Germany Outshines Japan
February 20, 2007
By Stephen S. Roach | New York
For the past 15 years, many a pessimist has had a field day with the so-called race to the bottom between the world’s second and third largest economies -- Japan and Germany. As a post-bubble Japanese economy became trapped in deflation and a series of rolling recessions, an increasingly sluggish and inherently rigid Germany economy was widely feared to be next. The verdict is now in -- those fears were vastly overblown. Not only did Germany never fall into a Japanese-like quagmire, but the engine of Europe is now very much on the mend -- with a newfound sense of vitality that is still missing in Japan.
Both economies have traveled very different roads in roads in recent years. Japan’s singular event was an epic asset bubble that all but obliterated its inherently shaky banking system and its keiretsu trappings of cross-holdings of company shares. Germany was weighed down by two external developments -- the reunification of the former East Germany and the steep costs associated with the launch of the European Monetary Union. Notwithstanding these differences, both economies share some striking similarities -- especially, rigid labor markets, high wages, and a seemingly chronic deficiency of private consumption. At the same time, the modern-day German and Japanese economies have both drawn disproportionate support from their export sectors. It is in that key area where Germany is now outshining Japan. German exports have surged even in the face of a strong currency, while Japan has had to rely on a sharp weakening of the yen to achieve a comparable -- albeit less spectacular -- outcome. In my view, this is emblematic of an important gap that is opening up between an increasingly solid German economy and a still fragile Japanese economy. Germany’s export prowess is nothing short of stunning. In a recent research note, Elga Bartsch details the record of Germany’s export accomplishments -- noting, in particular, the country’s leadership position in global merchandise exports for the fourth year in a row (see her 16 February dispatch, “Germany: Excelling at Exports”). As Elga points out, Germany has been alone in the industrial world in holding market share in the face of the extraordinary export growth coming from China and elsewhere in the developing world. The Germany-Japan export comparison has been especially striking over the past dozen years. Back in early 1994, both economies had roughly 10% market shares in overall global merchandise exports. In 2006, Germany’s global share remained about the same -- around 10% -- whereas that for Japan had tumbled to just 6%. The outperformance of German exports vis-á-vis Japan is all the more apparent in looking at two of the world’s most advanced product lines -- information technology and telecommunications equipment. Based on data compiled by Catherine Mann of the Institute for International Economics, Japan held the #1 position in worldwide IT exports in 1990 with a 20.4% market share; by 2004, Japan had slipped to #5 with just a 7.9% position (see Mann’s Accelerating the Globalization of America, Institute for International Economics, 2006). By contrast, Germany’s global market share in the IT export business held relatively steady at around 7% over the same period. In the communications area, Japan went from a dominant #1 position with a 26.7% market share in 1990 to only a 6.9% share in 2004, whereas Germany’s share in this key category actually rose from 7.4% in 1990 to 8.9% in 2004. Germany’s performance in these two product lines is all the more stunning in the face of China’s rapid emergence as a global export powerhouse. As recently as 2000, China still ranked #13 in global market share in IT and #5 in communications equipment. A scant four years later, China was #1 in world export shares of both of these key product lines. Both Japan and the United States wilted dramatically under the onslaught of the Chinese export juggernaut. Within the industrial world, Germany stood alone in holding its own (see my 11 September 2006 dispatch, “Global Speed Trap”). The hows and whys of Germany’s competitive prowess have long been debated. It’s always possible that Germany could simply be lucky -- a capital goods exporter that happens to be in the right place at the right time. As I travel through China, I certainly see highly visible signs of a voracious appetite for German-made products -- new factories equipped with the latest in German machinery as well as stunning examples of German infrastructure, such as the high-speed maglev train in Shanghai Pudong. Chinese imports of German-made products hit US$30.7 billion in 2005; that made China Germany’s 11th-largest export market -- behind the US and Germany’s largest European neighbors but ahead of Japan, Korea, Russia, and every other country in the developing world. But it is not just China. Germany is also playing a key role in supplying its neighbors in Eastern and Central Europe with the capital equipment that drives an increasingly vibrant outsourcing function. To me, the most impressive aspect of Germany’s export miracle is that it has occurred in the face of a strong currency and a