Third, Chinese banking reform is at the top of the nation’s policy agenda -- in part, because of the understandable fear of a serious and growing nonperforming loan problem. To the extent that the World Bank is correct, the current Chinese investment boom poses less of threat to the banks than would be the case under the Shan scenario. Where do I come out on this? Long ago, I realized that there is never a clear winner in these statistical debates. The numbers can invariably be sliced and diced in a variety of ways to validate a wide range of alternative hypotheses. In the case of China, there’s an added twist -- the statistics are a good deal shakier than in most other countries. That may especially be the case with respect to its newly constructed flow-of-funds accounts -- an elaborate matrix of cross-sector financial transactions that interfaces with the national income accounts. China has long been plagued with measurement problems in its macroeconomic data. Appending a flow-of-funds system to the national income accounts could well compound the problems. To the extent the World Bank findings rest on these data, I would be even more suspicious. Nor have I ever been all that comfortable in using national income accounts data to assess business sector profitability. Even in countries like the United States, with well-developed statistical systems, the profits estimates have typically been the weakest link in the chain -- subject to large revisions, to say nothing of frequent discrepancies with micro data gathered at the company level. Quite frankly, I have to say that I am astonished that the World Bank is leaning so hard on a literal interpretation of what could well be the least reliable piece of Chinese macro data. Shan’s approach stresses the inherent implausibility of the World Bank’s findings. If the World Bank’s upbeat conclusions on profitability are valid, he points out that several time-honored aspects of the China story need to be re-cast -- namely trends in aggregate debt-to-equity ratios as well as return on investment. In the World Bank depiction, these ratios would paint a picture of an increasingly vibrant Chinese business sector that has almost miraculously broken the profitless heritage of state ownership. Yet with material costs surging and wage pressures mounting, I have a hard time accepting that characterization in the current climate. At the same time, I have long been struck by one of the greatest contradictions of Chinese GDP growth: With fixed investment now fully 50% of Chinese GDP and still increasing at close to 30% per annum, it is actually quite astonishing that the overall economy hasn’t been growing a good deal faster than the 10% average over the past decade. The explanation must hinge on the inefficiency of aggregate investment -- consistent with Shan’s critique and very much against the grain of the World Bank’s conclusions. Martin Wolf, in a recent column in the Financial Times, sides with the World Bank -- endorsing the notion that Chinese macro policy should be directed at forcing enterprises to reduce surplus saving by paying out dividends (see his 4 October 2006 comment, “Why Beijing should dip into China’s corporate piggy bank”). He readily accepts his own depiction of the counter-intuitive premise that “…the lumbering state-owned sector is making large profits.” Wolf argues if Chinese business profits aren’t strong, then at least one of the following four assertions must be wrong: the current account surplus is overstated, government saving is understated, the investment share of Chinese GDP is lower than estimated, or the personal saving rate is much higher than reported. Since he presumes that none of these possibilities is likely, post hoc ergo propter hoc, profits must indeed be booming. The flaw in this logic could well lie with the personal saving rate. The combination of massive layoffs -- headcount reductions by state-owned enterprises exceeding 60 million since 1997 -- and the lack of a safety net is a classic recipe for a surge in precautionary saving. A Gallup Poll of Chinese consumers is, in fact, quite consistent with such a possibility -- finding that the level of dissatisfaction over household saving positions has risen steadily over the 1997 to 2004 interval. Moreover, the private consumption share of Chinese GDP fell to a record low of 38% in 2005 and has undoubtedly fallen further this year. In other words, it may well be that the official statistics have distorted the mix of China’s domestic saving -- allocating too much to the business sector and not enough to households. When it comes to China, I am an eternal optimist. My conviction is grounded in the nation’s unrelenting commitment to reforms and in the related push toward a market-based system. State-owned enterprise reforms remain central to this daunting transition. This has been a wrenching process -- in many cases creating companies from an agglomeration of former government bureaucracies. It takes time for these efforts to bear fruit. A burst of newfound profitability from the Chinese business sector seems highly unlikely at this overheated point in the development cycle.
