The Growth Machine
January 16, 2007
By Stephen S. Roach | New York
After four years of booming global growth, I have argued that the world is due for a rest -- not a hard landing but a marked slowdown from the strongest surge since the early 1970s. The verdict in the early days of 2007 is that I could well be wrong. For longer than I care to remember, my base case has argued that ever-mounting imbalances will ultimately crimp vigorous growth in global economy. While there can be no mistaking the imbalances of a US-centric world, there can also be no mistaking the extraordinary resilience of the great global growth machine. Is it time for a new approach?
The debate over the sources of growth is as old as the economics profession itself. That debate has great relevance for global rebalancing -- especially since it makes the important distinction between growth that is dependent on external or internal sources. In the end, only the latter strain of growth is self-sustaining. That raises one of the toughest problems of all for an unbalanced world: The demand side of the global economy has been dominated by the American consumer, where growth in recent years has been underpinned less and less by the traditional support of income generation and more and more by the wealth effects of an increasingly asset-dependent economy. As the balance shifts from income- to wealth-dependent growth, the risks of financial vulnerability can mount. That’s certainly been the case in the United States, with record levels of household sector indebtedness, sharply depressed domestic saving, and massive current account deficits. Similar sustainability concerns pertain to the supply side of the global economy -- increasingly dominated by China. In this case, the growth dynamic has been concentrated in China’s two most outward-looking sectors -- fixed investment and exports, which collectively account for about 80% of Chinese GDP. The sustainability requirements of such an externally-led growth framework are very different from those of the demand-side model. The investment process has to be rational, with capital allocated in the right dosage to the right industries -- avoiding both production bottlenecks and capacity overhangs that might jeopardize ongoing growth. The export process needs to match the needs and aspirations of China trading partners -- without creating undue cross-border frictions. My problem with sustainability of the current strain of global growth arises mainly out of the internal imbalances of the US and Chinese economies. In recent years, America’s asset-dependent economy has been prone to periodic bubbles -- first equities and now property. Post-bubble shakeouts crimp equity extraction from asset markets -- putting pressure on income-short consumers to rebuild income-based saving rates. By contrast, China’s supply-led model has been funded, in large part, by a relatively undisciplined system of policy-directed bank lending. That underscores the risks of a misallocation of capital that could lead to excess supply and deflation. At the same time, China’s export-led dynamic is now eliciting a mounting protectionist backlash from both the US and Europe. With growth risks tipping to the downside in both the US and China, I have argued that slowing is inevitable for a two-engine global economy; lacking in support from private consumer demand, the rest of the world is not nearly as decisive in shaping the global growth outcome (see my 20 November 2006 dispatch, “Two-Engine Slowdown”). Globalization has played a dual role in driving the great global growth machine. It has both real and financial dimensions -- with the former reflecting a sharp acceleration in cross-border trade in goods and services and the latter responsible for an even more dramatic increase in cross-border flows of financial capital. Moreover, several of the key implications of globalization have acted to reinforce the interplay between the income and the asset economy -- namely low inflation and low interest rates, as well as the recycling of global saving from surplus to deficit nations. But the implications of globalization also cut the other way. Key in that regard is a global labor arbitrage that has led to an unprecedented divergence between the returns to capital and the rewards to labor in the industrial world. That has triggered an equally worrisome political backlash that could certainly pose serious risks to financial markets and the asset-dependent growth that increasingly underpins the global economy. Ultimately, the question of sustainability is an exercise in “equilibrium economics.” I have long argued that it’s a bit like physics -- that an unbalanced economy is akin to a system in disequilibrium that is especially vulnerable to periodic shocks. It follows, in my view, that the further an unbalanced global economy moves away from equilibrium, the greater its rebalancing imperatives. With the gap between current account deficits and surpluses nearing an unprecedented 6% of world GDP in 2005, in recent years I became increasingly concerned about the possibility of a disruptive rebalancing. I was heartened last spring when the stewards of globalization -- namely the G-7 finance ministers and the IMF -- finally saw the world through a similar lens and moved to put in place a framework that addressed the imperatives