When Atlas Sneezes
Oct 26, 2006
Serhan Cevik (London) and Katerina Kalcheva (London)
A slowdown in America — an Atlas of our times — also threatens growth in the rest of the world. The global economy has performed exceptionally well in the past five years, growing at about 5% on average, even against higher commodity prices and geopolitical constraints. However, a dramatic slowdown in the US — one of the most critical pillars of the global economy — may result in a disorderly unwinding of global imbalances and a sharp correction in international trade. Although there are some signs of the weakening of aggregate demand, our baseline forecasts still suggest a continued robust output growth in the US as well as in the global economy. According to Morgan Stanley projections, there will be a mid-cycle correction in real GDP growth from 3.4% in 2006 to 3% next year in the case of America and from 5% to 4.2% for the world economy. However, even with a negligible likelihood of recession in the foreseeable future, there are certainly more clouds on the horizon than there were a year ago. This is why we want to quantify the sensitivity to growth volatility in the US of a group of countries in the Middle East and North Africa region with different economic and financial endowments.
Decoupling from a slowdown in the US is just a wishful thinking, in our view. The global economy may be on a stronger footing, but a disturbing range of imbalances make financial systems, especially in developing countries, vulnerable to sudden changes in sentiment and risk appetite. Take, for example, the first six months of this year, when market participants worried about runaway inflation and higher interest rates. Then, over the summer, with a marked slowdown in the US housing market, the fear of recession started dominating investors’ psyches. Even though recent data releases suggest a more benign rebalancing in the global economy and financial markets, investors are still like a cat on a hot tin roof, getting nervous about the fear of contagion from one country to others. Albeit exaggerated now and then, this is not a risk to be underestimated. The US is of course not the only engine of global growth, and other countries have already become almost as important as the American consumer, who is responsible for more than 15% of all spending in the world. Nevertheless, no country can escape a significant slowdown in the US economy; and the consequences of global rebalancing may pose disproportionate risks to the developing world. The composition of economic slowdown matters for spillover effects. Sentiment plays an important role in shaping expectations in today’s global network of financial markets and driving capital flows around the world. Therefore, how market participants feel about financial prospects matters for the degree of contagion as well as for growth performance. However, we want to focus here more on the trade-and-growth link among countries. Although this is actually the most straightforward transmission channel of contagion in the global economy, there is still widespread misunderstanding about the consequences of an economic slowdown in America. For example, many observers argue that emerging economies like Turkey are significantly more vulnerable to a slowdown in the US. But is that really the case? The best way to see what happens when Atlas sneezes to the world (or the Middle East in this particular case) is to run some regressions. Turkey is less vulnerable to a slowdown in the US, compared with the rest of the region. Countries with greater trade exposure to the US tend to have their growth rates highly correlated with the US economy. Therefore, as total exports from the Middle East to America surged from an annual average of US$19.1 billion in the 1990s to US$63.1 billion in 2005, the region has grown more sensitive to the US business cycle. However, since higher oil prices are the key factor behind exponential export growth, we should use disaggregated data, especially when estimating the sensitivity of oil importers in the region. Let us start with the much-debated Turkish case. Exports to the US accounts for 6.5% of Turkey’s total exports, even after increasing by 410% since 1990. With Europe as the main trading partner accounting for almost 60% of its international trade, Turkey has a limited direct exposure to the US economy. Indeed, correlation coefficients reveal that there is no significant interdependence between output growth in Turkey and the US, which is also confirmed by t-test estimations. With one-third of exports going to America, Israel is more sensitive to the US business cycle. Our analysis (assuming that the data are coming from similar distributions and have equal mean) shows that the variance of Israel’s output growth is highly correlated with the US economy. Increasing dependency is a risk to Israel’s export-led growth, but one also needs to consider the changes in the composition of aggregate demand before reaching a conclusion on the degree of contagion. For example, countries like China that predominantly service consumer markets are more vulnerable to a consumer-led US slowdown than a country like Israel specialising in technology-intensive capital goods and services. Of course, no country in the world can sustain business investment growth against a marked slowdown in consumer spending. Therefore, Israel’s export performance may eventually suffer a setback if America experiences a sharp worsening in economic activity across the board. The commodity channel makes oil-exporting countries highly sensitive to global growth. The global commodity boom has led to unprecedented wealth creation in oil-exporting countries in the Middle East. With