The Currency Foil
February 09, 2007
By Stephen S. Roach | New York
All eyes are on currencies on the eve of another G-7 meeting of finance ministers and central bankers. Fixation on the Chinese renminbi remains intense from the American side, and the Europeans are increasingly concerned about the weakness of the Japanese yen. In my view, these concerns are misplaced. In a world where the main misalignments are on the saving-investment axis, currency solutions are not the remedy. This timeworn fixation on foreign exchange markets detracts from the heavy lifting of structural change that is required to meet the competitive challenges of globalization head-on.
The politicization of the Chinese currency issue has been a hallmark of the US-China debate of the past several years. The “logic” is straight-forward: Most US workers are feeling enormous pressures on job and income security -- labor’s share of national income is back to historical lows and the gap between the rich and everyone else is getting larger and larger. Meanwhile, the United States is now suffering from the mother of all trade deficits -- an external imbalance that hit about 7% of GDP in 2006. The key presumptive link in this equation is that workers and their elected representatives have concluded that this ever-widening trade deficit is the source of labor’s deepening sense of angst. The smoking gun comes in the form of a Chinese bilateral deficit that now accounts for 29% of America’s total multilateral trade gap -- easily the largest portion of the US external shortfall. Washington views China as the culprit to all that ails the American worker. It then follows that an adjustment of an undervalued renminbi is the fix that can assuage the pain. Europe’s yen complaint is of a different ilk. Currently at 157, the euro-yen cross rate has strengthened dramatically in recent years -- now up over 75% from the all-time low in October 2000 to the strongest level in 8 1/2 years. For a European economy that is still lacking in vigorous support from internal demand -- especially private consumption -- any currency-related pressures on external demand are viewed with great concern. That’s especially the case with a still high -- albeit declining -- pan-regional unemployment rate of 7.6% and a persistence of relatively stagnant real wages. However, unlike the US with its massive trade deficit, Europe’s overall external position is nearly in balance -- a current account deficit that our estimates put at -0.3% of GDP in 2006-07. But here’s the rub for Europe: Despite a nice cyclical pop of 2.7% real GDP growth in 2006, Europe still views itself as a 2 to 2.25% grower -- in essence, lacking the vigor to provide much further relief for pressures bearing down on labor. For such a sluggishly growing European economy, any currency-related pressures on its external sources of growth are a much bigger deal than is the case for the US, which enjoys much more solid support from internal consumption. The recent weakness of the yen is perceived as a growing threat in that context. The question for G-7 policy makers is whether a currency “fix” -- namely, pushing for a stronger RMB and yen -- is in the world’s best interest. This is an interesting intellectual debate but probably misses the subtext of the real hand-wringing -- whether currency realignments will temper the domestic political concerns now evident in the US and Europe. The answer, in my view, is an unequivocal no. In the case of the US, the outsize bilateral imbalance is a symptom of a much bigger problem -- an unprecedented shortfall of domestic saving that drove the net national saving rate to historical lows of just 1% over the past three years. For an economy like the US, where the political constituency for rapid economic growth is very powerful, saving shortfalls create an inherent bias toward chronic trade deficits. America is left with no choice other than to import surplus saving from abroad in order to fuel its appetite for growth. The only way to get that foreign capital is to run large current account and trade deficits. The distribution of those deficits then follows along the lines of comparative advantage. China fits all too nicely into that equation -- both as a supplier of surplus saving and as a source of low-cost, increasingly high-quality goods. I do not believe a stronger RMB will force Americans to save more. The best Washington can hope for if it relies on such a “remedy” is to shift the China piece of the US multilateral imbalance somewhere else -- most likely to a higher-cost producer, which would be the functional equivalent of a tax hike on the American consumer. There’s another element of the “RMB fix” that bears noting insofar as the US is concerned. America’s trade problem is one of excess imports -- not insufficient exports. As of 4Q06, goods imports were running 73% higher than goods exports. The import surge, in my view, is very much an outgrowth of an extraordinary period of excess personal consumption -- with the consumer spending share of US GDP rising to 70% over the past five years from an average of 65% over the 1975 to 2000 period. With labor income growth unusually weak over the current economic recovery cycle -- private sector compensation tracking over $425 billion (in real terms) below the norm of previous cycles -- US consumers have drawn increasingly from the wealth effects of asset appreciation to finance both consumption and saving. With the income-based saving rate falling into negative territory for the first time since the early 1930s, the excess consumption and the outsize import surge it has spawned is a major source of America’s macro saving imbalance. I do not believe that a stronger RMB-dollar cross rate will temper this imbalance in any way whatsoever. The excesses of asset-driven consumption are best addressed through asset markets themselves -- a development that now seems to be under way as the US property bubble bursts. Moreover, given the sheer size of the imbalance between imports and exports, an equilibrating realignment of the dollar would be so huge that it would be politically unacceptable to the rest of the world -- not just the Chinese but also the Europeans, the Japanese, and America’s other Asian trading partners. Nor should Europe count on a realignment of the yen to underwrite its growth imperatives. In large part, that’s because Japan is far from Europe’s major trading partner. As of 3Q06, Japan accounted for just 2.5% of total pan-European merchandise exports -- well below shares going to the United States (14%), OPEC (5.3%), China (3.9%), and Latin America (3.9%). The same is true on the import side of Europe’s trade equation. Japanese-made products account for just 4% of total European merchandise imports -- well behind shares coming from China (10%), the US (9%), OPEC (8.9%), and Latin America (4.7%). Yes, the euro has, indeed, borne the brunt of the yen’s recent weakness. And, yes, Germany and Japan compete aggressively in several export markets. But given Japan’s relatively small share of overall European trade flows, it is by no means clear that a strengthening of the yen would have a material impact on European economic growth. Eric Chaney’s estimates suggest that a 20% appreciation in the broad yen index would add just 0.2% to pan-European GDP growth. In short, Europe’s yen fixation appears overblown. The G-7 doesn’t have much to do these days. The glory days of the Plaza and Louvre Accords of the 1980s are long gone. After last May’s highly celebrated recognition of the perils of global imbalances, the G-7 has retreated back into its ever-hardening shell of irrelevance. Traditionally, this gathering of the world’s Wise Men has been an important signaling mechanism for currency markets. And currencies, of course, have long been -- and still are -- a hot-button in political circles. Those concerns are heating up again -- especially in the US with respect to the Chinese RMB and now in Europe with respect to the Japanese yen. The communiqué from this weekend’s gathering in Essen, Germany will undoubtedly have some carefully worded, yet oblique, references to perceptions of certain “misaligned” currencies. Financial markets could well take these references seriously for a few trading days -- or possibly longer -- insofar as yen and RMB spot rates are concerned. But in a global economy beset by major saving imbalances and structural competitive issues, the impacts of a politically expedient currency fix are likely to ring increasingly hollow. The world needs to do a much better job in coming to grips with the stresses and strains of globalization.