of collective action in coping with mounting global imbalances (see my 1 May 2006 dispatch, “World on the Mend”). While I lowered the odds of a disruptive rebalancing accordingly, I still maintained my earlier view that the risks to global growth remained on the downside. A slowing of global growth is, in fact, a key implication of the rebalancing framework. That conclusion is an outgrowth of America’s unsustainable consumption binge -- the main force behind the extraordinary squeeze on income-based saving and the concomitant widening of massive US current account and trade deficits. Since these imbalances cannot be resolved without a reduction of excess consumption and since the world lacks another dynamic consumer that could fill the void in the event of a consolidation in US consumption, I have increasingly viewed a US-led global rebalancing as recipe for slower growth in world GDP. That’s, of course, exactly what has gotten me into trouble. Far from slowing, an increasingly unbalanced global economy just ended a fourth consecutive year of the strongest growth since the early 1970s. And so it turned out that an increasingly unbalanced world has not been nearly as vulnerable to shocks as I had thought would be the case. Not only did it weather a major oil shock, but the latest data coming out of the US -- especially employment and retail sales -- suggest the American consumer is hardly being derailed by the bursting of the property bubble. As always, the jury is still out on the risks associated with global rebalancing. That’s especially the case in light of an emerging China slowdown, a mounting protectionist backlash, and the still-to-be-determined extent of post-property-bubble aftershocks in the US. It’s certainly possible that any one of those adjustments could suddenly take a turn for the worse and thereby pose a serious risk to an unbalanced and still precarious world. But at least for now, there’s little sign of a meaningful slowdown in global growth or any collateral damage such an outcome might pose for financial markets. Our US economists are actually raising their sights on near-term growth prospects -- unambiguously good news for externally-dependent economies elsewhere in the world. Similarly, Washington is sending increasingly clear signals that an era of pro-capital policies may be coming to an end, but an earnings-sensitive stock market has hardly flinched. And despite the mounting risks of trade frictions, the US dollar has actually strengthened a bit in early 2007 -- once again defying the relative price adjustments of the rebalancing script. I’ve been around this track long enough to know when it’s game over for a big macro call. I must confess that my patience is definitely wearing thin. All this poses one of the toughest questions for the macro practitioner: Are you wrong if you have the analytical framework correct but the consequences wrong? It has long been said that being early on market calls is the functional equivalent of being wrong. I certainly concede that point with respect to the implications of my basic call. However, with many of the rebalancing tensions I have long been warning of now coming to the surface, I am not willing to concede on the analytics of the global rebalancing framework. I still believe it is a powerful way to understand the forces and risks that drive today’s unbalanced, yet increasingly interdependent, global economy. But that’s not enough. We live in a mark-to-market world, and it’s not acceptable just to counsel patience in waiting for the big calls to break one way or another. We owe it to ourselves -- and, of course, to our loyal followers -- to figure out why the consequences don’t match up with the analytical conclusions of the framework. My own explanation has long pointed in the direction of the global liquidity cycle -- especially the lack of interest rate pressures up and down the risk spectrum. Without a meaningful jolt to interest rates, the asset economy is able to keep cushioning the real economy from otherwise disruptive shocks. It’s as if excess liquidity has been the perfect complement to the tensions arising from the globalization of cross-border production, employment, and trade. Yes, as many have pointed out, excess liquidity has become the all too convenient rationale for all that seems awry in financial markets. This may be one of those times when the crowd is correct. If so, that conclusion does not bode well for a still unbalanced world. From tulips to dot-com, the cycle of fear and greed has all too often gone to extremes in asset markets. In an era of excess liquidity, asset bubbles are the norm -- not the exception. In the past seven years, there has been an equity bubble, a housing bubble, and now a risk bubble. I am not convinced that financial globalization has progressed to the point where an increasingly asset-dependent global economy is now self-cushioning -- essentially immune to the risks of post-bubble adjustments. Notwithstanding those concerns, the latest batch of data has certainly not broken my way. While that does not convince me I have the basic framework wrong, it certainly puts me on notice that the proverbial moment of truth could well be close at hand. If the great global growth machine doesn’t start to slow by the end of this year, it’ll be high time to give up the ghost.
