United States
Business Conditions In the Doldrums
January 12, 2007

By Shital Patel | New York

As 2007 dawned, there was no sign of improvement in business conditions, according to Morgan Stanley industry analysts.  The Morgan Stanley Business Conditions Index (MSBCI), based on a monthly canvass of our US analysts, posted its eighth consecutive sub-50% reading in early January, declining six points to 38%.  The less-volatile three-month moving average edged down two points to 41%, retracing December’s increase.  That pessimism contrasts with the recently-stronger run of official economic statistics but seems to be in line with surveys of large and small businesses.

For example, according to the Conference Board, CEOs (mainly of large companies) reported that current conditions in their own industries deteriorated in the fourth quarter from six months prior; the index declined two points to 46%.  Conditions improved for only three groupings — paper, printing and publishing, business services, and food, textile and apparel.  Likewise, confidence amongst small business owners also deteriorated in December.  The National Federation of Independent Business’ (NFIB) small business optimism index declined 3.2 points to 96.5. 

In our own survey, the breadth of results tilted towards weakness in early January.  While 54% of analysts noted that conditions were unchanged over the past month (the same as in December), the percentage of analysts noting deteriorating conditions rose to 35% from 30%.  Conditions improved for only five industry groups — food and drug retail, household and personal care, biotechnology, airlines, and chemicals.  Conversely, the materials, energy, consumer discretionary, financials, industrials, and IT sectors had deteriorating conditions compared to last month.  Those crosscurrents seem to echo the recent downdraft in commodity prices and a concurrent sense that global growth might be slowing.

Looking ahead, however, the CEOs and our analysts part company.  CEOs surveyed in the Conference Board canvass believe that conditions will improve in their industries over the next six months; their expectations index increased seven points to 52%.  In contrast, while the MS Business Conditions expectations index also increased by four points, the level was a miserable 40%, suggesting that analysts and the companies they cover expect conditions to deteriorate over the next six months.  Furthermore, our advance bookings index fell five points to 35% to the lowest level since April 2003.  For what it is worth, the consensus economic prognosis for 2007 has also deteriorated since June 2006.  According to the Blue Chip survey, consensus GDP growth for 2007 fell by half a percentage point over that period to 2.4% in the January survey.  Likewise, we reduced our own forecast during the second half of 2006 by 0.4 percentage points to 2.6%.  But we expect improvement to a healthy 3.1% in 2H07. 

For now, we believe that weakness in capital spending seems likely to extend the period of subpar growth into the first half of 2007.  However, there are glimmers of hope: According to this month’s survey, capex plans improved as 54% of analysts reported that companies under their coverage have plans to increase capex over the next three months, up from 43% last month.  Of these, roughly one-fourth plan to increase spending by 6% or more.  The industrials, consumer staples, energy, telecom services, and utilities sectors were most likely to increase capital spending.  Of the 46% of companies that plan to decrease capex from current levels, 46% would only reduce outlays by 0-3%, 29% by 3-6%, and 25% by 6-10%. 

Another key element to our outlook is moderate consumer spending helped by strong real income and job growth.  There’s also a ray of hope in our survey in that regard: 31% of Morgan Stanley analysts reported that companies under their coverage plan to step up hiring over the next three months, down slightly from 35% last month, but improved from the August-October 2006 average of 24%.  Hiring plans were concentrated in the industrials and utilities sectors.  Only 10% of groups plan to cut payrolls over the next three months, down from 13% in December.  One ominous portent: Hiring plans for small businesses were weaker according to the NFIB’s December survey.  A net 10% of small business owners planned to create new jobs, down from 19% in November. 

The inflation outlook is also uncertain: Although we still believe that inflation will move lower in 2007, there are lingering upside risks.  Supporting the trend, the pricing conditions index at 55% in early January was well below the peak of 76% in October 2005, although it moved up by four points from December.  40% of groups increased prices from a year ago, up from 33% last month, while 29% have lowered prices, down from 30%.  Lower prices were prevalent in the IT, telecom services, financials, energy and utilities sectors. 

