Sweden
Growth Hidden in 2007 Budget
Oct 18, 2006

Thomas Gade (London)

Following the recent change in government in Sweden, the new centre-right government has now released its budget proposal for 2007. The budget surplus is expected to decline from an expected 2.8% of GDP this year to 2.3% of GDP next year, mainly due to extraordinary capital tax revenue in the current year. Adjusted for the business cycle and one-off effects, the public budget surplus is expected to remain stable at 2.4% of GDP in 2007 according to government estimates. As such, the 2007 budget proposal does not contain a direct public stimulus to the economy. However, from the composition of the budget proposal, there are good reasons to believe that the budget proposal will be growth stimulating. We are therefore raising our GDP growth forecast for 2007 from 2.9% to 3.3% but lowering our inflation forecasts mainly due to one-off discretionary tax changes.

Consumption growth hidden in the composition …
The main budget proposal is to lower income taxes from January 1, 2007.  On the back of the budget and in line with our own positive consumption expectations, the government expects consumption to expand by 4.2% next year.  On a gross basis, the change in income taxes alone will lead to a total tax reduction of SEK 40 billion (1.5% of GDP) according to government calculations.  The reduction in labour income taxes will be implemented through an employment related income tax deduction.  On our calculations, the reduction in income taxes on labour is likely to affect employment by 1.5-2.0% in the long run (see Sweden Economics: Preparing for a Photo-Finish, September 11, 2006).  Further, the lower income taxes should significantly increase households’ disposable income.  We have previously calculated the disposable income growth effect to be around 6-8%.  Although our estimate of disposable income growth may be on the high side compared with government estimates, the indication is that the proposal will add a significant boost to consumption next year.

… supported slightly by a reduction in property taxes
The property tax cap is already effective from 2006.  This will be followed up in 2007 with a freeze on property tax at 2006 valuations and a minor tax rate reduction for certain house types.  While we think the effect on consumption growth or house prices is likely to be limited, the change alone may reduce CPI inflation by around two-tenths in 2006 and 2007, on our estimates.  In effect, the property tax will lead to a tax loss of SEK 1.9 billion in 2006 and SEK 2.5 billion in 2007.  The state property tax is to be scrapped in 2008.  We expect the effect on consumption and inflation in 2008 to be limited as the government plans to introduce a municipal property related tax of similar size.

Limited currency effect from halving the wealth tax
Financial markets have been monitoring the potential changes, in particular to the wealth tax and potential privatisation flows.  The wealth tax will be halved from 2007.  This means that personal wealth above SEK 1.5 million will be taxed at 0.75% instead of the previous 1.5%.  The halving of the wealth tax is likely to have a positive — but limited — effect on consumption as the reduction in the wealth tax will affect the high income fraction of the population mainly. Instead, it may lead to increased private savings.  According to the government, the reduction in wealth taxes will result in an income loss of SEK 1.9 billion in 2006 and SEK 2.5 billion in 2007 for the public budget.  As we previously have argued, the effect on potential capital flows is likely to be limited.  At best, the reduction in the wealth tax will reduce the current capital outflow of SEK 25 billion and as such provide some support for the SEK going forward.

The step-up in privatisations could be a trigger
The government plans to increase privatisation revenues and calculates that revenues of SEK 50 billion (1.8% of GDP) per year over the next three years is a reasonable estimate.  The government is likely to start with selling off holdings in already listed companies, we think.  The revenue generated from the sell-off will reduce public debt by a similar amount and create budget room through a reduction in interest expense on public debt.  In isolation, public borrowing requirements will be reduced by a similar amount and should be positive for Swedish government bonds.  Similar to our own expectations, the government expects 10-year government bond spreads relative to the 10-year Bund to become positive and widen over the course of 2007.  This is mainly a result of differences in the expected monetary policy path.  In Sweden, we expect the Riksbank to continue the monetary normalisation path through the first half of 2007.  Meanwhile, we expect the ECB to pause by the end of this year.  In isolation, the lower borrowing requirements resulting from a step-up in privatisations should contain the shift in spreads, but not prevent it, we think.

