Disconnects
Nov 06, 2006
Stephen S. Roach (New York)
We’re all data junkies. When a number comes out that supports our position, a rush of self-gratification courses through the veins. That’s true of investors looking at earnings reports, as well as economists looking at economies. Never mind that the data, by definition, offer backward-looking insights into forward-looking views. Never mind the quality of the data either -- an increasingly serious problem with today’s information flow. In today’s mark-to-market world, when the screens flash with a new piece of information, we react first and ask questions later. It’s the reality TV of world financial markets.
This is less of a gripe and more of a plea to take a deep breath. Deciphering the incoming data flow is as much art as science. Yet, for those of us wedded to an analytical approach, only the data check can keep us honest. My own approach continues to stress two key issues in the global macro debate -- America’s post-housing bubble shakeout and China’s lack of policy traction. On both counts, the latest data depict “growth friendly” outcomes. Yet in each of these cases, the analytics still provide considerable pause for thought. One way or another, I suspect these disconnects should be resolved in the year ahead. Most bulls on the US economy -- with the notable exception of Dick Berner -- have concluded that the worst is now over for America’s housing recession. Former Fed Chairman Alan Greenspan, who has a fair amount of reputational skin in the game in this one, has recently led the charge in that regard. September’s bounce in housing starts and home sales offers a couple of data blips in support of that conclusion. But with inventories of newly sold homes still 14% above year-earlier levels, that conclusion may be a bit premature. In fact, I would argue that the recession in homebuilding activity has only just begun. While residential construction expenditures -- the ongoing progression of homebuilding projects -- have declined at a 14% average annual rate in the two middle quarters of 2006, this has unwound only 27% of the record run-up that occurred over the past decade. This limited decline should hardly be surprising -- construction activity almost never turns on a dime. In most cases -- Thailand being a notable exception in 1997 -- builders tend to complete the pipeline of previously initiated projects even as the outlook sours for new construction. That tends to support employment in the homebuilding sector long after the demand underpinnings of the cycle have turned. The latest trends in the US labor market bear that out. Since peaking in February 2006, employment in the homebuilding sector -- namely, residential building and residential special trade contractors, combined -- has contracted by a mere 2.8%; this reverses only 12% of the outsize run-up in hiring that occurred in these industries since early 2001. In other words, the homebuilding sector is still basically staffed for the boom. As existing projects are completed, I suspect there will be a sharp fall-off of headcount in this once frothy industry -- with important implications for the state of the overall labor market, income generation, and personal consumption. The employment response of the homebuilding sector is a microcosm of a key macro characteristic of the US economy -- that the hiring shoe is typically the last to fall in a cyclical adjustment. Understandably, companies take the high fixed costs of hiring and firing quite seriously; distrustful of forecasts of the future and more sensitive to their own reality checks, businesses are slow to rehire in an upturn and equally reluctant to reduce headcount in a downturn. Current employment trends reflect just such a recognition lag. The disconnect comes when financial markets treat the lags as a counter-trend. That has certainly been the case in the aftermath of the past two labor market reports -- weak preliminary estimates of hiring in both September and October, accompanied by massive upward revisions to earlier months. In my view, either one of two explanations to the data-analytics disconnect is possible: The GDP is dead wrong and will be revised sharply upward from the sluggish 2.1% average annual pace of the two middle quarters of 2006, or it will just be a matter of time before this growth-recession-like outcome elicits the typical lags of the hiring response. My sympathies are with the latter line of reasoning. I do not believe that the same risk-averse US businesses that have been hoarding cash and holding back on capex for the past six years are suddenly throwing caution to the wind and loading up on high-cost labor at precisely the point when the cyclical debate is more contentious than ever. Halfway around the world, there is another very important disconnect -- Beijing’s response to a runaway Chinese investment boom. For the fifth time this year, the People’s Bank of China has followed the conventional counter-cyclical stabilization script and tightened monetary policy in an effort to cool off a white-hot economy. The latest action -- a third increase in bank reserve ratios in 2006 -- follows two earlier increases in overnight lending rates. This approach is not working. Bank lending growth for new renminbi loans held at 15.2% y-o-y in September -- down only fractionally from July’s peak 16.3% increase; moreover, total loan creation in the first nine months of this year has now exceeded the central bank’s full-year target by 10%. Yes, the growth rate of fixed investment is receding a bit -- decelerating from a peak comparison of 33% y-o-y in the second quarter of 2006 to 24% in the third period. But for a sector that rose to 45% of GDP in 2005 and could well climb to 50% this year, there is nothing comforting about a 24% growth outcome. It still speaks of a China that is headed toward massive capacity overhangs, with attendant risks of deflation. There are two dimensions of the China disconnect -- the first being a policy strategy that is at odds with the structure of the Chinese economy. The central bank has not achieved policy traction, in large part, because its actions do not filter down to the provincial and village levels; consequently, the autonomous lending practices of local branches are not influenced heavily by adjustments made by the People’s Bank of China at the national level. That China’s four large banks have long been in excess reserve positions further complicates the monetary control exercise. Moreover, with State ownership still controlling at least 35% of Chinese GDP directly and a considerably larger portion indirectly through government ownership of unlisted shares, macro control remains very much in the hands of China’s modern-day