oil prices soaring from US$25 a barrel in 2002 to US$53.4 last year and US$66.5 in 2006, export revenues of oil producers surged from US$251 billion in 2002 to US$593 billion in 2005 and US$780 billion this year. However, there is a dangerous vulnerability behind this veil of oil wealth. The commodity channel that has led to a cumulative current account surplus of 25.5% of GDP also makes the region’s oil-exporting countries highly sensitive to the global growth cycle. Our calculations show that correlation coefficients for output growth in Saudi Arabia and the United Arab Emirates vis-à-vis the US economy increased from -0.69 and -0.08, respectively, in the 1990s to 0.74 and 0.85 in the last five years. Of course, there is yet another interconnected channel — the recycling of petrodollars — that affects trade and capital flows of non-oil countries in the Middle East and beyond. For example, Egypt has long benefited from the region's higher oil revenues and become even more correlated with the US. Therefore, a major slowdown in the global economy would lower commodity prices and have negative effects on the region’s economic performance. Emerging economies are linked internationally through volatile financial flows. We should admit that our two-country estimates are less than satisfactory to analyse dynamic linkages in the global economy. A negative shock in one country may well be absorbed by the greater contribution of another. Indeed, while the US is likely to experience a mild correction in growth, other regions (like Europe and Asia) are expected to remain on track. Even oil-exporting countries in the Middle East are unlikely to suffer a major downturn, as long as oil prices stay above US$30 a barrel. On the other hand, given the overwhelming presence of the US in the global economy, no country (or region, for that matter) can decouple completely from a significant downturn in America. This is why risks to global growth and commodity prices are on the downside. Furthermore, the recycling of petrodollars through financial markets has contributed to the unusual phenomenon of low long-term interest rates and thereby robust growth against the oil shock. As a result, we are more worried about the volatility of financial flows that may trigger unexpected ‘accelerator’ effects and a vicious cycle of low growth (see Carried Away, September 27, 2006).
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Monetary Policy Hostage to Cell Phone Rates?
Oct 26, 2006
Takehiro Sato (Tokyo)
Still suffering the after-effects of the CPI shock The announcement of call rate cuts by the mobile phone industry’s third-largest player is making waves. This kind of strategic reduction in utility charges (as broadly defined) is symbolic of improved productivity in the economy as a whole emanating from the quasi-public sector, and of the resulting persistence of pressure to hold down prices. As such, it comes as no surprise to us, given our belief in super-stable prices amid ‘a quiet productivity revolution’. We expect such moves to occur with increasing frequency relating to not only mobile phone charges, but other areas like fixed-line charges and electricity/gas charges too. Nevertheless, since the aforementioned cuts were announced, we have been inundated with questions from both domestic and overseas investors regarding the likely impact on the CPI. It appears that the market is still feeling the effects of the CPI shock in August. We take this opportunity of summing up our house view, both for the short term and for the medium-to-longer run. Short-term impact (1) The consumer price survey looks at retail prices for individual items in 167 urban communities of varying sizes throughout Japan (the usual prices for which items are actually sold), obtained as a rule from the retail price survey data. These retail prices are as of the middle of each month (as recorded on either the Wednesday, Thursday or Friday of the week containing the 12th day of the month). The main point about the above is that these are ‘usual’ retail prices. In other words, the mobile phone charges everyone is talking about now are part of a campaign for subscribers with a limited period from October 26 to January 15 and therefore may be a form of special sale prices that would not ordinarily be reflected in the retail price data. If these discount charges were to be classified as special sale rates applicable for specific selling dates, then by their very nature they would not have any effect on the consumer price data. When we asked the Ministry of Internal Affairs & Communications (MIC) statisticians about their understanding of this matter, we were told that they were currently looking into it. Right now, therefore, it is unclear whether the charge cuts will be reflected in the data at all. Short-term impact (2) Assuming that the new rate tariffs were reflected at some stage, the next questions are when, and to what extent, this will be. On this point, the understanding of MIC’s statisticians is that, assuming that the new charges are reflected in the index at all, it would be from the release of data for November (i.e., the Tokyo figures for November) at the earliest. According to MIC materials, prices for mobile phone charges covered in its survey are based on its selection of the three companies with the largest number of subscribers, and for the three patterns of monthly usage (20 minutes of calls/4,100 packets, 200 minutes of calls/11,300 packets, and 660 minutes of calls/23,400 packets) on the rates in the cheapest plans at each individual company. This being the case, the part about the ‘cheapest plans’ is surely a key point. In other words, even if the new rates are a form of special sales