Budget proposals lowering inflation
On balance, the budget proposals will lower inflation in 2007, we estimate.  The total effect on UND1X inflation, which is the measure favoured by the Riksbank, is also likely to be negative on balance, but the inclusion of the dental reform in UND1X is likely to be controversial, we would argue.

So far, the indication from Statistics Sweden is that the effect of the dental reform will be included in UND1X.  The reaction of monetary policy to these one-off effects is likely to be limited.  We think the Riksbank is likely to view the direct effects as one-offs on inflation and not as a result of underlying inflationary developments.  The increase in disposable income from lower income taxes could reduce wage demands in the large wage rounds in 2007 and lower inflationary pressures.  We continue to see the Riksbank pausing at 3.5% by June 2007.

Budget proposal overshadowed by minor government crisis
Around the time that the 2007 budget proposal was delivered, the new government came under pressure from within its own ranks as well as from the centre-left opposition. The reason has been the alleged failure to make TV license payments and similar issues surrounding three ministers in the new government.  So far, the Minister of Trade, Maria Borelius, and the Minister of Culture, Cecilia Stegö Chilo, have resigned.  The new government has clearly got off to a bad start.  However, we do not expect these issues to lead to a major government crisis.  The release of the 2007 budget may provide some relief for now and finally allow the government to execute its plan of action.  The proposed budget for 2007 is a positive step on the way, we think.

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China
Not Yet Done with Tightening, NDRC Says
Oct 18, 2006

Denise Yam (Hong Kong)

NDRC Chairman Ma Kai Speaks

Recent statistical evidence that the Chinese economy is slowing is calming concerns over potential further tightening measures.  The National Development and Reform Commission (NDRC), China’s top economic planning body, nevertheless, is reiterating the need to maintain tightening, as detailed in Chairman Ma Kai’s statement last week.  It is certainly not unusual to hear contrasting opinions and predictions on the government’s policy stance, but the voice of the NDRC often receives the most attention.  Ma’s report stated very clearly the NDRC’s assessment of current economic conditions, achievements on rebalancing and restructuring, and policy principles and initiatives for 2H06.  Although the statement did not unveil any new measures, it serves as a very useful up-to-date summary of the government's policy stance, and a reminder that speculation that China is done with tightening may still be premature.  We trust that rebalancing, restructuring and redistribution come before growth in China’s economic plan for the next half a decade.

Counting Achievements - Strong Growth in 1H06 Was Different from 2003/04

China’s headline economic growth accelerated in 1H06, with real GDP expanding 10.9% compared to 10.2% in 2005, contrary to what tightening measures were intended to achieve, by public opinion.  Nevertheless, NDRC Chairman Ma Kai highlighted a few key differences in current economic conditions from those in 2003/04.  Shortages in agricultural and energy output have eased significantly, while transport bottlenecks have also been relieved; these developments have helped bring consumer inflation back to a stable range of 1-2% YoY, against the peak of 5.3% in 3Q04.  The NDRC also claimed success in industry and output rebalancing, through slowing capacity expansion in cement and metal sectors, while encouraging further development in hi-tech and high value-added equipment manufacturing sectors.  Downsizing and consolidation have been accelerated in relatively less efficient industries.

Outstanding Problems Keep NDRC in Tightening Mode

Chairman Ma warned against complacency given the apparent favorable economic conditions, and raised a number of problems that, if not resolved, could upset the satisfactory economic performance and exacerbate imbalances that would prove costly to economic development.  Specifically, he remains concerned with investment and monetary growth being too fast, and the trade surplus being too large.  Excess liquidity in the banking system has resulted in a sub-optimal allocation of loans, in Ma’s opinion, with too large a proportion directed to medium-to-long-term lending to big cities, large enterprises and sizeable projects, starving funds for SMEs and rural borrowers.  These ongoing problems are continuing to put stress on land use, resources and the environment.

