Currencies
Declining ‘Home Bias’ and the Japanese Yen
November 10, 2006

By Stephen Jen | London

Summary and conclusions

Japan’s ‘home bias’ has declined in recent years. This may be due to deregulation and better knowledge about foreign markets. In addition to these structural changes, the retiring baby boomers’ investment pattern has led to a sharp increase in Japanese retail outflows this year. This trend toward greater internalization of investment portfolios is not unique, since this is a regular feature of financial globalization that we’ve witnessed in most countries in the past few years. What makes Japan special is that Japanese investors’ interest in foreign assets seems to be greater than the JPY assets Japan can offer foreign investors.

I still believe that the JPY is significantly under-valued, but suspect that the prospective correction in EUR/JPY and USD/JPY will likely be a gradual one, unlike what happened in 1995 and 1998.

Declining ‘home bias’

It is well-known that Japanese investors tend to hold a high proportion of their wealth in JPY-denominated assets. While Japan’s ‘home bias’ is still high, relative to that of other developed nations, it has been declining in the past decade, and this decline seems to have accelerated somewhat this year. My own sense is that the ‘home bias’ has not declined that much for pension funds or life insurance funds in the past year. However, mutual funds (investment trusts) and retail investors (individuals) may have raised their foreign asset holdings.

I have identified three important reasons behind this trend:

1. Deregulation. One reason behind this recent trend could be deregulation. Not only has the pension system been altered, but government-managed financial institutions (GFIs) have also been structurally reformed in a way that means they can hold much more of their assets in financial wealth, first, and foreign financial wealth, second. In 1998, the informal asset allocation limit of 30% of pension and life insurance funds in foreign assets was abandoned. Also, in 1998, sales of investment trusts (some of which specialized in foreign assets) were permitted. In 2001, the GPIF (Government Pension Investment Fund) reform essentially liberated the state-controlled pension assets to be invested in financial assets, and not in infrastructural projects. Moreover, the reform of regulations on foreign exchange transactions in 1998 removed strict reporting requirements on capital outflows and restrictions on certain types of FX-related derivatives transactions.

These deregulation measures were put in place some time ago. But their delayed effect on capital outflows may only have been felt when Japan slowly climbed out of its economic trough and when investors’ risk-taking appetite recovered.

2. Declining FX volatility. Further, with the decline in volatility (actual and implied) in the currency markets, some Japanese investors seem to have exhibited a greater appetite for taking on currency risk.

3. Yield differentials. While yield differentials have not always been the dominant driver of USD/JPY (see below), they may be more important in the current environment, with Japanese investors’ risk-taking appetite being healthy, and the BoJ’s monetary stance being out of synch with the upswing in Japan’s risk-taking capability. While points 1 and 2 above are more ‘structural’ factors, yield differentials should be considered a ‘cyclical’ factor that has accentuated the structural changes. I stress this point because I think that too many investors/commentators may be overly fixated on yield differentials and have not placed enough emphasis on the structural changes that would have brought down Japan’s ‘home bias’ even if the interest rate gap were not as large.

A mini baby boom in the late 1940s

The accelerated decline in the ‘home bias’ for mutual funds and retail investors is worth a closer examination. While there is still no definitive explanation of this trend, there is a possibility that it may not be the case that the individual investors’ ‘home bias’ is genuinely lower, but rather that there is just more capital controlled by individuals and therefore more to invest overseas.

Something that happened 60 years ago may be one contributing factor behind the general weakness in the JPY. During 1946-1949, Japan experienced a mini baby boom. Though it was milder and shorter-lived than the US baby boom (from 1947 to 1964), it nevertheless created a big enough demographic bulge to have consequences now. Relative to a long-term average of around 1.2 million a year in the ‘natural’ rate of population (birth rate minus death rate), during these four years, the bulge in the demographic profile was close to 2 million, i.e., there was a net 2 million increase in population during this period — an average of 500,000 a year.

Sixty years later, in 2006, the first wave of these baby boomers reached retirement age. When they received their cash retirement payments, they may have allocated a greater portion of their assets overseas than in previous generations. This may have helped propel an accelerated decline in the collective ‘home bias’ of mutual funds and retail investment.

Continuation of this trend decline in ‘home bias’?

