UK
UK Housing: How Did We Get Here?
November 27, 2006

By David Miles and Melanie Baker | London, London

We estimate that a substantial part of the doubling in UK real house prices over the past ten years is due to income growth, population growth and falling real interest rates.  But one third to one half reflects changes in expected house price inflation.  A key question is whether, starting from here, we are likely to see significant falls in real house prices once those expectations come down. It is plausible that expectations do come down as average house price inflation falls from the current rate of close to 10% nominal.  We think it is quite likely that this would trigger falls in real house prices — but our simulations suggest that the timing is very hard to fathom and that we could still get a year or two of rising house prices.

UK house prices — on average — are still rising rapidly, having more than doubled in real terms over the past decade.  Have we reached a situation where house prices are so high that they cannot be sustained for much longer?  Very simple measures of affordability (most obviously the ratio of average house prices to average household incomes) look immensely stretched relative to past levels.  But unless we take some account of a much wider range of factors than just incomes, it makes little sense to talk of house prices as being unsustainable.  House prices are whatever they need to be to match supply with demand — this is a market that clears.  But it does not follow that we are in a sustainable equilibrium; we can be in a bubble. 

Explaining UK house price movements.  We assume that the demand for housing depends on three factors: 1) average per capita incomes; 2) the population; and 3) the real cost of home ownership.  The third factor — the real cost of home ownership — depends on real house prices, interest rates and other costs (e.g., house insurance, taxes), net of anticipated changes in house prices.  We assume that the new supply of houses depends, to a limited extent, on the price of housing.  We use estimates from the large literature on the UK housing market for the sensitivity of demand and supply to these factors. 

The major unknown factor in this procedure is figuring out how people form expectations of where they think house prices will be going.  We make an assumption that people attach some weight to what has happened to house price inflation in recent years, but also believe that there is a tendency for price increases to move towards some long-run average rate of increase.  The backward-looking part is potentially destabilising: if people believe that a period of rapid and high price growth means further sharp rises in prices, their demand is actually boosted by fast growth in prices, and this adds to price pressures.

Our model explains the 113% rise in real house prices over the past ten years.  Using our assumed sensitivities and plugging the change in income, population and user cost into our model suggests that we would expect real house prices to have risen 113% over the past ten years (when we assume that people form expectations by attaching equal weights to average house price inflation over the past five years, and to the long-run steady state inflation rate implied by the model — about 3%).  The 113% figure is roughly equal to the actual increase in real house prices over the same period.  In other words, if we believe in the validity of the model and in the elasticities used, and assume a 50:50 weight on the backward/forward elements of price expectations, there is no mystery in the rise in house prices we have seen over the past ten years. 

However, changed expectations play a very large role in explaining the rise in house prices.   Using slightly different specifications of our model suggests that changed expectations explain between a third and a half of the rise.  One might think of this as reflecting a speculative motive.

This makes the model unstable.  The fact that one apparently needs to put some weight on changed house price inflation expectations to explain actual house price inflation suggests that the current level of house prices may be rather unstable.  When we roll this model forward, assuming that the real interest rate, mortgage spread and ‘other costs’ elements are stable, and assuming steady 2.5% annual growth in household real disposable income, then the model predicts great volatility in house prices. 

Falling prices seem likely at some point, but timing uncertain.  A key question is whether, starting from here, we have to have a period of falling real house prices once those expectations come down, as they will, should real house price inflation move down from the current rate of close to 10% nominal.  We think this is quite likely — but our simulations suggest that we could still get a year or so of rising house prices.  We do find that significant falls in real house prices are needed relatively soon to match supply.  But the model shows why trying to ‘call’ the housing market over the next year or two is pretty much hopeless.  We find that very small changes in assumptions about the forward/backward weight in forming expectations, about income growth or about changes in real interest rates have a very large effect on the profile of prices and the timing of a downturn.  But most of the profiles we generated do show some falls in real house prices at some point over the next two years.

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Global
The End is Never the Same
November 27, 2006

By Stephen S. Roach | New York

KEY POINTS

 

* What’s new

Drawing comfort from a benign inflation outlook, financial markets are convinced that central banks pose little risk of a classic interest-rate-led endgame.  However, just because cycles of the past have been terminated by interest rate pressures, that need not be the case in the current cycle. 

 

* Conclusions

Three possibilities — none of them driven by interest rates — have the potential to trigger a cyclical endgame:  (1) A post-housing-bubble shakeout in the US could derail the American consumer and a still US-centric global economy.  (2) The renewed decline in the dollar is a reminder of the possibility that massive global imbalances could lead to a disruptive rebalancing of the world economy.  (3)  A pro-labor shift in economic policies could occur — reflecting a backlash over growing inequalities of income distribution; a post-election US is especially vulnerable, but there are similar risks in Europe, China, and India.

 

* Market implications and risks

Awash in liquidity, financial market participants have no compunction about putting more and more money to work in what they perceive to be benign circumstances.  I have my doubts.  The risk is that investors are trapped in the past — unprepared for an outcome that could be very different from the inflation- and interest-rate-led endgames of earlier cycles.

 

DETAILS

 

We are all creatures of habit.  That’s true of economists, investors, policy makers, and politicians — all of whom look to signs from the past as guides to the future.  That leaves us captives of history, whether we like it or not.  I have great respect for history and spend a lot of my time reading it.  But I have long been struck by the flaws of autoregressive thinking — extrapolating on the basis of recent trends and looking for guidance from historical patterns to predict the future.  Time and again, we learn that no two cyclical endgames are alike.  Yet time and again, we draw the wrong inferences from patterns of earlier periods.  This is one of those times. 

 

On one level, the world is in the midst of a very benign cyclical climate.  At work is a remarkably constructive inflation climate.  Absent the normal tendency of a cyclical upsurge in inflation, there appears to be no need for central banks to take the proverbial punchbowl away — to borrow from the imagery of former Fed Chairman William McChesney Martin.  A lot has been made about the recent updrift in core inflation — hitting 2.9% for America’s core CPI, 2% in the Euro-zone, and a fractionally positive reading in a long deflationary Japanese economy.  But let’s face it, by standards of the past 35 years, these are excellent outcomes.  In that context, the “normalization” response of central banks is a far more tolerable course of action than the wrenching monetary tightenings that have wreaked such havoc on cycles of the past.  Awash in liquidity, financial market participants have no compunction about putting more and more money to work.  Absent the primary peril of past cycles, goes the argument, there seems to be little to fear in the current cycle.