Tightening Still an Integral Part of 2H06 Policy

Among other initiatives, Chairman Ma reiterated policies assigned for 2H06 that are aimed at limiting the growth in investment, bank lending and the trade surplus.  Among them are stricter regulations on land use and the “cleansing” of new investment projects.  Six inspection teams have just been dispatched to 12 provinces[1] to assess new investment projects.  These teams are to report their observations by October 27 on projects that violate specified standards with respect to: 
(i) industry planning - whether the project is consistent with the planned production capacity and consumption of energy, water and natural resources.  Sectors with overcapacity[2] will continue to be monitored closely;
(ii) project approval;
(iii) land use approval;
(iv) the environment - high-pollutant industries such chemical, textiles dyeing and coking coal will be the most thoroughly inspected;
(v) financing - for violations in loan approval and misuse of loan funds; and
(vi) work safety - especially in coal and other mining industries.
Meanwhile, tightening could also come through monetary channels, including further hikes in reserve requirements to trim banking system liquidity.  Bank lending will continue to shift away from energy-intensive, polluting and overcapacity industries, but towards SMEs and rural areas.

Part of the macro controls are aimed at energy and environment conservation, which is a key area in China’s blueprint for sustainable development.  Chairman Ma stated that provincial and city governments will have to set targets on economizing on energy consumption, and these targets will be included in criteria for assessing economic performance.  Further pricing reform for energy and utilities will also serve to improve resource allocation going forward.

Tightening is unlikely to pare consumption, nevertheless.  Continued support to the agricultural sector, improving prospects for rural-urban migration, further lifting minimum wages and living standards in cities, and stepping up the provision of affordable housing, education, healthcare and social security will likely help drive consumption growth.

Rebalancing and Restructuring Rather Than Growth

Slowing growth and discouraging fixed investment have proved more difficult than expected, judging from China’s experience since 2003.  The decentralized political system is partly to blame for the limited effectiveness of macro tightening.  On the other hand, the continued and expanding balance of payments surplus has limited the impact of monetary tightening moves on interest rates.  The cost of capital has remained excessively low, which has made it difficult for policymakers to foster more efficient capital and resource allocation.

The jury is still out on whether the ongoing and proposed macro policy initiatives as outlined above will be an effective cooling medicine.  Nevertheless, we should recognize the apparent shift in China’s policy focus as spelt out in the 11th Five-Year Plan and reiterated in recent policy announcements.  Having cultivated the rapid economic growth of the coastal cities over the past two decades, China is, without doubt, shifting its policy focus to internal balances, narrowing regional disparities and enhancing social harmony.  Nominal GDP growth targets have been set at 7.5% per year over 2005-2010, versus 14% currently.  Economic themes in the next few years will likely be dominated by rebalancing, restructuring and redistribution, rather than growth, in our view.

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Peru
Building Resilience
Oct 18, 2006

Luis Arcentales (New York)

Six years into the current expansion, the Peruvian growth story looks brighter than ever.  By most metrics, Peru’s growth performance has been impressive: the recent acceleration – to 7.0% in the first seven months of the year – comes on the back of a 6.7% jump last year, the strongest since 1997.  With the economy firing on all cylinders, growth expectations have steadily trended higher, coinciding with muted inflationary pressures.  And thanks in great part to the commodity boom, Peru is set to end the year with both its fiscal and current accounts comfortably in surplus territory.   Indeed, while there are still unanswered questions about the political and reform outlooks, the view among most Peru watchers is that the economy will maintain its strong momentum into 2007.

Underneath all the optimism about Peru’s growth prospects, there was a fair amount of uncertainty about the resilience of the global economy among Peru watchers in our recent visit to Lima.  Top on the list was the impact of a slowdown on the prices for commodities.  With the durability of the commodity super-cycle coming into increased scrutiny, this concern does not seem at all misplaced (see Steve Roach’s “Whither Commodities?” in GEF, September 15, 2006).   After all, commodities – mainly gold, copper, zinc and fishmeal – represented three quarters of merchandise exports in the first half of the year and contributed nearly 90% of total export growth.  Indeed, of the major Latin American economies, only Chile and Venezuela are more exposed to commodities in their export mix.  In Peru’s case, last year non-manufactured exports represented nearly 18% of GDP.  By this metric Brazil – paradoxically held by many as pure commodity play – has only a relatively modest exposure to the tune of 7% of GDP.