It is difficult to tell if this structural trend will continue to push more capital overseas in the future. If the ‘Baby Boom Thesis’ described above is correct, then there should be continued large retail outflows until 2009. While the desire to invest overseas may remain, I am guessing that the fact that the JPY is so under-valued should matter. The purchasing power of the JPY for non-JPY assets is now so eroded that it may not make much sense for some foreign investments to take place. Conversely, Japanese assets are as cheap as they were 20 years ago. It is not clear that retail outflows will continue to drive the JPY weaker.

I admit that this is not a point I can prove analytically. But I believe that valuation is important at the extremes, and we are close to an extreme point. This is why I have been arguing that the JPY has established a medium-term bottom against the dollar.

Under what conditions can the JPY rally?

Confronted with a large negative carry, under what conditions can the JPY rally? By looking at the US-JPY cash yield differentials and USD/JPY relationship, we can identify three episodes: Episode I (the early 1990s); Episode II (the mid-1990s); and Episode III (1998-99).

In Episode I, USD/JPY fell, with a delay but much in synch with the decline in cash yield differentials. During that time, the Fed cut the FFR from close to 10% in 1989 to 3% in 1993. At the same time, after a period of rate hikes to contain the equity and property bubbles, the BoJ eased at a relatively gradual pace. Japanese repatriation, facilitated by falling yield pick-up, was the main reason behind the rally in the JPY. In Episode II, USD/JPY collapsed despite the sharply higher USD yield premium. Fed credibility was the key issue then. In Episode III, USD/JPY collapsed as massive JPY carry trades were unwound. Japan had no inflation, but the world thought that Japan had to generate inflation through money printing. The monetary-based trading idea pushed USD/JPY into massively over-valued territory.

These three episodes show that there is really no mechanical relationship between yield differentials and USD/JPY. USD/JPY can fall, even with a large negative carry. Valuation, economic fundamentals and central bank policy are all potential triggers. However, my guess is that, as long as Japanese retail outflows continue, USD/JPY will not collapse, but may gradually drift lower.

Bottom line

Part of the reason behind the declining ‘home bias’ in Japan is structural, and part is cyclical. While I believe that valuation is approaching stretched levels, financial globalization has exposed asymmetry in Japan’s appetite for foreign investments and the JPY assets Japan can offer to foreign investors.

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Europe
Pension Fund Rebalancing and Corporate Leverage — Demand Nearly Always Creates Supply
November 10, 2006

By David Miles | London

A common line of thinking on the impact of the evolving portfolio allocation of defined benefit (DB) pensions goes like this:

1. DB schemes need more bonds — either directly held or acquired indirectly using derivative positions — and they should hold less equities. In the UK in particular, the scope for much more hedging of duration risk is substantial, given that DB pension funds still hold around 60% of their assets in the form of equities but have debt-like liabilities.

2. The supply of long-dated bonds by governments is likely to be small relative to demand. Once again, the figures suggest that within Europe this potential mis-match is most acute for the UK.

The implication is drawn that the scarcity of long duration bonds is, and will remain, acute and that we had better get used to extraordinarily low long real yields; the real yield on the longest-dated index-linked gilts issued by the UK government now stands at under 70bp.

What this line of reasoning leaves out is the potential for the corporate sector to supply substantially more debt itself. And there is a natural reason why the corporate sector should do just that. If corporates are going to increase their hedging of interest rate risk created by DB pension liabilities they are — in effect — reducing overall leverage in their aggregate balance sheets. To hold effective corporate leverage constant, they can then afford to issue more debt held explicitly on the balance sheet.

There is very little sign that companies are doing much of this by directly issuing more long-dated debt. But the process may be starting by an indirect route. Leveraged buy-outs, a prime example of which is the typical private equity transaction that sees a public company taken private in a highly leveraged transaction, have increased in importance in recent years. Consider the following:

* According to the European Venture Capital Association (EVCA) private equity survey, in 2005 European PE funds raised €72 billion (according to the Financial Times (September 27), the figure for the last 12 months is €80 billion), more than double the 2004 level. Of that total, about 80% has gone into buyout funds (the rest is venture capital). The typical leverage for LBOs is about two-thirds debt to one-third equity invested.