high-wage work force. The euro is up more than 55% versus the dollar since mid-2001, and hourly compensation in German manufacturing stood at US$33.00 in 2005 -- fully 40% above that in the US and 52% higher than pay rates in Japan. With these disadvantages, it is nothing short of a miracle that Germany has done so remarkably well in the global export sweepstakes. Such an outcome is, in fact, quite consistent with the conclusions I reached last fall after an extensive tour of Germany (see my 22 September 2006 dispatch, “The New Wirtschaftswunder?”). At work, in my view, was an increasingly impressive improvement on the German productivity front -- driven by the confluence of IT-enabled investment, M&A-led restructuring activity, and a new “flexi” workforce dominated by rapid growth of part-time and temporary workers. Germany’s successes on the export front may well be a very important manifestation of this productivity dividend. It is not as if Japan has been standing still as Germany has gotten its act together. There has been plenty of restructuring -- both in the financial and nonfinancial segments of Corporate Japan. Moreover, Japan has moved aggressively to dismantle the worst of its labor market rigidities -- lifetime employment. And Japan has done an important about-face on its economic relationship with China -- embracing the Chinese outsourcing option as an efficiency solution rather than as a threat that might lead to the hollowing out of its domestic production base. But have these actions been enough? That remains a very legitimate question in light of Japan’s stunning loss of share in world export markets over the past 15 years. And it is an even more telling question in the face of Germany’s equally stunning successes during the same period. The hows and whys of Japan’s competitive prowess are very different from those of Germany. In the early decades of the post-World War II era, Japan competed mainly on the basis of cost and pricing. Then in the 1960s and 1970s, it began to compete on the basis of product quality. And in the 1990s, Japan’s competitive successes were in the area of process -- especially production, inventory control, and so-called quality circles. Throughout this entire period, however, a quasi-socialist system provided a warm blanket of support to banks, companies, and workers. The Great Bubble of the late 1980s marked this state-directed system to market and forced Japan and its reformers to find a new way. Prime Minister Junichiro Koizumi was the embodiment of that new direction, and during his tenure in office from 2001-05 pushed ahead vigorously on the reform front. Japan’s healing has been very different from that of Germany. Even now -- fully five years into economic recovery -- Japan has yet to distance itself from the risks of a deflationary relapse. The nationwide CPI is in positive territory only by the slimmest of margins (+0.1% y-o-y in January 2007), and is actually threatening to slip back into negative territory within the next month or so. The difficulty Japan is having in extricating itself from a post-bubble deflation may well be emblematic of deeper problems that continue to afflict the world’s second-largest economy. This same difficulty may also be having an important bearing on Japan’s competitive prowess. The damage from the bubble may well have been so wrenching and so fundamental to the system that it simply may be asking too much of Corporate Japan to rise quickly from the ashes and hold its own against the rapid emergence of China, the intense determination of Germany, and the solid gains evident by exporters elsewhere in the developing world. Unlike Japan, Germany did not have to reinvent its system -- it “simply” had to figure out a better way to cope with an uncompetitive cost structure and the external burdens of pan-regional unification and intra-German reunification. In many respects, those costs have now been absorbed and Germany is moving on to face to new challenges, with much to show for the efforts in terms of productivity growth and global export shares. Japan is still struggling. Yes, it finally has a sustainable recovery in the real side of its economy. But that is not enough -- especially if it turns out to be more of a cyclical rebound than a structural healing. Japan is still somewhere in between its old system and a yet-to-be-defined new system. And in one important respect, it continues to face a steep uphill climb -- it remains encumbered by a one-party political system that still has a stranglehold on the pace and breadth of a nascent transition. Japan’s progress looks monumental -- mainly because of where it has come from. Yet relative to the rest of the world, there is still plenty of heavy lifting ahead. To the extent that Japan’s progress continues to be heavily subsidized by the weakest currency and the lowest nominal interest rates in the world, it is hard not to underscore the still fragile state of its turnaround. By contrast, Germany has been stress-tested by a strong currency and an independent central bank. It has met the challenges of a new global competition head-on. It was never the “next Japan.” Only time will tell if the next Japan is truly a new Japan.