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Implications of Lower Oil Prices
January 16, 2007
By Richard Berner | New York
Fueled in part by exceptionally warm weather in parts of the United States and Europe, crude oil and refined product prices plunged to 18-month lows over the past week, potentially boosting global growth, reducing headline inflation, and redirecting patterns of global capital flows. West Texas Intermediate and Brent prices dipped below $53/bbl for the first time since June 2005, and US wholesale gasoline quotes fell to $1.40/gallon, about 30 cents below month-ago levels and more than $1 below their peak at the end of July. In turn, US retail gasoline prices have begun to decline again after rising over much of November and December, and if wholesale prices stabilize at current levels, retail quotes could fall by another 20 cents/gallon. Are these developments sustainable? And what are their implications for financial markets? As I see it, crude oil and wholesale product prices are unlikely to continue declining. Global demand is still robust, winter weather is returning, and OPEC may cut crude production again. But a return to previous levels is unlikely because the downdraft in price reflects easier supply more than it does weakness in global demand. Thus, the plunge in oil prices likely will be a short-term tonic for growth by boosting discretionary income in consuming countries, and it also will depress headline inflation. While boosting oil-consuming-country growth, the decline in prices will also reduce producers’ incomes — and thus the recycling of petrodollars into major markets. The combination should reinforce the rise in global real interest rates that began in December. Two months ago, my colleague Eric Chaney and I thought that the medium-term trend in oil prices was down, reflecting faster growth in supply than demand, but that a winter-induced, short-term rebound probably lay ahead (see “Oil Update: Short-Term Rebound Ahead,” Global Economic Forum, November 17, 2006). In addition to the onset of increased seasonal demand, we thought the just-announced OPEC production cut of 1.2 mbd would also help firm up the supply-demand balance, and that the price of Brent crude would move up to $65/bbl in the winter quarter. That was then. We did not anticipate that the brewing Pacific El Niño would make December in the United States the warmest in 106 years of record keeping, and that the unseasonably warm weather would also affect other regions, such as Europe. December’s level of heating degree-days — a composite indicating energy demand — was 14% below the 10-year average for that month. While the effects on energy quotes of the aberrant weather will be mainly transitory, some will linger. That’s because the "lost" heating days are gone and natural gas and distillate and US residual fuel oil inventories are commensurately higher — the latter 7.2% above year-ago levels, when the weather was also warmer than normal. Moreover, enforcing cohesion among OPEC members is difficult in a declining market. No single member is willing to play the role of “swing” producer and give the gift of market share to those who cheat, especially against today’s geopolitical backdrop. Beyond the price-depressing effects of warmer weather, however, there is a more important change in global oil markets: After four years of global demand growth outstripping supply, which made the supply-demand balance tighter and more vulnerable to shocks, supply is now starting to outstrip demand, alleviating the pressure on prices. This development matters for analyzing the effects of price change for growth and inflation. If weakening global demand was the source of the price declines, I could not argue that lower oil prices would be a tonic for growth; they would merely be the result of the global slowdown. But demand seems firm: Even with the warm weather, the US Energy Information Administration (EIA) estimates that global petroleum demand will increase by 1 mbd in the first quarter from a year ago. Two key factors enable us to identify increased supply as the key driver. At the refined products level, as we noted in November, refiners have invested in de-bottlenecking that has increased middle distillate (diesel and jet fuel) yields. And in crude markets, the EIA estimates that non-OPEC supply has increased by 1.5 mbd compared with a year ago. That may not sound like much for a world consuming 86.2 mbd, but it has more than offset the decline in OPEC supply. The influence on growth and inflation of oil price changes also importantly depends on whether those changes affect inflation expectations, how monetary policy responds, and on the magnitude, speed and duration of the price change. For example, although energy prices doubled over the last four years, with inflation expectations well anchored globally, central banks did not have to respond aggressively. The gradual pace of the increase also facilitated a moderate adjustment — calling it a shock seems a misnomer. Likewise, the recent oil price decline comes amid crosscurrents. It follows a much bigger decline from the peaks of last summer — one that brought gasoline quotes down by more than 70 cents from their peak. In comparison, the prospective price decline is less than half as large. And it comes when unseasonably warm weather may have lifted economic activity like construction somewhat above seasonal