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Business Conditions: The Long-Awaited Rebound?
February 09, 2007
By Shital Patel | New York
Business conditions rebounded significantly in early February, according to the Morgan Stanley Business Conditions Index (MSBCI): It jumped 13 points to 51%, posting its first reading above the 50% threshold since May. Our analytics convince us that this rebound will last, although it is not a prelude to significantly stronger growth. But two factors temper our optimism: The first is the persistent disconnect between official economic statistics, which have suggested a healthy rebound, versus survey-based data — and not just the MSBCI — which have painted a more subdued picture (see “Three Disconnects,” Global Economic Forum, January 22, 2007). Rather than signalling new strength, the surveys may simply catch up with official data. Second, our survey is quite volatile; even with the February snapback, the less-volatile three-month moving average edged up only three points to 44%. Nonetheless, the MSBCI is one of the first survey-based indicators to show significant improvement. These results and our analytics thus reinforce our confidence that downside risks to top-line growth are fading. Some “payback” is still likely in the early part of 2007, so while fourth quarter GDP growth came in a full point stronger than we had expected last month, we maintain our forecast for below-trend first-half growth at 2.6%. Another important disconnect may also be fading, namely between the weak top- and bottom-line indications from the MSBCI and hearty actual earnings growth. For example, in the fourth quarter, the MSBCI averaged an anemic 43%, while earnings for S&P 500 companies exceeded Street estimates by 5.1%. However, forward-looking profits gauges point to slower growth. For example, our strategy team’s earnings revision factor (ERF) has been in a downward trend since November, suggesting weaker earnings growth, and the bottom-up consensus estimate for 1Q07 earnings has been coming down since the end of December (from 8.2% to 4.4%). Moreover, the current S&P 500 1Q07 preannouncement ratio (positive/negative guidance) is the lowest since 2000. Now what? To assess factors affecting earnings more systematically, this month we introduced a series of questions that we will repeat quarterly during earnings seasons (February, May, August, and November). First, we asked analysts how the earnings quality of companies in their coverage universe changed in the past year. Of these, 31% reported that the earnings quality has worsened in the past year, while 22% said that the quality is better, and 47% of analysts reported that earnings quality is the same. We also asked analysts whether, if companies exceeded their estimates, the quality of the earnings beat was low or high. Fifty-four percent said the quality of earnings was low in these cases, while 46% said the quality was high. This does not surprise us for two reasons. First, upside surprises for reported earnings could have come from lower-than-expected tax rates. In particular, taxes on overseas earnings may be lower, and the sunset of bonus depreciation, or the sunset of repatriation under the American Jobs Creation Act of 2004 may have altered effective tax rates. Second, high levels of stock buybacks could have artificially boosted per-share earnings. Turning back to the top line, underlying details from our survey suggest the tentative strength in business conditions may be here to stay. Our business conditions expectations index increased 14 points to 54% while the advance bookings index increased 10 points to 45%. Business conditions are expected to improve over the next six months for the consumer discretionary, consumer staples, industrials, and energy sectors. This month we also asked analysts whether there are upside or downside risks to their earnings estimates; 52% noted upside risks. Higher-than-expected domestic results were an upside risk for 39% of the groups, while a combination of higher domestic and foreign growth could help 30% of the groups. 13% of analysts noted higher growth abroad could help earnings. Upside risks were prevalent in the consumer staples, energy, and healthcare sectors. Of those expecting downside risks, 52% were worried about domestic results, while 29% had doubts about both domestic and foreign growth. The consumer discretionary, IT, and utilities sectors are more inclined to have downside risks to their earnings estimates. The breadth of results also tilted towards strength in early February. The distribution of responses was near normal with 22% of analysts reporting improving conditions compared to last month (up from 10% in January), 20% reporting deteriorating conditions (down from 35%) and 59% reporting unchanged conditions. Conditions improved for the materials, consumer staples, healthcare, and utilities sectors, but deteriorated for the financials and IT sectors. The industrials and energy sectors had mixed conditions while conditions remained unchanged for the consumer discretionary group. Moreover, capex and hiring plans also improved in February. A full 56% of analysts expect companies under their coverage to increase capex over the next three months, up from 54% in January and the highest level since October. Forty-five percent of groups plan to increase spending by 0-6% from current levels, which is in line with our forecast for 5.7% growth in real equipment and software spending in the first half of 2007. Thirty percent will keep the level unchanged, while 9% will decrease spending by 0-6% and 5% will decrease spending by 6% or more. The industrials, IT, utilities, consumer staples, and consumer discretionary sectors have the most robust plans to increase capital spending. One key theme underpinning our economic outlook is that healthy gains in jobs and incomes will support consumer outlays. Along with upward revisions to nonfarm payrolls, results from this month’s analysts’ survey support those claims. On the hiring front, 38% of analysts noted that companies under their coverage have plans to step up hiring in the next three months, up from 31% last month. Sectors with plans to increase hiring include industrials, financials, IT, consumer staples, energy and utilities. Pricing conditions improved in early February; the pricing conditions index increased three points to 58%. But the dispersion is narrowing: The percentage of groups that raised prices from a year ago stood at 38%, down from 40%; the percentage noting lower prices also declined from 29% to 22%. However, the magnitude of price increases was higher as 27% of the groups increased prices by 3% or more, up from 23% last month. As in the past, prices declines were concentrated in the IT and telecom services sectors. Prices were also lower for the non-life insurers and the US homebuilders. Margin growth moderated over the past three months. Only 25% of analysts reported that prices charged have risen faster than unit costs at companies they cover over the last three months, down from 27% last month. Also, only 42% of analysts expect margins to grow over 2007, compared to 48% last month, while a full 40% expect margins to shrink, up from 29% percent in January. Analysts expect margins to expand at the consumer staples and industrials sectors, but shrink for the consumer discretionary, materials, and utilities sectors. Morgan Stanley analysts are more pessimistic than the Street consensus. Analysts on the Street still expect 67.6% of companies in the S&P 500 to have rising margins, down markedly from 74.1% in the beginning of the year. The deterioration in subprime mortgage credit quality seems to have triggered sharply tighter lending standards to individuals, according to the Fed’s January Senior Loan Officer survey. But in that canvass, credit standards on bank loans to large firms remained unchanged. Our survey echoes that conclusion: Credit conditions improved marginally for companies covered by Morgan Stanley analysts, as the credit conditions index increased two points to 53% (a reading above 50% indicates that financing has been easier to obtain over the past three months). It is worth noting, however, that fully 89% of analysts noted that the ability to obtain financing for companies under their coverage over the past three months has remained the same.
