Debating US-China Trade Policy
Oct 13, 2006
Stephen S. Roach (New York)
Debating US-China Trade Policy
The US-China trade debate could well be one of the most important and contentious issues in the current era of globalization. It not only has far-reaching implications for both nations but also for world financial markets and many of the pressures bearing down on the global economy. Recently, on the invitation of the Council on Foreign Relations, Desmond Lachman of the American Enterprise Institute and formerly of the IMF and Steve Roach engaged in an online debate on the topic: Is China Growing at the United States’ Expense? A transcript of our exchange follows: Don't Scapegoat China Stephen Roach, 9 October 2006 China has become the scapegoat for one of America’s toughest economic problems. Workers and their elected representatives are understandably concerned about the persistence of subpar job growth and a decade of nearly stagnant real wages. With these pressures occurring in the midst of a record foreign trade deficit and with China accounting for fully 25 percent of that imbalance, the blame game is on. Since the beginning of 2005, fully twenty-seven pieces of legislation have been introduced in the US Congress that would impose punitive actions on China for engaging in unfair trading practices with the United States. While I certainly think Washington needs to be tough in its trade negotiations with China — especially in the area of intellectual-property rights — I fear the politicians don’t get it. The US trade deficit — to say nothing of the Chinese piece of this deficit — has not come out of thin air. It is a reflection of our inability to face one of our biggest economic shortcomings as a nation — a dearth of domestic saving. In 2005, America’s net national saving — the combined saving of individuals, the government, and the business sector net of depreciation — fell to a record low of just 0.1 percent of national income. Lacking in domestic saving, the United States must import surplus saving from abroad in order to grow — and run massive current-account and foreign trade deficits to attract the capital. With the current account deficit running at an $870 billion annual rate in the second quarter of 2006, the United States needs about $3.5 billion of foreign capital each business day. The fact that the biggest portion of our trade deficit is with China is actually a good thing — it provides Americans with low-cost, high-quality products. If Washington were to get its way and raise the cost of doing business with China, that would be the functional equivalent of a tax on the American consumer. Barring an increase in national saving — namely, a cut in the government budget deficit and a boost to personal saving — the trade deficit would not go away. Instead, it would simply be directed toward a higher-cost producer elsewhere in the world. And China, for its part, would probably think seriously about its strategy of buying Treasuries and other dollar assets — putting pressure on the dollar and US interest rates. It’s time to stop blaming China for what ails us and look in the mirror. If we don’t get our own house in order and start saving more as a nation, the scapegoating of China could end up being a policy blunder of monumental proportions. ChinaMust Play by the Rules of the Game Desmond Lachman, 10 October 2006 Stephen Roach is certainly right in drawing attention to the important role that improved US savings performance must play in addressing today’s record payment imbalances and in improving US labor market performance. However, he is very wide of the mark in turning a blind eye to China’s pursuit of flagrantly mercantilist policies and to its deliberate manipulation of its currency to gain an unfair competitive advantage. Today’s unprecedented large global payment imbalances raise the very real risk of intensifying protectionist pressures that could in time undermine the world’s trading system. This calls for the orderly correction of the large US current account imbalance, which in turn will require both a reduction of US domestic expenditures as well as a switching of global expenditures toward the US traded goods sector. In proposing that the United States substantially improve its savings performance, Stephen Roach is focusing on only the expenditure reduction part of the solution to the US external deficit problem. However, if the United States is to correct its external deficit, while at the same time avoiding a deep recession, it will need not only a higher level of domestic savings but it will also need a much cheaper dollar to promote its exports and to discourage its imports. China now pays lip service to the need for a more appreciated Chinese renminbi as part of the solution to the global payment imbalance problem. In July 2005, China did appreciate its currency by 2 percent and it committed itself to a more flexible currency policy. Over the past fifteen months, however, nothing much has changed. China has only allowed a further 2 percent appreciation in its currency and it still, in effect, pegs to a depreciating dollar, which keeps its currency grossly undervalued by any reasonable measure. The net upshot of China’s currency manipulation is that China has now become the world’s largest surplus country and the world’s largest holder of foreign exchange reserves. China’s current account surplus has already surpassed that of Japan and it is on the way to exceeding $250 billion (in US dollars), or 9 percent of its GDP in 2007. In short, I fully agree with Stephen Roach that the United States should not simply scapegoat China and should address its own serious savings problem. However, if we are to avoid a train wreck in the global trading system, China should start playing by the international rules of the game and stop manipulating its currency. It should do so in both its own long-run interest and in that of the global economy. BeijingNot Ready for Reform Stephen Roach, 10 October 2006 Like all disputes, there are two sides to the US-China trade debate. What concerns me is the one-sided nature of this dispute. Desmond Lachman’s argument is classic in that regard — as is that of the Washington Consensus. To paraphrase: Sure, we in America need to fix our deficits — and maybe some day we will — but China needs to get its act together now. A stronger RMB may seem to be in our interest — although I have my doubts, as noted below. But it may well be that a currency revaluation is simply not in China’s best interest at this point in time. The reason: China has an undeveloped financial system. Its banks are only just starting to go public and its capital markets are tiny by our standards. Currency fluctuations could, as a result, place great strain on the Chinese financial system at a critical juncture in its economic development. We may not accept that logic, but at least we need to consider the possibility that China may know a good deal more about the inherent risks in its financial system than we do. This may be nothing more than a sequencing problem. Financial reforms may not have gone far enough in China to allow it to cope with the stresses and strains that might arise from sharp currency fluctuations. China is committed to the long-run objective of a flexible currency, and as Desmond notes, has taken some small steps in that direction. It has been very frank in admitting that it needs to go much further. Linking the timetable to a broader financial market reform agenda seems like a very prudent