We also asked analysts this month about margins in 2007 at companies they cover.  As we expected, margins finally seem to be coming under some pressure.  Only 27% of analysts reported that prices charged have risen faster than unit costs at companies they cover over the last three months, down from 34% in December.  Margins are expected to expand for 48% of the groups and shrink for only 29%.  Margins are predicted to rise for the industrials, healthcare, and consumer staples sectors.  According to our strategy team, however, our analysts are cautious relative to their peers: Analysts on the Street expect a whopping 74% of companies to have rising margins in 2007. 

The credit conditions index decreased four points to 51% — a reading above 50% indicates that financing has been easier to obtain over the past three months.  Further decreases in the index could be a risk to our outlook.  A full 81% of respondents noted that credit conditions were unchanged while 10% noted that conditions were easier.

Special Questions

All companies are now required to expense employee stock options beginning with the 2006 reporting year.  This month we asked analysts whether options expensing would affect earnings estimates at companies they cover.  Fully 48% said that expensing will not affect earnings estimates while 31% said that they will only slightly affect earnings.  Not surprisingly, options expensing will significantly depress earnings for the systems and PC hardware and semiconductor companies. 

A key reason that the change in accounting rules won’t have a bigger effect on earnings is that companies are taking steps to mitigate the impact.  Accordingly, we also asked analysts whether companies under their coverage accelerated the vesting of stock options or took other actions (such as ending employee stock option [ESO] issuance) last year to minimize their impact on earnings in 2007 and beyond.  A hefty 35% switched from ESOs to restricted stock while 23% accelerated vesting.  The business services group was the only group that ended ESOs. 

Last year saw companies announce and execute record share buybacks, as CFOs swimming in cash decided to re-lever their capital structure by reducing share count and in some cases issuing debt to do it.  In addition, buybacks were used to offset the exercise of ESOs and thus to avoid shareholder dilution.  Analysts confirm that such buybacks tend to be concentrated in a minority of companies, however.  Of the companies that announced a share buyback program in the past two years, analysts report this month that about one fifth used 60% or more of the buybacks completed to avoid dilution.  Roughly 70% of the companies used less than 40% of buybacks to offset potential dilution.  Of these announced buybacks, 41% of the analysts noted that 60% or more have been completed to date, while 34% of respondents reported that 40-59% have been completed.

Of course, buybacks aren’t the only way to re-lever; going private is the ultimate form.  We asked analysts what percentage of companies under their coverage have been associated with a potential public-to-private (PTP) transaction in the past 12 months.  Half have not been associated with any PTP transactions, while 30% of analysts noted that 0-24% of companies under their coverage could have been taken private.

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Currencies
Tracking the World’s Official Reserves
January 12, 2007

By Stephen Jen | London

  Summary and conclusions

We document the latest figures on the world’s official reserves.  The total stock of official reserves continues to grow rapidly.  Despite the recent trend to the contrary (the last month or so), we continue to hold the view that in 2007 we will witness waning interventions by the Asian central banks, with the sole exception of the PBoC/SAFE.  The returns on the underlying investments will account for an increasing share of the incremental changes in the official currency reserve position.  Regarding reserve diversification, we also maintain the view that, in 2007, we will see central banks taking a decisive step toward investing their ‘excess’ reserves like ‘sovereign wealth funds’ by diverting from the traditional investment patterns.  This prospective move will mark a watershed in central bank reserve management and for the financial markets in general. 

Additional calculations

We last issued a report on the status of the world’s reserves on November 2, 2006, in a note with the same title as this one.  Since then, we have made several additional calculations. 

First, we have expanded the set of countries covered.  Given the focus on Asian central banks and the central banks of the oil exporters, we now have more detailed sub-categories of countries in our coverage. 

