Firing on 12 Cylinders
February 14, 2007
By Eric Chaney | London
We raise our GDP growth forecast for 2007 from 1.9% to 2.3%, on the back of fourth quarter GDP data and more qualitative information from business surveys. At the same time, we cut our average inflation forecast from 2.0% to 1.8%. Stronger growth, lower inflation…this sounds like the famous goldilocks economics in the US in the late 1990s and, indeed, I believe that the European macro landscape is genuinely improving, although with some important caveats.
Let’s start with the fourth quarter GDP. Even observers as bullish as we are were taken by surprise by the new data. GDP growth of what was then the 12-country rich euro club accelerated to 0.9% in the fourth quarter (3.6% in quarterly annualised terms, 3.3% from one year ago). That was one percentage point (annualised) above consensus. True, GDP data are highly volatile and we have many reasons to believe that growth is already slowing and might even slow further in the second quarter. But volatility and exceptional circumstances should not be the tree hiding the woods. In my view, the fundamental reasons behind the acceleration of growth in Europe are two-fold. First, monetary policy works; maybe with lags, but in the end low real rates have an impact on real demand. Second, trend growth is accelerating, thanks to corporate restructuring, investment in technology and more flexible labour markets. By which margin we do not really know, but it would be unwise to ignore the change. Germany, Italy and Spain at the forefront Surprises were not evenly distributed. The first one came with the German GDP, up 0.9%, four-tenths above the consensus (itself influenced by some statements from the statistical office). That makes my colleague Elga Bartsch’s forecast (0.8%) all the more remarkable. Elga sided with the Ifo survey (although she takes the very high level of the Ifo index with a pinch of salt) and considered that a mix of stronger domestic demand, partially on the back of advanced purchases of durable goods, and buoyant overseas demand for German products, especially investment goods, would boost the German economy. This is indeed what happened. The second surprise came from Italy, where GDP jumped by 1.1%Q (4.6% quarterly annualised), 0.6 pp ahead of our above-consensus forecast. My colleague Vladimir Pillonca had noticed that not only had foreign orders for Italian manufactured products recently taken off (12.7% year on year in November), but domestic orders had also (10.2%Y). The German demand boost cannot be the sole factor behind this double-digit clip, even though it might partially explain the improvement in domestic orders for intermediate and capital goods. Again, even though a significant correction is likely to take place in the first and/or second quarter — Vladimir is now expecting a flat GDP reading in 1Q — the Italian comeback is impressive: one year ago, the consensus view was that Italian GDP would continue to stagnate and that doubts about EMU membership would become more entrenched. In reality, Italy’s GDP growth reached 2.0% last year, 0.7 percentage points above its average growth since EMU inception. The third surprise came from Spain, where GDP growth was also 1.1%Q. As far as Spain is concerned, the surprise was not that growth accelerated but rather that it remained so strong: the average quarterly GDP growth was 0.9%Q over the last four quarters. Although we have reasons to anticipate a slowdown in Spain, as higher interest rates start to bite on the buoyant housing sector and the share of construction starts to shrink, our concerns were obviously overblown. Euroland underlying GDP growth reached 3.5% in 2006 On our calculations, Euroland GDP growth reached 2.8% (2.7% according to Eurostat) in 2006 on average. We think that GDP data are likely to be revised upward, as they were almost systematically since 1999, probably to 3.0%, a speed that would be consistent with business surveys. This performance is all the more impressive, seeing that oil prices were up 20% in euros in 2006, the euro was super-strong and the ECB was in tightening mode. On our rough estimates, these macro headwinds probably sliced as much as 0.5% from GDP growth. In other words, the spontaneous growth rate of euro area economies was 3.5% last year. However, we cannot extrapolate these numbers, and here’s why. Mind the payback in 1Q and don’t forget the fiscal tightening We suspect that a part of the acceleration in domestic demand at the end of last year came from advanced purchases of durable goods in Germany. Although the evidence for Germany is limited, retail sales bounced back in December (2.2%M) and, according to the Ifo survey, overall demand (including from overseas) was as strong as it was in the immediate aftermath of the unification. Trade data from other countries are also giving some support to this thesis. In addition, some other