central planners -- namely, the National Development and Reform Commission. The NDRC issued a series of administrative edicts earlier this year aimed at targeting investment excesses in several overheated sectors -- aluminum, cement, steel, coal, glass and other building materials, motor vehicles, and residential property. Yet the latest trends in bank lending and investment underscore a profound lack of meaningful progress in the all-important area of Chinese macro control. A second aspect of the China disconnect comes in the form of its implications for the rest of Asia and the broader global economy. This goes back to the decoupling debate that I recently addressed (see my 30 October dispatch, “The Fallacy of Global Decoupling”). Once again, the unflinching vigor of the Asian economy is being taken for granted. The same is true of the commodity super-cycle. In my view, these conclusions are highly conditional on the Chinese growth outcome. If Beijing finally delivers on the slowdown front, I suspect there will be a quick and severe markdown of the economic outlook for Asia and the commodity complex. The case for a cooling off of the Chinese economy remains compelling: Ever-mounting imbalances in an investment- and export-led economy raise the odds of the dreaded hard landing that would seriously threaten the most important objective of China’s reforms -- social stability. Ultimately, the questions boil down to determination, leadership, and control. In that vein, the internal politics of China may well hold the key. The recent arrest of Chen Liangyu, Secretary of the Shanghai Communist Party and member of the Politburo, sends a strong signal that Beijing is getting more serious about challenging the regional fragmentation of its centralized cooling off campaign. At the same time, the resurfacing of Ma Kai, Chairman of the NDRC and China’s head central planner, sends an equally strong signal that macro control by administrative edict is likely to intensify. Recent tax increases (effective November 1) on selected Chinese commodity exports -- namely, alumina, copper, coal, and steel -- up the ante in this regard. In China, the disconnect boils down to making the macro call on the basis of the efficacy of countercyclical stabilization policies or the administrative edicts of central planning. My vote remains with the latter. I continue to believe that the Chinese leadership is about to up the ante on its cooling-off campaign. Disconnects always seem to have a way of coming full circle in resolving the macro debate. This is where the analytical approach has the advantage over the data-dependent approach. The risk, of course, is that we get the analytics wrong -- or that old relationships are rendered inoperative by new developments. Notwithstanding those risks, I still think it pays to focus on America’s post-housing bubble shakeout and on the staying power of the Chinese investment boom as the two most important moving pieces in the global economy. If both of these engines slow, as I suspect, a year from now the world will be in a very different place than it is today.
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The Two-Tier Economy
Nov 06, 2006
Richard Berner (New York) and David Greenlaw (New York)
Forecast at a Glance | | 2005A | 2006E | 2007E | Real GDP | | 3.2% | 3.3% | 2.9% | Inflation (CPI) | | 3.4 | 3.3 | 1.9 | Unit Labor Costs | | 2.0 | 4.8 | 3.5 | After-Tax “Economic” Profits | | 5.5 | 19.4 | 1.8 | | After-Tax “Book” Profits | | 32.6 | 17.0 | 0.5 |
Source: Morgan Stanley Research E = Morgan Stanley Research Estimates A two-tier economy has emerged: Housing and Detroit are in recession, but the rest of the economy appears to be growing strongly. No doubt, pessimists will dismiss that delicate balance as a fleeting pause before decelerating home values force an asset-dependent American consumer to retrench (see “The Great Debate,” Global Economic Forum, November 3, 2006 for the pros and cons of this debate). While we do not buy most of the doomsayers’ logic, much less their gloom, we’ll concede that some of the evidence has lately gone against us. Second-half annualized growth now seems likely to run at just 2.3%, or 0.6% below what we forecast a month ago. Primarily, that’s because the resilience we expected from other sources — capital spending, net exports, and government — and the effects on consumer spending of a supply-driven plunge in energy prices — failed to offset the weakness in housing and vehicle output. Some would say we’re still too sanguine. We’ll be the first to admit that the twin recessions, especially the one in housing, are far from over and that the spillover from those declines could be more significant than we anticipate. For example, we estimate that the decline in residential construction will depress overall growth by 0.8% in the current quarter, and by roughly ½% over the course of 2007 (see “Is the Housing Recession Over?” Global Economic Forum, October 20, 2006). However, we believe that those other, offsetting sources of growth are gathering pace and becoming more evident. As the intensity of the housing downturn fades and Detroit’s production cuts run their course, we still believe that the economy is poised to accelerate back to or above trend, keeping the Fed on inflation alert. Here’s why. Logic aside, incoming data do not yet portray a compelling upturn in final demand growth from the 1.7% pace of the third quarter, so our bullish forecast is still just that — a forecast. For example, the September bounce in new home sales and starts both look aberrant, especially in light of the ongoing slide in sales of existing homes and overwhelmingly limp anecdotal evidence. Vehicle sales slipped in October, and retailing results were mixed. Capital goods shipments slipped in September, creating a poor start for the fourth quarter. And while it may prove more statistical than real, a significant estimated third-quarter jump in motor vehicle output — part of the recently-released estimate for GDP growth — seems likely to be reversed in the fourth quarter, depressing growth in the latter period by roughly 0.7%. Nonetheless, we believe that evidence of stronger demand will soon dominate. Two key reasons are improving job and real income growth and the benefits of strong global growth for the US economy (see “All About Income,” Global Economic Forum, October 30, 2006). Moreover, we believe that the unwinding of the past eighteen months’ energy price hikes will magnify those gains when adjusted for inflation. In addition, financial conditions are still supportive of growth, courtesy of the 6% rally in stock prices, the drop in yields, and the further tightening of credit spreads over the past five months. And