Japan's Missing Link
Oct 20, 2006

Stephen S. Roach (from Tokyo)

The mood has shifted in Japan.  When I was last there six months ago, a clear sense of euphoria was in the air.  Conviction was deep that the long nightmare was over — deflation was coming to an end and economic recovery was finally viewed as sustainable.  Today, the view is more granular and disconcerting.  After extensive meetings with investors and business leaders, I detected two sets of concerns — one internal and other external: Worries were deepening over Japan’s lack of a personal consumption dynamic, and its excessive dependence on China was increasingly viewed as a potential risk.  No one feared the type of relapse that frequently punctuated the rolling recessions of Japan’s 15-year deflationary nightmare, but there was certainly a more cautious assessment of the staying power of the growth miracle that was so widely celebrated just a few months ago.

The private consumption story has long been the most important missing link in the current Japanese recovery dynamic.  Since the onset of the current economic upturn in the first quarter of 2002, private consumption has risen at just a 1.6% average annual rate — well below the 2.3% growth rate in overall GDP.  As a result, the consumption share of Japanese GDP has fallen from 58% in early 2002 to 56% in mid-2006.  Nor are there any signs in the recent data flow of any material improvement in the prospects for Japanese consumption.  In July and August, our calculation of what can be called a synthetic gauge of Japanese consumption, which incorporates data from both the supply and demand side sides of the consumer equation, fell 0.8% below the April-June reading for retail sales and 1.1% below the three-month earlier reading for shipments of consumer goods.  At the same time, the Cabinet Office’s quarterly index of consumer confidence slipped for a second quarter in a row in the three months ending September 2006 — a disappointing fallback after a hopeful rebound in late 2005 and early 2006.

These trends are quite consistent with our Japan team’s recent assessment of the Japanese consumption prognosis (see R. Feldman and T. Sato’s 18 August 2006 essay, “Moby Consumer”).   While they have had an upbeat call on the overall economy for most of the past three years, it has been much more of a capex and exports story than one driven by organic growth in consumer demand.  Their cautious assessment of consumption is tied to the likelihood that sluggish real wages will remain a persistent drag on household purchasing power.  That very much dovetails with what has been a most disappointing performance on the Japanese wage front in 2006.  After compensation per employee improved to a 1% y-o-y comparison during 2005, there has been a deceleration to just +0.5% growth over the course of this year; moreover, this slowdown has occurred in the context of a long-awaited rebound in core inflation (i.e., consumer prices excluding fresh food have moved up to +0.6% y-o-y in recent months) — underscoring a meaningful compression of any expansion in real wages.  Nor do Sato and Feldman believe that that this lingering stagnation in real wages will be offset by developments elsewhere in the Japanese economy; in particular, they reject the possibility of a spontaneous rebound in Japanese consumption driven by a declining personal saving rate, newfound wealth effects, or a shift in the distribution of income generation from capital to labor.

In my meetings this week in Tokyo, I got the distinct impression that concerns are mounting over this important missing piece to the Japanese economic recovery story.  A Japan that is lacking in support from a self-sustaining internal consumption dynamic is, by definition, more dependent on capex and external demand.  Significantly, external risk assessment suddenly looks a bit murkier as the Japanese peer into 2007 and worry about possible shortfalls in two of most important foreign sources of its recovery — the American consumer and the Chinese producer.  While US consumption has held up quite well so far — providing ongoing support for Japan’s largest export market — there is understandable concern that such support may diminish in a post-housing bubble climate.  And now there are concerns that a China slowdown may finally come to pass — undermining support for what has now become Japan’s second largest export market.  Collectively, the US and China currently account for fully 37% of total Japanese exports — by far, the largest and most concentrated piece of Japan’s external demand.  Moreover there has been a very important shift in the mix of Japanese exports to its two largest trading partners in recent years — a declining share to the US (from 29.7% in 2000 to 22.5% in the first eight months of 2006) offset by a sharply increasing share to China (from 6.3% in 2000 to 14.1% thus far in 2006).  Increasingly, China is the most powerful engine behind Japan’s long important export machine. 

Japan’s tilt toward China is on everyone’s mind in Tokyo these days.  In the normal course of my visits here, I hold a series of roundtable discussions with corporate executives and senior institutional investors.  I provide a brief macro overview and they then set the discussion agenda thorough their feedback.  Over the past couple of years, the topic of China has become an increasingly important subject of exchange during these sessions.  On this visit, the China focus was literally off the charts.  Recent events certainly explain part of the increased interest: Newly elected Prime Minister Abe’s first foreign mission was a quick trip to Beijing — underscoring the potential for a meaningful improvement in what had turned into a rather prickly relationship between these two Asian powerhouses in the Koizumi era.  Moreover, the North Korean missile crisis has certainly heightened the attention on the strategic relationship between the two nations. 

But there is an important economics angle at work as well: Leading Chinese officials have recently refocused the debate on the off-again-on-again “cooling off” campaign for this overheated economy.  The latest statements of Ma Kai, China’s leading central planner and Chairman of the all-important National Development and Reform Commission are particularly important in that regard (see Denise Yam’s 18 October dispatch, “China: Not Done with Tightening, NDRC Says”).  And then there’s China’s just-released third quarter GDP report — a still very rapid 10.4% y-o-y increase but a downshift, nevertheless, from the blistering 11.3% pace of the second period.  This could certainly be interpreted as the first installment on the road to a more meaningful slowdown — underscoring the potential for an important shift in one of Japan’s major external sources of economic growth.  All in all, there can be little surprise in the heightened interest I detected in Japan with respect to the China factor.