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Corporate Profits
Oct 06, 2006
Richard Berner (New York)
Marking myself to market on the outlook for corporate profits is getting to be a habit: By any measure, it appears that earnings have once again outpaced my expectations, and that they could well continue to grow strongly through year-end. Corporate profits boomed again over the first half of 2006, rising 17.4% (on a year-over-year basis) as measured by “economic” profits in the National Income and Product Accounts (NIPAs) and 12.9% (per share) for S&P 500 earnings. The first-half surge augurs a record-breaking fifth straight year of double-digit gains in S&P operating earnings — even with economic growth slipping below trend for the last three quarters of 2006. I may sound like a broken record, but I think earnings are poised to decelerate. The reasons: Fading operating leverage, accelerating costs, and slower economic growth likely all will promote convergence between the growth of earnings and the gains in nominal GDP or sales. Stronger overseas growth likely will be a significant offset, while lower energy prices probably will shift the mix of earnings growth to consumer and cyclical industries. The upshot: While I’ve been incorrectly expecting earnings growth to fade for a while, this time it’s for real. In fact, it’s hardly visible, but the long-awaited slowdown in earnings growth is already underway. Measured in the NIPAs, profit margins dipped slightly (by 20 bp) in the second quarter, after soaring to a record high 14.2% in the winter quarter. So strong were first-half earnings, however, that we now expect that 2006 earnings on a Q4/Q4 basis will rise at a double-digit rate, similar to the 14.4% consensus estimate for S&P 500 operating earnings per share. But in 2007, we expect that profit margins will flatten and earnings will decelerate to a pace below that of nominal GDP — and well below the 9.9% consensus forecast from industry analysts. Our colleagues in US equity strategy note that their S&P 500 three-month FY2 Earnings Revision Factor (ERF) tells the same deceleration story, falling to 5.5% from 7.0% last week. Notably, 14 of the 24 industry groups experienced a decline in three-month ERF over the past month. Not surprisingly, over the past week, energy and materials made downside contributions to the ERF, adding to the negatives from Pharma & Biotech, Food Beverages & Tobacco, Food & Staples Retailing, Autos, and Banks. Contrariwise, Real Estate, Consumer Services, Diversified Financials, Tech Hardware & Equipment, Media, Transportation, and Software & Services all showed upward revisions. Analyzing profit margins helps isolate the factors behind our call. Measured as the quotient of “economic” profits to corporate GDP, margins exploded by 570 basis points from late 2001 to the first quarter of 2006. At work were five factors: First, companies were able to exploit the high levels of operating leverage in their business. High fixed costs — primarily for depreciation —gave Corporate America significant operating leverage. When spread over a broader base in recovery and expansion, such costs decline significantly and contribute to a surge in margins. Over the past five years, depreciation charges as a share of GDP have declined by 230 basis points. In addition, corporate interest expense has declined as a share of corporate GDP by 190 basis points in the past five years, the product of both declining interest rates and CFOs’ efforts to clean up their balance sheets. Third, record productivity gains kept unit labor costs either falling or subdued. Over the past five years, productivity in nonfarm business rose by an annual average of 3.2%, restraining the rise in unit labor costs to an annual rate of 1.4%. That helped keep compensation charges level as a share of GDP. Fourth, pricing power has improved over the past three years as corporate capital discipline has boosted operating rates. The improvement is far from ubiquitous, but a host of industry segments such as hotels, rails, construction, insurance, healthcare, and even airlines have demonstrated improving pricing power. Finally, strong overseas growth has lifted results from US affiliates abroad. Such earnings accelerated, net of payments abroad, to a 29.6% rate in the year ended in the second quarter. The first four factors all seem likely to fade in the coming year, flattening margins and bringing earnings growth down. Earnings are highly leveraged to growth both at home and abroad. That leverage now works to the downside at home, as the slowing in domestic growth from above to below trend likely will promote a flattening or even compression in margins as operating leverage fades. Interest expense is now rising, both because rates are higher and CFOs have begun to re-lever the capital structure. Productivity growth has slowed to 2.4% in the year ended in the fourth quarter, and we expect a further deceleration in the year ahead. Concurrently, firmer labor markets have promoted an acceleration in wages and compensation; although official statistics now overstate the underlying pace, that trend has probably moved from 4% to 5½-6% over the past year. And finally, pricing power — a key investment theme for me and for our equity strategy team’s call over the past two years —seems likely to cool by next year as capacity growth begins to catch up with output growth. The fifth factor — overseas growth — may be a significant offset to this domestic earnings slowdown, and operating leverage may still work to the upside for earnings from overseas operations. With non-US growth likely to remain above the pace here, those results should rise more strongly than domestically-generated earnings. The upshot: While the first four factors that have lifted margins are now likely to fade, we expect that overseas growth will limit the margin compression. As a result, fears of a sharp deceleration in earnings are overblown. Broad gauges of equity prices have jumped by 9-10% in the past two months, accounting for all of 2006’s price performance. Nonetheless, I still like equities over bonds, so I agree with my colleague Henry McVey that investors should stay long (see his “Fall Classic,” October 5, 2006). But the current ‘sweet spot’ for equities — a soft landing for growth and the prospect of declining inflation and interest rates that allows some multiple expansion — may face two challenges soon: First, earnings seem likely to slow faster than the economy. Analysts’ earnings estimate for 2007 seem exceptionally optimistic in a few important industries, including technology (+18.2%), consumer discretionary (+13.8%), Utilities (+13.2%), Consumer Staples (+11.2%), and Health Care (+10.5%). But a second test also looms: Near-term inflation risks may challenge the assumption in bond markets that the Fed will ease early in 2007. Certainly, that’s the message from Fed Vice-Chairman Donald Kohn and Philadelphia Fed President Charles Plosser. For a year, I’ve been forecasting an earnings slowdown that has yet to show up. Corporate America’s ability to exploit operating leverage may once again surprise to the upside. This time, however, I think the clock is ticking on earnings that will surprise to the downside.