course of action. Even if Washington were to get its way, it might end up being very disappointed over what little would be accomplished by a sharp revaluation of the Chinese currency. America’s gaping trade deficit is, first and foremost, an excess import problem. In the second quarter of 2006, US merchandise imports were fully 84 percent larger than exports. This voracious appetite for foreign-made products is an outgrowth of an unsustainable consumer-buying binge — personal consumption has surged to a record 71 percent of GDP while personal savings has fallen into negative territory for the first time since 1933. A revaluation of the RMB — unless it was of a draconian magnitude — would do next to nothing to curtail excess consumption and reduce America’s import-led trade deficit. None of this is to argue that China shouldn’t work harder to reduce its large trade surplus. As I noted in my opening comment, it needs to do much more in preventing the piracy of intellectual property. And China also must stimulate its own consumer in order to boost purchases of foreign-made goods — actually, a goal that was underscored in its recently enacted eleventh Five-Year Plan. But just as America needs time to get its deficits under control, China needs time on the reform front. Sadly, that’s the other side of the story that Washington doesn’t want to hear. Current Deal Delays United States’ ‘Day of Reckoning’ Desmond Lachman, 11 October 2006 Stephen mischaracterizes my view as condoning US inaction on its budget deficit problem while pressing China for immediate currency action. To be clear, my view is that resolution of today’s global payment imbalances will require both (a) an early and credible medium-term US deficit reduction program and (b) significant and early movement in China’s exchange rate. More substantive Chinese currency action is required not simply to address China’s extraordinarily large current account surplus, but it is also needed to facilitate a more generalized appreciation of other Asian currencies. Stephen condones China’s paltry 2 percent currency appreciation over the past fifteen months at a time when China’s very large basic balance of payment surplus would suggest that its currency is undervalued by around 20 percent. He rationalizes China ’s currency inaction on the grounds that China ’s fragile banking system could not tolerate a greater degree of currency movement. He makes this argument even though the Chinese banking system does not have any significant currency mismatch between its assets and liabilities. He also does so knowing full well that if meaningful currency movement awaits the restoration to health of China’s chronically undercapitalized banking system, we will be waiting for many years to come. To question, as Stephen does, whether a greater degree of currency movement is in China’s best long-term interest is misguided for at least three reasons: First, without a greater degree of currency movement, together with measures to encourage domestic consumption, China will continue to run unacceptably large external current account surpluses. This will almost certainly invite damaging protectionist pressures against China in both Europe and the United States, especially in the event of a global economic downturn. Second, in the absence of greater currency flexibility, China’s central bank’s scope to use interest-rate policy to regulate the economy will continue to be highly limited by the unwanted capital inflows that higher interest rates would attract. This will make it difficult for China to avoid the type of overinvestment cycles and speculative excesses that it is presently experiencing, which in the end will further weaken China’s rickety banking sector. Third, China’s de facto pegging of its exchange rate requires that the Chinese central bank engage in costly foreign exchange intervention to the tune of a staggering $250 billion (in US dollars) a year. The dollars the central bank buys at an overvalued dollar rate could end up costing China as much as 2 percentage points of GDP each year. Stephen is, of course, right in suggesting that the United States presently has a good deal going for itself by having China send goods to the United States in exchange for dollar pieces of paper. The trouble with this deal, however, is that it dangerously increases China’s financial leverage over the United States and it only delays the United States’ day of reckoning for presently living well beyond its means. Currency Fix is the Wrong Medicine Stephen S. Roach, 12 October 2006 Desmond’s recommendation for “significant and early movement in China’s exchange rate” is a classic textbook prescription for fixing a large current account imbalance. Unfortunately, China is far from a classic textbook economy — making the currency fix the wrong medicine at the wrong point in time. Despite 27 years of extraordinary reforms, China is still very much a blended economy. Notwithstanding the emergence of a thriving market-based sector, State-owned enterprises still account for about 35% of Chinese GDP. Moreover, China is not a centralized, well-integrated macro system. Power still resides mainly in provincial, city, and village governments — making it very difficult for Beijing to steer the nation as a whole. The banking system is equally fragmented. As recently as late 2004, the four biggest banks collectively had over 75,000 branches — most of which have autonomous deposit-gathering and lending capabilities. A blended and fragmented Chinese economy cannot be effectively controlled by conventional macro stabilization policies. Beijing can pull the fiscal and monetary levers but there’s no telling what the response will be. Unfortunately, what Desmond misses is that the same is true of currency policy. Over the past decade, China’s exports have increased by six-fold. Yet fully 63% of that increase can be accounted for by “foreign-invested enterprises” — Chinese subsidiaries of foreign multinational corporations and joint ventures. In other words, the power of the Chinese export machine is mainly an outgrowth of a Western penchant for offshore efficiency solutions. Moreover, since the mid-1990s, China’s imports have quintupled — driven increasingly by demand for manufactured components from its Asian neighbors. This reflects China’s role as the world’s assembly plant — a very different function than that of the manufacturing behemoth the protectionists believe is gaining unfair advantage because of a cheap currency. In short, courtesy of globalization, China has experienced explosive growth on both sides of the foreign trade ledger. Can we truly expect a currency fix to stop cross-border economic integration dead in its tracks? This debate touches many of America’s economic hot buttons — subpar job growth, near stagnation in real wages, deficit financing, and the hollowing out of smokestack industries. These are critically important issues that the US can no longer duck. Historically, our greatest strength as a nation has been to look inside ourselves and rise to the competitive challenge. The scapegoating of China is antithetical to that greatness. I am deeply troubled that discussions of US-China trade issues always come back to what we in America think China is doing wrong. China is far from perfect and must accept greater responsibility for its role in trade disputes — especially with respect to intellectual property rights. But there’s a limit to what can be expected from China and a lot more we can ask of ourselves.
