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Strong GDP Growth in F2Q07
December 01, 2006

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

GDP Growth was at 9.2% in F2Q07

The Central Statistical Organization (CSO) announced that GDP growth in the quarter ended September 2006 (QE Sep-2006) was at 9.2% year on year (YoY), compared with 8.9% registered in QE Jun-2006.  This was ahead of our and consensus expectations of 8.5% and 8.9%, respectively, largely on account of stronger-than-expected growth in the trade, hotels, transport and communications segment (+13.9% in QE-Sep 2006 vs. 13.2% in previous quarter).  Growth in the services segment accelerated to 10.9% in QE Sep-2006 versus 10.2% in the previous quarter.  The industrial segment accelerated to 10.9% in QE Sep-2006 from 10.2% in the previous quarter.  Agriculture growth decelerated in line with expectations to 1.7% in QE Sep-2006 from 3.4% registered in QE Jun-2006. 

Manufacturing segment growth accelerated to yet another new high

Growth in the manufacturing segment accelerated to a new high (since quarterly data have been made available) of 11.9% in QE Jun-06.  This compares with 11.3% recorded in the previous quarter.  This was also reflected in the aggregate corporate sales growth (for our universe of 87 companies, excluding energy), which also accelerated to a new high of 26.1% YoY during QE-Sep 06, up from 25.2% during the previous quarter.

What drove the strong growth?

In our view, the key driver of the strong growth appears to be domestic demand, which in turn has been driven by debt-funded consumption growth.  Indeed, bank credit growth averaged 31% YoY during the quarter ended September 2006, compared with 31.9% in the previous quarter.  During the quarter, external demand also witnessed a rebound, with export growth accelerating to 25.4% YoY during the quarter from 18.6% during QE-June 2006.  However, this was offset partly by government expenditure growth decelerating to 5% in QE-Sept 06 from 44% in the previous quarter.

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Unprepared in Beijing
December 01, 2006

By Stephen S. Roach | from Beijing

Taking its cue from a powerful liquidity cycle and the frothy financial market conditions it has inspired, the world is not prepared for a meaningful shortfall of US economic growth.  That’s certainly the message I take away from my final stop of the year in China -- whose seemingly Teflon-like economy would hardly be immune to a global accident made in America.

As 2006 draws to a close, the debate inside of China remains quite focused on its own internal challenges.  At least, that’s the tentative impression that emerges from the first two days of a three-day swing through Beijing.  With visible signs of the boom literally everywhere you turn and an IPO-led stock market surging its way back toward the highs of early 2001, the mood remains as ebullient as ever.  While the latest monthly data are flashing signs of a slowdown, you would never know that in meeting with key decision-makers in Beijing.  The Chinese seem to be paying lip-service to the rebalancing imperatives that I and other macro types continue to stress -- the long-awaited shift from an export- and investment-led growth model to one that draws increasingly greater support from private consumption (see my just released Special Economic Study, “China’s Rebalancing Imperatives: A Giant Step for Globalization,” December 1, 2006).  Senior Chinese officials frame such a transformation as a longer-term objective of market-driven reforms.  For the foreseeable future, however, they believe they have the luxury of time to cope with what they believe to be an evolutionary shift in the macro sources of economic growth.

I fear an inward-looking China could be blindsided by more rapidly changing external developments.  Two such possibilities worry me the most, and they are both made in America.  First, is the risk of Washington-led trade protectionism.  Understandably, China is focused on the upcoming strategic bilateral talks between top US and Chinese officials slated for Beijing in two weeks time (December 14-15).  Led by Treasury Secretary Paulson, Fed Chairman Bernanke and US Trade Representative Schwab, and accompanied by Secretaries of Commerce, Labor, Energy, Health and Human Services, and Environment, this is as high-level a US delegation as I have seen that is traveling to deal with a major trade and international economic issue.  This strategic economic dialog is a very big deal in official China, where the lack of respect from the international community has long been a source of considerable concern.  Yet there’s one key problem with the emphasis that China is placing on this mission: In a post-election climate, US political power has shifted away from the Bush Administration officials who will be sitting at the table with their Chinese counterparts.  China doesn’t fully grasp the significance of the coming political power change and the deeply-rooted bipartisan anti-China sentiment that pervades both houses of the US Congress.  By our count, fully 27 pieces of anti-China trade legislation have been introduced in the Congress since early 2005.  The odds are rising that one of them will become law in 2007.  The political winds have shifted in America just as China sits down with great ceremony to negotiate with the “lame ducks.”

