Island of Isolation
November 29, 2006
By Serhan Cevik | London
The divided island of Cyprus continues to plague Turkey’s membership bid. After starting accession talks with the European Union last year, Turkey has continued to make progress towards screening and adopting the acquis. Unfortunately, the focus is not on the country’s institutional convergence, but on the Cyprus imbroglio. Be that as it may, another round of negotiations has failed to find even just a temporary compromise on the long-standing conflict between the Greek and Turkish communities of the island. As a result, the critical issue for the immediate future is the non-discriminatory application of the customs union agreement to all existing members of the EU, including the (Greek) Republic of Cyprus. Since Turkey does not officially recognise the Greek Cypriots as the sovereign representative of the divided island, the opening up of Turkish ports to Greek-Cypriot vessels remains a peculiar challenge for Turkey’s accession process. Although a provisional arrangement is still the likely outcome, we believe that the nature of the Cyprus conflict requires a comprehensive approach under the auspices of the UN that could help to find an equitable and sustainable solution.
The EU’s asymmetric approach has turned into an obstacle for peace on the island. Regardless of the reasons behind it, the intractable controversy could have been resolved decades ago. However, numerous governments failed to break the isolationist status quo and Turkey’s nationalist rhetoric led the international community to conclude that it was the obstacle for the reunification of the two Cypriot communities. Consequently, based on that crucial belief, the EU designed an asymmetric approach to deal with the problem — bringing the Greek Cypriots into the Union to encourage the Turkish side to accept a peace agreement. The strategy worked, at least to a certain extent, but failed “unexpectedly” at the final stage when more than 75% of Greek Cypriots rejected the UN plan to reunify the island while the Turkish Cypriots voted overwhelmingly in favour it. Since the Greek Cypriots joined the EU just a week after vetoing the peace deal, the EU’s asymmetric strategy has turned into an obstacle for the resolution of the conflict. Opponents to enlargement use the Cyprus dispute as a platform to antagonise Turkey. As a member of the EU, the Greek Cypriots have suddenly gained obvious advantages and started vetoing attempts to ease international restrictions on the Turkish community in the north of the island. As a result, the EU is struggling to end the isolation that has become a source of social and economic deprivation. We fear that the situation goes beyond a ‘tough’ approach to extract concessions from Turkey on the negotiation table and may reflect an underlying disinclination for reunification of the island. In addition, some European politicians appear to be using the Cyprus problem as a platform to oppose enlargement in general and Turkey’s membership aspirations in particular. Will the unresolved Cyprus conflict jeopardise Turkey’s accession process? The Greek Cypriot government will no doubt keep blocking Turkey’s membership talks until Turkey recognises its sovereignty, which will never happen unless there is a comprehensive agreement between the two communities on the island. Nevertheless, we believe that a complete suspension of the remaining negotiating chapters of accession talks is highly unlikely for technical reasons as well as for the fact that no one would benefit from an absolute breakdown of relations between Turkey and the EU. Therefore, the accession process, albeit moving forward at a slower pace, will likely remain on track. In the interim period, the best strategy for Turkey to minimise the fallout from a lack of progress on the Cyprus problem is to shift the focus on the acceleration of institutional convergence, in our opinion.
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GDP: First Signs of Decelerating Economic Growth Momentum?
November 29, 2006
By Michael Kafe | Johannesburg
Earlier today, Statistics South Africa published some data on the country’s Gross Domestic Product (GDP). According to the report, GDP rose 4.7% q/q, saar in the third quarter. This was in line with consensus estimates of 4.8% but slightly higher than our 4.4% estimate. Once again, the number was hugely impacted by net taxes on production, which, at 6.3% q/q, saar, came in much higher than our estimate of a 2% increase. If we ignore taxes and subsidies for a moment, the value of goods and services added to the SA economy rose by 4.5% —in line with our estimate of 4.6% q/q, saar. Growth momentum slowing despite upward revisions Statistics South Africa also made some historical revisions to the data: For example, GDP growth in 2005 has been bumped up from 4.9% to 5.1%, while the annualized quarterly rate of growth in the first two quarters of this year was also raised from 4% and 4.9% to 5% and 5.5%, respectively. Interestingly however, despite these big revisions, the data still support our view that the economy’s growth momentum —although still positive and impressive —has begun to slow since the rate hikes began in the early part of the third quarter. Of the 10 sectors that were surveyed, only two (agriculture and government services) showed growth rates that were higher than that of the second quarter. And it is important to note that the growth rate of agriculture, although an improvement, was still a disappointing negative 13%. Agricultural production is still weak While our estimate of aggregate value add was in line with the actual out-turn, there were nevertheless some sectoral disparities that warrant commentary. First is agriculture. Here, we had expected a marginally positive quarterly growth rate of 4.1% after the steep declines that were reported in the first two quarters of the