while banks have stopped easing their commercial lending standards and have modestly tightened their mortgage lending standards, credit is still abundantly available. The evidence for truly robust employment and real income gains is just now starting to accumulate. The two-tier economy was unmistakable in October’s employment canvass: Construction and factory payrolls together sagged by 60,000. But broad strength across professional and business services, healthcare, leisure, and government netted a healthy 152,000 gain in services jobs, and the private workweek rose in October, even in construction and manufacturing. Combined with the 0.4% rise in hourly earnings, the uptick in hours suggests a second straight hefty jump in wage income. Too, payroll growth in August and September was revised up by a whopping 139,000, bringing the average gain in the past three months to 157,000. Even with those revisions, the payroll survey may yet understate job growth, and thus, the economy’s potential to generate income. A past undercount, manifest in the likely 810,000 upward revision between March 2005 and March 2006 announced last month, may have continued in recent months. One clue: Employment in the household survey continues to outstrip the gains in payrolls. Since March 2006, monthly employment changes measured in the household survey (adjusted to be conceptually equivalent to payrolls) averaged 285,000, or more than double the 134,000 average in the payroll tally. While we think the payroll canvass is generally the more reliable one, Patricia Getz, assistant commissioner for industry employment statistics at the Labor Department, on Friday said that the BLS's so-called "birth/death model," which is the key factor that adjusts for the net job creation at new firms, is a "prime suspect” for the past undercount. Adjustments to that model will likely affect the payroll tally since March. Other data also evince signs of an acceleration. Capital goods orders rose by 2% in September and accelerated to a 16% annual rate in the past three months. Surveys of capital-spending plans — from small businesses (in the NFIB canvass) to large (in the NABE survey) — augur improving business conditions. Indexes of export orders from purchasing managers in both manufacturing and non-manufacturing industries jumped 2.5-4 points in October. Nonresidential vacancy rates continue to decline, rents are firmer, and commercial construction jobs continued to rise in October, indicating a significant offset to the housing recession. State and local hiring accelerated to a 2.7% annual rate in the three months ended in October, the fastest pace in five years. We estimate that such hiring, together with hearty gains in infrastructure outlays, signals a 5% annualized fourth quarter gain in real nonfederal government spending. Core readings on consumer inflation recently have moderated, offering hope to both market participants and Fed officials that the campaign to rein in inflation is working. For example, measured by the PCE price index, core inflation cooled to a 2.3% annual rate in the third quarter, compared with 2.8% in the spring. However, we agree with Fed officials that upside inflation risks still dominate, despite nine months of below-trend growth. Among the reasons: Elevated inflation expectations, limited economic slack, rising costs, and a sharp deceleration in productivity. Those inflation risks aren’t extreme; after all, long-term (5-10 year) inflation expectation in the University of Michigan’s consumer surveys stand at 3.1%, at the upper end of recent ranges. And distant forward (5-year, 5-year) breakeven inflation compensation is still below its summer peak. But the October decline in the jobless rate to 4.4%, factory operating rates above their historical norms, and the sense that the economy’s potential growth rate has declined to 3% — or possibly a tick lower — suggests that sub-par growth has yet appreciably to open up much slack between actual and potential output. Anecdotal evidence of pricing power and quickening wage gains both hint at rising cost pressures. The sharp, cyclical deceleration in labor productivity growth to 1.3% over the past year — half what we consider to be the trend rate — should make investors and policymakers cautious about productivity’s disinflationary power. The doubling of output growth we expect in the fourth quarter will lift productivity gains, but only to about 1½% at an annual rate. Yet we believe inflation will slowly decline as monetary policy contains inflation expectations, some slack emerges in the economy, and cost pressures begin to stabilize. The question now for financial markets is not whether, as the pessimists expect, the Fed will ease to rescue a floundering economy. Rather it is whether the current level of the Federal funds rate — and financial conditions broadly — will promote the moderate restraint required to make that inflation forecast a reality. The combination of growth moving back above trend and an inflation rate that is uncomfortably above the Fed’s comfort zone likely will translate next spring into another 25 bp move as inflation insurance. To be sure, the recent slowing in growth makes more uncertain than before the timing of any additional Fed tightening. Circumstances matter more than the calendar; at this point, the move could come at either the March FOMC meeting, as we assumed last month, or in May, if officials decide to wait for more information. A small credibility issue argues for sooner, rather than later: As Richmond Fed President Lacker points out, inflation running above the Fed’s presumed comfort zone of 1-2% for the core PCE price index for the past three years could erode belief that that the Fed wants inflation to decline. Pessimists disagree, taking the current inverted yield curve as proof positive that inflation expectations are dead and that the Fed’s credibility is unquestioned. In contrast, we think that parsing the curve into its term-premium, real, and inflation components tells a different story. Either way, the inverted yield curve signals that even modest Fed tightening is not in the price, although bond market participants have for now abandoned hope that the Fed will ease soon. For risky asset markets, which discount a nearly perfect soft landing, the road ahead may be bumpier. Risks still abound. Compared with a month ago, the risks to growth now seem less skewed toward weakness, although the extent and duration of the housing recession is still unclear, and a renewed, supply-induced energy price spike would again hurt consumers. By comparison, and despite the moderation in core inflation over the past three months, we still see inflation risks tilted slightly higher.