A second possibility that could provide an external shock to China would be a sharp slowdown in the US economy.  America is China’s largest export market -- directly accounting for 21% of its total exports over the past five years and a good deal more than that if re-exports from Hong Kong are added back in.  Moreover, exports are likely to exceed 35% of Chinese GDP this year -- making it, by far, the most externally dependent major economy in the world today.  Yet economic conditions in China’s largest export market -- the United States -- are deteriorating dramatically in the final months of 2006.  This is a big deal not only for China but for other externally-dependent economies elsewhere in Asia -- especially the big ones like Japan, Korea, and Taiwan.  These latter economies could well be hit with a “double whammy” in the event of a shortfall in US economic growth -- a reduction in their direct exports to America and a cutback in the demand for components they send to China that are then assembled in the “world’s factory” on their way to the US.  Lacking in support from domestic private consumption, a China-centric Asian economy is an unlikely candidate for decoupling in the event of a US growth accident.

It’s worth belaboring this latter possibility -- only because most remain in denial over the swift and sudden deterioration in the US economy.  That’s true in China, as well as in the United States and elsewhere around the world.  Yet there are now signs of cumulative weakness in the US economy that have all the classic manifestations of a looming cyclical downturn.  It all started, of course, in the housing market -- the sector where everyone has been calling the bottom over the past few months.  One of these months that call will certainly be correct.  However, October’s outsize decline in housing starts, together with downwardly-revised readings of new home sales and still sharply elevated backlogs of unsold dwellings, pose serious problems for the bottom-fishers.  Keep in mind that any call on housing starts pertains to the leading edge of homebuilding activity -- the initiation of a new building project.  Starts always bottom first -- even though they may not have done so yet.  What comes next -- and this is the key for the macro economy -- are the lagged impacts from a fallback in newly started units that then depress subsequent trends in construction, employment in the building sector, the income generation forthcoming from such activity, the furniture and appliances that go into new homes, real estate brokers, and so on down the feed chain.  Don’t kid yourself, even if housing starts have finally bottomed, there’s plenty to come in America’s nascent recession in the residential construction sector.

Meanwhile, in contrast to what you hear from the “compartmentalists,” the housing-led deterioration is rapidly spreading to other sectors of the US economy.  Two consecutive monthly declines for both retail sales and manufacturing output in September and October should hardly be taken lightly -- to say nothing of mixed early reports by retailers for November.  A renewed decline in consumer confidence in November, rising unemployment insurance claims, and a stunning downward revision of nearly $100 billion to personal income (mainly wage earnings) in 3Q06, belies the notion that ever-resilient American consumers are poised to come out of this swoon.  But the real kicker was a perfectly awful report on capital spending activity -- with forward-looking orders and backward-looking shipments both sagging sharply in October.  Capex has long been billed as the recipient of the great “baton pass” -- the sector that would seamlessly pick up the slack in the event of a downturn in housing and/ or consumption.  The latest data suggest the proverbial baton may have been dropped -- hardly surprising, in my view, since capital spending has long behaved as a “derived demand” that is highly sensitive to expectations of future pressures on capacity utilization.  With the housing and consumption outlooks shaky at best, the so-called accelerator models of business capital spending are flashing precisely the type of caution that the October data on capital goods conveyed. 

Adding it all up -- housing, consumption, capex, together with an upward revision to 3Q06 inventory building -- and the US economy may be on the brink of its second post-bubble recession in five years.  A surging bond market and a weaker dollar appear to be alone among major asset classes in figuring this out.  I continue to fear the implications of that realization for other markets -- especially equities and spread products, which remain priced for the veritable absence of any risk. 