Second, we have disaggregated the incremental increases in the value of currency reserves into (i) the returns on the underlying investments and (ii) the valuation changes from exchange rate fluctuations.  To do this, we had to make some simplifying assumptions, in light of the confidential nature of the data on reserves.  For (i), we used the currency weights from the IMF’s COFER (Currency Composition of Foreign Exchange Reserves) database.  We further assumed that these central banks hold sovereign debt in USD, EUR, GBP and JPY with 2-year maturity.  For (ii), we also used the COFER weights.  Monthly and quarterly changes in reserves were then decomposed into (i) returns on the underlying investments, (ii) valuation changes and (iii) implied interventions and ‘errors and omissions’ (E&Os).  While these are admittedly approximations — since neither the currency compositions nor the underlying asset holdings are public information — we believe that this de-composition nevertheless adds to our understanding of what the major central banks may be doing regarding their reserves.

Observations

We make the following observations:

1. Total reserves continue to grow at a rapid pace — about US$600 billion a year.  Based on the latest data available (different months for different countries), the world’s total currency reserves reached US$4.868 billion, an increase from US$4.246 billion at end-2005.  Asia still commands the largest pool of official reserves, with more than US$3 trillion, or around two-thirds of the world’s total.  It also accounted for a good part (83%) of the increase in the world’s reserves in the latest month.  The oil exporting countries, in the aggregate, own ‘only’ US$744 billion in official foreign reserves, even though collectively the oil exporters run as large a C/A surplus as the Asian countries: both groups ran C/A surpluses of around US$400 billion in 2006.  In many of these countries, many of the oil export receipts are kept off of the central bank’s balance sheet, and therefore are not covered by our calculations.  For example, ADIA of the UAE (possibly as large as US$350 billion) and the GPF of Norway (just under US$300 billion in size) are the official investment arms recycling the petrodollars.

2. The underlying returns are quite high, accounting for roughly one-third of the total changes in reserves.   The world’s total returns on the underlying assets are running at an annual pace of around US$200 billion, implying an average return of around 4.4%.  As the monetary authorities in Euroland, Japan and the UK continue to normalize, this figure should rise further.  Since 2004, global reserves have grown by an average of US$546 billion a year.  Annual returns on the underlying investments have accounted for roughly a third of the overall reserve increase.  The important point, in our view, is that, as interventions are gradually curtailed, and as EUR/USD’s uptrend abates, investment returns will become an increasingly important component of the C/A balances — a point we have raised in the past.  

3. Valuation changes have also been quite large, due to dollar weakness.  In the past year, valuation changes have accounted for about a tenth of the overall reserve changes.   But whenever the dollar weakens, there will be valuation gains.  All else equal, every 1% rise in EUR/USD would lead to a 0.3% rise in the world’s reserves in dollars, equivalent to around US$12.5 billion.  Since 2002, of the rise in global reserves of US$2,714 billion, US$254 billion arose from the dollar depreciation.  Many commentators have been using these official reserves as a component of the world’s ‘liquidity’ — an approach with which we disagree.  The rise in EUR/USD has led to a significant increase in official reserves, and therefore global ‘liquidity’, measured by the above metric.  Clearly, EUR/USD volatility affecting global liquidity doesn’t really make sense, for if we had used the EUR, instead of the USD, as the accounting currency, global liquidity would have been much less. 

4. Interventions by China and the oil exporters continue to be large, but those by the rest of the world appear to be very small.  The residuals of total reserve changes, the part not explained by the estimated returns on the underlying investments and currency valuation changes, could be either interventions or, especially in the case of the G10 countries, E&Os.  These E&Os could arise from the actual currency compositions and the underlying asset holdings being different from what we have assumed for the whole group.   In recent months, China alone has accounted for about half of all ‘interventions’ in the world.  Oil exporters, in the aggregate, have accounted for the other half.  

5. China’s reserves will continue to grow sharply.  China’s reserves continue to grow at a rapid pace, as a result of both large investment returns and significant balance of payments (BoP) surpluses.  After averaging close to US$200 billion a year in 2004 and 2005, China’s reserves are likely to have grown by US$230 billion in 2006.  With its trade surplus having risen to US$178 billion in 2006 from around US$100 billion in 2005, it is likely that China’s reserve accumulation will continue to increase in 2007.  Incidentally, we underscore a puzzle we have regarding China’s reserve data.  If the trade surplus was US$178 billion and realized FDI was about US$55 billion in 2006, the implied non-FDI capital flows, interest earnings and services balance would have been essentially zero in 2006.  This does not really make sense to us.  The return on China’s foreign reserve holdings should have been more than US$40 billion last year.  This implies that short-term outflows were quite large.  It is not clear to us why this should be the case.

