Unprepared for Globalization
February 02, 2007
By Stephen S. Roach | from New Delhi
There was a dramatic moment at this year’s World Economic Forum in Davos that I will long remember. It came during one of the sessions on the global economic outlook, when concerns were being raised about the possibility of a Washington-led political backlash against globalization -- a conclusion that I have long warned of. Montek Singh Ahluwalia, Deputy Chairman of India’s Planning Commission, was quick to respond along the lines of, “Don’t blame us. For years, you in the developed world demanded we in the developing world get our act together, open up, and reform. And now that we have and the payback is at hand, you don’t like it.”
I have had the pleasure of getting to know Mr. Ahluwalia over the years and have found him to be deep thinking and most engaging, with a razor-sharp analytical mind. His point is a very important one -- it challenges one of the great contradictions of the globalization debate. Yet it begs the question of why -- why the developed world is pushing back so hard against the very process of global integration it has so long espoused. Granted, motives are always open to subjective interpretation. But I suspect that “Montek’s complaint” also touches on one of the most important, but overlooked issues in the current global debate -- that the rich countries of the developed world are simply unprepared for the stunning successes of an IT-enabled globalization. Lacking in preparation, the developed world is now on the defensive -- and, unfortunately, ripe for a politically-driven backlash. A key element in all this is speed. Unlike the slowly evolving pace of the globalization of a century ago, the current strain is unfolding at lightening speed. A major difference is the technology of the distribution system. In Globalization I, it took ships, rail, and eventually motor vehicles to facilitate the cross-border exchange and delivery of manufactured goods. It also required the time-intensive construction of ports, rail systems, and roads. Globalization II built on this earlier infrastructure but then added a new twist of its own -- the revolutionary connectivity of the Internet. Where it took at least 30 years for the cross border network to reach a critical mass in the first globalization, this time around it all came together in less than a decade. There is, of course, nothing new about the accelerated rate of technology absorption that underpins both globalizations. Over time, each major wave of innovation has hit its critical mass of penetration considerably faster than the wave that preceded it. For example, it took 38 years for radio to reach 50 million US households; similar levels of penetration for television were hit in 13 years, for cable-TV in 10 years, and for the Internet in only 5 years (see The Internet Report by Mary Meeker and Chris DuPuy, Morgan Stanley Research, December 1995). While this is the norm in the long continuum of technological breakthroughs, in my view, it has played a key role in the current build-up of tensions in the global economy. The hyper-speed of this globalization stands in sharp contrast with the glacial pace of its antecedent a century earlier. Nor can there be any doubt of the unusual breadth of the current IT-enabled breakthrough. Unlike the first globalization, which was all about the cross-border exchange of tradable manufactured goods, the IT-enabled second globalization opens up a similar possibility for many once non-tradable services. This was not supposed to happen, according to the two-sector Ricardian models of economic theory. For high-wage economies, it was fine to trade away market share in manufactured products. Displaced workers could then seek refuge in non-tradable services -- incurring steep retraining and other transition costs but eventually drawing security from performing knowledge-intensive tasks (such as software programming, engineering, medical advice, and consulting) that played to their unique skill-sets. The Internet all but obliterated that sense of job security in an increasingly knowledge-based industrial world. With the click of a mouse, the output of a wide range of knowledge workers residing in low-wage developing countries can now be exported to desktops on a real-time basis from anywhere in the world. This has led to an unprecedented wave of white-collar shock, as once sheltered knowledge workers in the rich countries face the tough pressures of international competition for the first time ever. Both the speed and breadth of this globalization has caught the developed world by surprise. While the world’s leading economies have long been preaching the gospel of trade liberalization and international opportunities, they have done little to prepare for the sudden arrival of new competitive threats. But the hyper-speed of an IT-enabled globalization should not be seen as an excuse. In many respects, the rich countries of the developed world took job and income security for granted -- failing or unwilling to see the challenge that was rapidly building halfway around the world. That’s especially the case on the human capital side of the equation -- the essence of competitive advantage in the Information Age. Back in the pre-Internet days of the early 1990s, the US, Europe, and Japan were well in the lead in turning out newly-minted science and engineering graduates from their colleges and universities. A decade later, China and India had surged to the lead -- at precisely the time when IT-enabled connectivity gave these low-wage knowledge workers the opportunity to compete head-on with their high-wage counterparts in the developed world. Lagging educational reform in the industrial world only