All this is a long way away from the hustle and bustle of BeijingChina’s performance has been so impressive for so long that I sense a growing tendency to take the boom for granted.  Reflecting this belief, I am starting to detect an important shift in the Chinese mood, with long-entrenched feelings of self-doubt now giving way to a new-found confidence.  There’s nothing wrong with confidence -- it can be a critical element of any successful economic development strategy.  But confidence must be on solid ground to fuel sustainable growth.  Lacking in support from internal private consumption, the Chinese confidence factor is increasingly dependent on a powerful export-led growth dynamic and associated gains in fixed investment -- both very much tied to the open-ended expansion of China’s outward-looking export production platform.  This could turn into a surprisingly precarious situation.  What happens if the narrow underpinnings of China’s growth strategy are undermined by the twin surprises of Washington-led protectionism and a sudden deterioration in the US economy?  Beijing is unprepared for either of those possibilities -- as is, I’m afraid, the rest of the world.

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The Montenegro Option
December 01, 2006

By Serhan Cevik | London

The “suspension” of some chapters is not the end of Turkey’s accession process.  The European Commission has decided to recommend the “suspension” of eight chapters that relate to the customs union protocol and the introduction of new criteria for completing the remaining chapters of Turkey’s accession negotiations.  Surprising?   Not at all, once you consider the underlying problem: the Cyprus conflict.  Even though Turkey has made significant progress towards adopting the acquis communautaire, its refusal to apply the customs union agreement to all members of the EU, including the (Greek) Republic of Cyprus, remains an obstacle.  In other words, even if the Commission were to recommend no amendment in the management of Turkey’s membership talks, the Greek Cypriot government would have likely keep vetoing the opening of new negotiating chapters.  Therefore, the latest developments change practically nothing and may even be perceived positively, to a certain extent, as long as Turkey can move forward with the unblocked chapters of EU convergence.

Is the unification of the two Cypriot communities still a viable option?   Everything depends on the Cyprus conflict, but there is no sign of progress on horizon.  As a result, Turkey’s entire accession process faces a bottleneck that nobody really knows how to remove.  The EU is partly responsible for creating this bottleneck — or the Gordian knot as we call it — by granting membership status to the Greek Cypriots while isolating the Turkish side.  Consequently, even if Turkey implements the customs union protocol in a non-discriminatory fashion and opens its ports to Greek-Cypriot vessels, there is still no guarantee that the accession process would not be interrupted by new demands.  This is why all the parties need to shift the focus from temporary solutions to how to develop a comprehensive agreement under the auspices of the UN.  However, although recent events highlight the urgency of such a move, it is not yet clear how even the UN can find a new reunification deal that would be acceptable to the two Cypriot communities.  After all, 75.8% of Greek Cypriots rejected the reunification plan based on the so-called Belgium model, whereas 64.9% the Turkish Cypriots voted in favour in the 2004 referendum.  Moreover, election outcomes and opinion polls suggest that the Greek Cypriot community still maintains strong opposition to reunification of the island and favours a ‘solution’ based on conceding just minority rights to the Turkish Cypriots (see The Cyprus Stalemate: What Next?, International Crisis Group, March 8, 2006).

It is time to start considering other options, including the Montenegro model.  Reunification may be the first best choice, but the lack of progress has delayed Turkey’s full integration with Europe and become a source of social and economic deprivation in the Turkish side of the divided island.  Therefore, as long as the Greek Cypriots enjoy the asymmetric advantage of ‘being an insider’, there is almost no room for finding a real solution apart from futile diplomatic manoeuvrings.  This is why we believe that it is now time for the international community to start considering alternative approaches to the Cyprus dilemma.  One interesting and highly relevant example is the ‘civilised’ independence of Montenegro from Serbia — a decision eventually supported by the EU.  In the case of Cyprus, it may be a challenging option, but still much better than a dysfunctional union, in our opinion.  In any case, parties are still far from finding a workable, sustainable solution, and that unfortunately complicates Turkey’s accession negotiations with the EU.  The good news in the midst of all the uncertainty is that blocked chapters related to the customs union should not delay the accession process or alter Turkey’s commitment to institutional modernisation.

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United States
Will the Real Consumer Income Please Stand Up?
December 01, 2006

By Richard Berner | New York

We have touted improving income gains as a key building block for our case that consumer spending will remain resilient and that the economy will return to trend growth (see “All About Income,” Global Economic Forum, October 30, 2006).  Yet, recent significant downward revisions to wage and salary income in the spring raise questions about the sustainability of consumer spending power, and they are only one of several challenges to our view.  In contrast with the pessimists, however, we think that income growth is still on track to support both moderate gains in consumer spending and increased saving.  Here’s why.