6. Japan.   Japan’s reserves continue to grow at a pace of US$40 billion or so a year, not because of intervention, but from investment returns and valuation changes. 

7. Most other central banks had not, until last month, intervened aggressively.  While several Asian countries (e.g., Korea, Taiwan and Malaysia) may have intervened in December, the general trend is that the Asian countries, except for China, have sharply curtailed their interventions since early 2004.  We expect this to remain the case, even for more hawkish central banks such as the Bank of Thailand and the Bank of Korea. 

8. UAE’s official foreign reserves are tiny.  On December 26, 2006, the UAE’s central bank governor, Sultan Bin Nasser al-Suwaidi, announced that the central bank would raise its holdings of EUR from the current 2% to 10%.  Given the modest size of the central bank of UAE’s reserves (US$25 billion), such a change in weighting (which translates to US$2.0 billion) should not really have a material impact on the currency markets.  Commentators soon reacted by declaring that this was yet another piece of hard evidence that central banks were diversifying away from USD.  We remain skeptical about this assertion and the popular notion that there has been wholesale diversification from USD assets.  If anything, the announcement by the UAE had a bigger psychological effect than anything real.  In any case, we find it interesting that the UAE felt compelled to announce its decision, when it could have just adjusted the currency composition quietly. 

9. Iran and Venezuela will not have a dominant effect on the dollar.  These two countries have also announced their intention to diversify from their dollar holdings.  The official reserves of Iran and Venezuela are estimated to be US$38.3 billion and US$27.1 billion, respectively.  As with the case of the UAE, these reserves are too small to really matter in earnest, though their announcements and threats to diversify from USD assets may have had a negative sentiment effect on the market.  

10. Russia is important, however.  The Central Bank of Russia now has close to US$200 billion in foreign currency reserves.  What it decides to do regarding its currency and asset holdings matters a lot more than the likes of the UAE, Venezuela or Iran, in our view. 

Interventions to abate, we suspect

Right now, only China and the oil exporters continue to intervene in the currency markets.  While we expect these interventions to continue, we also anticipate that pressures (both financial and political) will mount for these activities to be gradually curtailed going forward.  This is an important part of our call that USD/AXJ will continue to head lower in 2007.  Incidentally, we stress that this call is not inconsistent with our ‘de facto dollar zone’ idea, which was never based on the concept of ‘exchange rate fixity’, which is the key assumption under the so-called ‘Bretton Woods II’.  Instead, our ‘de facto dollar zone’ is based on the notion that, before Asia could have fully convertible currencies that their trade partners would accept as settlement currencies for trade and financial transactions, Asia would continue to rely on the US dollar as the primary international vehicle currency.  Exchange rate fixity is not necessary; but relative exchange rate stability is desirable.  A cut-back in interventions is just that — a cut-back — not outright termination of interventions. 

‘Sovereign wealth funds’ increasingly important

China has recently announced that its Hueijing Holding Company, which is managed by SAFE, will start to invest some of the reserves in a broader portfolio of foreign assets than sovereign bonds and publicly guaranteed mortgage instruments.  Further, it is likely that Japan will also start to deploy the investment earnings on its stock of reserves (leaving the principal untouched) to more aggressive investments.  We have argued for a while that central banks, as they accumulate reserves that they don’t need for liquidity purposes, will start to invest the ‘excess reserves’ in more creative ways.  This process is likely to take a major step forward this year, we believe, with some official reserve money being allocated to equities and non-G3 markets.  

Bottom line

We have enhanced our monitoring of the evolution of official reserves, by broadening our country coverage and by making a first attempt at disaggregating reserve changes into (i) investment returns on the underlying assets, (ii) currency valuation changes and (iii) currency intervention and errors and omissions.  As we have detailed above, the results of our calculations are quite revealing, as they yield some very interesting trends.