norms, so it may appear that the energy-price effects on growth are substantial. It’s worth noting that the weather effects were regionally uneven — far from overheating, California is gripped by a freeze that could damage the citrus crop — and with cold weather coming elsewhere, the lift to growth may be short-lived. Moreover, while the decline in energy quotes may have helped to reduce core inflation slightly over the past few months, it has not produced a change in monetary policy. Thus, the direct impact of the energy price declines on US growth likely will be modest and transitory, about 0.1-0.2 percentage point. And in other regions, it may be even smaller. For example, our European team believes that a 20% sustained decline in Brent crude quotes would boost growth by just 0.1%. In the UK, the effect may also be small because that country is a significant energy producer. In many emerging market economies such as India, where deregulation and the end to energy subsidies is underway, effective retail energy prices are still set well below current market prices. So the recent price declines may have little effect, if any, on growth or inflation. Nonetheless, in my view, investors are reading the energy price plunge correctly. By raising hopes for growth, the decline contributed to higher equity prices. By coming at a time when US growth had already improved, the decline added to the trend toward higher real rates. And of course, falling energy quotes compressed inflation compensation. The global context also matters for real interest rates. Stronger growth abroad than in the US has lifted real rates globally, but by more outside the US. Consequently, trans-Atlantic spreads, which have narrowed by 50 bp since June, continue to shrink. More of the same seems likely for now, but investors should mind the coming “payback” from colder weather that could appear to reverse the climb in real rates by raising inflation and trimming growth. Risks to the current benign scenario abound. One is that investors ignore the transitory nature of the weather-cum-oil-price-induced growth improvement. For reasons unrelated to weather, such as a new shock to supply, energy prices could begin to rebound just as quickly as they have fallen, rekindling growth concerns. Moreover, with energy prices falling, core inflation subdued, and breakevens declining, a pickup in inflation is not in the price. Finally, what oil producers, especially Russia, do with their foreign exchange reserve portfolios may matter for both interest rates and the dollar. I do not believe that Asian capital flows and OPEC recycling of petrodollars were solely responsible for depressing US real yields over the past few years, accounting for the bond-market “conundrum.” Anchored inflation expectations, easy monetary policy with plenty of forward guidance, and declining term premiums all played important roles in depressing yields. However, courtesy of the massive change in the terms of trade for many Asian and oil-producing economies, income far outstripped the perceived level of living standards or “permanent income,” perhaps adding to the decline in US rates. Conversely, if energy prices stay where they are, the transfer of income to lower-saving, higher-oil-consuming economies could work to raise real rates.
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Life After the Downgrade
January 16, 2007
By Vladimir Pillonca | Italy
Only a few months ago, S&P and Fitch downgraded Italy’s sovereign debt. Since then, Italy’s economic growth has exceeded expectations, and the 2007 budget has been approved by parliament. The latest data show that tax revenues have been much stronger than expected, while the government’s public borrowing requirement for 2006 has fallen spectacularly short of the Treasury’s forecasts. What to make of all of this? First let’s look at the facts. The public net borrowing requirement fell to €35 billion in 2006, down from €60 billion in 2005 — a whole €12.5 billion ahead of the Treasury’s rather cautious forecasts. The mechanics behind this outcome are simple: While expenditures have continued to rise at a firm pace, government revenues have risen much more sharply. Central government tax revenues rose by 12% in the ten months to October 2006 from the same period last year, while expenditures increased by 4% on the same basis. What can explain such strong revenues? The steep trajectory of tax receipts reflects two factors: Strong economic growth and the government’s anti-tax-evasion measures. While it is hard to determine how much of this increase in government revenues is due to less tax evasion and how much is due to strong economic growth, this clampdown seem to be making a positive contribution. The government estimates that €5.0 billion of extra revenues are permanent, following the introduction of anti-tax evasion initiatives. This positive contribution could not happen at a better time, in our view: Less tax evasion could partly compensate for this year’s expected cyclical slowdown. The 2007 budget is factoring in an €8 billion contribution from anti-tax evasion measures for 2007. Any significant shortfall could endanger the government’s objective of a 2.8% budget deficit for 2007, while we expect a 3.0% outturn, unless economic growth slows less sharply than we anticipate (from 1.8% YoY in 2006 to 1.1% YoY in 2007). Italy’s debt to GDP ratio looks set to rise towards 108-109% for 