compounded the problem. High-wage workers in ever-complacent developed economies were, in effect, blindsided by the new globalization. The United States was even more reckless in its approach to dealing with intensified international competition. Drawing down its income-based saving rate to record lows -- a net national saving rate that averaged just 0.7% of national income over the 2003-05 period -- America became a huge importer of surplus saving from abroad, and had no choice other than to run massive current-account and trade deficits to attract that capital. This bias toward ever-widening trade deficits left the US exposed to the comparative advantages of the main beneficiary of the new globalization -- China. Unprepared on two counts -- under-saving and under-investing in human capital -- America is feeling the heat from the pressures of international competition as never before. Unfortunately, all this was a lethal combination -- a lack of preparation by the developed world, rapid development in the emerging economies, and a new IT-enabled cross-border connectivity. Out of this lethal combination, a new fear has arisen -- job and income security in the developed world. Add in widening disparities in the income distribution and record returns to the owners of capital, the fear becomes all the more palpable for middle-class workers in industrial economies. This angst has now sparked an important shift in the political winds of the rich countries, with the pendulum of power now swinging from the pro-capital Right to the pro-labor Left in the US, France, Germany, Italy, Spain, Japan, and Australia. Reacting to this shifting sentiment, politicians are now upping the ante on protectionist threats against the developing world -- in effect, shifting their support from globalization to the narrow self-interests of “localization” (see my 15 December 2006 dispatch, “From Globalization to Localization”). With the Doha Round of global trade liberalization on life support and Washington-led China bashing on the ascendancy, the risk of protectionism can hardly be taken lightly. What can be done to defuse this increasingly dangerous state of affairs? For the developed world, there is an increasingly urgent challenge to equip its highly-skilled workers with the modern-day tools of the Information Age. The imperatives of education reform and accelerated investment in human capital have never seemed more essential as tools of competitive prowess. In addition, the US needs to get its act together on the saving front -- eliminating what risks becoming an organic bias toward chronic and ever-contentious trade deficits. The developing world, for its part, needs to offer assurances that it is respectful of the core competencies of a new globalization -- namely, intellectual property rights. Clamping down aggressively on the widespread piracy of intellectual property could go a long way in defusing global tensions. Montek Singh Ahluwalia has an important point -- it didn’t have to be this way. Globalization is a two-way street. The poor countries of the developing world are finally making extraordinary progress in lifting their standard of living and offering opportunity for hundreds of millions of people to escape the ravages of poverty. It has taken courage and determination on the part of the developing world to push ahead on reforms and open itself to the rest of the world. And just when the poor countries begin to reap the benefits of this strategy, an unprepared developed world turns the tables and threatens to put up new walls of its own. Such hypocrisy could be the ultimate tragedy of this globalization. Both rich and poor countries, alike, need to own up to the shared responsibilities of defusing these tensions -- before it’s too late.
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2007 Green Budget
February 02, 2007
By David Miles | London
Morgan Stanley and the Institute for Fiscal Studies, the respected UK economic think tank, have collaborated again on producing their annual review of the state of the UK economy and the public finances. ‘The Green Budget’ is our definitive annual analysis of the ways in which the UK governments’ decisions on taxing, spending and debt management interact with the wider economy and financial markets. Here we summarise some of the key findings of this year’s report (the full version of which is available from the Morgan Stanley website). 2007 Green Budget Summary The economy and public finances If Chancellor Gordon Brown leaves the Treasury this year, he will leave the public finances stronger than he found them a decade ago, but having presided over a smaller improvement than has been achieved in most other industrial countries over the same period. Looking forward over the period in which Mr Brown hopes to fight his first general election as Prime Minister, he is aiming to cut his borrowing by a further £20 billion over the next five years to stay on course to meet his self-imposed fiscal rules. To that end, he is projecting a further £10 billion a year increase in the tax burden and has pencilled in a £10 billion a year cut in public spending over that period. On the spending side, the Chancellor has pencilled in £7 billion of spending cuts over the three years of the forthcoming Comprehensive Spending Review (CSR) — with more assumed to follow. If the Chancellor confirms these plans in the Budget, this will be Labour’s toughest spending review yet and (if delivered) would be the tightest squeeze since it stuck to the plans it inherited from the Conservatives in its first years in office — when it was helped by falling unemployment and debt interest costs. The Treasury now judges that a 10-year cycle started in 1997-98 and will