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Slightly Flattening the Paths for EUR/USD and USD/JPY
February 09, 2007
By Stephen L. Jen | London
Summary and conclusions We are tweaking our currency forecasts: our forecast paths for both EUR/USD and USD/JPY are moderately flattened. As we argued previously, this will no longer be a ‘dollar year’. In the absence of structural pressures, the dollar will strengthen against some currencies and weaken against others. The re-rating of the US economic outlook since mid-December and the persistence of a ‘carry culture’ are the two main motivations for our forecast revisions, but our story for 2007 remains basically unchanged: (1) The EUR is overvalued against both the dollar and the yen. While overshoots are possible, EUR/USD above 1.30 or EUR/JPY above 155 should not be sustained. We still expect a downward-sloping trajectory for EUR/USD and EUR/JPY, but now see slightly flatter paths. (2) While we still believe that a stronger JPY makes more sense, and are retaining a downward trend in USD/JPY, we warn that our conviction level is no longer as high as before, since we are struggling to predict when the ‘carry culture’ will end. (3) In any case, we maintain our view that USD/AXJ will trend lower, led by USD/CNY. Our year-end targets are now 1.24 and 112 for EUR/USD and USD/JPY (compared to 1.24 and 108 previously). Revisions and our forecast misses I highlight the two main factors behind our forecast revisions: • Factor 1. Re-rating of the US economy since late December. Since mid-December, data from the US began to surprise on the upside. By now we know that the US expanded at a healthy pace of 3.5% in 4Q — substantially above the new lower potential growth rate. As our US Economists Dick Berner and David Greenlaw pointed out a couple of weeks back, some of the acceleration in growth and deceleration in inflation in the US in 4Q was due to (i) sharply lower oil prices and (ii) unseasonably warm weather, and some effects of these transitory favourable shocks will likely reverse in the near future. However, the underlying strength of the US economy is likely to offset these ‘paybacks’ and keep the Fed from being pressured to either tighten or ease the FFR (fed funds rate) for the rest of the year. In terms of the quarterly GDP growth profile, our US economists now see 2.9, 2.3, 3.1 and 3.2% for the four quarters of 2007 (3.0% for the year). Rather than tightly ‘hugging’ this new GDP profile in formulating our forecast path for the dollar, we simply take note of the strength in the US economy in 4Q by reducing the size of the overshoot in EUR/USD and cable in 1H, and still show a rally in the dollar in 2H when the US economy is expected to reassert itself. EUR/USD is now expected to stay in the high-1.20s throughout 1H (compared to the low-1.30s in the previous forecasts), and cable is no longer expected to break 2.00. These slightly revised trajectories for EUR/USD and cable are consistent with the view we expressed last November, that 2007 will be somewhat ‘bifurcated’ as the US shows a softer phase in the first part of the year, followed by more strength. • Factor 2. Take note of the persistence of the ‘carry’ environment. The JPY staying weak in the past two months is a much more serious miss on our part than not foreseeing the extent of the resilience of the US economy in 4Q. A part of the strength in the USD against the JPY (and against the EUR) now reflects the re-rating of the US economy. However, by some measures, capital outflows from the retail sector in Japan remain large, and the fact that the BoJ was not able to validate its hawkish rhetoric with additional rate hikes in November, December and again in January has substantially undermined our strong-JPY scenario. In my opinion, a hawkish and assertive BoJ is a necessary but not sufficient condition for the JPY to rally. Without rate hikes, it will be difficult for the JPY to appreciate. The point above about the BoJ is obvious, in my view. However, the problems I am struggling with regarding the JPY are much more serious. I believe I know all the arguments why the JPY could stay weak, as well as the arguments why it should rally. The difficulty lies in weighing these two competing sets of arguments against each other. The traditional real fundamentals argue for a stronger JPY. I have held this JPY-bullish view since January 2006, thinking that the market’s focus would shift from nominal to real factors. This call has not been correct. However, there are other genuine issues for which I have no final conclusions, even though I agree with the logic of the argument. For example, it is very difficult to know if the Japanese retail investors’ exodus out of JPY assets is structural and these outflows will remain resilient to changes in the global fundamentals. Nobody really knows the answer to this question, mainly because this is a new trend that is occurring for the first time in modern history. I find the outflow story convincing, but am not yet certain how serious this story will be, weighed against other factors I can better measure, such as productivity, the C/A surplus, etc. In any case, I list my thoughts on some likely triggers for a turnaround in USD/JPY. My conviction level behind the strong JPY call is low, since none of these potential triggers seem that convincing to me. 1. Will the cash yield differentials between the US and Japan narrow? This will be a very gradual process, I’m afraid. Japan’s real growth rate has not been bad at all: 1.9% in 2005 and 2.1% in 2006, and 2.2% is likely in 2007. For a country whose potential growth is widely believed to be around 1.5-1.7%, Japan’s output gap is most likely to be quite positive and interest rates should not be zero in real terms. However, the problem in Japan is the lack of inflationary pressures. For an inflation-centered BoJ (it is not yet a strict inflation targeter), it will be very difficult for it to normalize rates when inflation remains so low, despite impressive real growth. A related issue is why nominal cash yield differentials are so important for exchange rates these days. I still don’t have a good answer to this question. Back in 2000-2001, the cash yield differentials between the US and Japan reached 6.50% at one point, and USD/JPY approached 105 then. A hypothesis I have discussed in the past is that ‘bond culture’ still dominates ‘equity culture’, and until this is reversed, exchange rates will be driven more by nominal rather than real variables. Currency hedging is another consideration. The date for this switchover is still quite uncertain. 2. Will the process of ‘Global Funnelling’ slow down? Last August, I proposed the idea that the structural rise in EUR/JPY could be due to ‘asymmetric globalization’ of the goods and the financial markets. As long as the net savings positions of Asia and the Middle East remain high, there could be a persistent downward pressure on the JPY, against the USD, EUR and GBP. The decisions by the central banks of Russia, the UAE and Switzerland late last year to raise their holdings of JPY may temper somewhat this process. Second, the general move towards ‘sovereign wealth funds’ by central banks should lead to a substantial increase in demand for Japanese equities, which should also temper this funnelling process. I am, however, uncertain as to how quickly the global funnelling process can be neutralized. 3. Is the decline in Japan’s ‘home bias’ genuine? The retiring baby boomers in Japan have been investing a remarkably high proportion of their wealth in overseas assets. This may not just reflect a generational shift in risk-taking, or a cyclical increase in risk appetite, reflecting the buoyancy of the Nikkei. Rather, it could also reflect a desire on the part of the retirees and those approaching retirement age to enhance the return on their investments, due to improved longevity. If this is indeed what has been behind the decline in Japan’s ‘home bias’ since summer 2005, then the JPY will struggle to appreciate. 4. Will currency politics halt the slide in the JPY? The single-most powerful factor, in my view, that may force the JPY higher is currency politics. However, Europe is simply too far from its ‘pain threshold’ for its complaints to be taken seriously by anyone else. Back in December, I had thought that protectionist sentiment would gain so much support in the US that, by this time of the year, both China and Japan would come under pressure from the US politicians to deal with their currencies. This was an erroneous view. If it will take longer for the US to turn more hawkish on Japan regarding the JPY, JPY could stay weak for longer than we think. Bottom line Our view on currencies for 2007 remains broadly unchanged. The two key factors behind our forecast revisions are: (i) re-rating of the US economy and (ii) persistence of the ‘carry’ environment. In response, we have flattened somewhat the downward trajectories of both EUR/USD and USD/JPY.
