Europe
Stronger Growth; Higher Rates (I)
November 22, 2006

By Eric Chaney and Elga Bartsch | London, London

Just as some short-term indicators are pointing to slower growth in the euro area and some commentators predicting an imminent recession, we are upgrading our GDP growth and interest rate forecasts for next year.  Two main reasons drive the upgrade.  First and foremost, thanks to cyclical improvements on the demand side and structural progress on the supply side, we believe that the underlying growth rate of euro area economies is stronger than we had previously assumed.  Second, some of the headwinds we had priced in our previous forecasts (see Enjoy the Good Times While They Last, May 15, 2006) look less threatening than we had believed.  The VAT rate hike in Germany in January should have less impact on retail prices than have previous hikes, we think.  In addition, crude oil prices should prove friendlier to oil importers than we thought a couple of months ago.  With stronger-than-expected GDP growth this year and next, we no longer expect the ECB to ease monetary policy in 2007.  On the contrary, we think that the ECB will buy further insurance against inflationary pressures over the course of next year, although less aggressively than this year.

This year, underlying GDP growth is close to 3.5%

Monthly manufacturing business surveys (Ifo, Insee, Isae and others) have consistently indicated that: 1) GDP growth this year is around 3%, i.e., higher than currently estimated on the basis of provisional GDP data for the first three quarters of the year; and 2) demand growth is practically as strong as it was in 2000, the best year for Europe since the German unification.  Had interest rates, the euro exchange rate and oil prices remained unchanged at their 2005 level, real GDP would today be growing a good half a percentage point faster, on our estimates.  In other words, the underlying ‘free’ growth rate of the economy is currently around 3.5% (See Enduring a Triple Whammy, Eric Chaney, July 26, 2006).  This is the result of two convergent forces, cyclical and structural.

The cyclical dimension: domestic demand is recovering

First, domestic demand is improving cyclically.  Fixed investment, currently growing at a 4.8% annual clip (2Q GDP data), is the most buoyant sector, itself fuelled by the renaissance of German construction, after a multi-year recession, and by corporate profits driving up capital expenditure.  The consumer sector, although trailing the corporate and housing sectors, is also sending positive signals.  A careful reading of euro area retail sales data (unfortunately blurred by high statistical ‘noise’, in particular because they include food and beverages) shows that, on trend, consumer spending bottomed out in 2003 and has been progressively recovering since then. On our estimates, the underlying quarterly annualised trend growth of retail sales was close to 2.0%, its long-term trend, in September. This compares with around 1% in the last three years.  The main driver of consumer spending is, in our view, the large pent-up demand accumulated since 2002 and progressively freed up by low interest rates and falling unemployment.  Consumer spending is now growing slightly faster than real disposable income, and the personal savings rate is declining faster than it did in 2003-2004.

The structural dimension; productivity revival

Although the cyclical dimension of the recovery should not be under-estimated, it cannot fully explain how the underlying growth rate of the economy could be as high as 3.5%.  The acceleration of productivity since 2003 is the other factor explaining the strength of the recovery.  In our view, the revival of productivity growth is more than a cyclical surge, or the result of labour hoarding during the years post the 2001 recession (see Productivity Is Accelerating, Eric Chaney, August 25, 2006).  In Western Europe, the main consequences of globalisation and especially of EU enlargement were to force companies to implement in-depth restructuring, both internally (headcount reduction, enhanced competition between suppliers, etc.) and externally, by means of labour outsourcing, in new EU members in particular.  It is also the result of massive investment in ICT over the years, a factor that has been disappointingly slow to produce macro effects, but which is now thriving, we think.

A stronger baseline for next year

All in all, we think that the baseline for our 2007 GDP forecast is probably around 3.0%, after 3.5% this year, instead of the 2.5% we had assumed previously.  By baseline, we mean the growth rate that the economy would theoretically enjoy if external or exogenous factors such as fiscal and monetary policies, exchange rates or oil prices were unchanged.  Needless to say, these allegedly exogenous factors are partially endogenous.  For instance, if GDP growth had been 3.5% this year and would reach 3.0% next year, the economy would soon be overheating, as it did in 1999-2000, inflation would pick up and interest rates would rise, soon curbing domestic demand.  Yet, for the sake of analysis, it is useful to have a fair idea of the ‘free’ growth rate.  As we explained in Enduring a Triple Whammy, the fiscal and monetary headwinds next year are likely to cut GDP growth by around 1 percentage point.  However, if the baseline is 3.0% instead of 2.5%, GDP growth is likely to hover around 2% next year, rather than 1.5%.  This is the conclusion we have reached in our revamped GDP growth forecast.

[In the second part of this article, we propose a ‘rational expectation’ theory of the German VAT rate hike, re-assess the headwinds facing the euro area next year and draw the consequences of our analysis for monetary policy and the yield curve.]