conclude in the current financial year, ending in March. Over this period, we expect the golden rule (to borrow only for investment) to be met with a little to spare and public sector net debt to remain below the 40% of national income ceiling set out in the ‘sustainable investment rule’. We also think it more likely than not that the golden rule will be met over the next cycle, but we expect net debt to move uncomfortably close to 40% of national income. Morgan Stanley is somewhat more pessimistic than the Treasury about the prospects for economic growth in the next couple of years, with consumer spending likely to be weaker and some fall in house prices quite likely. We also believe that the estimates of trend growth the Treasury uses to forecast the public finances are a reasonable central estimate, rather than cautious as the Treasury claims. Even so, on the Morgan Stanley central forecast, the sustainable investment rule would be met as would the golden rule, at least based upon the Treasury estimates of the cycle. The near-term outlook and debt management The nearer-term outlook for deficits and debt remains on a more solid footing than we have believed over most of the past three years. Risks, of course, remain. But the Treasury has two reasons to be cheerful. First, if borrowing is somewhat higher than expected in the near future, that is unlikely to make it much more expensive for the taxpayer. Second, the government could probably reduce the cost of borrowing further by changing the mix of debt that it issues. The Treasury might need to borrow more because of a shortage of tax revenue: either because it may get less than it hopes from every pound of economic activity, or because economic activity may be weaker than predicted. On the latter, important risks remain: consumers are stretched and their spending may be significantly weaker than the Treasury expects. House prices have risen enormously over the past ten years. The price of a typical house is about three times the average level of 1996. A significant fall in house prices remains a real possibility, though whether it will come and what its impact might be are very hard to judge. Would extra government borrowing be very costly? The stock of public sector debt in the UK has risen steadily over the past five years, but remains very much below the average of the past 100 years; it is also below the level typical of the 19th century. And it has rarely been cheaper for the UK government to borrow. What has also been striking over the past five years or so is how the UK government’s cost of borrowing has fallen — in both nominal and real terms — even though the amount it has borrowed has been rising and has consistently exceeded its own forecasts. The real cost of long-dated (30-year or more) debt issued by the UK government now is around 1%, significantly below the 3% which we estimate is the average expected real cost of long-term debt offered by the UK governments since it started issuing bonds over 300 years ago. Whatever the factors are that have driven the real cost of government debt down — both here and in the wider world — they have persisted now for several years. Given this, borrowing more than the government’s current forecast to handle a temporary economic slowdown that squeezes tax revenue relative to spending is a better strategy than temporarily raising taxes further or cutting back spending, especially if this means that capital projects with high probable payoffs are postponed. But what type of debt should the government issue? The Debt Management Office (DMO) has in recent years issued more long-dated bonds than has been typical over recent decades. It has also been issuing very long-dated (50-year) debt. As a result, the average maturity of its debt has been rising significantly. The DMO’s own modelling of the impact of random factors on different debt issuance strategies provides strong reasons to favour a strategy involving even greater issuance of long-dated debt. What about the case for issuing debt linked to longevity to help companies cope with longevity risks that have a big impact on the cost of their pension obligations? UK companies clearly face significant longevity risk because of the size of their defined benefit pension obligations, of around £700 billion. (The purple book: DB pensions universe risk profile, December 2006, available at http://www.thepensionsregulator.gov.uk/PurpleBook.pdf). The Pensions Regulator and the Pension Protection Fund estimate that each year added to longevity assumptions adds 3-4% to pension scheme liabilities, raising aggregate deficits by £20 billion or more. An explicit market in hedging longevity risk through the trading of financial instruments whose values are linked to movements in longevity has been very slow to develop. Partly as a result, there have been calls for the government to help such a market to develop by issuing ‘longevity bonds’ with values linked to life expectancy. (See, for example, “How to deal with ever-improving mortality”, by David Cule, principal at Punter Southall, Financial Times, January 8, 2007.) Clearly, the exposure of the corporate sector to longevity risk is very substantial. Could the exposure be reduced and risk handled more effectively if the government helped companies to hedge it? In fact, risk that sits with life insurance companies and with large quoted companies is actually fairly well spread because they are widely owned by a diverse group of end investors. So, despite the potentially large cost that the ultimate holders of longevity risk might need to be compensated with, it is not at all clear that this constitutes a market failure. There remains a rather weak case for government action in this area.