First, it’s important to look back at where we’ve been; initial conditions do matter.  Analytically, gains in “core” income — increases in real, after-tax wages and salaries — have always been the key driver for consumer spending.  Through much of this expansion, however, such real income gains for America’s consumers have fallen short of cyclical norms.  Many cite globalization and the global labor arbitrage as the culprits.  In contrast, I think three other factors accounted for that shortfall: Corporate America was trimming the hiring excesses of the 1990s.  Early in the expansion, surging healthcare costs and pension contributions further depressed job gains and the share of compensation that went to take-home pay.  And energy quotes soared 15.5% annually in each of the past four and a half years, eroding real pay gains and discretionary spending power. 

Globalization is still with us but the other three hurdles to faster income have faded in the past year.  While moderate, the combination of job gains and rising hours has improved to a sustainable 2% annual pace.  Pension and healthcare contributions have faded, and labor markets have firmed, boosting wage gains to a 4% rate.  And courtesy of improved refinery yields and energy conservation, apart from a winter bounce that is now underway, my colleague Eric Chaney and I believe that energy quotes have peaked (see “Oil Update: Short-Term Rebound Ahead,” Global Economic Forum, November 17, 2006).  As a result, headline inflation has fallen to 1.5% and further energy price declines should restrain it to 2% or less over the next year.  The combination should promote a 4½% gain in real wages and salaries.  Even with slower gains in property and transfers income, that would translate to gains in real disposable income well beyond the 3% spending pace we think likely over the next couple of quarters. 

In fact, until recently, official data showed that real wage and salary income gains were running at a much faster 5.6% clip in the year ended in September.  The reason: Statisticians at the Bureau of Economic Analysis (BEA) found in the spring that data from the Bureau of Labor Statistics (BLS) quarterly census of employment and wages (QCEW) — the so-called ES-202 data that serve as the benchmark for the payroll employment estimates — implied much bigger gains in first-quarter wage and salary income than first thought.  Indeed, at an annual rate, they raised the annualized increase in wage and salary income over the December-March span from 6.6% to an implausible 15%.  The common assumption was that the exercise of employee stock options and bonus payments in the first quarter exaggerated the gain, and that BEA’s estimate of a 6.4% wage and salary gain over March-June represented a return to trend.  However, preliminary and as-yet-unpublished second-quarter QCEW data showed a much smaller gain than BEA’s estimate, so statisticians revised wage and salary income down over March-June by $122 billion to show a 1.9% annualized decline. 

This long-winded explanation matters for interpreting these stunning revisions.  They pushed the personal saving rate sharply into negative territory, thus increasing the angst over consumer vulnerability.  Moreover, the seesaw pattern of income reinforced the notion that special, one-time factors boosted income in the first quarter, and that the trend was thus overstated.  In fact, BEA correctly argues that “irregular items” such as bonuses and stock option exercise would promote volatility in the data, and they could well have done so.  But there is no hard evidence to support that claim.  And there is another explanation: The QCEW data on which BEA bases the revisions are themselves quite volatile, and the humped pattern of compensation in the first quarter may reflect that volatility more than bonuses or stock options exercise.  Recall that, prior to annual revisions in July, there was a similar hump in compensation growth in Q4 2004 that seemed to be the result of stock option exercise.  It vanished in the revisions.

In fact, the official data when smoothed for this volatility now seem closer to the trend depicted by other metrics, and thus seem more likely to represent sustainable income gains.  The product of private hours worked and average hourly earnings — admittedly a flawed measure — and private wage and salary income are both running at a 6-6½% rate in the year ended in October.  Moreover, the sum of withheld and OASHDI tax collections — which over the course of the past year was a key indicator suggesting that official wage and salary income data were too low — rose 7.2% in the year ended in October, close to the rate in the other two measures.  Anecdotal evidence, for example in the Fed’s Beige Book, suggests that firm labor markets are generating faster pay gains.  And forward-looking indicators suggest that the current slowdown has yet to erode the trend. For example,  the National Federation of Independent Business October canvass of small businesses showed high levels of respondents planning to hire and step up compensation gains.  And in our own Business Conditions survey, which showed weakness in early November, the percentage of analysts noting that companies under their coverage plan to step up hiring over the next three months nearly doubled to 41%, the highest percentage in a year. 