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Germany
Closing the Books on 2006
January 12, 2007

By Elga Bartsch | London

It’s official now:  the German economy is back on track to become more of a locomotive on the European continent again.  The first European country to publish an official full-year GDP growth estimate for 2006, German real GDP expanded by 2.5% last year.  This is in line with our forecast and consensus expectations, and it marks the strongest growth rate since the boom year of 2000 and indeed a smart pick-up from the 0.9% recorded in 2005.  If you account for the fact that 2006 had a lower number of working days than the previous year, the calendar-adjusted like-for-like GDP growth rate would even show 2.7%, according to the Statistics office.  With this being nearly twice the trend rate of German growth of 1.4%, it underlines the strength of the recovery momentum.  The sustainability of the German economic revival is also underpinned by a robust labour market performance.  Employment expanded 0.7% last year, having declined by an average of 0.2% per year during the last five years.  As a result, unemployment fell to the lowest level since 2002 (see German Economics: Winter Wonderland, January 5, 2007).  Labour productivity per employee expanded by a strong 1.8% on average during 2006, while labour productivity per hour worked rose 1.9% (see Steve Roach’s comment, Global Economics: The New Wirtschaftswunder?, September 22, 2006).

The full-year numbers also show an encouraging recovery in domestic demand growth, which accounted for nearly 70% of the overall GDP growth, while net foreign trade accounted for about 30%.  The main reason for the domestic demand revival is a sharp rise in investment spending, which posted the strongest growth rate since reunification.  The recovery in investment spending came from both investment in machinery and equipment and construction investment.  While the former reflects the sharp rise in profits, the buoyant business sentiment and strong position in international trade, the latter indicates that the multi-year recession in the construction industry is now behind us for good.  Consumer spending also recovered, rising by 0.6%, but fell short of our and consensus expectations for a number twice that size.  This, together with incoming monthly indicators on retail sales and car registrations, suggests that there was in fact less reshuffling of consumer spending ahead of the VAT hike than generally assumed based on historical precedents (see German Economics: The Anatomy of a VAT Hike, September 18, 2006).  The flip-side of this argument, of course, is that the payback in early 2007 might be more muted than we and most other forecasters have assumed so far.  It’s still early days, but thus far there are only very limited signs of price increases in the retail sector in response to the three-point VAT hike that became effective on New Year’s Eve (see Euroland Economics: Kicking Off 2007 with an Inflation Dip?, January 8, 2007).  This might, of course, change with the end of the winter sales.

Unfortunately, the full-year estimate does not tell us that much about the near-term growth dynamics.  Assuming that the first three quarters of the year would not be revised, which would be a first, the fourth quarter GDP growth rate between a non-annualised 0.8% and 1.0% would be consistent with a full-year growth rate of 2.5%.  Incoming monthly activity data, including industrial production, manufacturing orders and retail sales up to and including November, would suggest a number at the lower end of this range.  In addition, it is likely that previous quarters will once again be revised up when the statisticians release revised estimates for the first three quarters and a flash estimate for the fourth on February 13.  The Statistics Office itself estimates 4Q GDP growth to have been a meagre 0.5%Q.  Taking into consideration that the 4Q numbers are likely to be biased upwards by the prospect of the VAT hike and by the unusually mild weather, an outcome as low as 0.5%Q would likely come as a downside surprise to many forecasters.  The consensus is currently going for a GDP growth rate of 0.7%Q during the last three months of 2006.  Nonetheless, carried-over growth into 2007 will be sizeable.  On our estimates, even if GDP was to stagnate at the 4Q06 level for the whole of this year, full-year 2007 GDP growth would still show a respectable rate of around 1.0%.  This is how strong the tailwinds are for the German economy at the moment.  If it turns out, in addition, that the VAT hike leaves a smaller-than-expected dent in the business cycle in first few months of this year, upside risks to our full-year forecast of 1.5% would arise — and a growth rate of closer to 2% might be more likely.