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Further Thoughts on the JPY Carry Trades
February 09, 2007
By Stephen Jen | London
Summary and conclusions We find the discussion on JPY carry trades a bit disturbing. (1) Since the concept of ‘JPY carry trades’ is ill-defined, it is misleading, in our view, to come up with a single-number estimate of the size of JPY carry trades. Specifically, given the vastly different types of JPY carry trades (conducted in the spot, forward and swap markets), we don’t understand how some commentators can sum up numbers that are intrinsically not additive. Further, there are types of JPY carry trade that are benign and stable, and other types that are destabilizing. Talking about JPY carry trades as a homogeneous group of investments is misleading. (2) Using some measures, we have found evidence of an increase in retail investment outflows from Japan. However, these ‘indicators’ of outflows are not corroborated by the more comprehensive portfolio flow data from the MoF or the BoJ. (3) Commentators may be mixing capital outflows with carry trades: much of the retail outflows are equity, not bond flows. Cash differentials are one important, but probably not the dominant, driver of the JPY. (4) We believe that the MoF may have a role in imparting two-way risk to USD/JPY and EUR/JPY, in order to prevent JPY carry trades from degenerating into more volatile types. There are already signs that more unstable types of speculative short-JPY positions have been established recently. We believe that the MoF should consider intervening to support the JPY if a vicious cycle develops. Thus, the motivation to intervene to stabilize JPY could come from Japan, not Europe or the US. Some thoughts on JPY carry trades We find the many discussions taking place on carry trades highly unsatisfactory. Presumptions mixed with a lack of data have led to quite misleading statements about these so-called ‘JPY carry trades’. In this note, we present some thoughts and provide some hard data on this subject. • Point 1. The concept of ‘JPY carry trades’ is ill-defined. Cash yield differentials are clearly playing a much more important role in the currency markets these days than in the past. Japan and Switzerland have large C/A surpluses (4% and 16% of GDP in 2005, respectively), a solid net investment position (36% and 114% of GDP in 2005), and higher-than-potential economic growth. Most economic theories predict that the JPY and the CHF should have appreciated in 2006. In fact, our valuation models, which are based on these economic theories, suggest that the JPY is now more under-valued than the Chinese RMB. For the JPY and the CHF to depreciate, their low cash yields have almost certainly played an important role. That large financial positions that are sensitive to cash yield differentials exist is not in doubt. However, in trying to quantify the size of the JPY carry trades, it may be useful to identify different types of these flows/positions. In a previous note, we proposed three types of JPY carry trades. Type 1 JPY carry trades consist of net fixed income outflows from Japan. This is the type of JPY carry trade we assume most investors have in mind — net fixed income outflows propelled by interest rate differentials. Type 2 JPY carry trades, we proposed, consist of ‘JPY duration trades’, whereby Japanese investors borrow short and lend long in the JPY market, to take advantage of the steep yield curve in Japan. To the extent that these positions affect the shape of the yield curve, they should also indirectly influence the JPY. Type 3 JPY carry trades consist of non-Japanese residents borrowing in JPY outside of Japan. We have already written a piece dismissing the importance of this type of JPY carry trades. These three types of JPY carry trades are not exhaustive. We propose additional types of JPY carry trades. Type 4 could consist of hedging positions: e.g., foreign equity investors hedging out their Nikkei exposure by buying USD/JPY forward. Type 5 carry trades may include non-commercial speculative short-JPY positions, such as those tracked by the IMM. Type 6 JPY carry trade may consist of off-balance sheet swap positions. Quantifying these different types of JPY carry trades is very difficult. Not only is it difficult to quantify each type of carry trade, these different carry trades in the spot, forward and swap markets are not additive. It is misleading to ask ‘how big the JPY carry trades are’; it would be even more misleading to offer one number in response to this question. • Point 2. It is not clear that Type 1 JPY carry trades are that large. JPY carry trades prosecuted by retail investors are perhaps what most people have in mind. Essentially, there are some data — uridashi flows and foreign currency investment trust fund (ITF) flows — that track the take-up rate by Japanese investors for different types of investments denominated in foreign currencies. Uridashi bonds are bonds issued in foreign currency terms, issued in Japan, while investment trust funds are similar to international mutual funds. At around US$2 billion a month, uridashi flows are not small, but certainly not large enough to drive the JPY weaker by themselves: Japan’s trade surplus is around US$10 billion a month. On the other hand, foreign currency ITFs did show a drastic increase in 2005 and 2006, compared with previous years. In the final months of 2006, these subscription rates rose to the US$10-13 billion a month range. These flows are indeed large. Importantly, we should note here that, while uridashi flows are genuine ‘JPY carry trades’, foreign currency ITF flows are partly equity flows and are therefore technically not pure JPY carry trades. While the aforementioned data are tracked by many analysts, the trend of rising capital outflows is not confirmed by other, more comprehensive flow data, specifically the MoF’s weekly flow data and the BoJ’s monthly balance of payments data. Essentially, the MoF and the BoJ data, which also include pension fund flows, life insurance companies and institutional investors other than mutual funds, don’t show any surge in portfolio outflows in 2006, even though, in theory, when the Japanese institutional investment funds deploy the subscribed ITFs into foreign financial assets, these flows should be captured by the MoF data. • Point 3. It is important to understand the motivations behind the JPY carry trades. Some have argued that the FFR and the ECB’s refi rate being at the top end of the neutral range do not undermine bloated global asset prices because massive JPY carry trades have continued to fund risky asset positions at a cash rate of 0.25%. According to this surprisingly popular argument, the relevant level of policy rate in the world is the BoJ’s rate. While we concur that there has been some ‘leakage’ of liquidity from Japan that may have ended up in risky assets, we are skeptical of the overwhelming scale of these flows implied by this argument. Settling this debate requires a ‘guesstimate’ on the size of a particular type of JPY carry trade: Type 6 carry trades, defined above. However, not only are these swap positions virtually impossible to quantify, there is also a conceptual issue of who is taking the other side of these swap arrangements? In other words, can the world be net short JPY? Furthermore, we know of very few macro hedge funds that are engaged in this type of trade. For something that is supposed to be the main pillar propping up global asset prices, it is curiously difficult to find proof of its existence. The motivation behind the JPY carry trades, therefore, has important implications for whether we should be worried about these positions. Again, as we argued above, merely asking ‘how big are these JPY carry trades’ misses the point. If there were indeed massive Type 6 JPY carry trades, then policy makers should be worried. However, if most of these ‘carry trades’ are Type 4 (currency hedging of equity positions) or reflect a structural shift in the way Japanese investors think about foreign currency risk, then the policy implications are more benign, as these positions are logical and don’t deserve countermeasures