Market participants are now discounting a continuation of sluggish growth, declining inflation, and an even chance that the Fed will begin easing monetary policy by March 2007.  The income dynamic that we observe, if sustained, implies that policymakers’ current rhetoric is a better guide to future policy moves.  For example, Chairman Bernanke this week gave no hint that he was contemplating an easing in monetary policy any time soon.

But risks obviously abound.  One key risk to our view is that sluggish growth begins to erode job and income gains.  There were clear signs in October’s payroll data that the two-tier economy is hobbling such gains in construction and manufacturing.  And over the last two weeks, the jump in jobless claims, which are likely to be closely associated with jobs in goods-producing industries, hints at outright layoffs.  The 5% plunge in October capital goods bookings, though possibly distorted, at least means that capital spending is now a question mark.  But with strong offsets from easy financial conditions and hearty global growth, we think that broader-based weakness in hiring is unlikely. 

A second risk is that decelerating home prices will prompt consumers to save rather than spend the income gains.  In my view, consumers will save some of their new income gains, including some of those resulting from the plunge in energy quotes.  Importantly, however, I think they will rebuild saving slowly, allowing ample scope for spending.  While it appears from data in hand that spending is only running at a 3.1% rate in the fourth quarter, real income appears to be growing significantly faster, so consumers may well turn less cautious in coming weeks.  Thus, the risk for markets is that our scenario will turn out be right after all.

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A Somewhat Cynical View on the Governor’s Speeches
December 01, 2006

By Takehiro Sato | Tokyo

Governor Fukui emphasises data dependence at press conference

We do not go into the length here are about Governor Fukui’s remarks in his several speeches and press conferences in the first half of this week, since the media have already reported on them in detail.  Our impression is that he hardened his data-dependent stance, as has been reported.  Given the growing gap between the BoJ’s optimism on economic activity and prices and the market’s caution, following a number of negative surprises in recent economic data, we think the BoJ has not done well in communicating with the market.  The stock market’s trend through last week represented investors’ negative reaction to the BoJ’s bias toward raising rates.  We think Governor Fukui is looking to make careful adjustments in light of these circumstances. 

The gap between the BoJ’s and the market’s views narrowed somewhat with the stronger-than-expected October industrial production figures.  He said the BoJ is prepared to raise rates promptly if the market’s and the BoJ’s views line up and the market is ready to accept a rate hike.  We believe fresh surprises on the economic and price fronts are needed to find such common ground, and based on the latest industrial production figures.

BoJ governor’s unusually high extent of public exposure, compared with Fed counterpart

What we find noteworthy about the BoJ’s dialogue with the market, for example through speeches by top officials, is that Governor Fukui is much more exposed to the media than other major central bankers are.  Frequent communication of information appears to be a good opportunity to enhance the BoJ’s dialogue with the market, but officials’ remarks are sometimes not correctly conveyed and can vacillate. 

For example, the BoJ governor holds a press conference after each of the 14 policy meetings each year, regardless of whether a policy change has been made.  He is also regularly called before the Diet, when it is in session, to make comments and sometimes gives speeches, and holds press conferences on monetary policy, as was the case earlier this week.  By contrast, the Fed chairman does not hold a press conference after the FOMC meetings and rarely gives speeches on the outlook for monetary policy.  The chairman is called before Congress to explain the Fed’s monetary policy, but only twice per year (four times if we count the appearances before the Senate and House of Representatives separately).  The ECB governor, meanwhile, has more chances to express opinions than the Fed chairman, but not as many as the BoJ governor.  The BoJ thus does more than the Fed and the ECB in terms of information disclosure, but the risks include occasional vacillation in and misunderstanding of BoJ officials’ remarks, as well as invitations for political intervention, as happened following the governor’s speech in November 2005. 

Silence is golden

We have recently started to believe that it would be enough for the BoJ just to say that it will quietly do what it needs to do to normalise monetary policy, regardless of whether the economic data strengthen or weaken slightly, and not worry about providing detailed explanations to the market. 