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Japan
Dream of 3% Nominal Growth
January 12, 2007

By Takehiro Sato | Tokyo

Unexpected upside is the main risk amid lingering bearishness

Both domestic and overseas economies overcame sluggishness from mid-year and clearly rebounded in Oct-Dec. We think that unexpected upside is the main risk for investors amid lingering bearishness, and we will be focusing on the potential for robust growth with the elimination of the nominal-real reversal effectively for the first time in 13 years. Below we review our outlook and potential risks (opportunities) for the Japanese and overseas economies in 2007.

Rebound in the growth rate

Japan’s economic momentum, particularly for personal consumption, is looking very different for the second half of F3/07 and F3/08 versus the first half of F3/07. Signs of this distinction are already evident in Oct-Dec consumption data. While the household recovery is still lagging the healthy corporate sector, there is little chance of a further reverse wealth effect caused by weak small/mid-cap stock prices that weighed on consumption in summer 2006 together with poor weather conditions. In fact, real consumption spending in Oct-Nov increased 2.8%, partially on a rebound from Jul-Sep weakness, even though real wages stayed in negative territory. Supply-side data (equipment retail sales and durable consumption goods shipments) were also upbeat. Corporate inventories for IT-related goods, a primary basis for bearishness, fell in November according to industrial production data for the first decline in seven months. Clothing sales were weak due to warm winter temperatures, but IT-related goods and other consumer electronics goods fared well during the US Christmas season. We think that healthy electronics sales helped move along inventory adjustments for technology components on a global basis.  

Our economic forecast projects 2.2% real and 2.8% nominal growth in F3/08. However, a slight upswing in the real growth rate could lift the nominal growth rate to 3% since relatively upbeat momentum for Oct-Dec 2006 and Jan-Mar 2007 real GDP is likely to raise the base contribution and the GDP deflator’s positive margin might widen since oil prices have declined faster than anticipated. Although investor reception of the growth strategy outlined by the Abe government has been somewhat cynical, we do not find 3% nominal growth out of reach and have decided to adopt this as a central theme for 2007.

Two-digit growth in corporate profits

Bottom-up corporate earnings forecasts remain cautious, but with labor’s share of income stable and low, from a top-down perspective we continue to expect double-digit growth in corporate profits (about 10%). As noted earlier, personal consumption picked up clearly in Oct-Dec after a soft patch in Jul-Sep, but unfortunately we still cannot expect a particularly buoyant consumption environment in 2007, given that labor has a low, stable share of income. However, this weakness in workers’ incomes means that corporate capital’s share of income will remain high, implying that capex should continue to expand steadily and productivity improvement will not flag. Wage stability does favor sustainable growth in the economy.

Historically, an increase in labor’s share of income triggered recession, since this causes a drop in capital’s share of income. The Abe administration is hoping ahead of the upper house election in July to raise labor’s income share in the economy in response to weak regional economies and widening income differentials, but the points above imply that this could be counter-productive. The business community reacts coolly and critically to any such demands, as it values the preservation of cost competitiveness. So, the chances of wage increases that are large enough to compromise productivity damaging the economy are slim.

On the other hand, capital spending facilitated by brisk corporate earnings should continue to propel domestic demand. Automobile and IT investment, the earlier drivers of capex in manufacturing industry, are on the wane, but we expect a widespread pick-up in non-manufacturing industry investment that is independent of the global economic cycle, providing powerful capex support.

The recent December Tankan also pointed to revitalized land purchasing by corporations. Acquisition plans for manufacturers still call for YoY declines, but the increases by non-manufacturers mean that there is already positive growth when measured across all industries. These land purchasing conditions indicate that future capex has a solid grounding.