2006 and is unlikely to fall much thereafter in the absence of policy change. But now some bad news. The borrowing requirement numbers reflect the fact that the central government’s tax revenue flows are increasing faster than its expenditures. But these estimates exclude local government authorities, which may partly spoil the picture. Besides, Italy’s stock of government debt has reached €1,605 billion in October 2006, up from €1,543 billion in October 2005, according to recent numbers from the Bank of Italy. Even assuming that the level of debt doesn’t rise any further in November and December, it would still get close to 109% of GDP in 2006, the highest level reached since 2000, and is unlikely to decline much in 2007 in the absence of policy change. While the 2007 budget should do a good job of bringing the budget deficit down to Maastricht-compliant levels, a lot more needs to be done to position Italy’s stock of debt on a sustainable downward trajectory. A positive and sustainable gap between government revenues and expenditures needs to be opened to bring down Italy’s stock of debt over time. Italy’s primary surplus — on a declining path since 2000 — has to be raised significantly from its recent levels, and on a lasting basis. The government still has a lot to do on this front, and a significant effort needs to be made to curb the expenditure side of the equation. Conclusions — debt to GDP ratio remains the key long-term concern. Tax revenues have been rising more sharply than the expected, reflecting strong economic growth, while anti-tax evasion measures seem also to be contributing to this positive trend. The contribution of these measures is uncertain at this early stage, but if it proved lasting it could increase Italy’s likelihood of reaching the Maastricht-compliant budget deficit level of 3.0%, and could partly offset the risks to this scenario implied by a sharper-than-expected cyclical deterioration. However, more needs to be done to provide structural solutions to bring down Italy’s stock of government debt in a lasting way. Italy’s debt to GDP ratio looks set to rise towards 108-109% for 2006 and is unlikely to fall much thereafter in the absence of policy change. This remains a matter of longer-term concern.
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A Tour of the Nordics
January 16, 2007
By Thomas Gade | London
Our View on Sweden: Strong but Slowing Growth · The economy — We expect GDP to grow at a strong 3.3% this year, following a likely super-strong 4.5% in 2006. The labour market will tighten, dampened by increased labour supply. Inflation will remain subdued but volatile. Monetary policy remains expansionary, despite gradual tightening. · Politics — A center-right coalition government ousted the long-governing social democrats from power in September 2006. The new government will introduce lower income taxes, cut the wealth tax in half, freeze property taxes and plans to sell off SEK 50 billion of government assets per year. · Financial markets — We expect 75bp of monetary tightening in Sweden this year against 50bp tightening in Euroland and probably 25bp easing in the US. Yield spreads will therefore likely narrow in 2007. Equities can outperform Europe, but mind wage growth and currency strengthening. We expect the Swedish economy to expand at 4.5% in 2006 and to remain strong, if slowing to 3.3% this year. On our projections, 2007 will mark the fourth year of above-trend growth and the sixth year of European outperformance. Following a couple of years of jobless growth, employment continues to pick up in 2007, we estimate. The labour market will gradually tighten, with unemployment declining to 4.2% this year. However, lower income taxes in the form of a tax ‘job deduction’ and very high net immigration could boost worked hours and the labour force by 2-3% in the long term, we estimate. As a result, we see increased consumption growth in 2007. Also, initial wage demands just below 4.0% in the near-record-large round of wage negotiations in 2007 may have been subdued by the expected higher income and increased labour supply. Business sentiment is high, but companies’ expectations still hint at a high but gradually lower growth rate. Manufacturing operating rates have risen to record highs above 90%. The pass-through to inflation may still be limited, but the elevated operating rates should sustain investment growth in 2007, despite continued gradual monetary tightening. Productivity growth is already slowing and is expected to slow further in 2007. Combined with high wage growth, unit labour cost growth will likely rise and gradually feed into inflation. Consumer price inflation is low and remains below the official 2% inflation target. With a fair value estimate of 8.75 against the euro, our FX team expects the krona to gradually strengthen this year. Higher unit labour costs and a strengthening currency will gradually weaken the competitive position of the Swedish economy, we think. The public surplus will remain high at around 2.5-3.0% of GDP this year, in our view. The negative 10-year yield spread could narrow by 25bp against Euroland and 65bp against the US, but the government plans to sell off state assets of SEK 50 billion per year, reducing funding needs, which could be a wild card in this respect. Our View on Denmark: Trend Growth, but High Risks · The economy — We expect the Danish economy to slow to 2.4%, just