non-identified factors might explain the stunning acceleration of growth in Italy. Thus, a combination of demand borrowed from the future and exceptional factors, such as very mild weather conditions, have probably added some artificial colour to the end of year fireworks. In addition, the German and Italian fiscal diets, each worth slightly more than 1% of GDP, have not magically disappeared: the German VAT hike, whether taken on profit margins or from consumers’ pockets, is there and will have an impact on aggregate demand. The same holds for Italy. As a result, we stick to a cautious call for 1Q GDP growth (0.3%), even though our early GDP indicator is more optimistic, at 0.6%Q. In our view, a slowdown in the first half of the year is unavoidable, but it could be spread across more than one quarter. 2007 GDP growth forecast revised to 2.3% Back to the bigger picture, we take stock of the improvement in both structural and cyclical factors in the euro area and upgrade our 2008 GDP growth forecast from 1.9% to 2.3%. Compared to our previous baseline, oil prices are lower, the global economy is slowing less than we had thought previously and, more importantly, the underlying trend of domestic demand is accelerating. Even though inflation is likely to be lower than we had anticipated one month ago, the strength of the real economy, underpinned by strong credit growth to the private sector, vindicates the cautious tightening stance taken by the European Central Bank, in my view. With nominal GDP growing probably above 5% (year on year), why would the ECB hibernate at 3.75% after the March meeting?
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Tracking Petrodollars
February 14, 2007
By Serhan Cevik | London
The recycling of petrodollars has turned into a dominant force in the global financial system. The surge in oil prices from an average of US$25 a barrel in 2002 to US$66 last year has brought a spectacular windfall to oil-producing economies. With export revenues growing from US$251 billion in 2002 to around US$900 billion by the end of last year, the collective current account surplus of these countries widened from 5.4% of GDP to 25.8% over the course of the same period. Put differently, oil exporters’ current account surplus soared from a mere 0.1% of global GDP in 1999 to 0.4% in 2003 and then an astonishing 1.4% last year, dwarfing what Asian countries accumulated altogether. In our view, this unprecedented level of income transfer from oil-consuming to oil-producing economies — reaching US$1.8 trillion (or about 4% of global GDP) on a cumulative basis in the past five years — has made a significant contribution to global imbalances and influenced the direction of financial flows around the world. Indeed, the recycling of petrodollars is one the crucial pieces of the puzzle of record-low real interest rates and term premiums (see The Petrodollar Connection, January 29, 2007). Therefore, what happens next to petrodollars will likely alter capital flow patterns and global asset allocations. Tracking petrodollars and the impact on international capital markets is a difficult task. Petrodollars can be recycled back to the rest of the world economy in two ways: importing more goods and services or investing windfall gains back into the global capital markets. Unfortunately, national statistics of most of the oil producers are just too opaque to pinpoint the composition of financial investments abroad. Likewise, counterparty data (such as those published regularly by the Bank for International Settlements) only account for 30% of capital outflows from these countries. That leaves us with a US$1.3 trillion question. Unlike the oil shock in the 1970s when current account imbalances adjusted quickly, the widening gap between export revenues and import growth in oil-producing economies has delayed the adjustment in the current cycle. Since the beginning of 2002, oil exporters have spent less than half of the windfall on imports of goods and services, compared to more than three-quarters during the previous oil booms. While a number of countries in the region have dedicated extra funds to debt repayment — lowering debt-to-GDP ratios by as much as 50% — the abundance of liquidity has also led to rapid credit growth and speculative asset valuations. However, domestic bubbles later collapsed under their own weight and accelerated the recycling of petrodollars into the global capital markets (see The Great Arabian Bubble, December 4, 2006). A wholesale repatriation of Middle Eastern funds from America is just a myth. With the deep correction in equity markets, oil exporters have stepped up the accumulation of foreign assets from 1.5% of global GDP in the first half of the decade to 2.5% in 2005 and 3.8% last year. The figures are huge — even by today’s standards — but we must look into the composition of asset allocations. In contrast to the behavior in the 1970s, oil-rich