 

Yet this time is different.  Sure, that’s the classic “ah ha!” — code words for ever-cynical investors to ignore anything that follows.  But it’s important to understand the corollary of this reaction — namely that nothing ever changes.  That’s where I have a serious problem.  Consider globalization — the most important mega-force of our lifetime.  This is the first time that the powerful disinflationary forces of globalization have had a major impact on the endgame of a modern-day business cycle.  Consider IT-enabled technological change; this is the first time that revolutionary breakthroughs in connectivity, miniaturization, and software programming have shaped the cyclical endgame.  Consider ever-mounting global imbalances — a disparity between current account surpluses and deficits that has reached a record 6% of world GDP.  This is the first time that imbalances of this magnitude have threatened the global economy and world financial markets.  Consider also the gap between record returns on capital and the sharply depressed rewards of labor in the developed world; it’s been a long time since the potential social and political consequences of such tensions were in play.  I could go on and on — underscoring the unprecedented growth in synthetic securities (i.e., derivatives), the doubling of the global labor supply traceable to the emergence of China, India, and the former Soviet Union, rapidly aging populations in the developed world, unfunded retirement and medical-care liabilities, and surging M&A and LBO activity.  The point is that it makes no sense whatsoever to ignore the truly unique features of the current climate.  Those who dismiss such possibilities because of the legendary lore of four words — “this time is different” — do so at great peril, in my view.

 

The cyclical endgame is invariably a by-product of the excesses that build up during an expansion.  This cycle is no different in that regard — it is just distinguished by its own unique strain of excesses.  Three such excesses are at the top my list — a profusion of asset bubbles, ever-mounting global imbalances, and the growing potential for pro-labor shifts in economic policies.  Cyclical history conditions us to look for the proverbial trigger that might take an excess to the breaking point.  Interest rate pressures brought about by anti-inflationary monetary tightenings are the classic candidate for such a trigger.  The current cycle, with its absence of serious inflationary pressures, seems almost trigger-free in the context of cyclical excesses of the past.  Little wonder that liquidity-driven markets continue to rise to ever-higher highs — or that traditionally risky assets such as emerging market debt and equities, corporate credit, or mortgage-backed securities continue to be priced for a veritable absence of risk.  In a benign inflation climate, there seems to be nothing to fear.

 

Playing off a famous line from Franklin Delano Roosevelt, former US Treasury Secretary Larry Summers recently quipped, “We have nothing to fear but the lack of fear, itself.”  I couldn’t agree more.  Yes, normalization may well be the worst-case outcome for inflation-phobic central banks — thereby ruling out the interest rate pressures that have triggered many a cyclical endgame in the past.  But that doesn’t mean we should conclude that late-cycle excesses pose little or no threat to the current global business cycle. 

 

The bursting of the US housing bubble is an important case in point.  Despite a lack of interest rate pressures, there can be no mistaking the abrupt sea-change in America’s housing market.  This is quite consistent with conclusions of Yale Professor Robert Shiller, who has devoted as much effort as anyone to studying the excesses of speculative activity.  Shiller has long argued that asset bubbles don’t need to be pricked by a pin (i.e., rising interest rates) — that they invariably implode under their own weight.  That’s pretty much the way the equity bubble burst in 2000, and six and a half years later, such a thesis applies equally well to the demise of America’s property bubble.  David Miles is making a similar argument with respect to the UK housing market (see his 22 November 2006 report, “UK Housing: How Did We Get Here?”).  The only questions insofar as the US shakeout is concerned — and they are obviously quite important questions — pertain to the extent of the post-bubble downside in housing markets and the broader macro impacts of such a development.  I am in the camp that believes these post-bubble adjustments are a big deal for the asset-dependent American consumer, as well as for a US-centric global economy that remains overly reliant on the US consumption dynamic as the sustenance for economic growth.  I may be wrong on the conclusions, but it is important to stress that it didn’t take an interest rate trigger to bring this issue to a head.

 

Nor does a disruptive rebalancing of an unbalanced world require an interest rate spike to mark it to market.  I will concede that I have certainly been wrong in warning of the imminent consequences of America’s coming current account adjustment.  By now, I am probably the last person in the US who even thinks about such a possibility.  But with the dollar now under pressure again amid renewed talk of central bank diversification out of dollar-denominated assets, it’s important not to lose sight of the fundamental saving disparities that might allow this adjustment to take on a life of its own.  Most investors and currency experts see the trigger of recent developments in foreign exchange markets as a “euro overshoot.”  That’s quite possible, but here as well, let the record show that currency markets are on the move in a relatively benign interest rate climate.  The dead weight of America’s massive current account deficit may finally be coming into play at just the point when most believe it is not a problem.  The long history of currency markets — especially the time-honored tendency for a tightly bunched consensus to get it wrong — hints at just such a possibility.  

 

A similar conclusion is evident with respect to the potential for pro-labor shifts in economic policies.  This could be an outgrowth of mounting concerns over widening disparities in the income distribution.  This is a highly contentious issue, with statistical support on both sides of the debate.  Here, as well, the experience in the United States is germane to the issue of the cyclical trigger.  The issue is especially noteworthy in that America has been largely alone in the developed world in experiencing a significant and sustained surge of productivity growth — normally considered a sure-fire recipe for increased labor income.  Yet Ian Dew-Becker and Robert Gordon of Northwestern University recently have found that only the top 10% of the US income distribution experienced growth in labor income equal to or above aggregate productivity growth; it follows that for the remaining 90%, gains in real compensation have fallen short of productivity growth (see “Where Did the Productivity Growth Go,” Brookings Papers on Economic Activity, 2005).  This was a key issue in the recent mid-term elections in the US, providing an important point of traction for pro-labor Democrats in many parts of the country.  While it remains to be seen if there are major policy consequences of the ensuing political realignment that might derail financial markets or the real economy, here as well, the macro trigger had nothing to do with interest rates.  Nor does the US have a monopoly on the income-distribution debate.  Such concerns are also evident in Europe, China, and India.

 

In the absence of interest-rate pressures, most believe that financial markets enjoy a Teflon-like immunity from any and all potential sources of adversity.  I have my doubts.  A number of potentially powerful macro forces are now in play that could challenge this conclusion — namely, a bursting of the US housing bubble, renewed dollar weakness, and a pro-labor swing of the political pendulum.  Any one of these developments has the potential to derail a seemingly benign macro climate.  A combination of them would be all the more destabilizing. 

 

The risk is that investors are trapped in the past — aiming their defenses in the wrong direction.  Such a possibility reminds me of the legendary Battle of Singapore in 1942.  Convinced that the next war would be like the ones of the past, British military strategists positioned their fixed artillery for a classic invasion by sea.  The Japanese, of course, invaded by land from the North — leading to what historians have called one of the largest and quickest capitulations in British military history and Winston Churchill’s worst disaster.  Here’s where history may have something to say about increasingly complacent financial markets.  No two endgames are alike.