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Dangerous Trends - the Evolving Role of Governments Across the World
Oct 06, 2006
David Miles (London)
Over the last 150 years, the role of the state in the economy has increased dramatically in almost every country in the world. Around 1870, the average share of government spending in GDP across some of today’s most developed economies was a bit above 8%; on the eve of the first world war it was just under 10%; just before the outbreak of the second world war it was around 22%; by 1950 it was just under 30%; and today the average across the developed economies is about 45%. Although there is significant variation across countries — with government spending in the US well under 40% of GDP and spending in France and Sweden well over 50% of GDP — the trend over the longer term has been sharply upwards everywhere. Can this continue? Are the forces that have driven government spending higher inexorable? If they are, what are the consequences? Let us start with the consequences. Most government spending is financed out of general taxation, so if spending rises then — ultimately — so must the average rate of tax. A useful bit of economic theory says that the distortions generated by taxes — that is, the harm done to incentives to work and invest when taxation reduces the gain from so doing — goes up more than proportionately with the tax rate. In other words, all else equal, a rise in the average tax rate from 40% to 41% is about twice as bad as a rise in the tax rate from 20% to 21%. Governments may figure out smarter and less distortionary ways of raising tax, so this might offset some of the rising damage from higher average tax rates. But if government spending financed by taxes goes on rising, then it is nonetheless highly likely that the damage done will ultimately become crippling. How close might we be to the point where significant further increases in tax-financed government spending cause very real harm to be done to economic prosperity? Some recent research provides a not very reassuring answer — at least for many European countries. Harald Uhlig and Mathias Trabandt have calculated for a range of countries how far the average rate of tax is from the point at which further rises in tax rates so diminish economic activity that the overall tax take actually falls. This is an attempt to see how far we are from the peak of the so-called Laffer curve — the curve that shows the relation between the average tax rate and tax revenue. As Laffer noted some 30 odd years ago, there is likely to come a point where raising tax rates further so harms economic activity that the level of tax generated actually falls. Uhlig and Trabandt calculate that no developed countries have obviously got to that point yet. But they reckon that, on average across Europe, tax rates on labour — and particularly on capital — are not very far from the self-defeating point beyond which further rises reduce revenue. They also find that most European countries are a lot nearer to that point than is the US. They find that, across Europe taxes on labour income are often within 5% or so of the self-defeating point; capital tax rates are often even closer to that point. So if there are powerful forces driving government tax-financed spending ever higher, this finding of Uhlig and Trabandt is very worrying. What are those forces? There are two trends that push in very different directions as regards the size of the public sector. On the one hand, many services that are often provided in the public sector have an income elasticity above 1 (e.g., health, education and maybe even transport). In other words, as we gradually become better off, we may want to spend disproportionately more on health and education — things that are largely provided by the state in many economies. This in itself drives the size of the public sector up — and may increase overall taxation if user charges are not used. But on the other hand, technological improvements mean that user charges for many services may now be feasible (e.g., road charging, water metering). And the development of much more liquid financing instruments means that private financing of very big projects is now feasible. This means that projects that historically have often been in the public sector — roads, rail, hospitals, utilities — can now be undertaken and funded in the private sector. Often the income steams generated by infrastructure and utilities projects can be used to create securities much in demand by long-term investors (e.g., pension funds). Derivatives can be used to create securities that match funding needs to investor appetite. For example, a major infrastructure project (a road) could be built and run by a private sector entity and financed by issuing conventional long bonds. An inflation swap can mean that the issuer effectively turns them into a real (inflation-indexed) liability that matches cash flows generated by user charges on motorists. Which of these forces — on the one hand pressures for government to provide even more services, and on the other the pace of technological and financial developments that make financing out of general taxation less necessary — are more powerful will be a major factor behind the trends in growth and well-being across the world. 1How Far From the Slippery Slope? The Laffer Curve Revisited, Centre for Economic Policy Research Discussion paper no. 5657, September 2006. 2Allegedly by drawing a graph on the back of a napkin.