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Hong Kong
From Easy Money to the Volatile Real Economy
November 22, 2006

By Denise Yam, CFA | Hong Kong

Growth rebounds in 3Q06

Hong Kong’s economic growth rebounded significantly in 3Q06.  Real GDP growth picked up to 6.8% YoY, from the revised 5.5% rate in 2Q, beating market (5.4%) and our (5%) expectations.  Liquidity-driven asset price gains have underpinned the pick-up in domestic demand growth (excluding change in stocks +6.2% YoY in real terms versus +4.5% in 2Q), in our view, while the rebound in trade growth (+8.6% YoY in real terms versus +6.8% in 2Q) and the expansion in the net exports surplus also contributed to growth.  On a QoQ seasonally adjusted basis, the economy expanded by 3.5% (0.3% in 2Q), unseen since the post-SARS rebound in 3Q03.  Nominal GDP growth picked up in line to 6.6% YoY, although the GDP deflator (-0.2% YoY) was again hurt by the loss in terms of (merchandise) trade (-2% YoY).

Domestic demand — investment surges, consumption not as strong as expected

After cooling briefly in 2Q, private sector investment in machinery and equipment rebounded sharply in 3Q, jumping 22.9% YoY in real terms (+13.7% in 2Q), though still not matching the pace in 1Q06 (+26.2%).  Overall construction spending remained subdued nevertheless, down 5.7% YoY, worsening from the 3.7% decline in 2Q, led by the cutback in public sector works (-21.4%).  Overall public sector investment continued to contract sharply, by 18.3% YoY in real terms.

Contrary to expectations for a further pick-up on the back of stronger retail sales in the quarter (+5.8% YoY in real terms versus +5.3% in 2Q), private consumption growth slowed to 4.4% YoY, from 5.1% in 2Q.  Deviating from trend in 2Q, consumers increased spending on consumer durables (+6.1% versus +4.4% in 2Q), while service consumption slowed (+4.6% versus +5.7%).  In addition, Hong Kong consumers allocated a smaller portion (11.1% versus 11.4% a year ago) of their spending on outbound travel and shopping overseas (+1.3% in real terms), in contrast to the increase in expenditure abroad in 2Q (+7.3%).

Service exports remains a structural growth driver

Merchandise trade growth rebounded after the lull in 2Q.  Export growth averaged 8.4% YoY (nominal) in the quarter, up from 5.2% in 2Q, while import growth recovered to 10.6% (+7.8% in 2Q).  The merchandise trade activity bolstered the growth in Hong Kong’s exports of services.  Trade-related service exports grew 11.3% in real terms and 12.9% YoY in nominal terms, up from 10.8% and 11.4%, respectively in 2Q.

Nevertheless, the biggest driver of the 14.1% gain (nominal) in overall service exports was the expansion in the provision of financial, consultancy and other business services, as Hong Kong continued to leverage on China’s development.  Although a more detailed breakdown is not yet available, service exports excluding those related to trade, transportation and travel sustained strong growth of 28.5% YoY in nominal terms, which in our view was boosted in part by the listing of Chinese enterprises in Hong Kong.  An interesting trend to note is that Hong Kong seems to be able to price up such exports significantly in the recent months, as seen in the divergence between growth in nominal versus real terms, suggesting that Hong Kong has moved up the value chain in service exports (especially financial services), demonstrating outstanding strength in these sectors.  In 3Q06, such service exports grew 11% in real terms against 28.5% in nominal terms, implying a price increase of 15.7% YoY for the service exporters.  Meanwhile, although growth in visitor arrivals slowed to 6.7% YoY versus 8.4% in 2Q, inbound tourist spending (= exports of ‘travel’ services) still grew 9.6% YoY (+12.9% in 2Q), implying continued increase in per-visitor (per trip) spending to HK$3,410 (+2.7% YoY).  Hong Kong’s services trade surplus therefore continued to expand, to a record 19.5% of GDP (nominal), contributing 2 percentage points to real GDP growth.

Economy still underpinned by friendly liquidity environment

We have long stressed that liquidity conditions and asset market performance have a strong influence on real economic activity in Hong Kong.  The influence has further stepped up this year on the back of the increase in large-size listings of Chinese enterprises in the Hong Kong stock market.  The HK$-denominated financial asset base has grown significantly upon these IPOs, and even more so with the subsequent appreciation in these financial assets on the back of foreign investor invest drawn by optimism towards China.  Asset market expansion has powered monetary expansion far ahead of economic growth.  The gap between deposit and loan growth, which tracks more in line with the growth of the economy, has resulted in excess liquidity in the banking system (a falling loan-to-deposit ratio) and allowed interest rates to stay low, further supporting asset market valuations and gains.  With global liquidity continuing to surprise on the upside and Hong Kong asset markets particularly supported by optimism associated with China, it appears that the monetary normalization that began in mid-2004 — when the Fed first hiked interest rates in the current cycle — was never completed.