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Review and Preview
Nov 06, 2006
Ted Wieseman (New York) and David Greenlaw (New York)
Treasuries posted decent front-end-led losses in the past week after an absolutely brutal rout following Friday’s very strong employment report more than reversed significant gains that had been posted through Thursday. The key data through the first part of the week had suggested that the economy might have started off the fourth quarter on a disappointingly soft note, with the manufacturing ISM posting a surprising decline to a three-year low and weak auto and chain store sales results pointing to a soft October retail sales report. But perceptions of the economy’s resilience were dramatically recast by the blowout employment report, which, aside from a slightly smaller-than-expected October payroll gain, was strong across the board. There were sharp upward revisions to past months’ job growth, a significant drop in the unemployment rate to a new cycle low, another massive gain in the household measure of employment (which might suggest that the payroll survey continues to undercount true job growth), a good increase in hours worked, and a robust gain in aggregate weekly payrolls (a proxy for wage and salary income), which should result in extremely strong real income growth after the likely further decline in headline inflation in October. And the further tightening in the labor market and concurrent strength in earnings recast the previously reported surge in unit labor costs in 3Q in a more negative light after the report had only a small, transitory negative market impact when it was released a day earlier. Fed pricing in the futures market flip-flopped as dramatically as Treasury yields in reaction to the employment report. After a major repricing that peaked Wednesday, a rate cut by March was seen as quite likely, but by Friday’s close the idea of an early rate cut had been just about abandoned and some minor fear of another hike had even started to creep back into the market. Benchmark Treasury yields rose 1-7bp over the past week and the curve flattened significantly — with 2s-30s moving into marginally negative territory for the first time since July — but only after a 10-15bp collapse on Friday reversed significant gains that had been posted through Thursday’s close. The worst performer on the week was the 3-year, whose yield rose 7bp to 4.75%, tracking underperformance by the red (Dec 07 to Sep 08) eurodollar futures, which were off 10bp on average on the week after a 19bp shellacking Friday. The 2-year yield rose 6bp to 4.82%, the 5-year 5bp to 4.69%, the 10-year 4bp to 4.71%, and the long bond 1bp to 4.81%. At the extremes hit Wednesday in the aftermath of the soft ISM report, the futures market had been pricing in a 20% chance of a rate cut in January, a 66% chance of a cut by March, and a 4.50% funds target by early 2008. But the reversal in Fed pricing was even more violent than in Treasuries, with the low-rate Mar 08 eurodollar contract plunging a whopping 20.5bp Friday and 25bp from its best level Wednesday. In the aftermath of the post-employment reversal, a tiny risk of a rate hike was actually seen in January, only a small risk of a rate cut by March, and a 4.75% funds rate trough in early 2008. On the week, the February fed funds contract lost 2bp to 5.255% and the April contract 3.5bp to 5.21%. The Dec 06 to Dec 07 eurodollar spread steepened 9bp to -46bp, with the former off 1.5bp to 5.39% and the latter losing 10.5bp to 4.93%. The low-rate Mar 08 contract was off 11bp on the week to 4.905%. Non-farm payrolls rose a slightly less-than-expected 92,000 in September, as sharp declines in construction (-26,000) and manufacturing (-39,000) partly offset decent gains in various service sector categories, including professional and business services (+43,000), healthcare (+28,000), leisure (+35,000), and government (+34,000). The small miss on September payrolls was about the only modest soft spot in an otherwise very strong report. Payroll growth in September (+148,000) and August (+230,000) was revised up a whopping 139,000. Another huge gain in employment in the household survey (+437,000) caused the unemployment rate to fall two-tenths to 4.4%, the low since May 2001. Even adjusted for definitional and coverage differences compared with the establishment survey, the household payroll gain at +426,000 was way stronger than the establishment count. Generally speaking, we place much greater credence in the establishment count because of its far larger sample size. But given the massive miss the establishment survey had in the year through the March 2006 benchmark month, the household count probably deserves closer than normal focus at this point. In the year through March 2006, the average monthly employment gain in the household survey adjusted for comparability with the establishment survey was +245,000. The average gain in payrolls over this period as currently reported was only +169,000. But including the estimated 810,000 benchmark adjustment announced last month, this would rise to +237,000, nearly identical to the adjusted household count. In the seven months since the March 2006 benchmark month, monthly payroll growth has averaged +134,000, while payroll concept-adjusted household employment has averaged a much higher +285,000 — a potential signal that the establishment survey is continuing to have problems with undercounting. In addition to the drop in the unemployment rate and sharp rise in household employment, other details of the employment report were also uniformly strong. The average workweek rose a tenth to 33.9 hours, leading to a solid 0.3% gain in aggregate hours worked. Notable within the hours results was that, even with the huge drop in payrolls, an expansion in the average workweek left overall factory sector hours worked unchanged, pointing to a modest rise in ex motor vehicles manufacturing production in the upcoming industrial production report, a somewhat more upbeat picture than suggested by the weak ISM report. Meanwhile, average hourly earnings rose an elevated 0.4%. Because of some unusual hurricane-driven swings in earnings around this time last year, this led the year/year rate to