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United States
Sticking with Rust Not Bust
November 27, 2006

By Richard Berner | New York

It’s now conventional wisdom that the long US housing boom created a nationwide housing bubble, and that the bursting of that bubble will promote nationwide declines in home prices.  Apparently confirming that view, nationwide measures of prices for homes sold, which began to decline in August, have continued to fall.  The declines in some cases are startling: The median price of new single-family homes sold plunged by 9.7% and that for existing single-family homes sold fell by 2.2% in September from year-ago levels.  Moreover, a still-significant mismatch between supply and demand surely means that the ongoing housing recession has further to go, and that prices are still at risk. 

Two months ago I argued that these developments marked the beginning of stagnation (“rust”) in home prices appropriately measured, rather than the start of a housing price bust (see “Bust, Not Rust?” Global Economic Forum, September 29, 2006).  Today, there’s no mistaking the downside risks to prices, but I haven’t changed my view.  I continue to think that aggressive cuts in housing starts and support from job and income growth will realign supply with demand, limiting the chance of a bust in price.  Here’s an update.

The choice of home price metric continues to be crucial for drawing any conclusions.  Measured by the Office of Federal Housing Enterprise Oversight (OFHEO) home price index (HPI), we expect that inflation-adjusted housing prices will decelerate from a 6.6% rate in 2Q06 to zero over the next 9-12 months.  Measurement isn’t just a technical issue, because the differences among homes can be huge.  To be sure, all home price measures are telling a similar directional story; none is accelerating.  But the degree of deceleration or decline varies substantially, and the gaps between them are widening.  Indeed, some commonly-cited pricing metrics can be highly misleading when looked at over periods less than two years.  And even ‘matched-sample’ measures covering several major markets won’t accurately depict the behavior of prices on a nationwide basis. 

The Census Bureau’s and the National Association of Realtors’ median home prices (in dollars) for both new and existing 1-family homes sold each month are the most problematic.  Shifts in the size or value composition of sales will heavily skew even median price measures for new home sales because these metrics inherently compare apples and oranges — the homes that happen to be sold this year with those sold last year (average prices are still more distorted).  A shift to sales of less expensive houses will depress the median separately from any underlying change in the price of comparable units. 

Such shifts in the mix explain why the median price of new homes sold has tumbled so rapidly over the past year.  The median price stood at $217,100 in September.  But sales of new homes priced between $300,000 and $400,000 tumbled by 43.8% over the past year, while those priced up to $300,000 declined by merely 0-20% depending on the price bucket (sales of houses priced over $400,000 fell by 5.3%).  The bigger plunge in sales of the somewhat more expensive houses depressed the median.  The NAR composite of median prices of existing 1-family homes sold is similarly flawed.

In contrast, the OFHEO HPI — a ‘matched-sample’ index and thus a more reliable measure — increased in the second quarter by 10.1% from a year ago.  That is the slowest year-on-year pace in two years, and the quarterly gain of 1.2% is the slowest pace since 4Q99.  The monthly S&P/Case-Shiller matched-sample composite of prices in the top ten markets has decelerated to 5.2% in August, and prices in one market — San Diego — actually declined by 0.5%.  Another relatively reliable measure, the Census Bureau’s constant-quality home price index, increased by only 2.9% from a year ago and fell by 0.8% in the third quarter (none of these measures is seasonally adjusted). 

The OFHEO nationwide price index and similar measures, such as the S&P/Case-Shiller index, are the most reliable home price metrics.  They track repeat sales of the same single-family properties and thus eliminate most of the mix shift problems inherent to other measures.  But even these gauges may overstate ‘pure’ price appreciation in housing, because they don’t take remodeling into account.  That is, owners added to the value of the property by investing in additions and alterations, but neither index is adjusted for such increases in ‘quality.’  The difference can be substantial: The Census Bureau’s index of median new home prices rose by 47.3% in the five years ended in 2005, while a similar index adjusted for quality rose by one third less, or 32.4%.  In addition, ‘appraisal bias’ may inflate the OFHEO measure; a ‘purchase-only’ version of the OFHEO measure shows that home price appreciation peaked at 11.3% a year ago and ran at 8.3% in the year ended in June.

Measurement issues matter, but they should not obscure the real debate over the house price outlook.  If there really was a nationwide bubble, prices could decline significantly.  And there is some risk that prices could decelerate faster than we expect or even decline — after all, investor and speculative activity in housing has picked up in the past five years.  Markets with extremely high investor shares (Las Vegas 24%, Orlando 19%) are more susceptible to outright price declines. 

But in my view, the deceleration in prices has been the product of two factors that fall short of bubble territory: Sinking housing affordability that undermined demand, and builder exuberance that created an overhang of new supply and inventories of unsold homes.  Because housing demand in the short run is relatively insensitive to price changes, a buildup in inventories can produce a sharp deceleration in prices.  Equally, that also implies that builders’ aggressive efforts to slash housing starts and cut back inventories will promote a better supply-demand balance and help to stabilize prices. 

There are encouraging signs: At 6.4 months’ supply, new home inventories are well below their peaks, because builders have slashed 1-family housing starts by 22.8% in the past six months, while sales have declined by only 4.1%.  And just as accelerating price increases eventually hobbled demand, I think a sharp deceleration in prices will help stabilize it, perhaps at levels 15-20% below September's.  As evidence, the Realtors’ housing affordability index jumped 7.5% in the past two months after tumbling nearly 25% in the past two years.  Investors thus should not assume that a bust in housing activity would promote more than rusting home prices.

Nonetheless, prices may fall in markets that are affected by a weak economy (e.g., Detroit), by high speculative activity (e.g., some condominium markets), or where there is a preponderance of second homes (e.g., in Florida or the Sunbelt).  Those examples underscore the fact that local economic conditions are typically the dominant forces driving home prices, not the other way around.

My colleagues David Miles and Melanie Baker arrive at a more dire outlook for UK home prices, concluding that a substantial decline in real home prices is likely in that market, because one-third to one-half of price increases over the past decade has been speculative (see “UK Housing: How Did We Get Here?” November 22, 2006).  They base their conclusion partly on stylized models of home prices using plausible estimates of supply and demand elasticities and representations of expectations. 

While I find their analysis quite sensible, unfortunately for the US, parameters for similar models are unstable.  I find that statistical estimates of such key parameters can change dramatically with small changes in specification.  And the range of such parameter estimates in the literature is correspondingly large.  For example, estimates of the price elasticity of supply range from 0.3 to 3.7 — and the difference matters hugely for analysis; one model would predict a sizable decline in home prices, while another would predict a significant further increase.  Thus, models of US home prices are not yet helpful for either forecasting or analysis.  But Miles, Baker, and I agree that on both sides of the pond, the influence of housing wealth on consumer spending is probably smaller than most believe.