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Business Conditions
Oct 13, 2006
Shital Patel (New York) and Richard Berner (New York)
The slide in business conditions may be ending, according to the latest reading of the Morgan Stanley Business Conditions Index (MSBCI). This gauge, which is based on a monthly canvass of our industry analysts, bounced back eight points to 45% in early October, although August and September weakness brought the three-month average down another point to 41%. We hasten to point out that it’s early days for any turnaround: October’s improvement might mark the end of the yearlong decline in the MSBCI, but this sub-50% reading still represents a deterioration. Thus, while we expect above-trend US growth this quarter and in 1Q07, thanks in part to healthy consumer and business spending and stronger exports, other factors may have contributed to depressed analyst sentiment. One such factor may be that 61% of all S&P 500 companies have preannounced negative earnings guidance for 3Q06; this is the highest such percentage since 2Q03. Although these backward-looking data should technically not weigh on current business conditions, surprises may color current thinking, and the breadth of negative preannouncements could have contributed to the decline in the MSBCI. Similarly, estimates for 4Q06 earnings have come down from 13.7% at the beginning of June to 11.6% in October. Indeed, our strategy team and we expect a significant, further deceleration (see “Corporate Profits: Leaving the Sweet Spot,” Global Economic Forum, October 6, 2006). The Conference Board’s measure of CEO confidence also hit its lowest level since September 11, 2001. We believe this is a coincident indicator since the current conditions and expectations indexes move in tandem. Since the survey period was mid-August to mid-September, prior to the bulk of the rally in the stock market, we believe CEO confidence will improve in the coming quarters. For their part, industry analysts as a group tend to follow consensus forecasts. Bearing that out, the smoothed MSBCI also moves in line with an index that illustrates GDP forecast revisions. However, our work suggests that this GDP revision index is a coincident indicator and we expect it to head higher in coming months. There’s an ironic twist in today’s outlook: The bottom-up consensus outlook is typically too optimistic. In contrast, we think that analysts’ assessments of business conditions now are too pessimistic, and believe that risks favor better outcomes. In September, the MSBCI predicted the lower-than-expected manufacturing and non-manufacturing ISM indexes, and we expect that this turn in our index foreshadows improvement in those indicators. Indeed, the forward-looking MSBCI components rounded the corner in October: The business conditions expectations index retraced its three-point, September decline back to 39% while the advance bookings index advanced four points to 48%. Still, these sub-50% readings imply that conditions are still contracting. This month revealed a new hiring-capex dichotomy: A strong 59% of the groups plan to increase capex over the next three months, while only 20% plan to increase hiring, the latter being the lowest share since September 2003. However, details from this month’s survey of Morgan Stanley research analysts suggest that conditions are improving on the margin. First, 46% of the groups noted that stronger overseas growth has increased top line results, supporting our thesis that stronger exports will boost GDP growth in 4Q06 and 1Q07. Financial conditions were easier in October compared to September; this subindex increased four points to 52%. In addition, while the percentage of analysts reporting deteriorating conditions remained virtually unchanged at 34%, the percentage noting improving conditions jumped to 22% from 9% last month. The manufacturing and services sub-indexes both climbed seven points in early October to 42% and 45% respectively. Breadth by industry is lacking, however: Consumer staples and healthcare were the only two sectors with improving business conditions; conditions deteriorated for all other sectors except for the telecom services companies, where conditions remained unchanged. The pricing conditions index declined by another two points to 57% in early October. However, prices charged for 30% of the groups have increased faster than unit costs, or in some cases, particularly for the IT group, prices charged have fallen slower than costs have fallen. Material and/or labor costs outpaced prices charged for 28% of the industries covered, down from 34% last month. Concurrently, analysts expect margins to expand in 2007 at 54% of the groups, up from 49% last month, and only 20% expect margins to shrink, down from 28% in September. Margins are expected to expand at the consumer staples, healthcare, industrials, and consumer discretionary sectors. Of those expecting margins to expand, 72% expect companies to increase operating leverage, 44% expect companies to cut costs, and 44% expect increased pricing power. Sell-side analysts as a group are even more optimistic: 80% expect margins to expand in 2007 according to our strategy team’s preliminary estimates —a far cry from both our and our strategy team’s outlook for flattish margins. This discrepancy explains some of the difference between our strategy team’s forecast for 5.5% earnings growth in 2007 versus the bottom-up consensus of 10% (see “Modifying S&P 500 Earnings and Price Targets,” October 12, 2006). We also asked analysts this month whether the recent decline in energy prices has affected costs, and thus earnings, at companies under their coverage. Remarkably, 61% of analysts noted that the decline in energy prices has had no impact, although it has reduced costs somewhat for 27% of the groups and reduced costs significantly for 5% of the groups. This cost savings has helped the industrials, materials, and consumer discretionary sectors. Lower energy prices have reduced earnings for 7% of the groups, including energy exploration and production, trucking, and hardline retail vendors. Bookings: Turning the Corner? The advance bookings index increased four points to 48% this month, suggesting order activity continued to contract, but at a slower pace. Groups noting lower bookings included newspapers, life insurance, industrial conglomerates, semiconductors, chemicals, and the homebuilders. In contrast, over half the IT groups had higher bookings along with the airlines, business services, and the wireless services. Hiring-Capex Dichotomy The percentage of groups planning on increasing hiring over the next three months fell to 20%, the lowest percentage since the inception of this question in September 2003. In contrast, 59% of the groups plan to increase capex over the next three months, the highest level since March. We think this dichotomy will end with stronger growth in hiring. According to Morgan Stanley analysts, the industrials and IT sectors have plans to increase both hiring and capex, while the healthcare group only plans to increase hiring. Capex plans are higher for the consumer staples, financials, and telecom services groups. According to the Conference Board’s CEO Confidence Survey, 28% of the respondents reported increases in their companies’ capital spending plans since January while 9% reported cuts; in 2005, 34% reported increases while 12% reported cuts. The most common reason for changes to capital investment plans was increases or decreases in sales volume. Pricing Power Positive, but Continues Its Slow Retreat The pricing conditions index slipped another two points to 57% in early October. The percentage of analysts noting that prices charged have increased compared to a year ago fell five points to 44%, while the percentage noting that prices have declined edged down one point to 29%. Pricing power was prevalent for most groups except IT, telecom services, and energy where prices charged declined from a year ago. Pricing conditions slipped in the financials sector as spreads tightened and commissions narrowed. The magnitude of price increases continued to decline as only 22% of groups increased prices by 3% or more, down from 43% in June. Pension Reform Comes as CFOs’ Pension Concerns Fade This month we asked analysts whether recent changes in pension law and pension accounting prompted companies under their coverage to change pension funding. The responses echo the fact that pension funding today is not the concern for CFOs that it represented three years ago. Fully 37.5% of the groups do not have defined benefit (DB) plans. Moreover, 10% of the groups’ pensions are fully funded, and another 10% said that companies would freeze their DB plans. Thus, only 12.5% of respondents said companies would increase funding in 2006 compared to 2005, which sounds conservative to us. Most companies that will increase funding in 2006 will do so with cash on hand. 30% will not increase funding.