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Hike like Clockwork
Oct 06, 2006
Elga Bartsch (London)
As expected, the ECB raised interest rates by 25bp to 3.25% this past week, thus marking its fifth consecutive rate hike since December 2005 at one of its regular out-of-town meetings. The press conference following this week’s decision, which was broadcasted from Paris, clearly signaled another such move at the December meeting, we think. This would bring the refi rate to 3.5% by year-end. In the introductory statement to the press conference, the ECB Council reverted back to “monitoring risks to price stability very closely” — a phrase that has historically implied another rate hike at the meeting after next. Even after today’s move, the ECB still considers its monetary policy stance as accommodative. According to the ECB, a further withdrawal of monetary accommodation is warranted if the ECB’s baseline case of growth close to its potential is confirmed in the coming months. Asked about the ECB’s outlook for 2007, ECB President Trichet refused to commit to a certain course of action, saying that he has “absolutely nothing to say” and repeating that the ECB would do what it had to do to maintain price stability over the medium term. His refusal could indicate that there is a controversial debate within the ECB Council as to whether interest rates should be hiked above 3.5%. Given that 3.5% is a level that many would view as broadly neutral, the debate will likely centre on the question of whether the ECB should take its foot off the accelerator or whether it should also step on the brake. While there seems to be widespread support for the former, the latter might be more controversial. This probably why the Council has agreed to keep all options open until the December staff projections have become available. While new formal staff projections will only become available in December, the ECB’s assessment of euro area growth seems to have become marginally more upbeat on the back of the recent drop in oil prices. In this context, the ECB President highlighted the favourable labour market trends and falling unemployment for the first time in this tightening cycle. Meanwhile, the recent drop in inflation is regarded as temporary by the ECB, partially because it seems to see oil prices rebounding. As a result, average inflation is still expected to remain above 2% this year and next, with risks clearly tilting to the upside. Regarding monetary analysis, a reference was inserted to stress the fact that money supply growth has been strong for several years now. Despite these slight changes in tone, the ECB’s summing up of the risk to price stability remained virtually unchanged. Looking beyond the near-term outlook, there is some indication that the ECB is slowly starting to prepare for a different pace of policy making in 2007. This is because the word “progressive” in the phrase “a progressive withdrawal of monetary accommodation”, which is needed if the ECB’s baseline is confirmed, has disappeared in today’s introductory statement. Instead, the ECB now talks just about further withdrawal of monetary accommodation. While this could also mean that the ECB wants to revert back to the quarter-point-per-quarter pace, on balance, we wouldn’t expect further ECB interest rate hikes in 2007. However, due to the three-point German VAT hike, which will become effective in January 2007, the ECB will likely maintain a hawkish posture, in our view. With yet another wage-round just getting underway, the ECB will likely aim at avoiding any second-round effects from higher wage demands. In this month’s assessment of the economy, the ECB for the first time not only highlighted the downward trend in unemployment, but also stepped up the language regarding the potential risks that could stem from stronger-than-expected wage increases. In our view, the ECB will look through the boom-bust pattern in spending that the German VAT hike will likely create in early 2007. In addition, it will also regard the impact on HICP inflation as a one-off effect on inflation that in isolation does not warrant a monetary policy reaction. On balance, however, we would view the risks to be skewed towards another refi rate hike in early 2007. A lot will depend on the German wage round, where the metal-sector wage contract expires at the end of March. It’s unlikely that the ECB will give an all-clear on the risks to price stability before it has gained some more visibility about how the wage round is panning out — not just in Germany but also in the rest of the euro area.
