Turkey
Looking Beyond the Wall of Noise
December 15, 2006

By Serhan Cevik | London

Turkey is moving into an election cycle, but we should look beyond the wall of noise.  It is the time of the year when we update our economic analysis and roll out new projections looking into 2008.  However, before we even get there, a challenging period of elections and global fears will greet us next year.  Turkey has so far enjoyed an unprecedented era of uninterrupted expansion and become the fastest growing OECD country in the last five years.  But as the burst of global volatility earlier this year reminded us, it has a troubling exposure to liquidity-driven capital flows and remains sensitive to noise and global sentiment.  One of the main sources of market noise next year will be the country’s political cycle, starting with a presidential election in May and then general elections in November.  We will regularly survey the political landscape over the coming months, but for now we believe that political developments (including the EU accession process) are unlikely to unsettle the favourable business cycle.  And on the external front, although global imbalances may result in bursts of financial volatility, Turkey is less vulnerable to a US-led global slowdown (see When Atlas Sneezes, October 25, 2006).  All in all, Morgan Stanley’s forecasts point to a mild correction in global GDP growth from 5% in 2006 to 4.3% next year and then 4.5% in 2008.  Furthermore, the projected strength of Europe should keep the composition of growth favourable to the Turkish economy, given its extensive links to the continent. 

Macroeconomic normalisation reflects fundamental improvements, in our view.  On our estimates, Turkey will continue growing faster than the global economy in the coming years.  We expect real GDP growth to slow from 7.4% in 2005 and 5.8% in 2006 to 5.6% next year, but reaccelerate to 7.2% in 2008.  In our view, tighter financial conditions and slow recovery in real disposable income growth will moderate domestic demand growth, as the rate of increase in consumer spending eases from 8.8% in 2005 to 5.3% in 2006 and 4.4% next year.  However, we are confident about income generation and financial penetration over the medium term, and thus expect private consumption to grow 6.2% in 2008.  On the other hand, investment spending is more sensitive to transitory shocks and exhibits higher volatility.  As a result, the annual growth rate of gross fixed investment expenditures is likely to lose pace from 24% in 2005 to 13.2% in 2006 and 7.5% next year.  But we see this deceleration as a healthy sign of consolidation after a 104% cumulative increase in the past four years, and we expect a 12.8% increase in 2008.  Overall, while domestic demand moderates toward a more balanced growth path, the rise in exports should support the economy and even help bring stabilisation in the current account.

Inflation should remain high in the first half of next year, but then start declining.  The Turkish economy, albeit standing on stronger footing, still faces a number of challenges — mainly stemming from exogenous factors (like higher energy prices) and domestic excesses that emerge during the normalisation phase.  In our view, the best policy anchor to manage these risks is the correction of fiscal imbalances.  And thanks to prudent policies, the budget deficit has already narrowed from 15.2% of GDP in 2001 to about 1.2% this year, making the Treasury a net debt payer for the first time ever.  The marked reduction in the public sector’s dis-saving rate not only improves debt dynamics but also supports the disinflation process.  This is why we prefer looking beyond short-term volatility and focusing on fundamental drivers of the secular shift toward price stability.  With sustained productivity gains that have outpaced wage growth and expanded the country’s supply frontier, we expect inflation to decline from 9.8% in 2006 to 5.8% by the end of next year and 3.6% in 2008.

The extent of monetary easing should be limited next year but accelerate in 2008.  In our view, the Central Bank of Turkey will keep interest rates unchanged in the next six months, as it has to bring disinflation — firmly and visibly — back on track.  Once inflation starts moving toward the “uncertainty” range, the authorities should be in a position to ease their monetary stance by 150 basis points in the second half of 2007 and 300 bps in 2008.  That may not be immediately exciting for financial markets, but we think maintaining stability in a challenging year would be priceless, nonetheless.

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ASEAN
Heading for a Soft Landing in 2007
December 15, 2006

By Chetan Ahya and Deyi Tan | Mumbai

Cyclical growth story to face challenge in 2007.  The ASEAN region has achieved respectable average growth of 5.6% over the last three years.   However, in 2007, the ASEAN-5 countries are likely to remain middling performers in terms of their growth trend.   The region is still struggling to stimulate internal demand on a sustainable basis, resulting in a high dependence on exports.  With global growth likely to decelerate in 2007, the region is likely to lose support from its major growth driver — exports.  We are looking for a global soft-landing scenario in 2007, with world GDP growth decelerating to 4.4% from 5% in 2006.   Reflecting this trend, we expect ASEAN-5 GDP growth to decelerate to 5.1% in 2007 from 5.6% in 2006.

Not yet realizing its potential.  The growth potential for this group, considering its demographic trend, is still very high.  Indeed, the demographic trend for the region is as favorable as that in India and China.  However, after the 1997 crisis, growth rates in the region have consistently been below potential.  The most important challenge for the region (except for Singapore) is to build a stable political structure and a transparent institutional framework that will enable it to shift from an individual- to an institution-driven policymaking process.

Private consumption trend lacks vigor.   The region’s overall efforts to pursue domestic demand growth strategies have not been very successful.  Both Malaysia and Thailand, which had managed to revive domestic demand in the recent past, have witnessed a reversal in this trend.  In Thailand, a lack of stable government has again made the economy dependent on export growth for sustaining its overall growth rates.  In Malaysia, we believe the household balance sheet is already too stretched to continue with strong growth in private consumption in 2007.  Indonesia is the only country in the region that should witness a meaningful improvement in private consumption in 2007, although from a low base in 2006.

Still struggling to revive domestic investment.   The investment-to-GDP ratio for the ASEAN 5 has remained significantly below savings since the 1997 crisis.  Apart from the unwinding of excess investments in the construction sector as one of the key reason for this poor overall investment trend, we believe the region’s private business investments have also been unable to fill the void.  This is likely a function of the speed with which these countries are implementing structural reforms.  In our view, Indonesia’s investment climate needs a major overhaul in the areas of infrastructure, tax and labour, whilst Malaysia needs to reform the softer institutional framework to push through higher productivity growth.  On the other hand, Thailand continues to suffer from lack of stable political structure, which is necessary for pushing investments.  For Singapore, the savings-investment gap is large, and investment is low by way of economic policy design and will likely remain so.

No major support from monetary or fiscal policy.  Policy interest rates have peaked out but we are unlikely to get major support from rate cuts.  We expect Thailand to start cutting rates in 1Q07 whilst Malaysia’s monetary policy will likely mirror the Fed’s.  Only Indonesia is likely to see substantial cuts in interest rates in the near term.  On the fiscal front, none of the ASEAN 5 countries is likely to pursue an aggressively expansionary policy.  The interim government in Thailand is unlikely to take up the mega-infrastructure projects on the same scale planned by ex-PM Thaksin, and the Malaysia government is also planning to implement more disciplined fiscal policy to reduce its deficit in 2007.  While the Philippines will see some increase in its deficit in 2007, it will most likely be marginal.

Thailandlikely to be worst performer in 2007.   Indeed, specifically in terms of each individual country, we expect the growth trend for Singapore and Malaysia to be largely linked to global demand, given their degree of export orientation.   On the other hand, domestic factors are likely to play a more significant role for Indonesia and Thailand, spurring growth in the former and constraining it in the latter.   Prospects look most promising for Indonesia, where the government is likely to be successful in implementing structural reforms and reviving domestic demand.   We expect GDP growth in Indonesia to be the highest in the region at 5.5% in 2007 and 6% 2008.  Thailand will likely record the lowest growth at 4.5% in 2007 amid continued political uncertainty.   For 2008, we believe that private consumption and investment should support a recovery in GDP growth to 5%, assuming elections are held by the end of 1Q2008.   Lastly, the Philippines is likely to continue to deliver modest growth in the absence of major improvement in the pace of reforms.

Bottom line — moderation in external demand to cause a growth slowdown in 2007.  ASEAN 5 GDP growth has increased at a respectable rate of 5.6% average over the last three years.  However, over the next 12 months, as external demand moderates in line with global growth, we believe aggregate GDP growth for ASEAN 5 will dip to 5.1% in 2007. 

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China
Who’s Subsidizing Whom?
December 15, 2006

By Stephen Roach | New York

Federal Reserve Chairman Ben Bernanke offered the Chinese much in the way of good advice in a speech he recently gave in Beijing as part of the newly-instituted Strategic Dialog discussions that were just held between the US and China (see “The Chinese Economy: Progress and Challenges,” December 15, 2007).  Unfortunately, he also offered some very bad advice in assessing the ramifications and risks of Chinese currency policy.  In essence, the Bernanke critique was a one-sided interpretation of a key issue that could backfire and lead to a worrisome deterioration in the economic relationship between the US and China.

The offensive passage in the written version of the Bernanke speech posted on the Fed’s website was the assertion that the current value of the Chinese renminbi is an “…effective subsidy that an undervalued currency provides for Chinese firms that focus on exporting rather than producing for the domestic market.”  The use of the word “subsidy” is a highly inflammatory accusation — in effect, putting the Chinese on notice that America’s most important macro policy maker believes that RMB currency policy provides the Chinese with an unfair advantage in the world trade arena that fosters distortions in China’s economy, the US economy, and the broader global economy.  In my view, this is a very biased assessment of the state of Chinese currency policy and reforms.  It pays little attention to the context in which RMB policies are being formulated and, ironically, fails to provide any appreciation for the benefits that accrue to America as a result of this so-called subsidy.  Moreover, Bernanke’s spin continues to downplay the role that the United States is playing in creating its bilateral imbalance with the China — to say nothing of the role the US is playing in fostering broader imbalances in the global economy.

The real question in all this is, Who’s subsidizing whom?  Conveniently overlooked in the Bernanke critique is an important flip side to the “managed float” that continues to drive RMB policy — China’s massive purchases of dollar-denominated assets.  The exact numbers are closely held, but there is close agreement that between 60-70% of China’s $1 trillion in official foreign exchange reserves are split between some $345 billion invested in US Treasuries (as of October 2006, according to the US government’s TIC reporting system) and a comparable amount held in the form of other dollar-based fixed income instruments.  With Chinese reserve accumulation now running at over a $200 billion annual rate, that implies new purchases of dollar-denominated assets of at least $120 billion per year.  Such foreign demand for American financial assets is absolutely critical in plugging the funding gap brought about by an unprecedented shortfall of domestic US saving — a net national saving rate that fell to a record low of just 0.1% of national income in 2005.  Without China’s purchases of dollar-based assets — a key element of its efforts to mange the RMB in accordance with its financial stability objectives — the dollar would undoubtedly be lower and US interest rates would be higher.  In effect, that means China is subsidizing US interest rates — providing American borrowers and investors with cut-rate financing and rich valuations that otherwise would not exist were it not for the dollar recycling aspects of Chinese currency policy. 

There is an added element of China’s subsidy to the US.  As a low-cost and increasingly high-quality producer, China is, in effect, also providing a subsidy to the purchasing power of US households.  Close down trade with China — as many in the US Congress wish to do — and the deficit would show up somewhere else, undoubtedly with a higher-cost producer.  That would be the functional equivalent of a tax hike on the American consumer — cutting into the subsidy the US currently enjoys by trading with China.  The Fed Chairman is making a similar suggestion: By allowing the RMB to strengthen, China’s dollar buying would diminish — effectively eroding the interest rate and purchasing power subsidies that a saving-short and increasingly asset-dependent US economy has come to rely on.

We can debate endlessly the appropriate valuation of the Chinese currency.  Economic theory strongly suggests that economies with large current account surpluses typically have under-valued currencies.  China would obviously qualify in that regard — as would, of course, Japan, Germany, and many Middle East oil producers.  That fact that China is being singled out for special attention is, in and of itself, an interesting comment on the biases in the international community.  Nevertheless, it is quite clear that China understands this aspect of the problem.  By shifting to a new currency regime 17 months ago, Chinese policy makers explicitly acknowledged the need for more of a market-based foreign exchange mechanism.  The RMB has since risen about 6% against the dollar — not nearly as much as many US politicians are clamoring for, but at least a move in the right direction.  Risk-averse Chinese policy makers feel strongly about managing any currency appreciation carefully — understandable, in my view, given the still relatively undeveloped state of China’s highly-fragmented banking system and capital markets.  The potential currency volatility that a fully flexible foreign exchange mechanism might produce could have a very destabilizing impact on an undeveloped Chinese financial system.  And that’s the very last thing China wants or needs.

Chairman Bernanke’s criticism of the Chinese for subsidizing their export competitiveness by maintaining an undervalued RMB completely ignores the benefits being enjoyed in the US through equally important subsidies to domestic interest rates and purchasing power.  Sure, a careful reading of the Bernanke China speech will find it laced with the typical caveats of Fedspeak that, in this instance, acknowledge America’s role as a deficit nation in contributing to this problem, as well as special considerations China deserves as a developing economy.  But the tone and emphasis are clear: The Fed Chairman is paying no more than lip-service to the other side of the coin through his emphasis on a sharp critique of China’s monetary and currency policies.  Particularly striking in this regard is Bernanke’s failure to acknowledge the extraordinary fragmentation of a highly regionalized Chinese banking system — dominated by four large banks that still have well over 60,000 autonomous branches between them.  How a central bank gets policy traction with such a decentralized banking system is beyond me.  Moreover, he basically overlooks another critical reason for China’s irrational investment process — the lack of well-developed capital markets and the continued reliance on policy-directed lending by China’s large banks.  Instead, Bernanke suggests that a flexible currency is the best means to foster an efficient allocation of investment projects.  In short, the flaw in the Bernanke critique is his failure to appreciate the very special transitional needs of a still blended Chinese economy — currently straddling both state and private ownership systems, as well as centrally-planned and market-directed allocation mechanisms.  The Fed Chairman is offering advice as if China was a fully functioning market-based system — perfectly capable of achieving policy traction with the traditional instruments of monetary and currency policies.  Nothing could be further from the truth for today’s Chinese economy.

This is not the first time Ben Bernanke has assessed an international financial problem with such one-handed analysis.  In his earlier capacity as a governor of the Federal Reserve Board and then as the Chairman of President Bush’s Council of Economic Advisers, he led the charge in pinning the problem of mounting global imbalances on the so-called “saving glut” thesis — in effect, arguing that the US was doing the rest of the world a huge favor by consuming an inordinate surplus of saving (see Bernanke’s March 10, 2005 speech, “The Global Saving Glut and the US Current Account Deficit,” available on the Fed’s website).  While a most convenient argument from the Administration’s standpoint, it downplayed America’s role in fostering the problem — unchecked structural budget deficits and a plunge in the income-based saving rate of US households.  Lacking in domestic saving, the US must import surplus saving from abroad in order to grow — and run massive current account and trade deficits in order to attract the capital.  This is quite germane to the debate over China.  As noted above, the Chinese have emerged as important providers of saving for a saving-short US economy.

The scapegoating of China remains a most unfortunate feature of the global climate.  US politicians want to pin the blame on China for America’s trade deficits and pressures bearing down on US workers.  Now Ben Bernanke piles on by accusing China of using its macro policies as de facto export subsidies.  Sure, China could do better on trade policy — especially in the all-important area of protecting intellectual property rights.  But I think the world can also expect more of the global leader — like facing up to a very serious and potentially destabilizing saving shortfall that requires the rest of the world, including China, to subsidize its own profligate ways.  The longer the US frames this debate in such a biased and one-sided fashion, the more difficult it will be for others in the world, like China, to accept a face-saving compromise. 

There are some interesting footnotes to the Bernanke speech.  Significantly, the Fed Chairman actually flinched when it came to the oral version of his speech — offering a last-minute substitution of the word “distortion” for “subsidy.”  That may have saved him from an embarrassing moment or two on the stage in Beijing, but it did nothing to diminish the subsequent flap that has arisen over this accusation.  Meanwhile, US politicians were quick to take the cue from Bernanke.  Sander Levin, Democrat Congressman from Michigan and soon-to-be Chairman of the House Sub-committee on Trade, immediately threatened to re-introduce legislation that would require the US Commerce Department to cite Chinese currency manipulation as a violation of US anti-subsidy laws — thereby allowing US companies to seek the remedy of offsetting, or countervailing, tariffs.  Moreover, while Bernanke may have stumbled on the word “subsidy” in public, it remains the operative concept on record in the official version of the speech on the Fed’s website.  Sadly, as evidenced by the predictable reactions of Washington protectionists, the damage has already been done.

I have long argued that the US-China relationship could well be the most important bilateral underpinning of a successful globalization (see my March 20, 2006 Special Economic Study, “Globalization and Mistrust: The US-China Relationship at Risk,” presented to the 7th annual China Development Forum in Beijing).  I worry increasingly that the economic tensions between these two nations are in danger of being politicized, with the nation-specific considerations of localization increasingly taking precedent over globalization.  I am encouraged by US Treasury Secretary Hank Paulson’s attempts to put the China debate in a much broader context.  Unfortunately, the Bernanke speech is a major step backward.

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Latin America
A Dose of Stability
December 15, 2006

By Gray Newman, Luis Arcentales and Daniel Volberg | New York

As the risks surrounding a global slowdown increase, it might seem overly optimistic to be upbeat on the prospects for Latin America for 2007.  After all, the region has benefited in recent years from a period of unprecedented Chinese demand that has boosted prices for commodities from the region and contributed to a prolonged bout of above-trend US growth and low interest rates.  Interest rates have now been rising around the globe, the US economy has slumped in the post-housing-bubble shakeout, and there is increasing debate over whether China will engineer a successful moderation of growth.  Meanwhile, the region continues to have its “problem countries.”  In the past month, Hugo Chavez was re-elected as president in Venezuela, and Ecuador voted in a new president who campaigned on the moral need to repudiate the country’s debt.  Still, we are optimistic about Latin America.

Latin America is benefiting from the arrival of macro stability and a dose, however partial, of certainty.  In a region where growth has frequently been punctured by crises that have brought down currencies, economic models, and heads of state, the mere fact that 2007 should mark the fifth year of good growth and low inflation is an important accomplishment.  Is it enough?  Most certainly not.  Most of the region’s inhabitants still suffer from glaring shortcomings — from inadequate healthcare and education to an irregular regulatory framework — all of which have limited stronger growth in productivity.  But we would argue against underestimating the power of a dose of stability.

Perhaps nowhere is the change that the region is undergoing clearer than in Brazil.  Just four years ago this month, Brazil watchers were engaged in a debate over whether the country was on a path leading to debt default and capital controls.  Today, Brazil has zero net public external debt (net of international reserves), a declining debt path for its domestic debt, and inflation hovering around that of the US. 

Benefits from Macro Stability Should Not Be Underestimated

Our optimism on Brazil might seem mistaken.  Indeed, Brazil’s disappointing growth record has prompted calls from within the global economics team at Morgan Stanley to strip the country of its place within the BRICs (see “Hitting a BRIC Wall,” in This Week in Latin America, September 25, 2006).  But we would argue that this is precisely the wrong moment to disqualify Brazil from its place within the BRICs.  We suspect that Brazil is on the verge of much stronger growth in 2007 and in the coming years, as it delivers continuity on the macro front of the sort that we have seen in recent years. 

Our upbeat assessment on Brazil’s growth path in 2007 is predicated on our view that there is a strong case for significant interest rate reduction.  Indeed, perhaps nowhere in the emerging markets is the case for a reduction in rates stronger than in Brazil.  Inflation has plummeted even as real rates have remained largely unchanged.  And that, we believe, sets Brazil up for an important bout of monetary easing in 2007 as real rates begin to decline at a pace previously reserved for nominal rates.

We expect the targeted Selic interest rate to reach 11.25% by the end of 2007 and to fall further in 2008.  With projected real rates at their lowest level in decades, we expect Brazil’s growth path to improve.  Of course, the challenge is not simply a matter of monetary policy.  The economy needs a stronger investment platform, and that means changes in the regulatory environment, improved infrastructure, and a healthier public sector.  But the benefits from stability and hence lower interest rates are likely to prove powerful forces boosting the investment cycle in Brazil. 

Looking elsewhere in the region, even in Mexico there is still room for progress.  Although we are less optimistic about the new administration’s ability to build the much-needed consensus for reforms on the fiscal and energy fronts, there is still room for progress on the stealth reform agenda.  Low inflation — core inflation has been running within Banco de Mexico’s target range for the past four years — has begat a dramatic extension of the yield curve and the birth of mortgages and credit to those who had long been beyond the reach of financial intermediaries.  That trend is likely to continue uninterrupted in 2007 and provide a significant cushion to a slowing export-based manufacturing sector.

And we still expect Argentina to remain the fastest-growing economy in the region despite its distortionary policy mix.  While price controls, negative real interest rates, a heavily managed exchange rate appreciation, and export regulations aimed at controlling inflationary pressures are not long-term sustainable policies, the long term is unlikely to arrive in 2007.  Even in the most vulnerable sector, namely electricity generation, we see no major dislocations in 2007.  In fact, we expect the economy to keep powering ahead, with domestic consumption doing most of the heavy lifting through expanding credit, a real estate market boom, and rising real incomes. 

Bottom Line

We are fairly upbeat on the prospects for Latin America for 2007.  If our global team is right and the world sees good, albeit slower growth, Latin America should post another above-trend result.  Now five years into the current growth upturn, we have seen little of the excesses of past upturns in the region.  The current cycle has not produced the ballooning trade and current-account deficits fueled by consumer spending seen in the past, nor widening fiscal deficits, nor the spectacle of central banks burning through reserves to prop up woefully overvalued currencies.  Thus, while the region is hardly immune to a potential global slowdown, we suspect the consequences would be much milder than in the past and would ultimately strengthen the region’s newfound stability. 

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Romania
Big Picture
December 15, 2006

By Katerina Kalcheva | London

Strong output trend will continue following EU accession. Romania is preparing to embark on the many opportunities offered by EU membership. The economy has been on an upward path since mid 2005, and we believe that the positive trend will continue post-accession, at a moderate pace and in spite of signs of overheating.   Year-end growth is set to reach 7.3% in 2006 and keep stable throughout 2007 at 6.8%, which is well above 2005’s 4.1%.   GDP growth hit 7.8% in 3Q year on year, the third highest quarterly growth rate since the peak of 9.7%, registered at the end of 3Q04.   Indeed, during the first three quarters of 2005, growth had declined as a result of the massive floods, which caused low agricultural and industrial output. The current rapid recovery is mainly demand-driven, supported by positive contributions from consumption (9.6%) and investments (4.4%).   On the supply side, construction is gradually expanding (19.2%Y), although it has a smaller weight in GDP.   Thus, according to the National Institute of Statistics, in the first three quarters of 2006 demand for building authorizations increased by around 40%.   In the first nine months, almost 21,000 dwellings were completed, which is 2,500 more than over the same period of 2005.   At the end of 3Q06, over 100,000 dwellings were at various stages of execution, with 11.8% financed by the state budget.

We remain confident of Romania’s prospects for quickly catching up with the more advanced EU members. Its capacity to quickly absorb the EU funds will be crucial for improving infrastructure and encouraging investments.