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When Will the ECB Stop?
Oct 13, 2006
Elga Bartsch (London)
Views on ECB monetary policy diverge … There seems to be widespread agreement regarding the ECB policy outlook in the remainder of this year. Like us, money markets are expecting a year-end level for the refi rate of 3.5%, with a last 25bp rate hike in December. There is widespread disagreement, however, about the course of ECB monetary policy in 2007. Many forecasters, including yours truly, expect the ECB to go on hold in 2007. Others think that the refi rate will be ramped up to 4% or higher. These divergent views reflect, at least partially, different macroeconomic forecasts. But they will also likely reflect different estimates of the neutral level of euro-area interest rates. Estimates of neutral interest vary from 3.25% to 4.25%, and occasionally numbers closer to 5% are mentioned. … due to different estimates of the neutral refi rate level
The neutral level of interest rates is a powerful concept for thinking about the implications of monetary policy on the economy and on asset markets (see The Natural ECB, Joachim Fels, October 3, 2006). Monetary policy practitioners tend to be sceptical about the usefulness in practical decision-making. Hence, debating the neutral level of interest rates might not be very useful in forecasting near-term central bank action. In this note, we take a different approach. As we approach year-end, probably a watershed in the current ECB interest rate cycle, we look at the levels for key euro area indicators that would suggest that the ECB will go on hold. We present a new tool — the ECB Refi-Meter — that allows us to track the probability of further ECB tightening on a real-time basis. Contrary to our official forecast, the Refi-Meter suggests that the next ECB rate hike should come in November rather than in December. While we would not tie our forecasts mechanistically to a statistical model, we believe that a rate hike as early as in November has some merits. Introducing the ECB Refi-Meter … To gauge the probability of further ECB tightening, we estimated a simple statistical model, which indicates the probability of another refi rate hike. Given the ECB’s monetary policy strategy, such a model should contain an economic activity variable, an inflation variable and a monetary variable. To track economic activity on a monthly basis, we prefer so-called ‘soft’ survey data to so-called ‘hard’ data such as industrial production and retail sales, because surveys are timelier and more reliable. Here we use the EU Commission’s aggregation of the national sentiment surveys. We looked at the Economic Sentiment Index (ESI), the Business Climate Index (BCI), Industrial Confidence and Consumer Confidence (CC). … which yields a probability estimate of an ECB rate hike Furthermore, we considered several inflation indicators. Eyeballing a chart, which plots headline and core inflation against interest rate changes, shows that the ECB pays little attention to the coincident inflation. So, don’t get too excited about the recent fall in HICP inflation to less than 2%. Headline inflation 12 to 24 months out seems to have a little more influence on ECB interest rate decisions, but not much. As an alternative, we therefore turned to indicators of inflation expectations. While consumers’ inflation expectations are not of much use as rate decisions have mostly preceded elevated levels in these expectations, breakeven inflation rates proved to be a reasonably good predictor. Based on a small set of Euroland indicators Turning to monetary variables, we started out by looking at broad money supply growth. But even when adjusted for portfolio shifts, M3 money supply growth didn’t seem to systematically affect ECB interest rate decisions. The relationship between M3 money supply dynamics and actual ECB decisions might be difficult to pick up, as the ECB likely looks at long-term trends in M3 growth when assessing the risks to price stability, and not monthly gyrations. Interestingly, loans to the private sector and narrow M1 growth did a lot better than M3. While loan growth can probably be regarded a key driver of underlying money supply dynamics, narrow M1 money supply growth is likely also a reflection of the monetary policy stance. ECB Refi-Meter points to a November rate hike All variables enter the Refi-Meter with a lag, which allows us to project the probability of further tightening into the future without having to resort to our forecasts for these indicators. In the past, a Refi-Meter reading of above 40% has meant heightened probability of an ECB rate hike. The Refi-Meter has correctly predicted 9 out of the 11 rate hikes. While the Refi-Meter remains well above that level in November (73%), it falls to 23% in December. While we would not mechanistically tie our forecasts to a statistical model, we believe that it is useful to put one’s priors to the test. In line with our call for the ECB to go on hold beyond year-end, the Refi-Meter assigns a zero percent probability to further rate hikes in early 2007. We stick to our December call nonetheless A November rate hike would avoid a potential clash with new ECB staff projections that will be released in December. These projections will likely show a downwardly revised inflation rate for 2007 (currently estimated at 2.4%Y) on the back of more favourable oil price assumptions, fiscal tightening in Italy and Germany and a lower GDP growth forecast (currently estimated at 2.1%). In addition, the roll-out of the 2008 projections will likely show an inflation print comfortably below 2%, helped by the German VAT hike dropping out of the year-over-year inflation rate. Several members have indicated that the December staff projections will be key to the policy outlook for 2007. The question is whether they would also derail the December rate decision. After the clear signal from ECB President Trichet at the October press briefing, we believe that a continuation of the gradual tightening is more likely. But our ECB Refi-Meter sends a timely reminder that the December rate hike isn’t a done deal yet.