below trend and following a strong 3.8% in 2006. The labour market is showing severe signs of shortages, but consumer price inflation remains modest. The unwinding of the housing bubble remains a key risk factor. · Politics — The current centre-right coalition government is on its second term. The next elections are scheduled for February 2009 at the latest. With a fixed exchange rate and frozen taxes, economic policy options are limited. A shift in the tax base to lower income taxes would need to be neutral. · Financial markets — With a fixed exchange rate, Danish monetary policy shadows that of the ECB. We expect 50bp more of tightening from the ECB this year. The negative spread to Bunds will narrow through 2007, but sound public balances and a lower borrowing requirement could dampen this development. The Danish economy is likely to slow to 2.4% this year — just below trend. It will still mark an outperformance of Europe in terms of growth, but this is partially a result of fiscal consolidation in Europe. The Danish economy faces two key risks: significant capacity pressures and a bursting housing bubble. The labour market is currently very tight, with unemployment at 4.0% at the end of 2006. A rising percentage of companies are reporting labour shortages as limiting production and we forecast the unemployment rate to average 3.5% this year. The labour shortage could cause upward pressure on wages through 2007, in particular locally negotiated wages. Already, employees have marked higher wages in the ongoing wage negotiations as a top priority, according to several labour market polls. Net immigration, equalling a moderate 0.4% of the labour force, will need to pick up further this year to ease wage pressures, as well as the impact of possible offshoring. Inflation has so far remained contained below 2%, but rising wages and industrial operating rates at a record-high of 87% remain key risk factors for inflation going forward. Domestic demand has been the main driver of economic growth. Investment growth will likely slow but remain sustained by high operating rates and the still expansionary monetary policy. Due to the favourable income dynamics and wealth effects in recent years, private consumption growth has been high. With the housing bubble already starting to correct, we expect household consumption to slow going forward. As the krona is pegged to the euro, Danish monetary policy shadows the decisions of the ECB. Monetary policy thus remains very expansionary in Denmark, despite the continued expected 50bp normalisation by the ECB this year. We expect the 10-year government bond yield spread to the Bund to narrow over the course of the year, but high public surpluses and lower borrowing needs could dampen this development. Our View on Norway: Stable Growth but Tight Labour Market · The economy — We expect the Norwegian economy to expand by 2.7% this year, following similar, around-trend growth of a likely 2.7% in 2006. Operating rates are high and rising. The labour market is very tight. Norges Bank will likely continue monetary policy normalisation. · Politics — The current centre-left coalition government appears to have shrugged off recent political pressure. The next parliamentary elections are scheduled for September 2009. The government’s policy initiatives will focus on reducing labour shortages, education and healthcare and transport. · Financial markets — With the monetary policy rate at 3.5%, we expect continued monetary normalisation through 2007. 10-year government bond yields are trading close to 4.4%. We expect the positive spread towards Bunds to increase. NOK appears slightly undervalued against the euro. We expect the Norwegian economy to expand around trend at 2.7% this year. Stripping out oil-related activities, the mainland economy continues to expand at a higher rate of 4.3%, we estimate. As in Denmark, the Norwegian economy is facing significant labour shortages. Unemployment is currently at 3.0%, which we expect to be the average unemployment rate through this year, despite an ongoing increase in the labour force. Net immigration has risen continuously during the last three years and the net inflow now makes up 0.9% of the labour force per year. The increase in immigration will likely continue this year and may abate otherwise rising wage pressures. In the manufacturing sector, operating rates at 90% are rising and running well above their long-term average. High productivity growth has so far subdued growth in unit labour costs. However, should productivity gradually slow, while wage growth is rising, then a greater pass-through of higher costs to inflation is very likely. Consumer price inflation has risen above Norges Bank’s target of 2.5%. Norges Bank has been normalising monetary policy through 2006, with the monetary policy rate reaching 3.5% in December. We expect Norges Bank to continue withdrawing monetary stimulus at 25bp per quarter through this year. This is in contrast to both the ECB and the Riksbank, where we expect a lower pace of monetary tightening. In the US our US colleagues expect the Fed to cut rates by year-end. The currency is trading at 8.35 against the euro, which compared with our FX team’s estimate of fair value at 8.18 seems slightly undervalued. 10-year government bond yields are currently trading close to 4.4%. Through this year, we expect the current spread to Bunds of close to 40bp to widen.