Bond investors are pricing a harder landing for housing wealth and thus for consumer demand than we think is likely.  An extended period of home price stagnation lies ahead, and given the magnitude of the coming inventory adjustment, the near-term risks for home prices are tilted lower.  But the faster the builders cut starts, the faster they will reduce the mismatch between sales and production, and the pressure on prices will abate.  Beyond the outlook for home prices, however, I think investors are ignoring the substantial improvement in household income now underway that will likely support both increased saving and moderate spending gains (see “All About Income,” Global Economic Forum, October 30, 2006).

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Malaysia
Rates Left Unchanged
November 27, 2006

By Chetan Ahya and Deyi Tan | Mumbai, Mumbai

Rates on hold at 3.50%: The central bank (BNM) kept the overnight policy rate unchanged at 3.50% in its meeting today for the fifth consecutive time in a row. This is in line with our and market expectations.

Benign October inflation supports pause in rates: Inflation dropped to 3.1% YoY in October (versus 3.3% in September), its lowest rate since August 2005. Breaking this down, most of the components either decelerated or maintained the pace seen last month. Specifically the prices in the Alcohol and Tobacco category decelerated to 5.1% YoY in October (versus 11.8% in September).  In fact, the central bank governor, Zeti Akhtar Aziz, recently signaled that interest rates are at “appropriate'' levels, underpinned by the moderating trend in inflation that is being observed.

Monetary policy stance likely to remain unchanged: The economy has been growing at a steady rate, recording GDP growth of 5.8% YoY in 3Q06 and 6.0% YoY year-to-date. In its monetary policy statement, the central bank said it believed that the growth momentum is likely to be sustained into the fourth quarter.  Although inflationary pressure has reduced, we believe that the BNM is unlikely to lead the Fed in cutting policy rates.

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United States
Review and Preview
November 27, 2006

By Ted Wieseman and David Greenlaw | New York, New York

Treasuries posted decent gains across the curve over the past week, a very quiet trading period with almost no economic data, little in the way of Fedspeak, two early closes surrounding a holiday, and minimal trading volumes as desks across the Street were lightly staffed. Despite the lack of fundamental news, the market ground steadily higher through the week, seeing small upside every day, which by week-end had cumulated to leave yields at the long end at their lowest levels since February (and with the 10-year yield right at the bottom of the range seen since mid-August) and Fed pricing in the futures market at its most dovish stance in over three weeks. This rather odd move, which had no obvious fundamental basis, also reverberated through the FX market, where the dollar was down significantly on the week on the more negative view of the US economic outlook reflected in the drop in Treasury yields and dovish repricing of the Fed. Stocks seemed much more in line with the holiday calendar, barely budging on the week.

For the week, benchmark yields fell 4-6bp and the curve flattened slightly, with 2s-10s down 1bp and 2s-30s 2bp on a 4bp decline in the 2-year yield to 4.73%, a 5bp drop in the 10-year yield to 4.55%, and a 6bp rally in the long bond yield to 4.63%. The 3-year and 5-year yields each fell 5bp to 4.61% and 4.55%, respectively. A more dovish Fed path in the near and medium term was priced into futures markets.

The February fed funds contract rallied 1bp to 5.23% and the April contract 1.5bp to 5.16%, putting the odds of a rate cut by the March FOMC meeting at about 35%. In both cases these were low rates since November 2 and, for the latter, a sizable move from the 5.215% level seen in the middle of the prior week. In the eurodollar futures market, the Dec 06 to Dec 07 spread flattened 2.75bp to -60bp, with the former gaining 0.75bp to 5.365% and the latter 3.5bp to 4.765%. The low rate June 08 contract gained 5bp to 4.69%, a low since November 1 (and before that October 4), moving back in the direction of favoring a 4.50% trough for the funds target in 2008 instead of 4.75%.

There was very little economic news the past week, with the only particularly notable releases being the University of Michigan consumer confidence and jobless claims reports, the latter helping set preliminary expectations for the employment report, which will be released later than normal in December because of the late November survey week. The University of Michigan’s consumer confidence index was revised down marginally to 92.1 for all of November from 92.3 early in the month, a 1.5 pullback after an 8.2-point surge in October. The current conditions (106.0 versus 107.3) and expectations gauges (83.2 versus 84.8) showed about equal size dips relative to October. According to the University of Michigan, the current level of sentiment would be consistent with real consumer spending growth of +3.0%. For the first time in over a year, more survey respondents said the economy improved in the month than worsened. Another positive aspect of the report has been a dramatic improvement in attitudes toward buying a house that has largely been driven by consumers’ recognition of price concessions and better deals, though the survey noted that survey respondents still remained reluctant to buy now because of uncertainty over how much further prices might fall. Meanwhile, inflation expectations remained surprisingly elevated despite the collapse in gasoline prices, with both the 1-year and 5-year median inflation forecasts down a tenth to +3.0%.

For the more important longer-term gauge, this was only slightly below the highs of +3.2% hit in August and May and still at the upper end of the range seen in the past decade. Market-based inflation gauges have shown a more benign recent trend. After holding very close to 2.5% for the past few months, the 5-year/5-year forward inflation breakeven based on the benchmark issues had fallen to 2.43% at the end of the latest week, near the low since March. This was also down almost to levels prevailing at the end of last year after this gauge had risen towards 2.7% in May and August, tracking the upswing in consumer inflation expectations in these months.

Meanwhile, initial jobless claims posted a surprising jump in the latest week, which was the survey week for the November employment report, and the 4-week average hit its highest level since August, showing some worsening relative to the October survey period. Continuing claims have been very steady at a low level, so overall the claims results recently have been mixed, but they are not obviously pointing to any significant improvement in job growth this month relative to the 92,000 gain posted in October. Our preliminary forecast for November non-farm payrolls is +125,000, however, as two special factors should provide a boost. First, it was unusually warm across the nation in the week prior to the November survey week and to a lesser extent in the survey week itself. Second, this is an unusual year in which Veterans’ Day did not fall within the survey week. This normally only happens every five to six years (and can be double that depending on leap year patterns), and when it does there has been a frequent pattern of elevated job growth in November.

Investors were looking for some straws in the wind Friday about the kickoff of Christmas sales. Of course, there wasn’t much to go on so early other than the usual “Wow, these malls are crowded!” news reports that you see every year. But there were a number of positive early signs. Federated CEO Terry Lundgren told Bloomberg, “I was here [at the flagship Macy’s store in New York] last year, and the year before, and this is clearly the biggest opening. They are shopping in big quantities and walking out with bags.” Bloomingdale’s Chairman described sales as “very strong.” Wal-Mart’s web site experienced some outages as it was swamped with traffic, with the company explaining, “Due to a higher-than-anticipated traffic surge, Walmart.com experienced an issue with site availability early this morning.” According to the head of Walmart.com, it is the third most visited e-commerce site after Amazon.com and EBay. Also, the National Retail Federation released a statement midday Friday describing early traffic as “huge.”