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GPIF Outflows Still a Headwind for JPY
Oct 13, 2006
Stephen L. Jen (from Tokyo)
Summary and conclusions The JPY remains weak, relative to both history and Japanese economic fundamentals. Nominal cash yield differentials are an important headwind for the JPY, and the ‘Global Funneling’ process may also have undermined the JPY. In this note, I argue that an important structural factor — continued diversification by the Government Pension Investment Fund (GPIF) — is yet another force investors should keep in mind when thinking about the JPY. Though I continue to believe that, over the coming months, the JPY is more likely to trade meaningfully stronger as current pricing is already very stretched in valuation terms, I recognize that risk-reward for the near term is in favor of JPY shorts. I see the low 120s in USD/JPY and 150-155 for EUR/JPY as the multi-year peaks for these two crosses. The basic story I first wrote about this issue on August 5, 2004 in GPIF Outflows as a Medium-Term Support for USD/JPY. In that note, I argued that the GPIF, which manages some US$1.4 trillion in assets, was on track to invest more than US$100 billion overseas between 2004 and March 2009. In March 2005, the end-2009 targeted foreign asset holdings were raised from 15% of total assets to 17%. At the current exchange rate, this translates into cumulative outflows of close to US$77 billion between April 2006 to March 2009, for average annual outflows of close to US$26 billion over the next three years. This GPIF argument is totally separate from the other arguments I’ve presented in recent weeks on USD/JPY and EUR/JPY. It is a multi-year plan that has somehow not attracted as much attention from investors as it should have, in my opinion. In March 2001, as a part of FILP (Financial Investment and Loan Program) Reform, or the ‘Zaito Reform’, the way in which government-managed pensions (or the pension reserves) were invested was significantly altered. Before the reform, all pension reserves had to be deposited with the MoF’s FILP account. Of these funds, most was then directly lent to various public works projects (called the FILP projects), while the rest (about 15% of the total assets as of end-March 2001, or about ¥10.7 trillion, including investments in Japanese and foreign equities and foreign bonds) was invested in non-FILP assets (e.g., stocks and bonds). The non-FILP investment fund is the Nempuku Fund. After the Zaito Reform, the Nempuku Fund was reorganized into the GPIF. The key aim was to sever the hard financing link between the pension reserves and the public works projects under the FILP. From 2001 onward, public pension funds would enjoy a great deal more flexibility in the assets it can hold, while the public works projects (the FILP projects) would compete for financing in the open capital markets, like any other project or business, but with government guarantees in some cases. In other words, in theory, the FILP projects would need to, directly or indirectly, issue a large amount of their own bonds in the market, while the public pension funds would be relatively free to decide whether or not to invest in these bonds. To minimize the ‘shock’ impact of this change — keep in mind that the FILP projects were worth a huge ¥147 trillion (or about US$1.2 trillion) — this transition in the financing scheme was to be spread out over eight years. The aim was that, by end-March 2009, the publicly managed pensions would have no direct financing links with the FILP projects. The basic ‘benchmark portfolio’ targeted for 2009 includes a healthy size of foreign portfolio holdings. Between April 2006 and March 2009, I calculate that some ¥9.2 trillion (equivalent to close to US$76.7 billion) in new foreign bonds and stocks will be bought, mostly unhedged, which translates into about US$26 billion in outflows in each of the coming three years. In FY2004 and FY2005, net outflows from the GPIF were a bit higher, at some US$35 billion each year. These planned outflows are of a significant size — equivalent to about a third of Japan’s total trade surplus — and should help keep the JPY undervalued. A bit more detail on the updated calculations As of March 2001, when the diversification program began, GPIF had ¥173 trillion in total assets, 85% of which was directly invested in the various FILP projects, with another 8.5% invested in JGBs. Not counting ‘short-term assets’, only 6.1% of total assets (or ¥10.7 trillion — the figure I mentioned earlier) was invested in Japanese stocks or foreign stocks and bonds. As of March 2006, GPIF had ¥161.9 trillion in total assets. Foreign asset holdings had risen to 11.3% (from 2.5% in 2001, and against a target of 11.0%) of total assets. The absolute value of foreign security holdings was ¥18.3 trillion. For March 2009, the targeted foreign asset holdings are 8.0% in foreign bonds and 9.0% in foreign stocks. This means that, from an initial share of 2.5% of total assets held in foreign securities back in 2001, the aim is to raise these holdings to 17% by 2009. In absolute terms, this corresponds to an increase in foreign security holdings of ¥23.2 trillion (or close to US$200 billion) over the eight-year transitional period. My thoughts I have the following thoughts: 1. JPY carry trades over-rated. I am in no way disputing the existence of JPY carry trades. However, I think investors place too much emphasis on this idea, and may miss other factors that need to be considered in thinking about the JPY. In my September 28 piece, Why Is the JPY So Weak?, I pointed out that bond outflows from Japan have not increased with the widening in cash yield differentials vis-à-vis the US and Europe. I also suggested that currency hedging, the ‘Global Funneling Hypothesis’, and now GPIF outflows are also important factors to consider. The prospective EUR/JPY and USD/JPY sell-off I envisage for the coming years will be a gradual one, due to these headwinds for JPY. 2. Fed-BoJ discussion is critical for USD/JPY. Given the importance of the cash yield differentials, what the Fed and the BoJ do is clearly very important. Our official view is that the Fed is likely to hike one more time in early 2007 to take the FFR to 5.50%. For the BoJ, the outlook is at least as uncertain. There will be some technical factors that will perturb CPI in the coming months: changes in cell phone charges may add 0.25% to CPI; the rise in medical costs may add another 0.10% to CPI; but the fall in gasoline prices could reduce CPI by 0.20%. What this means is that, when the BoJ meets in December, CPI (ex-fresh food) may be running at 0.2-0.4%. December seems to be the first opportunity for the BoJ to consider another rate hike, as the next Tankan and the Tokyo November CPI will be out by then. My belief is that the BoJ has a good chance of taking the policy rate to 0.50% at its December meeting. Of course, the next Outlook Report, to be released at the end of this month, will provide important guidance on the BoJ’s policy path. Specifically, the discussion on consumption and wages will be key, as muted wage pressures is the number one economic puzzle in Japan right now. 3. Declining ‘home bias’ a real issue for the JPY over the medium term. In general, declining ‘home bias’ has been a common theme in the world in recent years. I myself have written on the fall in the Feldstein-Horioka S-I coefficient, and this trend is one explanation for why global imbalances have not posed nearly as acute a problem for the USD, the AUD and the NZD as traditionalists may have thought. Even in Japan — a country known for exceptionally high ‘home bias’ — there has been a broad-based increase in interest in and appetite for foreign assets. 4. GPIF outflows do not dictate USD/JPY’s trend. It is important to keep in mind that GPIF outflows are one of several factors to consider. In no way do these outflows dictate the trajectory of USD/JPY. For example, in 2002-04, USD/JPY drifted lower, despite some US$65-70 billion worth of capital outflows from the GPIF. Similarly, US$26 billion in annual outflows from the GPIF should be seen as a headwind for the JPY and not something that will necessarily sink it. Bottom line GPIF will continue to invest US$26 billion in each of the next three years in foreign securities. I believe that this will pose yet another headwind for the JPY, cushioning the eventual fall in USD/JPY and EUR/JPY.