* Globally, PE firms have about US$350 billion in cash currently, we estimate, so with leverage they potentially have over US$1 trillion to invest.[1]

* In the first half of 2006, buyout activity in the UK almost trebled compared with the same period in 2005, reaching about £35 billion.[2]

Much of the debt used to finance these transactions is initially in the form of bank debt, and so not at all in a form that creates the sorts of assets needed by DB pension fund seeking to hedge the exposure created by debt-like pension liabilities. But banks are likely to want to re-package and pass on that debt, and ultimately it can come into forms more suitable for pension funds.

Consider how a typical levered private equity transaction happens. The debt part of the funding is often two to four times as great as the equity component. Initially banks provide the largest part of the debt. But recent evidence from the FSA illustrates how quickly that debt is distributed. The FSA survey showed that banks that initially provided finance for levered private equity deals typically only retained about 20% of that exposure after 120 days.[3] Much of that debt gets parcelled out to other banks. Some goes to hedge funds, and some — but as yet quite a small proportion according to the FSA survey — is in the form of high yield bonds.

It may take considerable time for the large amount of debt that has been created as a result of leveraged buyouts to come to be in a form that fits in with the needs of DB pension funds seeking to hedge out interest rate risk. And it may come to them in very indirect routes — some coming via an increasing exposure of pension funds to hedge funds, who in turn seek to buy debt that provides the financing for private equity deals that see publicly traded equity extinguished.

The routes by which leverage is created and equity extinguished may be very indirect. But behind it all one force may continue to be at work. This is the increasing realisation by many companies and pension fund trustees that hedging more of the interest rate exposures created by holding debt-like liabilities is a sensible long-run strategy. That process is likely to accelerate in the UK because so many DB schemes are closed to significant new inflows and are effectively in run-off. Increasingly, mature schemes will find the logic of greater hedging of interest rate risk ever more compelling. It is the fallout from that process which is in part responsible for a lower long-term cost of debt, and that is the price signal that has created the incentive for levered buy-outs. And it is those buyouts which ultimately create some of the debt which pension funds seek to hold. Demand will — in the end and with a lag — create supply.

1. See Buoyant Corporate Activity: the Facts and Figures, Morgan Stanley Strategy, Teun Draaisma, Ronan Carr, Graham Secker, Edmund Ng and Charlotte Swing, November 1, 2006.

2. Private equity: a discussion of risk and regulatory engagement, FSA Discussion paper, November 2006.

3. Private equity: a discussion of risk and regulatory engagement, FSA Discussion paper, November 2006.

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Global
The Return of Disinflation
November 10, 2006

By Serhan Cevik | from Washington

Disinflation will once again become more pronounced, but just not in the near future. From whatever angle you look at it, this has been a lost year for disinflation efforts in Turkey. First, higher oil prices hit the country’s inadequately diversified, import-dependent energy infrastructure, creating a wave of inflation pressures, especially on the supply side. Then, unprocessed food prices started increasing at an unprecedented pace (possibly due to weather anomalies). And finally, the burst of global financial volatility weakened the Turkish lira enough to push import prices and production costs even higher. Consequently, consumer price inflation accelerated from 7.4% at the end of last year to 11.7% earlier this year. However, the central bank’s aggressive response — raising the policy rate by 425bp and withdrawing excess liquidity from domestic money markets — has helped re-establish the sense of stability and setting the stage for the return of disinflation. Indeed, the latest inflation figures suggest that the peak in inflation is now behind us. Nevertheless, although disinflation is likely to gather speed in the second quarter of next year, inflation rates will likely remain well above the target range in the foreseeable future, unless we see a further correction in energy quotes and unprocessed food prices.

The headline inflation rate eased from the peak of 11.7% in July to 10% last month. The CPI posted a monthly increase of 1.3%, slightly better than our estimate of 1.5%, in October. As a result, the year-on-year inflation rate declined to 10%, from 10.6% in September and the recent peak of 11.7% in July. The stabilisation of energy prices as well as the currency pass-through effect and a lower-than-expected increase in unprocessed food prices contributed to bringing inflation back to the single-digit threshold. In fact, disinflation has already become more pronounced in consumer prices excluding seasonal variations, due largely to a marked rise in the clothing and footwear category. As we have long argued, Turkey suffered a series of supply-side shocks, disturbing inflation dynamics, and will now enjoy gradual normalisation. It may not be exciting, but we still expect inflation to come down to 9.2% by the end of this year and 5.8% next year.