Liquidity challenges economic forecasting

The expansion of Hong Kong’s financial asset base in the last few years has been driven by China’s increasing appetite for international capital.  The performance of the asset markets is not so directly representative of Hong Kong’s domestic economic fundamentals, but has ironically become the driver of monetary conditions and economic sentiment.  Many argue that the ongoing appreciation in the renminbi should be a key driver of inflation in Hong Kong through imported Chinese goods.  However, in our view, the more immediate impact could actually be through the appreciation of Hong Kong-listed Chinese equities.  Hong Kong’s stock market capitalization has surged to HK$11.3 trillion, or close to 8 times GDP of late, topping the rest of the world by a wide margin.  Average daily turnover rose to HK$37 billion in October 2006 (2.5% of GDP).  In other words, each 1% rise or fall in the stock market represents an amount equivalent to 4% of broad money (M3), or 8% of GDP.

Over the past couple of years, we have seen robust pick-up in consumption and investment on the back of asset appreciation and low interest rates.  Consumption has been lifted by the positive wealth effect, while employment, wages and household income have only been catching up in the last two quarters.  Consumer businesses have also turned more positive on expansion plans amid stronger consumption, in addition to the support from low interest rates.  However, it worries us that, as a small, open economy with a fixed exchange rate, Hong Kong’s strong leverage on liquidity conditions and asset market performance results in volatile business cycles driven by non-domestic factors.  

Because of the heavy influence of non-domestic factors on asset market performance, economic forecasting for Hong Kong has become a challenging task.  While we are reluctant to make purely speculative forecasts on further deviation of HK$ interest rates from their US$ counterparts (hence sustained strength in asset prices), it is quite possible that anomalous monetary conditions sustain for even longer.  Indeed, banks in Hong Kong had lowered deposit and lending interest rates lately, in line with the softening in interbank rates.

Lifting forecasts on sustained liquidity and china growth

Similar to the case we made for our upward revision in China’s GDP growth forecast for 2007 (see Soft Patch in 4Q but Friendly Liquidity Cushions Landing, November 17, 2006), we believe that the maintenance of friendly liquidity conditions will underpin growth in Hong Kong ahead.  The correction in commodity prices in the international market and apparent taming of inflation expectations of late have caused markets to expect a more dovish monetary policy stance from the major central banks.  Specifically, our US economists believe that tightening by the Fed is close to an end (with one more 25bp hike), and easing could kick in as soon as 2H07.

Factoring in the strong growth in 3Q06, strong asset market performance since October and the recent softness in interest rates, we now see the economy growing 6.6% in 2006, revised up from 5.6% previously.  We expect growth in 4Q to be hurt by softer trade growth, but it can still remain robust at around 6%, in our view.  The upward revision comes primarily from our upgrade in private fixed investment, to 12% growth this year, versus 8% originally.  Meanwhile, reflation in Hong Kong proved to be more gradual than we earlier expected, after CPI data fell short of expectations for the last two months (+2% YoY in October and +2.1% in September, down from +2.5% in August).  We now see CPI inflation averaging just 2% this year, revised from 2.3% in our previous forecast.

Looking to next year, in line with the recent upgrade in our China growth assumptions, we are also lifting our 2007 growth forecast to 5%, from 4.5% previously.  We continue to expect softer merchandise trade growth next year in line with weaker external demand as the US (+2.9% in 2007 versus +3.3% in 2006), Euroland (+1.9% versus +2.6%) and Japanese (+2.3% versus +2.8%) economies slow; we project 6% growth in exports and imports, down from 7.8% and 10%, respectively this year.  Our upgrade in overall growth is therefore attributed to stronger growth in private investment (+7% versus +5% previously) and consumption (+4.2% versus +3.5%) on the back of accommodative monetary conditions and asset market resilience.  We also lifted our forecast for the growth in service exports (+10% versus +8%), driven by sustained demand from China’s globalization trend.  Our revised forecasts take us above the consensus (November survey: 5.9% for 2006 and 4.9% for 2007), but it is likely that other forecasters will also be lifting their projections following the latest data report.

We are optimistic on Hong Kong’s economic prospects over the medium term, believing that the economy is well-positioned to leverage on opportunities from China’s multi-decade development.  Moving further up the value chain as Hong Kong secures its role as the service center in South China underpins the structural upgrade in household income and living standards.  Nevertheless, forecasting cyclical turns in the Hong Kong economy is now complicated by the volatile fluctuations in global asset market sentiment in response to liquidity conditions.  Our updated forecasts assume the maintenance of accommodative monetary conditions in the next year, so downside risks remain in a global stagflation scenario where real economic activity is hurt simultaneously by weaker global demand and tighter liquidity.  With gigantic asset markets (under the influence of foreign liquidity) relative to the size of the local economy, Hong Kong has to get accustomed to more volatile business cycles, in our view.

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Europe
The 2007 Wage Negotiations — Expectations and Implications
November 22, 2006

By Thomas Gade | London

Massive round of wage negotiations in 2007

The Swedish economy will see the largest round of wage negotiations since ten years in 2007.  Close to 2.8 million employees — or approximately 65% of employment — will have their wage contract up for renegotiation during the next year. Most of the wage rounds are likely to be completed by mid-2007. The renegotiations of wages will start with close to one million employees from the construction sector and the service sector (not financial services). The final result of these first rounds of wage negotiations will likely be reached by the end of March. Later in the year, a new wage agreement for the municipal and county council employees will likely be ready by the end of June. Finally, 240,000 or so central government employees will have their wages renegotiated by September.    