While commodities are but one part of the Peruvian growth puzzle, there is no mistaking the importance of the commodity factor for Peru.  In the early stages of the recovery that began in mid 2001, export-linked primary sectors – agriculture, mining, fishing and certain manufacturing industries – did most of the heavy lifting.  As Peru’s terms of trade began to slowly improve and new mining projects came online, we estimate that the direct boost from primary sectors – which represent around a fifth of the economy – represented around half of total GDP growth in the second half of 2001.  On the fiscal front, central bank simulations assuming 2003 export prices suggests that the boost to the fiscal accounts has been to the tune of 1.2 percentage points of GDP.  Against this backdrop, it is not surprising that time and time again Peru’s growth story has been labelled as solely a derivative of record commodity prices. 

Increasingly, the ongoing expansion has had a domestic demand flavor to it.  During the first half of 2006, the primary sector contributed just over 10% of total value added growth, a far cry from the experience of 2001 and near the lowest contributions in the current cycle.  Instead of a reason for concern, as the boost to growth from export-linked primary sectors slowly abates, the drivers of domestic demand are in place to take center stage in sustaining hearty growth.  In turn, this trend – combined with the cushion from Peru’s dual surpluses – should make the economy less susceptible to a global downturn.  The shift towards domestic-demand led growth is not a new trend.  However, it is worth highlighting because the drivers of consumption and investment appear to be consolidating at the same time that export volume growth has come to a near standstill this year.

The combination of rising jobs, record confidence and ample credit availability is underpinning healthy private consumption growth.   Given the strength and breadth of the upswing in the economy, it is not surprisingly that urban job growth and confidence have remained at very high levels. The optimism is not limited to consumers: the September survey of manufacturers shows that over half of the participants expect an improvement in activity in the next three months.

One of the most dynamic consumer tailwinds has come from the explosive expansion in credit, which has been growing at an annual clip of around 30% annually since late 2005.  Importantly for the sustainability of loan growth, expanding credit has come hand in hand with an improvement in the profitability and overall health of the banking system.  To be fair, Peru remains a very underbanked economy by regional standards; however, the trend towards further financial deepening seems now well established. 

Indeed, one of the most encouraging initiatives by the private sector consists of a concerted effort to extend small loans to Peruvians in rural areas that previously had no access to the banking system.  Beyond the obvious benefits of deepening the degree of financial development, such programs are likely to slowly help raise the incomes of some of the nearly 48% of Peruvians currently living in poverty, which represents Peru’s greatest challenge (see “Peru: The Abundance Divide,” in GEF, March 14, 2006). 

In line with the upbeat signs from the consumer front, the prospects for investment spending are also tilted favorably.  Business confidence is riding high and business credit is expanding briskly.  And the public sector is also doing its part to boost investment: actions by the new administration have prioritized capital expenditures, thus the announcement of an “investment shock” for the second half of the year.   While the first signs from the new administration have carried a generally pro-business message, we would warn Peru watchers against reading too much into them: Peru is still in the midst of an electoral process that will only end with the regional elections next month.  Only after the elections, we are likely to get a clearer picture of the political and policy landscapes.

One common concern we hear among Peru watchers is a delay in the ratification of the bilateral free trade agreement by the US congress.  While Peru is proactively taking action to lobby for the FTA and creating facilities to bridge the potential period between the end of ATPDEA benefits at yearend and the ratification of the free-trade agreement, delays could impact the current upbeat business sentiment.  Beyond that, however, we suspect that the ratification of the free-trade agreement is just a matter of time.

Bottom line

Peru’s ongoing boom is today more than just a derivative of the commodity super-cycle.  While primary sectors sparked the initial upswing, the drivers of growth have progressively shifted towards non-primary sectors more closely linked to domestic demand.  In turn, that should leave the economy less vulnerable to a correction on the commodity front.

But even as the fundamental improvement in the Peruvian economy is worthy of praise, the social and political stability needed for sustainable long-term growth will remain elusive insofar as the benefits of Peru’s impressive growth run fail to lift the living standards of nearly half the population still in poverty.  While so far several actions by the new administration have reflected a clear understanding of the urgent need to tackle the country’s income divide, Peru is still in the midst of a pre-election process.  Only when the November regional elections are behind us, we will likely get more clarity on whether the new administration is up to the challenge of prudently using today’s abundance to strengthen institutions and efficiently channel public investment to help ease Peru’s vast income disparities.

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