Fundamental factors support the return of disinflation, but there are still a number of risks. Temporary shocks to the behaviour of inflation are normal, especially in a country that has lacked price stability for almost four decades. Turkey has a long journey to internalise low inflation, which depends on the mix of macroeconomic policies as well as on structural factors. In our view, the state of the economy is strong enough to absorb shocks and bring disinflation back on track. While the supply frontier keeps expanding, thanks partly to productivity gains, domestic demand growth is moderating towards a balanced trajectory. In the medium term, we expect both the end of fiscal dominance and labour-market dynamics to restrain inflation pressures even as the economy grows at an above-trend pace (see Normalising, August 30, 2006). That said, there are still a number of risks that may result in a deviation from our baseline projection. Supply-side shocks, which have distorted inflation dynamics in the first place, still present a risk to the return of disinflation. For example, along with the lagged effect of energy price increases, climatic conditions may lead to adverse changes in food prices (see Stay Tuned to the Weather Channel, August 4, 2006).

Despite improving inflation dynamics, monetary easing remains a distant possibility. The normalisation of inflation dynamics is an encouraging development, but it is still not enough, we believe, to support the case for monetary easing in the near future. The Central Bank of Turkey is well aware of endogenous and exogenous challenges and therefore maintains a cautious stance. Unless the economy experiences positive supply-side shocks, we do not see the possibility of initiating a monetary easing campaign before May/June 2007 that may gradually lower short-term interest rates no more than 150bp by the end of the year. But would that be bad news for financial markets? Not at all, in our view. With a more appropriate liquidity structure in domestic money markets, the lira would not come under intense pressures, even in a noisy election year.

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Global
SARB Monetary Policy Review: Streaks of Light at Tunnel’s End
November 10, 2006

By Michael Kafe | Johannesburg

Yesterday, the SARB published its second bi-annual Monetary Policy Review (MPR) for 2006. While the bank continues to highlight possible upside risks to inflation, it has nevertheless made it clear that, from here on, “Future monetary policy responses will be guided in part by the reaction of demand to the current levels of interest rates”. (SARB Monetary Policy Review, November 2006, p32).

This statement that ties in firmly with Morgan Stanley’s October 16 assessment that “...a final rate hike in December is no more a certainty...because we believe that we have now crossed over the ‘pre-emptive stage’ of the tightening cycle...we expect undercurrent macro-economic auto stabilizers to start kicking in, firstly as a result of the policy action taken so far, but also because we think that the unexpected but sustained fall in oil prices will combine with fledgling signs of a return of fixed capital formation in the mining industry to bring forward the trough of the J-curve effect... further moves in the policy rate will thus be heavily data-dependent”. (For a detailed discussion, please see South Africa: Acknowledging the Unfolding Macroeconomic Dynamics by Michael Kafe, October 16, 2006.)

But, as can be expected of any inflation-targeting central bank worth its salt, the SARB of course desisted from jumping the gun and making any clear calls on the possible direction of future policy action, firstly because we are still at a turning point in the cycle —where data typically tends to be rather murky —but also because they clearly perceive inflation risks to be on the upside. In the concluding section of the Review, the SARB highlights a number of key risks, namely:

(a) Oil prices
(b) Strong domestic demand pressures, and
(c)A weaker exchange rate

We address each one of these concerns below:

Oil prices

The SARB is concerned (and rightly so) that undesirable geopolitical events could combine with strong demand conditions versus tight supply, to take oil prices up in coming months. The bank also highlights elsewhere in the Review that near-term oil futures prices are in contango, with Brent crude oil for March delivery priced at US$64.5/bl —a clear indication that the oil futures market is expecting oil prices to rise in coming months.

Well, we think these concerns are justified. In addition, Morgan Stanley admits that any weather-related increases in demand for oil during the western winter season could exert some short-term upward prices on oil. Hence the recent change to our oil price forecasts, where we now look for a revised peak of US$66/bl by December 2006, and an average of US$65/bl in the first quarter of 2007 (i.e., we maintain the winter season hump), before declining to close 2007 and 2008 at US$55/bl and US$50/bl, respectively.