rates, if these are continued after the campaign period has ended they are likely to have to be recognised as rate tariffs in continuous application. Consequently, we see a certain rationale in the view that they could be applied in the data for Tokyo from November at the earliest. To look now at how much of an effect this may be expected to have…unfortunately (if that is the right word), the impact is likely to be so small as to be negligible (charge cuts of 2% (assumed) x mobile phone charge share of nationwide consumer prices, i.e., 208/10,000 x 16% share of this particular telecom company, so working out at less than 0.01%). Moreover, discussing one of the new payment plans, our telecom industry analyst says “The plan looks cheap at first, but there are separate call and data service charges. If the services with extra charges total ¥3,000, for example, the effective cost would be about ¥6,000/month.” Thus, our analyst’s view is that the new charges may not be so low after all. While it is unclear which particular payment plans the MIC will actually use as model plans, even if it were to use these new payment plans, we think the impact on the consumer price data would be minuscule. Of more significance — and severity — is the impact of the drop in landed oil prices on prices of gasoline and other energy forms. Medium-to-longer-term impact We think the impact lower rates are likely to have in the longer term is very clear. Probably what telecom carriers want to avoid most is a game of chicken arising from price-cutting competition. However, it is also true that price cuts can be the fastest means of securing share. In fact, the operator making the cuts discussed here has pledged to cut its prices further in the event of a competitor lowering its rates. Ultimately, it seems likely that eventually all carriers will become embroiled in discounting competition. Nevertheless, with regards to when that might be reflected in the retail price data, looking at the past pattern we think that the MIC is likely to retain a certain amount of discretion. Looking at how discounted telecom charges have been handled in the consumer price data in the past, there have been two examples in the last two years of sudden changes in the handling of rate samples and of discount rates not being reflected immediately, however quickly the discount rates penetrated. The first pertained to fixed-line call charges in November 2004, and the second to mobile phone charges in July 2006 (with the actual impact made retroactive to November 2005). So why was it that in both cases the new charges were applied from November? This may have been a simple coincidence, though it remains a puzzle. Moreover, since the MIC’s review of its sample took place considerably later than the actual price cut, a sudden fall in the CPI occurring at a time when the event of the charge cut itself had largely passed out of mind generated a veritable panic among market participants. We cannot say with conviction that a similar event would not occur in the future. We anticipate a spate of similar moves regarding not only mobile phone charges but other utility-type rates (fixed-line phone charges, gas/electricity rates, etc.) going forward. Thus, while the short-term impact may be very slight, the medium-to-longer-term effects could be something to be reckoned with. Implications for monetary policy The markets have reacted unexpectedly sharply to the news of the mobile phone rate cuts, but to us this looks like an overreaction. The basic policy stance of raising interest rates should not change even if lower utility charges or oil prices hold the core inflation rate close to zero percent. It is easy to misunderstand the effects of a monetary policy that is guided by core inflation, as we have become used to the backward-looking policy framework in place in the era of quantitative easing. The important point is that alongside abandonment of quantitative easing, the BoJ is moving towards a forward-looking framework based on two perspectives. This means that the latest inflation reading need no longer be decisive. It all boils down to how the BoJ views the future headline inflation number and the trend for asset prices. We should understand that the free hand of the BoJ will not be compromised significantly even if prices continue to lack buoyancy due to declines in broadly defined public utility charges and oil prices. Following the reasoning above, we now see the BoJ as positioned to make a second interest rate hike at the January monetary policy meeting, in the earliest case. We have opted for January specifically rather than the January-March quarter as before: corporate sentiment and profit projections in the December Tankan are likely to improve in line with the BoJ’s expectations, the sizable pick-up in net external demand could push July-September GDP above our cautious reading, and October-December GDP is poised to bounce back from the previous quarter, and to show comparatively favorable data for domestic demand-related components. The ideal situation for the BoJ would be for the market to discount for another rate hike automatically in response to these encouraging economic fundamentals. Conversely, the BoJk would not be favored if the market over-discounts for higher interest rates and creates pressure for further hikes. Whether the BoJ will wait until the February meeting after the announcement of October-December GDP is becoming a concern. Any hole in the above scenario would be more likely to come from political event risk rather than the economy. For example, the furore over the BoJ governor’s personal investments seems to have died down, but could flare up again at any time while the Diet is in session.