Implications of a drop in consumer prices are complex

Fundamentals are favorable, but there are a number of headaches for policy makers. Since oil prices are dropping faster than expected, the possibility of a drop into negative territory for the CPI is moving beyond just a risk and becoming the main scenario. The economic impact of lower energy prices is like that of tax cut, and since this enhances the real purchasing power of consumers, negative growth in prices does not necessarily mean a reversion to deflation. And since a drop in the import deflator pushes up the GDP deflator, the symbolic event of the latter turning positive, on the heels of the domestic demand deflator doing so in Jul-Sep last year, this could closely coincide with a negative turn in the CPI inflation rate in the Apr-Jun quarter. Falling prices would not necessarily damage market sentiment, therefore. However, the possibility of these developments occurring after the next rate hike, which is expected in mid-January, could make for a delicate relationship between the government and the BoJ reminiscent of Governor Hayami’s time. This argues for a higher market risk premium.

The stepping down of two members of the BoJ’s policy board with a background in industry when their terms expire in April, and then the reshuffle of the governor and deputy governor posts in March 2008, could have some impact. As an extreme case, which does not seem very likely yet, the next governor could prove not to be the consensus pick, the current deputy governor Toshiro Muto, but an external figure with a reflationary bias. This reshuffle of the BoJ’s top personnel will not be an issue until after the July upper house elections, however.

Political logjam would not be a crisis but an opportunity

Political events will be an important investment theme this year again. The probability of the ruling coalition not attaining a majority in the upper house is not low, but rather than leading to crisis, we think this contains a hidden opportunity. Namely, if the coalition does not gain a majority, it would need to be reconfigured. A likely strategy is that the LDP would move closer to the right wing of the DPJ, driving a splinter through the democratic party. In this case, a new coalition could be formed by the LDP and right wing elements of the DPJ cohering with a consensus on diplomatic and security treaty policy. The economic and diplomatic policy fissures in the current political landscape could then be dissolved, leaving the political world to be guided by more purely political considerations. This would be extremely positive for the structural reform agenda that seems to have reached an impasse, and should be welcomed by investors.

Policy and market implications

Although the BoJ is likely to tighten twice during 2007, interest rates are still far from the neutral policy rate (2.5%, setting the economy’s potential output growth rate at 1.5% and the inflation target at 1.0%), and effectively this would still amount to tinkering. We anticipate a continuation of accommodative monetary conditions (MCI) along with yen weakness on a real, effective basis due to the carry trade.

The bond market should remain steady even with rate hikes. A negative turn for the CPI’s core inflation rate would allay speculation about a third rate hike, and with JGB issuance declining as Japan’s fiscal situation improves, and arbitrage with bank lending rates returning amid weak growth in bank lending, Japan is likely to be no exception to the global trend of flattening. A flattening yield curve at an extremely low level may lie ahead.

For the equity markets, on the other hand, we expect gains fuelled by corporate profit growth. Yet, the main topic will likely be political developments rather than the economy, and there could be another rally like the summer of 2005 after the dissolution of the Diet over the post office privatization agenda. However, the government is seeking a higher share for labor among income, and if it interferes with private sector employment practices and focuses too much on ironing out inequalities, the market may sense a decline in economic vigor and react warily.

Finally, the yen is increasingly being seen globally as the funding currency, and there is a risk that the yen may continue to drop in the near term, running counter to the movement of overseas asset markets. Catalysts for yen depreciation to be reversed could be an unexpectedly rapid narrowing of the gap between domestic and overseas interest rates, or a sharp correction in overseas asset markets. But with inflationary pressure relenting, overseas monetary authorities are likely to gradually relax their policy tightening stance, and excess liquidity in fact appears more likely to increase than to be dissolved, so we do not see catalysts for such a correction on the horizon.

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Japan
Financial Regulation at a Crossroads
January 12, 2007

By Robert Alan Feldman | Tokyo

The most fundamental form of human stupidity is forgetting what we were trying to do in the first place.  -- Nietzsche.

 

A string of scandals

The financial regulatory system in Japan stands at an important crossroads. Investor confidence in the financial system has been eroded by the spate of scandals and blunders over the last 18 months. Meanwhile, foreign markets are gaining competitiveness. Without better regulatory performance by both private and public sectors, the efficiency of intermediation will suffer. It would be tragic if financial regulation became a barrier to more efficient allocation of capital, just when demographics and globalization make such allocation even more imperative. Is the financial regulatory system likely to improve?