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PolandTrip Notes: Strong Growth, Low Inflation Set to Endure
January 16, 2007
By Pasquale Diana | London
NBP grapples with globalization, labour markets and wages Our discussions at the NBP revolved mainly around the inflation outlook. There is widespread acceptance that the October inflation forecast looks too high and a downgrade to the CPI projections in January looks likely. This is due to a lower starting point, with inflation in 4Q06 tracking roughly 0.7% below forecast, and to a stronger currency over the last three months than the forecast envisaged (the zloty was assumed to depreciate). There are a variety of views at the NBP about what FX assumptions should be used in the inflation model. Overall, there is still opposition to using exogenous FX assumptions, and the FX is modeled endogenously using UIP (Uncovered Interest Parity). We believe that this will likely continue to yield some zloty weakness in the projection (as domestic rates are higher than those of trading partners), thus biasing the forecast to the upside. Recall that a 1% depreciation of the zloty pushes up inflation by 0.2% over two years in the NBP model. In addition, the current forecast assumes a 100% pass-through from higher excise taxes. This is another source of downside risk to the current projection, as it is likely that at least some of the increase will be absorbed by retailers in the form of lower margins instead of being passed on to consumers. From a more medium-term perspective, there appears to be intense debate within the Council on issues such as globalization and its impact on the inflation projections. While it is widely accepted that globalization acted as an important disinflationary force over the recent period (via lower imported prices and higher domestic competition), there is less agreement on how these forces will affect inflation in the future. The current forecast implicitly assumes that the impact from globalization is set to fade in the coming quarters, but opinions on this are mixed. For instance, the increase in the global labour supply of 1 billion people could continue to bear down on inflation for many years. Furthermore, there are serious doubts on the Council regarding the latest labour market statistics. The unemployment rate fell to a record-low of 13% in 3Q06, down 4.4% from the previous year, suggesting rapid labour market tightening. While the strong growth in employment appears consistent with strong labour demand, the participation rate numbers appear to lag this improvement, with the activity rate remaining surprisingly low in relation to employment growth, likely due to the large number of Poles that have exited the labour force, due to migration. The fall in labour supply has tightened the labour market significantly more than the pace of job creation would have suggested. It is also not clear how migration flows may evolve in the future, and whether a large number of migrants could return to Poland should their new host country (say, the UK) experience an economic slowdown. Labour market tightening is putting pressure on wages. According to the latest data, domestic wage growth stood at 3.1% year on year in November, after 4.7% in October. However, ex-bonuses, the NBP observed in its latest press release that wage growth accelerated to 5.7% year on year in November, from 5.6% in October. And looking at the economy as a whole, nominal wage growth stood at 5% in 3Q. From an inflation standpoint, high wage growth is not necessarily a source of price pressures if it is offset by higher productivity, and this certainly seems to be the case in manufacturing. On our calculations, strong productivity growth in manufacturing is translating into negative unit labour cost (ULC) growth on an annual basis. For the economy as a whole, however, the NBP stresses that the picture is more worrying: ULC growth accelerated from 2.7% in 1Q06 to 4.5% in 2Q06 to 6.1% in 3Q06. That said, it is problematic to estimate output and productivity in the services and government sectors, so the aggregate ULC picture might be less reliable. Window for rate hikes in 2007 is narrow, and closes fast. We see rates on hold throughout the year We remain confident that there is limited room for rate tightening this year. We expect inflation to average just below 2.0% in 1Q07, still an acceleration due to a base effect and some hikes in excise taxes, but then to fall back during the year, to below 2%, and then to reaccelerate towards year-end. Therefore, unlike the NBP, we expect inflation to stay below the 2.5% target. Note that, according to internal NBP sources, the Council discussed rate hikes in each of the three last meetings, with the hawks (Balcerowicz, Noga, Wasilewska-Trenkner and Filar) being outvoted 6-4 by the rest of the Council. While the hawks on the Council are likely to continue to argue for a rate hike, the latest CPI data and the departure of Mr. Balcerowicz from the Council imply that they will likely remain in a minority in the coming months. In addition, inflation remaining below the NBP target should further strengthen the doves’ case. We therefore now see interest rates being left on hold throughout 2007 (previously +25bp).