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Resumption of Equity Inflows Key to Our Call on AXJ
Oct 06, 2006
Stephen Jen (New York) and Charles St-Arnaud (Hong Kong)
Asia can de-couple from the US Here are our thoughts. • Thought 1. The US is already soft landing, yet the sky has not fallen in Asia. Many investors/commentators fret about the acute impact of any — however modest — slowdown in the US on Asia. However, we observe that the US is already in a soft landing. Its 2Q GDP growth was only 2.6%, and our US economists believe it is tracking 2.2% in 3Q. At the same time, most indicators in Asia remain strong, including the August data. In other words, the US has already soft-landed. The lack of meaningfully negative real and financial effects on Asia is remarkable. To some extent, the decline in the world’s long-term interest rates and the fall in oil prices will provide important stimulus for Asia, cushioning the direct impact from slowing US consumption. • Thought 2. Asia didn’t get severely hurt from the US recession in 2001. In 2001, when the US fell into a sharp, albeit brief, recession, the spillover effects on Asia were much more muted, relative to history. Asia slowed as well, but not nearly as sharply as the US did. In fact, AXJ did not experience an outright contraction in IP, as the US did. (We should say that the Asian currencies did weaken in late 2000 and 2001. However, that was primarily due to the sharp weakening in the JPY for Japan-specific reasons. USD/JPY rose from 105 to 135 during that period due to fears of deflation in Japan and massive market speculation on the idea that the BoJ would need to ‘print money’ to generate inflation, which, of course, proved to be quite an erroneous idea.) In fact, a structural break in the growth linkages between the US and AXJ may have taken place around 1990. From examining industrial production growth in the US and Asia (GDP- weighted), one can see that, until 1990, AXJ had been extremely coupled to the US, in terms of IP growth: the relationship between these two series was very tight. Surges in the US IP growth in the mid- and late 1980s dictated the trend in AXJ’s own IP growth. However, since 1990, this relationship has weakened somewhat, with Asia underperforming the US in the late 1990s, but outperforming the US since 2002. Though the turning points in the IP series continue to look rather synchronized, the link is clearly not as tight as it was before 1990. • Thought 3. Equity flows into Asia have not recovered since the May sell-off. Equity flows into emerging markets were particularly strong in 2003 and 2005. For Asia, total cumulative equity flows were negative US$1.9 billion in 2002, and US$11.5 billion, US$1.6 billion and US$13.5 billion in 2003, 2004 and 2005, respectively. The flows in the first four months of 2006 were exceptionally large, at US$4.6 billion. Since then, outflows have totalled US$10.7 billion. While the AXJ currencies have weakened somewhat since May, the currency sell-offs have been remarkably muted. For example, USD/KRW rose from 927.8 in May to 947.5 now (a 2.1% move); USD/MYR rose from 3.58 in May to 3.69 now (a 3.0% rise); and USD/SGD rose from 1.56 in May to 1.58 now (a 1.2% rise). These are very modest moves indeed. IDR and TWD weakened by more (5.7% and 5.5%, respectively), but the idiosyncratic factors were likely the main culprits for their underperformance. BI’s rate cuts and Taiwan’s political situation and low interest rates likely contributed to the currency weakness. In any case, overall, the AXJ currencies have performed rather well, in light of the US growth scare, threats of further Fed hikes, and the stagnant Asian equity markets. The rise observed in foreign equity investments in emerging markets may be a structural trend that is unlikely to reverse, unless there is another violent round of risk reduction. As assets under management grow in the developed world, and as financial globalization continues, flows into these emerging equity markets should continue, in our opinion. In other words, we believe that net equity inflows into Asia should resume if the world is perceived to be soft-landing, and that Asia could de-couple from the US. • Thought 4. Non-linearity. Given the major structural changes in recent years associated with both goods and financial globalization, it is difficult to draw firm conclusions from past relationships between US