Given the large scale of the wage rounds next year, the Riksbank and financial markets will be monitoring developments closely. Because of the low inflationary environment, with inflation persistently below the official 2% target for a number of years, the Riksbank may in fact view upwards pressure on wage growth as beneficial. We expect the wage negotiations of the construction and service sectors to attract most attention from the Riksbank and financial markets. A number of factors are likely to influence the wage negotiations, we think.

• With the exception of the large manufacturing sector, a rising number of companies are reporting labour shortages within their sectors. This is likely to cause upwards pressure on wages.
• Profitability on the corporate sector is currently at high levels compared with previous wage rounds. Labour unions are likely to use this to step up wage demands, causing upwards pressure on wages.
• Parts of the wage pressures from labour shortages can be expected to be reduced from an increase in the labour supply.
• A lower tax payment on labour income from 2007 could subdue wage demands slightly, we think.

Wage formation and expectations

Wage formation in Sweden is to a large extent governed by the rules laid out in the 1991 Rehnberg Agreement — or simply, the ‘Industrial Agreement’. The agreement limits local wage formation and was set up partially to secure a stable wage formation and to avoid wage drift. Also, parts of the agreement specify that the sector exposed to international competition acts as wage leader. Jointly with the introduction of a formal inflation target for monetary policy in 1994, the Industrial Agreement has been one of the factors responsible for the stable and responsible wage formation observed during the last 15 years.  This would also suggest that wage growth going forward is likely to remain responsible and stable, but an increasing number of wage agreements are now determined at the local level. This could potentially set the stage for a larger wage drift going forward.

Calculations by the National Institute of Economic Research (NIER) suggest that a wage increase of 4.5% per year in the years ahead would be economically responsible and in line with the official 2% inflation target (NIER: Wage Formation in Sweden, 2006).  Early general recommendations from the Swedish Trade Confederation Union (LO) have set the stage for demands of no less than a 3.9% increase per year over the next three years (Swedish Trade Confederation Union: Gemensamma Krav infoer Avtal 2007). The recommendations still leave some room for individual union-specific agreements. The LO is the main labour union confederation in Sweden. It consists of 15 industry-specific unions with a total of 1.8 million members.  A large part of the wage agreements up for renegotiation during 2007 will be governed by the recommendations laid out by the LO. 

Implications for inflation and monetary policy

As we will argue below, there are both upside and downside factors affecting the potential wage growth from the 2007 wage negotiations. We expect the upside risks to wage growth from high corporate profitability and reported labour shortage to outweigh the downside risks from a further rise in the labour supply from increased immigration and a lower tax on labour income. On balance, we expect wage growth to be around 4.0% on average in the three years covered by the 2007 wage agreement. Risks are skewed to the upside, in our view.

We expect monetary policy accommodation to be gradually withdrawn at 25bp per quarter up to 3.75% by the end of 3Q07. This is broadly in line with market expectations. From 3Q07 onwards, we expect the Riksbank to continue withdrawing monetary accommodation, but at a slower pace of 25bp every other quarter. This is above current market expectations. The Riksbank will likely reach neutrality around 4.5%, in our view. While inflation in Sweden is likely to continue rising going forward, we are forecasting inflation in the euro area to slow in 2007 (see Stronger Growth; Higher Rates, November 21, 2006). As the current monetary policy rate is lower and the neutral rate likely higher in Sweden than in the euro area, the Riksbank is likely to continue raising monetary policy rates when the ECB stops. As a result of continued monetary withdrawal and divergence in inflation developments between Sweden and the euro area, we expect 10-year government bond spreads to Bunds to widen during 2007. However, the privatisation of government assets remains a wild card in this projection.

Wage talks amid favourable economic activity

The 2007 wage round will take place amid favourable business cycle conditions. With an annualised growth rate of 5.5% during the first half of the year, the Swedish economy is currently experiencing the strongest rate of growth since the boom year of 1999. At the same time, the unemployment rate has been on a downward trend since the beginning of 2005, following a number of years of high job-less growth. Currently, the unemployment rate in Sweden is 4.9% in October on our own break-adjusted and seasonally adjusted numbers. 

High growth in the Swedish economy and declining unemployment is also reflected in an increasing number of Swedish companies reporting labour shortages within their industry. The largest fraction of companies reporting labour shortages is in the construction sector, where close to 70% of construction companies report problems with attaining enough workers. Less so, but still on a rising trend, 30% of companies in the private services sector now report problems with recruitment. Meanwhile, 14% of companies in the business sector (trade) report labour shortage. More constant, only 4% of companies in the large manufacturing sector are currently reporting labour shortage. The low level of companies reporting labour shortage in the manufacturing sector is not surprising, as the manufacturing sector has been the main sector behind the high productivity growth rates in Sweden during recent years — subsequently resulting in the years of job-less growth. We expect hiring in manufacturing to pick up going forward.

