Missing Piece
December 13, 2006
By Serhan Cevik | London
An unambiguous agenda for peace would significantly improve Israel’s economic prospects. The Israeli economy recovered robustly out of the recession triggered by the burst of the global high-tech bubble and the eruption of violence. As fiscal correction and structural reforms cleared the path for private sector-led expansion, real GDP grew at an annual rate of 5% in the past three years. However, though the state of the economy has improved in terms of job and income growth, it would be a mistake to overlook the influence of above-trend global growth on Israel’s technology-intensive sectors. The continuing rise in exports that has been the leading growth engine could become a challenge if we end up with a US-led slowdown. For the time being, our global economics team projects a manageable deceleration in the global economy from 5% in 2006 to 4.3% next year. But growth risks are on the downside, and countries lacking strong domestic demand may face a troubling period. Israel’s domestic economy, albeit gaining strength, is still not robust enough to compensate for the export engine. This is why we believe that the country needs an unambiguous agenda for peace, not so much for shielding against shocks but, more importantly, for realising its true, unappreciated potential.
The drop in US investment spending is likely to lower Israel’s export-driven growth. Real GDP was growing at a year-on-year rate of 5.6% before the outbreak of the guerrilla war in Lebanon. Although growth slowed abruptly to 3.6% in the third quarter, the economy has recovered quickly from the military shock and is already on its way to posting an annual increase of 4.8% this year, according to our estimates. Nevertheless, we expect real GDP growth to come down to 4.4% next year, before showing a marginal reacceleration to 4.6% in 2008. The slowdown is mainly a reflection of lower export growth from 4.9% in 2005 to 4.1% in 2006 and then 3.2% next year. That is of course a result of the coming drop in business spending on equipment in the US — one of the key drivers of Israel’s export growth — and the shekel’s appreciation. Our US economic team now expects the growth rate of corporate investment outlays on new equipment to decline from 7.1% in 2006 to 6.1% next year and 4.9% in 2008. This may not be a dramatic shift in growth dynamics, but is still enough to make Israel’s technology-intensive growth vulnerable to global winds. Furthermore, the shekel’s recent strength puts pressure on low-tech, labour-intensive sectors, which are already struggling, with almost no export growth, against competitors from the developing world. Israel has internalised low inflation, but the pass-through effect remains a challenge. We occasionally witness bursts of inflation, but Israel has come a long way in internalising price stability. Consumer price inflation declined from 20% at the start of the 1990s to 0% by the end of 2000 and remained at an average of 1.7% since then. Nevertheless, inflation volatility is still a risk for the economy and financial markets, as it ranged, for example, between 3.8% and -0.2% this year. The problem stems from the legacy of exchange-rate indexation in certain sectors, bringing higher inflation when the shekel weakens or even deflation when the shekel starts appreciating. And this is exactly what has happened in recent months, as the shekel’s strength pushed dollar-linked prices lower (see Technical Deflation, November 20, 2006). We expect inflation to remain below the lower bound of the central bank’s target range of 1-3% and gradually increase towards the mid-range by the end of next year. In our view, Israel can maintain a negative interest rate differential vis-à-vis the US. The correction in energy prices and the shekel’s appreciation should allow the Bank of Israel to maintain a reasonably accommodative monetary stance. Indeed, the current level of interest rates is not an obstacle to growth, and therefore we see no reason for an aggressive policy shift. If anything, as the current account surplus narrows over the course of the coming years, the authorities should be more cautious in giving an unnecessary weight to currency movements in determining the policy stance. That said, the real challenge is not economic policy adjustments, but developing a comprehensive peace agenda that would allow Israel to take advantage of its incredible human capital endowment and entrepreneur capacity, in our view.