and AXJ growth and between financial flows and currency responses. We suspect that financial flows will dictate where USD/AXJ will go, not necessarily the real economic fundamentals. In other words, we believe that AXJ has a good chance of de-coupling from the US (i.e., slowing less than the slowdown in the US itself). However, global risk-reduction in fear of a global slowdown could be more damaging for Asian currencies than the impact on the real economies. We have discussed the issue of non-linearity before, using the ‘Dollar Smile’ framework, and continue to believe that it is the right framework to think about this issue. The Fed and currency hedging Most exchange rates remain in a holding pattern. While the bond and the equity markets have expressed their different opinions on the US and global economy without hesitation, the currency markets have been more reserved. This may be due to the high uncertainty regarding the four issues we raised previously: (1) whether the US will fall into a recession; (2) de-coupling; (3) the Fed; and (4) risk-taking appetite, or simply that many investors were hurt from the position unwind in May/June. Alternatively, the currency markets may be implicitly assuming that the world is almost ‘perfectly coupled’, that the whole world rises and falls in synchronism, and therefore the opportunities for currency trades at turning points of the global business cycle are unclear, even though there may be trends in the global bond and equity markets. We believe that all four issues mentioned above will be resolved in due course, allowing the dollar to descend against Asia. We believe that the Fed having a tightening bias, with the policy rate already at a relatively high level of 5.25% (relative to the rest of the world), will continue to keep the opportunity costs of not hedging, from the perspective of USD-based investors, high. Though the market cap-weighted hedging premium has declined recently, from a peak of 2.7% to 2.5% now, it is still quite high, and may keep the USD supported for some time. When the dollar does start to descend, it is likely to be a gradual slide, in light of this consideration. Bottom line We stand by our call that USD/AXJ will eventually trade lower in the months ahead. The US will likely experience a soft landing, and Asia is in a good position to de-couple from such a US slowdown. However, we believe that a resumption in equity inflows will be critical for this call to be correct.
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Dollar Index Looking Fair, but Some Crosses Look Misaligned
Oct 06, 2006
Stephen Jen (New York) and Luca Bindelli (London)
Basic framework We have had the same basic FV framework for five years now. The calculations are based on quarterly data. We run FV calculations for the USD index, as well as the top 11 bilateral exchange rates. The USD index calculations are based on a BEER (Behavioral Equilibrium Exchange Rate) approach. For the 11 bilateral exchange rates, we also run four other approaches. Altogether, we run 13 equation specifications for each bilateral exchange. The equations are parsimonious and not nested to bring into sharper relief how the FVs could be driven by different perspectives. Our calculation results 1. The USD index is fairly valued. Contrary to popular opinion, that the dollar ‘must’ be grossly over-valued if the US C/A deficit is still so large, we believe that the current value of the dollar is consistent with the values of the underlying variables that have dictated the trajectory of the dollar over the past 33 years. In a sense, our results are less of an ‘equilibrium’ concept in that they correspond to some sense of ‘equilibrium’ in either the US C/A trajectory or the financeability of the US external imbalance. Rather, they are more of a ‘fair value’ concept in that they correspond to where the determinant variables are at this point, as they themselves may be out of their long-term equilibrium values. From this perspective, it does not surprise us that the dollar has been range-bound for several months: there are few factors powerful enough to perturb the dollar index away from its FV. This is unlike in 2004, when the dollar index also converged back to its equilibrium value, from a significantly over-valued level in late 2001. In mid-2004, we strongly argued that the dollar index had reverted to its FV and that further dollar weakening would