A rate hike to 0.50% or even 1.0%, while prices are very stable, would lead to a flattening of the yield curve.  Bank lending rates would stay steadily low, we believe, and the impact of the rate hike on the real economy would be almost neutral.  Furthermore, a rise in deposit rates could positively affect consumer spending by encouraging a flow of income, however minor, from the financial system to households.  For the government, which has the greatest shortage of funds, a flattening of the yield curve would be a good opportunity to lengthen the duration of liabilities.  In this regard, we think the argument that government spending would increase because of a rise in debt servicing costs clearly lacks balance. 

But for these rate hike benefits to come about, the market’s expectations would have to stabilise and the yield curve flatten.  The central bank would focus mainly on the stabilisation of expectations and be pressed to raise rates orderly and quietly, as the Fed did during its most recent rate hike cycle.  We doubt we are the only ones who believe silence is golden in this regard.

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Inflation Deceleration Continues
December 01, 2006

By Deyi Tan and Chetan Ahya | Singapore, Singapore

November inflation rose 5.3% year on year (YoY): Prices rose at a slower 5.3% YoY in November (vs. 6.3% in October), bringing the YTD inflation to 13.8% YoY.  Our full-year forecast stands at 13.3% YoY.  On a sequential basis, prices rose at a slower 0.3% month on month (MoM) after the Idul Fitri season accelerated it to 0.9% MoM in October.  Core inflation showed a similar trend, slowing to 5.9% YoY from 6.9% YoY in October.

Inflation deceleration concentrated on food segments: For November, the bulk of the deceleration came from the food (+8.1% YoY vs. +10.0% in October) and processed food segments (+5.9% vs. +7.5% in October), and contributed 1.9pp (vs. 2.3pp in October) and 1.0pp (vs. 1.3pp in October), respectively.  Since the base effects faded out in September, prices in the transport segment have remained largely stable at 1.0% YoY (vs. 1.7% in October). 

Next monetary policy meeting on December 7: The inflation data remain conducive for further monetary loosening.  On the latest data, real benchmark rates are standing at 5.0% based on headline inflation and 4.3% based on core inflation.  The Central Bank has begun signalling in its last two monetary statements that it intends to bring rates down at “a gradual and cautious pace”.  We believe it could shift from making 50bps cuts to 25bps cuts at its December 7 meeting.  This would bring the benchmark rate down to 10.0%.

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Pre-Budget Preview: Setting the Stage
December 01, 2006

By Melanie Baker and David Miles | London, London

On December 6, the Chancellor presents his Pre-Budget Report.  He is likely, we think, to sound confident of meeting the Treasury’s fiscal rules and economic forecasts for this year.  Although further fiscal tightening looks necessary to us, significant measures seem very unlikely as yet.  1) The margin for error on meeting the ‘golden rule’ looks small to us, but with the cycle forecast to end in 2008/09 there is still time to make up ground.   2) Net debt is still below the 40% limit. 

However, this Pre-Budget has the potential to generate a few surprises and send broad signals on the likely future direction of economic policy.  Next year sees the government’s biennial comprehensive spending review (which sets departmental spending plans and limits for three years) and probably the current Chancellor’s last Budget.  This Pre-Budget may be used to set the scene for both these reports and beyond.

2006 GDP forecast should be comfortably met.   For 2006, the Treasury expected real GDP to grow between 2% and 2½% (and by 2¾% to 3¼% in 2007).  To achieve at least 2.5% GDP growth (at the top end of the Treasury’s range for 2006) we would need 4Q GDP to grow by only around 0.5%Q (non-annualised).

Less on target with borrowing, but pretty close.   So far, public-sector net borrowing (PSNB) is on track to generate outcomes only slightly worse than the Treasury’s 2006 Budget forecast.  PSNB is running some £2 billion above where we were this time last year.  If that differential were maintained, PSNB in 2006/07 would be around £39 billion, in contrast to the Treasury’s £36 billion forecast.  Corporate profit growth, however, has been relatively healthy this year and one of the biggest months for corporate tax revenue (January) is still to come.  This gives the Treasury plausible scope to make up the lost ground.

Golden rule likely to be met this cycle … just.  Whether or not the Treasury meets the ‘golden rule’ (borrowing only to invest — that is, have a current budget of zero as a percentage of GDP or less when averaged over the whole cycle) this cycle is a close call.  If the cycle is deemed likely to end in 2008-09 (the Treasury’s current forecast), on our central forecasts the golden rule will just be met (by a margin that leaves very little room for error).  However, exactly when the cycle ends is somewhat controversial and the Treasury has previously revised its assumptions. 