The big puzzle in all this is Japan’s lack of internal support for private consumption.  I am struck by the similarities between the Japanese predicament and conditions in other major industrial economies.  In my view, this is an unmistakable manifestation of one of the great paradoxes of globalization — a powerful global labor arbitrage that continues to put unrelenting pressure on the labor-income generating capacity of high-wage industrial economies (see my 5 September 2005 dispatch, “The Global Growth Paradox”).  Japan is hardly alone in feeling this pressure — it’s a serious constraint in Germany and even the United States.  By our calculations for the “G-7 plus,” the real compensation share of national income fell to 53.7% of gross national income in early 2006, fully 2.3 percentage points below peak rates in early 2002.  Until, or unless, the industrial economies figure out how to convert productivity improvements into enhanced labor income generating capacity, their private consumption dynamic should remain under pressure.  That may be an uphill battle.  To the extent that the fixation on intensified global competition and productivity enhancement rests on the tactics of increasingly aggressive corporate cost cutting ongoing — and that labor continues to account for the lion’s share of business costs — it is hard to envision a spontaneous improvement in internally-driven income generation. 

Sure there are some unique aspects of the Japanese consumption experience that separate this economy from that of other industrial nations — namely, the ending of lifetime employment, a more urgent demographically-driven aging problem, and, of course, the very vivid recent memories of 15 years of rolling stagnation and deflation.  But I don’t think it is a coincidence that Japan is suffering from the same problem of labor income compression that afflicts the rest of industrial world.  The initial euphoria of recovery tends to swamp those concerns — especially, since in Japan’s case, it came after such a long nightmare.  But as recovery matures and gives way to expansion, reality often sinks in and there is a perfectly natural refocusing of attention to any economy’s lingering stresses and strains.  That refocusing is now under way in Japan.  The mood in Tokyo is very different than it was six months ago.  With the American consumer and the Chinese producer in play, the missing link of the Japanese economy suddenly seems more problematic.

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United States
Is the Housing Recession Over?
Oct 20, 2006

Richard Berner (in Orlando, where home sales are still falling)

There are glimmers of hope that the housing recession might be over, contradicting our bearish stance on housing demand and activity.  Notably, single-family home sales plunged by 23% between their peak in May 2005 to July 2006, but in August bounced 4.1% off their lows.  Likewise, 1-family housing starts tumbled by 24.5% over the six months ended in August, but rebounded by 4.3% in September.  And sales of existing homes stabilized in August after sagging by 13% over the previous 13 months.

Call me stubborn, but I still think the housing recession has a long way to go.  Regarding demand, the 14-year boom left little pent-up demand and affordability is still low.  And on the supply side of the equation, despite a slight dip in August, inventories of unsold homes stand well above where we think builders would like them.  As a result, further significant declines in starts to trim the inventory overhang are likely.  The overhang also means that would-be buyers can be choosy and wait for further concessions from the sellers.

Nonetheless, the latest data suggest that the intensity of the housing decline may be fading somewhat, and with it some of the concurrent downward pressure on housing prices.  If so, one of the biggest perceived risks to the US economy may be smaller than feared.  Here’s why.

Beyond sales and starts, there’s no mistaking the hints of bottoming in both housing demand and activity: Indexes of housing affordability stopped declining in August, some October surveys suggest that home-buying sentiment and traffic have improved slightly, an index of pending home sales improved recently, and the volume of mortgage applications for home purchase may have stabilized.  According to the National Association of Homebuilders, “The market correction appears to be approaching the bottom in terms of sales volume,” which they attributed to lower rates, falling energy prices, rising consumer confidence, and “substantial sales incentives.”  Indeed, homebuilders’ stock prices have risen smartly over the past three months, seemingly telling us that we’re too pessimistic.

Don’t get me wrong; housing isn’t in for a multi-year contraction.  Indeed, I think that the longer-term, secular demographic supports for housing are still relatively favorable.  Population growth, including for the 25-44 year old cohorts, has slowed, but a slow upturn for the younger groups is occurring, as the echo boomers — children of the baby boomers — are starting households.  Immigration seems to be continuing, despite post-9/11 concerns that it would stop.  And homeownership rates for many population groups are still well below those for the population as a whole, hinting at the potential for improvement. 

In my view, however, the cyclical risks to housing demand still lie to the downside.  The slight decline in homeownership rates that began last year, following an unprecedented 500 basis point surge to 69.2%, suggests that much of the pent-up demand created by those demographic trends was satisfied in the long boom.  And while income is now beginning to outstrip home prices — two key ingredients in the affordability recipe — popular indexes of affordability stand some 40% below the levels that kicked off the boom in the early 1990s. 

The near-term risks to the supply side of the equation, as I see it, are even more transparent.  Inventories of unsold new homes stood at 6.6 months’ supply in August, at least 30% and possibly 50% higher than where I think builders would like to see them.  The worst imbalance seems to be in the Midwest, where jobs associated with the ‘legacy’ motor vehicle and parts industries are disappearing or migrating south.  Such inventories in the Midwest census region appear to be at the highest level in relation to sales since the 1980-82 downturn.  In the more affluent and supply-constrained Northeast, the imbalance now appears to be improving.  But the Northeast accounts for only 8% of new, 1-family homes sold, and the imbalances in the South and West are at decade-long highs.  In all, I calculate that if single family sales decline by another 12-14% and subsequently recover over the second half of 2007, it will require a further 16-18% decline in 1-family housing starts to reduce inventories to acceptable levels — 4.5 months’ supply.  And that supply-demand imbalance is a major source of the downward pressure on home prices, as the market has shifted to choosy buyers.