year. However, according to Statistics SA, food production was down again in the third quarter, thanks in large measure to poor field crop performance. For the first three quarters of this year, the fall in food production has averaged a whopping 19%. This has to unwind at some point, in our view. Already, upward revisions have been made to the data for the first two quarters of the year, and we will not be surprised to see further revisions and indeed a reversal in coming quarters as the onset of good rains and higher food prices encourage a better planting season this year. Government services post continued strong growth Second is the stronger-than-expected growth in government services. We had, on the basis of the slower-than-expected increase in government spending during the third quarter of the year, expected government services to slow down further from the paltry 1.5% rate that was posted in the first quarter of the fiscal year (second quarter of the calendar year). The data, however, show a recovery in the rate of delivery of government services during the third quarter, following some significant upward revisions to the first quarter numbers. Construction and retail weathering the rate hikes well … Third, we continue to be surprised by the strength of the construction and wholesale/retail sectors, even in the face of higher interest rates. We had expected both sectors to slow down. However, the data show that, after posting a high growth rate of 14.5% in the second quarter, the construction industry still managed to rise by 14.3% in the third quarter, despite the sharp fall in building plans passed and completed. Also, despite the disappointing monthly car sales data towards the end of the third quarter, the retail/wholesale sectors still powered ahead to report a 6.25% q/q, saar rate that was much higher than our expectation of a deceleration to 4.5%. Perhaps the number was buoyed by the record vehicle sales that were reported in August. If this is the case, then we could see a moderation in growth going forward, given that car sales have remained weak since. … but impact of tighter money being felt everywhere else But there were other sectors that did worse than we had expected. These range from manufacturing, finance, real estate and personal services to electricity, gas and water. Quite importantly, these are all interest rate-sensitive sectors, and highlight the risk that the impact of monetary tightening since June this year could end up being stronger than anticipated. Current account/GDP ratio to fall marginally On the whole, the huge revisions that were made to historical data continue to highlight the estimation problems that Statistics SA continues to grapple with. But more importantly, these revised figures also point to possible downward revisions in the deficit-to-GDP ratios that will be reported by the SARB in its 4Q Quarterly Bulletin that will be released at the end of next week (December 8). Unfortunately, Statistics SA does not publish seasonally adjusted and annualized nominal GDP figures, so one cannot run estimations on a like-for-like basis. However, assuming no further adjustments are made for seasonality in today’s revised GDP numbers, and assuming that the implied GDP deflator as published by the SARB remains unchanged, we estimate that the current account deficit-to-GDP ratio for the first two quarters of this year would have fallen by 0.1 pp. That is, the 1Q ratio drops to 6.3% of GDP (from the 6.4% that was published in June) while that of 2Q is capped at no more than 6% of GDP. SACU payments a wild card Looking forward, Morgan Stanley expects the 3Q current account deficit to come in below 6% of GDP. However, we must highlight that this will be contingent on the timing of fiscal outflows to the other Southern African Customs Union (SACU) member-countries —Botswana, Lesotho, Namibia and Swaziland. In October, the Minister of Finance announced that fiscal —and, by default, external —payments to the SACU member countries would rise from R19.7 billion to R29.2 billion this fiscal year ending March 31, 2007. While SACU payments are usually evenly spread over four quarters, the fact that such a huge revision was made halfway through the year as intra-regional trade gathered steam certainly has some implications for the final current account print. A bit of perspective is required here: The country’s current account deficit averaged some R24.5 billion during the first two quarters of this year, while the marginal increase in SACU payments as announced in the MTBP framework is in the order of R9.5 billion. Spreading this potential outflow equally over the remaining two quarters of the year would imply that, ceteris paribus, the current account deficit could rise by more than 20% —assuming that no adjustments are made for seasonality. But given that the government must have known about the overrun in the common SACU revenue pool ahead of the presentation of the MTBPS in late October, it is possible that some of the payment backlog could have been front-loaded in 3Q06 with the view to smoothing out the impact over three quarters, as opposed to two. Our investigations so far do not support the latter payment arrangement, so we have not included this in our 3Q current account estimate. In any case, these SACU payments are made in rand. Hence, there is no contingent foreign exchange financing requirement. It is simply a fiscal obligation for which the counterparty is domiciled outside the country. There could well be a second-round effect as Botswana —one of the SACU member-countries —converts part of its rand receipts into SDR units in order to maintain the fixed weights in its currency basket, but this is unlikely to be significant (Botswana’s currency basket comprises the rand and the SDR, respective weights of which are not officially published but are believed to be heavily weighted in favor of the rand).