With our revised oil price forecasts, we now see CPIX peaking at about 6% in March 2007 and coming down to close 2007 at about 5.2%. We then have CPIX falling to the mid-point of the inflation target in the second quarter of 2008, before rising to just above 5% by year-end. Given that monetary policy has an impact lag of some 12-18 months on inflation in South Africa, we do not see the need for any further adjustment in the monetary policy stance in December.

According to the MPR, the SARB’s own forecasts show inflation coming in around 6% in the last three quarters of 2007 before declining to 5.4% by the end of 2008. But the SARB was at pains to mention that this forecast does not incorporate the 50bp hike that was implemented in October. It will only be incorporated in its December 6-7 MPC estimates, which, ceteris paribus, should have an inflation trajectory with CPIX peaking below 6% in 2007 and coming down to some 5% by the end of 2008 —an outcome that does not quite justify the need for further tightening either.

Strong domestic demand

It is true that the South African consumer is firing on all cylinders. This has no doubt contributed to the country’s burgeoning current account deficit. But while we agree that the consumer may need to be tamed, there are emerging signs that this may already have started happening.

First is the strong growth in private sector credit. While the September print certainly surprised on the upside, the details show that mortgage growth, which accounts for more than half of all lending to the private sector, slowed down from R15.9 billion in July, through R15.3 billion in August to no more than R13 billion in September.

Looking forward, we expect this number to stabilize between R12 billion and R14 billion in coming months. The SARBs own Review shows that, on a year-on-year basis, total building plans passed have collapsed from 45.2% in 2005 to 3.2% in the first eight months of this year, while buildings completed have halved from 36.6% to no more than 15.3% over the same period. What’s more, the decline in residential building plans passed fell 99.7% over the period in question (i.e., more than the fall in total building plans passed). This, together with the comforting deceleration in home prices lately, should help place a lid on mortgage growth.

Also, the surprise element in the last private sector credit number came from ‘net other loans and advances’ —a catch-all category for distress borrowing by corporates, not consumers. This category of credit has been rising steadily since the currency spiked in June, confirming Morgan Stanley’s view that it largely reflects a currency play by corporates, who switch out of offshore loans into local credit as the currency weakens and vice versa. With the rand having stabilized and in fact appreciated since the beginning of October, it is very likely that there is a slowdown here in coming months.

The Review also rightly mentions that, although total private sector credit remains high, instalment sales and leasing finance has declined from 19.6% in March to 16.4% in September, while the growth in credit card advances, which account for some 3% of total credit, have also dropped from 47.4% in December 2005 to 40.8% presently.

Also important to note is the fact that, after raising earlier concerns that the consumer was not responding to the first two hikes, the SARB’s October MPC statement correctly acknowledges that the impact of monetary tightening would normally come through with a lag. We took this to be the first signal that the SARB had perhaps now reached a point where it could consider a pause to see the impact of the 150bp of tightening so far. This view is further supported in the last paragraph of the Monetary Policy Review, where the bank made it clear that future policy action would be guided by the responsiveness of domestic demand to the current levels of interest rates.

Second is the swelling import bill, which has contributed in no small way to the country’s burgeoning current account deficit. Here again, while we do agree that imports of durable goods are uncomfortably strong, one must nevertheless remember that there are tentative signs of a slowdown here as well: It is still very early days, but the September trade data showed that machinery imports, mechanical appliances, electrical equipment, etc were all down in September; and while the inherent volatility of trade data calls for a great deal of caution in interpreting single data points, we are certainly of the opinion that the currency’s recent weakness is already combining with the upward move in interest rates to slow down durable consumer imports. The data on new car sales support our view: After printing record sales in July, new vehicle sales tumbled 3.7% in August as both prices and interest rates rose, and only posted a minor recovery of 0.4% m/m in September (the apparent jump in y/y growth rates from 5.6% in August to 14.1% in September was due to a distorted base).

We also expect the slowdown in imports to be met by rising exports as capacity returns to the mining sector, and as manufactured exports gather steam. Combining this with our view that dividend payments will likely fall in the fourth quarter of the year suggests that the current account deficit may have already peaked. At the same time, the entrance of offshore private equity money looking to start nibbling away at South African companies ahead of the 2010 World Cup should help provide support for the capital account of the balance of payments and, by implication, the currency.