from the authorities. • Point 4. JPY carry trades are degenerating, suggesting a role for the MoF. Speculative JPY shorts (Type 5 carry trades) have surged sharply in recent months. In fact, the IMM positions have set all-time records for several weeks in a row. This is the main reason why we believe that the MoF should consider intervening in the market at some stage, to prevent what may have been relatively benign outflows driven by diversification by Japanese retail investors (the decline in the ‘home bias’) degenerating into unstable speculative short-JPY positions. The Type 6 JPY carry trades we mentioned above could also surge, if hedge funds realize that the MoF will allow the JPY to continue to weaken. As we have argued, we don’t expect the G7 meeting this weekend to yield any explicit joint statement on the JPY. However, we believe that it is in the interest of Japan to prevent the emergence of unstable short-JPY positions. ‘Currency manipulation’ is not synonymous with intervention. If the market gets out of balance, there will be a role for the MoF, even in the absence of political pressures from Europe or the US. Bottom line It is impossible to come up with one number that summarizes the size of the JPY carry trades, since different types of JPY carry trades are not additive. While there are some measures that suggest that capital outflows from Japan have accelerated, these measures are not confirmed by more comprehensive statistics from the MoF and the BoJ. Further, investors need to be sensitive of the different types of interest rate-sensitive flows, as they have vastly different implications for the stability of the JPY market and for policies. So far, our view is that most of the outflows from Japan are benign and stable in nature. However, there are signs that speculative JPY shorts are being accumulated. If this trend continues, we believe that there will be grounds for the MoF to consider intervention.
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Should the UK Government Issue Longevity Bonds?
February 09, 2007
By David Miles | London
Gradually over time we should expect the duration of debt to rise because increasing life expectancy is likely to lengthen working lives and so lengthen the horizons over which those with debt can repay. Increasing life expectancy is also likely to lengthen the periods over which those with obligations to pay pensions have to make payments, and because of that it raises the duration of the debt assets they want to hold against those obligations. So, on both the demand and supply side it is likely that rising life expectancy is working to slowly increase the duration of debt. But the scale of the increase in life expectancy is highly uncertain. UK companies face very significant longevity risk because of the size of their defined benefit pension obligations. 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 develop by issuing ‘longevity bonds’ with values linked to life expectancy(see, for example, the article by David Cule, principal at Punter Southall, “How to deal with ever-improving mortality”, Financial Times, January 8, 2007). We have argued in the past that there is no compelling case for the UK government to issue such debt — largely because it already has massive exposure to unexpectedly fast rises in life expectancy from its commitments to pay state and public sector pensions and from its role in heath and social care (see chapter 6 of R. Chote, C. Emmerson, R. Harrison and D. Miles (eds), The IFS Green Budget: January 2006, IFS Commentary (http://www.ifs.org.uk/budgets/gb2006/index.php)). The UK Debt Management Office (DMO) — having consulted on the issue in 2005 — has made it clear that it has no plans to do so(DMO, Issuance of Ultra-Long Gilt Instruments: Consultation Document, December 2004; DMO, Issuance of Ultra-Long Gilt Instruments: Response to Consultation, April 2005). But have developments over the last few years meant that those assessments should be revised? During 2006, the government has adopted the recommendation of the Pensions Commission to increase the age at which state pensions are normally received from 65 to 66 between 2024 and 2026, 66 to 67 between 2034 and 2036 and 67 to 68 between 2044 and 2046. To the extent that such changes become linked to movements in life expectancy, the exposure of the public sector to changes in life expectancy is reduced and so its scope to issue longevity bonds might seem to have risen. But the very long time lag between announcements of changes to the state pension age and actual implementation means that the scale of exposure to changes in life expectancy — which can be very large in relatively short periods — remains huge. One recent development rather weakens the case for the government issuing longevity bonds. There has been a substantial increase in the number of life assurance companies in the UK willing to take on longevity risk by buying pension obligations from other companies. There is still a question as to whether the scale of the longevity risk held by non-financial companies is so large that the entrance of new players in the market to buy corporate pension obligations can make much difference. Even if much of the risk does come to sit with life insurance companies, the question remains as to whether that is the most efficient place for it to reside? The scale of the exposure to shifts in life expectancy held in the corporate sector can be measured in various ways. The most obvious is to look at the value of DB pension liabilities — a number recently estimated to be around £700 billion (The Purple Book: DB Pensions Universe Risk Profile, December 2006 (http://www.thepensionsregulator.gov.uk/pdf/PurpleBook.pdf)). The Purple Book, a joint publication of the Pensions Regulator and the Pension Protection Fund, contained an estimate that each year added to longevity assumptions adds 3-4% to pension scheme liabilities, raising aggregate deficits by an amount likely to be £20 billion or more. Given that realised longevity arises gradually over time (as opposed to assumptions about future longevity, which can change sharply in a short period), how much should DB schemes be prepared to pay to hedge against their long-term longevity risk? The regulatory capital required to be put against longevity risk held by financial firms should be some guide as to the cost of longevity exposure. Under life insurance regulations (PS04-16), there is no so-called Pillar I capital requirement related to longevity risk. Any longevity capital charge would arise only under so-called Pillar II, which is the internal capital assessment (ICA) and is not public information. We estimate, however, that for annuity companies, capital held against longevity risks might amount to about 6-7% of annuity reserves. According to FSA returns, annuity reserves among the major market participants amount to more than £160 billion. This would put the longevity capital charge in the region of £10-11 billion. The liabilities of DB pension schemes — which are in many ways analogous to the annuity exposures of life insurance companies — are around £700-800 billion (on an FRS17 basis). If we applied a capital charge of 6-7% against this, it would mean that extra capital held to handle the risk would be £45-55 billion. If the real cost of equity capital is about 7% (a plausible figure and one close to the typical earnings yield on large UK companies), the annual cost of that capital would amount to around £3-4 billion. But the value of pension liabilities might well be some 30% or more higher based on a buyout measure (that is, the amount a life insurance company might need to take on the liabilities), in which case the annual capital charge might be nearer £4-5 billion. This is a rough and ready calculation and there is great uncertainty about what the true cost to those who hold longevity risk is. But it is clearly not a small amount. The issue is whether it could be reduced and risk handled more effectively if government played a role in helping that risk be more effectively hedged. But 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 only a rather weak case for government action in this area.