dip to +3.9% from +4.1%. But if earnings were to rise another 0.4% next month, the year/year rate would pop to a more than eight-year high of +4.3%. The upside in earnings and hours combined for a strong 0.6% gain in aggregate weekly payrolls, a proxy for wage and salary income. If our estimate of a 0.4% plunge in headline CPI in October is close to the mark, this implies a second straight extremely strong gain in real wage and salary income, the key driver of consumer spending. The further tightening in the labor market and acceleration in income growth seen in Friday’s employment report shed a more ominous light on Thursday’s ugly unit labor cost results in the productivity report, which at the time of their release only elicited a small and brief negative market reaction. Non-farm business labor productivity was unchanged in the third quarter as a 1.6% gain in output was matched by a 1.6% rise in hours worked. On a year/year basis, productivity slowed from +2.4% to +1.3%, a nine-year low. With compensation per hour up 3.7%, unit labor costs rose 3.8% in the quarter, lifting the year/year rate two-tenths to +5.3%, matching the highest reading since 1982. Surging labor costs are likely to pressure corporate profit margins going forward and potentially lead to higher inflation if demand growth remains solid enough to continue to support rising business pricing power. While the employment report ultimately dominated the week’s activity, up until Friday the tone of the data was much more negative, casting some doubts on the prospects for a robust recovery in 4Q growth after the sluggish third quarter. Early signs on consumer spending in October were not good and pointed to a soft retail sales report. Motor vehicle sales fell to a 16.1 million unit annual rate in October from 16.6 million in September, and the mix was poor, with sales of domestically produced vehicles down to 12.3 million from 12.9 million while imports rose to 3.8 million from 3.7 million. Meanwhile, overall chain store sales were disappointing, as strong results in aggregate from department and drug stores were offset by softness at discounters, clubs and clothing stores. Incorporating the auto and chain store sales results and a likely further significant price-related drop in gas station sales, we look for overall retail sales to fall 0.4% in October and ex auto sales to dip 0.2%. With inflation expected to be down significantly, however, the results should be significantly better in real terms and, combined with a strong gain in real consumption in September and our expectations for a positive Christmas shopping season in November and December, we still see 4Q consumption on track for an acceleration to +3.7% growth. Meanwhile, the factory sector seems to be having some problems, much of it apparently driven by the travails of the auto sector, judging from the ISM report and the sharp drop in manufacturing payrolls in the employment report. The composite ISM diffusion index fell to 51.2 in October from 52.9, the lowest reading since June 2003. Pullbacks in the key orders (52.1 versus 54.2) and production (51.9 versus 56.1) gauges explained the drop, while the employment measure (50.8 versus 49.4) improved a bit. Only eight of 18 industry sectors reported growth in the month, down from 12 in September. The prices paid index plunged 14 points to 47.0, the first reading below the 50-breakeven level in more than a year, on lower energy and metals prices. The text of the report did indicate that the relief on prices was providing some support, but obviously not enough to boost overall growth. One area of notable strength, though, was the export orders index, which hit a nine-month high. Meanwhile, non-manufacturing activity seems to be holding up much better, with the headline non-manufacturing ISM business activity index jumping to 57.1 from 52.9. Note that this is not directly comparable to the manufacturing ISM headline, since it is not a weighted average but a separate question the ISM considers analogous to the manufacturing production index. If it is treated as such and a composite index constructed similar to the manufacturing survey, the non-manufacturing composite index would have improved to 54.9 from 54.3, obviously still quite a bit better than the manufacturing result, but not quite as robust as the headline print. The upcoming week has a very quiet data calendar, with the only particularly noteworthy releases on Thursday. With the (small) quarterly refunding on tap, supply will probably be a bigger focus than data, with a US$19 billion 3-year being auctioned Wednesday (US$2 billion smaller than last time) and US$13 billion 10-year Thursday (unchanged from August). Certainly the elections on Tuesday could be of some market interest. As far as the Treasury market is concerned, a Democratic takeover of one or both Houses of Congress would seem clearly to be the best outcome. As long as the economy continues growing at a reasonable clip, gridlocked government would provide an excellent backdrop for continued improvement in the budget deficit, with any significant new spending programs having little chance of getting past a White House veto and any attempt to extend or make permanent various temporary tax cuts a likely non-starter in a Democratic Congress. Gridlock certainly worked wonders in the second half of the 1990s for the budget. The only key data releases due out in the coming week are the trade balance and University of Michigan survey on Thursday. We look for the trade deficit to narrow US$3.5 billion in September to US$66.4 billion, with exports down 0.3% and imports down 2.0%. On the export side, industry data point to a sharp rise in aircraft, but the recent pullback in auto assemblies should lead to a significant decline in autos, shipments figures suggest little change in capital goods, and lower prices should pressure industrial materials. On the import side, a sharp price-related drop in energy products should account for the majority of the decline. Slower growth in inbound cargo through the key West Coast ports also suggests a decline in non-energy goods. Note that our deficit forecast is about US$2 billion larger than the BEA assumed in preparing the advance estimate of 3Q GDP.