Labour unions in Sweden were viewed as being economically responsibly during the 2004 wage bargaining round. During the 2004 wage round, the moderate wage demands were partially a result of a relative high unemployment rate and the need to preserve jobs relative to wage growth. This time around, the labour unions are not subject to the same degree of consideration due to the now-lower unemployment and reported labour shortage. As the labour shortage is particularly present in the construction sector and the services sector, the first wage agreements reached in 2007 are likely to be on the high side of the minimum 3.9% nominal wage increase per year suggested by the Swedish Trade Confederation Union (LO).

Positive labour supply effects could abate wage demands

Despite the rise in companies reporting labour shortages, there are good reasons to believe that fiscal factors contained in the 2007 budget as well as an increase in immigration will result in an increased labour supply. An increase in the labour supply will abate some of the wage pressure in the sectors where labour shortages are being reported.

First, the budget proposal for 2007 — released in early October — contained a reduction in the income tax on labour income to the tune of 5 percentage points on average. We have previously calculated the labour supply effect to increase the labour force by some 1-2% in the medium term by using a conservative estimate for the labour supply sensitivity relative to disposable income (see Sweden Economics: Growth Hidden in 2007 Budget Composition, October 17, 2006).  This is a result of people already in employment deciding to work more as well as people from outside the labour force deciding to enter the labour force, i.e., both from an hour effect and from a participation effect.

Second, Sweden and the UK were initially the only two countries in the European Union not to place any restrictions on labour mobility during the EU enlargement with the Central and Eastern European Countries back in 2004. As a result, Sweden along with the UK has seen a very rapid increase in immigration — between 2005 and 2006 in particular.

Extrapolating the trend in immigration through September this year, some 100,000 people are likely to have immigrated into Sweden during 2006. This is a 51% rise from 2005 immigration numbers. As the number of people emigrating out of Sweden has remained broadly stable, the net immigration number of 56,000 alone this year is the equivalent of 1.2% of the labour force. While the emigration from Sweden is likely to be high value-added jobs, a large part of the increase of immigration into Sweden is likely to be in low value-added job functions. As such, the construction and service sectors stand to benefit the most. However, the massive net immigration numbers are likely to abate wage pressures only, despite the labour shortages being reported in many sectors.  

Corporate profitability supports wage demands

Companies in Sweden are currently experiencing some of the highest profits for 15 years. Using the gross operating surplus (GOS, derived from the national accounts. It is calculated as the gross value added less compensation of employees and indirect net taxes paid by producers. In macroeconomics, the GOS is therefore used as a proxy for total pre-tax profits.) from the national accounts, it is clear that in particular private services and the manufacturing sector have experienced very strong profits during recent years.  Also, the construction sector has experienced high profit growth during recent years, following years of lower real profits during the 1990s.  Parts of corporate profits are paid out to investors and parts are ploughed back into corporate investment. We expect corporate investment to continue expanding in the years to come, although at a gradually declining rate.  

During the previous wage round in 2001, unemployment was low, but so was profit growth in many sectors. During the 2004 wage round, corporate profits were in a recovery phase, but the unemployment rate was higher and rising. While wage demands were hard to demand during the 2001 bargaining round, labour unions may have opted for job security relative to wage growth during the 2004 wage round. All in all, subduing wage growth was seen during the 2001 and 2004 wage rounds. In the 2007 wage round, corporate profits are high and the unemployment rate is lower and declining. We therefore expect labour unions to claim a larger share of corporate profits in the upcoming wage round, even despite dividend pay-outs and a continued rise in investment spending. As wage compensation and corporate hiring are likely to rise, corporate profit growth could be subdued.

High relative wage growth hampering competitiveness 

The outcome of the 2007 wage negotiations is not only important for inflation and monetary policy. Wage growth in the Swedish business sector is also one of the medium-term factors determining the overall competitiveness of the Swedish economy. Naturally, competitiveness is also determined by other factors such as innovation, productivity and the nominal exchange rate. Determined by compensation growth and productivity, unit labour costs are typically a good measure of the underlying longer-term development in competitiveness of an economy. In Sweden, nominal compensation in the business sector has been growing at an average rate of 3.6% during the last five years. This ranks Sweden unfavourably high in terms of wage growth in an international comparison, only surpassed by the US and the UK among the large industrialised countries. Only due to a relative high productivity growth rate of 2.6% on average during the last five years, has the Swedish economy maintained a relatively favourable competitive position in international comparison.

Going forward, cyclical productivity growth is likely to slow as corporate hiring will likely continue expanding, we think.  As the Swedish economy has benefited from IT investment at an early stage, structural productivity growth from capital deepening may start to abate. Meanwhile, productivity growth in the euro area — the most important market for Swedish exports — has been lagging behind most other developed countries during the last five years. In the euro area, unit labour costs have mainly been subdued as a result of low wage growth — in particular in Germany — as well as low growth in non-wage costs such as employers’ social security contribution. There are now indications that productivity growth in the euro area has started to catch up with that of other main industrialised economies (see Euroland Economics: Productivity Is Accelerating, Eric Chaney, August 25, 2006). A potential productivity slowdown in Sweden combined with a pick-up in productivity in the euro area would make the upcoming wage round all the more important.  As wage growth is already unfavourably high in Sweden, continued high wage growth in the upcoming wage negotiations along with a potential productivity slowdown could revert the favourable developments in unit labour costs observed over the last five years and undermine the competitiveness of the Swedish economy going forward.