Third is consumer confidence indicators: The SARB’s Review admits that the FNB/BER consumer confidence index declined modestly by 3 percentage points to +17 in the third quarter of 2006. However, it notes in the same paragraph that the third quarter reading is only 4 percentage points below the all-time high achieved in the first quarter. Here, Morgan Stanley shares the SARB’s sentiment about consumer confidence, and we do not expect this to decline very quickly, given that the average consumer’s optimism is driven by other things outside of interest rates and currencies: Political stability, self-worth, perceptions about one’s country relative to neighbours, personal wealth, status, etc are all important drivers of consumer sentiment that are unlikely to fade simply because interest rates are higher or because the currency is weaker.

Weaker exchange rate

The SARB highlights the exchange rate as another inflation risk factor, and highlights that, by the October MPC meeting, the rand had depreciated by almost 22% on a trade-weighted basis, necessitating the need for monetary policy action to ensure that inflationary pass-through is minimised. We agree that such a move in a relatively short time is likely to impact on inflation if left unchecked. However, the important thing is to look forward: Since October, the nominal effective exchange rate of the rand has appreciated by 4%, while oil prices have surprised on the downside. This would suggest that, ceteris paribus, a re-run of the SARB’s inflation models for the December MPC —particularly after incorporating the October rate hike —should produce a much more benign inflation outcome than was the case in October. Also remember that, given all the information that was available to the SARB in October, it felt that only a 50bp rate hike was necessary to help maintain inflation within the target range. Now that some (if not most) of those variables are looking less worrying than they were in October, we do not think that it is unreasonable to expect a pause in December, or perhaps a 25bp hike? One must note that the first rate hike was motivated by the SARB’s contention that oil prices could take CPIX above the target in the first quarter of 2007. The second hike was motivated by the strong consumer, the wide current account gap, as well as the SARB’s view that still-high oil prices would combine with the currency’s weakness to take inflation above target in the first two quarters of 2007. Then came the third hike in October, which was again justified on the grounds that the consumer was still strong, the current account deficit wide, and that the rand’s weakness posed a threat to inflation. This time around, the SARB forecasted inflation to remain uncomfortably close to 6% in the last three quarters of 2007 (in fact the inflation fan chart produced in the Review shows a slight breach of 6% in the second and fourth quarters of 2007). The big question is, will the SARB be able to justify another rate hike in December if its own forecasts show a meaningful improvement in the inflation trajectory going out to the end of 2008 —particularly if there is further corroborating evidence (e.g., lower retail sales, slowing private sector credit, slowing durable goods imports, a narrowing trade balance, waning consumer confidence, weaker manufacturing production, etc) of an already-slowing economy?

Inflation expectations

One must not forget that inflation expectations also play a key role in the SARB’s reaction function. After the 0.4% deterioration in inflation expectations in 2007 as published by the BER inflation expectations survey, we expect inflation expectations to have moved sideways in the fourth quarter or, in fact, improved by 0.1%. In fact, the break-even yields between fixed coupon bonds and inflation linkers at the front end of the yield curve (R194/R198 spread) have fallen from 680bp in the first week of December to 620bp this week (a decline of more than half a percent), while break-even yields in the belly of the curve (R153/R189 spread) have also fallen from 620bp in the first week of October to less than 565bp this week. Finally, the right wing of the yield curve (17-20-year area) also reports a similar decline in inflation expectations, as shown by the decline in the R186/R197 spread from 576bp in the first week of October to 510bp this week. With such encouraging improvements in inflation expectations across the full spectrum of the yield curve, we struggle to see why the SARB would still find it necessary to tighten further.

Bottom line: What is our call for December?

It is still early days yet, but with all the information available to us right now, we are finding it harder and harder to justify another 50bp hike in December. We now think the probabilities are evenly drawn right now: While our conviction clearly points to the SARB staying on hold in December to assess how the earlier tightening percolates before deciding on the next move, we certainly do not have sufficient data points to corroborate the view. We expect both oil prices and the currency to move sideways, while upcoming data releases on CPIX, PPI, PMI, inflation expectations, Business Confidence Index, etc head southwards, thereby obviating the need for further tightening. But, given that we do not have enough data to support our strong conviction, we will have to stick to our call for a final 50bp hike in December for now, and look to reassess at the month’s end.