countries have stopped simply depositing funds with international banks and started channeling — directly or through intermediaries — an increasing amount of the windfall into new financial instruments, institutions and markets. In our view, these new features also explain the myth of a wholesale repatriation of funds from the US. Not only are the great majority of oil producers still keeping their currencies pegged to the dollar, but a substantial part of sovereign and private wealth also remains invested in dollar-denominated assets. According to a recent study by the Federal Reserve Bank of New York, oil-exporting countries purchased US$314 billion worth of assets in the US between 2003 and last year (see Matthew Higgins, Thomas Klitgaard and Robert Lerman, Recycling Petrodollars, December 2006). With offshore holdings and indirect recycling, that would mean more than half of petrodollars coming back to the US markets. The recycling of petrodollars via financial channels has so far supported the US economy. If oil stabilizes at around US$60 a barrel this year (down from US$66 in 2006), the cumulative current account surplus of oil producers would decline for the first time in six years. But the price of oil has little to do with this correction. As all the governments in the region have revised up oil price assumptions from around US$20 to the US$45-50 range, domestic consumption and investment will increase at faster rates and thereby give a boost to the demand for imports of goods and services. In fact, after lagging well behind the rate of increase in export revenues, import growth has accelerated since late 2005, reaching 21% last year. However, if sustained, this may also result in scaling down the accumulation of foreign assets. Of course, the recycling of petrodollars via imports has different implications to the recycling through financial channels. While the US has enjoyed disproportionate benefits of capital flows from oil exporters, the recycling through the trade channel favors mostly Europe and Asia, given higher shares in imports of oil-producing economies. In truth, given data constraints, we cannot be absolutely sure about the effects of petrodollar recycling, but it is clear that a change from the capital account channel to the trade channel would play a critical role in determining the next stage of long-lasting global imbalances.
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US$250 Billion Credit Party — Drawing to a Close
February 14, 2007
By Chetan Ahya | Mumbai
Unusually strong credit cycle so far Credit outstanding has increased by US$250 billion to US$440 billion over the past three-and-a-half years (since the start of this credit cycle in September 2003). Low real rates and a sharp rise in bank credit have been at the heart of India’s growth acceleration story over the past three years. Bank credit growth had accelerated from the bottom of 10.7% in September 2003 to a peak of 33% in June 2006 before slowing to 30% in January 2007. Indeed, this current credit cycle is the longest that India has witnessed since the early 1970s. Commercial bank credit has increased to 50% of GDP as at January 2007 from 34% in September 2003. From excess liquidity to tight liquidity Over the last 12 months, liquidity conditions have tightened for two reasons. First, a widening current account deficit is offsetting capital inflows, resulting in reduced intensity of net injections of foreign currency inflows even as domestic credit demand has remained strong. Second, even if global capital inflows were to rise, resulting in higher liquidity in the banking system, the RBI may intervene to reduce the credit-funded aggregate demand due to concerns over potential overheating. Indeed, we believe that there are already clear signs of aggregate demand continuing to be higher than productive capacity, as reflected in inflationary pressure, a sharp rise in asset prices and a widening current account deficit. This tightening liquidity has begun to push up borrowing costs meaningfully over the last six months. Banking sector balance sheet is now overstretched Aggregate bank deposit growth has been 17% on average over the past three-and-a-half years as compared with average credit growth of 25% in the same period, leading to an increase in the bank credit/deposit ratio to 74% currently from 54% at the start of the cycle. This is now limiting banks’ capability for credit creation, as they have to meet the minimum statutory liquidity ratio[1] (SLR) of 25% of net demand and time liabilities. As a result, banks will find it difficult to grow their credit books at current growth rates, in our view. Although the government has recently permitted the Reserve Bank of India (RBI) to reduce the SLR, we think that the RBI is unlikely to resort to a reduction soon as it remains concerned about the risks emanating from strong credit-funded aggregate demand. Risk premium