Net debt rule not in imminent danger.  The debt rule (that public-sector net debt as a percentage of GDP should not exceed 40%) looks likely to be met comfortably this year.  However, with significant infrastructure spending still needed in the UK, the possibility that the ONS might further reclassify some currently off-balance-sheet government liabilities as government debt, and with the government committed to meeting any cost overruns related to the 2012 Olympics, the debt rule may be in danger of being breached before the golden rule.  We continue to think, however, that dramatic cuts in government spending plans/increases in taxes solely in order to meet this rule are unlikely.  More likely is that more asset sales will be announced and/or that the rule itself will be revisited at some point in the next couple of years (particularly since the 40% number is rather arbitrary and conservative, given debt levels in most other developed economies). 

Media highlighting green taxes.  News sources have highlighted the possibility of announcements on various environmental taxes, including Reuters reporting a potential rise in fuel duty (which has been frozen for several years on petrol).  The Stern Report on climate change, published in October, emphasised the importance of early action on carbon emissions and gave the Chancellor a basis on which to announce changes to environmental taxation should he so choose. 

Several major reviews due at the time of the Pre-Budget.  Alongside the Pre-Budget, next week should also see the publication of several reviews including on transport, skills and planning.  The transport review, in particular, may afford the Chancellor an opportunity to drop a few hints on the potential for user charging for formerly free-at-point-of-use services (e.g. road-charging) and the mixture and type of government borrowing and taxation strategies (including the future of PFI deals in funding infrastructure spending).  These reviews, this pre-budget, next year’s budget and next year’s comprehensive spending review will give the Chancellor the opportunity to set the fiscal agenda for some years ahead.

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CA Balance Remains in Positive Territory
December 01, 2006

By Deyi Tan and Chetan Ahya | Singapore, Singapore

Current account surplus in October: The current account balance remained in positive territory at US$856 million in October (vs. US$826 million in September).  Specifically, the trade balance narrowed to US$723 million from US$1,402 million in September on the back of 20.9% year-on-year (YoY) (vs. 14.5% in September) growth in exports (BOP basis, US$ terms) and 8.9% YoY (vs. 9.1% in September) in imports.  Net services, income and transfers turned positive at US$133 million (vs. negative US$576 million in September). 

Exports sustained on the back of machinery and food segments: In terms of the export breakdown, on a custom basis (Bt terms), the momentum was sustained by machinery (+8.3% YoY and +3.9pp), food (+17.3% YoY and +1.9pp) and crude materials (+27.0% YoY and +1.4pp). 

Capital imports weak across the board: On the import front (custom basis, Bt terms), momentum weakened across all categories.  The contraction in capital goods worsened in October (-11.8% YoY vs. -5.9% YoY in September).  Despite the pickup in consumer confidence, consumer goods imports decelerated to 2.1% YoY (vs. 6.1% YoY in September).  Raw materials and intermediate goods on the other hand grew by 2.1% YoY (vs. 0.2% YoY in September).

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The Final Showdown
December 01, 2006

By Takehiro Sato | Tokyo

This is where the game is decided

The previous September Tankan headline number was surprisingly strong, despite slowdown concerns on the global economic front.  The key to the December Tankan is whether confirmation emerges of continued improvement in business conditions DIs, even if there is some evidence of actual economic slowdown in Japan and the US.  If corporate sentiment again were to shake the tough external environment and solidify, this would be another pleasant surprise on the heels of the latest industrial production data.  Indeed, we think corporate sentiment will strengthen in its own way. 

Forecasts for business conditions DIs

We foresee a current DI for business conditions at large manufacturing enterprises of +26, a 2pp improvement from the September survey.  For large non-manufacturers we anticipate +19, a 1pp drop from last time.

We expect manufacturers’ sentiment to remain steady in the face of rising uncertainty in the external environment, fuelled by (1) higher corporate profit levels thanks to lower breakeven points, now that they have streamlined fixed costs; and (2) a weaker yen in real effective terms.  For non-manufacturers, we expect to see some sense of stagnation in light of slackening demand on poor summer weather and the like.