not be justified, and should be seen as an undershoot. The market, fuelled by the fears of global imbalances, artificially pushed the dollar to such an under-valued level that the dollar’s recovery in 2005 was inevitable, in retrospect. The dollar index is likely to be again pushed away from its FV. We suspect it is more likely that the dollar will be pushed to the weak side, rather than the strong side. 2. EUR/USD is over-valued. EUR/USD is around 12% too expensive. But we suspect it will stay on the expensive side for the foreseeable future, as investors will continue to view EUR as the ‘anti-dollar’ or EUR/USD as the ‘path of least resistance’ if there is a run on the dollar. Our mental benchmark is that EUR/USD only managed to reach its equilibrium level last summer (1.15-1.16), on the back of two failed referendums and wild talk of a break-up of the EMU. We cannot identify potential shocks that will be so severe that EUR/USD would be pushed back to the 1.15 range again. Rather, what is more likely is that EUR/USD will drift modestly lower, because of a slowdown in growth in 2007, eroding export competitiveness, and the spillover effects from a strengthening JPY. We have maintained our long-standing targets of 1.24 for end-2006 and 1.20 for end-2007. 3. USD/JPY is over-valued. USD/JPY is around 15% over-valued — roughly unchanged from 1Q. With EUR/JPY being so much higher than it was three months ago, the narrow JPY index has now reached the same level as in September 1985 — right before the Plaza Accord. With Japan in a recovery, and with Japanese exporters continuing to gain market share both in the US and Euroland, persistent JPY weakness, even if it is a result of capital flows, may have political consequences, particularly if both the US and Euroland slow in 2007. Japanese officials may have the view, we suspect, that the JPY’s weakness should be contained now in order to suppress the protectionist sentiment in the US and Euroland. In addition, the BoJ is likely to gradually normalize interest rates, just as the FFR peaks. We believe that USD/JPY is establishing its multi-year high, as is EUR/JPY. 4. EUR/JPY is massively over-valued. We have discussed this matter in detail in several of our recent pieces. Our FV of EUR/JPY is 108. Again, only the BEER models generate FVs that are close to the current spot rate. To some extent, EUR/JPY’s up-trend in the past five years has been a natural derivative of the asymmetric nature of globalization. As long as there is a strong bias in favor of financial assets from the US, Euroland and the UK, and as long as the Asian central banks and the oil exporters accumulate foreign reserves, EUR/JPY will enjoy some support. Having said this, as the BoJ normalizes rates and as foreign equity flows into Japan resume, we believe that EUR/JPY will sell off. The 150-155 range should be seen as a multi-year peak, from which EUR/JPY will trade gradually lower over the coming years. 5. Other crosses. In general, the commodity currencies (CAD, AUD and NZD) remain over-valued, and the EUR appears to be a bit expensive in most of the EUR crosses. There is no general theme for the FVs of the AXJC (Asia ex-Japan ex-China) currencies, as some look a bit expensive while others a bit cheap. Our long-standing call for USD/AXJ to trade lower is not based on valuation, though valuation is an important factor for the two big currencies in Asia (JPY and CNY). It is a call on the global business cycle. Special calculations for USD/CAD In addition to the equation specifications in this valuation framework, we have also conducted specific calculations for USD/CAD (see CAD in Overshoot Territory (March 31, 2006) and Multiple Shadow Prices for the Canadian Dollar (August 17, 2006). Given that real energy prices could be an important determinant of CAD’s FV, we have simulated how USD/CAD’s FV is affected by changing oil prices. Specifically, compared to 1.17 back in 2Q06, when oil was trading at US$72 a barrel, the FVs of USD/CAD increase to 1.18, 1.20 and 1.23 for oil prices of US$70, US$60 and US$50 a barrel, respectively. Bottom line We have updated the quarterly FV calculations. The results are essentially unchanged: (1) The narrow dollar index is almost perfectly valued; (2) the dollar is over-valued against the JPY but under-valued against EUR; and (3) the EUR is very over-valued against the JPY but less so against other European currencies.