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September Production Higher than Expected
Oct 26, 2006
Deyi Tan (Singapore) and Chetan Ahya (Singapore)
September production rise higher than expected ... Industrial production rose 7.6% YoY in September after the 5.2% YoY seen in August. For 3Q06, industrial production expanded by 10.6% YoY, a slight moderation from 12.7% in 2Q06. Nonetheless, this is higher than the 10.0% in manufacturing production growth expected by the government in its advance estimate statement earlier this month. This represents an upside risk of 0.2%-pt to the 7.1% 3Q06 advance GDP growth estimate, all things equal. ... but Electronics and Biomedical cluster data not that bullish. While the headline accelerated, industry cluster data paint a less bullish picture. Electronics expansion decelerated further to 0.8% YoY (versus +7.2% in August and +5.9% in 3Q06). Except for semiconductors (+22.0% versus +35.2% in August) and consumer electronics (+12.3% versus -4.5%), other electronics sub-segments contracted. Performance in the biomedical segment was also subdued at 0.1% (versus -18.0% YoY in August) due to the high base a year ago. Pharmaceuticals rose 1.0% YoY (versus -21.5%). Medical technology contracted 10.6% (versus +14.5%). Transport engineering led the September acceleration. Transport engineering rose by a strong 45.7% YoY (versus +26.6% in August) and was the only other industry cluster, other than chemicals (+4.1% YoY versus 0.4% in August), to register an acceleration. The strong performance was on the back of the 60.8% YoY (versus +28.4% YoY) rise in marine and offshore engineering.
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A Hike Too Far?
Oct 26, 2006
Gerard Minack (Sydney)
Today’s higher-than-expected CPI solidifies the case for another RBA rate hike. But another hike will exacerbate to the downside risks to growth in 2007, in my view. All the important inflation measures are now at, or above, 3%. The headline CPI increased by 0.9% in the September quarter (0.7% expected) to be 3.9% above year ago levels. The RBA-calculated measures now sit at 2.9% (trimmed mean) and 3.2% (weighted median). The case for another rate increase at the November RBA board meeting now seems solid, although not overwhelming: - Inflation pressures are intensifying even after excluding obvious one-offs (such as another big jump in fresh fruit prices, which added 0.3% to the 0.9% quarterly rise in headline inflation).
- The market expects a move (a majority of market economists expects a November hike, while short-end futures are pricing in a 90% chance of a move by year-end).
- Partial growth indicators — notably employment and lending — continue to surprise on the upside.
The principal reason for the RBA not tightening is that GDP growth has already slowed. Slower growth almost always leads to lower inflation — but with a lag. The recent softer GDP data point to inflation moderating in coming quarters. Having said that, RBA Governor Glenn Stevens has questioned whether the recent slowdown in GDP can be reconciled with the recent strength in employment — or if both series are correct, then that implies a major step-down in productivity growth, which itself is a worry for inflation. On balance, therefore, I expect that the RBA will increase the cash rate target by 25bp to 6.25% at the upcoming Board meeting. I remain very bearish on growth for next year. Another RBA rate increase is not critical to my pessimism, but obviously every additional tightening supports my view that the risks to growth are greatly slanted to the downside. The key elements of my low growth forecast are the ending of the investment contribution to GDP growth; a tepid consumer; and the impact of the drought. Overlaying that is my view that the RBA is likewise aiming to ensure that growth remains at a moderate, non-inflationary pace next year. However, the real test of my views will come when the growth slowdown leads — as it inevitably will — to labour market softness. My view is that even a moderate labour market deterioration will put intense pressure on the state of household finances. The RBA may be aiming (as always) for a controlled soft landing, but I still think that the landing will be fairly hard.
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