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Global
Between the Lines of the Governor’s Speech
November 10, 2006

By Takehiro Sato | Tokyo

Support from economic data for an early additional rate hike is receding, and the text of Governor Fukui’s speech on November 7 did not depart from the BoJ’s upbeat but moderate view in the October Outlook Report. However, the governor again showed signs of a forward-leaning stance on future rate hikes, commenting that “we will take moderate action in advance”, which is not in the official text of the speeches. The governor also underlined the importance of a forward-looking approach to avoid drastic fluctuation in the future economy and prices.

Although his remarks sound hawkish in light of recent soft economic indicators, we were more or less prepared for that. In the Q&A session, however, the governor even appeared to suggest that the BoJ may prepare the ground for future rate hikes. Given this, we still look for a hike in the Jan-Mar quarter next year, and specifically at the January MPM (January 17-18), even with some softer data flow ahead such as in the Jul-Sep GDP on November 14.

Our reasons are threefold: (1) In the text of his speech and in the Q&A session, the governor’s rationale for future rate hikes placed greater emphasis than contained in the Outlook Report on a monetary policy framework based on “second perspectives”, in which the checkpoints would be along the lines of the BoJ monitoring the risk factors that are not high at this moment, but still have important implications for the economy and prices. Namely, the governor is trying to justify a rate hike even in the midst of weak economic data, for fear of an asset bubble emerging through an ultra-accommodative policy. (2) The Outlook Report envisages a scenario where the market discounts for the level of the policy interest rate, and the BoJ justifies raising rates in response to this process of discounting by the market. Otherwise, there may be a large swing in the economy and prices, according to the BoJ.  (3) In laying the groundwork for rate hikes, establishing a regular cycle of increases three months after the bi-annual Outlook Reports (namely in January and July) would stabilize formation of market expectations and, by extension, long-term interest rates.

So, what should we expect ahead?  Even with soft economic data, it would be safer to assume comments around the end of the year/early next year to pave the way for a rate hike. Indeed, Governor Fukui did note during the Q&A session that there is a gap between the current perception of economic conditions at the BoJ and in the market, and implied that the market’s view should be aligned with that of the BoJ.  It is worth noting that the recent rate of core CPI inflation has been coming down due to falling oil prices, posing downside risk for the BoJ’s scenario, but the core CPI is no longer of paramount importance to the BoJ as a checkpoint. What matters more is the BoJ's (not our) view of the future headline CPI.

On top of this, opinions would be divided among investors as to whether moves by the BoJ to prepare for rate hikes amid soft economic and price data should really be termed ‘forward-looking’. Arguments for a rate hike based on the level of the policy rate that has been discounted by the market are also at risk of circularity.  We reiterate this because we are fairly skeptical on the growth in demand for funds, given the recent sluggish bank lending numbers.

As a matter of fact, although the October bank lending number held in positive territory, growth has waned since the summer. Major banks in particular turned to negative growth for the first time in five months. The flattening of the yield curve as the BoJ hikes interest rates under loan weakness would be negative for equity markets and positive for the bond market.  Because of factors such as policy interest gaps between the US and Japan, this also undermines the yen. We need to track the basic trends of loans for the time being to discern whether an early rate hike would harm the economy and market.

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Global
Exporting Services Beyond the Liquidity Boom
November 10, 2006

By Denise Yam, CFA | Hong Kong

Services exports – Hong Kong’s dominant growth driver

Our growth model for Hong Kong comprises three main exogenous drivers: (1) exports of services, (2) liquidity and capital flow conditions, and (3) fiscal policy.  These drivers have each in turn powered growth over the past decade.  The deficit budget provided significant support to growth over 1998-2003.  But then, as the global liquidity party got underway in 2H03, kick-starting the bull run in asset prices and, hence, the recovery in domestic demand, fiscal policy turned contractionary with the narrowing deficit.  With a fixed exchange rate, which does not respond to a balance of payments surplus, further impetus was given to asset price gains, prolonging the support to domestic demand growth.

However, Hong Kong is vulnerable to a turnaround in liquidity.  Although sustained enthusiasm towards China-related equity assets in Hong Kong could probably help offset the US Fed’s withdrawal of liquidity, it is now time for Hong Kong to secure growth from its most sustainable and structural growth driver, the export of services.