After the past week’s lull, the upcoming week’s calendar is packed with economic data, supply and Fed news. On the last of these, Fed Chairman Bernanke will speak Tuesday on the “Economic Outlook.” The Chairman has not made a speech or other remarks on a directly market relevant topic like this since all the way back at his July monetary policy testimony, so this speech will certainly be very closely watched for any signs that the Fed is moving towards backing away from its tightening bias after the benign October CPI report. The Beige Book prepared for the upcoming FOMC meeting will also be released on Wednesday. On the supply front, the Treasury will auction a US$20 billion 2-year Tuesday and US$14 billion 5-year Wednesday, both sizes unchanged from last month. We expect coupon sizes to be bumped up a bit in the first quarter, seasonally the biggest borrowing quarter of the year normally as the bulk of tax refunds are paid out. The economic data calendar is packed, with key releases including durable goods, Conference Board consumer confidence and existing home sales Tuesday, revised GDP and new home sales Wednesday, personal income Thursday and ISM, construction spending and motor vehicle sales Friday. Additional anecdotal and company level reports on the opening of the Christmas shopping season will also be closely watched for:

* We expect the Conference Board’s consumer confidence gauge to rise to 108.0 in November. Despite a continued decline in energy prices, the Conference Board gauge was flat in October even as the Michigan index surged eight points. Perhaps this was related to some pre-election anxiety. In any case, the weekly ABC survey posted a sharp jump in early November to stand at its highest reading since early 2002. This would appear to point to at least some mild improvement in the Conference Board index.

* We look for October durable goods orders to plunge 7.0% as, based on company reports, we expect to see an unwind of the aircraft-related elevation that was evident in September. A further decline in automobile bookings should add to the downturn in the headline. And with the ISM orders component slipping to its lowest reading in 16 months, we look for some softness in the underlying details as well. Indeed, the key core category — non-defense capital goods excluding aircraft — is expected to be down about 0.5%, which would represent the first outright decline since April. Finally, shipments of capital goods appear due for some improvement, reflecting the prior strength in order activity.

* We forecast October existing home sales of 6.15 million units at an annual rate. The NAR’s gauge of pending home sales has stabilized somewhat in recent months. So, we expect resales to post only a fractional dip (-0.5%) in October. For the year as a whole, it looks like sales will be down about 10%.

* We expect 3Q GDP growth to be revised up to +2.0%. Upward adjustments to business investment, state and local government purchases, inventories and foreign trade should more than outweigh a downward revision to consumption, leading to a higher reading for overall GDP growth in 3Q relative to the initially reported +1.6%.

 

* We look for about a 2.5% pullback in October new home sales to a 1.05 million unit annual rate on the heels of the surprising gains seen in both August and September. Indeed, the recent upside in the midst of a cooling housing market has raised concerns regarding inadequate accounting for cancellations in this data series. While there appears to be plenty of evidence that cancellations are running higher than normal, we are somewhat skeptical of the anecdotal reports that suggest cancellation rates are 30% or higher. While this may certainly be the case for individual projects in some of the most highly speculative markets, it seems quite a stretch for the nation as a whole. Existing home sales are tallied at closing and thus do not suffer from the cancellation problem that could potentially impact the new home sales data. At present, the ratio of existing home sales to new home sales is virtually identical to the long-run average. Obviously, this comparison is hardly a definitive indication that cancellations are not a problem — but it does suggest that rumors of an extreme volume of cancellations on sales of newly built residences do not appear to be consistent with the overall home sales picture.

* We forecast a 0.5% gain in October personal spending and a 0.1% uptick in spending. The employment report pointed to another solid advance in personal income — which should look especially healthy in real terms after factoring in the expected decline in the headline price index.

Meanwhile, the retail sales results pointed to only a fractional gain in October spending, along with a likely downward revision to September. Still, real consumption appears on track for about a 3.5% rise in 4Q. Finally, the core PCE price index is expected to match the core CPI’s 0.1% advance, which should reduce the annual rate a tenth to +2.3%.

* We forecast a 51.0 reading for the November ISM. The regional surveys released to this point have been mixed, with Empire showing some solid improvement and Philly pointing to further deceleration. So, we look for little change in the national index relative to the 51.2 seen in October. Meanwhile, the price gauge is expected to register another energy-related pullback.

* We expect construction spending to fall 0.8% in October. The plunge in housing starts implies a sharp drop in the residential component that should more than offset a solid gain in non-residential spending and modest upside in government activity.

* Preliminary industry reports point to a modest uptick in motor vehicle sales in November to a 16.4 million unit annual pace from the 16.1 million unit rate seen in October. Lower fuel prices appear to be providing some support. Also, a couple of the foreign automakers have apparently rebuilt inventories of popular models that were in short supply. However, heading into the month, inventories of 2006 models at the Big 3 were somewhat lower than normal, which means reduced incentive offerings and less aggressive deal-making in general. Also, the planned cutback in fleet deliveries appears to be starting to take hold.

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Japan
What’s ‘Funny’ About Consumption?
November 27, 2006

By Robert Alan Feldman | Tokyo

Introduction

Investors around the world are worried about Japan. Indeed, it has been a frustrating year, in which many expected Japan to outperform, but it has underperformed. Among the most oft-cited worries is consumption. During the course of the last year, the year to year growth rate of real consumption (in the national accounts) has decelerated from 3.7% in 4Q05 to a mere 0.4% in 3Q06.

 

Compounding the worry is a deep-seated view that an economy cannot continue to grow quickly unless investment growth gives way to consumption growth as the leading source of demand. This view has its origins in textbook Keynesian economics, and the theory of the multiplier. Investment (or exports) starts a recovery, and the increases of income then spur consumption, which takes over as the leading source of growth.

 

I argue that the first concern, the data on consumption, is overblown. I also argue that the second concern is obsolete, in light of the capex needs of Japan’s aging society. Let me address these concerns one by one.

 

The data on consumption

The data on consumption have certainly been a disappointment this year. Although the nearly 4%Y/Y rate reached at the end of 2005 was clearly not sustainable, the sharpness of the slowdown this year has been a surprise. In addition, the deceleration in compensation (whether measured by compensation per worker from the national accounts or by hourly earnings from labor data) has also been a surprise ― especially with record-high corporate profits. The weak growth of wages is all the more puzzling in light of tightening of labor markets shown by a number of indicators. Yes, the weather has been weird this year, but that cannot be the whole story. What is going on?