is coming back Excess liquidity conditions in late 2003 and 2004 resulted in banks searching for yield and charging negligible risk premiums for loan assets with inherently higher risks. Just about 12 months ago, banks were making little distinction between pricing credit risk for various types of loan assets. Almost all loans were being priced in a very narrow range of around 7.5-8%, which was very similar to the 10-year bond yields then. Indeed, banks’ lending behavior implied that the risk of lending to a low-income-bracket borrower (for whom there is little credit history available) for the purchase of a two-wheeler was not meaningfully different from the risk of investing in government bonds. The bulk of the fresh lending of US$250 billion over the last three-and-a-half years has come at a time when banks have been inadequately pricing credit risk. However, tightening liquidity is likely to cause a reversal in this trend. Credit growth to slow further Although banks have started to hike lending rates over the past 12 months, initially they were slow to move lending rates. Moreover, banks also cushioned borrowers by extending loan tenures to keep EMIs (equated monthly installments) constant. As a result, though credit growth peaked out in August 2006, the pace of deceleration was slow. However, over the last three months, with borrowing costs (one-year deposit rates) increasing by 1.5% points, banks have been forced to hike lending rates more quickly. For instance, ICICI Bank, the largest private sector bank, has increased its mortgage lending rate by 1.5% points to 11% over the last three months, versus a mere 0.5% point increase in the preceding six months. The stretched banking sector balance sheet will ensure that borrowing costs continue to rise further, in our view. Assuming that the RBI does not cut the SLR, banks are likely to face severe capacity constraints on the current rate of loan growth. If the past two months’ average credit growth of 30% and deposit growth of 22.5% are maintained, the banking sector SLR ratio will reach its maximum limit of 25% by March 2007. Our base case assumes that the banks will continue to hike lending rates, resulting in a further deceleration in credit growth. We expect bank credit growth to decelerate to 20-22% by the end of 2007 from 30% currently, slowing credit-funded aggregate domestic demand growth and overall GDP growth over the next 12 months. What could prevent a credit slowdown? We believe that a sustained sharp increase in global capital inflows would result in a higher balance of payment surplus and improve domestic liquidity conditions. Although the RBI could continue to intervene to slow aggregate demand, the effectiveness of its tightening policy stance would be weakened under such circumstances. We believe that such an outcome would increase the risk of a hard landing in the growth trend as macro indicators such as inflation, current account deficit and asset prices could further worsen to precarious levels in the intervening period.
[1]Note: Statutory liquidity ratio (SLR) is applied on banks’ net demand and time liabilities (NDTL), which include aggregate deposits, borrowings and other demand and time liabilities and not just aggregate deposits.
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4Q06 GDP Higher than Expected
February 14, 2007
By Deyi Tan | Singapore
Economy expanded faster than expected in 4Q06: 4Q06 GDP rose 6.6% YoY, higher than our and consensus estimates of 5.9% YoY. 1Q06 GDP growth was revised down from 10.3% to 10.1% YoY, bringing full-year growth to 7.9% YoY (versus +6.6% YoY in 2005), marginally higher than our estimate of 7.8% YoY. The government revised up its 2007 GDP growth forecast from 4-6% to 4.5-6.5%. Our 2007 forecast stands at 5.0% YoY. Domestic demand mixed but external demand slowing: In 4Q06, public consumption remained moderate at 3.8% YoY (versus +18.7% YoY in 3Q06). However, domestic demand was buoyed by a slight uptick in private consumption, which rose 2.7% YoY (versus +2.4% in 3Q06). The biggest ppt contribution (+1.2ppt) came from fixed investment, which rose 17.1% YoY (versus +10.3% YoY in 3Q06), reflecting lumpy investment in aircrafts in 4Q06. External demand, however, showed a considerable slowdown to 3.4% YoY (versus +9.9% YoY in 3Q06), reflecting the electronics deceleration we have been seeing in the export numbers. Manufacturing decelerated; Services showed slight uptick: The goods-producing industry decelerated to 7.2% YoY (versus +8.9% YoY in 3Q06), underpinned by slower momentum in manufacturing (+7.7% YoY versus +9.5% YoY in 3Q06), construction (+4.7% YoY versus +5.8% YoY in 3Q06) and utilities (+4.4% versus +5.5% in 3Q06). Services expanded slightly faster at 6.6% YoY (versus +6.3% in 3Q06), with the bulk of the momentum coming from financial services (+11.1% YoY versus +7.4% in 3Q06).
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