Nonetheless, the latest data suggest that the intensity of the housing decline may be fading somewhat, and with it some of the concurrent downward pressure on housing prices.  That fading intensity has been a longstanding feature of our outlook: We expect that residential construction activity declined at an 18% annual rate in the third quarter, that it will decline at a 16% rate in the current quarter, and by 6.7% over the four quarters of 2007.  But our third and fourth quarter views now look a tad too pessimistic, and the pace of decline may moderate further.  If so, one of the biggest perceived risks to the US economy may be smaller than feared. 

For market participants, these developments are critically important.  Many investors are now backing away from the idea — so prevalent in the summer — that a collapsing housing market would drag the economy down and force the Fed to reverse the course of monetary policy.  If the intensity of the downturn is indeed fading, further backpedaling from the housing collapse story seems likely. 

For our part, the combination of upside inflation and reduced economic risks makes us wary of bonds at current levels.  As evidence that investors continue to back off from the notion that the Fed would have to ease monetary policy to rescue the economy from a housing-led downturn, a rise in real 10-year yields accounts for all of the recent yield backup.  But markets only discount a sliver of a chance that inflation risks might prompt further tightening. 

As always, it’s important to check risks: Anecdotal evidence seems to confirm our bearish housing story, and risky asset markets may be drawing too much comfort from the soft-landing backdrop.  Combined with other factors we see supporting growth — the effects of falling energy quotes, favorable financial conditions, strong US income gains and hearty global growth — a less-intense housing downturn would underpin our reacceleration view.  Indeed, growth could be stronger than we expect. 

Contrariwise, the deterioration in mortgage credit quality is just beginning.  We think that lenders are more at risk than are borrowers, and that only a small minority of stretched consumers will suffer.  But a sharper-than-expected rise in interest rates could ultimately create more stress for both lenders and borrowers.  And the combination of colder weather and a supply disruption could push energy prices temporarily but significantly higher, again menacing growth and boosting headline inflation. 

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Whither Euro Area Wages
Oct 20, 2006

Elga Bartsch (London)

All eyes on the labour market …

One factor is clearly gaining prominence in the ECB’s deliberations of the risks to price stability over the medium term: labour market dynamics and their implications for future wage developments.  For the first time in the current tightening cycle, ECB President Trichet highlighted favourable labour market developments — falling unemployment, rising employment and robust employment expectations — in the introductory statement to the October press briefing.  Unlike the US, where employment growth is clearly lagging behind the pattern seen in previous recoveries, euro-area labour market performance in the current upswing clearly stands out compared with the historical norm. 

… and its impressive track record …

Sooner or later, this impressive labour market performance is bound to give rise to concerns about a potential pick-up in wages.  If such a spill-over into higher wages were observed in the coming quarters, this would “pose substantial upward risks to price stability”, according to the ECB.  In that event, the ECB would likely hike interest rates considerably above the 3.75% peak for the refi rate that money market futures are currently pricing in, and even more above our own forecasts.  In this note, we assess the risks of a pick-up in euro-area wage inflation.  We argue that structural factors will prevail over cyclical pressures, ensuring continued wage restraint.  If, contrary to our expectations, we were to see a pick-up in wage inflation next year, we think this would more likely dent corporate profits and payrolls than push consumer price inflation higher.  Yet it could still trigger a strong response from the ECB, we think.

… compared with the historical norm

At this stage of the recovery, which is broadly in line with the historical norm, the unemployment rate has historically been considerably above its previous cyclical trough.  In the downturns of the 1970s and 1980, for instance, the unemployment rate roughly doubled in the first five years after a cyclical peak.  Even in the first half of the 1990s, the unemployment rate rose by about one-fifth.  Similarly, employment is now standing about 4% above its late 2000 peak.  Historically, employment was still trailing below its previous peak at this stage of the recovery.  There can be little doubt that the euro area economy has been generating more jobs for any given rate of GDP growth in the last few years.  Structural improvements in the functioning of the European labour market have likely reduced labour productivity growth temporarily by half a percentage point. 

Unemployment rate approaching the speed limit

At 7.9% of the labour force, on the latest monthly figures, unemployment is now getting very close to traditional estimates of the labour market speed limit.  Estimates of the level of unemployment consistent with stable inflation, the so-called non-accelerating inflation rate of unemployment (or NAIRU, if you are into acronyms) range between 7.6% and 8%.  Leading indicators of labour market activity, such as hiring intentions, suggest further improvements in the coming months.  As unemployment falls further and payrolls keep expanding, the potential for a resulting pick-up in wage inflation will likely gain prominence in the debate about the course of ECB interest rates in 2007. 

Wage inflation has remained subdued until now

Having been subdued for the last three years, wages have shown some signs of pick-up in the second quarter.  Rising 2.4%Y between April and June, negotiated wages seem to have gained momentum from the 2.1%Y pace recorded in the two years before.  At this stage, we would not make too much of this acceleration, for several reasons.  First, the rise has been driven partly by a one-off payment in the German metal industry and thus might turn out to be temporary.  Second, compensation per employee — a broader and more reliable metric measuring effective rather than negotiated wages, including social security contributions — has been trailing behind negotiated wages by about half a percentage point during the last year.  Hence, actual labour costs faced by companies have seen much more limited increases than negotiated wages and salaries would suggest. 