 

Several hints are provided. Using a simple model of consumption growth, with real compensation, inflation and stock price movements as the determinants, each has a statistically significant contribution to explaining the growth rate of consumption, and each has contributed to a slowdown this year.

 

A second factor is real consumption growth. The volatility of consumption has risen significantly over the last five years. The differences in the year to year growth rates of consumption between troughs and peaks have expanded sharply since the early part of this decade. Only during the period of the recession, consumption tax hike and banking panic in the late 1990s were the swings larger. Although theory says that income and wealth effects should be the largest determinants of spending, these factors ― even when augmented by a bit of money illusion in the form of the change of consumer prices ― explain less than half of the variance of consumption growth.

 

Clearly, other factors are affecting consumption more than they used to. The most likely factor is optimism (or lack thereof) about the future of the country, which swings significantly with both political and geopolitical factors. It is probably no coincidence that consumption surged after the election of September 2005, when PM Koizumi won a stunning victory over the opponents of economic reform. Nor is it a coincidence that consumption slowed as he left office. As more worries about the sustainability of the reform process emerged over the summer, consumers naturally tightened their purse strings.

 

The model bias problem: Asimov points the way

A deeper problem lurks in the disappointment with consumption data. This problem concerns the very human tendency to try to fit data into predetermined patterns. When the data do not fit the predetermined pattern, people are wont to become disturbed, rather than to question whether the predetermined pattern may be wrong. This idea was best expressed by science fiction writer Isaac Asimov, who once said, “The most exciting phrase to hear in science, the one that heralds new discoveries, is not ‘Eureka!’ (I found it!) but ‘That’s funny...’”

 

What is “funny” at the moment? Consumption is decelerating while capex is accelerating and profits are still rising ― all this after what has already been the longest expansion in post-war history. There is a problem of consistency here. Corporations are predicting an outright decline of profits in the second half of the year. But if firms are so worried about profits, why are they investing so much?

 

In my view, consumers, corporations and investors have a strong bias in favor of ‘cyclical’ models of the economy. If things were good yesterday, they will be bad tomorrow. And the heavy emphasis in the media on the current cycle surpassing the Izanagi cycle of the late 1960s has only strengthened fears about tomorrow. Never mind that IT has revolutionized supply chains and changed the dynamics of the business cycle.

 

Cycles are cycles, goes the mantra, and if things are good today, they have to turn bad tomorrow. If we have not seen the downturn yet, it must be coming soon. So, consumption swings wildly, and firms continuously undershoot profit estimates. So far, the number of people saying “That’s funny” is small. However, the longer the anomaly of strong capex and weak consumption continues, the more likely will emerge others (like myself) who will claim that high capex and low consumption is the correct structure for the economy.

 

Why? The idea is simple:  As Japan ages, there will be a much faster shrinkage of the labor force than of the population. Hence, each remaining worker will need a lot more capital in order to keep productivity growth fast enough to maintain living standards. Economic growth theory ― in contrast to standard macroeconomic theory ― tells us that high capex and low consumption is just what an economy needs when aging. The implication for investors is equally simple:  Stop worrying and love the high-capex economy.

 

Looking forward: The good news

As a practical matter, however, consumers and investors will need more time before they accept that consumption need not become the engine of growth. Thus, any impetus to equity prices from consumption will depend on the determinants of consumption. We need to separate determinants into measurable ones and the un-measurable ones.

 

Among the measurable ones, the volatility of consumption growth is probably the most dramatic. After the sharp plunge of consumption growth rates over the last three quarters ― in the absence of any clear shocks ― it seems reasonable to expect a rebound in consumption growth. Moreover, the credibility of corporate earnings growth forecasts is low. After a rise of about 15% Y/Y in the first half of the fiscal year, it seems unlikely that a plunge into negative territory will occur in the second half ― which is what full-year forecasts now imply. If profits indeed turn out well, then further increases of wages seem likely. Third, inflation seems to be decelerating. The drop of oil prices has brought gasoline prices down already. Moreover, core inflation seems to be decelerating as well.

 

The un-measurable factors are also important. The Abe government has seen little payback, at least in the stock market, for its successes so far. It has stabilized relations with China, and has pushed several economic issues ― such as innovation and tax reform ― to the top of the economic agenda.

 

The tax area is particularly encouraging, even if investors are taking it the wrong way for now. The government is proposing cuts of the corporate income tax, pushing for the tax changes needed to implement triangle mergers, and raising deductions for depreciation significantly. The market has ignored these major changes and instead focused on the minor issue of returning the tax on capital gains back to 20%, where it was before emergency measures were instituted a few years ago. This negative bias in news interpretation is common in the Japanese media, but it cannot last forever, in my view.

 

Indeed, PM Abe’s government has embraced what is now coming known as the ‘rising tide’ theory, i.e., that a concerted focus on innovation, tax reform, structural reform and government reforms will unleash significant growth potential. A recent book by LDP Party Secretary Hidenao Nakagawa (Ageshio no Jidai (An Era of Rising Tide)) outlines the theory. The assertion is that this growth will allow fiscal deficits to decline with only minimal rises in taxes, and simultaneously allow lower income differentials.

 

While it is possible to debate parts of this approach, the fact is that those opposed to it do not have an attractive counterproposal. Thus, growth theory has become the PM Abe’s equivalent of postal reform for PM Koizumi. So long as PM Abe pushes the rising tide approach strongly, his political opponents will have a hard time opposing him.

Looking forward: The bad news

Of course, the road to higher consumption is not free of potential bumps. As the model at the beginning of this note suggests, the equity market itself is a statistically significant determinant of consumption. Moreover, the coefficient on rising equity prices is rather low, implying that a very large increase of the equity market would be needed to spur consumption a lot. For example, even if the Nikkei 225 rose to 18,000 and stayed there in 1Q07, this level would be only 11% above that of 1Q06, and lead to an increase of consumption by only 0.2%-pts Y/Y. Thus, it is extremely important that wages rebound and that prices decelerate, in order for the measurable determinants of consumption to contribute to a re-acceleration.

 

Moreover, there are non-measurable factors that could dampen consumer sentiment, even if PM Abe’s reform efforts win more praise. Of course, geopolitical factors (such as new North Korean nuclear tests) could worsen sentiment. Political setbacks or misjudgments could also damage sentiment, as could declines of global economic growth. Renewed surges of energy prices could also be disturbing.

 

The fundamental case for optimism

Even if these adverse factors do come into play, however, my view is that their impact on the economy will be less serious than investors fear. The key reason for my optimism is simple: The combination of aging demographics and structural reform has created a new dynamic in Japan. This new dynamic will keep capex and productivity rising, and obviate the need for as much consumption growth as would have been necessary at an earlier stage of Japan’s economic history.