Widening current account deficit and persistent inflation will be the main points for caution in 2007.   The 12-month current account deficit increased to around 10% of GDP in 3Q06.  Looking forward, investment imports should continue growing, as Romanian producers are upgrading their production lines to meet EU standards.  Inflation fell to 4.7% y-o-y  in November (from 4.8% in October) mainly due to a favorable base effect.   Although low, the reading was above the consensus expectation (4.4%).   The monthly numbers also suggested a reverse in the downward trend, as inflation rose by 1.1% m-o-m in November from 0.2% in October, due to a gas hike (8.5%) and higher food and transport prices.

Nevertheless, the overall inflation rate strongly suggests that interest rates will be kept on hold at the bank’s next meeting on Dec 29.   We should not forget, however, that one of the main factors behind low inflation, the low base effect, will diminish next year.   Combined with growing consumption as standards of living rise, this is likely to trigger higher inflation.   We continue to think that higher interest rates will be needed in the first quarter of next year to offset the planned tax hikes and growing wages, in order to reach the inflation target of  4% (+/-1%) for 2007, which may become ambitious.  In addition, the government envisages higher public spending next year, prompted by the co-funding of EU-sponsored projects, which will put pressure on the balance of payment and on prices.

Political tensions are gradually building, and likely to result in pre-term elections.   The pressure on the ruling coalition has increased, as a faction of the Prime Minister’s Liberal party broke away to form a new party, the Liberal-Democrats.   The faction accused PM Calin Tariceanu of having an authoritarian style and left the government to struggle to maintain a majority in the parliament.   This is the second such incident for the ruling coalition, after the small Conservative group also left the cabinet last month.  These political moves, coupled with constant disputes over ministerial positions, have increased the general feeling of political instability and the likelihood of pre-term elections in 2007.

Foreign exchange market will see higher volatility.   The RON rallied against both the euro and the dollar (appreciating by almost 17% against the dollar) in the last 12 months.   In 2007 the positive interest rate differential and the catching up process should lead to further strengthening of the RON.   We believe that the widening current account deficit, although sustainable in the presence of FDI, combined with a higher fiscal deficit, will increase volatility next year.   Similar to Slovakia in the first year of its becoming an EU member, the central bank is likely to intervene more actively in order to keep the RON from excessive appreciation, in our view.   As of January 1, 2007, the banks will be able to lend in foreign currency, as the central bank decided to remove restrictions requiring three times a bank's equity capital for funding in foreign currency, which will improve the competitive position of the domestic banks.  Despite all the challenges, Romania has made significant progress in curtailing inflation and in attracting record high foreign investments during the past year. Prospects for quickly catching up with EU members look bright, and further structural improvements should guarantee relatively smooth economic integration.

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Japan
If Prices Were To Decline Again ...
December 15, 2006

By Takehiro Sato | Tokyo

Prices could contract again if the core of core does not rebound soon

What we outline here is a risk scenario, not our main one. Nevertheless, we do not think it is a low-probability scenario, considering that the latest reading on price growth is very low, at just 0.1% YoY.   In light of oil price trends, the Japan-style core CPI could contract again YoY in 2007 H1, contrary to our constructive economic outlook.

We currently do not expect such a development for our main scenario; rather, we assume the core of core (excluding energy, broadly defined utility charges, and other special factors) will rebound solidly.   In the six months through October, however, the core of core vacillated around -0.1% YoY.

Meanwhile, BoJ officials appear to be expecting the November nationwide CPI, to be announced on December 26, to show no negative contribution from declines in mobile phone rates, as in the past year, and they appear to have more or less given up on a rate hike in December and instead to be leaning toward a rate increase in January.   The November nationwide core CPI, however, is likely to be up only 0.1% in light of the November decline in gasoline prices, the indications in the November Tokyo-area CPI of an impact from price declines for winter clothing owing to the warm winter, and the weakness in the core of core figure.

We doubt the core of core CPI will suddenly rebound in the next few months; if it is flat YoY, the Japan-style core CPI may contract starting around April-June, or even earlier because the contribution from oil prices may turn negative.

BoJ’s view on output gap based on revised GDP figures

The recent, substantial, retroactive GDP revisions confirm the weakness in the core of core CPI. For the F2006 national accounts, real GDP was revised downward by 0.9 ppt to 2.4%, which should have more than a negligible impact on estimates of the output gap since the economy’s potential growth rate is just shy of 2% at best.   Based on the revised GDP data, the pace of the contraction in the output gap in F2006 declines by almost 1 ppt.   If the improvement in the output gap is only modest, the spillover effect on prices would naturally be that much weaker.

BoJ officials, however, believe the output gap is not affected because the GDP revisions also lower the potential growth rate, or that the output gap has nothing to do with the GDP revisions because it is calculated from capacity utilization, rather than the divergence between actual and potential GDP.   We doubt we are the only ones who sense sophistry in this argument.   The output gap is traditionally calculated as the difference between actual and potential growth, the latter based on inputs of capital and labor using the historical averages for capacity utilization and labor participation rates.   If actual GDP declines substantially, the potential growth rate also declines, but to an extent that is negligible.   Rather, we think it would be prudent for policymakers to focus on the substantial slowdown in the pace of improvement in the output gap stemming from a decline in actual GDP.   Under such conditions, market participants find it difficult to understand the BoJ’s concern more for the future upside risks to prices and asset prices than for the near-term downside risks to prices.

Worst-case scenario: Downturn in prices after another rate hike

Let us consider what might happen if the risk scenario does play out.   Even with the slump in prices we mention above, much depends on whether the BoJ raises rates for a second time by January.   We assume it does for our main scenario, but the likelihood has lessened somewhat, considering the weak extent of the positive spillover from the corporate sector to the household sector. The following scenario is thus a worst-case one.   If the Japan-style core turns negative several months after the next rate hike, it would be easy to imagine the BoJ being in a politically difficult situation in terms of putting a crimp in the Cabinet/ruling coalition’s pro-growth policies.   Governor Fukui would not likely have to resign, but the choice of his successor after his term ends in March 2008 could be affected to some extent. To be more specific, Deputy Governor Toshiro Muto, who is currently widely expected to be the next governor, may be less likely to be promoted and the government and the ruling coalition may instead look for a candidate outside the BoJ. Leading candidates in that case would be money-focused Heizo Takenaka, the former FSA minister, and Takatoshi Ito, a member of the Council on Economic and Fiscal Policy and an advocate of inflation targeting.   If someone with a strong monetarist bent is named to be the next governor, Japan could be stuck in an ultra-low rate environment for a long time, with price growth hovering very low.   If policy is focused on an increase in money supply, the BoJ may increase the supply of reserve deposits and put the policy rate back to near 0%.

If the economy and stocks do well, a rate hike would be positive for the Administration

The above is essentially a mental exercise.   After all, a prolonged, ultra-low rate environment would not be positive at all for the ruling coalition’s base of support.   Rather, if the economy and stocks do well, a rate hike would be beneficial for the government and the ruling coalition.   In fact, LDP officials, who had continued to try to check the BoJ’s moves, ended up embracing the BoJ’s moves in March to July, resulting in an end to ZIRP.   Moreover, politicians and the media have generally reacted positively following increases in deposit yields.

A decline in the Japan-style core CPI would stem from a decline in oil prices and boost consumers’ real purchasing power, albeit not to the same extent as in the US.   The US-style core CPI is likely to rebound moderately even if the Japan-style core CPI is weak.   Also, the GDP deflator is likely to turn positive YoY around April-June, in a good contrast with the core CPI.   Hence, assuming the government and the BoJ are at complete odds while prices are declining, such a scenario would likely be criticized for evidencing a lack of composure.   To avert such a standoff, we think it would be natural for the BoJ to extend a certain amount of consideration and thereby protect its independence as well in an environment of price stability.

The market has priced in expectations of a rate hike roughly every six months, but we think the pace of rate hikes could be more moderate as a risk scenario, in which case medium-term yields would decline noticeably and the yen would continue to depreciate in real effective terms.   Such a development would be generally positive because the stock market is concerned about a prompt rate hike while the economic data are weak.   However, we find it paradoxical that stock investors, who had been so eagerly looking forward to a rise in rates, are now concerned about a rate hike. 

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United States
Business Conditions - Bouncing Along the Bottom
December 15, 2006

By Shital Patel and Richard Berner | New York

Business conditions continued to deteriorate, remaining below 50% for the seventh consecutive month, but the deterioration isn’t intensifying.  The Morgan Stanley Business Conditions Index (MSBCI) increased by four points in early December to 44%, retracing some of November’s decline.  The less-volatile three-month moving average edged up two points to 43%, the highest level since August.  At 43%, the fourth quarter average only stands one point above the third quarter average, meaning analysts are essentially just as pessimistic in the current quarter as they were last quarter. 

Last month we noted that our bullish forecasts were out of sync with gloomy analyst reports, although we admitted that analysts were more accurate on conditions in the 3rd quarter than we were.  Earlier this week, given incoming data, we sharply lowered our near-term GDP forecast, with the three quarter growth rate ending in 1Q07 averaging only 2%.  However, there are also glimmers of improvement: A positive employment report and a blow-out retail sales report have led us to revise our current quarter GDP tracking estimate up 0.9 pp to 2.5%.  Furthermore, advance bookings were higher in the Empire State manufacturing survey.   Score: Analysts 1: Economists 1?  The jury is still out!

Results from this month’s survey suggest that analysts may be preoccupied with slower volume growth and fading pricing power, leading to lower top-line results in nominal terms.  On the volume side, the advance bookings index declined three points to 40%, the lowest level of the index since April 2003.  Also, our pricing conditions index plunged twelve points to 51%, the lowest level since January 2005.  The breadth of responses was roughly equal between lower prices compared to a year ago, unchanged prices, and higher prices; only one-third of analysts said that companies have increased prices, down from the peak of 64% in February. 

So what about the bottom line?  Despite the moderation in price increases, a full 34% of analysts noted that prices charged have increased faster than unit costs over the past three months, the highest percentage since June.  Furthermore, a full 61% said that margins are higher compared to a year ago at companies under their coverage.  Luckily, our survey is in line with analysts on the Street: As of this Wednesday, Street analysts expected 61% of companies in the S&P 500 to have rising margins in 2006.  S&P 500 earnings revisions have also improved, from 4.8% in early November to 7.9% this week.

We also asked analysts this month about the impact of lower energy quotes and higher materials prices on the bottom line.  Lower energy prices will have little to no impact for 65% of the groups and will be a negative factor for the energy and utility companies.  Higher metals and industrial commodity and foodstuff quotes will hurt the bottom line somewhat for 17% of the groups and significantly for 9% of the groups.  Half of the analysts reported that these commodities have no impact on earnings.

Still, results from this month’s survey suggest that there is no sign of a revival yet, at least according to Morgan Stanley analysts.  Along with the dismally low advance bookings index, our business conditions expectations index declined four points to 36%, matching September’s record low.  This month, only one-fifth of analysts expect business conditions to improve over the next six months.  Plans to hire and increase capex also declined in early December; 35% of groups plan to increase hiring over the next three months, retracing some of November’s record bounce to 41%.  Only 43% of groups plan to increase capex, below the historical average of 46%.  However, a full 45% of the groups that plan to increase capex plan to do so by 6% or more.  We still maintain that there is pent-up demand for capital spending and expect that the deceleration in equipment and software outlays in 2006 will give way to roughly 7% annualized growth in the first two quarters of 2007.

The breadth of results narrowed in early December.  54% of analysts noted that conditions were unchanged over the past month, up from 41% in early November, while the percentage of analysts noting deteriorating conditions was only 30%, down from 41%.  No analysts reported either noticeably deteriorated conditions or noticeably improved.  Conditions improved for the consumer staples group and marginally for healthcare, while conditions deteriorated for IT, materials, industrials, financials and consumer discretionary. 

On a positive note, the credit conditions index remained at 55%, indicating that financial conditions are still supportive of growth.  We believe the decline in interest rates, the tightening of credit spreads, and the decline in the dollar have recently made financial conditions easier.  We also asked analysts this month how much the declining dollar will contribute to bottom-line results at companies they cover.  A full 41% said the dollar will have no impact, while 22% said it would have a marginal impact.  The declining dollar will have a larger impact mostly for the consumer staples, IT, and materials groups, but will actually be a negative factor for the wireless services and railroads.

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Europe
About Decoupling, Reforms and Tensions
December 15, 2006

By Eric Chaney | London

The short-term outlook for the euro area is clouded by major macro uncertainties, from the nature of the slowdown in the US to the consequences of a three-point VAT rate hike in Germany, effective on January 1.  Yet we believe that the domestic recovery, fuelled by a powerful monetary stimulus and structural improvements such as faster productivity and more flexible labor markets, should provide a robust base for growth next year.  While GDP growth should decelerate significantly, from 2.7% in 2006 to 1.9% in 2007, on our forecasts, the consequences of the VAT hike in Germany should be limited, being fully anticipated by German consumers and companies operating on the German market.  Nevertheless, uncertainties are so high that financial markets may turn much more volatile than they were in 2006.  These uncertainties will likely also cause the ECB to approach further tightening more cautiously (see Elga Bartsch’s “The ECB’s Balancing Act” in this issue).

While increasing risks for investors, volatility also generates investment opportunities.  Here are three macro themes that could provide investors with such opportunities: US-Europe decoupling; labor market reforms and tensions between capital and politics.

1.  A ‘soft decoupling’ between the US and Europe.  A widespread view in the markets is that Europe follows the US cycle with a six-month lag.  This theory may regain popularity, but for the wrong reasons, we believe:   growth is likely to slow in Europe in the first months of 2007, for domestic reasons — a 150 basis point monetary tightening by the ECB and a 0.6% of EMU GDP fiscal tightening in the German and Italian budgets.  Rather, we anticipate a ‘soft decoupling’ between the US and Europe:   GDP growth falling significantly below trend in the US while decelerating towards trend in Europe.  Because domestic demand is the main driver of growth in both regions, business cycles are not necessarily synchronized.  For sure, financial linkages matter, as we learned during the previous downturn, when European companies slashed investment projects from 2001 to 2003.  Massive capital outflows to the US — mostly driven by acquisitions — at the outset of EMU had made investment projects by European companies highly sensitive to the US capex cycle.  However, this time, the US slowdown is coming from housing investment, to which neither companies nor investors in Europe seem to be exposed.  As we see it, once fiscal policies relax their grip, growth should re-accelerate in Europe, where the personal savings rate should decline further, while the US economy is likely to continue to grow below trend speed, as the personal savings rate rises.  Thus, ‘hard’ decoupling could become a popular theme in the course of the year.

2. Labor markets: end of ‘easy reforms’?  So far the rapid decline in euro area unemployment hasn't fuelled wage inflation, a sign that structural unemployment is steadily declining.  Policies aimed at reducing the cost of low-skilled jobs (by cutting social contributions most of the time) have worked, but their unwelcome side effect was the creation of two-tier labor markets.  Also, the secular upward trend in the female participation rate is increasing the share of flexi-jobs, on trend, which helps reduce structural unemployment.  However, with euro area unemployment likely to ebb towards 7% in the next 12–18 months, tensions in labor markets may appear, leading to higher wage inflation.  Since dual labor markets generate inefficiencies and social tensions, governments will have to consider more far-reaching reforms, such as relaxing wage-bargaining systems, removing obstacles to redundancies or simplifying labor contracts.  Labor market policies are likely to be hotly debated ahead of the French presidential election but could also return to the forefront of political debate in Italy and Germany.  More ambitious reforms would probably help the ECB keep rates lower, thus boosting growth and profits.

3.  Watch tensions between capital and politicians.  Together with ample liquidity, rising cross-border capital flows within the single currency area and divergent dynamics in domestic demand have fuelled rising current account imbalances.  While Spain is heading towards a double-digit current account deficit to GDP ratio, Germany and the Netherlands are both running a current account surplus to GDP ratio of similar magnitude.  A potential rise in intra-EMU imbalances may fuel political tensions, we think, against a general backdrop of anti-globalization sentiment.  Interestingly, in the new EU member states, capital inflows also seem to fuel political tensions here and there.  With slower growth ahead and large war chests accumulated in previous years making companies more aggressive, tensions may rise further next year.  Taking a longer-term view, political leaders seem to have largely underestimated the practical implications of the European Monetary Union and of the EU enlargement: with capital easily crossing borders, restructuring has become a permanent and obsessive theme for European companies.  The result is that companies operating on a pan-European basis and having global ambitions have a growing influence on economies, while governments have less.  The tug-of-war between the power of capital moving freely across borders, while most workers won’t, and institutions changing slowly, creates investment opportunities.  For that, investors need to pay attention to two elements: political resistance, which differs across countries and sectors, but also the long-term picture, which is in my view the emergence of large global companies operating from their historical European base. 

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Korea
To Survive the Slowdown in 2007
December 15, 2006

By Sharon Lam | Hong Kong

The Korean economic cycle is often perceived as volatile, and as a result it is common to see overly optimistic growth projections during an upturn and overly pessimistic ones during a downturn, in my view.  The resulting adjustment to miscalculated forecasts will therefore often cause unnecessary disappointment, (which happened in mid-2006) or false excitement (which is happening now).

The Korean economy rebounded in 3Q as we had predicted, bringing positive surprise to the market, which led to more pundits looking for further acceleration of the economy.  I believe, however, it is too late to look for further rebound in the economy.  The export sector and liquidity conditions are turning less favorable, which will only weaken the economy.

We forecast GDP growth to slow from an estimated 5.1% in 2006 to 4.3% in 2007.  We are sticking to this 4.3% forecast we set a year ago, and we think it still looks realistic, while throughout the year the market consensus has revised down its 2007 outlook from 4.8% in the beginning to 4.4%, meaning our view has become a consensus.  We predict GDP to slow to 3.6% in 1H07 but to pick up to 4.2% in 2H07.  We expect the recovery to continue into most of 2008 when we predict growth to be at 4.8%, i.e., slightly above trend. 

Meanwhile, we expect inflation to tick up next year on the back of higher housing rent and an increase in service sector charges.  The upside in inflation, however, will be offset by a strong currency and therefore we only foresee a moderate pickup in inflation from an estimated 2.3% in 2006 to 2.6% in 2007.

Export slowdown on the way.  Exports have been the major growth driver throughout most of 2006.  The rosy export picture, however, is likely to be reversed.  Korea’s two most important markets, China and US, are both slowing down although it is expected to be a soft-landing in both countries. 

Adding to the pressure is KRW appreciation, which is largely narrowing the price discount between Korean and Japanese products.  KRW appreciation against other Asian currencies has got to a point that will begin to hurt Korea’s competitiveness, in our view, as Korea’s export prices in USD terms have already been rising faster than Japan’s and Taiwan’s.  Korean products that compete directly against the Japanese and Taiwanese will be in trouble, in our view.

Apart from its impact on competitiveness, exporters’ earnings are also directly affected by KRW/USD, as most export items are priced in USD terms, thus leading to earnings lost after conversion into local currency.  This was not a problem when export volume was good, but now volume is likely to turn down, and as a result, we believe Korean exporters will be facing double pressure on both volume and price. 

Yet consumption may relatively outperform.  Consumption generally cannot escape an economic slowdown.  However, we believe the slowdown in consumption will be much milder than that in exports this time, implying consumption will relatively outperform next year.  

First of all, Korean consumers did not overspend during the consumption recovery in 2005–06.  The wealth multiplier on consumption is declining because the extra wealth is now saved for a longer life expectancy, lack of social security and higher property prices, in our view.  Nevertheless, the good news is that a more conservative spending pattern has helped Korea to avoid overspending during the boom, and consequently there is no need for correction during the downturn.  We expect consumption to remain stable going forward.

At the same time we do not see forces pulling down consumption next year.  First, the wealth effect is still slightly positive as we believe property prices will be upheld next year.  Second, wage growth and the labor market are stable.  Third, there is no overheating in household credit cycle. 

We forecast private consumption to slow only marginally from to 4% in 2007 from 4.2% in 2006, which is much milder than the slowdown in exports and overall economy.

And the government will strive to keep sentiment buoyant.  There has been a lot of speculation about extra spending from the government to spur the economy before the presidential election at end of next year.  If policymakers’ attention becomes merely election-focused next year, then Korea may see a U-turn in housing market regulations, i.e., from restricting to relaxing.  This would be the most bullish case for 2007 outlook, yet it will at the same time increase chances of a hard-landing in 2008.  Our core assumption is that the government will continue to keep the property market in check, yet instead of using tax measures we expected it to adopt what we see as a “win-win strategy” — increasing housing supply. 

We believe property prices will remain strong next year as there is still a housing supply shortage.  Meanwhile, new satellite town development will also prop up prices in the short term due to anticipation of a better living environment.  We only see prices declining when more new housing is completed, which will be from 2008 onward.  With housing prices staying strong next year, if not increasing, consumption growth will not deteriorate.

Whether the government delivers real supportive measures does not matter, in our view.  What matters is there will be continuous supportive talk from the government to keep up market expectations.  This will help consumer confidence to defy a slowing economy in the first half of next year. 

However, do not hope for monetary easing.   Cutting interest rates is another way to stimulate the economy next year, yet the property market issue has complicated an interest rates decision.  If property market crashes when interest rates are too low to begin with, then the central bank will be left with no policy option to save the economy and a Japan-like recession could happen.  We believe the Bank of Korea will keep interest rates unchanged in the next six months.  We see chances of further interest rate hikes in 2H07 to cool down property prices. 

2008 outlook — recovery to continue but rising risks of property market deterioration.  We expect the economy to start recovering in 2H07 and into 2008 on the back of (i) pickup in construction activities as government pledges to increase home supply; (ii) stable consumption as we believe the government will strive to keep sentiment intact; and (iii) exports improving as the Beijing Olympic Games approaches, which will drive more demand for Korean-made chips, consumer electronics and automobiles.

However, we also see an increasing chance of property market deterioration in 2008 when more new housing construction is completed, exceeding demand.  Careful control of the housing market to avoid excessive price increases should top the policy agenda in 2007.

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United States
Fiscal Outlook
December 15, 2006

By Ted Wieseman | New York

After a flood of revenue growth that offset continued elevated spending led to a sharp narrowing in the budget gap in the past two fiscal years, we look for stabilization in FY2007, with revenue growth normalizing back towards GDP growth and spending growth decelerating to its slowest growth of the Bush Administration as tight budgets the past couple years take hold and gridlock rules in Washington.  Net Treasury supply should rise relatively modestly this year, but with a compositional shift towards bills and away from coupons.  Relative stability should rule through 2008, but the outcome of the 2008 elections and a sharp rise in maturing coupons in FY2009 create considerable uncertainty for the budget and Treasury financing beyond then.

Surging revenues drove another upside surprise in FY2006.  With significant additional spending on tap for hurricane rebuilding and the beginning of the Medicare prescription drug plan and an expected moderation in tax revenue back towards the growth rate of the economy after the 14.6% spike in FY2005, we came into FY2006 expecting a significant temporary widening in the budget deficit to over $400 billion from the $319 billion recorded in FY2005.  And boy were we wrong — revenues continued to surge, spending proved a bit more restrained than expected, with little growth on an underlying basis in nondefense discretionary outlays, and the deficit surprisingly narrowed significantly further to $248 billion, or 1.9% of GDP versus 2.6% in FY2005.