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Hawks Falling from the Sky
February 09, 2007
By Thomas Gade | London
Pulling the trigger and taking a short breather The Riksbank will meet again next week to decide on monetary policy. The Riksbank will most likely pull the trigger and raise the repo rate by another 25bp, we think. Such a move will bring the repo rate to 3.25%, and still be expansionary, on our estimates. The Riksbank will also for the first time provide its own interest rate forecast instead of using an assumption of future short-term interest rates as priced into financial markets. As a precursor to putting out its own interest forecast, the Riksbank saw the need to align by far too hawkish market expectations with its own likely interest rate path earlier this week. Markets responded by taking out 10bp of monetary policy tightening on a one-year horizon, adding the same in the slightly longer term. Market expectations are now in line with our own expectations on a one-year horizon. There may still be scope for further curve steepening out to a two-year horizon, we think. Slower pace more likely than faster pace On our own forecast, we have had a long-held view of an ongoing gradual pace of monetary tightening. We continue to believe that a pace of 25bp per quarter up to the end of 3Q07 is the most likely. Depending on the future developments in the wage negotiations, productivity growth and inflation as well as credit expansion to the household sector, the Riksbank could engage in a slower pace of monetary tightening, we think. Our proprietary repo-meter model provides only limited evidence of more than one rate hike up until June. On our forecasts, the probability of further monetary policy tightening is currently kept low by the continued low level of inflation and the previous strengthening of the krona against other currencies, in particular the US dollar. Fundamentally, the krona remains undervalued. With a fundamental value of 8.75 against the euro, our FX team expects a further strengthening of the krona in the medium term. Should the krona continue to strengthen, this could call for a reduction in the pace of monetary tightening in the second half of this year. The risks to our monetary policy forecast of 3.75% by year-end 2007 therefore currently seem balanced. Our model does not take house prices or the rapid growth in monetary aggregates and more specifically credit expansion to the household sector into account. Although the rapid raise in house prices and credit expansion to the household sector has been of some importance in the current tightening cycle, this is a more recent phenomenon since the start of the inflation-targeting period in 1993. Bank lending to the household sector rebounded in December and continues to expand at 12.5%Y, a very elevated rate of expansion, which currently shows very few signs of slowing. However, given the continued low rate of current inflation as well as inflation on our forecast, a continued rapid credit expansion to the household sector is not likely to cause the Riksbank to step-up the pace of monetary tightening this year from the current pace of 25bp per quarter, we think. On the contrary, should credit expansion start to show signs of a slowdown as we expect and inflation remain subdued, then this would support a slower pace of monetary tightening from 3Q07 as on our current projections. Providing an interest rate forecast for the first time The Riksbank will switch to providing its own interest rate forecast from a method of using market-based short-term interest rates as implied by financial markets. As such, the Riksbank now implements a similar step taken by the Reserve Bank of New Zealand in 1998 and later by Norges Bank in November 2005. Experience from Norges Bank showed that such a step normally should not cause market volatility as the interest rate forecast usually is quite aligned with market expectations. In genera,l the ratio between the policy rate and three-month rates relative to the similar ratio for the euro area has been much less volatile in the period following the introduction of the interest rate forecast by Norges Bank in November 2005. Nevertheless, the Riksbank felt the need to correct the implied monetary policy expectation embedded in financial markets ahead of the release of its own interest rate forecast. Following the traditional speech on ‘Current Monetary Policy’ ahead of a monetary policy meeting, markets took out 10bp on a one-year horizon, while adding the same on a two-year horizon. Correcting the overly hawkish market expectations was called for, we think. Going forward, the yield curve out to two years could steepen further, we think. The interest rate forecast will be published three times a year with the Inflation Report, which will be renamed the Monetary Policy Report. Also, the new interest rate path will likely be published following monetary policy meetings which resulted in a change in the interest rate. In between, the Riksbank may still need to verbally correct misalignments between market expectations and its own view on monetary policy, as is the current communication practice.
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Carry-trade Magnet
February 09, 2007
By Serhan Cevik | London
Low real interest rates in the developed world make ‘risky’ assets more attractive. The world has changed — a lot and fast. Just a few years ago, we were wondering about the disappearance of liquidity (see O Liquidity, Where Art Thou? March 20, 2001), but now we instead mull over ‘excess’ liquidity in the global financial system. Indeed, these days, the focus is on nothing but the so-called liquidity super-cycle that has contributed to the decline in the term premium and altered the behavior of economies and asset markets all around the world. In our view, not just monetary easing, but a variety of factors — ranging from financial innovation and globalization to petrodollars — have played a role in determining the extent of liquidity growth and the level of risk appetite among investors. And this is exactly why higher short-term interest rates in the developed world, albeit occasionally triggering waves of risk reduction, have not really changed the abundance of global liquidity. Even after 425bp of tightening in the US and 125bp in Europe, real long-term interest rates remain below historical norms, reducing volatility, at least in the short run, and making ‘risky’ assets like emerging-market debt and equities more attractive. Liquidity overhang makes interest rate differentials even more important. Financial volatility, measured by the CBOE index, declined from an average of 20.1 between 1990 and 2002 to 12.6 in 2006 and 10.9 so far this year. Coupled with the lower cost of funding, the moderation of volatility helps to keep the liquidity overhang and encourages greater risk-taking. As a result, carry trades — investing low-yielding currencies into high-yielding markets — become more popular. Economic fundamentals of course do play an important role in shaping investment decisions, but interest rate differentials (even before adjusting for exchange-rate risk) could become the overwhelming factor, especially in today’s setting. And this is precisely what is happening to lira-denominated assets. Supported by Turkey’s strong fundamentals, higher interest rates have attracted a sea of global liquidity and become the most important determinant of short-run currency dynamics. Foreign capital inflows have reached the peak for both debt and equities. Turkey had already accumulated $US110.5 billion in net capital flows in the last five years, allowing the central bank to increase its currency reserves from US$18.8 billion to over US$62 billion. The share of direct investment and long-term loans may have risen above 70% of the current account deficit, but liquidity-driven inflows are still significant. In fact, with global calm and higher risk appetite, foreign investors have increased exposure to lira-denominated assets to new peaks this year. While holding 69% of the free float in the Turkish equity market, non-resident investors have accumulated more domestic government debt. According to the latest figures covering up to the third week of January, foreign holdings of domestic fixed-income securities soared to 38.5 billion lira, from 21.2 billion lira recorded after last year’s volatility shock and 11.5 billion lira at the end of 2003. In other words, foreign investors now account for 33.5% of non-bank holdings of domestic debt, up from 20.7% in June 2006 and 11.5% in December 2003. Furthermore, the quality of these holdings has also improved in terms of duration, as foreign investors now own about 70% of Turkey’s 5-year bonds. Nevertheless, asset prices are still sensitive to political noise and especially changes in global risk tolerance. An unexpected rise in the term premium in the developed markets could increase volatility. Our US economics team expects the Federal Reserve to keep short-term interest rates unchanged until the end of 2007 and then start easing towards 4.75% by the end of next year. Although such an outlook for the US monetary policy stance would support the gradual normalization of global financial conditions, an unexpected rise in the term premium and the resulting withdrawal of global liquidity could still lead to the unwinding of leveraged positions and an eruption of volatility. Of course, the sheer magnitude of capital movements makes the conduct of independent monetary policy exceedingly challenging in an emerging economy like Turkey. Nevertheless, current liquidity conditions in domestic money markets and the level of interest rate differentials should cushion Turkey against exogenous risk adjustments, as long as fiscal consolidation remains firmly on track, in our opinion.