Mind the wage drift and the tax wedge

The shortfall between negotiated wages and total compensation can be attributed fully to a negative wage drift, according to ECB estimates.  As the wage drift tends to react faster to near-term changes in labour market conditions than negotiated wages, this trend could reverse in the coming quarters.  However, improved public finances provide room for a reduction in social security contributions or payroll taxes.  Such reductions are planned, for example, in Germany and Italy for next year.  Finally, as the Bank of International Settlements notes, the correlation between labour costs and consumer price inflation has become very loose in most industrial countries over the last decades.  The disconnect is likely to reflect both increased credibility of central banks and rapidly advancing global labour arbitrage.  But even though the inflationary consequences of higher wages can be debated, a pick-up in wage inflation would likely be perceived by the ECB as adding substantially to the upside risks to price stability. 

Germanyto be the tipping point in the next wage round

Despite concerns about backward-looking wage indexation in some countries, where the wage setting mechanism allows for compensation for past inflation overshoots, and the potential impact of government-induced hikes in minimum wages in other countries, the focus in the coming wage round will be on Germany.  For starters, it is the largest economy in the euro area.  In addition, its prolonged and pronounced wage restraint has been key in keeping euro area wage inflation in check.  Furthermore, Germany is one of the few countries where major sector-wide wage talks still take place.  Many of the present wage agreements will expire next spring.  Finally, a three point VAT hike becoming effective in January 2007 will likely cause a spike in consumer price inflation in early 2007, probably reducing consumers’ purchasing power by around €15 billion.  Together with the past oil price increases and record corporate profits, this could induce trade unions to demand compensation of loss in real incomes. 

But even the German metal workers will be moderate

The key event in the annual wage round in Germany is usually the IG Metall wage talks.  The metal workers’ wage contract expires at the end of March 2007.  On balance, however, we would expect a moderate outcome in next year’s metal wage round. 

  1. First, when the talks get under way, the economy will likely be at its weakest stage in the coming mid-cycle dip caused by a combination of fiscal consolidation and slower global growth.  As a result, companies will likely postpone hiring until the rough patch is behind them.
  2. Second, many companies in the car industry and capital goods sectors, IG Metall’s traditional stronghold, are still in the process of restructuring and, despite a smart cyclical upswing, have announced further layoffs in recent months. 
  3. Third, a net reduction in social security contributions of ~ 1% of gross wages in January will boost take-home pay. 
  4. Fourth, IG Metall will likely be upstaged by the chemical workers’ trade union, IG Chemie, which is likely to be the first to negotiate a new wage agreement in early 2007.  In the past, IG Chemie has proven to be more pragmatic and moderate than IG Metall, thus taking some of the pace out of the annual wage round. 
  5. Last but not least, on our current projections, lower oil prices will likely offset about half of the inflationary impact of the VAT hike.  In addition, there is some anecdotal evidence that the pass-through of the VAT hike may be lower than expected (see German Economics: The Anatomy of a VAT Hike, September 18, 2006). 

Structural factors to prevail over cyclical pressures

On balance, we expect the structural factors conducive to wage moderation to prevail over potential cyclical pressures.  As a result, actual wage inflation should remain below a norm that the ECB would likely regard as consistent with its price stability ceiling.  Assuming trend productivity growth of 1.25% suggests that pay rises of up to 3% should still allow ECB Council members to sleep peacefully at night.  Our below-consensus GDP growth forecast of 1.6% for next year should help cap the cyclical pressures.  More important, however, the euro area labour market has become more flexible over the last ten years.  The share of flexible jobs such as part-time and temporary contracts in total employment has risen noticeably.  Flexible jobs, which now account for over one-third of total employment, are a key factor behind the wage moderation observed in the last ten years.  Some 75% of the jobs created last year, for instance, were temporary ones.  In addition, globalisation continues to put pressure on labour markets in industrialised countries.  Contrary to initial fears that globalisation would result in huge jobs losses, the impact thus far seems to have been mainly on wage formation.  As a result, real wages have stagnated and the labour share has been on decline.  Even if nominal wage inflation picked up, rising labour productivity growth would limit the impact on unit labour costs.  In the end, we think higher wages are more likely to dent profits and payrolls than to boost inflation. 

There are risks to our benign outlook for wage pressures.  We might underestimate the build-up of cyclical pressures in the euro-area labour market.  Similarly, we might over-estimate the taming effect of globalisation on trade unions.  In addition, the ECB may get worried if the German government goes ahead with plans to introduce minimum wages next year.  If the ECB gets worried about wage inflation, it will likely consider a restrictive monetary policy stance appropriate.  In this case, markets should reckon with a refi rate above 4%. 

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"Fast and Steady"; Macro Controls Maintained
Oct 20, 2006

Denise Yam (Hong Kong)

Economy expands 10.4% YoY in 3Q06.Economic growth decelerated in 3Q06, led by a slowdown in fixed asset investment that more than offset the further pickup in exports. Real GDP growth came in at 10.4% YoY, down from 11.3% in 2Q. Nominal GDP reached Rmb5003.4 bn in 3Q06, with the YoY increase slowing to 11.7%, down from 14.3% in 1H06. For the first three quarters in aggregate, the economy grew 10.7% in real terms and 13.4% in nominal terms.

Fixed investment slowed in response to macro tightening:The slowdown in (urban) fixed asset investment growth from 33% YoY in 2Q to 24% in 3Q was the main driver behind the growth deceleration. Including capex in rural areas, total fixed investment in the economy also cooled somewhat, up 27.3% in the first nine months, down from 29.8% in 1H06, totaling Rmb7.2 trn. Administrative controls on lending and capex in specific industries, as well as stricter rules on land use, appear to have brought down gains in investment, and the government first "celebrated" such success with the August urban FAI data, which showed growth dropping significantly to 21.5% YoY. Nevertheless, the gain in September actually reaccelerated to 23.6% YoY. This probably helps explain the faster-than-expected gain in industrial production in September, at 16.1% YoY (+15.7% in Aug) to Rmb775.4 bn.