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The SNB Won’t Stand in the Way of a Weakening CHF
February 02, 2007
By Stephen Jen | London
Summary and conclusions We believe that the SNB will not take measures to counter the weakening trend in the CHF, by either tightening rates more than it otherwise would or by directly intervening in the currency markets. If anything, the risk to the SNB’s rate path is biased to the downside, relative to what is priced in the bond markets. Specifically, it is quite likely that the SNB will pause after its June meeting. Also, we investigated ‘carry trades’ as a driver of the CHF’s weakness in the past year or so, and found that it could only explain a small part of the variability in the EUR/CHF rate of return. This result suggests that other factors may have been more important drivers of the CHF. Bottom line: EUR/CHF may drift higher in the months ahead, triggering no response from the SNB. We believe that the risks to EUR/CHF will remain to the upside in the near term. The SNB to normalize rates only gradually We give a brief status report on the state of the Swiss economy, and argue that, while the SNB remains on a normalization path, the risks to its policy rate are biased to the downside, relative to what’s priced in the market. Here are our thoughts on the state of the Swiss economy and policies. 1. The economy is doing just fine; all the risks are external to Switzerland. Following a slight slowdown in 3Q, the economy regained composure in 4Q. It is possible that Switzerland’s growth will moderate somewhat in 1Q, but our view is that growth will be well-sustained (e.g., KOF). On the back of 3.0% growth in 2006, Switzerland is likely to register 2% growth in 2007, above its potential growth rate. Consumption, investment and trade remain robust. In sum, the economy remains in excellent shape. The current account (C/A) surplus is still large (14% of GDP), balanced out by capital outflows. The single most important structural shock to the economy comes from the positive labor supply shock. If this shock is sustained, which we believe will be the case, the urgency for the SNB to act on inflation in the short run is less, but in the long run, the SNB will need to raise rates towards a higher neutral interest rate, if potential growth indeed accelerates ‘permanently’ due to labor migration. 2. The SNB will continue to normalize rates, despite the downward revision to its inflation forecast, but will do so with slightly less urgency. The SNB’s inflation forecasts are conditional on its own past monetary action. This was one reason for the downward revision to the SNB’s inflation forecast path. A more important reason was the sharp decline in oil prices in the latter part of 2006: the decline in the first week of 2007 should also add to this downward pressure on inflation. Since the output gap remains positive, and the monetary stance remains accommodative, the SNB will likely continue to normalize rates. Having said this, our sense is that there is less urgency for the SNB to increase the pace of its tightening pace at its quarterly meetings. 3. The increased flexibility in the labor market has kept a lid on inflation. After several years of gradual liberalization of its labor market, by May 2007, Switzerland will take the final steps to make its labor market fully open to the citizens of the EU. The unemployment rate fell to 3.1% in November, but could continue to drift toward 2-2.5%, with limited pressure on wages. This structural break in the relationship between unemployment and wages suggests that the traditional Phillips Curve framework may not work too well, and that the traditional output gap framework would also need to be taken with a grain of salt, given the instability of aggregate supply. There is likely to be considerable uncertainty on the part of the SNB about the sustainability of this trend in migration. But as long as wage pressures remain muted, the SNB will most likely not push rates into the restrictive zone in a hurry. 