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3Q06 Current Account Improves Significantly, but Quality of Capital Flows Deteriorates
December 13, 2006
By Michael Kafe | Johannesburg
The South African Reserve Bank (SARB) published its December Quarterly Bulletin last Friday. This contained detailed information on demand-side GDP and balance of payments data, among other things. The Bulletin showed that South African consumers may have already started responding to the SARB’s tightening activity. At the same time, the country’s current account deficit came in better than anticipated, although the quality of financing capital still leaves much to be desired. Gross Domestic Expenditure decelerates Data from the Bulletin confirmed that demand-side excesses have moderated since a 14.4% spike in Gross Domestic Expenditure (GDE) was reported in the first quarter of this year. Since then, GDE fell to 7.6% in 2Q06 and rose by no more than 2.1% q/q, saar in 3Q06, following 100bp of tightening. But the fall in GDE was also exaggerated by a R7.2 billion slowdown in inventory accumulation as gold miners ran down their stockpiles to boost sales and take advantage of the strong rally in commodity prices; and as local oil refineries ran down on accumulated inventories while maintenance work was being carried out. There was also a 4% decline in the government sector, due mainly to statistical base effects as military-related expenditure slowed. Durable/non-durable goods’ consumption fell as rates rose … Total final consumption growth by households remained at a relatively elevated level of 7.2% — down only marginally from 2Q06’s 7.8% print — thanks in large measure to a rebound in services and continued strength in semi-durables. But details elsewhere showed that durable goods’ consumption had already halved from 13.1% q/q, saar in 2Q06 to 7%, while non-durables have collapsed from 6.8% to 1.8% q/q, saar. Clearly, the decline in durables and non-durables here suggests that consumers may have already started feeling the pain from the 100bp of tightening that was implemented during 3Q, and no doubt points to some further deceleration in consumer spend in coming quarters once the extra 100bp of hikes that were delivered in 4Q06 starts to impact. Already, the report notes a steep decline in the consumption of personal transport equipment — mainly new motor vehicles. This could well be a harbinger of things to come. … but capital formation continued at a brisk pace The Bulletin showed that Gross Domestic Capital Formation (GDFI) remained firm, accelerating from 11.3% in 2Q06 to 13.8% in 3Q06, lifting the GDFI/GDP ratio to a record level of 18.7%. The strong growth here was driven by: - Capital intensity in agriculture as local farmers, encouraged by higher food prices this year, stepped up their purchases of tractors and other farming equipment;
- The construction of new shopping malls;
- Public sector imports of machinery and equipment in the power and communication sectors; as well as
- Capital outlays on road construction. Capital spending by Transnet was particularly strong.
In our view, the strong trend in capital formation is likely to be sustained as implementation of the government’s three-year capital expenditure program gathers steam. Significant current account deficit improvement With regards to the external payments position, the SARB reported that the balance of payments on the current account had fallen from a revised deficit of 5.7% (6.1% previously) of GDP in 2Q06 to 5.2% of GDP in 3Q06. (We note that adjustments to the 2Q06 GDP estimate had virtually no impact on the ratio. Rather it was the R7 billion revision in the nominal deficit from R102 billion to R95 billion that brought it down. Please see South Africa: SARB Annual Economic Report: A Close Look at Household Spending and the Balance of Payments, August 29, 2006, page 3, for details.) Exports (including gold) rose from R402 billion in 2Q06 to R467 billion in 3Q06, while imports only rose from R438 billion to R492 billion, leading to a narrowing of the trade balance from a revised R36 billion in 2Q06 (R44.4 billion previously) to R24.9 billion in 3Q06. According to the SARB, the weakness of the exchange rate alone contributed as much as 9% to export revenue growth, adding to already strong volume growth in exports of machinery, electrical equipment, vehicles, base metals, gold and platinum group metals. Imports, on their part, rose by 3% in the third quarter: Non-oil import volumes rose from 7% in 2Q06 to 8.5% in 3Q06, but this was more than offset by a fall in crude oil imports, as local refineries were shut down for maintenance work. Seasonality of trade flows We note with interest that, in the second quarter of this year, the SARB’s visible trade balance turned out to be worse than what was suggested by the preliminary data published by the South African Revenue Service (SARS). This seems to have swung around in 3Q, where the SARB’s visible trade balance turned out to be a lot better than SARS reports indicate. We think this has a lot to do with the data mining and seasonal adjustment process carried out by the SARB – which, of course, makes the art of forecasting a lot more challenging. Deterioration in net invisible payments Net invisible outflows