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Selling ‘Mumbo-Jumbo’
January 16, 2007
By Serhan Cevik | London
Institutionalized paranoia opens the door to the peddlers of mumbo-jumbo. Some degree of mental inertia during stabilization is understandable, but what we have witnessed in Turkey is more like institutionalized paranoia. Despite all the fundamental improvements in the last five years, it seems that the country’s volatile history still stimulates biased risk assessments and opens the door to the peddlers of mumbo-jumbo (see The End of ‘Mumbo-Jumbo’, September 15, 2004). Given the ambiguity of noise, there are no limits as to how far-fetched such speculations could become. You may have forgotten it, but market participants were bombarded with commentaries suggesting the possibility of a military coup in the summer of 2005 against the government’s efforts to meet the Copenhagen criteria for the start of membership talks with the EU. Even though nothing really happened, noise has remained all around us, creating ‘perfect storms’ or various ‘dark clouds’ surrounding the country’s future. More recently, for example, expectations about the collapse of Turkey’s accession negotiations with the EU also turned out to be hearsay. But the peddlers of mumbo-jumbo never run out of material and keep shifting the attention from one ‘threat’ to another. And now, as Turkey moves into an election period, we hear even more mind-boggling conspiracy theories. Elections increase uncertainty everywhere, but Turkey is not a banana republic. The normalization of the Turkish economy and its greater resilience against financial volatility have frustrated the catastrophists, but fetishising the question of political stability remains a prized subject. The election of new president, which had always been problematic, is a new opportunity for mumbo-jumbo peddlers. Extrapolating what happened in the past, some argue that the possibility of a military coup this year is not negligible (see the Newsweek article, Turkey’s Coming Coup, published on December 4, 2006). That would certainly be a devastating shock, but is it really likely? We think not. Turkey is not a banana republic without any institutional safeguards; and there is no systemic risk to the fundamental principles of the republic in the first place. Therefore, these coup scenarios are just a groundless speculation, in our view. The ruling party has a strong parliamentary majority to elect the country’s new president without causing political paralysis. However, market participants will still go through a period of intensified political noise simply because the presidential election is just a sideshow to the coming general elections later in the year. Although it is too early to project the election outcome, we expect ‘mean reversion’ in voting behavior but no significant fragmentation. Hence, even a coalition government is not necessarily a risk to economic management and structural reforms after the elections. The longest stretch of economic growth will become even longer, according to our projections. Prudent policies and structural reforms have helped Turkey to overcome the vicious boom-bust cycles and achieve the longest stretch of uninterrupted output growth in the past five years. While inflation moved rapidly from 73.2% at the beginning of 2002 to the single-digit territory, real GDP increased by 43.8% on a cumulative basis. As we have long argued, this is not an idiosyncratic development but a result of fundamental improvements like fiscal consolidation and higher productivity growth. Therefore, the economy is far more robust than many assume. Indeed, after the global volatility shock that lowered output growth from 7.1% in the first half of last year to 3.4% in 3Q06, economic activity has already bounced back and become more balanced. In other words, despite the burden of higher interest rates, we believe that the Turkish economy will remain vigorous and gain further momentum in 2008 (see Looking Beyond the Wall of Noise, December 12, 2006). Moreover, the slowdown in domestic demand and the continuing shift in the composition of growth should help to reaccelerate disinflation over the course of this year. The biggest risk is not the current account deficit, but the behavior of global liquidity. We have never treated Turkey’s current account deficit as a major threat, since it reflects higher business investment spending, not an imbalance in the public sector. Indeed, the data clearly show that the widening deficit is a result of higher energy prices, strong investment appetite, pent-up consumer demand and structural changes in the composition of industrial sectors. Even if we just strip out the effect of higher oil and natural gas prices, the current account deficit would have been about 4 percentage points of GDP lower than its latest reading (see Mirrors of Distortion, September 26, 2006). Moreover, its financing has improved dramatically, as the share of foreign direct investment and long-term debt reached over 70% in recent years. Of course, although the public sector’s positive savings rate for the first time ever eases pressures during the transition phase, Turkey ultimately needs to deal with its structural bottlenecks that have resulted in higher import dependency and kept export growth below its potential. In our view, the biggest challenge for Turkey is the behavior of global liquidity. The so-called ‘hot money’ flows, albeit shrinking in relative terms, are still large enough in absolute terms to trigger abrupt fluctuations in financial markets. Nevertheless, we hope that Turkey’s fundamental strengths will eventually put the peddlers of mumbo-jumbo out of business.
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