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Global
The Retail Revolution – Part I – The Macro Story
November 22, 2006

By Chetan Ahya and Mihir Sheth, CFA | Mumbai, Mumbai

Domestic private sector is rushing to announce retail plans

Even as the government continues to delay the decision to allow FDI in multi-product retail chains, the fast-emerging Indian retail sector is becoming widely recognized among domestic entrepreneurs and investors as one of the biggest opportunities in India. Apart from existing players (such as Pantaloon) ramping up their retail chain store operations, many large business groups, including Reliance Industries, Birla Group and Bharti Enterprises, have announced their intention to cumulatively invest over US$10 billion over the next five years to capture a share in the fast-growing pie of the organized retail sector. In addition, various foreign players like Walmart and Tesco have announced their intention to enter the domestic market via a joint venture with a domestic Indian player. Major consumer spending items currently form part of the addressable market for the retail chain stores format and include food and grocery, general merchandise (such as furniture and furnishings) and apparels. While growth estimates for the organized retail sector vary, forecasts by our consumer analyst, Hozefa Topiwalla, indicate that India’s organized retail market is likely to grow from the current US$4 billion (2.1% of total relevant consumer spending) to US$ 64 billion (10.8%) by F2015.

It’s not just about the new shopping ambience

Up until 2002, even consumers in India’s top cities, such as Mumbai, had no choice but to purchase their daily food and consumables from small-scale ‘mom & pop’ stores. The meaningful introduction of organized retail chains across the major metros has started only over the past 3-4 years. Prior to this, the Indian consumer had access to a limited variety of goods, and the quality of available goods was poor. The existing distribution system is completely fragmented, with mom & pop shops that operate with little use of technology. Inventory management is inefficient and the fragmented structure implies that they have little negotiating power when purchasing goods from wholesale traders.

However, the shopping experience for Indian urban consumers is now changing completely. What is triggering this change? On the demand side, rising per capita income of the fast-emerging middle-aged population and easier access to credit are triggering a change in consumption patterns. On the supply side, the private sector is responding with investment, taking advantage of the positive support from capital markets.  Retail shopping space is also growing exponentially. Mall space has increased to 54 million square feet (mn sq. ft) currently from 2.2 mn sq. ft four years back. According to Images Retail, the space is likely to rise further to 88 mn sq. ft by the end of 2007.

In the first phase of the retail revolution, the focus of entrepreneurs has been largely on capturing the consumers’ attention and providing them with a new shopping experience. There has been little effort on reforming the back end of the supply chain. However, going forward, the rising scale of the organized retail distribution network and increasing competition will force players to focus on reforming the whole supply chain to improve productivity and provide an attractive deal to customers, in our view.

Restructuring the supply chain

The retail revolution, involving an increase in input of capital, technology and new management practices, can potentially reform each and every part of the retail business chain over the next few years. It will restructure: (a) the retail distribution via higher asset turnover and better inventory management; (b) intermediary and logistics management; and (c) production management in the case of both agriculture and manufacturing.  Although total spending through organized retail chain store format is likely to be only about 10% of the addressable market by F2010, the impact of this trend on productivity across the retail food chain can be more than proportionate, in our view.

Transformation in retail distribution: Currently, Indian retail distribution is completely fragmented, with about 12 million players. The majority of these are very small players operating from small shops (below 50 square feet in size) and handcarts. These retail outlets are spread across the country in over 5,000 towns and 600,000 villages. In the absence of complete data related to the distribution of current mom & pop retail shops, distribution of fast-moving consumer goods (FMCG) distribution could be used a proxy, in our consumer analyst’s view.  Data from AC Nielsen indicates that the top six cities contribute around 19% of FMCG consumption, whereas the top 23 towns represent around 29%, and the top 301 towns about 48%. In our view, large retail companies are likely to be more aggressive in the top 20-30 towns. Penetration in the smaller towns is not likely to begin in a hurry. Apart from obvious improvement in consumer satisfaction, retail chain store distribution will help improve efficiency in distribution via higher asset turnover and better inventory management. 

Reducing large inefficiencies in the agriculture-related supply chain: This segment suffers from maximum inefficiency currently. Cumulative wastage in this supply chain is estimated to be about US$11 billion, or 9.8% of the agriculture component of GDP. Over the years, owing to government intervention in the input and output pricing, there has been little incentive for farmers to improve efficiency. Moreover, in the past few years, public investment in agriculture as a percentage of GDP has also been gradually declining. The archaic infrastructure for getting the agricultural produce from farm-gate to consumers has meant huge losses in transit and large mark-ups in pricing due to extra layers of intermediation. Until recently, most states controlled the marketing of agricultural produce through the Agricultural Produce Marketing Committee (APMC) Act. Not surprisingly, due to this lack of government support on infrastructure and restrictions on private sector participation, the agricultural sector has only been growing at an annual average of 1.8% over the past five years.