Output gap following Asian crisis drove surge in services exports

The popping of the asset bubble with the onset of the Asian crisis and the negative wealth effect dealt a huge blow to domestic demand in Hong Kong.  The share of fixed investment in GDP declined continuously from 33% in 1997 to 21% in 2005, driven by a structural downshift in construction activity (down from 16% of GDP in 1997 to 8% in 2005).  While currencies were devalued in other Asian economies to export their way out of recession, this was not the best strategy for Hong Kong, where manufacturing had already diminished to just 5% of GDP following more than a decade of production relocation to China.  It was the export of services that came forward to fill the output gap.

Exports of services have been growing at a compound rate of 9% a year since 1998.  The services trade surplus has been expanding continuously and has been a key growth driver for Hong Kong, sustaining a contribution of more than two percentage points to overall real GDP growth a year.  The surplus reached 16.8% of GDP (US$30 billion) in 2005, up from 5.2% in 1998.

Services exports — the current status

Generally, we divide exports of services into two broad categories: those that are merchandise-trade-related and those that are unrelated to merchandise trade.

As a re-export center between China and the rest of the world, Hong Kong has rich experience in providing trade-related services.  These include transport, storage and logistics services related to the goods handled through Hong Kong, as well as ‘merchanting’ and ‘merchandising’ of goods, the majority of which never pass through Hong Kong (offshore trade) and are therefore not captured in customs trade statistics.  Merchanting is the process whereby Hong Kong companies purchase from and sell to parties outside Hong Kong, earning a margin between the purchase and selling prices.  Merchandising, on the other hand, is where the Hong Kong companies earn a commission or service fee from simply arranging the sale of goods between buyers/sellers without taking ownership of the goods in the process.  These services, i.e., transportation, merchanting and merchandising, represent around 60% of total exports of services, with offshore trade gaining share over time.  While the growth in exports of these trade-related services clearly fluctuates with the global cycle, China’s integration with the rest of the world post-WTO undoubtedly provides a structural boost.

As a superior and efficient services hub in Asia/Pacific, Hong Kong has fostered the growth of non-trade-related service exports that span several of its tertiary economic sectors, such as the hospitality industry (inbound tourism), finance and insurance, business consulting, marketing and public relations, entertainment, communications, IT and professional services.  These currently account for 40% of Hong Kong’s total exports of services.

Positioning the services sector to complement China

While mainland Chinese customers account for less than 30% of Hong Kong’s services exports, with the US (20%) and Western Europe (18%) still contributing much to overall demand, we believe that China’s globalization process will be the most significant driver of growth in services exports in the next decade.  Hong Kong is undoubtedly positioning its services sector to be complementary to China’s, that is, focusing on areas where China still has a comparative disadvantage.  In our view, China’s main weakness is the lack of flexibility in its financial industry, and this has benefited and is continuing to provide opportunities for Hong Kong’s financial sector.  In particular, Hong Kong has been attracting mainland enterprises to raise funds in its financial markets, and ambitiously preparing for opportunities in renminbi offshore financial services.  Financial services exports increased from 6.2% of total services exports (1.3% of GDP) to 11.1% in 1H06 (4% of GDP) and have considerable potential for further expansion, in our opinion.  The Closer Economic Partnership Arrangement (CEPA) also offers Hong Kong companies and individuals liberalized access to China’s services sectors.  We believe that non-trade-related services will represent an increasing share of Hong Kong’s exports.

Needless to say, Hong Kong’s unskilled labor force remains under pressure in view of the labor arbitrage within the Pearl River Delta, and Hong Kong has yet to fully overcome the hollowing-out effects since the 1980s.  The apparent revival of manufacturing production in the past couple of years amid (1) zero-tariff access of domestic exports to China under CEPA; and (2) the diversion of textile orders from developed markets due to protectionist measures against Chinese goods, is merely slowing the final wave of manufacturing downsizing.

We believe that Hong Kong will continue to enhance its status as the regional services center and that exports of services, especially to China, will continue to be a key driver of the territory’s economic growth over the medium term.  The ongoing expansion in Hong Kong’s current account surplus suggests that productive capacity still exceeds domestic demand.  The economy appears to be still experiencing consolidation amid increasing integration with China’s.  Nevertheless, the continued growth in its role as China’s services center and the gradual shift towards higher value-added industries from traditional manufacturing and construction will, we believe, underpin the structural uplift in per capita income and living standards, enabling a sustained upgrade in domestic consumption over the long term.

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