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India
The Retail Revolution – Part II – A Catalyst for Agriculture
November 27, 2006

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

Summary

The agricultural sector, which accounts for about 20% of GDP and employs about 220 million people, has been neglected so far.  Over the years, owing to government intervention in 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 declining gradually.  The present agriculture supply chain has a tremendous amount of inefficiencies at the farm level, the intermediary level and at the marketing and distribution level.   However, we believe that the emergence of organized sector retailing can prove to be a significant catalyst for the growth environment in the sector.  Indeed, private corporate entities are influencing government policy to improve the business environment for the sector.  This, coupled with increasing political pressure to revive agricultural growth, has forced the government to initiate some important reforms over the past two years.

Agriculture has been a neglected sector so far

Growth in India’s agriculture sector decelerated to an annual average of 2.4% over the period F1996-F2006, from 3.5% during the five years ending F1995 and 4.6% during the 1980s. The agriculture sector, which provides employment to approximately 60% of the workforce (220 million people), continues to be dependent on the monsoon rains as only about 40% of the cultivation area is irrigated.  Crop productivity growth has gradually decelerated over the last ten years.  In fact, productivity levels for cereals in India are 60% lower than in China.  The sector also suffers from huge inefficiencies on the distribution side in terms of lack of organized pricing information, inadequate storage and transport infrastructure and a high level of intermediation. Cumulative wastage in this supply chain is estimated at about US$11 billion, or 9.8% of the agriculture component of GDP.

Current farm produce supply chain is outmoded

The Indian farming industry is dominated by small and marginal farmers and has suffered from lack of investment in the supply chain for years.  Some of the major structural issues with the sector are as follows:

Fragmented structure of farm produce market: About 60% of the farm land area is with marginal, small and semi-medium farmers (about 107 million land-holdings).  The average land size per farmer is only 0.005 square miles (1.4 hectares).  These farmers lack the bargaining power to deal with market intermediaries and hence are often exploited.  The archaic infrastructure for transporting 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.

Outdated marketing structure and laws: Currently, much agricultural produce is sold by farmers, primarily via government-mandated market yards (known locally as ‘mandis’).  Until recently, the private sector was restricted from directly purchasing agricultural produce from farmers. The market yards serve, at an average, a very high radius of almost 459 square kms (177 square miles), and so farmers have to travel long distances to sell their limited produce. 

Additionally, the mandis are mired with inefficiencies.  There is considerable malpractice, which results in farmers realizing less than market value.  Transactions tend to favor traders. Often traders who buy produce from farmers operate in a coordinated manner, resulting in lower realizations for farmers.  The infrastructure of the marketplace is also lacking in terms of efficiency, frustrating the farmers.

Until recently, most states controlled the marketing of agricultural produce through the Agricultural Produce Marketing Committee (APMC) Act.  The government’s effort to regulate the farm produce market through the APMC Act, so as to ensure better realization to the farmer, is now effectively becoming a major hurdle to achieving that very objective.  APMCs are supposed to be formed through regular elections with farmer representation, but in many states government machinery dominates the governance of these markets in practice.

To summarize, the current market structure has many problems, including: (a) large number of farmers with fragmented holdings and multiple levels of intermediation; (b) a restrictive regulatory environment; (c) large mark-ups between farmers’ realizations and final consumer prices; (d) lack of transparency in price determination; (e) lack of infrastructure; and (f) lack of encouragement to improve the product mix towards higher-value-added items as there is a lack of standardization, gradation and certification. 

Laws related to food processing still not conducive enough: We see the food processing industry as a critical spoke in the agriculture growth story — higher value addition of the marketable agriculture surplus should help increase farmers’ remunerations, increasing the shelf-life of agricultural products should help reduce wastage and, most importantly, exports of processed products should help Indian farmers participate in globalization.  However, the growth of the food processing industry has been constrained by the regulatory environment.  Although the government has removed a number of reservations in food processing industries for the small-scale sector, the overall regulatory environment is still not sufficiently conducive to encourage the required participation from the private sector.  Government support in creating the infrastructure for bulk handling and storage has also not been forthcoming.

Government spending mix was previously skewed towards subsidies: The mix of spending on capital and subsidies was skewed towards subsidies up until F2003.  The government had focused on providing subsidies instead of investing in infrastructure.  Expenditure on agriculture-related subsidies (food + fertilizer + power) was 2.3% of GDP in F2003, up from 0.6% in F1982.  Note that our subsidy calculations exclude the sizeable tax exemptions on agricultural income earned by large farmers.  Over the same period, the government reduced capital spending in agriculture to 0.4% in F2003 from 1.2% of GDP in F1982. However, over the past two to three years, the mix has started improving again, with the government increasing capital expenditure and keeping the subsidy burden in check.

The retail revolution promises to catalyze the process of change

The emergence of organized sector retail chain stores and a rise in competition is encouraging these players to look towards improving efficiency in the agriculture-related supply chain.  Some of the large players are beginning to initiate efforts to improve efficiency in terms of how the produce is procured from farmers.  The private sector is influencing the government to liberalize regulations that constrict the operational environment.  In addition, political pressure is also rising, invoking a response from the government to change the regulations so as to enable farmers to operate more productively.  We note below some of the key changes in the farming-related business environment that should help bring about an improvement in agricultural output over the next three to four years:

Regulatory environment has already started changing: Many states have recently amended the APMC Act, which in effect was restricting the private sector from directly transacting with farmers.  This Act forced farmers to use government-mandated markets (mandis) to market their produce.  Thirteen states and three union territories have amended the APMC Act, allowing private sector participation in the direct purchase of agricultural produce from farmers.  The most important change in the amended AMPC Acts is encouragement to the private sector to transact directly with farmers.  Currently, due to malpractice and the high number of intermediaries, the farmers’ share of the final price paid by consumers is lower than one-third.  Price discovery is not transparent and commission agents take an unduly high share of the final price.  Amendment of the APMC Act should provide the regulatory environment to allow private sector participation.

Information access is changing: Large consumer staple companies such as ITC and Hindustan Lever are making a significant effort to improve information access for farmers and help reduce malpractice in the farm produce trade. Indeed, the objective of these companies is to build a competitive advantage over other players by building a franchise with farmers, which, in turn, should help them reduce their farm produce procurement costs and increase the distribution reach for their products.  For instance, ITC has installed about 6,500 internet kiosks (called e-Choupals) in the distant villages, allowing 3.5 million farmers to access information related to agriculture.  Each e-Choupal helps the farming community come together and access information related to weather, gauge local/global market prices of farm produce and order inputs such as fertilizers and seeds.  Each community elects one of its members who is sufficiently well educated to access the internet (which is being offered in local languages such as Hindi) to share the information with the other members.  ITC is also providing capital subsidies for minor infrastructure projects, which help farmers improve the crop yields.