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Good Things Come to Those Who Wait
Oct 06, 2006
Takehiro Sato (Tokyo)
The auction on October 5 for inflation-indexed JGBs again demonstrated the solidity of demand for this type of security as an inflation-hedging tool, despite the decline in the expected rate of inflation seen since the CPI shock. As the issuance volume of inflation-indexed bonds rises, investors both at home and abroad are becoming more keenly interested in the inflation outlook for the next decade. It will never be possible to reach a view on the economy and prices for the coming ten years that is universally accepted, but in this note we provide food for thought by outlining three scenarios based on a simplified ‘sticky price model’. Scenarios for consumer prices under a sticky price model How will long-term price levels be determined? First we assume that while prices and nominal wages will be sticky in the short term, they will gradually adjust to equilibrium levels over the long run. To determine the pace of this adjustment (the rate of inflation) we must zone in on two gaps, and build scenarios for CPI inflation from scenarios for these gaps. (1) Output gap: This is the gap between potential and actual GDP. Models here are founded on the simple assumption that the speed at which prices react depends on supply and demand for goods and services. There is a positive correlation between the output gap and the core CPI inflation rate. (2) Real wage gap: This measures the degree of divergence between real wages and labor productivity. As wages are by nature downwardly rigid, the pace of real wage adjustment is less flexible than that of labor productivity. That means that as corporate margins change, prices face adjustment pressure in the following channels: (i) Case in which the real wage gap > 0: Since real wages > productivity, margin squeezes create pressure to raise output prices, and thus fuel inflation. (ii) Case in which the real wage gap < 0: Since real wages < productivity, widening margins create room to lower prices, and thus lower inflation. In these cases, there is also a positive correlation between the real wage gap and the core CPI inflation rate. But since wages intervene to cushion the knock-on impact on prices, there is weaker correlation with inflation here than for the GDP gap. The formula below encapsulates the relationship between both gaps and core CPI inflation. Core CPI inflation rate = (α x GDP gap) + (β x real wage gap) Thus, we get the results of our calculation of core CPI inflation over the next ten years based on this formula. Under the most likely soft landing scenario, the inflation rate for the core CPI comes to 6.7% for the coming 10-year period (i.e., 0.67% per year, excluding any increase in consumption tax). This exercise is based on a simple top-down outlook calculated from case studies of the two gaps. It does not explicitly take into account the impact of prices for primary goods such as oil and rice, of productivity improvement in semi-public sectors reflecting deregulation and spending cuts, or of increases in indirect taxation over the next decade. The consumption tax issue in particular will be influential for the future index level, as the Ministry of Internal Affairs and Communications frowns upon statistics that exclude consumption tax, and the Ministry of Finance also favors the standard CPI, which includes consumption tax, as a reference of the inflation-indexed JGB. Consumption tax rate scenarios Assuming PB>(r - g) [D/Y] (PB: primary balance/nominal GDP, R: debt cost, g: nominal growth rate, D/Y: nominal GDP as a ratio of government debt), we calculate that an improvement of about JPY 10 trillion is needed to even out the primary balance, and that another JPY 10 trillion in fiscal funding must be found over the next ten years to meet the needs of the ageing population. To finance this solely via a tax increase, consumption tax would need to rise by at least 10 percentage points (from 5% to 15%). However, with the current administration prioritizing spending cuts over tax increases, and uncertainty about the political situation next summer after the upper house elections, we think it is impossible to predict whether the government will be able to implement a consumption tax hike by F2009, as the consensus appears to expect. However, unless the government abandons the goal of a primary balance surplus by 2011 contained in its so-called ‘broad-boned’ policy agenda, we believe that a minimum consumption tax increase of at least 2% will be needed by 2011. The government is also committed to extending the primary balance surplus up to the middle of the 2010 decade by cutting government debt as a proportion of GDP to the extent possible. This suggests that even in 2011, after one tax increase, the government is likely to keep campaigning for a rate of at least 10%. We therefore make the assumption that there will be another 3% hike in F2016. Based on the qualitative considerations above, we allowed for 4% upside to the cumulative CPI inflation over the next ten years (assuming a pass-through rate of 80%, prices would rise 4% under a 5% increase in consumption tax). This would push up inflation over the entire period to 11.0% (1.1% per year on average). Policy and market implications The average core CPI inflation rate for the next 10 years implied by current levels of inflation-indexed JGBs (on a basis that includes a higher consumption tax rate) is just around 0.6%, suggesting that the markets are being quite conservative on the outlook for inflation when compared with our discussion. We attribute this to a number of factors: firstly, the rise in the weighting of IT-related goods and services following revisions to the statistical basis in August has increased the structural impediments to price growth; secondly, the oil price is falling at present; and thirdly, the new cabinet’s focus on growth in its economic policy has shaken the market’s confidence with regard to the schedule for consumption tax hikes. Hence risk factors prevailing at the moment are potentially dampening the market’s view on the inflation outlook. Admittedly, the second matter of the oil price decline is not a burning issue in the context of an investment period of 10 years’ duration. Meanwhile, even with the economic growth focus of the new cabinet, we think the possibility is as high as before of the consumption tax rate being raised at key points in F2011 and mid-F2010s, given the political objective of moving the primary balance into surplus that would be sufficient to reduce the debt to GDP ratio. Consequently, even in the current challenging times, we think there is still long-term upside potential for price-linked government bonds. As in the saying, ‘haste makes waste’, with regard to investment in this type of security it is vital not to be oversensitive to every passing disruption.
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