rose in the third quarter — from a revised R59.7 billion (R57.3 billion previously) to R65.5 billion. This was slightly higher than our forecast of R62.6 billion. The key drivers here were dividend and interest outflows, as well as upward revisions to payments on transportation, architectural, engineering and other technical services. Morgan Stanley expects the net service line of the invisible trade balance to remain pressured as reliance on foreign professionals for the implementation of the state’s capital expenditure program intensifies. Quality of 3Q06 capital flows a worry … The capital account continues to register surplus capital inflows that are in excess of the current account deficit. However, the quality of these flows remains worrisome (see Exhibit 4): A close look at the details here shows that net foreign direct investment (FDI) fell to a record deficit of R35 billion as MTN paid for its US$5.5 billion Investcom acquisition. At the same time, portfolio flows – which have now become the bread-and-butter of the capital account – fell from R49.5 billion in 1Q06, through R32.8 billion in 2Q06 to R21.4 billion in 3Q06. Clearly, the inflows from portfolio investments were not enough to plug the hole in the FDI line. Hence, South Africa had to once again rely on ‘other investments’ (R32.3 billion) and ‘unrecorded transactions’ (R17.1 billion) to fill the gap. As we have mentioned on numerous occasions, the latter are extremely volatile capital flows that could very easily reverse. In fact, unrecorded transactions are simply a glorified balancing item, in our view. We agree that capital flows are fungible, but history has often showed that the quality of flows does matter eventually. So while the low-quality flows are helping buoy the currency right now, one must be careful not to get carried away into thinking that it will last forever. … but outlook is less worrying Fortunately, though, the huge FDI outflows that were reported in 3Q06 may have come to an end, after the currency’s weakness rendered offshore acquisitions more expensive. Also, there is mounting evidence that foreign private equity players are beginning to nibble at South African companies ahead of the 2010 World Cup. Although these types of investors may prefer to fund their targeted acquisitions locally – given their low foreign exchange risk tolerance – they are still likely to augment whatever is raised locally with some offshore capital. Hence we look for an improvement in net FDI flows over the course of 2007, which caps the need to rely on capricious capital. Finally, net foreign portfolio inflows in the first two months of this quarter have already exceeded what was reported for the whole of 3Q06. Were this trend to continue into 2007, we should have less of a funding issue. Conclusion As discussed above, selected data in the SARB Quarterly Bulletin suggest that consumers may have already started responding to interest rate hikes in South Africa. This obviates the need for any further tightening in 2007, in our view. The poor quality of capital flows to the financial account of the balance of payments, together with possible political jitters ahead of the ANC’s economic policy conference in June 2007 and party presidential elections in December 2007, call for some caution as far as the outlook on the currency is concerned. Even so, we expect only moderate currency weakness in 2007 as the present haemorrhage in FDI dries up.
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Rates Left Unchanged
December 13, 2006
By Chetan Ahya | Mumbai
Policy rate steady. The Bank of Thailand (BoT) left the policy rate (14-day repurchase rate) unchanged at 5.0% for the fourth consecutive occasion, in-line with the market and our expectations. Headline inflation accelerates while core inflation decelerates further. Inflation accelerated to 3.5% YoY in November (versus 2.8% YoY in October), while core inflation slowed slightly to 1.7% YoY (versus 1.8% YoY in October). The BoT stated that “price pressures remained in the economy though they have moderated somewhat”. Respectable headline growth supports current policy stance. The BoT believes that economic stability has improved and the economy has been expanding at a commensurate pace, underpinned by robust expansion in exports. However, the BoT cited that it would closely monitor the momentum of private investment going forward. Benchmark for policy rate to be changed from next meeting. The Monetary Policy Committee (MPC) has decided to replace the 14-day repurchase rate with the 1-day repurchase rate as the policy interest rate effective from the next MPC meeting on January 17, 2007. The move is aimed at improving efficiency in monetary policy implementation and facilitating the development of local financial markets. Rate cuts will continue to lag. We continue to believe that while the headline GDP appears to be healthy, the underlying trend weakened further in 3Q, warranting a rate cut. However, we believe that the BoT is focusing on maintaining macro stability in an environment of political uncertainty, and this has led to higher-than-warranted real interest rates. We are currently maintaining our view that the BoT will cut rates by 25bp in 1Q07.
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