Total revenue jumped another 11.8% in FY2006, making for the strongest two-year rise since FY1980-81 (and with inflation running in double digits back then, the real rise the past two years was much stronger).  Upside was seen across all categories.  Individual income taxes rose 12.6%, with withheld taxes up 7.9% and nonwithheld 20.7%, the latter apparently reflecting in part the surge in options and bonuses that so sharply boosted Q1 wage and salary income in the national accounts.  Corporate taxes jumped 27.2% and have now nearly tripled since the FY2003 trough.  Social insurance taxes gained 5.5%.  And driven by sharply higher remittances from the Fed, miscellaneous other revenues even spiked 17.6%.  Meanwhile spending rose 7.4%.  While this was in line with the elevated gains during the prior four years, on an underlying basis the results pointed to improvement.  In particular, excluding defense, Social Security, Medicare (which was boosted by about $25 billion by the beginning of the prescription drug plan), Medicaid and other health programs, and net interest, spending rose 6.7% or $48 billion.  Almost all of this reflected two special items — a $29 billion increase in spending by FEMA for flood insurance and other hurricane cleanup related spending, and about $15 billion in noncash accounting adjustments to revalue subsidies on student and housing loans made in prior years.  Stripping these out clearly indicated that the tight lids on nondiscretionary budget authority passed in FY2005 and FY2006 finally started to take hold in a major way to restrain nondefense discretionary outlays — an underlying improvement that should be much more evident in FY2007 without the one-off boosts to spending.

Stabilization in 2007.  We look for the deficit to widen modestly in FY2007 to $265 billion, which would keep it steady as a share of GDP at a relatively low 1.9%, with both revenue (+4.6%) and outlays (+4.8%) growth expected to moderate significantly.  Relative to GDP, revenues plunged from a peak of 20.9% in FY2000 to a low of 16.3% in FY2003 before recovering to 18.4% in FY2006 — very close to the long-term average.  We look for revenue to hold close to this share in FY2007, with growth expected to be just slightly less than our estimate for nominal GDP growth.  This slightly slower expected revenue growth compared to GDP is largely from two sources.  First, individual tax refund growth should be unusually strong relative to recent history in 2007 as a result of consumers’ ability to claim a refund of previously paid long distance telephone excise taxes that were overturned by the courts on their 2006 tax returns.  This should boost refunds in 2007 by about $10 billion.  Second, we are looking for a sharp slowing in corporate profits over the course of 2007.  After rising at about 25% a year the past four years, we expect pre-tax corporate book profit growth to moderate to less than 5% in FY2007, and we also expect the effective tax rate to moderate slightly after a sharp surge in recent years.  Taken together, we expect net corporate taxes to be up 4.0%.  Otherwise, we expect withheld income (+5.4%), nonwithheld income (+5.9%), and social insurance (+5.2%) taxes together to run in line with our estimated growth in personal income, which we recently scaled back somewhat as we marked down our 2007 GDP forecast and incorporated the downward revisions to income in the last GDP revision.

The significant slowing in underlying nondefense discretionary spending growth that was seen in FY2006 should become more apparent in FY2007.  This underlying restraint, the absence of special items that boosted outlays last year, and some continuing moderation in defense spending growth should help to offset upside in nondiscretionary spending — particularly Medicare and interest — to keep overall spending growth at +4.8%, which would be the smallest rise since FY2001 and a major improvement from average rises of 7.3% in the first five full years of the Bush Administration.  On the upside, Medicare spending growth is likely to accelerate significantly further in FY2007 with the first full year of the prescription drug plan and a legislative change that shifted some payments out of 2006 and into 2007.  Since the Medicare prescription plan picks up some costs that were previously covered by Medicaid, it makes more sense to look at them together — we expect overall spending in Medicare, Medicaid, and other health programs to rise 11.3% this year after rising 6.0% last year, accounting for more than half of the overall spending rise we project.  Interest expense growth should moderate somewhat from the sharp surge seen last year as rates flatten out, but still see significant growth. 

Meanwhile, on the positive side, discretionary spending growth, particularly nondefense, looks set to decelerate significantly.  Since surging 16.3% in FY2003, defense spending growth has moderated each year since to +6.8% in FY2006, and we expect further slowing in FY2007 to +4.9%.  After having surged 73% from FY2001 through FY2006, defense spending appears to moving towards gradually topping out at a high level.  Meanwhile, after the spending spree of the early years of the Bush Administration, the White House requested and Congress passed tight limits on regular nondefense discretionary budget authority in both FY2005 and FY2006 of only about +2% in each year.  And after a bit of a lag, this restraint clearly became apparent on an underlying basis in FY2006, even as overall spending was boosted by unusual items.  Clearly, after the recent election the outlook here is somewhat cloudy for FY2007.  With the outgoing Congress having passed only two of the eleven appropriations bills, the bulk of the budget is operating under a continuing resolution through February 15 that holds spending at last year’s levels.  Our baseline case is that the likely gridlock next year keeps discretionary spending growth on a tight leash, as happened for an extended period during the Clinton Administration, which along with the continuing impact of the tight budgets passed the prior couple years should keep overall nondefense discretionary spending growth slow in FY2007.  Adding in the impact of the absence of the special factors that boosted outlays in FY2006, we expect spending outside of defense, Social Security, Medicare, Medicaid and health, and interest to fall 2% this year.

Treasury financing implications.   We expect overall net Treasury issuance to rise to $249 billion in FY2007 from $213 billion in FY2006.  The $17 billion increase we expect in the budget deficit explains only about half of this. The rest should result from a smaller contribution from nonmarketable debt issuance and “other means of financing.”  The combination of these two items reached a record +$103 billion in FY2005, and, while moderating significantly, remained very elevated at +$61 billion in FY2006.  We look for some normalization to +$5 billion in FY2007.  Nonmarketable debt issuance — which is primarily State and Local Government Series (SLGS) debt that municipal governments use as a means to invest proceeds from pre-refundings without running afoul of laws against their arbitraging the tax advantaged status of their debt — has already slowed sharply from a record $64 billion in FY2005 to $13 billion in FY2006.  We look for a modest further slowing to $8 billion this year.  The much bigger swing factor we estimate to be other means, which ran extremely strong relative to typical levels in each of the prior two years, as various off budget sources or uses of money turned significantly more positive.  Our base case at this early stage is that these positive swings have run their course and other means will swing from a $48 billion source of cash in FY2006 to a slight use of money this year. 

At current coupon sizes, we estimate Treasury faces a financing gap — the amount of increased market issuance through higher coupon sizes and net bill issuance needed to fund the budget gap plus nonmarketable funding sources or uses — in FY2007 of $97 billion.  This — and any reasonably likely deviation from it — can be easily met within the current financing structure.  The main shift we project in the current fiscal year is some rebalancing between bills and coupons.  In FY2007 the first full year of revived 3-year notes will mature, leading to a $50 billion increase in overall coupon maturities.  We expect coupon sizes to move somewhat higher starting with the 2-year and 5-year issues at the end of January and continuing with the February refunding and for these slightly levels to be maintained through year-end.  We project a $2 billion boost in the 2-year size to $22 billion, a $1 billion increase in the 5-year to $15 billion, a $1 billion increase in the 3-year to $20 billion, and a $1 billion increase in the 10-year to $14 billion new/$9 billion reopening.  Starting in February, 30-year issuance will shift to quarterly from semi-annual, with new issues in February and August and reopenings in May and November.  We expect the run rate for 30-year issuance to rise from $24 billion to $30 billion ($9 billion new/$6 billion reopening), but since there was no bond in November, actual bond issuance would be unchanged at $24 billion in FY2007 under this pattern.  Combined with an expected $70 billion in TIPS issuance, we see overall gross coupon issuance rising $20 billion to $698 billion, but net issuance falling to $190 billion from $217 billion.  Offsetting this should be a pickup in net issuance of bills.  The recent budget surprises led to net bill paydowns in each of the last two fiscal years and a sharp decline in the bill share of the outstanding publicly held debt from 22.4% at the end of FY2004 to 18.0% at the end of FY2006.  The debt managers have suggested that the recent paydowns were neither intended nor particularly desirable and have seemingly driven the bill share below where Treasury would like it to be.  The swing to about $60 billion in net bill issuance we project for FY2007, would start to rectify this, lifting the bill share about a half percentage point.

Medium-term issues.  The Democratic takeover of Congress clearly presents significant uncertainties for the medium-term budget outlook.  Our assumption is that not much of anything will happen for the remaining two years of the Bush Administration, keeping spending relatively restrained and the deficit near current levels as the trend like GDP growth we anticipate keeps revenue growth reasonably healthy.  The key uncertainties will not be decided until the 2008 elections.  The major Bush tax cuts begin to expire at the end of 2010, and unless Republicans hold the White House and retake Congress most of them likely will be allowed to expire.  A Democratic sweep in 2008 would probably mean that the increased revenues this would bring in would be spent on programs the Democrats feel were neglected under the Republicans.  A continuation of split government, in which tax cuts expired and not much in the way of new spending was able to get past the White House, could put the budget on a significantly improving path.  As far as more medium-term funding issues, assuming the deficit stays reasonably close to current levels, the existing financing calendar is fine through FY2008.  In FY2009, however, the first full year of monthly 5-year issues mature, leading to a sharp rise in coupon maturities and a large resulting financing gap that could possibly call for more substantive adjustments to the current auction schedule than the relatively small swings in coupon sizes and net bill issuance we expect for the next couple years

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Currencies
A Retrospective on 2006: A Cyclical Dollar Downturn
December 15, 2006

By Stephen Jen | London

This is a time for reflection on 2006

I am saving my 2007 outlook for the first week of January.  Instead of looking ahead, I think it is useful, at the end of the year, to take a moment to reflect on the year that has just gone by, and to evaluate my calls this year and draw lessons from how the currency markets behaved this year. 

What I said at the beginning of the year

1.    “The story for the dollar this year will be cyclical and closely linked with the developments in the US housing market.”  I argued that the ‘trendy’ phase was over and for 2006, I saw a “gentle turn in the dollar in sync with a soft-landing in the US housing market.  I also argued that the US current account deficit would reach an ‘inflection point’ in 2006, which should diffuse much of the angst about the dollar from a structural perspective. 

2.  “2006 will be the Year of the CNY.   More flexibility and more meaningful appreciation of the Chinese currency are expected.”  As the CNY appreciates, it will push all the Asian currencies stronger against the dollar.   JPY will be the laggard in this bunch due to its very low yield … China will become the largest foreign reserve holder in the world later this year, surpassing Japan.

3.  “The dollar’s movements this year will likely be asynchronous against various currencies.”  “In contrast to the previous four years, the dollar’s movements are likely to be asynchronous against different currencies.  In other words, the USD is likely to peak at different points in time against various currencies.

My good and bad calls this year

In my view, my call for a cyclical dollar correction centered on the US housing market has been broadly correct.  I argued a year ago that EUR/USD was forming a bottom in the 1.17-1.18 range.  I was also correct in expecting USD/AXJ, led by USD/CNY, to trade lower this year, with USD/JPY being the laggard due to the low yields in Japan.  Importantly, my prediction that the US current account deficit would reach an inflection point this year also seems to be correct. 

I was, however, wrong on several fronts.  (1) I had underestimated the market’s support for EUR/USD and the ability of the Euroland economy (Germany in particular) to recover.  (2) In contrast, I was too aggressive on USD/JPY this year, thinking that USD/JPY would go on being weighed down by positive real economic fundamentals, and that the relative low nominal yields would matter less over time.  (3) I underestimated the scope for EUR/JPY to trade higher.  Even though I proposed the ‘Global Funneling’ concept as an explanation for this upward structural drift in EUR/JPY, I did so quite late (August).  (4) I had expected the three commodity currencies to depreciate against the dollar, as the global economy decelerated with the US, and because these currencies were already over-valued.  Further, I had expected that the prospective unwinding of the JPY carry trades would weigh on these high yield commodity currencies. 

Lessons from 2006

There are several key lessons from 2006 that will be important to keep in mind for 2007.

•   Lesson 1.   Financial globalization will remain a powerful driver of exchange rates.   By financial globalization, I mean the sharp rise in cross-border capital flows, both private and official, in recent years.  Trade balances and globalization of the goods markets are clearly important, but I believe that capital flows and financial globalization are even more important in dictating where exchange rates go. 

First, it has been a global trend that ‘home biases’ have declined in most countries.  This has made current account imbalances a much less powerful predictor for exchange rates. 

Second, as virtually all countries are diversifying, it has been difficult to draw clear, definitive conclusions for currencies.  As a result, investors have thus been forced to extrapolate from announcements made by a few central banks and countries that are unfriendly toward the US, such as Iran, North Korea and Venezuela.  My view on this subject of central bank diversification is quite different from popular opinion in the market, but I concede that since the prevalent view can neither be proved nor disproved, comments and rumors will continue to fuel bouts of mini-attacks on the dollar, interrupted by sporadic surges in the dollar based on economic fundamentals. 

Third, as the official reserves of several key central banks in the world exceed what are needed for liquidity purposes, many central banks will likely deploy the additional or new foreign reserves to investments that are higher-risk but with higher expected returns.  This evolution from pure reserves to the ‘sovereign wealth funds’ has begun, and will have very significant implications for not only the currency markets but also bond and equity markets in the years ahead. 

Fourth, in thinking about the fair values (FVs) of exchange rates, it is also important to consider a concept I proposed several years ago: Multiple Shadow Prices.  The basic idea is that, while most fair value calculations, including ours, are based on real economic fundamentals, given the importance of global capital flows, a parallel concept is that some countries may have very different exchange rate FVs, from the perspective of capital markets. 

•   Lesson 2.   Cash yield differentials will likely remain important.  I have long resisted accepting that nominal cash yield differentials could be such the dominant driver for exchange rates.  To me, over time, real economic fundamentals (such as productivity and the terms of trade) should be important and carry should not.  How the currency markets have behaved in 2006 suggests otherwise, however. 

First, cross-border asset holdings have grown drastically in recent years, the need to hedge should also have increased.  Since hedging costs are dictated by nominal short-term interest rates, cash yield differentials may have become a more powerful driver than in the past. 

Second, I have recently realized that the sensitivity of exchange rates to nominal cash interest rates may also have been due to the enhanced transparency of central banks in their communication strategy. 

• Lesson 3.   Don’t bet against the Fed.   To me, the Fed has been the best forecaster of the US economy.  At virtually all turning points since 2002, the Fed has been ahead of the market and made the correct call.  I am not saying that the Fed does not make mistakes, but merely pointing out: (i) the remarkable level of confidence the Fed’s detractors have in this environment of uncertainty; and (ii) the recent superior track record of the Fed, compared to anyone else in the market. 

•   Lesson 4.  Beijing to be more flexible in the years ahead.  I believe that the single most important development in China this year has been the explosive growth in its trade surplus.  There is no way around: (i) China’s additional reserves being converted into a ‘sovereign wealth fund’; and (ii) the rate of crawl of USD/CNY accelerating further.

•   Lesson 5.  Don’t underestimate any economy, even Euroland.   Back in early 2005, Japan surprised many with its economic recovery, as did Germany a year later. The point here is that a lesson I have learned is not to dogmatically cling to preconceived notions: a structurally flawed Euroland can exhibit surprising resilience.  The durability of the recovery we are witnessing is the next test for Euroland, but commentators (like myself) and investors should be open-minded about this. 

Bottom line

Many of the key themes that have dominated this year will likely carry over to 2007.  I will present my 2007 currency outlook in more detail early next year. 

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France
We Have a Problem, Mr(s) President
December 15, 2006

By Eric Chaney | Paris

2007 is an important year for France.  First, the macro environment will be less friendly for growth and profits than it was in 2006, since France’s two main trading partners, Germany and Italy, are undertaking major fiscal consolidations that should slow their imports.  Second, the presidential election, immediately followed by parliamentary elections, will give the country a new leadership for the next five years.  In a context of still low interest rates, domestic demand should be robust enough to allow the economy to grow by around 1.9%, i.e., only a couple of tenths below potential.  However, tougher competition from German producers – the VAT rate hike is partially financed by exporters to Germany but not by German exporters — combined with a stronger euro and slower global demand will squeeze profit margins and make companies more reluctant to hire.

The risk of populism in the electoral debate

Against this tepid macro backdrop, I see a significant risk that the political debate might drift toward populism, as it has already started to do.  Candidates from either side of the political spectrum may find it rewarding to overbid on themes such as the mandate of the European Central Bank, household purchasing power, or globalisation.  Changing the ECB’s mandate in order to include growth and employment in the bank’s targets is totally unrealistic: It would require a unanimous view from all EMU countries, which has a zero probability.  All candidates know that fact; they are also aware that the financial markets do not really care about these statements, because traders cannot short the French franc as they would certainly have done eight years ago. 

However, this behaviour may weaken the credibility of the next government regarding EMU governance issues and, in any case, reinforces the impression that French politicians are more interventionist than ever, which cannot be good for investment.  Increasing purchasing power by either raising the minimum wage or distributing more taxpayers’ money to low income families is a more serious threat in my view, against a backdrop of eroded competitiveness and record high government spending (53.8% of GDP in 2005).  Also, letting French voters think that policy makers have the power to insulate the economy from globalisation is a dangerous illusion: Even though promises on that front are cheap, they have dangerous side effects such as increasing capital outflows and reinforcing domestic rigidities.  This brings me to the broader picture and to the challenges the French economy is facing.

We have a problem, Mr(s) President

Three indicators show how serious are these challenges.  First, French exports outside of the euro area are 16% lower than at the outset of the monetary union, relative to EMU exports.  Comparable numbers for Germany, Italy and Spain are respectively +11%, -1% and +2%.   In this zero sum game, France is the loser, Germany is the winner, while Italy and Spain have broadly maintained their relative positions.  Although the time frame is somewhat arbitrary – at the outset of EMU, Germany’s competitive position was still deeply damaged by the consequences of the unification — this rough competitiveness indicator is consistent with more elaborate studies (see for instance Pr. Lionel Fontagné and Patrick Artus’ report to the Council of Economic Analysis, ‘Recent trends in French foreign trade’, 2006).  Second, French unemployment, at 8.8% (October 2006, Eurostat definition) is now the second highest in the euro area, just behind Greece, and more than a full point above the euro area average (7.7%).  Third, the share of wage earners at the minimum wage level has risen to 16.5%, while it was less than 10% in 1996.  Not only does this imply that rigidities have increased since 1997, but also that unemployment could rise disproportionately during the next downturn.  If his or her economic advisor dares tell the truth, the first words the next President of the French Republic hears from him should be: “We have a problem, Mr(s ) President”.

Three priorities for the next President

I believe that three reforms should be undertaken in the very first period of the President’s mandate: 1/ labour markets, 2/ public finances and 3/ deregulation of services.  Without entering into the details, the labour market reform should tackle the minimum wage abscess, by freezing its real value until the share of minimum wage earners is back below 10%.  Also, the government should introduce a new generic labour contract which would allow employers to fire employees without obstacles, in exchange for a progressive severance compensation (an idea promoted by Pr. Olivier Blanchard of the MIT, among others).  Progressively, this would cure what I have called the ‘insider disease’ that characterizes the labour market rigidities and generates dangerous frustrations in French society. 

As for public finances, the main target of the reform in a first stage should be to reduce welfare spending (social transfers), in particular medical spending.  The spirit of the healthcare system, i.e., guaranteeing free access to medicine with very few restrictions, is naturally generating inefficiencies and waste.  At stake is nothing less than unemployment: since the healthcare system is mostly financed by payroll taxes, every euro saved would reduce the cost of labour and thus help create jobs.  Last, deregulating services, from the retail sector to hotels, cafes and restaurants, is the surest way to create jobs in France, given that, in manufacturing, globalisation will continue to reduce headcounts, especially at the low end of the qualification ladder.  In this regard, freezing the minimum wage would help considerably in low-skilled labour-intensive services, as well as cutting payroll taxes.  This last remark shows how entangled are the three fields I have selected and answers the priority question.  All three reforms should be undertaken simultaneously in order to create a virtuous circle of job creation and support from the population.

There is nevertheless a priority: Tell the truth to the French.  If, as in 1981, 1988, 1995, and 2002, candidates tell fairy tales to voters, history might repeat itself: Reforms would progress at a snail’s pace while the world accelerates, a trap I once called the “White Queen Syndrome”. 

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Asia
Asia's Decoupling Story -- The Litmus Test
December 15, 2006

By Chetan Ahya | Mumbai

Decoupling debate back to forefront.  The increasing level of globalization has meant that cycles in both real economies and financial markets in Asia and the US have tended to move in a synchronous manner.   However, major strengthening of Asia Ex-Japan’s balance sheet over the last few years is fuelling expectations of a decoupling from the US economic growth.   In 2006, AXJ’s nominal GDP is estimated to increase to 45% of US’s GDP from 33% in 2000.   The debate is intensifying as recent data from the US indicate a potentially significant deceleration in America’s growth trend.  Indeed, our US economics team now expects GDP growth there to slow to a 15-quarter low of 2.2% YoY in 1Q07.   The key question for the markets in 2007 is whether AXJ will follow the US in the ensuing downcycle or will it emerge as a “decoupler”?

The case “for” decoupling.  There are two key arguments supporting the case for decoupling.   First, AXJ’s trade dependence on the United States has been declining gradually over the past few years.  This is evidenced by the fact that the US share of AXJ’s exports decreased to 17% in 1H06 from 22% in 1998.   Second, the rise in nominal interest rates in AXJ has been slower than the rise in interest rates in the US in the current cycle.  Since the US Federal Reserve began its tightening campaign in June 2004, average nominal short-term rates in AXJ have risen by only 85 basis points (150 bps, excluding China), while US short-term interest rates have risen by almost 380 bps. 

Evidence suggests linkages remain strong.  The actual trend for AXJ export and GDP growth indicates that these economies remain highly correlated with US GDP growth.  Since a period of divergence during 1997–98 (when AXJ’s growth decelerated sharply due to the Asian crisis), AXJ has been closely coupled with the US.  Moreover, AXJ equity markets have also exhibited a tight correlation with those in the States.  Indeed, over the trailing 24 months, monthly returns in Asia ex-Japan have shown a correlation of 0.8 with returns in the US.

We view 2007 as a testing year.  For AXJ to decouple, the single-most important factor will be its ability to stimulate domestic demand (the major components being fixed investment and private consumption).  In AXJ (excluding India), fixed investments are made with an eye on potential future global demand rather than domestic consumption.  Hence, the fixed investment trend has tended to follow the region’s export and global growth cycle.   The structural dynamics of private consumption are also uninspiring.  Already decelerating, the private consumption trend in the region is unlikely to accelerate much in 2007, barring a sharp cut in interest rates.  Indeed, a slowdown in US consumption would only reduce the region’s trade surplus and therefore lessen support provided by excess liquidity.  Even though nominal interest rates in the region have lagged the Fed, short-term real interest rates have been rising and are now almost converging with those in the US.

Accounting for 17% of the region’s GDP growth, India is so far the only large economy in the region to have successfully stimulated private consumption growth.  However, a large part of the country’s consumption growth is debt funded and dependent on global liquidity trends.  Consumption growth in India is now beginning to reflect the rise in interest rates, which in turn have been influenced by the US monetary policy.  We believe that the lagged effect of higher interest rates will further slow India’s consumption growth in 2007.