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Too Much Debt
February 09, 2007
By Serhan Cevik | London
The continuing increase in Egypt’s public debt stock is a threat to stability. Egypt once achieved significant fiscal consolidation, lowering the government budget deficit from 17.5% of GDP in 1991 to 0.9% in 1997 and gross public debt from an average of 117.6% of GDP in the first half of the 1990s to 75.4% by the end of the decade. Unfortunately, that is now as much in the past as the country’s magnificent pyramids. The budget deficit widened to as high as 9.2% of GDP in 2002 and an average of 6.7% in the past six years, resulting in a marked increase in gross public debt to 96.1% of GDP in the last fiscal year. More importantly, net public debt snowballed from 47.4% of GDP in 2001 to 69.8% last year. Even though favorable global conditions and petrodollar liquidity have so far eased the debt burden and allowed the Egyptian economy to grow at an accelerating pace, we think that fiscal imbalances nevertheless remain an important source of economic distortion and a threat to financial stability. Cyclical and one-off revenue increases lowered the deficit, but expenditures are growing fast. Thanks to strong growth, higher privatization receipts and the settlement of tax arrears, government revenues increased by 63% on a cumulative basis in the last three fiscal years and stabilized the budget deficit at 8.3% of GDP last year (marginally lower than the average of 8.9% in 2002-2005). However, public expenditures are still growing at a discomforting pace, even after increasing from an average of 32% of GDP a year in 2001-2005 to 38.8% in the past fiscal year. This is why we are worried about the risk of a cyclical downturn on the revenue side that could destabilize public finances. In light of fiscal imbalances, negative real interest rates present a puzzle. With a disappointing fiscal performance, one would expect to see, at least, an increase in the risk premium. But real interest rates in Egypt have instead declined in recent years and even become negative in the last couple of months, as inflation surged from around 3% in 2005 to above 12% last year. So what is the explanation for this puzzle, especially when the government has no plan for significant fiscal consolidation? A recent IMF working paper provides insightful clues, not just for the Egyptian case but also for the rest of the Middle East (see Manal Fouad et al, Public Debt and Fiscal Vulnerability in the Middle East, January 2007). The authors argue that ‘special financing features’ have helped Middle Eastern countries to avoid debt crises, despite having much higher debt levels compared to other emerging economies. Indeed, all these countries share a similar funding structure, relying heavily on non-marketable debt instruments, a dedicated investor base and, of course, petrodollar liquidity. In addition, with its practically pegged exchange rate regime, Egypt is also attracting carry-trade investors who do not mind negative real interest rates as long as they receive the expected return in dollars and therefore provide even more (short-term) liquidity in the domestic debt market. Nevertheless, all these features do not mean that unsustainable fiscal policies have no effect on the country’s credit quality in the long run. Good times offer an opportunity to put public finances on a sustainable path. Given the extent and strength of the global liquidity cycle, carry-trade and dedicated regional investors could keep the ball rolling in Egypt’s financial markets, even though macro imbalances have already resulted in overheating of the economy. According to the official statistics (which, by the way, underestimate inflation because of the weight of administered prices and methodological shortcomings), consumer price inflation increased from 3.2% in 2005 to 12.4% last year. We may see some degree of correction thanks to base effects and the aforementioned statistical quirks, but the expansionary mix of monetary and fiscal policies should keep fuelling unbalanced growth dynamics (see The Dangers of Overheating, December 14, 2004). Moreover, the authorities will — sooner or later — have to deal with the consequences of distortionary subsidies and face even more inflation pressures. Unfortunately, we believe that the government’s proposed fiscal adjustment package is too small and too gradual to put public finances on a sustainable path in the foreseeable future.