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The Mystery of Ramadan
Oct 13, 2006
Serhan Cevik (from Milan)
The effect of Ramadan intensifies seasonal price variations in certain sectors. Many economic variables exhibit seasonal behaviour with a usual pattern of variations around the year. Food prices are a good example for such fluctuations — declining in summer months and rising in the autumn. Likewise, clothing and education-related prices show strong seasonality, resulting in higher readings in certain months of the year. Even a simple statistical analysis reveals that consumer prices in Turkey are influenced by seasonal fluctuations on the upside in September and October. For example, the consumer price index posted a monthly rise of 1.3% in September — enough to raise the annual inflation rate from 10.3% in August to 10.5%. But there is nothing precarious about the latest figures, which exhibited the typical seasonal jump in food prices. However, although seasonal factors made the most significant contribution to the rise in headline inflation, this year’s reading was higher than what the seasonal pattern would suggest. In our view, the key reason is the effect of Ramadan that has intensified seasonal variations and supply constraints in certain sectors of the economy. The lunar calendar is a source of shifting ‘seasonality’ in pricing behaviour. Based on the lunar calendar, Ramadan starts 10 days earlier every year and therefore is a source of shifting ‘seasonality’ in countries with a predominantly Muslim population (see Karim Abadir and Laura Spierdijk, The Festivity Effect and Liquidity Constraints: A Test on Countries with Different Calendars, 2005). The Ramadan and festivity effects are influential especially over food and clothing prices. And this is exactly what is happening now in Turkey and other countries around the world. Take, for example, the food and non-alcoholic beverage component of the CPI basket. The rate of monthly increase accelerated from 1.3% in September 2005 to 2.9% this year, as the beginning of Ramadan led to more pronounced seasonal adjustments. This is not really a surprising outcome, since the Ramadan effect increases food consumption by around 20% from the average of the rest of the year, but exacerbates supply constraints in the agriculture sector, which we have highlighted as a source of inflation pressures (see, for example, The Mysterious Vegetarian Demand Bubble, June 19, 2006 and Stay Tuned to the Weather Channel, August 4, 2006). Similarly, clothing prices posted a monthly jump of 2.4%, after declining by 13.4% in the previous two months, and the start of the new school year resulted in a 3.7% increase in the education category. The October figure will be high as well, but then we should see gradual disinflation. On our estimates, the CPI will show a monthly increase of 1.5% this month, due to, once again, seasonal factors and the festivity effects on food and clothing prices. Although the rise in unprocessed food prices, which is by the way a global phenomenon, remains a risk, the headline inflation rate should start to come down in the final months of the year. The continuing correction in commodity prices has already lowered domestic fuel prices by about 15% from the peak in August and thereby should bring direct and indirect benefits on the disinflation front. We also think that the moderation of domestic demand will help mitigating inflationary consequences of exchange-rate volatility earlier in the year. That would ease inflation pressures, especially in non-tradable sectors of the economy that have exhibited higher price increases. All in all, despite all the challenges, we expect the annual inflation rate to decline to 9.2% by the end of this year and then 5.8% next year. There is no reason to expect further monetary tightening, in our view. Inflation may still be running well above the central bank’s target range, but we see no reason for further tightening of the monetary stance. In fact, our calculations suggest that short-term interest rates are approximately 800bp above the ‘neutral’ level, which supports our constructive assessment of the inflation outlook. However, this is still not enough to make a case for monetary easing campaign in the near future. The central bank still needs to maintain its cautious stance and focus on liquidity management. In the meantime, improving inflation dynamics could bring a compression in the longer end of the yield curve, but keep in mind that digesting all the technical and structural changes in money markets will take time and limit the appreciation of bonds.