Bottom line — case for decoupling is weak.  Although the jury is still out, we believe the case for AXJ decoupling remains weak.  Exports and export demand-dependent fixed investment continue to be the key anchors of AXJ’s growth story.  In the absence of structural reforms, private consumption is unlikely to take charge any time soon.   We believe the case for decoupling is not convincing as we see little indication that AXJ economies can stimulate internal demand enough to offset a potential slowdown in the US.

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The Netherlands
Roundtrip
December 15, 2006

By Elga Bartsch | London

The Dutch economy is the first country in the euro area that has successfully completed a full roundtrip in terms of relative growth performance.   This is not only very good news for the Netherlands, which at 2.4% on our forecasts is set to grow above its own trend rate and above the European average next year.   Thus, after several years of relatively meagre growth performance, the Netherlands is now firmly back in the European growth league.   But the comeback of the Dutch economy is also very good news for the euro area, where the continued growth discrepancies have prompted discussion on whether there is a properly functioning adjustment mechanism that can correct these intra-EMU growth and inflation differentials (see EU Commission: Adjustment Dynamics in the Euro Area – Experiences and Challenges, November 22, 2006).  Some observers have voiced worries that the adjustment process that would cause overheating countries to cool and underperforming ones to recover might not be powerful enough to correct these growth divergences.   As the ECB’s monetary policy by definition has to be “one-size fits-all,” such deepening divides in terms of growth and inflation could potentially undermine the proper functioning of the currency union.

But the relative performance of the Dutch economy over the past ten years shows how such an adjustment mechanism can work successfully.   However, to date the Netherlands is the only country that completed the full cycle.   Germany could potentially be another such case, but we first have to see whether the current recovery proves to be a lasting one and whether it manages to withstand the cyclical headwinds it will face in 2007 (see German Economics: Putting the Recovery to the Test, December 15, 2006).   Being small and very open, the Dutch economy very much feels the heartbeat of global trade cycle due to its role as a logistics hub.   But it also feels the heartbeat of the intra-EMU tensions and the adjustment processes these can trigger.   This is the reason why in my view the Dutch government was so quick to react to a marked decline in the deterioration of cost competitiveness vis-à-vis the rest of the euro area, and after consulting with trade unions and employers, the government essentially imposed a two-year wage freeze in 2003.   The turnaround in the cost-competitiveness is one of the reasons for the smart rebound in Dutch growth, in my mind.

In the late 1990s, the Dutch economy was one of the star performers in Europe, and investors were referring to its stellar growth performance as the “Dutch miracle”.   Policymakers from other parts of Europe considered copying the Polder model to revive growth dynamics while maintaining social cohesion.  In 2001, however, the Dutch economy hit rock-bottom due to a combination of shocks; including the global equity market crash, a subsequent cooling of the Dutch housing market and a sharp rise in labour costs.  During this period Dutch GDP growth fell short of the euro area average by a considerable margin, and sentiment indicators registered record lows that were even more depressed than the levels observed in neighbouring Germany.

Today, Dutch GDP growth is broad-based: consumption is picking up as a result of an increase in purchasing power and employment growth; export demand and investment spending are rising considerably.   As a result, unemployment which at 3.9% of the labour force is already way below the Euroland average of 7.7% is decreasing rather rapidly.   Increasing labour supply is a key issue for the long-term growth prospects of the Dutch economy.   But as in the UK, there is substantial hidden unemployment amongst people on disability and early retirement schemes.   A key aspect in boosting labour supply in the Netherlands will be to encourage people to work longer hours, thereby reversing a trend towards part-time work, which has reduced the average work-week in the Netherlands to around 30 hours.   Nevertheless, inflation and wage developments are expected to remain moderate in 2007 and stay well below the euro-area average; thus further improving the competitive position of the Netherlands.   For the first time since the boom year 2000, the general government budget will be in the black again.   In addition to a reduction in corporate tax from 29.1% to 25.5%, various relief measures (including an income tax cut for low income earners) will provide overall tax relief of EUR 1 billion (equivalent 0.25 % of GDP).   

Looking at the election results.   Notwithstanding the turnaround in the economy and an impressive track record on reforms, the centre-right government led by Jan-Peter Balkenende suffered a major defeat at the general election held on November 22.  The surprising winners of the general elections were the populist left-wing Socialist Party as well as a number of smaller parties at the fringes of the political spectrum.  Contrary to Germany, the two main parties in the Netherlands don’t even have enough seats to form a “purple” coalition, the Dutch equivalent of Chanceller Merkel’s “grand” coalition bringing together the country’s two largest political parties.   This increasing fragmentation of the political spectrum, where extremist parties both on the left and on right gain at the expense of the political centre, likely reflects the bifurcating forces of globalisation.   In the Netherlands, alas, it might take several months before a new government is being formed.  

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Nordics
Sweet Dreams or Nightmare?
December 15, 2006

By Thomas Gade | London

Strong growth and substantial risks
The Nordic economies (Denmark, Finland, Norway and Sweden) continued to pace ahead during 2006. On aggregate, we expect the Nordic region to expand by a staggering 4.2% this year, slowing to 2.9% in 2007 and further to 2.4% in 2008. Despite variations within the Nordic economies, growth in the Nordic region remains above that of the euro area on our forecasts.   The Nordic economies in general have benefited from high productivity growth, strong foreign demand and increasing domestic demand, fuelled by a prolonged period of expansionary monetary policy and significant wealth effects. The key risk factors going into 2007 are increasingly stretched housing markets in Denmark, Norway and Sweden, as well as very tight labour markets in Denmark and Norway and a still loose but tightening labour market in Sweden.

Three factors suggests slower growth

With the exception of Norway, we expect the Nordic economies to slow during over the forecast horizon. The three main factors driving the slowdown will be a continued withdrawal of monetary stimulus, a gradual currency strengthening and — more fundamentally — the increasingly scarce labour resources. As small open economies, the Nordic economies are sensitive to developments in the global economy, in particular to developments in the euro area. On the upside — although it is not our baseline case — sustained structural productivity growth and increased immigration could subdue some of the expected growth slowdown and abate otherwise increasing wage pressures. On the downside, a more abrupt slowdown in house price growth — not to mention a drop in house prices — could significantly hamper household consumption going forward.

Loose monetary policy still fuels demand
Although monetary policy is still expansionary and spare production capacity increasingly scarce in the Nordic region, the continued withdrawal of monetary policy by Riksbanken, Norges Bank and the ECB is likely to gradually slow investment spending growth throughout the region. Despite ongoing monetary policy during 2006, monetary policy remains accommodative in all the Nordic countries. As Finland is a member of the euro area and Denmark has a fixed exchange rate towards the euro, the monetary tightening will be determined by the ECB (see Elga Bartsch’s note in this publication). In Norway and Sweden, we expect Norges Bank and Riksbanken to outpace the ECB through 2007 and to continue to withdraw monetary stimulus possibly through 2008 also. Financial conditions are likely to tighten further by a gradual currency strengthening. This will particularly be evident in Norway and Sweden, we think.

Tight labour markets and little immigration
Labour markets are tightening across the Nordic region. Labour markets in Denmark and Norway look particularly tight, while some slack remains in the labour markets in Sweden and Finland, we estimate. In Denmark and Norway, a rising proportion of companies are reporting labour shortage in several sectors ranked from construction and financial services through manufacturing. It is striking that the tight labour markets in Denmark and Norway has not led to a higher degree of wage inflation yet. Part of the explanation can be found in an increasing degree of flexibility in the labour markets, which has also resulted in a low rate of structural unemployment. Second, parts may be assigned to a higher degree of off-shoring. On our measure of structural unemployment (NAIRU), only the unemployment rates in Sweden and Finland are above the structural unemployment rate at present. Unemployment below the NAIRU in Denmark and Norway will likely cause upward pressure on wage growth over the forecast horizon.

Whether labour markets remain tight and result in increasing wage pressure will also depend on the labour supply from the new EU member states in particular. In recent years, a rise in the inflow of labour supply has been significant in Sweden only. Obtaining larger inflows of labour supply from the Central and Eastern European economies will become increasingly important to abate some of the labour market pressure in Norway and Denmark. On our baseline scenario, we would however still expect wage compensation and unit labour costs growth in Denmark and Norway to outpace wage growth in Sweden and Finland.   Increasing the labour supply is especially important today. Facing an aging society across the Nordics, it is not a short-term issue. Depending on the developments in labour supply, we see significant downside risks to growth in the years ahead — particularly in Denmark and Norway.

Stretched housing markets a major risk factor
Housing markets in the Nordics look increasingly stretched, with the exception of Finland. In a recent OECD study, three of the Nordic countries are unfavourably ranked in the top-seven with respect to the probability of house prices ‘nearing a peak.’ In particular, the Danish housing market — ranked first among the OECD countries — looks prone for a potentially sharp adjustment. Across the Nordics, the rise in house prices over the last 10 years has been accompanied by a similar build up in household debt. Meanwhile, interest payments as a percent of disposable income have declined over the same period of time.

The drop in the ratio of interest payments to disposable income may not only be explained by decreasing interest rates over this period of time. Particularly in Denmark, the drop may have been exacerbated by an increasing share of short-term maturity and flexible rate borrowing. As such, Danish households, with the highest debt to income ratio in the Nordics, have become increasingly sensitive to developments in short-term interest rates. In Denmark, the unwinding of the house price bubble could be severe. As our colleagues David Miles and Melanie Baker recently pointed out in a study on the UK housing market, a large part of current UK valuations can be explained by expectations of further price rises only. Valuations are therefore very much dependant on expectations and could potentially be volatile (See UK Economics: How Did We Get Here? Nov. 22, 2006). Although this may also be the case in Denmark, a revaluation would still need a trigger. The massive rise in the number of houses for sale during recent months and stagnating sales prices may be exactly such a trigger. On balance, the potential abrupt slowdown in house prices constitutes a significant downside risk to consumption demand for Sweden and Denmark in particular. Meanwhile, our baseline case for Sweden and Norway remains for a gradual slowdown in house price appreciation. This may hamper consumption growth, but in Sweden this will likely be offset by the expected rise in household disposable income growth, induced by lower income taxes and employment growth.

Bottom line — Sweet Dreams or Nightmare?
The Nordic economies have shown impressive growth rates during recent years. In particular, demand has been fuelled by a very expansionary stance of monetary policy, but also productivity growth has been impressive on the supply side. Monetary policy is being gradually tightened, and the currencies are gradually strengthening. We therefore expect the economies to gradually slow, but for aggregate growth to remain above that of the euro area. Two risk factors in particular need to be addressed:   labour markets and housing markets. Labour supply will need to be increased.   In Sweden, this is already happening through increased immigration flows and changes in the tax base. The remaining Nordic economies are lagging behind in this respect. Housing markets look increasingly stretched; in particular, for Denmark, the unwinding of the housing bubble could be severe. There is still scope for sweet dreams in Sweden, but be prepared for potential nightmares in Denmark.

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Global
Freer Trade Matters
December 15, 2006

By Jeffrey Matsu | New York

Global trade linkages have deepened across all major regions in 2005, with global trade as a share of GDP expected to exceed $14 trillion, or 30% of world GDP, this year.  From 1987 to 2005, global trade accounted for 36% of global GDP growth (at market exchange rates), more than double the 17% seen during the 1974 to 1986 period.  According to IMF estimates, world trade volumes of goods and services will have grown 8.9% in 2006, well above the 7.5% longer-term growth trend and our call for 5% GDP growth this year.  While technological advances contributed to a sharp reduction in transportation and telecommunications costs, thereby stimulating trade, it was a more inclusive trading system that generated tailwinds for economic growth and recovery.  Developing countries are benefiting from this integration as well — the ratio of trade to GDP of least developed countries increased from 25% in 2000 to 30% in 2004, the latest year for which data are available.  As a result, any move toward reduced openness could limit their potential for growth.

Pundits have argued that a mix of factors preordained the death of Doha — decision-making based on consensus in an increasingly disparate WTO membership, recalcitrance of developing countries represented by the G-20, and the more prominent role of bilateral and regional free trade agreements.  Reluctance of the US and Europe to meaningfully liberalize their highly subsidized agricultural sectors has not helped either.  Yet it is precisely those countries and regional blocs most exposed to the competitive pressures of globalization that have reaped the benefits of free trade in recent years.   Between 2003 and 2005, average annual growth in the export of goods from ASEAN, Mercosur and the Andean Community exceeded that of the EU-25 and NAFTA (18%, 25% and 31%, respectively, versus 13%).  While the former are dwarfed in absolute size by the latter, their export and import shares with the rest of the world are considerably higher.  This is not to say that free trade alone fuels economic performance, as fiscal prudence and balance of payments are equally, if not more so, important, but it helps.  GDP growth in the Mercosur is expected to remain above 4% this year and next, and our prognosis for the ASEAN-5 is equally strong with 5%+ growth projected through 2008.  This contrasts with a deceleration of growth below 3% in NAFTA next year, and weaker growth in Europe as well.

If free trade is so beneficial for growth, then why have negotiators refused to compromise?  Poor countries, led by Brazil, India and South Africa, have argued that as latecomers to a game created by and primarily for the rich, they are at a distinct disadvantage and hence should be expected to yield less ground.  Yet inter-regional export diversification is most pronounced in Africa, the Middle East and Latin America, accounting for trade shares of 84%, 72% and 90%, respectively.  Bilateral trade flows between China and Africa have more than tripled since 2002, and Africa’s net trade with China is now positive.  Moreover, according to the World Bank, more than half of the costs associated with the exports of poor countries results from restrictions imposed by other poor countries.  For example, the tariff structure imposed by India on textiles from neighboring countries such as Bangladesh and Sri Lanka effectively doubles or triples final product prices, heavily skewing the terms of trade.  Roughly sixty percent of total customs duties collected on merchandise imports worldwide accrue to the developing world, based on data from the WTO.

Unfortunately, the explosion of bilateral and regional trade deals over the past several years has distracted from multilateral efforts, consuming limited political capital which will be needed if Doha is eventually to succeed.  Asking politicians to repeatedly take the stand for trade liberalization, no matter how small or inconsequential the deal, is neither a smart nor sustainable strategy.  Yet just about all 149 WTO members participate in at least one of the nearly 200 regional trade agreements currently in effect.  Not only does this lead to inefficiencies for multinational companies who must devote more resources to understand the myriad of rules and regulations affecting their products, but it negatively impacts smaller or poorer countries that often do not possess the clout to extract favorable trade terms.  To fix the mess they started, the US and Europe must exercise greater leadership in curbing preferential trade agreement (PTA) contagion if discipline is ever to be restored to the global trading system.  This is particularly urgent given the enabling clause of the GATT, whereby trade amongst developing countries is unbound by Article 24 and the nondiscriminatory most-favored nation rights that apply to developed countries.  For burgeoning economies such as China’s, which is expected to become the world’s second largest trader in 2007, the unrestrained ability to cherry-pick who gets what level of preferential tariff treatment is unlikely to nurture support for freer trade elsewhere in the world.

Acknowledging the redistributive nature of trade and implementing more robust mechanisms to support those who fall between the cracks will be necessary to stem the backlash against globalization.  Deep-seated mistrust for further global integration has already been evidenced through a bevy of protectionist events ranging from the razor-thin passage of CAFTA in the US, rejection of the EU Constitution, and economic patriotism vis à vis the failed deals of Unocal/CNOOC and Dubai Ports World.   China-bashing is also on the rise, with more than two dozen pieces of anti-China legislation circulating in the US Congress.  Expanding trade adjustment assistance, in the form of worker retraining programs, enhanced educational opportunities and wage/health insurance schemes, could rebuild public support for freer trade in industrialized countries at relatively little costs.  Estimates by the Institute for International Economics show that this would amount to an additional $3-12 billion annually in the US, a paltry sum compared to the $500 billion potential gain from further liberalization.  Finally, multilateral organizations such as the World Bank are in a unique position to incentivize poor countries to open their markets through the administration of aid-for-trade programs that provide technical assistance and compensation for lost tariff revenues and special preferences.

To regain momentum on the global trade front, the world needs a policy jolt akin to the inaugural Asia-Pacific Economic Cooperation (APEC) summit held in November 1993.  What worked as a catalyst for the Uruguay Round could work again for Doha.  With roughly 40% of the world’s population, the 21-country trading bloc accounts for 57% of world GDP and 48% of world trade.  As was the case then, the economic costs associated with the potential exclusion from an Asian Union or Free Trade Area of the Asia Pacific could bring Europe and other major holdouts back to the bargaining table.  Aspirations of the Association of Southeast Asian Nations (ASEAN) to accelerate the creation of a single-market economy amongst its 10 members by 2015, and the proliferation of PTAs throughout the region, could also promote an outgrowth of competitive liberalization that reinvigorates Doha and puts global trade liberalization back on track.

Bilateral and other less-than-multilateral trade agreements are a poor substitute for a global deal, and lead down a dangerous road pot-holed with reciprocal barriers and other retaliatory measures.  By further reducing market distortions such as tariffs, subsidies and quotas, Doha has the potential to reintroduce much needed discipline into trade negotiations that have increasingly favored one-off deals driven more by political rather than economic considerations.  As part of a rules-based regime, developing countries are for once on a level playing field to have their voices heard.  Threats from terrorism, escalating confrontations in the Middle East and heightened tensions with North Korea further underscore the imperatives to reform rogue states through economic integration rather than isolation.  While laissez faire liberalism may not be the answer, neither is forfeiting on a more inclusive international rules-based trading system. 

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Germany
Putting the Recovery to the Test
December 15, 2006

By Elga Bartsch | London

In 2007, the much-applauded economic recovery in Germany and, more importantly, financial markets’ conviction in the revival story, will be put to the test, I think.   This is because a number of negative factors will likely weigh on GDP growth in the coming months.   The key question is by how much.   My main-case scenario is that after several years of heavy restructuring, the economy should now be in better position to withstand negative headwinds without falling back into its old ways of dipping in and out of stagnation.   On our forecast, real GDP growth will nonetheless slow from an estimated 2.5% in 2006 to its trend rate of 1.5% in 2007.  This is two-tenths above consensus estimates in each of the years.

Don’t be fooled by the decline of the annual average growth rate though. The decline is almost entirely due to a negative real GDP growth rate in the first quarter of 2007.   This forecast of an outright contraction in economic activity in early 2007 reflects a three-point VAT hike becoming effective on January 1st and a considerable fiscal consolidation package of around 0.75% of GDP of which it is a key part.   But the German economy should be recovering from this shock as early as the second quarter.  Due to the substantial hike in the VAT, consumer spending will feel the brunt of the fiscal tightening in 2007.  As a result, consumer spending growth will likely halve from the 1.1%, it is likely to register in 2006.   A considerable part of that weakness in consumer spending will simply be a payback after purchases of big ticket items that have been brought forward to late 2006 to avoid the higher VAT.   A similar but less pronounced pattern is likely to be observed in residential construction investment.   Notwithstanding such a temporary setback, the German construction industry is emerging from a multiyear recession, in my view.

Slowdown likely in machinery/equipment spending growth.  Meanwhile, corporate spending on machinery and equipment, which has been a major driver of the recovery in the past few quarters, will likely to show moderation in growth rates in 2007 as profit growth slows, interest rates rise and wage bills increase.   In late 2007, the prospects of tightening the depreciation rules under the planned corporate reform could provide a temporary boost to corporate investment spending.   Given that pricing power is still limited in many sectors it is also likely that companies will have to absorb a part of the VAT increase in their profit margins.   The downward pressure on profit margins will only be partially offset by a reduction in non-wage labour costs due to a cut in unemployment insurance contributions.   A 2.3% reduction in the contribution rate to the statutory unemployment insurance will further boost cost-competitiveness of German companies, I believe.   This along with the past wage moderation and still rapid labour productivity growth would act as boon against any further marked appreciation of the euro.

Internal tensions in the euro area could rise in 2007.   The further improvement of the cost-competitiveness of German companies vis-à-vis their euro area peers will likely cause economic and political tensions within the euro area to rise next year.   Germany’s unit labour cost dynamics have already been falling short of the euro area average by nearly 20 percentage points over the last 10 years, and the marked reduction in non-wage labour costs next year is likely to deepen the divide even further.  As a result, export market shares should develop further in Germany’s favour.   Some of the neighbouring countries, where domestic demand dynamics seem to have come off the boil as local house price momentum cools, might be looking at the combination of a cut in non-wage labour costs and a rise in the VAT as a new version of beggar-my-neighbour policies within a fixed exchange rate system.   While such concerns are understandable, in my view, they miss the key point:   the gales of globalisation.

German companies are not restructuring to take away market share from their French, Italian or Spanish competitors.   They are restructuring to survive in the face of low cost competition from Central and Eastern Europe and Southeast Asia.   As a high-wage country with above-average exposure to export destinations outside the euro area and a traditional capital exporter, Germany was the first to feel — and to react to — the gales of globalisation and their impact on the relationship between capital and labour seen in many industrialised countries.  Other euro area countries will need to follow sooner or later in the recalibration of the share of wages and profits in national income seen in Germany in the last few years.   But a potential rise in intra-euro area imbalances may also fuel political tensions within the European Union as long as governments remain in denial on how rapidly the global economy has changed already.

There can be no mistaking the risk of several negative factors causing a bigger than expected dent in German GDP growth over next 6–12 months.   These negative factors, potentially hurting the cyclical growth momentum by more than expected include a three-point VAT hike implemented in January as part of a considerable fiscal consolidation package, a more pronounced slowdown in export demand due to cooling trade growth and a stronger euro, the lagged impact of past increases in interest rates and bond yields, the proclaimed end of wage moderation propagated by trade unions, and the introduction of minimum wages muted by the government reducing incentives for companies to hire and invest in Germany.   On the positive side, the recent rebound in a number of sentiment indicators — such as hiring intentions for instance — suggest that the underlying momentum of the economy might be stronger than most forecasters (ourselves included) currently acknowledge.

In my view, the likely pullback in German GDP growth in early 2007 provides an opportunity to value-oriented investors to revisit the great restructuring stories in corporate Germany.   A combination of slower top-line growth, rising margin pressure and a stronger currency will reinforce the need for strict cost-control and capital discipline.   So make sure you have a list of best stock ideas handy when business sentiment starts to rebound.   Historically, it was when the Ifo business climate started to rebound that the more cyclical German stock market outperformed its European peers.  

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United States
A Tale of Two Tiers
December 15, 2006

By David Greenlaw | New York

Over the past few months, the two-tiered nature of US economic activity has become increasingly apparent.   The goods sector has displayed significant softness — primarily concentrated in the homebuilding and motor vehicle industries.   Meanwhile, the service sector looks to be cruising along at a healthy growth clip.   To be sure, the results of the Institute for Supply Management (ISM) surveys covering the manufacturing and service sectors in November highlighted the sharp divergence.   However, there now appear to be indications of a near-term bottoming in motor vehicle assemblies as well as a possible moderation in the pace of decline in home construction. 