4. The weakening in the CHF has been somewhat of a puzzle to the SNB. The SNB is paying a great deal of attention to the CHF, and has raised this subject at its recent Board meetings. It has also launched a research effort to better understand why the CHF has weakened since mid-2006. Aside from the underlying causes of CHF weakness, which we will discuss below, there is also the question of the SNB’s policy response. The key here is that, as long as inflation pass-through, measured by non-oil import prices, remains subdued, there is no urgency for the SNB to react by turning more hawkish. The recent quarterly pace of 25bp increases still seems appropriate from this perspective. EUR/CHF could drift higher The median of our fair value (FV) estimates for EUR/CHF is 1.38. Despite this, the near-term risks to EUR/CHF continue to be biased to the upside, in our view. There are several reasons why we believe this is the case. • Reason 1. Carry trades may have played a key (though not dominant) role. The two currencies in the world that carry extraordinarily low interest rates — the JPY and the CHF — have also been the ones that have depreciated steadily in the past year or so, despite already being under-valued. While it is not straightforward to calculate the size of the ‘carry trades’ acting against the CHF and JPY, it is most likely the case that the low yields were a detractor to these currencies, despite their relatively strong real economic fundamentals. Thus, as long as interest rates in Switzerland remain relatively low, CHF may struggle to assert itself. Further, the cash yield differential between Euroland and Switzerland is expected to remain unchanged until this summer. Having said the above, we underscore our view that, contrary to popular opinion, ‘carry trades’ have not been the dominant factor behind the weak CHF and the weak JPY. In the case of the JPY, we have pointed out in our previous writings that the measurable ‘JPY carry trades’ are not that large, and some types of JPY carry trades that many presume are large are in fact small and declining in size. Similarly, for CHF carry trades, we suspect that there are more preconceived notions than ideas well-supported by facts. Our variance decomposition exercise suggests that only 20% of the variations in EUR/CHF return can be statistically explained by (i) nominal yield differentials and (ii) implied volatility of EUR/CHF. • Reason 2. The CHF losing its reserve currency status. With the emergence of the GBP and EUR as reserve managers’ favorite currencies in recent years, both the JPY and CHF have been crowded out somewhat. Though not as severely as the case of the JPY, the CHF’s share in the world’s reserve pool has declined: between 2003 and now, the CHF’s share has declined by one-third (from 0.24% to 0.17%), while EUR’s share has risen. One key reason is the relatively low liquidity of Switzerland’s sovereign bond market. At around US$110 billion, the market capitalization of the Swiss sovereign bond market is even smaller than that of Sweden (US$134 billion) or Canada (US$587 billion). As central banks’ excess reserves evolve into ‘sovereign wealth funds’, equity market caps become important, and here Switzerland’s equity market is also relatively small: US$1 trillion in market cap, compared to US$1.3 trillion in Canada, US$3.1 trillion in the UK and US$6.6 trillion in Euroland. • Reason 3. The CHF losing its status as a ‘safe haven’ currency. There are signs that the CHF may have lost some of its shine as a safe-haven currency in recent years. During the broad-based risk-reduction phase last May/June, EUR/CHF traded from 1.58 to 1.55 — a remarkably modest move, considering the scale and breadth of the risk reduction. The hypothesis that the rise of the EUR as a counter-weight to the dollar may have ‘crowded out’ the role of the CHF as an ‘alternative’ currency is one we find persuasive, even though it is a claim that is difficult to prove. In any case, the global financial markets are still in a risk-taking mode. In this environment, it would be difficult for the CHF to assert itself even if it still commanded a safe-haven status. The possibility that the CHF is neither a ‘high-beta’ currency nor as good a safe-haven currency as in the past suggests an upward bias in EUR/CHF, from a risk-reward perspective. Bottom line Despite valuation and fundamentals, EUR/CHF may continue to drift higher in the coming months. As long as the weakening CHF does not lead to a rise in import prices, the SNB is not likely to respond. If anything, a slight deceleration in growth, coupled with the sharp fall in oil prices recently, suggests that the SNB will not be in a hurry to complete its rate normalization process. The risks to the SNB’s policy path are biased to the downside, relative to what is priced in the bond market (another 75bp by year-end), and risks to EUR/CHF are biased to the upside.