Robust and resilient consumer demand:As policymakers intended, macro tightening was not targeted at consumption. Support given to the household sector, such as raising minimum wages in cities and subsidies and support to rural households, has given a boost to consumer demand. Retail sales growth stayed strong at 13.9% YoY in September (+13.8% in Aug), maintaining such a strong pace in the past 2 quarters. Although we remain wary that China's  "retail sales" data incorporates part of the fixed investment story, such as the sales of construction and renovation materials and furniture, consumers are indeed spending more. There has been some genuine pickup in sales of non-investment-related consumer goods, such as cosmetics, jewelry and autos.

On track to reach 10.5% growth forecast for 2006:As macro tightening softens domestic investment demand, strong exports and the expanding trade surplus have once again regained importance as a driver of growth. We believe that real GDP growth, having averaged 10.7% in the first three quarters, is on track to reach our 10.5% forecast for 2006. Meanwhile, Chinese producers are continuing to push output onto the international market. Our forecasts incorporate further expansion in China's trade surplus, to US$154 bn this year (US$110 bn in the first nine months), and US$178 bn in 2007. The current account surplus is expected to remain above 7% of GDP this year and next.

Enhancing controls in place; wait and see before more measures:With respect to whether further tough measures on the economy will be introduced, recent statements by Premier Wen Jiabao, NDRC Chairman Ma Kai, and Statistics Bureau spokesman Li Xiaochao today send a consistent message. While claiming the success of tightening policies so far, they all reiterated the need to maintain, and even strengthen, controls on the economy. In particular, Mr. Li stated that external economic conditions and trade data in the next few months will help determine the need for further policy moves.

Chinarolled out a wide range of tightening measures over the past few months, and the impact of such measures is just showing up in the latest economic indicators. The macro controls currently in place, in the form of raised barriers for market entry, stringent approval criteria for new investment projects, and strict controls on land use, should help contain the growth in capex. Inspection teams have been dispatched this week to 12 provinces to investigate and "clean up" investment projects that are not consistent with national economic planning. Cooling excessive investment should help ease the pressure on the environment and the supply of natural resources, and hence their prices.

We agree that tight controls need to be maintained to prevent overheating again. Excessive investment in China has been supported by the availability of low cost capital, made possible by the large balance of payments surplus over the past few years. China has continued to run surpluses on both the current and capital accounts, amounting to US$91.6 bn and US$37 bn, respectively, in 1H06. Capital inflows, sustained by the gradual currency appreciation and expectations for further advances, is one of the biggest determining factors for monetary conditions. In our view, the liquidity injection from capital inflows has been offsetting the impact of interest rate hikes, sterilization in the interbank market, and increases in reserve requirements, hence the need for such a complex combination of administrative and market-based measures in managing the economy.

The shift in China's policy focus from growth to rebalancing, restructuring and redistribution underlies our medium-term outlook for the economy. We believe that even if the government does not raise interest rates again in the near future, rates will need to head higher towards a more neutral level consistent with the pace of economic growth. This should enhance the efficiency in capital and resource allocation. Investment opportunities will likely come through sustained gains in domestic consumption over the long term, as opposed to exports and investment over the past few cycles.

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Wobbling and Waiting-- US Investors' Are Still Cautious on Japan
Oct 20, 2006

Robert Alan Feldman (Tokyo)

Travels though the East Coast and the Mid-West of the US this week have revealed an investor community that remains cautious in its views on Japan. There are a number of concerns that investors have, and thus a number of hurdles that need to be cleared before weightings in Japanese equities are raised again.

The first hurdle concerns the economic data. Investors are more sensitive than ever to monthly wiggles in the economic data. This concern about Japanese data may have been triggered by concern about the US economy, about which investors are more than usually divided. Regardless of the source of the concern, however, more consistency in Japanese indicators will be needed before investors can be confident.

Unfortunately, such consistency is not likely to emerge soon. Upcoming 3Q GDP data are likely to show a further deceleration, while the machinery orders, industrial production, and inventories data continue to display a “business wiggle” rather than a business cycle. (See “Doubts Fade, Hopes Grow,” Weekly International Briefing, Oct 10, 2006, Morgan Stanley).

That said the ups and downs of US investor sentiment appear to be dampening. At least compared to the gloom of mid-September, the current adverse wiggle of sentiment seems modest. Moreover, the fundamentals of business investment remain so strong that concerns about the sustainability of the business cycle should fade toward year-end.

A second hurdle is the BoJ. There is renewed debate over whether a BoJ rate hike might come within the year. Some slightly more hawkish rhetoric is coming out of the BoJ. In addition, growing impatience with the weakness of the yen is spurring expectations (especially in Europe) that a rate hike may be used to strengthen the yen and thus to ease protectionist pressures. Moreover, as the new Abe administration normalizes fiscal policy, some voices in the BoJ are calling for a parallel “normalization” of monetary policy.

In my view, the prospects for an early rate hike are weakening, not strengthening. If indicators continue tepid, price changes hover near zero, wages growth remains modest, and events in North Korea disturb markets, then the BoJ would be risking its reputation in both markets and political circles for the questionable gain of a small rate hike. Moreover, with Japan sitting on a mountain of unneeded foreign exchange reserves, it seems far more likely that the Ministry of Finance (MoF) would sell reserves as a tool to reduce protectionism than the BoJ would hike rates.