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ECB Good to Go Again
Nov 06, 2006
Elga Bartsch (London)
Following the reaction to this week’s press briefing, the ECB might start having second thoughts about using certain code words to signal its policy intentions. The fact that the ECB emphasized twice a need to act “timely and firmly” in the key passages of the introductory statement to ensure price stability went largely unnoticed. The “need to act in a firm manner” is mentioned for the first time in the current tightening cycle. We believe that the new lingo is noteworthy. If ECB President Trichet had not said in the subsequent Q&A that he intends to say nothing to alter current market expectations for the remainder of this year, we would probably have read this as an indication that the Council might be contemplating a 50bp increase at the December meeting. Nonetheless, the new-found firmness in the ECB’s policy stance is key, we think, and might have important implications for the ECB’s course of action in 2007. However, if ECB-watchers and financial market participants are just looking for changes in the code words they were primed for, they are overlooking other important changes. Even though the ECB president refused to give markets guidance on the likely level of ECB interest rates beyond December, the Council deemed a “further withdraw of monetary accommodation warranted” if its baseline case of growth around (or slightly above) potential and HICP inflation slightly above its 2% ceiling plays out. But it seems to us that there is still a lively debate about the appropriate course of future monetary policy action within the Council once interest rates have reached the lower end of the neutral range in December. In this context, the Council’s rising concerns about monetary developments might gain importance. It is clear that the renewed rise in M3 money supply growth and, more importantly, loan growth worries the ECB Council. During the Q&A, Trichet emphasised the importance of the monetary pillar in the Council’s decision-making and explained that monetary developments were the main reason why the ECB started to hike late last year. It could well be that monetary developments will keep the ECB in tightening mode even if the ECB staff projections don’t show an uptick in HICP inflation. That said, monetary aggregates should loose some of their dynamism in the coming months on the back of rising interest rates and slower growth. But, in the view of the Council, monetary developments warrant very close monitoring. Meanwhile, the Council members don’t seem to have changed their outlook for growth and inflation much. As before, they expect growth to hover around potential — possibly slightly above, according to Trichet — in the coming quarters. Yet, for the first time, they called the recovery a more “self-sustained” one, which suggests a slightly more bullish read on the recent set of indicators. Viewing the recovery as self-sustaining also implies that the impact of the German VAT hike and the fiscal tightening that comes with it is less reason for concern than it was when it was first incorporated in the projections in the spring. Inflation is still seen to average more than 2% both this year and next, with risks tilting to upside for a number of reasons. The tipping in the ECB’s assessment of the risks to price stability will likely be wage developments across the euro area and in particular in Germany (see EuroTower Insights: Whither Euro Area Wages? October 20, 2006). It is clear that another 25bp interest rate hike at the December 7 meeting is in the offing — thanks to the familiar use of “strong vigilance" in this week’s statement. But the debate of the appropriate level of ECB policy rates beyond December still continues. The Council deems a “further withdraw of monetary accommodation as warranted” if its baseline case of growth around (or slightly above) potential and HICP inflation slightly above their 2% ceiling plays out. Yet Trichet repeatedly refused to commit to a specific future course of action. The widely overlooked “need to act in a timely and firm manner” suggests that there might be more tightening ahead in 2007. Much will depend on the rollout of the 2008 forecast. Stay tuned.