The ‘mole hunt’ phenomenon

One aspect of the Japanese regulatory system is the ‘mole hunt’ phenomenon. (The term is a direct translation of mogura-tataki, a common Japanese amusement park game. In the game, toy moles emerge from holes in a horizontal board, and the player must bump the moles on the head with a soft mallet. The moles pop up randomly from the holes, with accelerating frequency. The player who bumps the most moles on the head in a given period of time is the winner.) When a problem arises, the problem is handled in the way that is bureaucratically and politically easiest, regardless of earlier actions or principles or effects on the economy. A perfect example of the ‘mole hunt’ phenomenon was the imposition of draconian sanctions on an auditing company over the summer, just when firms were closing their books for the fiscal year. The result was disruption of financial reporting by thousands of listed companies — not conducive to either accurate financial information or investor protection. The financial regulatory system forgot what it was trying to do in the first place.

I believe that the system needs a redesign, based on principles. In this context, it is essential to start with the ultimate principle, enhancing economic welfare. For Japan today, the overwhelming economic challenges are demographics and globalization. Financial regulation should be designed first and foremost to promote efficient allocation of resources. This is only natural, because the financial sector is a key tool for governance of resource allocation. In addition, the regulatory system must combat both market failure and government failure.

The news media can play in important role, by watching the watchers. However, media independence in Japan is compromised by three key factors — press clubs at ministries, the price maintenance rules for newspapers, and the licensing arrangements for broadcasters. In addition, many investors complain about the accuracy and objectivity of financial reporting. For example, the Japanese press enforces no qualifications on who may write financial articles.

Another problem is concentration of all three functions of the regulatory system (design, inspection, oversight) in a single body, the Financial Services Agency (FSA). This structure violates a fundamental principle of governance, the separation of powers. Justice is not served when a single entity serves as ‘sheriff, judge and jury’. Nor can justice — or economic efficiency — be served when a single regulator performs design, inspection and supervision.

Signposts for improvement

With all these problems in financial regulation, investors are naturally looking for signposts of improvement. This is particularly true in light of Tokyo’s apparent loss of competitiveness to London and Hong Kong. Among the potential areas for improvement are (a) competition in financial system design, (b) improvements in communication between the regulators and the financial industry, and (c) organization changes at the FSA.

System design was monopolized until 2002 by the Financial System Council, an advisory body to the FSA. This committee was singularly unsuccessful in the 1990s in proposing effective reforms. A successful plan emerged only in late 2002, when the ad hoc Takenaka Committee of reform-minded, private-sector practitioners brought competition to financial reform policy.

Is competition now returning in the area of financial system design? The good news is that PM Abe’s own ‘Asia Gateway’ initiative includes Japan’s financial system competitiveness. Thus, a committee organized directly under the PM’s office is competing with the FSC. The bad news is the lack of contribution from the private sector. Why? In my view, the silence of the private sector stems from fear of antagonizing the FSA and the lack of an industry-wide trade association.

It is also clear from discussions with both regulators and industry people that communication is far too thin. Current rules on discussions between the regulator and the private sector are overly restrictive, such as the near prohibition on taking meals together. No doubt, the rules in the 1990s were too lax. Now, however, both sides are afraid to talk, for fear of transgressing a rule. The result is lack of understanding, and ultimately loss of competitiveness.

In contrast, rules on discussions between the regulator and the media should be tightened. There are far too many leaks of confidential information. Investors would likely welcome a move by the government to abandon the press club system entirely, and switch to an ‘accredited journalist’ system.

Finally, the lack of separation of powers is the chief source of fear of intimidation. Moreover, the continued regulatory separation of banking, capital market and insurance sectors ignores the significant crossover among the sectors. Instead of the current universal regulator, a system that separates design, inspection and supervision would be a step towards better pre-emption, and greater competitiveness.

Should steps in these areas — competition in design, improved communication and separation of powers — be taken, then investor confidence in Japanese financial markets should rise, and the risk premium on financial sector stocks should return to normal.

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