The motor vehicle industry — accounting for about 3% of overall GDP — has certainly undergone a gut-wrenching correction over the course of 2006.   In an attempt to improve long-run profitability, low margin fleet sales have been pared and legacy costs have been written down.   The downsizing has been significant.   From 2002 to 2005, domestic vehicle production averaged 12.1 million units annually — with very little variation around that pace (specifically, output was 12.3 in 2002, 12.1 in 2003, 12.0 in 2004 and 12.0 in 2005).   Over the course of 2006, assemblies were cut to about an 11.0 million unit pace.  Based on the Federal Reserve’s seasonally adjusted data, the downshift in vehicle production played out gradually over the course of this past year.   Indeed, after troughing at 10.4 million units (annualized) in October, current assembly schedules point to sequential upticks in both November and December, followed by a flattening out in the first quarter of 2007.

Is such stabilization reasonable?   We think it is.   Our latest US economic forecast shows overall light vehicle sales (including imports) running near 16.1 million units in both 2007 and 2008.  This represents a further slowing relative to the 16.5 million units sold in 2006 and the 16.8 average pace recorded during 2002–2005.  Most importantly, current inventory levels appear to be in reasonably good shape.   Indeed, at the end of November, stockpiles were 3.5% below last year and the lowest for that particular month in the past five years.   So, with domestic production having been shaved by more than 1.0 million units relative to the 2002–2005 run rate and with sales likely to decline by a somewhat smaller amount — even after allowing for some pickup in imports — the industry appears to have already reached a production equilibrium.   Thus, the powerful economic headwind associated with the downshift in motor vehicle production may now be behind us.

One other quirk involving the motor vehicle sector deserves mention.   In 3Q, the statisticians at the Fed came up with a dramatically different estimate of seasonally adjusted motor vehicle output than seen in the GDP data.   Specifically, the Fed’s IP figures showed a sharp decline in assemblies — enough to subtract 0.6 percentage point from GDP growth.   Meanwhile, the GDP accounts showed motor vehicles adding 0.8 percentage point.  While there is always some divergence between these two measures, due largely to differing seasonal adjustment factors, the gap evident in 3Q is unprecedented.   We expect to see an offsetting swing in the respective measures in 4Q and have built this into our GDP estimate.   However, the Fed’s data series is cleaner and certainly fits much better with the widespread indications of a significant pullback in vehicle production during 3Q.   Down the road somewhere, we wouldn’t be at all surprised to see the Commerce Department revise its motor vehicle data in a manner that brings it into better alignment with the Fed series.

What about the other major identifiable headwind confronting the US economy — housing?   As my colleague Dick Berner laid out in a recent analysis, while there have been some encouraging signs of late — in particular, a noticeable upturn in weekly mortgage application volume — it is still far too early to call a bottom (see “False Dawn for Housing Demand?” December 8, 2006).  But, it does seem clear that progress is being made. The accompanying chart shows the NAR’s measure of housing affordability.   The affordability gauge is a relatively simple metric that can be used to help value the housing market. It’s based on only three variables: home prices, mortgage rates and median household income.  The higher the index the better — that is, a high reading implies high affordability and vice versa.  Over the course of much of the past decade, affordability remained elevated despite skyrocketing home prices.   Obviously, this was largely a reflection of declining mortgage rates.   Only in the past year and a half did affordability start to show signs of becoming increasingly stretched as home prices continued to rise as mortgage rates bottomed out.   By mid-2005, the affordability gauge was pointing to a fundamental misvaluation in the housing market.   And the market now appears to be undergoing a price correction that will eventually restore a reasonable degree of affordability.   Indeed, the figure shows historical data plotted through October with an extension of the series going forward based upon the following assumptions:   (1) a 5% decline in home prices over the next year, (2) steady mortgage rates, and (3) a trend rate of growth in household incomes.   In such a scenario, affordability is restored to an equilibrium level within a year or so.

Obviously, such an outcome does not necessarily mean that prices won’t go down by more than 5% in some markets.   As seen in the figure, while affordability in the West (dominated by California) is consistently more stretched than for the nation as a whole, a 5% price drop would not be sufficient to restore the index to its 1995–2005 average.   Indeed, certain regions of the country already appear to be experiencing significant price declines in response to severely stretched affordability.   But this is all part of the adjustment process.  As long as mortgage rates don’t rise too much, we expect the price correction nationwide to be roughly in line with that experienced in the 1990 episode.   In that instance, real home prices, as measured by the OFHEO index, declined by about 6% over a 1-year timeframe.

What would such a price swing imply for the consumer?  With the household sector’s holdings of residential real estate valued at a shade over $20 trillion as of end-3Q, a 5% decline in home prices would lead to about a $1 trillion loss of wealth.  Applying a standard wealth effect of .04 (that is, a 4 cent impact on consumer spending for every dollar of change in wealth), implies a $40 billion hit to consumer spending in a static sense.   This is significant, representing nearly 0.5 percentage point of consumer spending.   However, it actually pales in comparison to the potential short-run impact associated with the recent plunge in gasoline prices.   Through much of the spring and summer, the national average price of regular gasoline hovered around $3/gallon.  Over the past few months, the price dipped to about $2.25/gallon.   With gasoline and fuel oil accounting for 4% of overall consumer spending, such a swing in prices frees up roughly $90 billion of discretionary spending.  In our view, this is one factor — in conjunction with generally stimulative financial conditions — that has helped to prevent the spillover of the housing market correction to the rest of the economy.

Of course, the sharp drop in homebuilding activity experienced during recent quarters has been a major direct hit to the overall economy.   Indeed, our latest estimates suggest that Fed Chairman Bernanke was spot on when he indicated during a Q&A session following an October 4 speech that the decline in residential construction activity would shave about 1 percentage point from GDP growth during the second half of 2006.  However, as the inventory of unsold new homes begins to respond to the cutback in new construction, the drag on the overall economy from reduced homebuilding should begin to ebb as we head toward mid-2007.

Setting the stage for 2007 growth.   In sum, we appear to be at the end of a major correction in the motor vehicle sector and within a quarter or two of experiencing a deceleration in the pace of decline in residential construction activity.   This should set the stage for the economy to resume growth at (or even a bit better than) trend in the second half of 2007. 

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South Africa
Opportunities Galore
December 15, 2006

By Michael Kafe | London

We expect 2007 to be another year of opportunities in South Africa. Four major risk events to watch out for are (i) the South African Reserve Bank (SARB)’s first monetary policy meeting on 14 February; (ii) a peak in the inflation cycle during the first half of 2007; (iii) developments in the country’s current account deficit composition towards the middle of the year; and finally, (iv) the ANC’s party presidential elections in December.

The Macroeconomic Dynamics

This week, we took a final look at our macroeconomic forecasts for 2007. We revised our 2006 GDP growth number from 4% to 4.9%, thanks largely to historical data revisions by Statistics South Africa, but we have kept our 2007 forecast unchanged at 4.3%.   Quite importantly, we look for consumption growth to slow down to 4.5% by the end of next year, as the 200bps of tightening seen earlier this year takes its toll on consumers. Also, Gross Domestic Capital Formation (GDFI) will likely decelerate from 13.8% in 3Q06 as private investment slows, but should remain above 8% — supported in large measure by investment spending under the government’s capital expenditure program.  The external sector is also likely to show some improvement, with the current account deficit coming in only marginally above 5% of GDP as exports see some volume growth, thanks to capacity enhancements, and as the import bill sees moderate relief from low oil prices. Finally, a continuation of sound fiscal management will likely result in a government budget surplus in 2007.  With the government already sitting cash-flush, we expect central government borrowing to shrink. Positive sentiment here could place a cap on bond yields.

Curve Normalization (Bull Steepening) in 2007

With the above scenario in mind, we do not see justification for any further rate hikes in 2007. However, the market is still pricing in a 50bps rate hike in February. We would seriously regard this as an excellent trading opportunity to receive ZAR rates. We look for the SARB to be on hold for the greater part of the year, and expect it to consider easing no earlier than December 2007. But if our view on declining oil prices and benign food inflation in H2 2007 is correct, then the market could start discounting prospects of easier money long before it actually happens. Importantly, therefore, we expect the next big move in South African interest rates during 2007 to be a normalizing yield curve (bull-steepening).  Timing the move is always tricky, but one should consider looking for entry opportunities from as early as February/March 2007 (i.e., just before inflation peaks).

Positive Metamorphosis in Current Account Mix

Another important thing to watch is the external accounts. In 2007, although lower oil prices will no doubt take some pressure off import spend, we expect the country’s import bill to remain under pressure as the government’s capital expenditure program kicks off in earnest. The government plans to spend R372bn on infrastructure over a three-year horizon. With the first year already behind us, it is clear that it will need to step up its act in 2007.   This means we could see some huge increases in capital imports over the course of next year, particularly given that the import penetration ratios for some of the projects (especially railways and ports) are as high as 40–60%.  The bigger question though, is, will the market still penalize South Africa for running a current account deficit that is in excess of 5% of GDP as it did in 2006?   Or will the switch in the current account mix, from consumption goods to capital goods that have positive implications for the country’s growth trajectory placate the market?  Also important is the funding of the deficit. Will the huge net outflows that were reported on the FDI line of the capital accounts this year continue into 2007, forcing further downward adjustments in the currency?

Morgan Stanley’s view is positive on both counts. We expect the market to become more sympathetic as it gets its mind around the composition of the current account deficit. We also expect the haemorrhage in FDI to dry up next year as local companies slow their foreign acquisition drive, and as private equity inflows gather steam. At the same time the ‘sweeter’ carry in the interest rate market as South African rates rose in the second half of 2006 should continue to attract more offshore portfolio inflows. Against this background, we have revised our outlook for the Rand, and are now looking for no more than 6.5% depreciation next year — down from 8% previously.

Risks:

As always, however, there are some risks. For 2007, we think the biggest risk is politics. This is not because we think South Africa is headed for a political stalemate — as a matter of fact, there is no shortage of able leadership in South Africa. Even so, we think that uncertainties surrounding important political events could send some jitters through the market.

First is the ANC’s Economic Policy Congress in June: The market is likely to be concerned that the African National Congress (ANC) will give in to rising pressure from labour, particularly in the wake of the Jacob Zuma saga. We don’t think they will.

Second is the ruling ANC party’s presidential elections in December: The elected president of the party will in all likelihood become the next president of the country following national elections in April 2009. Key issue of concern here would be whether the left succeeds in pushing ousted deputy president Jacob Zuma into the top seat.

Third, an appeal by Zuma’s alleged accomplice-in-crime was dismissed in November 2006, thereby opening the way for the National Prosecution Authority (NPA) to reinstitute corruption charges against Zuma.   A re-opening of the case will likely be resisted by the trade unions, and union attempts to either challenge the validity of the charges or to influence the outcome of his trial could send wrong signals that upset the currency markets.  Conversely, and perhaps more importantly, any reluctance on the part of the NPA to pursue the case could also be viewed negatively by the international community.

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Global
Dr. Jekyll and Mr. Bond
December 15, 2006

By Joachim Fels | London

Jekyll and Hyde  Following the ‘conundrum’ of low long-term yields during 2005 despite rising US short rates, global bond markets staged a (reverse) ‘Jekyll and Hyde’ performance during 2006, pretty much as I envisaged in my 2006 outlook piece a year ago (The Passing of the Batons, 8 December 2005).  A sell-off during the first half of the year gave way to a powerful bond rally during the second half when the Fed paused and the signs for an economic slowdown in the US started to accumulate.  As a consequence, the US 10-year Treasury yield now trades around 4.5%, only slightly higher than a year ago, but some 80 basis points below the peak of mid-2006.  However, gazing into my crystal ball, I visualize a bearish scenario for the G3 bond markets in 2007, with yields moving back to, and possibly above, the temporary highs of last summer. 

Three main drivers.   In thinking about bond markets, I continue to focus on what I consider the three main medium-term drivers of yields: (1) the economic cycle and (2) inflation expectations, which together shape expectations of future central bank policy rates; as well as (3) the global liquidity cycle, which I suspect has been a key factor influencing the recently vanishing ‘term premium’ in bond yields (see also M. Pradhan, The Term Premium: A Puzzle Inside a Riddle Wrapped in an Enigma, in this issue).  Here are my assumptions and expectations for how each of these drivers will develop in 2007. 

A global mid-cycle slowdown, but no recession.  I assume that the global economy entered a mid-cycle slowdown during the second half of this year that will become more apparent during the first half of 2007.  While this is qualitatively consistent with our global economic team’s forecast of a slowdown in global GDP growth from 5.0% this year to 4.3% (see Stephen Roach’s Global Transitions for details), I agree with Steve that the risks to this number are on the downside.  Importantly, however, I assume that the slowdown won’t lead into recession, but will give way to a second leg of this expansion, albeit milder than the first leg in recent years, starting some time during the second half of 2007.  A crucial assumption here is that the US slowdown remains temporary and largely bottled up in the housing sector, as our US economics team expects (see Richard Berner and David Greenlaw. It’s a Growth Recession, Not a Lasting Downturn, 11 December 2006).  If so, at some stage next year, investors will likely revise significantly upwards their expectations for the path of the Fed funds rate in 2008 and beyond.

… with Europe disappointing and Japan surprising.   Looking elsewhere, I envisage the euro economy disappointing the upbeat consensus expectations, but Japanese growth surprising on the upside in 2007.  Japanese monetary policy is still very accommodative and the yen is super-competitive.  Meanwhile, even though there may be a nascent pick-up in potential output growth in the euro area reflecting past corporate restructuring efforts and labour market reforms, cyclical growth is likely to be hit by the removal of monetary stimulus over the past year, fiscal tightening in Germany and Italy, and the trade-weighted appreciation of the euro.  As a consequence, while I’m outright bearish on all the G3 bond markets, I do expect euro area bonds to outperform US Treasuries and JGBs in the sell-off, reversing their underperformance of the last six months or so.

Sticky inflation.    While my view that this is a mid-cycle slowdown (though possibly a sharp one) rather than the onset of recession is in line with mainstream thinking among investors, my view on inflation isn’t.  As I see it, market- and survey-based inflation expectations are too low and are likely to be revised up in the course of next year.  The most likely trigger will be higher-than-expected actual inflation rates in the US and, possibly, Europe.  One reason is that, in my view, the US economy is experiencing a structural slowdown in productivity growth, following a ten-year acceleration in trend productivity in response to the IT revolution, as US companies have now reaped most of the productivity-enhancing benefits of this revolution.   Thus, labour costs per unit of output will rise more rapidly and potential output growth will fall.  Moreover, the rise in the profit share to multi-year highs in the US and Europe suggests that some wage pressures are likely to emerge, supported by a growing consensus in society and political circles that workers should get a “fair” (read: higher) share of national income.  Break-even inflation rates do not fully reflect these risks, and so I expect inflation linkers to outperform nominal bonds in 2007.

Tighter global liquidity, higher term premium.    The experience of the last few years suggests that, even if short-rate expectations are revised up due to, say, higher inflation expectations or a better growth outlook, this need not translate into a rise in long-term bond yields, because this might be offset by a decline in the term premium.  (Recall that the term premium is usually defined as the gap between the expected average short-term interest rates over the lifetime of a bond and the yield on that bond.)  Most estimates suggest that the term premium has declined significantly in recent years (see J. Fels and M. Pradhan, Fairy Tales of the US Bond Market, 26 July 2006).  While there are several competing explanations for the vanishing term premium, I continue to think that global excess liquidity, created by central banks around the world due to overly expansionary policies, is the main culprit. 

While the Fed and the ECB are no longer expansionary on our measures, the Bank of Japan is still at the pump, and perhaps even more important, other Asian central banks along with their peers in the Middle East, Russia and Latin America are still flooding bond markets with excess liquidity as they recycle their growing external surpluses.  Excess liquidity is unlikely to drop sharply in 2007, but it should become tighter at the margin.  The Bank of Japan is likely to raise interest rates at least twice next year.  Thus, G3 excess liquidity is likely to tighten further, at least until the Fed starts to cut interest rates.  Moreover, with the global slowdown unfolding, Asian external surpluses will grow less rapidly or even shrink, and lower commodity and oil prices resulting from the slowdown would reduce producers’ revenues.  Thus, Asian, Middle Eastern and Latin American central banks would have less fresh money to recycle into global bond markets, and so, somewhat paradoxically, weaker global growth would push bond yields higher.

Market outlook for 2007.   I expect a combination of a global mid-cycle slowdown, re-emerging inflation concerns, and tighter global liquidity to push bond prices lower during 2007.  In each of the G3 countries, I expect 10-year bond yields to climb towards and possibly break above their temporary highs reached in mid-2006 — 5.25% in the US, 4.15% in the euro area, and 2% in Japan.  Investors should brace themselves for steeper yield curves and consider buying inflation protection.  Euro area bonds should outperform US Treasuries in the bear market, as the upbeat expectations about European growth are likely to be disappointed.  And with liquidity getting less plentiful and bond yields expected to rise significantly, risky assets will have a tough time repeating their stellar performance of recent years.  Exit Dr. Jekyll, enter Mr. Hyde!

 

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Japan
Buy Mr. Abe on Dips
December 15, 2006

By Robert Feldman | Tokyo

I think PM Abe will be an effective reformer, although the signs may be hard to read.   His agenda is market-oriented and supported by the public.   He has the political skills and support to push this agenda.   Equities, the yen, and real estate should benefit from more reform.   The rise of interest rates and yields will be modest, in light of low inflation and falling fiscal deficits.   The main risk is complacency, in public and corporate sectors.

First, it is important to recall the reality of the Koizumi years, not the rose-colored memory.   There were many compromises along the way to reform.   Second, PM Koizumi was continuously bashed by the media and resisted by anti-reformers in his own party.   So will it be with Mr. Abe.   Mr. Koizumi had the philosophy and fortitude to persist.   So does Mr. Abe.

The real problem — efficiency.   Japan’s efficiency agenda remains unfinished.   The one and only solution to demographic and fiscal problems is higher productivity.   This applies to both public and private sectors, and requires more policy push on public sector reform, technology, and resource reallocation.

The public wants reform, and has voted for it.   Investors want higher earnings, both from corporations and from fixed-income investments.   The only path to such higher earnings is higher efficiency.

Growth philosophy — rising tide to 4% GDP growth.  Thought leaders in the ruling party have an agenda to address these issues, the Rising Tide Theory.   They are pushing for greater innovation, more flexible labor markets, a tight fiscal/loose monetary policy mix, and fair income distribution.   The result, they claim, would be nominal GDP growth of 4%, with only 1% inflation — i.e., 3% real growth.

So far, opponents of the Rising Tide Theory have only been able to criticize, not offer alternatives.   Thus, the Rising Tide theory is winning the public debate.

Execution — ambition versus disappointment.  That said, the political economy of execution has a key contradiction.   To achieve lofty goals, one must set ambitious targets.   On the other hand, falling even slightly short of targets typically generates sharp criticism.   Thus, setting ambitious targets undercuts the credibility needed to achieve the targets.   The only answer is to stick firmly to policies, and appeal to the public on the basis of the outcome.   PM Koizumi was a master of this.   He never achieved 100% of his goals, but even 70% was major progress.   The public rewarded him at the polls.

PM Abe has taken up the challenge.   He has defined an ambitious agenda in education, innovation, tax reform, labor reform, pension reform, trade reform, medical reform, and other issues.   He has created competition between task forces in the PM’s office and the bureaucracy.   If anything, the press is criticizing him for not being tough enough, which only strengthens his hand.   Facing an election next July, even foot-draggers in the LDP will be forced to go along.

Japan’s efficiency agenda remains unfinished.   The public wants reform, and PM Abe has defined an ambitious agenda.

Market implications.  For markets, more successful reform means positive surprises for growth and an end to deflation.   Both near-term and long-term earnings are likely to beat expectations.   This combination implies that equity prices and the yen should be strong, and that real estate will continue to recover.   Yields should rise, but modestly, due to progress on fiscal consolidation.

The big risk — complacency.  If market pressure on government and board rooms is ignored, then Japan’s future is dim.   Fortunately, such pressure seems to be working.   “What will foreign investors think?” is the mantra among both domestic investors and government officials.   For this reason, “buy on dips” seems like sound advice for those concerned about PM Abe’s commitment to reform. 

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UK
Benign Central Case Belies the Risks
December 15, 2006

By David Miles and Melanie Baker | London

We end 2006 with the economy and financial markets having had another decent year. GDP has risen consistently and, for the year as a whole, at marginally above what we estimate is the trend rate.  Interest rates — in nominal and especially in real terms — remain low, and the exchange rate has been relatively stable on a trade-weighted basis, though on a more volatile upward path against the dollar. Unemployment has edged up but so has employment, while stock prices and house prices have moved higher over the year.   But inflation ends the year substantially higher than at the start of the year, and we expect it to rise a little further early in 2007.   There is a real risk that this triggers an acceleration in wage settlements; if RPI inflation is close to 4% in the spring, then no change in the pace of earnings growth would mean stagnant real incomes.   Zero real wage growth is not implausible — in fact it is quite likely.   But there are obvious risks that wage rises move up and interest rates are increased to reduce the chances of above target inflation becoming persistent.   Even without interest rate rises, house prices look vulnerable in the UK.  However, we are not convinced that falling house prices — themselves likely at some point — need trigger a sharp slowdown in consumer spending.  

Central GDP projection: solid but lacklustre

Our central projection for the UK economy is for solid, but slightly sub-trend, growth in 2007.  After 2.6% real GDP growth in 2006, we project 2.3% in 2007 and 2.5% in 2008.  This forecast, however, embodies two key assumptions.  First, potential growth has not risen and does not rise significantly; second, export-weighted global growth slows (very moderately).  On the first, we assume that the pace of immigration seen in the UK since 2004 does not continue at quite such a high rate and that productivity growth remains rather disappointing.  There has been no sign of any increase in the rate of productivity growth in the UK in recent years — indeed, the evidence, if anything, is to the contrary.  On the second, our global economics team regards risks to the global outlook as skewed to the downside.

Components of GDP growth: a sluggish consumer

We continue to think that consumer spending will not pick up significantly in 2007, keeping overall growth subdued.  Household savings still look on the low side, debt levels and debt service levels remain high, and risks are skewed to the downside in the housing market.  Arguably, the low volatility environment we’ve seen in the UK over the past decade may have helped sow the seeds for a more volatile period ahead.  Less fear of sharp gyrations in the economy has likely been a factor behind households building up very high levels of debt (which may leave the economy less able to weather shocks, such as a sharp move in interest rates or deterioration in the labour market, in 2007).  With slower global growth, investment spending growth may decline a touch and the contribution from net exports may be marginally negative.  Against that backdrop, growth slightly below the pace of 2006 seems likely to us in 2007.

Inflation: risks on the upside

In our central forecast, we see year-on-year inflation rising into the turn of 2006 before gradually declining towards 2.0% (the Bank of England’s target).  We believe it is likely that GDP growth runs slightly below potential in 2007 and that current upward pressures on inflation, from factors including electricity and gas bills, diminish and then fall out of the year-on-year comparison.  However, two main factors suggest that inflation risks lie more on the upside than the downside of that profile: 1) we think there is little spare capacity in the UK economy; and 2) wage increases may become more inflationary.  So far, wage growth has been very benign, but a number of factors are coinciding at an important time for wage negotiations (the turn of the year).  These give us some cause for believing that wage growth risks are on the upside across a range of sectors and job types.  First, RPI inflation (more important in wage negotiations than CPI) is likely to rise towards 4.0% year on year by the beginning of 2007; second, the minimum wage rose 5.9% in October 2006; third, discretionary income (the amount of money households have left after paying taxes and energy bills and after debt repayments) has been squeezed, which may persuade some to push hard for higher wages; and fourth, profit growth has been relatively strong in the UK in 2006.