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Building a Foundation for Reviving Infrastructure
Nov 06, 2006
Chetan Ahya (Mumbai) and Deyi Tan (Singapore)
We attended a three-day infrastructure summit (the second in the last two years), which was held in Jakarta on November 1-3, 2006. The summit, organized by the Government of Indonesia, aimed to market investment opportunities to investors and lending institutions. In this note, we have summarized our observations on the infrastructure summit and our thoughts on the government’s efforts to reform the infrastructure investment environment in Indonesia. Changing political economy of infrastructure Indonesia’s infrastructure investments have fallen sharply to around 2% of GDP currently from more than 6% of GDP in the pre-crisis period. Not surprisingly, the existing state of infrastructure in the country is deteriorating. Increasing infrastructure gaps are deterring business entities and adversely affecting the quality of urban life. According to the World Bank, around 40% of the households are not connected to an electricity network, about 80% of households are not connected to piped water supply and 45% of the population does not have access to sanitation. As per the 2006 World Economic Forum Survey of 125 countries, Indonesia was ranked 89th on basic infrastructure provision compared with 60th for China and 38th for Thailand. However, the political economy of the infrastructure appears to be changing in Indonesia. A rising working age population in a democratic environment provides little leeway to the government to ignore the needs of this segment of the population. The government is facing mounting pressure to accelerate overall investment to boost job creation, given Indonesia’s already high level of unemployment and rapid rise in the working age population. The government is aiming to increase annual infrastructure investment to 5-6% of GDP in five years time, with the goal of accelerating its annual GDP growth to 7% on a sustainable basis. On our approximate estimates, this would translate into targeted cumulative investments of US$100-110 billion over the next five years (an average per annum investment of US$20-22 billion). In 2006, Indonesia is estimated to have spent about US$8-8.5 billion (2.3% of GDP) on infrastructure. The key challenge for the government is the funding of this increase in infrastructure spending. Post the 1997 crisis, the government has been very conscious of managing public finances in a prudent manner. Under the current fiscal constraints, the government is unlikely to meet the increasing infrastructure investment requirements solely through its own balance sheet and hence it is trying to get the participation of the private sector. However, attracting private sector participation is a difficult task. As per World Bank estimates, about 70% of the infrastructure investment in developing economies comes from the government or government-owned entities, while the average private sector contribution has been 20% (largely in telecom) with the remaining 10% tending to come from multilateral or bilateral agencies. In Indonesia, as per World Bank estimates, the private sector is currently contributing to only about 20-25% of the total investments. Increasing participation from the private sector will likely entail major changes in the government’s policies, institutional and regulatory framework and its public sector’s managerial skill sets. Second attempt in two years to market infrastructure investment opportunities After a not-so-successful attempt to attract private sector participation in early 2005, the Government of Indonesia (GOI) organized a second three-day Infrastructure Summit on November 1-3. Judging just by the number of people attending the summit (over 1,000), it appeared to be very successful. However, the attendance was higher primarily because this time, apart from just investors, the summit was also attended by consultants, lawyers, lenders and equipment suppliers. The second summit included exhibitions and presentations by the government, multilateral lending agencies and private sector infrastructure players, unlike the previous summit, which was more focused on the investors. Government relatively better organized this time The government had done a lot more groundwork in terms of feasibility studies and commercial viability this year, learning from last year’s experience. The top government team including the President, the Vice President, the Coordinating Minister for Economic Affairs and the Finance Minister presented at the conference, relaying the efforts made over the past two years to change the country’s investment environment. The government also showcased ten projects in different sectors to be developed as models. Recognizing the change needed to attract private sector investment, the government has initiated a number of legal and regulatory reforms since the first summit in January 2005. Smaller number of projects showcased The government has also been less ambitious and targeted only ten projects totaling investments of US$4.5 billion (1.4% of GDP) for private sector participation. Some of the investments planned are: telecom (US$1.5 billion), electricity, toll roads (US$1.5 billion), a sea port (US$0.3 billion), the water supply and a ferry terminal (US$0.2 billion). The government is looking to build credibility with the successful implementation of these projects. In the previous summit, while the government offered 91 projects (valued at US$22.5 billion), the progress on these projects in terms of participation by the private sector and implementation has so far been poor. We believe that the new, more focused approach is likely to yield better results. The government plans to offer more projects in the near future using a similar approach. On the right path … Indonesia has, over the last five years, initiated a number of measures to improve the overall institutional framework of governance to reduce rent-seeking and corruption within the public sector. More specifically, the government has taken significant measures over 2005 and 2006 to improve the environment for private sector participation in infrastructure. Some of the key measures taken to improve the Public-Private Partnership (PPP) investment environment are: New policies for PPP framework: In November 2005, a new presidential regulation was issued that provided a framework for private sector participation in the infrastructure sectors. It provided for a transparent and accountable basis for private sector participation in infrastructure. The regulation requires that procurement of PPP concessions is done on a competitive and transparent basis. It requires the government entities to conduct proper due diligence and also forces them to focus on the aspect of fiscal sustainability while providing financial support to a PPP project. The government has also taken measures to strengthen the Inter-ministerial Committee on Policy for Acceleration of Infrastructure Provision, which is responsible for co-ordination with line ministries for infrastructure investments. The government has already enacted new laws for toll roads, and water supply and sanitation. Draft laws for ports, airports and railways have been submitted to the parliament and are expected to be enacted in the first half of 2007. These new laws will phase out the monopoly of SOEs in the provision of infrastructure services in those sectors. Improving regulatory framework: For various infrastructure sectors, including oil and gas, roads, electricity and telecom, the government has already separated regulatory functions away from the government entities operating the businesses