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A Contingent Liability Comes Due
Oct 13, 2006
Robert Alan Feldman (Tokyo)
What’s new DPRK’s (North Korea) nuclear bomb test raises the downside risks for the Japanese and world economies in several ways. Upside potential is much less. Conclusions (1) If the outcome of UN actions with DPRK is positive, Japan will still bear a significant fiscal burden. If negative, the burden could be even greater. (2) The main risks to the Japanese economy are protectionism, consumer sentiment, fiscal costs, supply chain disruptions, refugees and inflation. The precise combination of risks depends heavily on UN negotiations. Market implications The blasé reaction of markets to the DPRK actions is naïve, in my view. Things could go wrong in many places. Successful negotiations would lower geopolitical risk but raise fiscal risk. Unsuccessful negotiations would raise both. Risks Sino-Japanese cooperation on the DPRK issue may lead both sides to recognize their common agenda more clearly. Success may benefit both countries more than the costs of the DPRK clean-up. The test of a nuclear bomb by North Korea (DPRK), even if the bomb itself was a failure, has opened a whole new chapter in North Asian security relations. The soft-line countries — China, Russia and South Korea — are all furious with the DPRK. Moreover, the DPRK’s defiance of UN resolutions has handed the US and Japan a golden reason to continue developing a missile defense system — a development that China in particular has tried to stop. In addition, the UN itself is in jeopardy, because it cannot maintain credibility without acting to sanction those who violate its resolutions. The issue, however, is not blaming and bickering, but devising a way forward. The way forward is a complex decision tree, with many branches at many stages. The branch that leads to a lasting peace in the region implies heavy burdens for rebuilding in the North. The branch that leads to increased tensions and possible conflict implies even heavier ones. The potential silver lining is the growth that could come as tensions in the region ease, and as rebuilding of the North generates new economic opportunities. The good scenario The DPRK nuclear test was very badly timed — for the DPRK. The test came on the heels of a successful summit between new Japanese PM Shinzo Abe and Chinese Party Chairman Hu Jintao. Both leaders are eager to revive Japan-China political relations. No clearer demonstration of the need for such a revival could have been made than the nuclear test by the DPRK. Indeed, the deterioration in Japan-China relations gave the DPRK the room to hope that it nuclear adventurism would pay off. Now, all countries are working toward a UN resolution that will sanction the DPRK, but also bring stability. The optimistic scenario can hardly avoid the UN establishing a trusteeship of DPRK, administered mostly by China. In order to do this, there would almost certainly have to be leadership change in the DPRK, even though regime change may not be necessary. For example, elements of the DPRK military might invite Chinese aid, in order to prevent a civil war. Regardless of how this trusteeship is achieved, there would be the need for a massive rebuilding program in the DPRK. The costs of such a rebuilding program will be very high. My colleague Sharon Lam has estimated that the total cost could reach US$2 trillion over several decades. This cost would have to be borne mostly by the nations in the region — South Korea, China and Japan — although contributions from around the world would likely come forth. For Japan, which is already struggling with huge budget deficits, the extra potential expense comes at a very bad time. Moreover, rebuilding the DPRK economy would require it to follow an export-led development path. With extremely cheap wages, the former DPRK could attract many potential investments, once infrastructure is built. The result, however, would be a flood of exports, which would dislocate workers in many countries around the region and the world. Alternatively, there could be a huge outflow of refugees, most of whom would go to South Korea. Even though refugees from the north have had serious trouble adapting to life in the south, the language factor would keep most in Korea. The difficulties of absorbing low-skilled immigrants from formerly Communist countries are well known in Europe. And since the DPRK has a living standard far below that even of the former Communist countries of Europe at the time of their changes of government, the absorption of these refugees could be even more difficult. It is not clear whether the ‘good’ scenario would result in inflation or deflation. There would surely be inflationary pressures as the rebuilding of the DPRK strained world resources. However, the increase in supply from new factories would dampen inflation. In this sense, the DPRK would be China’s China — a source of very cheap labor and deflation — although far smaller in scale. (The DPRK has only a 23 million population, 1/50th that of China.) My sense is that the inflationary pressures would dominate in the first few years, at least. The bad scenario Many observers think that the DPRK will react harshly to any sanctions. Diplomatic pressure to avoid this outcome will be strong, but a shooting war is possible. Such hostilities would carry risks of finger pointing and blame among the nations in North Asia. Moreover, showing off military strength necessarily scares counterparts, and triggers demands for stronger arms. True, PM Abe recently reiterated Japan’s commitment not to possess nuclear weapons. However, the complex interaction of events might spur Japan to reverse this commitment, especially if the United States seems less than fully committed to Japanese security. In short, there could be an arms race in the region, with a general increase in tensions. An arms race would be disastrous for everyone, in my view. Trade and investment would slow sharply, and perhaps even reverse, in the face of an Asian cold war. There would be immediate and sharp inflation pressure as supply chains were disrupted. The fiscal costs would be enormous, and the consequent loss of productivity growth (since technology would go into non-commercial military spending) would lower living standards. Protectionism around the world would rise, and compound the inflation problems. The very large foreign exchange reserves held by some countries in the region would become a major question mark: With so much fiscal need, the pressure to liquidate reserves would be high, and the consequences for global bond markets would be severe. The limbo scenario Prior to the good and the bad scenarios lies the ‘limbo scenario’, as pointed out by my colleague, Takehiro Sato. Under this scenario, China, Japan and other powers keep DPRK in limbo. The motivation for this strategy would be to support political agendas. In China, a tough stance on DPRK would help establish China as a stakeholder in the geopolitical order, buy goodwill in Washington, and reduce protectionist threats from the US. In Japan, a continued threat from the DPRK could hasten consideration of revisions to the Japanese Constitution, These revisions are aimed precisely at allowing Japan to help on international problems that require collective defense. The benefit of the limbo scenario for Japan and China is that it transforms the DPRK problem from an excuse to bicker into a reason to cooperate. The problem with the limbo scenario is that it cannot last much longer. The DPRK is likely to become more provocative in the face of UN and other nations’ sanctions. New aggressive actions by the DPRK would raise security risks for China, Japan and South Korea. After a further period of limbo, events are likely to turn either to the good or the bad scenario mentioned above. Market implications For now, the limbo scenario will continue. However, over the longer run, events will turn. Obviously, the good scenario is far better than the bad scenario. In either case, the fiscal burdens and the economic disruptions would be serious. The tax burden would rise, leaving less for firms to invest or to pay out to stockholders, and for consumers to spend. Interest rates would have to rise in order to stem inflationary pressures, adding to the burden, and lowering asset valuations. Yields would be higher as well, because higher demand for capital will have to be allocated through the market. Thus, even the good scenario would have a significant adverse impact, in my view. So far, markets have shown little reaction to the DPRK nuclear test. The most likely reason for the calm attitude is the lack of clarity on what might follow. Moreover, the successful Abe-Hu summit may have increased confidence in the ability of nations in the region to deal with the crisis. However, my sense is that markets have not recognized the costs of the very large contingent liability that the DPRK represents.