Interest rates: on hold with upside risks

With a central profile of around trend GDP growth and inflation remaining above target, but gradually declining over 2007, our central (single most likely) scenario is that interest rates remain on hold throughout 2007.  However, with inflation risks still on the upside, we think that the risks to this profile for rates are skewed more in the direction of further rate rises rather than further cuts.   Bond yields, however, end the year at levels that seem to imply little chance of interest rate increases of all but the most minor and temporary sort.   Given that situation, we believe that gilts will move lower (yields move higher) in 2007.  Equity prices seem more fairly to reflect risks and stock market valuations are more robust to the impact of a possible pick up in inflation and interest rates.

Politics: Continuity, despite changes

Tony Blair looks set to step down as Prime Minister some time in the first half of the year — probably close to the 10-year anniversary of his leadership in May.   It is overwhelmingly likely that his successor will be Gordon Brown, who will inherit a substantial parliamentary majority and who will, as a result, be under no pressure to call an election.   (There need be no election until 2010 so, in principle, the new Prime Minister will have almost three years before needing to face opposition parties at the polls; in practice, it is likely that an election is called before 2010).   Since Brown has been in charge of the overall direction of economic policy for several years, the thrust of fiscal and monetary policy — including the policy of simply ignoring the option of adopting the Euro — looks set to continue.   The strategy on spending and taxing will continue to be one where expenditure rises only marginally above 40% of GDP.   But that will be a very tough strategy to implement — particularly with the 2012 Olympics approaching and significant infrastructure spending still required.   Keeping overall government spending contained may prove very tough.

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United States
CPI - A Shocking Development
December 15, 2006

By David Greenlaw | New York

There have certainly been bigger market movers in recent years, but Friday’s CPI report was one of the most shocking data releases in memory.  The reason -- unlike employment numbers or retail sales data -- the CPI figures tend to exhibit very little month-to-month volatility. In fact, a forecast miss of 0.2 percentage points on the core CPI is about a two standard deviation event. To put it another way, over the past 10 years, the core CPI outcome has been 0.2 percentage points higher or lower than the consensus on only 8 occasions (or 6.7% of the time).  Most importantly, when such a surprise does occur, it is almost always traceable to a big move in a single volatile component -- such as tobacco or hotel rates. In this case, there was no such sole special factor responsible. And, to top it all off, the big downside surprise in November followed on the heels of a notable -- although not quite as large -- downside surprise in October.

Friday’s report was particularly shocking from another standpoint. Mathematically, it is virtually impossible to get a 0.0% result for the core when the shelter category, which accounts for 41.7% of the core, is up 0.4%. Yet that is exactly what happened in November. As seen in the accompanying figure, the core CPI excluding shelter was -0.2% in November -- the lowest reading in the 40-year history of the data.

From our standpoint there are three possible explanations for the sharp deceleration seen in the core CPI over the past two months.

1)  The data are correct and should be taken at face value. Core inflation experienced a significant run-up in the first nine months of the year (rising from around +2.0% to a +2.9% yr/yr rate in September) and we are now simply seeing a rapid unwind, reflecting the pullback in energy prices and a weaker economy.  Of course, the problem with this story is that the transmission from energy prices to consumer prices is hardly instantaneous. It takes at least a few months -- if not a few quarters -- for this chain of events to play out. Moreover, while economic growth has slowed, labor markets remain very tight and cost pressures -- even after taking into account the latest revisions -- continue to edge gradually higher. We assign about a 20% probability to this scenario.

2)  The October and November data reflect statistical quirks that will be unwound in relatively short order.  While there was no single special factor responsible for the much lower than expected core CPI results over the past couple of months, some of the categories that played important roles simply do not seem to square with reality. Two obvious such items are motor vehicles and air fares. Automakers have pared production dramatically over the course of 2006 so that they could discount less -- not more. Indeed, vehicle inventories at the end of November were at their lowest level for that particular month in the past five years -- hardly a recipe for a stepped-up pace of price cuts. Meanwhile, airline industry load factors remain quite elevated and industry pricing data simply do not support the notion that there have been sizeable fare reductions of late. It’s certainly conceivable that we will see a sharp rebound in vehicle prices and air fares along with a flattening out of apparel prices and a continued escalation in OER over the course of coming months. This could put us right back at a +2.9% yr/yr rate by February. We assign about a 35% probability to this scenario.

3) Finally, it’s quite possible that the October and November data merely reflect an unwind of some quirks which had temporarily elevated the core CPI readings in the first three quarters of the year. In other words, both the prior up moves and the down moves of late have merely reflected statistical noise. Core inflation has actually been holding fairly steady all along. One possible culprit in this scenario is inadequate seasonal adjustment. Interestingly, in both 2004 and 2005, the core CPI experienced a run-up in the early part of the year followed by significant deceleration later on. While this seems to us to be the most likely scenario -- we assign it a 45% probability -- there are still plenty of unanswered question. Specifically, while a seasonal bias may be evident in the data over the past few years, the swings in both 2004 and 2005 are almost entirely attributable to big moves in a single volatile category -- hotel rates. And, there does not appear to be any sign of such a seasonal bias in the core CPI for the 10 years or so prior to 2004. 

In the end, only time will help tell us which one of these scenarios best explains the swings in the core CPI over the course of 2006.  In the meantime, it seems reasonable to assume that the inflation picture is not as scary as previously feared. However, with labor markets still tight, with productivity showing signs of some modest cyclical slowing, and with energy prices remaining quite elevated relative to a few years ago, it would be wrong to assume that inflation risk has disappeared entirely.

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Global
Looking to 2007
December 15, 2006

By Stephen Roach | New York

Our baseline forecast points to a sustained global expansion through 2008.  After expanding at a 4.8% average pace over the 2003-06 period — the strongest four years of global growth since the early 1970s — we are forecasting a modest downshift to 4.3% in 2007.  Such an outcome would be well above the 45-year growth trend of 3.7%, suggestive of a global economy that is coming in for a classic soft landing.  Our first cut for 2008 calls for a fractional re-acceleration to 4.5% global growth. 

The global downshift in 2007 should be broad-based.    The US and Europe are expected to lead the deceleration in the developed world, and a slowing of Asia ex Japan stands out in the developing world.  In the US, we expect a housing-related “growth recession” to persist through 1Q07, with important knock-on effects for export-led economies heavily dependent on US demand — especially China, Mexico, Canada, Japan, and other Asian economies tied to China’s supply chain.  China’s progress in cooling off an overheated investment sector should provide another impetus to the coming global downshift. 

The risks are on the downside of our 2007 global soft-landing scenario.  As post-housing-bubble adjustments begin to play out in the US, the risks of spillovers to other sectors — especially personal consumption and business capital spending — are especially worrisome.  Lacking in support from private consumption, the rest of an export-dependent world could be surprisingly vulnerable to a US growth shortfall.  Pro-labor political shifts in the US, Germany, France, Italy, Spain, Japan, and possibly Australia could shift the pendulum of economic power from capital to labor — raising the risks of trade frictions and earnings pressures that could prove quite problematic for world financial markets.

This is the final issue of the Global Economic Forum for 2006. We hope that the following 36 dispatches will provide you with ample food for thought as you ponder the outlook for the world economy and financial markets in the coming year. We will resume regular publication on Tuesday, January 2, 2007.  Our very best wishes for the Holiday Season.

Morgan Stanley Global Economics Team.

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Italy
Flickers of Light
December 15, 2006

By Vladimir Pillonca | London

For the first time in a decade, there are positive signs of change, and a medium-term improvement of Italy’s macro performance is becoming a more concrete possibility. We are finally witnessing two crucial changes from Italy’s policymakers: 1) acknowledgement that Italy has serious long-term economic problems; and 2) willingness to tackle these problems.  For example, the government has reduced the huge debt burden and liberalized key sectors of the economy, ranging from banking to the retail sector, as outlined in the recently made effective Bersani Decree.

Provided the current government coalition holds, the next few years could provide the foundation for higher future economic growth. The beginning of the legislature is the ideal time to push on with reforms, some of which will be painful in the near term. This will likely diminish popular support for the government in the short term, raising political uncertainty.  But not only will supply-side reforms be instrumental in raising Italy’s sustainable longer-term growth, they will also make the reduction of Italy’s enormous debt burden a more manageable task, increasing the longer-term attractiveness of investing in Italy.

Flickers — not sparks

Italy’s economic growth has been strong this year, following a decade of chronic macro underperformance: GDP growth averaged just 1.4%Y in 1995-2005, compared with 2.1% in the euro area and 2.8% in the UK.  Reversing Italy’s persistently negative growth differential will take time — but an improvement relative to its own recent history is becoming a more concrete possibility. The government’s initiative to liberalize services is an essential step toward strengthening the services sector, while encouraging competition.  Encouraging competition in the services sector should help to reduce Italy’s exposure to the internationally competitive and volatile manufacturing sector.  This is also an important step toward boosting potential growth, and one of the reasons why we are positive on Italy — provided the reform effort intensifies.   

Clever consumers avert recessions

Next year marks an important test for the Italian economy: a significant degree of fiscal tightening takes place domestically, while a VAT hike becomes effective in Germany, a key export market for Italian firms. In principle, next year’s fiscal tightening could trigger a recession and could have a particularly adverse effect on consumption. However, we expect consumers to behave in a forward-looking rational way, and to look through the temporary phase of higher fiscal pressure, and lower economic growth in 2007, in anticipation of higher economic growth in 2008 and beyond.  The expectation of higher growth in the future could strengthen if the reform effort gathers pace, underpinning confidence.  Consumers don’t typically allow their consumption to fluctuate as much as their income; instead, they smooth their consumption expenditure over their life cycle, even when their income falls temporarily. It is the longer-term expectation of the future stream of income that tends to dictate consumption patterns.  This explains why the volatility of consumption is normally much lower than that of consumers’ disposable income.  Hence consumer spending could hold up relatively well next year, while the savings ratio falls slightly, though admittedly there are downside risks to our central consumption forecasts.  Besides, the payroll tax wedge will be cut by five percentage points next year, which should help to insulate consumers’ take-home pay from income tax increases, which will mostly affect higher-earning individuals and holders of financial assets.  Finally, we expect annual CPI inflation to decline to 1.7% in 2007, while nominal wage growth is unlikely to edge much lower than 3.0%Y, implying approximately a 1% gain in real wages.

Credit deepening and corporate awakening

Households’ access to credit has improved in recent years, and loan-to-value (LTV) ratios have risen.  Italy’s mortgage debt/GDP ratio has increased from 10% in 2000 to 17.2% by the end of 2005.  But even so, consumers’ mortgage debt/GDP ratio remains relatively low at 17% in Italy, compared with 52% in Germany and 80% in the UK. Rising interest rates might slow credit deepening in the near term, but we think this process has further to go in Italy over the medium term. On the corporate side, our tentative impression is that the restructuring process is at a barely nascent stage, and is more likely to start with the larger corporates.  We expect fixed investments to rise in line with GDP growth in 2007, and to pick up appreciably in 2008. M&A activity has the potential to extend beyond the banking sector, but stringent labour protection laws suggest that the restructuring process is likely to be a slow-moving phenomenon.  If reforms do progress, the corporate environment should improve, and the room for improvement is large.

Bumpy outlook ahead — but no crashes in sight

A sharper US or global slowdown than we expect would imply downside risks to our central euro area forecasts. In our central case, GDP growth in the euro area slows from 2.6%Y this year to 1.9%Y in 2007, before picking up again in 2008. Next year’s slowdown also reflects fiscal tightening in Germany and Italy, the lagged effects of higher interest rates and a strong euro.  In Italy, we forecast GDP growth to slow to 1.1%Y in 2007 from 1.8%Y this year.  This projected slowdown would amount to a robust performance by Italian standards, especially given the significant degree of domestic fiscal tightening, while Germany’s VAT hike will likely curb demand for Italian exports.  So, we expect net exports to be neutral on growth next year, after adding to GDP growth in 2006.  While fiscal tightening should be enough to push the budget deficit down to 3.0% of GDP next year, it won’t be enough to position Italy’s massive stock of debt on a lasting downward path.  For this reason, fiscal policy is likely to remain tight beyond 2007. 

Risks and alternative scenarios

While the above discussion focused on a central scenario, there are two representative alternative scenarios worth highlighting:

i) Negative scenario: Fiscal hangover cracks fragile recovery

Under this scenario, consumption growth slows in 2007, reflecting the impact of an effective increase in tax pressure.  The VAT hike in Germany in 2007 reduces demand for Italian exports in 2007, while a strong euro has an adverse effect on many Italian firms’ fragile competitive position.  Any combination of these factors could advance Italy into yet another phase of low growth or even an outright recession.

ii) Optimistic scenario — a low probability event

Under this scenario, a series of coincidences would have to materialize simultaneously: i) GDP growth remains significantly above trend across the euro area, particularly in Germany, despite the VAT hike, while global and US growth defy expectations of a slowdown; ii) much lower energy prices result in significantly lower inflation, underpinning households’ purchasing power much more markedly than in our central case; and iii) a sharp drop in consumers’ savings ratio, as consumers significantly increase their debt levels.  The probability of these events occurring concurrently is very low, in our view.

Distribution and assessment of risks: Our central GDP growth forecast is closer to the positive case than the negative scenario, but there are many risks on the horizon, coming from multiple directions.  Political instability could thwart the reform effort, fiscal policy could have more of a restrictive impact than we anticipate, and a persistently strong euro could undermine the fragile competitive position of many Italian firms, especially in the manufacturing sector. Overall, we feel risks are skewed to the downside of our central forecast for economic growth.

A more in-depth report on Italy’s outlook is available: See “Flickers of Light at the End of the Tunnel,” December 2006.

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Global
The Term Premium - A Puzzle Inside a Riddle Wrapped in an Enigma
December 15, 2006

By Manoj Pradhan | London

Sir Winston Churchill may well have been mistaken for a market strategist talking about the term premium rather than the foreign policy of the former Soviet Union.   Bond yields and term premiums have stubbornly refused to come off their lows in spite of rising policy rates, strong growth and rising inflation.

The enigma: Why are bond yields so low? Will they stay low?   Our proprietary model MS-FAYRE suggests that US 10-year Treasury yields should be at 5.5% — a whole 100 bps above their current levels (Fels and Pradhan, Fairy Tales of the US Bond Market, July 2006).   If historical relationships are still valid, then the 17 increases in the fed funds rate and rising inflation expectations should have led 10-year rates higher.   In this sense, 10-year rates have stayed too ‘low’, well below the fair value predicted by MS FAYRE and models of other researchers.   The fact that the 10-year rate has stayed flat despite the tightening of monetary policy led ex Fed Chairman Greenspan to dub the enigma of low bond yields a “conundrum”.  

A direct implication of the conundrum is that some factor(s) must be exerting downward pressure on the 10-year rate equal in magnitude to the upward pull from the factors included in fair value models.

Yield curves in the US and euro area have flattened dramatically since mid-2004, with the 10y-30y segment flattening more than the 2y-10y flattening would warrant.   This is about the time that pension funds started buying long-dated bonds to cover the shortfall in duration from their liabilities.   As the bonds with the highest duration at the end of the curve get richer, demand shifts to earlier points on the curve, with yields falling in inverse proportion to the duration of the bond.

Asian central banks have accumulated reserves far in excess of import requirements.   Given the risk profile of these institutions, government securities in the US and Europe have been obvious destinations without much sensitivity to the price.   Their sustained presence in bond markets is likely to have kept bond yields low (see Mutkin, Guzzo, Pradhan, Dec. 2006). 

The impact of these factors also has implications for the estimates of term premiums from quantitative models.

The Riddle — Why has the term premium fallen?   Will it stay low?   The term premium estimated from the FAYRE model and from the model of Fed researchers Kim and Wright (2005) are highly correlated even though they use very different methodologies (see Fels and Pradhan, July 2006).   These robust estimates suggest that the term premium has fallen since the 1980s as part of the Great Moderation, and has stayed close to zero during the 'conundrum' period.   What accounts for such low term premiums, and will they continue to stay so low?

The potential solutions to the 'conundrum' may partly explain why the estimated term premium has been pushed so low.   These recent forces have pushed bond yields lower than they would have been otherwise.   What remains beyond the effect of the standard factors, i.e., the term premium, will be a much lower number than would have been the case.

However, the term premium riddle is not so easy to solve.   The term premium can itself fall for fundamental reasons, taking yields lower with it.   Thus, we are left with a ‘signal extraction’ problem:   did yields fall because of special factors, or did they fall because of a decrease in the term premium?   The answer probably is a bit of both!   The term premium on the 10-year Treasury rate has been very well correlated with the MOVE index, an index of implied volatility on options on Treasuries.   Intuitively, lower volatility in the market for Treasury securities implies investors will receive lower compensation for the reduced uncertainty, pushing term premiums and yields lower.   The decline in volatility is at least part of the answer to the riddle of the low term premium.   Finally, if interest rate volatility and the term premium are related, then volatility coming off its lows could mean a similar movement in the term premium and yields.

The Puzzle — Why has volatility fallen? Will it stay low?  The correlation between interest rate volatility and the term premium leaves us with a final puzzle:   What could have moved interest rate volatility to its current lows, and what could a trigger a rebound?   Implied volatility on interest rate options tends to reflect periods of uncertainty regarding interest rate decisions, macroeconomic events or technical factors.

There are indications, however, that the current bout of low volatility can be attributed to a much-talked-about and less easily defined force — excess liquidity coupled with increasing integration of financial markets.   The intuition behind excess liquidity can be extended to refer not just to the easy availability of credit and loose financial conditions, but also to the willingness to use these conditions to enter into leveraged positions seeking returns.   This 'search for yield’ has led investors from asset class to asset class, bidding up prices and sustaining investor interest in spite of adverse news and events.   The willingness to take on and maintain positions has made prices less pervious to shocks and news, i.e., it has lowered volatility across asset classes.   As a result, spreads have compressed and implied volatility measures across interest rates, equities and currencies have moved to near-historic lows together.

However, if excess liquidity is reason enough for volatility to plunge, then its withdrawal should be reason for it to surge. Even though some measures of excess liquidity suggest a withdrawal of liquidity is at an advanced stage, no tell-tale surge in volatility has taken place as yet to confirm this link.

Excess liquidity is difficult to define and equally difficult to measure.   Metrics that view excess liquidity via its price (i.e., interest rates) or its quantity (measures of money stock) may provide different answers.   Quantity measures of excess narrow money in the G5 set of countries suggest that liquidity is no longer excessive (see Fels, Turn of the Liquidity Cycle, May 2006) . However, measures for broader definitions of money don't give the same answer, suggesting that financial conditions may still be easy.   While our proprietary natural rate of interest models suggest that interest rates are at neutral in the euro area and above neutral in the US, this is definitely not the case in Japan or even China.   Another proprietary measure of G-10 interest rates relative to their long-term mean (Stephen Jen, Charles St-Arnaud, Aug 2006) suggests that interest rates still have a distance to go to reach ‘normal’ levels.   The upshot is that there are indications of a broad-based withdrawal of liquidity from the world economy, but this withdrawal has not yet become ubiquitous.  

With US rates unlikely to push below neutral, and most other central banks looking to normalize interest rates (i.e., bring them in line with neutral rates), it seems but a matter of time before the withdrawal of excess liquidity shows up in most metrics, and most importantly in the availability of credit and the attitude of investors.   The end of easy financial conditions in 2007 could put the puzzle together, sending volatility higher.   Term premiums may follow, solving part of the riddle.   Finally, the increase in term premiums would take yields higher, providing at least partial relief from the 'conundrum' of low bond yields. 

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China
Liquidity, Liquidity, Liquidity
December 15, 2006

By Denise Yam | Hong Kong

Liquidity trends appear to have dominated the discussion of macro outlook for the Greater China economies of late.  The relationship between liquidity and each economy has rather different characteristics, and we offer a descriptive account of each of them in this note.

China— managing excess liquidity.  The Chinese government has been claiming success in macro tightening, reporting slower economic activity in response to administrative controls in the last few months.  However, China has not yet resolved the fundamental problem of excess liquidity from the large trade surplus and capital inflows.  The cost of capital remains too low, leaving the economy vulnerable to a revival in overheated and speculative investment.  Recent PBoC rhetoric has shifted the policy focus to liquidity management, through lifting reserve requirements and/or issuing bonds.  In 2006, the PBoC has hiked interest rates twice and raised reserve requirements on Renminbi deposits three times.  Meanwhile, issues of central bank bonds have been kept up to absorb liquidity from the banking system.  However, these measures have not been enough to offset the supply of liquidity from the balance of payments surplus.

Each percentage-point increase in the reserve requirement supposedly locks up Rmb320 billion of banking system liquidity.  However, financial institutions' deposits with the PBoC totaled Rmb3.8 trillion at the end of September, already covering 11.6% of total deposits, exceeding the requirement.  In other words, the "required" ratio of 9% has not been a binding constraint on liquidity.  In fact, subsequent to the sharp increase in reserve deposits in 4Q03 following the first tightening move (August 2003), which brought loan growth down effectively over 4Q03-2Q04, the actual reserve ratio has again drifted downwards since early 2005, allowing or possibly contributing to the reacceleration in loan growth.

Because the reserve requirement has not been a binding one, the total achieved sterilization (increase in actual reserve deposits and central bank bonds outstanding) has fallen short of the intended sterilization (increase in required reserves and bonds) as well as the BoP surplus.  The BoP surplus of US$207 billion in 2005 met with only a US$146 billion (71% of the surplus) increase in reserve deposits and bonds.  In 2006, sterilization remains incomplete, at 76% in 1H06 (US$122.1 billion BoP surplus vs. US$92 billion achieved sterilization) and worsened to 59% in 3Q06 (US$46.8 billion increase in FX reserves vs. US$27.4 billion sterilization).  The unsterilized surplus since 2005 therefore totaled US$110 billion.

Quantifying the impact of sterilization against the BoP surplus helps explain why the monetary tightening measures so far have not been sufficient to lift the cost of capital meaningfully, which we believe is vital in discouraging wasteful fixed investment.  The bond issuance program has been far from aggressive in recent months, suggesting that the PBoC remains reluctant to lift interest rates significantly.  We believe that this incomplete sterilization underpins the friendly liquidity environment in China, leaving lending, investment and overall economic activity vulnerable to a rebound.  Although government policy continues to target slower growth, ample liquidity amid incomplete sterilization of the expanding BoP surplus should limit the harshness of the deceleration.