However, the outlook for the agricultural sector is finally improving as state governments have started implementing legislative reforms. Thirteen states and three union territories have amended the APMC Act to allow private sector participation in direct purchases of agricultural produce from farmers. We believe that the rise in the presence of the organized retail sector will accelerate reform in the agriculture sector. Farmers will be incentivized to adopt improved management techniques to increase efficiency, improve the quality of output and also provide the needed variety to consumers. As scale builds up, increased commercial opportunity should also attract the private sector in agriculture logistics management, reducing the number of intermediaries. The plans announced by some of the likely large retail players reflect the potential food-chain restructuring that could take place.

Indeed, certain large players have already begun participating and investing in this area. For instance, ITC — a large Indian FMCG company — has initiated an effort to place computers with internet access in rural farming villages (known as e-choupals (‘Choupal’ is a Hindi word that translates into meeting place.)). Via these kiosks, the company provides the farmers with a more transparent pricing mechanism and secure operating framework. The company has been able to procure agricultural products at a lower cost and farmers are able to increase their realizations.

SME manufacturing should get major demand boost and also face pressure to increase efficiency: The development of the organized retail sector should also result in restructuring of small and medium-scale manufacturing. We believe that some of the large players in the retail business will encourage the emergence of efficient small and medium-sized suppliers of modern retail goods. Two major segments in the small and medium-scale manufacturing sector that could get a boost from the emergence of the retail chain stores are textiles & clothing and food processing industries. In industries such as fast-moving consumer goods, where India already has a large organized sector presence in the supply chain (via MNCs and domestic companies), efficiency should come from better inventory management and responsiveness to customer feedback. 

However, in the near term, the organized retail chain stores could rely on imports for certain segments such as toys, select types of general merchandise and electronics goods. Unlike India, China’s organized retail sector is being developed before a globally competitive SME sector has been developed. Moreover, China has already built economies of scale advantages in certain goods, where it will be difficult for Indian players to compete in the near term. Success of Indian players will also be dependent on the government’s support in improving infrastructure and enabling tax legislations.

Intermediation/Logistics: One of the key hurdles to Indian agriculture and small/medium-scale manufacturing sector productivity growth has been a lack of infrastructure support from the government. In 2005, infrastructure spending was US$28 billion in India (3.6% of GDP), compared with US$201 billion in China (9.0% of GDP). The IMD World Competitiveness Year Book (2006) ranks India 47th among 61 nations in terms of distribution efficiency. The reason for this poor score is inadequate investment in infrastructure and the fragmented nature of the logistics industry. We believe that development of the organized retail sector could trigger a change in this industry as manufacturers and retailers rely on outsourcing to third-party logistics providers and also create economies of scale advantages for warehousing and transportation.

Macro impact — more positive than negative

The emergence of the organized retail sector is likely to have a transcending impact on India’s macro economy. Some of the key macro implications are summarized as follows:

Productivity growth and inflation: The obvious positive effect of the emergence of organized retail trade in the competitive market will be an increase in productivity and reduced inflation in the economy. The productivity benefit will stem from the aforementioned supply chain changes and the increased disintermediation in the system. For instance, according to a study by the McKinsey Global Institute, the retail sector contributed to nearly one-fourth of the productivity growth jump in the US from 1987-95 to 1995-99. The productivity benefit will likely be shared with the consumers (lower end-product prices) — hence leading to lower inflation.

Trade balance and export competitiveness: Initially, due to supply-side constraints and lack of economies of scale in select goods, increased demand could lead to an increase in imports from other countries and a wider trade deficit. Our discussion with the existing retail chain store players indicates that, currently, chain stores that cater to the middle class segment of the population already have an import content of about 15%. Chain stores that cater to the upper middle class and higher-income population tend to have an even higher proportion of import content. Over the next few years, as the small and medium-scale sector further builds scale and capabilities to manufacture, they could be able to substitute imports of some of these goods as well as improve their revenues from exports of agricultural and manufactured products. We believe that this trend will be further supported if the FDI in retail is allowed.

Employment trend:  The retail and wholesale trade sector contributes to 13% of GDP and employs about 40 million people (9% of workforce). It is the third-largest employer after the agriculture and manufacturing sectors. The sensitivity of the retail sector restructuring on the lower middle class population is indeed very high. A large of number of households depends directly on this sector for their livelihood. A majority of these mom & pop shops are very small in size (below 50 square feet) and are being used as a last resort employment opportunity by many of the low-skilled working-age population. In many ways, it has been acting as a safety net for a specific section of the poor.