Third, the ability of the Abe Government to execute on reform agenda items is not proven. Yes, the Cabinet is solid. Yes, PM Abe appointed excellent members to the Council of Economic and Fiscal Policy (CEFP). However, no major economic issue has actually been resolved. Moreover, the Education Commission, which PM Abe appointed to draft a blueprint for his flagship issue of education reform, has a huge 17 members, with very diverse backgrounds. Such a large, diverse committee is likely to agree on little, and thus become a tool for bureaucrats to hijack the agenda. In addition, the government is (quite rightly) heavily distracted by the problem with North Korean nuclear weapons.

While I see some danger signs, these signs are most likely attributable to lack of experience. It is important to recall that PM Koizumi had trouble getting bureaucrats under control in the first two years of his administration, even with such huge issues as the bad loan problem. (Recall that PM Koizumi himself had to direct the Financial Services Agency to make “strict inspections” of bank loans to troubled borrowers, in order to prevent banks from under-reporting bad loans.) I think that the Abe Administration will learn fast. An important sign will be whether the Education Commission can be brought under control. If PM Abe himself steps in to do this, then the impression of strong leadership will be established in investor minds.

There are other actions that could convince investors that PM Abe is serious about reform and an open economy. For example, the issue of triangle mergers will re-enter the agenda soon. One problem is tax treatment. Unless triangle mergers involving foreign firms receive the same tax deferrals as those involving domestic firms, investors will see the government as reneging on its commitment to openness. The other problem is investor protection. Currently, Keidanren, the major business organization, is reportedly proposing the foreign firms undertaking triangle mergers in Japan be required to be listed on a Japanese stock exchange, in order for local investors to be sure that such firms are adequately sensitive to investor needs. In fact, however, such a listing requirement would effectively prevent such mergers, since very few foreign firms would want to take the trouble or expense to maintain a listing in Japan, just to effect a merger. If the Keidanren proposal is adopted, investors would likely see the government merely pretending to be open, but in fact bowing to local vested interests.

In short, investor concerns about economic indicators, the BoJ, and about the execution of reforms remain significant. I believe that events will prove most of these concerns invalid. However, time and evidence will be necessary before investors can make a final judgment.

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OECD Indicator Need Not Foreshadow a Recession
Oct 20, 2006

Takehiro Sato (Tokyo)

OECD leading indicator for Japan has nosedived since May

Japan’s standing in the G7 pecking order measured by the OECD’s leading indicator has been sliding since May. This contrasts with the leading indicator for the US, which has held up well in the face of slowdown concerns linked to correction in the housing market. There are some investors who read this as a sign that Japan’s economy is likely to be in retreat, but we do not share this view. Each component of the OECD’s leading indicator must be examined separately to get a proper perspective.

OECD leading indicator and economic cycle are not necessarily linked

Investors are keenly focused on the OECD leading indicator. According to the OECD, the rate of change compared with six months earlier is a leading indicator for countries’ GDP 6-9 months ahead. In Japan’s case, the index did do a fairly good job of predicting the onset of recessions in 1997-98 and 2000-01 and the timing of the ends.

However, in the current phase of economic growth that kicked in early in 2002, the rate of change compared with six months previously in the OECD’s leading indicator has been negative on three occasions, including the latest. The rate of decline this time is also larger than either the drop in the second half of 2002 or the drop in the first half of 2005. The reality, however, is that despite two lulls (in the first half of 2003, and between the second half of 2004 and first half of 2005), the economy has maintained a firm tone at least so far, with rotating growth drivers coming to the fore. This suggests that even if the index decline presages some slowing of Japan’s growth, this will not necessarily feed into a recession. And when we look at the background to this latest drop, our skepticism is reinforced.

Stock market declines and narrowing long-term/short-term interest rate gap account for most of the drop

In Japan’s case, the OECD looks at the following seven measures of the economy when formulating its leading indicator:

(1) Inventory to shipment ratio of the manufacturing and mining, (2) export/import ratio, (3) loan to deposit ratio, (4) overtime hours in manufacturing industry, (5) housing starts, (6) TOPIX, and (7) spread between long- and short-term interest rates.

It is the last three elements — housing starts, TOPIX and interest rate spreads — which appear to have led to the decline in the leading indicator since May. Data for the first four measures show, respectively, progress with a minor bout of inventory adjustment, strong exports, a halt to the decline in bank lending, and an increase in overtime hours, indicating that the performance of the manufacturing-based economy is actually solid. We estimate that the OECD leading indicator decline can be attributed almost entirely to the stock market correction between May and July and the narrowing of the gap between long- and short-term interest rates resulting from the end of ZIRP (zero interest rate policy).

It is debatable whether stock prices are a genuine leading indicator for the economic cycle, but they are generally regarded as foreshadowing the economy by about six months. Under this view, the sharp market correction from mid-May can be seen as an accurate pointer to the subsequent stagnation in Japan’s GDP. However, the floor for the stock market has been gradually rising from a bottom in mid-July, in line with our scenario, as expectations for corporate earnings revisions perk up. Judging from the past, as outlined above, this GDP weakness could also be a blip.

There is also some circularity in technical discussion of stock market direction based on an OECD leading indicator that includes the stock market level as one component. It makes little sense to argue that a drop in this indicator spurred by a market decline means the market is going to drop further.

In the particular case of Japan, the inclusion of the long- and short-term rate spread as an index component is also problematic. This gap has narrowed from a peak of about 1.8pp in April to about 1.2pp in August. The background to this was a rise in short-term rates up until July as the removal of ZIRP was being anticipated, and then a drop in long-term rates in August accompanying the CPI shock.