with the sector. For instance, for toll roads the government has unbundled regulatory functions from the main SOE (Jasa Marga) and transferred the responsibility to a new regulatory body. Explicit subsidy compensation to SOEs: The SOEs are indirectly funding the subsidies for many basic services that they provide. The government has recognized that this practice does not follow the principles of transparency and accountability, and also adversely affects government efforts to improve the performance of SOE through benchmarking. The government has started implementing the new policy that requires it to compensate SOEs directly for the full costs of the basic services that they provide. This new policy is currently being implemented in the electricity sector. Reform of land acquisition law and land acquisition fund: Progress on many of the infrastructure projects involving the private sector has been stalled due to land acquisition delays. To reduce the delay in land acquisition and cap the land cost, the government has passed two presidential regulations (one in 2005 and another in 2006) that amended the law relating to land acquisition. Moreover, the government is now setting up a fund, which will help acquire land for infrastructure projects before tendering of projects. Risk management committee: The government has been conscious of fiscal sustainability issues arising out of government support for PPP-based infrastructure projects. In October 2005, the Ministry of Finance established a risk management committee to help evaluate the case for the government to share project risks (political, project performance and demand risk) after fulfilling the affordability and transparency criteria. Infrastructure Guarantee and Infrastructure Fund: The government plans to launch the Infrastructure Guarantee Fund by mid-2007. The government will use this fund to provide guarantees for certain risks that would be necessary for it to undertake to attract private sector participation. The government is also planning to start a separate Infrastructure Fund, which will play a role in funding infrastructure projects. The government has already set aside Rp4 trillion (about US$440 million) for a guarantee and infrastructure fund. However, the government is fully cognizant of the need to build the institutional capacity to ensure that the risks undertaken are within limits permitted by the size of the funds. … but there still are a number of issues to be addressed Despite the progress over the last two years, there still are a number of challenges to achieving a major rise in infrastructure investments with the support of the private sector. Some of the issues that came up during the discussions in the presentation and that were also acknowledged by the government officials are as follows: Re-alignment of government functions is still not fully set up: The ideal institutional arrangement for a PPP framework as recommended by the government-appointed committee for infrastructure is one where functions of policy making, regulator, contracting (awarding contracts) and that of operator are separated. In many sectors these four functions have not been fully unbundled. The government will need to enact new laws for some of these sectors to make the unbundling effective. In some cases, line ministries still have policy making as well regulatory responsibilities. In certain sectors, regulatory bodies are still performing the contracting function. In cases where regulatory bodies have been formed, they are still not perceived to be functionally independent. Creating an environment for long-term domestic infrastructure funding sources: Currently, there are very limited long-term debt issues for non-government borrowing. Pension and insurance companies have not been participating in infrastructure funding. The government needs to initiate measures to develop the domestic capital markets, which will help mobilize long-term funding. We believe that, to the extent that the new initiative from the government is helping to promote bankable projects, it will make it easier to attract long-term funding from pension funds and lending institutions. Strengthening of newly formed institutions: Interacting and dealing with the private sector needs a mindset change. It also requires a different kind of skill set to handle the complexity of decisions and to manage the risks involved. While a number of new institutions are in place, the capability of these institutions to operate within the new environment is still not up to scratch. The institutional capacity to deal with a PPP framework at the local government level is even weaker than that at the central level. Credit quality of the SOE counterparty: For many infrastructure projects, the buyer of the infrastructure services is a SOE, which may not have a strong balance sheet. In such cases, the buyer guarantee mechanism is unlikely to provide the comfort to the private player. For instance, in the case of the electricity sector, under the current law, PLN, the state-owned electricity company, has the monopoly in distribution and therefore the private independent power producer (IPP) depends on PLN’s guarantees for the purchase of electricity produced. However, PLN’s balance sheet is weak and may not provide the comfort required by the private players to enter into a long-term electricity purchase agreement. New approach is slow but more credible and sustainable Indonesia is attempting to move away from a structure where decision making for policies and investments was taken by select few individuals on behalf of the government in an ad hoc manner. This structure allowed greater opportunities for rent-seeking activities and also ignored the principle of fiscal sustainability, while promising government support to attract private sector participation. The new approach aims to transition into a structure where decisions are taken by institutions in a relatively transparent and credible manner. While the former approach allowed for quick decisions and rapid progress in the near term (as was the case in the pre-crisis era), it is not sustainable, in our view. The new approach, once fully implemented, is clearly not a push button event but rather a long drawn-out difficult process, which should create an environment of sustainable growth in infrastructure investments. Bottom line: Modest pick-up in infrastructure investment On balance, we believe that the inflexion point in infrastructure investment trends has already occurred. The government’s balance sheet has been restructured, with public debt to GDP estimated to fall below 40% from 100% in 1999. The government has also been able to gradually change the mix of public expenditure in favor of development spending. We believe that this itself is beginning to provide some acceleration in infrastructure spending. In 2006, the government estimates that real public infrastructure spending will grow by 26% YoY. Moreover, there is also likely to a modest rise in private sector participation, particularly in the roads sector, in response to continued efforts to reform the PPP-related institutional framework. In the telecom sector, the private sector participation has already increased significantly. We believe that, if the government continues its efforts to implement reforms related to the infrastructure sector with the same vigor as witnessed in the last two years, Indonesia’s infrastructure investments could increase to at least 3.5-4% of GDP (in line with the average in developing countries) over the next 4-5 years, from around 2.3% in 2006. We acknowledge the contribution of Tanvee Gupta to this report.
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