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Cooling Momentum
November 29, 2006
By Sharon Lam | Hong Kong
The economy is slowing: Korea’s macro data beat market expectations in previous months and helped revive market confidence in the economy. However, we believe it is too late to be positive on the economy as we now expect to see a further export-led slowdown in the coming months. We believe that macro data will disappoint in the coming months, contrary to the late positive sentiment. Production and corporate investment should be dragged down by exports and we believe that the October data have started to reflect such a trend. The economy will have to rely on construction and consumption to sustain growth next year, in our view. Slower production; higher inventory: The slowdown in production has been expected, as the push-out of delayed automobile shipments lifted up output in September. The October slowdown came in worse-than-expected as it was not mere normalization but it dipped far below trend growth. Production growth eased to +4.6% (versus consensus +6%), the slowest since mid-2005 (excluding July this year when labor strikes plunged automobile output), and well below the YTD trend of +10.5%. The Chusok holiday (which fell in October this year versus September last year), which reduced the number of working days, can be partly blamed for slower output last month, but we have rarely seen the timing of the Chusok holiday have such an impact on production in the past as September and October are always the busiest pre-Christmas production months; as a result, a certain production level has to be maintained in order to meet the Christmas orders. We believe that the abnormally low production level last month reflects not only fewer working days but also the expectation of cooling external demand going forward. In order to compensate for the fewer working days, inventory should have been depleted to meet demand, but the opposite happened. Inventory rose +7.2% in October, up from +6.8% in September and higher than the YTD trend of +5%. Declining output and rising inventory signal a slowdown in the economy. Slower exports mean that the widening current account surplus is not sustainable: Korea’s current account surplus widened for the fourth straight month to US$1.7 billion in October, the highest level in a year. The expansion in the current account in the past few months was mainly due to a cheaper import bill on the back of declining commodity prices. While we believe that the current account will remain in surplus in the coming months, we expect it to shrink moderately as exports now appear to be under pressure from both cooling demand and won appreciation. Meanwhile, a stronger won should prompt more overseas travel and business expansion, which would further widen the service account deficit. In sum, we do not see any positives to support a widening current account surplus in the coming months. The economy’s liquidity conditions will be under pressure next year, in our view, from both external (shrinking trade surplus) and internal (monetary tightening) ends. Meanwhile, the financial account turned into a deficit of US$2 billion in October as foreigners sold Korean equities (US$0.3 billion) while Koreans themselves bought overseas equity investments (US$0.5 billion). What is also worth noting in last month’s data is the reduction in the ‘other investment’ account, which turned into a deficit at US$1.3 billion, yet the YTD ‘other investment’ account is in a surplus of US$40 billion which quadrupled the level from a year ago. The ‘other investment’ account captures foreign loans, and a surplus means that Koreans have been borrowing from abroad. We believe it reflects increasing hedging demand from exporters under won appreciation and also borrowers taking advantage of the lower interest rate abroad. This, however, could be a risk when the short-term rates on foreign loans rise, especially on yen-denominated loans. The Financial Supervisory Service has called for banks to refrain from extending too many foreign loans, and the October financial account data may indicate some success in controlling foreign loan growth. Capex will also be dragged down by weaker earnings: We have been bullish on Korea’s capex, based on real demand, since late last year, but we now believe that the best is behind us. Cooling demand and won appreciation are both adding pressure to export earnings, which will undoubtedly drag down corporate earnings, in our view. In fact, Korea’s capex cycle has already been extending longer than expected, and we believe that all the replacement kind of investment is close to completion. Korea no longer needs any expansionary investment as the country is maturing. Total machinery orders also declined in October to -3.7% from +34.8% in September, mainly dragged down by a plunge in overseas machinery orders. Meanwhile, domestic machinery orders held up due to government purchases, but those by the private sector have cooled down. Consumption to remain stable: In contrast to falling exports and production, consumption growth moderated only marginally in October to +4.5% from +4.7% in September. The Chusok holidays must have played a part in sustaining sales last month, in our view. Nevertheless, we expect consumption growth to remain stable even though the economy is slowing, as there was no over-consumption during the boom, and thus there is no need for a sharp adjustment on the downturn; furthermore, in our opinion, consumer confidence will top the policy agenda during the presidential election year in 2007.
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3Q06 GDP Dips to 4.8%
November 29, 2006
By Deyi Tan | Singapore
3Q06 GDP rose 4.8%: The economy rose 4.8% YoY in 3Q06 (versus +5.8% in 2Q06 and 1H06). Year-to-date, the economy expanded 5.4% YoY. Private consumption spending is key support: Private consumer spending remained the key growth driver, contributing 4.2%-pt to headline growth. Private consumption momentum sustained at 5.3% YoY (versus +5.4% in 3Q06) on the back of the 12.6% rise in remittances in 3Q06. However, government spending was almost flat at 0.4% as the government operated on a supplementary budget for 2006 with the appropriations bill not passed. Investment continued to lack vigour. Gross capital formation rose 4.4% (versus +1.4% YoY in 2Q), but that was due to inventory additions. Fixed capex declined 1.1% YoY as durable equipment uptake contracted 2.1%. External demand moderating: The external demand slowdown flowed through, with total exports rising 9.1% YoY (versus +20.4% in 2Q06). Total imports also decelerated to 1.2% YoY (versus +4.0% YoY in 2Q06). The growth contribution from the net external balance stands at a smaller 4.4%-pt (versus +6.8%-pt in 2Q). Agriculture and industry slowed: The agriculture sector expanded 4.1% YoY, following the 7.0% in 2Q06. Industry also decelerated to 4.0% YoY (versus +5.6% in 2Q06) as manufacturing registered 4.8% YoY (versus +6.5%). Only the services sector remained the same, at the 5.6% YoY seen in 2Q06.
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