The question to answer is whether these factors sending interest rates up and down have any meaningful implications for risk to the economy. The spike in short-term rates was a move to discount the BoJ’s decision to end ZIRP, and a development that was basically consistent with steady expansion of the economy and prices. The decline in long-term rates, meanwhile, was an overreaction by the market to the startling impact of the once-in-five-years statistical benchmark revision of the CPI, an event that was divorced from the economy’s fundamentals. Long-term interest rates sank close to 1.6% in the CPI shock aftermath but have moved back up to the pre-shock level of 1.8%, so the decline was temporary. The answer to our question — does the narrowing spread between long- and short-term rates ring alarm bells for the economy? — is a clear “no”.

The OECD leading indicator may be revised up ex post facto

Turning our focus to the future, economic indicators since August have been mixed, but point to a pick-up from July overall. The most recent September data, such as the BoJ Tankan and Economy Watchers Survey or department store sales, which provide the most up-to-date picture, have either come in stronger than expected or shown an improvement, and the pessimism infecting the stock and bond markets in the summer is now clearing. If history is any guide, the OECD leading indicator may well be revised up ex post facto, and this too should help correct undue investor pessimism. It should be noted that this indicator is frequently revised retroactively, and ends up very different from its initial form.


Nothing should be taken for granted, however. We are concerned the July-September quarter GDP (TBA: Nov. 14) may be sluggish just like April-June quarter GDP, mainly due to slack personal consumption amid poor weather and stagnant wages. This would make the OECD indicator decline consistent with faltering GDP. However, the pick-up in sentiment since September argues for a recovery to some extent in October-December quarter GDP (available in mid-February). That should quash speculation that Japan’s economy is in retreat.

Important Disclosure Information at the end of this Forum

JPY Is Bottoming; A Forecast Update
Oct 20, 2006

Stephen L. Jen (London)

Summary and conclusions

We believe that the JPY is likely to be forming a bottom, against both the USD and the EUR, and continue to expect the JPY and other Asian currencies to outperform both the USD and the EUR in the coming year.  However, the JPY’s weakness in the past four months has surprised us and, in this forecast update, we are marking-to-market our near-term JPY forecasts, while retaining our long-term bullish view on the JPY. 

Our year-end targets are 1.24 for EUR/USD (which has been our target since November 2005) and 116 for USD/JPY.  For end-2007, we expect to see further EUR weakness (1.20) and JPY strength (108). 

Our forecast changes

The biggest revisions involve the JPY.  We did not anticipate the depreciation in the JPY since May of this year, as we had held the view that improving economic fundamentals in Japan and the soft landing in the US would allow the undervalued JPY to strengthen.  At the same time, since May, EUR/JPY drifted gradually and steadily higher, surprising us. 

Our end-2006 USD/JPY forecast is raised from 112 previously to 116.  For 2007, we are now targeting 108 for USD/JPY, compared to 102 previously. 

Thoughts on the JPY

The JPY is very weak, both by historical standards and relative to Japan’s economic fundamentals.  In REER (real effective) terms, the JPY is as weak as it was on the eve of the Plaza Accord in September 1985.  Its fair value, however, may be 20% stronger than where the spot rates are.  In fact, as an index, the JPY may be more under-valued than the Chinese RMB. 

We believe that the JPY is approaching a bottom against both the USD and the EUR.  I have five thoughts: 

1. Large cash differentials have affected currency hedging.  These cash differentials between Japan, the US and Euroland may have encouraged non-Japanese investors to run a high currency hedge ratio, and Japanese investors to run a low currency hedge ratio, particularly when FX volatility is so extraordinarily low.  Since these hedge ratios are adjusted for the entire stocks of Japan’s US$4.3 trillion worth of foreign assets and US$2.2 trillion of its foreign liabilities, changes in the policy rates of the Fed, the ECB and the BoJ could have quite significant effects on USD/JPY and EUR/JPY.  

Going forward, I believe that the Fed-ECB-BoJ yield spreads will most likely narrow.   Governor Fukui’s comments suggest that the BoJ is very much on track to tighten rates further in December.  A soft landing in the US will ultimately be negative for the dollar, and EUR/JPY should fall because it is massively over-valued.  At the same time, I expect currency volatility to rise to undermine the attractiveness of carry trades. 

2. ‘Global Funneling’ has penalized the JPY, but this process may weaken going forward.  There is what I call a ‘Global Funneling’ process at work, whereby oil export receipts and Asia’s trade surpluses are funneled exclusively into USD, EUR and GBP assets.   Financial globalization has benefited primarily the currencies of countries with developed financial markets.  As long as Asia and the oil exporters keep running large balance of payments surpluses, the JPY may stay under-valued. 

Having said the above, lower oil prices should weaken the Global Funneling process.  Further, Asian central banks are also likely to slow down the pace of their reserve accumulation, and direct the new reserves into sovereign wealth funds, which should be less concentrated in the USD, EUR and GBP markets. 

3. A decline in Japan’s ‘home bias’.  Demographics may have led to a decline in the ‘home bias’ of Japanese investors.   It is still difficult to prove this point, but there is ample anecdotal evidence that Japanese investors’ willingness to take on foreign currency risk has increased in the past year.  While the trend of financial globalization is not unique to Japan (for example, we’ve seen US real money managers diversifying out of the US in the past three years), the fact that Japan has for a long time had a very high ‘home bias’ and that Japan’s savings pool is a massive US$15 trillion, means that small diversifications may have significant consequences for the JPY.  

While demographics-motivated capital outflows may persist, I am less sure that these flows will be as large as those we have witnessed so far this year, at this level of weak JPY.  Further, net equity withdrawal from Japan by non-Japanese investors is abnormal, in my view, given the outlook of the Japanese economy, and the healthy risk-taking attitude of global investors.  I expect equity inflows to resume, helping to counter-balance the capital-leakage from Japan. 