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Probing the Gap in Tokyo & Nationwide Prices
February 09, 2007
By Takehiro Sato | Tokyo
No readily apparent difference... The latest December headline CPI was up 0.3% YoY both nationwide and for the Tokyo area, while the core CPI (excluding fresh food) was up 0.1% nationwide and 0.2% for the Tokyo area, indicating no clear difference between the nationwide and Tokyo metropolitan figures. However, a closer analysis of the component items shows noticeable differences for particular items. We believe that the price trends for these particular items will have some impact on overall price trends as well as macroeconomic policy. …but item-level comparison highlights differences between nationwide, Tokyo CPIs We estimated the contributions of the nearly 600 CPI components to the YoY changes in the nationwide and Tokyo-area CPIs. The only items with notable differences in contributions are reading & recreation (specifically flat-panel TVs), housing (imputed rent), and transportation & communication (gas). The first two had a substantial negative impact on the nationwide CPI, and the last one a substantial positive impact on the nationwide CPI. Of the three items, gasoline has a relatively high contribution to the nationwide CPI because it accounts for 224/10,000 of the nationwide CPI, versus only 84/10,000 of the Tokyo-area CPI. So, this is a purely technical factor. In addition, gasoline tends to have more of an impact on price changes in local areas than in urban areas because of a transport cost. Meanwhile, we find it interesting that the decline in flat-panel TV prices is greater on a nationwide basis than in Tokyo, suggesting tougher price competition in local areas. If this gap can be attributed to differences in household purchasing power in Tokyo versus local areas, then the question is why this trend is apparent only for flat-panel TVs. Competition to sell consumer electronics is actually intense in the northern Kanto area, the home base of two major electronics discounters. That such discounters do business mainly in the suburbs rather than central Tokyo apparently affects price data. The latest difference in imputed rent (owners’ equivalent rent) on a nationwide basis and in the Tokyo area is -0.6ppt YoY, not as great as the difference for flat-panel TVs. However, because of its substantial weighting (1,422/10,000 in the nationwide CPI and 1,855/10,000 in the Tokyo-area CPI), imputed rent has a substantial -0.09ppt contribution to the difference in CPIs (nationwide – Tokyo area) and is the biggest factor behind the latest difference in the two CPIs. The imputed rent puzzle One question, then, is why there is such a difference in imputed rent in Tokyo versus the whole country. The YoY change in imputed rent on a nationwide basis turned negative in August, and the decline worsened to 0.4% by December. By contrast, the change in imputed rent in the Tokyo area turned negative, to -0.4%, in September, but then steadily recovered to a rise of 0.2% in December and a stronger rise of 0.5% in January. As we note later on, however, we see no logical explanation for a widening nationwide-versus-Tokyo differential only for imputed rent, as private-sector housing rent has been steadily declining both nationwide and in the Tokyo area. We double-checked the way imputed rent is calculated. The Ministry of Internal Affairs and Communications’ guide on CPI calculations states that imputed rent is based on data on private rental housing in the Housing and Land Survey (conducted every five years) and a regression equation with housing rent as the dependent variable and housing characteristics as independent (explanatory) variables, using as the housing characteristics of those home-owner households surveyed in the National Survey of Household Income and Expenditure. The private-sector housing rent that is the basis of the estimate is the amount in the Household Income and Expenditure Survey (HIES) that home-owner households pay for their residences (specifically, residence costs less land rent less maintenance and repair costs). Based on how imputed rent is calculated, as noted above, we can infer that one reason for relatively substantial changes in housing rent and imputed rent over a short period of time is the frequent distortion in residence costs in the HIES resulting from sample bias. In other words, it could be that households with low residence costs have been surveyed on a nationwide basis, while households with high costs have been surveyed in the Tokyo area. If so, then the differences in imputed rent on a nationwide basis versus in Tokyo do not necessarily reflect trends in land values or asset prices. Structural differences in price trends nationwide versus Tokyo? In any case, we think that the unnatural trend in imputed rent has affected nationwide and Tokyo-area prices and is the main reason for the nationwide core CPI’s recent underperformance of the Tokyo-area core CPI. We see two issues. The first is whether it is appropriate to judge price trends on a basis that includes imputed rent, which may distort the data, and the second is whether the difference between the nationwide and Tokyo-area data will continue. The MIAC actually also provides a way of looking at price trends excluding imputed rent. For example, the HIES’s real household expenditure deflator is a price index that excludes imputed rent. We believe that price trends need to be broadly viewed based on the usual core CPI, the core core (excluding special factors), and also an index that excludes imputed rent. Excluding imputed rent, the YoY changes in the December headline CPI, the core CPI, and the core core CPI on a nationwide basis improve by nearly 0.1ppt. To gauge whether the difference between the nationwide and Tokyo-area data will continue, the trends in imputed rents as well as actual rents need to be analyzed. Incidentally, both imputed rents and private-sector housing rents declined 0.3% YoY in December on a nationwide basis and fell 0.2% in the Tokyo area. Although imputed rents rose in the Tokyo area, actual rents have not improved, despite a rebound in land prices. The change in rents in the Tokyo area since 2000 has frequently been negative. We think that an explanation for this trend is that housing rents reflect supply-demand conditions in the rental market and wage trends, but not necessarily land price trends. This trend is fundamentally not very different in the Tokyo area, where residential land prices have been rising, versus the country as a whole. In local areas where wages and incomes have been slow to recover, a decline in actual rents makes perfect sense. If so, we think the recently widening nationwide-versus-Tokyo differential in imputed rent will also depend on the trends in wages and incomes, and it is conceivable that the rise in imputed rents in local areas, where residence costs stagnate due to sluggish wages, will continue to underperform that in the Tokyo area. We believe that rent trends will have some impact on overall price trends as well as macroeconomic policy because of the relatively heavy weighting of rent in the CPI. With no indications of a notable rise in wages, rent trends are one indication of how slowly deflation is ending, as if in slow-motion, and contrary to the market’s expectations. Hence, based only on general prices, we see no need at all for the BoJ to hastily raise rates. Some believe that the BoJ should monitor not only general price trends, which have been moderate, but also asset price trends. As part of its new policy framework following the end of quantitative easing, the BoJ has actually pointed to a sharp rise in asset prices as a risk factor. However, in light of Japan’s failures in the early 1990s, other major central banks have not managed policy with a heavy focus on asset prices. If they were to do so, it has been our experience that they would nip sustained economic growth in the bud. Policymakers’ patience is likely to be tested anew.
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December Export Growth Decelerates
February 09, 2007
By Chetan Ahya | Singapore
December export and import growth decelerates: Export growth decelerated to 6.2% YoY in December after rebounding to 18.4% YoY in November (revised up from 17.5% YoY). Import growth also decelerated to 1.6% YoY (versus 21.4% YoY in November). Even on a sequential basis, exports and imports decelerated/contracted (2.1% MoM and -3.8% MoM in December) following increases of 7.0% MoM and 9.4% MoM respectively, in November. Consequently, the trade surplus stood at US$3.4 billion in December (versus US$2.5 billion in November). Key trends in export segments: Most export segments saw a deceleration in growth in December from November. Specifically, exports of electrical and electronic products eased to 6.2% YoY (versus 9.3% YoY). Exports of chemical and chemical products, palm oil and wood products decelerated sharply to 10.6%, 12.4% and 14.0% YoY from 49.2%, 42.4% and 42.5% YoY, respectively. However, export growth picked up for crude petroleum (7.7% YoY versus -24.3% YoY in November) and refined petroleum products (26% YoY versus 25.3% YoY in November). In terms of market destinations, exports to all the major destinations decelerated MoM in December. Exports to the US, EU and Japan slowed to 5.3%, 19.7% and 4.6% YoY from 14.3%, 33.4% and 18.5% YoY, respectively, in November. Export growth decelerated; import growth accelerated in 2006: Export growth eased to 10.3% YoY in 2006, compared to 11% YoY in 2005, in line with the slowdown in export demand seen in other Asian economies. Import growth on the other hand accelerated to 10.7% YoY in 2006 following an increase of 8.5% YoY in 2005. The trade surplus for 2006 stood at US$29.6 billion.
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