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Fiscal Policy
Oct 13, 2006
Chetan Ahya (Mumbai) and Mihir Sheth (Mumbai)
Public debt/GDP up by 19% of GDP over the last decade The large size of the fiscal deficit is reflected in the rise in the public debt/GDP ratio to 79.5% as of March 2006 from 66% in March 2000 and 61% in March 1996. Since 1996, public debt has grown at 14% compounded annually compared with 11% growth in nominal GDP. The main driver of this steep rise in public debt has been a deterioration in government finances, with internal debt for states growing at 16.5% and for the central government growing at 13.7% during the period. The high level of debt/GDP stock has resulted in a large pre-emption of revenues for payment of interest. The combined (central plus state government) interest payments increased to an estimated 5.8% of GDP in F2006 from 4.9% in F1996 and 4.3% in F1991. Off-budget burden is also rising — some for genuine infrastructure spending The off-budget burden for both the central and state governments has also been rising significantly over the past few years. Although no aggregate data are published by the government, anecdotal evidence suggests a rapid rise. Some of the major areas where the off-budget burden is increasing are pension dues for government employees, debt of state electricity boards, oil subsidies and special purpose vehicles for investment in infrastructure created by the government. In addition to these off-budget liabilities, both central and state governments have built up contingent liabilities, amounting to 10% of GDP in the form of government guarantees. Unprecedented global capital inflows mask fiscal risks Typically, the cost of a high fiscal deficit would have been higher real interest rates. However, India has witnessed an unusually low real interest rate environment right at the time when its fiscal policy has been expansionary, as reflected in rising public debt/GDP. The key to lower-than-warranted real interest rates is the supply of global liquidity in form of portfolio and debt inflows. Almost 83% of the total US$76 billion capital flows that India has received over the past three years have been in the form of non-FDI flows. Indeed, it is the change in pace of these inflows which, at the margin, has caused the rise in the Indian real interest rates recently. No major risk to macro stability likely … Although we believe that India’s public debt/GDP is way too high, it is unlikely to cause any instability in the near term. We believe that two key factors have allowed such a large deficit to be sustained without a major shock to the economy: First, until recently, the government has maintained strict control over the capital account, ensuring adequate domestic savings for funding the government deficit. Second, India’s deficit has been largely funded through domestic debt as opposed to external debt. In fact, the ratio of external debt to India’s total public debt was only 6.7% as of March 2006. … but cost will come in the form of lower future growth Clearly, expansionary fiscal policy is currently playing a big role in boosting India’s growth — seemingly without any concomitant costs. The costs of this policy will be evident in the form of higher real interest rates and slower growth, and these costs will get magnified if global capital inflows were to slow down, in our view. One could argue that considering India’s long-term fundamentals, global capital inflows should continue unabated and a further rise in real interest rates would be prevented for longer. However, the past trend indicates that these global capital inflows have invariably witnessed significant moves up and down, influenced by US monetary policy. Moreover, the current high level of unproductive government expenditure and public debt is weighing on the long-term growth potential. The government’s spending on productive areas such as infrastructure, education, health and welfare has been constrained by high levels of non-development expenditure and a high starting point of the debt level. The government’s development expenditure has averaged 14.8% over the last five years, declining from 17% at the commencement of the liberalization process in F1991. Highest public debt/GDP in the emerging economy space To help put the magnitude of India’s public debt problem into perspective, we analyzed the current level and the change in public debt trend across 14 emerging markets. In 2000, India already ranked high — second out of 14 countries — in terms of stock of public debt as a percentage of GDP. Over the past five years, eight of these countries have seen an increase in public debt/GDP, with India seeing the fourth-highest increase. Following this, India has the highest public debt/GDP ratio among these 14 countries. As of 2005, India’s public debt was 79.5% of GDP, while the country with the second-highest public debt, Turkey, was at 69.3% of GDP. This compares with the median public debt/GDP ratio of this universe of 46%. Fiscal Responsibility Act — right intentions but inadequate implementation After a long period of debate, in July 2004 the government passed legislation, known as the Fiscal Responsibility and Budget Management (FRBM) Act, which requires it to improve fiscal management. The legislation requires the central government to eliminate its revenue deficit and reduce its fiscal deficit to 3% of GDP by F2009. While on paper the Act is expected to improve fiscal balances significantly, implementation has been inadequate. Although the reduction in the headline deficit of the central government appears to be line with that targeted by the FRBM Act, we do not think it is a structural reduction in the deficit. There has been very little action on expenditure reforms. Conclusion: Road to sustained fiscal correction is hard, but necessary We believe that a heavy fiscal deficit burden is one of the major hurdles to the government achieving its GDP growth target of 8-10% on a sustainable basis. As discussed in our earlier note (see Fiscal Policy: It’s All About Discipline and Flexibility – Part I, October 11, 2006), the government has benefited from a cyclical rise in the tax/GDP ratio, and there has also been an understating of the subsidy burden on oil products, reducing headline revenue and the fiscal deficit over the past five years. A sustainable reduction in the government’s deficit would have to entail difficult and politically sensitive measures, in our view. First, the government could initiate major expenditure reforms and move effectively to outcome-based expenditure management from the current outlay-based system to cut non-interest revenue expenditure. Second, interest costs currently form about one-third of revenues and one-fifth of total expenditure. Indeed, interest costs have been consistently higher than capital expenditure since the mid-1990s. To control the interest cost component, India needs not only to stop accruing fresh debt for funding less efficient current consumption expenditure, but also to reduce its stock of debt/GDP. The government could reduce the debt burden in a short period by stripping out its assets in the form of large public sector entities (PSEs). The government could sell stakes in PSEs worth, say, US$15-20 billion a year in the next five years to invest in infrastructure. This in turn would help accelerate GDP growth, change the growth mix from current debt-funded consumption-driven to capex-driven and increase the tax/GDP ratio on a sustainable basis and, thereby, reduce the deficit as well as debt/GDP.
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