Hong Kong — enjoying liquidity inflows, but wary of volatility.  Liquidity conditions and asset market performance have a strong influence on real economic activity in Hong Kong.  The influence has further stepped up this year on the back of the increase in large-size listings of Chinese enterprises in the Hong Kong stock market.  The HK$-denominated financial asset base has grown significantly, powering monetary expansion far ahead of economic growth.  Capital inflows, absorbed by the banking system in the form of an expanding net foreign asset position (US$25 billion over the 12 months ending Oct-06), have resulted in a downtrend in the HK$ loan-to-deposit ratio, and lower HK$ interest rates (against their US$ counterparts) in recent months, further supporting asset market valuations and gains. 

The expansion of Hong Kong’s financial asset base in the last few years has been driven by China’s increasing appetite for international capital.  The performance of the asset markets is not so directly representative of Hong Kong’s domestic economic fundamentals, but ironically has become the driver of monetary conditions and economic sentiment.  Stock market capitalization has surged to HK$12.1 trillion, more than 8 times GDP.  In other words, each 1% rise or fall in the stock market represents an amount equivalent to 4% of broad money M3, or 8% of GDP. 

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

The imminent crossing of the RMB/US$ and HK$/US$ exchange rates upon further RMB appreciation has lifted expectation that the HK$ will follow.  We sympathize with the psychological impact of the RMB breakthrough on the HK$, but believe it will prove to be temporary.  We believe that the expanding HK$ financial asset base is the dominant factor behind the current low interest rate environment, meaning that low interest rates could be sustained even beyond the speculation for HK$ appreciation subsides.  While we are reluctant to make purely speculative forecasts on further deviation of HK$ interest rates from their US$ counterparts (hence sustained strength in asset prices), it is quite possible that anomalous monetary conditions sustain for even longer.

Taiwan— reliant on foreign liquidity.  Amid sluggish domestic demand and continuous outward investments by local enterprises and individuals, asset markets in Taiwan have been supported by loose monetary conditions, made possible by the accommodative stance of the central bank, the current account surplus, and sustained foreign interest in Taiwan’s financial assets.  Balance of payments trends clearly demonstrate Taiwan’s increasing dependence on external demand and foreign portfolio investment.  The persistently large current account surplus, likely to reach 6% of GDP in 2006, reflects the output gap amid structural weakness in domestic consumption and investment.  In the financial account, Taiwan has been a net exporter of direct investment capital, totaling US$10.7 billion since 2004 and US$20.7 billion since 2001.  Portfolio flows, on the other hand, are characterized by local investors investing increasingly abroad but partially cushioned by foreign investments in Taiwan equities.  Foreign portfolio inflows totaled as much as US$13 billion in 4Q05, buoyed partly by the MSCI re-weighting, but these have been offset by accelerated outbound investments by locals since 2004, leaving the overall financial account barely in balance since 2004.  The overall balance of payments surplus since 2001 has contributed a great deal to the easy monetary conditions in Taiwan and the recovery in asset prices.  Ample liquidity in the banking system has kept interest rates low.  Rates are low even at the long end, with the 10-year government bond yield hovering around 2% at present, keeping financial assets afloat even amid a weak domestic economy.

Nevertheless, easy monetary conditions and low rates should not be assumed indefinitely.  Foreign capital inflow is a crucial factor in the current delicate monetary balance.  Monetary conditions, and, hence, asset prices, are extremely vulnerable to an abrupt turnaround in foreign portfolio flows.  The size of and swings in short-term capital flows have increased significantly in the past decade amid increasing global financial integration.  Quarter-on-quarter swings in short-term capital flows could be as great as 20% of GDP and could be extremely destabilizing for financial markets.  Needless to say, measures to slow the pace of capital exporting by local investors or even encourage repatriation of earlier outflows would be ideal, although the unfavorable political climate and business uncertainty prior to the drawing up of a concrete roadmap governing cross-strait exchanges are to be blamed for the persistence of the outflows at present.  Fortunately, in Taiwan’s favor is the buffer of excess liquidity stored in NCDs (outstanding NT$3.74 trillion, or US$113 billion), which the central bank can release to the money market to maintain accommodative conditions and low interest rates in the face of unfavorable capital flows.  Moreover, the US$260 billion-strong foreign exchange reserves provide an additional shock absorber.

The 2007 outlook for all the three Greater China economies is very much dependent on global liquidity trends.  The correction in commodity prices and apparent taming in inflation expectations have caused markets to expect a more dovish monetary policy stance from the major central banks.  Specifically, our US economists now believe that the Fed is done with tightening, and easing could kick in as soon as 2H07.   Nevertheless, it would still be irresponsible to deny the growing risk of a contraction in global liquidity that could have a greater impact than in the past.  Upside surprises to inflation continue to haunt the industrialized world, heightening risks of further tightening.  In the much-feared scenario of global stagflation, investment fund flows to emerging markets will unlikely avoid an adverse turnaround, drying up funds for China’s investment, and forcing asset prices to correct in Hong Kong and Taiwan.

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Egypt
The Dangers of Overheating
December 15, 2006

By Serhan Cevik | London

Egyptis a prime example of liquidity-driven growth stories around the world.   The Egyptian economy has grown at an accelerating pace in recent years, as real GDP growth surged from an average of 4.4% in the 1990s and 3% in 2002 to 6.9% in the 2006 fiscal year.   The authorities expect even faster economic expansion, reaching 7% in the current fiscal year and 7.5% in 2008.   Tiger on the Nile?   We do not think so.   There is no denying the fact that exchange-rate flexibility, albeit limited, and bureaucratic reforms played a role in jump-starting the engines of growth, but Egypt’s staggering performance is mainly a result of expansionary macroeconomic policies and the global liquidity injection.   Consequently, the euphoria surrounding the country’s elevated growth trajectory could easily subside if the global economy goes through an abrupt and painful adjustment phase.   Indeed, our econometric analysis of growth dynamics in the Middle East and North Africa region suggests that Egypt’s vulnerability to a US-led slowdown is not insignificant and has become even more pronounced in the last five years (see When Atlas Sneezes, October 25, 2006).   This is not a surprising finding, since the Egyptian economy has benefited tremendously from the recycling of petrodollar liquidity and therefore faces a greater risk.

The pace of output growth has reached the overheating territory, in our view.   Real GDP growth increased to an annualised rate of 7.2% in the first quarter of the 2006-07 fiscal year — the fastest rate of expansion in the last two decades. Though data-related problems make it difficult to estimate Egypt’s potential growth rate, around a 2% increase in labour productivity and less than 1% growth in total factor productivity suggest that the current rate of expansion is well above the sustainable rate of growth. Furthermore, the latest figures confirm that the leading engines of growth are still the natural gas industry and the construction boom, fuelled by expansionary policies and petrodollars from oil-exporting countries in the region. Unfortunately, the nature and composition of growth put the Egyptian economy more at risk of overheating and hard landing at a later stage.

Signs of unsustainable, liquidity-driven growth are already visible.   When an economy’s productive capacity lags behind the rise in aggregate demand, consumer price inflation would eventually start rising.   And this is exactly what is happening in Egypt.   The year-on-year inflation rate has already surged from 3.2% at the end of 2005 to 11.8% in October 2006.   Even if we ignore the downward bias in official statistics, inflation is already beyond the price stability range and presents a significant risk to stability.   ‘One-off’ factors (such as the adjustment in fuel subsidies) may explain part of the increase in inflation, but we believe that there are more important, fundamental factors behind overheating in the economy and the resulting inflation pressures. One of the root causes of the unbalanced, inflationary growth is the expansionary mix of fiscal and monetary policy.   The Central Bank of Egypt increased interest rates by 50 bp, to 8.5%, in November, but the policy stance remains overly expansionary.   With negative real interest rates, it is not surprising to see the inflationary boom, especially when the country’s budget deficit hovers around 10% of GDP.

Fiscal imbalances are a source of inflation and a threat to sustainable growth.   Despite some encouraging steps in the last couple of years toward creating a better business climate, policymakers have failed to tackle fiscal imbalances in a meaningful way.   The budget deficit narrowed marginally from 9.6% of GDP in 2005 to 8% in the 2006 fiscal year.   But, contrary to the consensus view, we do not see this as a sign of success, since it is entirely due to a cyclical revenue increase.   In our view, the continuing rise in expenditures from 30.5% of GDP in 2003 to 33.5% last year keeps the quality of fiscal performance low.   As a result, with an expanding debt stock, the central bank’s monetary claims on the public sector keep growing at a dangerous rate.   And the resulting fiscal dominance in turn threatens economic sustainability and financial stability over the medium term.   This is why we are not comfortable with the ‘China of the Middle East’ story and argue that the extent of policy adjustments so far is not sufficient to bring the economy to a sustainable growth path.

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United States
Inflation Uncertainty
December 15, 2006

By Richard Berner | New York

Inflation appears to have peaked in September, and inflation risks seem to have moderated, as both inflation expectations and growth have cooled over the past few months.  For example, year-over-year “core” inflation measured by the CPI has declined by 0.3% in the past two months to 2.6% in November, and measured by the Fed’s preferred gauge, the personal consumption price index (PCEPI), it probably declined to 2.2%.  Surprising softness in a broad range of categories — motor vehicles, air fares, communication and apparel — yielded a flat core rate in November.

Adding to the good inflation news, longer-term inflation expectations calculated by the University of Michigan’s consumer canvass remain below their summer peaks, although they edged up to 3.1% in early December.  And distant-forward (5-year, 5-year) inflation compensation has moved down by 25 basis points from summer levels.  Together with slower growth, those factors prompted us to reduce slightly our baseline inflation forecast for 2007 to 2.4%, and to predict a steady monetary policy until late next year.  Is that inflation forecast now too high?

It could be, but before jumping to that conclusion, it’s worth remembering that there’s still considerable uncertainty over inflation measurement and key inflation determinants, and thus about the outlook.  That uncertainty will probably dominate the inflation outlook and thus the monetary policy debate in 2007.  Some officials legitimately take comfort from today’s well-anchored inflation expectations.  But as I see it, neither policymakers nor investors should take them for granted; today’s well-behaved readings could change and don’t guarantee that inflation will recede.  The commitment of monetary policy and possible policy action to assure that outcome is the missing link.  Thus the Fed’s policy bias may be slow to change.

There is, to start, uncertainty over the “right” measure of underlying or core inflation.  The two popular measures of core inflation both moved up over 2006, but the core CPI accelerated by 60 bp but core inflation measured by the PCEPI rose by only 0.1%.  The main culprit for the divergence: Shelter, which has twice the weight in the core CPI as in the PCEPI, took off with increased demand for apartments and a sympathetic response in the so-called owners’ equivalent rent category.  As these and other factors fade, these two metrics are converging.  In the three months ended in November, the core CPI rose at just a 1.6% rate, while the core PCEPI probably decelerated to 1.8%. 

Nonetheless, these data may exaggerate the inflation downshift.  We’re suspicious that some of November’s price softness may exaggerate reality or may not last.  In particular, motor vehicle discounting may ebb with inventories of new cars and trucks back to desired levels.  Moreover, while airlines may have passed on lower fuel costs to fares in recent months, load factors are high and anecdotal reports point to a recent rebound in fares.   And the unusual weakness in the communications category this month largely reflected a sharp drop in the price of internet access services — perhaps tied to recent price slashing by a major provider.

What’s more, there’s much less certainty over how to measure key inflation determinants and the model that links them to inflation.  What are those determinants?  The workhorse “markup over cost” inflation model has proven increasingly less reliable, courtesy perhaps of good monetary policy, globalization, and changes in firm pricing behavior.  Indeed my own analysis suggests that firms now price “to market,” setting prices based on conditions of demand and supply in global product markets. 

Both models do include three key elements, however: A measure of inflation expectations, a gauge of slack in the economy, and factors that “pass through” to underlying inflation, like changes in energy or import prices.  But it appears that the slack-inflation relationship has loosened over the past several years, and that the pass-through has also diminished.  This flattening of the so-called “Phillips curve” means that as slack dwindles, inflation may not rise as much today as it did in the past.  But it also means that the cost of bringing inflation down may have risen. 

Or has it?  The price to market model may help explain this phenomenon, as companies absorb costs, including currency swings more readily into margins.  But lower and more stable inflation expectations may also have shifted the relationship rather than altered its slope, so that empirical analysis must consider all these factors.  Indeed, recent studies show that inflation expectations may exert a “gravitational pull” on inflation so long as a credible monetary policy provides a “nominal anchor” for them (see Brian Sack and Joel Prakken, “Inflation Modeling,” Macroeconomic Advisers, December 13, 2006).  The pricing dynamics of such models are consistent with my price-to-market hypothesis.

Operationally, however, our inability to measure economic slack and inflation expectations with any precision also adds to inflation uncertainty.  Measures of slack in the economy, like the output gap, are unobserved, and the unemployment rate only measures slack in labor markets, not in product markets.  Some fear that potential growth has recently shrunk by as much as 1 percentage point to 2½%.  In my view, it has declined, but to about 3%.  In any case, that issue is a key source of today’s inflation uncertainty among policymakers and investors alike. 

Likewise, Fed Vice-Chairman Kohn recently noted that “the reliability and usefulness of the existing data [on inflation expectations] are less than we might like.”   And “inflation compensation measures are ‘contaminated’ both by an inflation risk premium and by differences in liquidity between the markets for nominal and indexed Treasury securities…and give only a sense of where inflation is expected to go, not why it is going there.” 

That statement highlights a risk in using market-based measures of inflation compensation as independent evidence on inflation expectations: Fed policies affect market prices, so breakeven inflation reflects the Fed’s own views.  Thus, Vincent Reinhart, FOMC secretary, opined in 2003 “to rely exclusively on market prices to inform policy decisions is like looking in a mirror” (“Making Monetary Policy in an Uncertain World,” August 28, 2003).  

But there is also a positive element to such market-based measures: They serve as barometers of the Fed’s commitment to keeping inflation both low and stable.  Fed officials can look to such measures as one barometer of their commitment to assure the right outcome.  But they are not the only such measures.  Richmond Fed President Lacker worries that three years of inflation running above the Fed’s presumed comfort zone will allow inflation expectations to drift higher.  In that context, the Fed’s tightening policy bias serves as a commitment to cap inflation, and a contingent signal for action if needed.

Given inflation uncertainty, inflation risks seem evenly balanced around our baseline outlook: A stumbling economy could reduce inflation faster than we think likely, while stronger growth that reduced product and labor-market slack would boost it.  In the spirit of the holiday season, however, it’s worth noting that one admittedly uncertain metric puts inflation well above the Fed’s presumed “comfort zone:” PNC’s Christmas Price Index.  According to the 22nd annual survey, the cost of the gifts in “The Twelve Days of Christmas” is $18,920 in 2006, a 3.1 percent increase over last year.  Even so, I’m most certain that the Fed’s tolerance for higher inflation than today’s is limited. 

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Global
From Globalization to Localization
December 15, 2006

By Stephen Roach | New York

On one level, there seems to be no stopping the powerful forces of globalization.  Not only has the world just completed four years of the strongest global growth since the early 1970s, but in 2006, cross-border trade as a share of world GDP pierced the 30% threshold for the first time ever -- almost three times the portion prevailing during the last global boom over 30 years ago.  What a great testament to the stunning successes of globalization!

On another level, however, there are increasingly disquieting signs.  That’s because of a striking asymmetry in the benefits of globalization.  While living standards have improved in many segments of the developing world, a new set of pressures is bearing down on the rich countries of the developed world.  Most notably, an extraordinary squeeze on labor incomes has occurred in the industrial world -- an outcome that challenges the fundamental premises of the “win-win” models of globalization. 

It is a great theory -- but it’s not working as advertised.  The first win -- that going to the developing world -- is hard to dispute.  China has led the way, with more than a quadrupling of its per capita GDP since the early 1990s.  Other developing countries have lagged the Chinese experience but have still made considerable progress in boosting living standards. 

The problem lies with the second win -- the supposed benefits accruing to the rich countries of the developed world.  And that’s where the going has gotten especially tough.  In recent years, the benefits of the second win have accrued primarily to the owners of capital at the expense of the providers of labor.  At work is a powerful asymmetry in the impacts of globalization and global competition on the world’s major industrial economies -- namely, record highs in the returns accruing to capital and record lows in the rewards going to labor.  The global labor arbitrage has put unrelenting pressure on employment and real wages in the high-cost developed world -- resulting in a compression of the labor income share down to a record low of 53.7% of industrial world national income in mid-2006.  With labor costs easily accounting for the largest portion of business expenses, this has proved to be a veritable bonanza for the return to capital -- pushing the profits share of national income in the major countries of the industrial world to historical highs of 15.6% in 2Q06. 

This asymmetry in the second win is not without very important consequences.  In days of yore -- when labor and its organized unions actually had bargaining power -- the current squeeze on labor income in the developed world would have undoubtedly resulted in some form of a “worker backlash.”  In today’s increasingly globalized world, however, workers have no such power.  But their elected political representatives most certainly do.  And there can be no mistaking the important shift that has recently occurred in the political alignment of the industrial world -- with the majority shifting from the pro-capital right to the pro-labor left.  Not only is that the case in the United States, but such a tendency is also evident in Germany, France, Italy, Spain, Japan, and possibly even Australia.

The stunning results of the recent mid-term elections in the US could well be the canary in this coalmine. A newly-elected Democratic Congress is about to find itself center stage in the battle between capital and labor.  The old Congress was quite transparent as to where it was headed in this regard -- having introduced, by our count, 27 separate pieces of legislation since early 2005 that would impose some type of punitive actions on trade with China.  The new Congress could go further -- not just on the trade frictions front but also in embracing additional elements of a pro-labor agenda.  In fact, newly elected Democratic leaders already have promised immediate passage of the first increase in the minimum wage in ten years.  In my view, these are just the early warning signs of a US Congress that is likely to be far more sympathetic to the plight of labor than it was in the past. 

Nor is America alone in tilting to the pro-labor left.  In France, the ascendancy of Ségolène Royal offers a modern-day mix of pro-labor politics with a protectionist bias.  Italy’s Prodi is also pro-labor, and in Spain, Zapatero is certainly more sympathetic to the plight of labor than Aznar was.  In Germany, Merkel has tilted increasingly toward labor after she nearly lost the election running on a pro-market reform agenda.  The new Abe government in Japan has teamed up with the center right in support of the “second chance society” -- attempting to make certain that the victims in the rough and tumble arena of global competition are given the opportunity to come back.  And in Australia, Kevin Rudd, the newly anointed opposition leader, seems set to center his platform on the struggle of the average worker.

I am not heralding the demise of globalization.  What I suspect is that a partial backtracking is probably now at hand, as a leftward tilt of the body politic in the industrial world voices a strong protest over the extraordinary disparity that has opened up between the returns to capital and the rewards of labor.  The extent of any backtracking is a verdict that lies in the hands of the politicians -- specifically, how far they are willing to go in legislating an effort to narrow this disparity. 

As the self-interests of nation-states become increasingly prominent, the pendulum of political power should swing from globalization to “localization.”  That would imply very different characteristics to the macro climate.  The most obvious -- wages could go up and corporate profits could come under pressure.  But it also seems reasonable to expect pro-labor politicians to direct regulatory scrutiny at excess returns on capital -- focusing, in particular, on the perceptions of excess returns in financial markets (i.e., hedge funds and private equity) as well as on the inequities of rewards at the upper end of the income distribution (i.e., tax cuts for wealthy citizens and the excesses of executive compensation).  Moreover, localization taken to its extreme could also spell heightened risks of protectionism -- especially if the global economy slows and unemployment starts to rise in 2007, as we anticipate.  Under those circumstances, inflation could accelerate, leading to higher interest rates, greater volatility in financial markets, and a potentially vicious unwinding of an over-extended credit cycle.  And, of course, the protectionist ramifications of localization could prove equally challenging for the beneficiaries of globalization’s first win -- dynamic new companies in the developing world and the employment growth they generate.

Don’t confuse prognosis with advocacy.  Many of these potential developments, especially a drift toward protectionism, are without any redeeming merit, in my view.  But this is what happens when trends go to extremes.  In free-market systems, the pendulum of economic power then invariably swings the other way.  An era of localization will undoubtedly have more frictions than the unfettered strain of capitalism and globalization that has been so dominant over the past decade.  The big question, in my view, pertains mainly to degree -- how far the pendulum swings from globalization to localization.  The answer rests with the body politic.  The repercussions lie in economics and financial markets.

 

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Australia
The Real Slowdown Starts
December 15, 2006

By Gerard Minack | Sydney

Australian growth slowed in 2006, but no one seemed to notice.  Next year should see the real thing.  We look for another year where the consensus will be surprised on the low side – and this time we think it will matter more to financial markets.  

First up, however, is one important caveat: I have never seen, in 25 years of watching the Australian economy, such hard-to-reconcile signals from the data.  There are three conflicts to note: first, between soft GDP and strong employment; second, the discrepancy between anecdotes of rising labour costs and official data which show wages slowing; third, the gap between softening top-down profit data and the ongoing strength in reported company earnings.  These conflicts mean that there is a greater-than-usual chance of important revisions to the data changing the starting point. 

Those conflicts also explain why the 2006 slowdown had no effect on investment markets.  Assuming a 0.5% rise in December quarter GDP, full year 2006 growth will finish at 2.4%.  This compares to the year-ago consensus forecast of 3.3% growth (the lowest forecast of 19 responses to a Bloomberg survey was 2.6% – I didn’t participate, but my forecast at the time was for 2.2% growth.)   Despite that growth undershoot, the RBA tightened by more than forecast, earnings were stronger than expected, and equity market returns were higher. 

There are three reasons to expect a material slowdown in growth in 2007.  First, the benefits of the commodity-price boom area starting to fade.  In particular, business investment – which has been the mainstay of growth through the past 2 years – seems set to make a negligible contribution to growth.  Exhibit 1 shows that the boost from investment is already fading.

Second, the drought looks set to directly knock ½-¾ percentage point from growth, with additional second-round effects.  Third, consumers will face the lagged impact of higher interest rates. 

These factors point to domestic activity falling to below-trend in the first half of 2007.  The big issue, however, is how the household sector copes with rising unemployment.  My view is that it won’t cope well. 

My pessimism on the consumer is due to concerns about the structural health of household finances.  Australian households continue to run a negative saving rate, are increasingly leveraged – with a rising share of highly-indebted households – and are facing a rising debt-service burden that is already at all-time highs.  

I have been wrong in the past to expect that these problems would spontaneously lead to the consumer rolling over.  Now, however, I think that there needs to be a trigger to bring these problems into play.  The obvious trigger is labour market weakness.  

In turn, the obvious trigger for labour market weakness is a softer economy.  As noted above, the discrepancy between GDP weakness and labour market buoyancy is unprecedented.  However, if GDP falls below 2% – as I expect next year – I think it’s inevitable that employment will follow.  Remember that the one undoubted positive for growth in 2007 – a pickup in the volume of mining exports – is a capital-intensive affair.  The mining sector accounts for around 1½% of total employment. 

The contentious part of my forecast is that a rise in unemployment would lead to a quite quick precautionary rise in the saving rate – pushing it back above zero.  That in turn would produce powerful second-round effects, as soft consumer spending would come on top of the other growth-damping factors in 2007. 

The big risk to my forecasts is that consumer spending does improve in 2007.   This would be possible if employment continues to defy the GDP slowdown, and if consumers get further tax cuts next year.  In addition, the six months to September has seen a revival in home equity extraction.  I don’t expect that to survive the most recent RBA rate increases, but I could be wrong.  If the consumer does pick up the slack left by the slowdown in business investment, then the outlook will be for close to trend growth – with commensurately less risk of material labour market weakness. 