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Reversal of Real and Nominal Growth, and Corporate Earnings
February 02, 2007
By Takehiro Sato | Tokyo
Acceleration in nominal growth expands nominal income pie The economy came out of a mid-year slump and sharply recovered to 3.8% growth (real basis; our estimate) in October-December, in line with our scenario. For all the pessimism pervading the market, we think that risks are to the upside, mainly because of exports and business investment. Nominal growth could be stronger in light of solid overseas economies, the decline in oil prices, and the weakness in the yen’s real effective value. We forecast F3/08 real growth of 2.2% and nominal growth of 2.8%, but the latter could reach 3% even if real growth is only slightly better because of the nature of the GDP deflator, as we outline below. Reaction to the Abe administration’s growth strategy has been generally cool, but we do not think nominal growth of 3% is a pie-in-the-sky number. We expect a reversal of real and nominal GDP growth for October-December (QoQ) and this April-June (YoY), and an acceleration in nominal growth could lead to upside for corporate earnings. We raise our 9% top-down forecast for recurring profit growth in F3/08 (for large companies, excluding financials, with more than ¥1 billion in capital; based on MoF’s Corporate Statistics), in light of the recent decline in the yen and oil prices. Top-down profit forecasts of continuous double-digit growth In corporate management accounting terms, real growth under deflationary conditions means sales and profit growth from volume increases or restructuring, while an increase in nominal growth from an end to deflation means not only benefits from volume increases and restructuring but also prices (i.e., higher sales margins). Since the GDP deflator, the link between real and nominal growth, is not just a function of prices but also a proxy for income, an improvement in the deflator means an improvement in income, either household or corporate sector. For instance, the decline in oil prices leads to an improvement in the GDP deflator through a decline in the import deflator, but a decline in oil import costs leads to a transfer of income from oil-producing to oil-consuming countries, to the same extent as tax cuts. In other words, an acceleration in nominal growth from a positive turnaround in the GDP deflator leads to an acceleration in growth in the nominal income pie. We estimated large companies’ sales based on nominal GDP forecasts and the first reversal of real and nominal GDP growth in 13 years. We came up with surprising upside to 13.5% in F3/08 and 12.8% in F3/09, versus 10.5% in F3/07 (we assumed a F3/08 average of US$53.5/bbl and ¥115/US$, separately from our current economic forecasts). Impact of oil prices and exchange rates We analyzed the impact of oil prices and exchange rates using elasticity and breakeven analysis. We estimate that a 10% rise in oil prices and the yen’s value has a 3% negative impact on recurring profits. If we assume F3/08 averages of ¥120/US$, corporate recurring profits could rise by 1.5% (the exchange benefit scale relies on exchange contracts and thus the aforementioned impact may not be fully realized). Also, our Japanese equity strategy colleague estimates a fair value for TOPIX of 1,810-1,930, assuming F3/08 corporate earnings growth of 13.5%. Support for corporate earnings from low labor share of income, in other countries as well The household and corporate sectors’ shares of the total income pie are determined by labor’s share of income. This proportion has been low in Japan in the past two years, but to address the increasingly high-profile social issue of income disparities ahead of the upper house elections, the government implicitly and explicitly expects the corporate sector to increase labor’s share of income. Labor’s share is low not only in Japan but also elsewhere in the world, reflecting globalization. Since it does not make strategic sense for Japanese companies to be the only ones to increase labor’s share of income, we do not currently consider the impact on corporate earnings of a rise in labor’s share of income or a decline in capital’s share of income. A rise in labor’s share of income has tended to lead to a decline in capital’s share of income and economic downturns because of downward rigidity in wages and a consequent rise in labor’s share of income during economic downturns, and not because a rise in labor’s share of income directly leads to an economic downturn. Nevertheless, if the government more actively involves itself in private sector companies’ employment and wage policies and unreasonably pushes for increases in labor’s share of income, a longer-term decline in capital’s share of income would make companies cautious on business investment and thereby contribute to a slowdown in economic growth. In this sense, we have problems with the government and ruling party’s inconsistent concern over the private sector’s employment and wage policies, specifically postponing a bill to broaden a system of flexible work hours (i.e., no overtime) but pushing forward a bill to increase the percentage premium for overtime wages, as originally scheduled. Decline in oil prices a double-edged sword In any event, we think that the outlook is generally bright but expect the economy to lack strong momentum because of the poor prospects for wage and income growth stemming from globalization. Corporate earnings growth, however, should be robust thanks to a weak yen, a decline in oil prices, and a reversal of real and nominal economic growth. If we were to specify risks in such a scenario, they would include government involvement in private sector companies’ employment and wage policies and a halt in global demand growth from a reversal of the existing mechanism of global income redistribution stemming from a decline in oil prices. Although high oil prices lead to a transfer of income from oil-consuming to oil-producing countries as a result of an overheated global economy, oil-consuming countries also actually benefit from feedback effects, namely demand from oil-producing countries. A decline in oil prices, however, diminishes the feedback effects in the likely form of sales declines. We believe that demand trends in Middle Eastern oil-producing countries and in emerging markets need to be closely watched.
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