ITC has also gained specific permission from the relevant state governments to procure farm produce from farmers.  Transacting through e-Choupals is helping cut the cost of transactions by about 40-50%, with savings being shared between the farmers and the company.

Retail chain stores also beginning to change the environment: Food and beverages account for about 70% of the addressable market (relevant private final consumption expenditure) for the retail chain stores (supermarkets and hypermarkets).  We believe that all large companies intending to build a major network of chain stores are working on a plan to connect to farmers for sourcing their requirements at a reasonable cost and at the right quality.  The private sector has refrained from investing in agri-marketing infrastructure because of excessive government intervention and the dominance of the unorganized sector.

However, with the new regulatory environment and the trigger from organized sector retailing, the private sector is now likely to begin investing, albeit gradually.  First, large players should bring about a change in the way farmers sell their produce. Instead of using the current chain, which results in large mark-ups due to the multiple number of intermediaries, the farmers are beginning to transact with large corporates, reducing inefficiencies. These players should also start encouraging standardization, gradation and certification of farm produce. Second, some of the large players will start contract manufacturing with farmers, providing them with the right quality inputs (fertilizers and seeds), capital support and signals on the mix of output they need to produce to earn maximum returns.  Third, an increase in direct sourcing by large players will encourage the private sector to invest in the logistics and infrastructure needed to improve the productivity and efficiency of the supply chain, in our view.

Changing price discovery mechanism through commodity exchanges: The government has also encouraged exchange-trading in agricultural commodities.  In F2004, the government removed the prohibition on futures trading in all commodities.  The volumes of exchange-traded commodities have increased significantly and helped improve the efficiency of agricultural marketing in the country.  The new trading systems, which allow trading based on warehouse receipts, should help reduce price risk.  The National Commodity and Derivatives Exchange has also initiated pilot projects in a few states to help farmers start hedging their price risk by trading on the exchange.  Efficient price discovery, better price dissemination to farmers, provision of a delivery platform, warehousing logistics support and provision of quality checks are some of the key advantages of full-fledged commodity exchanges.  As participation in the commodity exchanges rises, these benefits should start accruing to farmers.

The government has recently given permission to start a national electronic spot market exchange.  The National Spot Exchange for Agricultural Products (NSAEP) plans to start operations in three states in January 2007.  The NSAEP has identified 11 agricultural commodities for spot trading.  The new exchange intends to integrate the current fragmented markets electronically. It will result in efficient price discovery, make it easier to procure commodities from one centre, which aggregates output produced in multiple locations, provide warehousing receipt financing and guarantee timely payment to farmers.

A lot more still needed from the government

The policy-makers in India have been very vocal in their concern about the low growth in the agriculture sector and its impact on inequality trends.  Ideally, the government would look to capitalize on the opportunity provided by the retail revolution by simultaneously initiating complementary reforms in the agriculture sector.

Accelerate growth in basic infrastructure investment: Currently, only 40% of the cropped area is irrigated.  This implies very little improvement in the penetration of irrigation facilities, given that the ratio stood at 34% in F1991.  Low penetration of irrigation facilities has left a large part of the area under cultivation exposed to the vagaries of the monsoon.  The government’s policy programs need to encourage investment in irrigation facilities to reduce this high dependence on monsoon rains.  In addition to this, almost 56% of the villages in India were unelectrified as of 2004.  Even in the electrified villages, there are frequent power outages — averaging almost 14 hours a day.  This has a collateral impact on irrigation facilities as well, since farmers have to rely on more expensive generator sets to irrigate their plots, leading to a higher cost of production.

As we mention earlier, public investment in agriculture as a percentage of GDP had also been declining gradually until F2003.  However, the outcome of general elections in 2004 was a gentle reminder to the politicians who appeared to be ignoring the poor, particularly in the rural parts of India.  The UPA government has made an effort to pick up the spending, although the effort has been constrained by a stretched government balance sheet.  Although official data for public investment in agriculture for F2006 are unavailable, the government budget denotes an up-tick in spending over the past two years.  We believe that the government needs to ensure that this spending momentum is accelerated, especially in areas such as rural electricity and irrigation facilities.

Upgrade the food supply chain: Although the spread of private participation and investment in market yards (mandis) and other agriculture-marketing infrastructure will likely pick up, it is going to be gradual.  There is a need for the government to take the lead and initiate an upgrade of the existing marketing infrastructure.  Investment in rural roads, cold storage and market yard development is also key, in our view.  In addition, we believe that the government needs to create a conducive institutional environment to attract private investment in the food-processing sector, which is currently constrained by a multiplicity of food-related laws.

Modify fertilizer pricing policy: The government’s fertilizer policy has distorted the trend in fertilizer consumption and therefore the mix of soil nutrients.  While the government subsidizes nitrogenous (N) fertilizer and has decontrolled phosphatic (P) and potassic (K) fertilizers, the prices of decontrolled fertilizers are relatively higher than urea (controlled fertilizer).  Farmers therefore use more urea, which has a higher nitrogen content.  The result is that the NPK ratio in India has deteriorated to 6.4: 2.5: 1, resulting in low productivity.  The ideal usage ratio of nitrogen, phosphorus and potassium (NPK) is 4: 2: 1.  Although the private sector players are trying to educate farmers, we think the government also needs to adjust its fertilizer pricing policy to encourage farmers to make this shift in fertilizer use mix.

Increase spread of crop insurance: Indian farmers face uncertainties in the form of weather and prices.  Hence, proper insurance products need to be introduced that can help alleviate financial risk.  Although the National Agricultural Insurance Scheme (NAIS) was introduced in F2000, its reach has not been significant so far — just 1.5% of farmers availed themselves of this insurance in the Rabi season (winter crop, harvest April-May) of 2004-05 and 5.4% of farmers used it in the Kharif season (summer crop, harvest October-November).

Credit availability: The government has encouraged the commercial banks to increase lending to the agriculture sector over the last two years.  The growth of institutional credit to agriculture has accelerated to 31% in the three years ending F2006, compared with 14% in the preceding three years.  In addition, 55.6 million credit cards (covering about 25% of the farm sector) have been issued to farmers under the Kisan Credit Card Scheme.  These cards allow farmers to gain access to short-term crop loans for seasonal operations and also to term loans for agriculture and allied activities.  The government has also provided interest subsidies on new loans availed by farmers in F2006.  In our view, the government needs to ensure that the momentum in agriculture credit flow is sustained over the next few years.

Bottom line

The new environment should help boost productivity growth and per capita income in the rural economy, where almost 70% of the Indian population resides.  Although it could take three to four years before the positive impact of the changing environment starts to be reflected in the growth numbers, the first signs of a turnaround are now visible.

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