As the business conditions DI moves up, there is a tendency for forward projections to turn weaker.  Indeed, we expect the outlook assessments for large manufacturing enterprises to come in 4pp lower than the current assessments at +22.  Though we do not see this as particularly worrying, contrary to usual trends, the outlook DI in the Reuters Tankan, a leading indicator, also looks to be below current assessments for manufacturers.  Corporate outlook sentiment seems to be turning more wary despite the healthy headline. 

Forecasts for management plans in F3/07

(1) Sales and profit targets: in the September Tankan, F3/07 sales were projected up 3.1% year on year (YoY) for large manufacturers in all industries, for growth of 1.7% in recurring profit.  On the other hand, actual recurring profits for listed firms in the July-September quarter were about 10% YoY, although there were discrepancies in the consolidated and parent results, as earnings continued strong from April-June.  However, companies have left their full-year profit plans largely intact since revising after April-June quarter reporting.  This seems overall conservative, considering 1H earnings results, and as such, we do not expect radically different sales and profit plans in the December Tankan versus the September data. 

Contrary to our outlook, companies did not revise up their full-term forecasts after 1H reporting, which temporarily stifled the uptrend in equity markets.  Nevertheless, we expect full-year forecasts to be revised up in a relatively significantly after October-December quarter results show similarly upbeat earning trends, as companies would need otherwise to offer logical explanations for maintaining forecasts showing large profit declines for January-March alone.  As such, we would not deem it a negative surprise if earnings forecasts in the December Tankan were not radically different from the September Tankan. 

The case of F3/06 is still fresh in mind, when profit forecasts called for essentially flat YoY growth initially, but projected 10% growth at the interim, and eventually came in at close to 20% growth for the term.  If the type of upward profit forecast revisions from F3/06 resurface this term, our double-digit growth projection will still be well within grasp. 

(2) Capex plans: Revisions for capex plans for large companies in the BoJ Tankan are usually largest in the June survey.  We think this is due to few firms having set concrete plans by the March survey, but then a sudden burst of firms having both the previous year’s results and definitive plans for the current term set by the time the June survey rolls along.  The revisions between the June and September Tankan are the smallest.  The survey is conducted before interim results are available, when few firms actually revise their capex plans.

Meanwhile, revisions in the December Tankan are usually dependent on the economic cycle; an expansionary economy will see upward revisions and a slowing economy downward revisions.  Data for the past three years since F3/04 all came in as upgrades.  This time, based on revision rates against the September data for the past three years, we project the revision rate for large companies to be +1.1% (+1.0% for manufacturers and +1.2% for non-manufacturers).  Thus, we expect capex plans for large companies in all industries to rise 12.7% (+18.1% for manufacturers and +9.8% for non-manufacturers).

Policy implications

The BoJ would need the following to implement a second rate hike: (1) confirmation from the Tankan of stable corporate sentiment; and (2) reconfirmation that F3/07 capex plans are being maintained or pegged up.  Indeed, if the headline improves marginally, capex plans appear healthy and further signs emerge of supply/demand tightness in the output-gap-related DIs (such as production capacity and the employment condition DI), this would give the BoJ fewer practical reasons for pushing back the next rate hike into January, and likely make December suddenly a more plausible timeframe. 

On the flip side, if the Tankan headline figure is essentially flat or down slightly, this would diminish the BoJ’s fuel for a rate hike, though other factors such as capex plans would have some influence.  Sluggish sentiment in non-manufacturing industries is also a likely hot-spot.  To be doubly sure, the BoJ will likely need to reconfirm: (1) the mild production uptrend in manufacturing industries after seeing industrial production results, as well as upward revisions to the METI’s manufacturing production forecast survey; and (2) whether price trends in the CPI mesh with the BoJ’s scenario after the impact of cellular phone charges falls out. 

We should be able to confirm the former (mild rise in manufacturers’ production trends) through the November IIP data to be released on December 28 and the METI's manufacturing production forecast survey results for December-January.  The latter (whether price trends in the CPI fit with the BoJ’s scenario after the impact of cellular phone charges falls out) would have to wait for the November nationwide CPI data, expected on December 26.  Should these indicators come in more or less in line with its scenario, we think the BOJ will decide to go ahead with the second rate hike at the January 17-18 Policy Board meeting at the latest.  A potential risk would be for the media and the market to take for granted a December rate hike solely on the basis of the Tankan, without waiting for the above data.

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