4. Russia’s decision to start to accumulate JPY reserves could be important.  I suspect this is an important event.  Central banks, in the aggregate, have been steadily reducing their exposure to the JPY.  The JPY’s share, in percent of total world reserve holdings, has declined from 6.5% in 1999 to 3.6% by end-2005.  As of 2Q06, this share has declined further to 3.3%.  The aversion to JGBs — central banks usually hold reserves through sovereign debt instruments — is understandable, given Japan’s parlous fiscal state and the low yield.  However, there are several reasons why I suspect this trend in declining JPY holdings may be coming to an end. 

First, the JPY is still a G3 currency.  It is difficult to say what level of exposure is appropriate for central banks, but I suspect 3.3% is just too low.  Second, the JPY is weak, which means JPY assets are cheap.  Russia may have made a very wise bet on the JPY — wiser than its decision to buy EUR/USD in the high 1.20s and low 1.30s.  While other central banks may or may not follow Russia’s decision, I believe it is quite a telling sign that investors in general are aware of the fact that JPY assets are very cheap.  Third, if I am correct that much of the reserves in the world will evolve into ‘sovereign wealth funds’, more GIC-ADIA-like funds will be able to invest in Japanese equities, not just the JGBs.  Including Japanese equities in the universe of investable assets for foreign official entities, the current 3.3% exposure is definitely too low. 

5. The MoF and the BoJ are increasingly uncomfortable with the weak JPY.  The JPY is weak against the EUR, the USD and the KRW, and Japanese exporters have clearly benefited from the windfalls.  However, Japanese exporters don’t need a weak JPY; they would be very profitable even with a stronger JPY.  Excessive JPY weakness could attract unwanted political attention from foreign governments, which may lead to a number of complications that Japan could live without.  I don’t think the MoF is considering actual interventions, but gentle verbal interventions may have already started. 

US dollar still in a holding pattern in the coming weeks

The path of the US economy is still not definitive enough for the dollar to exhibit a clear trend.  In 2Q and 3Q, the US economy indeed grew below trend, but it may reaccelerate in 4Q.  For 2007, growth is likely to be slightly below potential, but higher than we witnessed in the middle of this year.  There is, however, considerable uncertainty regarding both the output path and the inflation trajectory.  What we strongly believe in is that the US will not fall into a recession in 2007 (we see only a 20% probability of recession).  However, the ‘wiggles’ in the US GDP are still very difficult to forecast.  The dollar may remain in a holding pattern in the coming weeks.  I see EUR/USD and USD/JPY lower by year-end, but don’t see a big story for the USD index for the next three months.   

EUR should steadily trend lower

EUR/USD and EUR/JPY remain over-valued, in my view.  I suspect that there are still a lot of stale EUR longs, established in the past two years because of the fear of a dollar collapse.  Regular readers of my work should know that I have strongly argued against the view that a large US C/A deficit would lead to a sharp dollar correction or a dollar collapse.  The fact is that the infamous US ‘twin deficits’ are turning: the US fiscal balance continues to improve and the US C/A deficit may have already reached its peak, in percent of GDP.  The inability of EUR/USD to rise on the back of superior 2Q growth data of Euroland is indicative of how ‘long’ the market is in EUR/USD. 

We believe that EUR/USD will gradually drift lower in the coming year or so.  Euroland’s growth will likely slow due to Germany’s VAT.  Further, the ECB will likely enter a period of greater uncertainty as it pauses.  As was the case with the Fed this summer, the ECB’s credibility will be tested and the EUR could be exposed to some downside risks.  The prospective growth slowdown and the ECB’s pause could expose the latent structural EUR longs.

We have had the year-end target for EUR/USD of 1.24 since November 2005, and still believe that it is an appropriate forecast.  Implicit in our 1.20 target for 2007 is our view that Euroland may slightly outperform our European economists’ forecast of 1.5% growth.  However, in the event that German VAT proves to be as damaging for Germany’s consumption as our European economists now believe it will be, the risks to EUR/USD are biased to the downside. 

Chinese RMB to underperform my aggressive target

It is quite unlikely that my long-standing target of 7.50 for USD/CNY will be achieved.  The period of inaction by Beijing from April to June of this year was precious time lost.  I do believe that Secretary Paulson’s approach is very well received by Beijing and the rate of crawl of USD/CNY will remain high.  This prospective CNY appreciation should not be seen as a tool for macro stabilization.  Rather, it should be interpreted as a way in which China could buy ‘insurance’ against protectionist measures from the US and other countries.  In the 110th Congress, it is likely that protectionism will be a bigger issue than it has been so far.  The Grassley-Baucus bill could easily degenerate into something that is more protectionist in nature.  China will likely guard against this risk by allowing the renminbi to appreciate, in my opinion. 

Beyond the CNY, we continue to have a constructive view toward the AXJ currencies.  If the global economy only soft-lands, and risk-taking is preserved, Asian currencies should outperform both the USD and the EUR, in our view. 

Commodity currencies to weaken

We continue to maintain the assumption that the global economy will only soft-land in 2007, from 5.0% growth this year to 4.2% in 2007.  The US and China will take the lead.  Commodity prices should decline modestly, and the commodity currencies should weaken.  We have not altered our forecasts for USD/CAD, AUD/USD and NZD/USD. 

Bottom line

We have updated our forecasts.  Our basic thesis remains unchanged: against a benign global backdrop, USD/Asia and EUR/Asia should trend lower.   We have been surprised by the JPY’s weakness in the past three months, and are marking to market this development.  However, we believe that the JPY is forming a bottom against both the USD and the EUR.

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