The prospect of weak growth and rising household saving is a bearish combination for profits.  Australian corporates are now enjoying record margins.  In large part that’s been made possible by the fall in household saving, which has driven a wedge between consumer spending (which is sales for business) and wage income (which is a cost for business).  The related combination of slower growth and rising saving would inevitably put pressure on those margins, particularly for domestically related earnings.  As it is, the top-down (national accounts) measure of non-financial earnings has already slowed over the past year – not that this has been reflected yet in reported earnings (another one of those odd data discrepancies). 

The market implications from this economic outlook are fairly clear.  First, this is a setting where the RBA is more likely to be cutting rates than raising in 2007.  I expect that the first cut will come late in the first half of the year.  If the consumer proves to be as vulnerable as I expect, there will be more rate cuts in the second half of the year. 

Second, the prospect of lower rates will undermine a key support for the A$.  However, our global team is also forecasting a softer US$, which may moderate the A$’s decline against the greenback.  Expect, however, significant losses on the cross rates.

Finally, it seems to me that corporate earnings are likely to fall well short of consensus forecasts next year.  However, the degree of that downside – and the actual performance of the market – will depend in part on the performance of global asset prices.  Rising asset prices are now providing an important source of earnings support for several sectors of the market.  If our global strategists are correct and equity market P/Es rise next year, then the Australian market may be able to cope with downgrades.  But if the mood in global markets sours – and asset price cycle turns – then the Australian equity market could see substantial decline in the second half of 2007. 

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Israel
Missing Piece
December 15, 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 post 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 to4.6% 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 strong human capital endowment and entrepreneur capacity.

 

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Europe
The ECB's Balancing Act
December 15, 2006

By Elga Bartsch | London

So far, tightening monetary policy in the euro area was easy.   Coming from a record low of 2% for its main refinancing rate, the ECB Council was unanimously in favour of a gradual withdrawal of monetary stimulus over the last 12 months.   Throughout the first year of the new ECB interest rate cycle, inflation and GDP growth forecasts were steadily upgraded providing arguments for nudging interest rates higher.   Money markets and ECB watchers, by and large, anticipated the future course of ECB action correctly thanks to a set of code words signaling the timing of the next move.   Financial markets took the ECB’s tightening campaign in stride.   The common currency grinded higher only gradually, with the brief exception of a more rapid rise in late November.   Yields of longer-dated government bonds hovered in a trading range between 3.5 and 4.0% for most of the year.   The next 12 months are likely to demand a much more delicate balancing act from the ECB, in our view.

We expect the ECB to hike interest rates further in 2007 — in the light of GDP growth at or above trend, ongoing robust job creation, and rapid money and credit growth.   We forecast a total of 50 bps of ECB interest rate hikes by December 2007.   This compares with market expectations of slightly more than 25 bps.   A total tightening of 50 bps would constitute a noticeable slowdown in the pace of tightening compared with the ‘every-other-meeting’ pace pursued in the second half of 2006.   The much more gradual tempo of tightening reflects the fact that the ECB would be pushing the refi rate towards the upper end of the neutral range, which we estimated to be between 3.5% and 4.0%.   Even though the inflation outlook isn’t showing significant pressures at present, the risks remain tilted to upside, in the view of the ECB.   This perception was emphasised again in the December press conference.   Even though that press briefing gave conflicting signals with regard to the timing of the next move, we still believe that the most likely timeframe is March.   But by stating that it “monitors risks to price stability very closely” — a phrase that in the past indicated that the next rate hike was only two meetings away — February is a possibility too.

Against this backdrop of further ECB tightening, we expect ten-year Bund yields to rise from the current 3.76% level and eventually break markedly above 4% in 2007.   Demand for long-dated bonds, a moderation in nominal GDP growth and pre-emptive monetary policy action will likely limit the rise in bond yields at the far end of the yield curve though.   As a result, would not even rule out a renewed inversion of the yield curve in the next 6–9 months.   When the spread between the ten-year Bund and two-year Schatz briefly dipped into the red in November, investors debated whether this would signal a recession.   This debate could resurface if the spread would move into negative territory again.   Historically, the yield curve has been the most reliable leading indicator for recessions.    But a number of factors distorting the long-end of the bond market suggest that the message is less clear today (see Debating the Yield Curve, November 25, 2005 by our Global Economics and Strategy Team).   These factors range from pension fund demand, central bank buying, compressed term-premia to excess liquidity and/or a savings glut.

The discussion about the ECB’s appropriate policy stance — both within the Governing Council and outside — is expected to become much more controversial in the coming year than it was in the year just ending; for the following reasons:  First, at a refi rate of 3.5% euro area short rates are getting closer to the neutral level, which we would deem to be between 3.5% and 4.0%.  While there was broad agreement that the bank should gradually take its foot off the monetary accelerator, whether it might need to push interest rates towards the restrictive end of the neutral range (or even higher) will likely be debated much more heatedly.   The ECB itself uses a broader concept than just the short rate to assess the stance of its monetary policy.   The rapid rate of expansion in monetary aggregates is one of the reasons why it is still regarding its monetary policy as accommodative.   Second, the euro economy is likely to enter into a phase where risks to growth are tilted to downside and risks to inflation to the upside.  The combination of moderating real GDP growth and intensifying inflation pressures always makes an awkward mix for a central bank.   This also holds for a central bank that — like the ECB — gives precedence to inflation concerns.  

Third, the ECB might find its policy decisions getting more than the usual amount of unsolicited advice from politicians as France heads for a presidential election, as domestic demand growth cools, and as the currency strengthens.   While an independent central bank is unlikely to pay much attention to such broadcasts, this does not make its task any easier, especially in communication with the public at large.   Fourth, the two pillars of the ECB monetary policy strategy — the broad-based inflation outlook and the monetary analysis — might soon send diverging signals.   The persistent, strong expansion of monetary aggregates will likely continue to signal upside risks to price stability even after the broad-based inflation outlook stopped signaling such risks.   Strong money supply growth caused the present tightening campaign to start earlier.   It could also cause it to last longer (see EuroTower Insights: The Meaning of Money, November, 13, 2006).   Finally, the uncertainty about the near-term economic outlook seems to be on rise at present.   The unknowns include whether the US economy will be able to avoid a hard landing this winter, whether the German economy will be able withstand a three-point VAT hike, and whether financial market volatility could show a renewed rise.

A year of challenges.  To sum up, the year in which the euro area will welcome its thirteenth member — Slovenia — is likely to hold several challenges for ECB policymakers as the bank’s refi rate approaches the neutral level.   Hence, discussions about the appropriate policy stance both within the Council and outside will likely liven up.   After a year of successfully micro-managing money market expectations by using a standard set of code words (see EuroTower Insights: Too Much Communication?, May 19, 2006), ECB Council members might start to send much more mixed messages in 2007 as the bank attempts to delicately balance a number of different factors.

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Sweden
Hot or Not?
December 15, 2006

By Thomas Gade and Elga Bartsch | London

The land of positive surprises
The economy of Sweden has expanded at impressive rates during recent years.   Going forward, we expect a gradual slowdown in GDP growth from 4.5% this year to 3.3% in 2007, and slowing further to trend growth of 2.6% in 2008.   On our forecasts, the Swedish economy continues to outpace that of the euro area.   The risks to growth are on the upside, we believe.   Inflation on the favourite Riksbank’s measure, UND1X, will likely remain subdued throughout the forecasting period and head above the official 2% inflation target towards the end of the forecast period only.   On our baseline scenario, a combination of continued withdrawal of monetary stimulus by the Riksbank, gradual strengthening of the Krona, as well as a cyclical slowdown in productivity growth will weigh down on growth.   Meanwhile, the lowering of income taxes as announced in next year’s public budget proposal will likely sustain private consumption growth going forward.   In our baseline case we continue to expect a gradual normalization in house price appreciation.   However, the increasingly stretched housing market remains a significant risk factor.   The second key risk will once again be developments in productivity growth. We expect a gradual slowdown in productivity growth, but we wouldn’t rule out further upside surprises.

Withdrawal of stimulus, but a change in pace
With nominal GDP growth likely at around 5.7% this year, the current monetary policy rate of 3.0% remains quite expansionary and well below neutral, we estimate.   The period of very accommodative monetary policy has been one of the main drivers of demand, we believe.   Throughout 2007 we expect the Riksbank to continue withdrawing monetary stimulus at a gradual pace.   Depending on the future developments in consumer price inflation and house price inflation, we expect the Riksbank to continue towards a neutral rate, which we estimate to be around 4.5%.  From the end of 2007 and onwards, we expect the Riksbank to continue removing monetary stimulus, but at a lower pace.

Inflation on both the CPI and less so the UND1X measure will be constrained through 2007 by a series of politically induced one-off effects.  These one-off effects will unwind in 2008 and inflation should rise.  UND1X inflation continues to be the favourite Riksbank measure.  This could possibly create slight pitfalls in monetary policy going forward, since UND1X and the formal CPI target measure will continue to diverge.   The latter, which is important for inflation-linked bonds, does not strip out interest payments on mortgages, while the UND1X measure does, so the two will likely continue to diverge as the monetary policy tightening continues.   The key risk factors next year for the Riksbank will be the outcome of the large rounds of wage negotiations, productivity growth, and developments in house prices and household debt.  Wage demands and the possible outcome (although still high) already seem to settle slightly below our expectations of 4% on average, so the key risk factor for inflation will once again be productivity growth, we believe.

The all-important productivity growth

The recent period of high GDP growth and subdued inflation in Sweden has been largely driven by a high rate of productivity growth.   Should higher productivity growth remain sustained, Sweden could be in for several years of above-trend growth.   Meanwhile, wage growth has been high in an international context in recent years and looks likely to remain on the high side for the next three years.   This is indicated by initial wage demands set out before the large 2007 wage negotiations.   A subdued rate of growth in unit labour costs (ULC) and inflation will be contingent on a continued high rate of productivity growth.   Should productivity growth slow as we are expecting, then growth in unit labour costs will be on the rise (See Sweden Economics: The 2007 Wage Negotiations - Expectations and Implications, Nov. 21, 2006).

More specifically, we expect cyclical productivity growth to slow going forward as hiring and employment pick up.   Structurally, productivity growth is benefiting from a growing ICT sector and capital deepening associated with the use of ICT equipment in other sectors from an early stage.   The Swedish economy has enjoyed both a higher capital-to-worker ratio as well as a relatively higher degree of ICT penetration.   In this way the Swedish economy resembles the US economy.   Efficiency gains from capital deepening may raise the productivity level permanently, but boost productivity growth only temporarily.   Thus productivity growth will likely abate as the efficiency gain from the use of new technology starts to level off.   However, structural productivity growth need not necessarily slow going forward provided there is ongoing innovation in ICT equipment.   Nevertheless, other regions, particularly the euro area, in which capital deepening started at a later stage, may start to catch up and experience higher productivity growth and lower ULC growth going forward.   Thus there is a risk that the competitive position of the Swedish economy could slip going forward.

Potentially a poisonous cocktail for exports

The key factor needed for controlling growth in unit labour costs (ULC) is a sustained high rate of productivity growth.   In particular, as the preliminary wage demands suggest, the 2007 wage negotiations will likely result in wage growth somewhere around the expected 4% on average over the three years traditionally governed by the wage contracts.   Should wage growth rise by half a point on average from the previous years’ level and productivity growth slow to around 2%, unit labour costs could rise by 2.5% in the years ahead.   Add to that a potential strengthening of the trade-weighted exchange rate (TWER) of 4% in 2006 and about 1% in 2008, as projected by our currency economists, and this combination has the potential of significantly hampering export growth and manufacturing and service sector revenue and profits in the years ahead.

Bottom line - Hot or Not?
The answer is: it depends. It depends on productivity growth. The Swedish economy is likely to slow, while staying above trend and above Europe.   Domestic demand growth will be sustained by private consumption growth as disposable income will see a significant rise due to lower income taxes and higher employment.   Investment spending growth will likely continue due to high capacity utilization, but the investment spending momentum may slow as the Riksbank continues to withdraw monetary stimulus, we think.   Indeed, demand-driven growth appears likely to stay hot.   Inflation will gradually creep higher as we expect cyclical productivity growth to slow.   However, we cannot rule out further positive surprises in productivity growth.   Should that be the case, Sweden may once again be in for high growth and low inflation.

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Central Europe
Continuing Progress on the Path to Convergence
December 15, 2006

By Pasquale Diana | London

For Central Europe, 2006 was another year of strong growth, with GDP growth surpassing analysts’ expectations across most of the region.   For next year, we expect a benign outlook for Eurozone growth and supportive domestic demand dynamics to bode well for continued above-trend growth in the region, with the exception of Hungary, where growth looks set to slow dramatically due to the fiscal package.

Poland: strong fundamentals to support the zloty and cap monetary tightening

Across the region, Poland is probably the country that enjoys the most favourable fundamentals. Investment-led growth has raised the country’s growth potential and inflation has remained well under control. Continued fiscal discipline should lead to a narrowing of the budget deficit (from around 4% of GDP this year to 3.7% next year), and the current account, whilst likely to widen on the back of strong import growth, should remain capped at around 3% of GDP, mostly financed by net FDI. Whilst politics are likely to remain shaky, our base case is that the PiS-led coalition will hold together and there will be no early elections. With this backdrop, we believe that the pressure on the zloty will be to appreciate, and we see EUR/PLN trending towards 3.65 by end-2007.

On the monetary policy front, the NBP is expected to come under pressure to raise rates as early as Q1, as inflation rises above 2% due to base effects and some regulated price adjustments. However, we would argue that the scope for rate hikes is quite limited, as a strong zloty and favourable base effects should keep headline inflation below the 2.5% target. In addition, we note that the end of Balcerowicz’s term as Governor of the NBP (he will be replaced by the less known Mr Sulmicki) in January 2007 is likely to result in an even more dovish skew on the board. Our outlook is for Polish rates to rise at most 50bp in H107, and then hold at 4.50% for the rest of the year.

Hungary: fiscal progress to pave the way for rate cuts in H22007

After many years of seemingly unstoppable fiscal profligacy and a dismal track record of missing budget targets, Hungary seems to finally have embarked on a credible path of fiscal consolidation. A large dose of fiscal tightening should drive the fiscal deficit down from over 10% of GDP this year to around 7% of GDP next year. The impact on growth will be large, though some degree of consumption smoothing should cushion the effect on household consumption. We expect overall GDP growth to slow from this year’s 3.8% to just over 2% in 2007, and see the current account deficit narrowing by nearly two points, to 5% of GDP.   While Hungary’s imbalances remain large, we believe that what will drive markets next year will be recognition that the country’s fundamentals are at last improving. For this reason, we are constructive on the HUF, which we see appreciating to around 245 against the euro by end-2007.

In terms of interest rates, large increases in regulated prices should push inflation up sharply in Q12007, to around 9%. We expect this spike to keep the NBH on edge, and perhaps to trigger another hike, to 8.25%. That said, with growth and inflation slowing during the course of the year and the fiscal numbers showing signs of improvement, we believe that the second half of the year will be characterised by rate cuts. Also, we note that the departure of some hawkish MPC members from the MPC will likely further increase the number of doves on the Council. We see Hungarian official rates at 7% by end-2007.

Slovakia: advancing steadily towards the euro

Following a rise in headline inflation, a bout of SKK weakness and euro-unfriendly comments by the new SMER-led government, Slovakia’s chances of meeting the Maastricht criteria looked seriously in danger earlier this year. However, a drop in oil prices and renewed SKK strength have dramatically improved the country’s chances of meeting the inflation criterion, which in our view was (and remains) the most challenging. In addition, a relatively conservative 2007 budget and a favourable fiscal starting point imply that the chances of keeping the deficit below 3% of GDP in 2007 are good.

The National Bank of Slovakia increased official rates by 175bps in 2006, in an effort to tighten monetary conditions to rein in inflation. We believe that the combination of higher rates and a firmer SKK (currently roughly 10% stronger than the ERMII parity) have tightened monetary conditions sufficiently and that the NBS will refrain from hiking again. In addition, a sharp improvement in the current account due to auto exports coming on the market should keep the market biased towards SKK strength in the quarters ahead (we expect an exchange rate of 33.5 against the euro by end-2007), which would also support disinflation. It is worth bearing in mind that more pronounced SKK appreciation might even test the lower end of the +/-15% ERM2 band, with the NBS forced to intervene or revalue the central parity, or even cut rates.

Czech: economy still in good shape despite lack of leadership

The June elections delivered an inconclusive outcome, with both factions winning exactly 100 seats. To date, no cabinet has yet been able to gain a confidence vote in parliament, and early elections look like the only sensible way out (other than a German-style grand coalition between centre-right ODS and the Social Democrats). Meanwhile, the economy has shown no sign of weakness yet, with growth on track to be around 6% this year and to slow down marginally to 5.5% next year, still above potential. While the growth outlook is positive, we note that, in contrast with the rest of the region, there are signs of fiscal slippage. The 2007 budget envisages a deficit of CZK91bn, up from this year’s upwardly revised target of 83bn. In ESA95 terms, the deficit next year could be as high as 4% of GDP. Note that, unlike in the rest of the region, the Czech Republic still has to approve the pension reform, which will add to the deficit in the short-medium term.

On the policy front, the CNB has raised rates twice in 2006, to 2.50%, in response to fears about the inflationary consequences of expansionary fiscal policy and possible second-round effects from hikes in regulated prices, which will take place in 2007. With inflation currently already tracking 0.5% below the latest CNB estimates, we believe that the CNB will not hike again until March at the earliest. In total, we believe that a favourable growth-inflation trade-off will limit the scope for hikes to 50bps next year.

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India
Beyond the Cyclical Boom
December 15, 2006

By Chetan Ahya | Mumbai

Unusually strong growth cycle.  India has achieved strong economic growth of 8.2% over the past three years versus 6.2% in the preceding ten years.  This compares with average economic growth of 10.3% for China and 5.3% for Emerging ASEAN countries in the past three years.  Although we believe that some acceleration is warranted due to structural factors, the greater part of growth has been a result of the sharp rise in capital flows in response to an increase in the global risk appetite.  The global liquidity spillover into India has allowed the government to pursue relatively loose monetary and fiscal policies, which have supported the acceleration in cyclical growth.

Structural story – an interplay of three macro factors.  The interplay of three key macro factors – demographics, reforms and globalization – justifies a gradual speeding up in India’s pace of growth.  India’s age dependency has fallen (the share of the working population in the total has risen), from 64% in 2000 to 59.6% in 2005, and is likely to continue to drop, to 55% by 2010 (according to United Nations’ forecasts).   The government’s implementation of gradual but progressive reforms has improved the utilization of the working-age population, a key resource.  Finally, a backdrop of strong globalization has enabled growth in job opportunities to accelerate.  India’s exports are expected to rise to 21% of GDP as of 2006 from 12.6% as of 2000 (based on our estimates).

Cyclical story – facilitated by low global real rates.  We believe that India has witnessed an unusually loose monetary policy over the past few years.  The genesis of this has been the large capital inflows into India (and emerging markets in general).  Cumulatively, over the past three years India has received capital flows of US$72 billion versus US$28 billion in the preceding three years.  Low real interest rates globally and the consequent rise in risk appetite have driven this disproportionate increase in capital inflows into India.

With a weak supply-side response, India’s absorption of liquidity for investment has been less than optimal, resulting in excess liquidity.  Over the past five years, households and the government have lapped up this liquidity, increasing India’s debt-to-GDP ratio by 26 percentage points, which has supported the acceleration in GDP growth.   This compares with increases in the debt-to-GDP ratios of the US and China of 25 and 8 percentage points, respectively, during this period.  This debt has, in turn, been used either to bolster consumption or to fuel asset prices, and has boosted growth beyond sustainable levels, in our view.

Persistent acceleration in growth raises risk of sharp contraction.   If the growth acceleration trend is sustained by household and government borrowing at a time when corporate credit demand remains strong on account of capital spending, this could raise the risk of a steeper deceleration in growth.  A trigger could be one of the following macro challenges:

Inflation pressure:With domestic demand (as reflected in strong credit growth) remaining strong, the central bank, the Reserve Bank of India (RBI), has been especially concerned about potential inflationary pressure.  Headline wholesale price inflation (WPI) has reaccelerated to 5.3%, close to the RBI’s maximum tolerance level of 5-5.5%.  Indeed, we believe the pressure on headline WPI will intensify as a result of increases in global commodity prices (other than oil) in the past few months.

Current account deficit:We have argued for a while that, in an open economy, if aggregate demand is higher than supply (reflecting a slower pace of domestic capacity creation), this contributes to a current account deficit as well as inflation.  The current account balance turned to a deficit of US$6.1 billion (3% of GDP, annualized) during the quarter ended (QE) June 2006 from a surplus of US$1.8 billion in QE March 2006, driven by an all-time high trade deficit.

Stretched banking sector balance sheet:The gap between credit and deposit growth has been a key concern.  Although credit growth has currently moderated to 29% from the peak of 33% in June 2006, it remains significantly higher than deposit growth of 21%.  The trailing one-year incremental credit-deposit ratio is also very high, at over 90%.  With the banking sector’s holding of government-approved securities (largely government bonds) already at 29.6% (close to the statutory minimum of 25%), there is little scope for banks to continue with the current high credit disbursement rate.

Credit quality: In addition to the strong growth in credit, the quality of credit being disbursed is causing concern.  Banks have not only been lending more to riskier segments but have also been mis-pricing the credit.  The RBI is clearly worried about the strong credit growth in the retail and real estate sectors.  Although the RBI has initiated administrative measures to reduce the bias towards funding consumption and less productive sectors, there has not been a meaningful correction in this trend so far.

Property market euphoria:As discussed above, excess liquidity without an adequate supply response in the form of absorption of investments is resulting in higher asset prices.   For property, the less supportive regulatory framework and the government’s inadequate and slow response to the need to create urban infrastructure have resulted in weak growth in property supply.   As a consequence, property prices have risen by 100-300% in major cities in the past two years.

Global developments and re-pricing of risk:We believe the loose monetary and fiscal policies have supported a large increase in debt to GDP, which in turn has contributed to a spike in growth rates above sustainable levels.   This rise in debt to GDP, without a commensurate increase in market-driven interest rates, has been due to large inflows of foreign capital, particularly portfolio equity flows (driven by a growing global risk appetite).  Without these large capital inflows, real interest rates would have been higher and growth rates lower. We believe that any slowdown (not necessarily outflow) in capital inflows due to a change in the global environment could result in a disruptive rise in interest rates.

Our base-case forecast remains a soft landing.   We expect growth to soft-land over the next four quarters to around 7%, driven by the lagged impact on credit growth of higher real rates and the central bank’s administrative measures.  In the event of growth surprising on the upside, we think the risks of a sharp spike up in the cost of capital and an aggressive landing of the growth cycle would rise sharply.  In our view, the government needs to implement measures to stimulate the supply-side response by investing in infrastructure, implementing labor reforms, improving the management of government finances and strengthening the administrative framework.

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