Over the next two-to-three years, the development of the retail sector may not have a significant impact on the existing mom & pop shops. However, in the medium term, as the reach of chain stores increases, some adverse impact on mom & pop shops is inevitable, in our view. We believe that not allowing FDI in the retail sector is hardly a solution to prevent the adverse effect, as the domestic private sector will still be a force to reckon with.  In our view, opposition to evolvement of organized sector retail chain stores is no less legitimate than opposition to removal of protection provided to many sectors in the early 1990s liberalization program. The liberalization program of the 1990s had also forced a major restructuring of the workforce. Restructuring of an economy that is still at a developing stage in today’s globalizing, competitive world is inevitable. Embracing such a change is less difficult for a country like India, whose population has a median age of 24 years.

The issue of employment should not only be assessed from the perspective of the welfare of the specific segment of lower middle-income group (LMIG) population dependent on mom & pop shops but also from the viewpoint of welfare of the overall LMIG population.  Although a specific section of LMIG already employed in mom & pop shops may be adversely affected, the emergence of the organized retail sector will create new jobs for a different section of lower middle class in low-end modern retailing distribution, small-scale manufacturing, packaging, construction, infrastructure and transport sectors. Moreover, we believe that the lower middle class also stands to gain from the higher productivity (in the form of lower inflation) benefit that the organized retail sector offers. The quality of employment should also see a vast improvement as larger institutions will be able to provide better social security, training and growth opportunities. Indeed, increased organized sector activity should help increase aggregate tax to GDP, which would allow the government to initiate measures for direct intervention, to reduce the adverse impact on any specific section of the population.

Pace of change likely to depend on government’s response function

While we believe that the emergence of the organized sector will itself be a trigger to restructuring of the supply chain, the government’s response in enabling this transition will be a key factor in determining the pace of the improvement, in our view. Some of the areas where a supportive role from the government will be important are as follows:

Infrastructure investments: Although we expect some push to infrastructure investments from the private sector as it attempts to build an organized supply chain, there is clearly a need for a strong response from the government in building the infrastructure needed for quick transition in the supply chain. We believe that the primary responsibility for development of infrastructure lies with the government. These projects by their very nature are long-gestation and low ROE projects that are highly dependent on government regulations. The response from the government on infrastructure development will determine Indian producers’ (SMEs and farmers) capability to compete with other developing economies like China in filling up the shelves of the organized retail format, in our view. Although infrastructure spend is finally picking up as a percentage of GDP, we believe that the pace needs to be more rapid.

Foreign direct investment: In January 2006, the government approved new FDI norms for the retail sector and allowed up to 51% FDI in single-brand retailing. However, the decision to allow FDI in the multi-product retail chain stores has been delayed and remains a politically sensitive issue. There are some political groups who are opposing this decision due to its perceived implications on the mom & pop shops. We believe that not allowing foreign players is hardly resolving the issue as the domestic private sector is continuing to ramp up retail chain stores in any case. Indeed, if participation of foreign players is allowed in partnership with domestic players, it can help evolve the sector in a more efficient manner as these foreign players bring technology and expertise. Increased presence of the foreign players can also potentially help Indian manufacturers participate in the international goods outsourcing market — an area where India has struggled to compete with China. We believe that if the government desires to be conservative, it could allow FDI with certain restrictions.  The entry of foreign players could be restricted by limiting the geographical distribution and the quantum of stores that can be opened in a particular region. The government could screen the entry of foreign players on the basis of minimum investment requirements. Foreign players could also be required by the government to have a minimum domestic sourcing requirement or even have a reciprocal goods outsourcing requirement.

Agriculture sector: One of the key reasons for the low growth in the agriculture sector over the past few years has been the gradual decline in the government’s capital spending on the sector to 0.5% of GDP in F2006 from 1.2% in F1982. Although the government has finally started initiating measures to improve agricultural productivity, the pace of the change is still slow. The government needs to make a concerted effort to increase capital investment in the agriculture sector and improve the effectiveness of current spending.  In addition, the government also needs to support an acceleration in agriculture productivity growth in the sector (via a better fertilizer pricing policy and improved irrigation facilities) and also help diversify the agriculture product mix (via provision of better storage facilities, encouraging the development of the food processing industry and providing proper crop insurance products). Finally, the government also needs to further liberalize trade in the agriculture commodities so that farmers become more commercially oriented towards export markets.

Legislative reforms: The government needs to create an enabling environment in many areas to ensure swift development of the sector.

Various states are yet to implement legislative reforms in property-related laws such as the Urban Land Ceiling Act, Stamp Duty laws and the Rent Control Act. These laws have been slowing property development in the country and hence have been one of the factors resulting in rising property prices (and hence rentals). These high prices could prove to be a major hurdle for the organized sector retail players in acquiring the necessary real estate.

In addition, the government also needs to ensure quick implementation of the reform in the inter-state trade-related taxation law. Currently, the central government charges 4% sales tax on all inter-state sales of goods. This regime encourages companies to set up storage facilities in each state to avoid being taxed on these movements. This proves to be a disincentive to the development of a nationwide distribution system, especially via third-party logistics providers. Indeed, the government has announced a road map wherein the levy on output by the central government (central sales tax) will be merged into a common nationwide rate by April 2009.

In part II (to be released on November 24, 2006) we will focus on how the emergence of organized retail will benefit the entire agriculture supply chain.

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