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Beyond the Payback
February 20, 2007
By Richard Berner | New York
Suddenly, the economy looks weak again. A weather-induced “payback” in economic activity has unmasked the ongoing housing recession, and the manufacturing slump continues, renewing doubts about the economy’s resilience. Coupled with declining inflation and inflation expectations, this new weakness appears to set the stage for an easier monetary policy. So why does Ben Bernanke continue to emphasize that upside risks to inflation remain the Fed’s biggest challenge? The answer in my view is that the “two-tier” economy is still in place and Fed officials are unsure that there is enough economic slack to foster further declines in inflation. The housing recession is not over, but we believe the manufacturing downturn is ending and other sources of strength will underpin growth. Vagaries of the weather, overlaid on the housing downturn, have obscured those trends: Just as warm weather temporarily boosted economic data in November-December, so now the return of winter temporarily is exaggerating the weakness in economic activity. This “payback” will mainly affect construction activity, but could for now also spill over into collateral weakness in related industries and undermine construction employment (see “Paybacks Ahead?” Global Economic Forum, January 29, 2007). Beyond the payback, however, we continue to think that the intensity of the housing recession will fade, the downturn in manufacturing will end, and output will resume growing at or possibly even slightly above its 3% trend rate. While core inflation probably has peaked, we share Chairman Bernanke’s view that some upside inflation risks linger, for three reasons. There isn’t much slack in the economy, and stronger growth would prevent slack from increasing; the linkage between slack and inflation is looser than in the past; and import prices are rising again. Details and implications for markets follow. There’s no mistaking the weakness in incoming data, but it may understate economic reality because it suffers by comparison with the strength of late 2006. Following warm-weather-induced increases in November and December netting to 5.1%, single-family housing starts plunged by 11.2% in January. Jobless claims jumped by a net 49,000 in the two weeks ended February 10, hinting at significant layoffs in construction and possibly manufacturing. Factory production in January fell 0.7%, reversing a December increase, as Detroit’s downturn and the housing recession weighed on suppliers. Retail sales excluding motor vehicles and building materials rose a bit less than expected in January, and a downward revision to November’s results cut the trajectory headed into the first quarter. And business surveys from the New York and Philadelphia Federal Reserve Banks netted to ongoing softness in Northeastern manufacturing activity. It’s impossible to know how much of this renewed weakness is genuine and how much simply reflects a reversal of warm-weather-induced strength in prior months. Indeed, the weather has turned especially severe in some parts of the country over the past month, so it may have exaggerated the payback in January-February readings. For example, January’s nationwide average temperature of 31.8ºF was just a degree below the 1996-2005 average, but the December-January downswing was 3.4ºF greater than the average January decline over that decade. The evidence for weather effects is mainly circumstantial. For example, I think the fundamentals point to steady apartment construction, but actual multifamily housing starts jumped by 34.4% between November and December and plunged by 24.1% in January. Those appear to be weather-induced fluctuations. More recently, inclement weather may have temporarily boosted jobless claims, which probably reflect heavy layoffs in construction. Warm weather in late December and early January seems to have underpinned a surprising 22,000 January jump in construction payrolls. A sharp decline in February construction payrolls that would more than reverse that increase would not surprise me. But stepping back from the monthly volatility, three developments are important. First, as we’ve stressed for some time, the housing recession has further to go, but its intensity is probably fading. January’s plunge in 1-family housing starts puts new construction back on the sharp downtrend needed to correct the overhang of unsold new homes. At December’s sales rate, that excess stood at 5.9 months’ supply at year-end 2006 — down from a peak of 7.2 months but well above the 4½ month norm of the past decade. Mr. Bernanke opined last week that it might take until the end of 2008 to get supply back to that level in relation to sales, but I think that timetable may be too pessimistic. Even if warm weather elevated sales in November-December, and they fell another 6% from October’s level (i.e., 16% below December’s pace), starts are falling much faster than sales, so the inventory overhang would be gone by October 2007. And if the recent stability in homebuilder sales and traffic surveys is sustained, the sales decline may be far more muted. Second, I think the manufacturing recession is winding down. While production may have stagnated through early February, courtesy of earlier cuts in output, inventories are getting lean again. The manufacturing and trade inventory-sales ratio dipped in December after drifting higher for much of the summer and fall, and inventory diffusion indexes, like those in the ISM index, plunged in January. More important, demand seems to be stabilizing. Business surveys — from small businesses in January (the NFIB survey), and from the regional Fed banks and our own industry analysts in early February — suggest that order books are improving. Although it stayed below 50%, the advance bookings index in the Morgan Stanley Business Conditions Survey jumped 10 points in early February (see “Business Conditions: The Long-Awaited Rebound?” Global Economic Forum, February 9, 2007). That leads to the third and most important point: Healthy job and income growth domestically and strong economies abroad should support US demand. Even if job gains cool further in February, as seems likely, I think the momentum in income is sufficient to support consumer spending. I estimate that real wage and salary income rose at a 3.7% annual rate in the three months ending in January. And while frosty weather may have chilled readings on consumer sentiment in February, they remain well above their fourth-quarter averages. Meanwhile, business surveys also hint that export bookings remain in growth mode. So where does that leave the Fed? Last week, House Financial Services Committee Chair Barney Frank asked Fed Chairman Bernanke why rising inflation is a greater risk than slower growth, when the FOMC’s central tendency forecasts involve below-trend growth for at least a couple more quarters and further declines in inflation. It’s a great question. The answer has three parts, and Barney Frank is smart enough to understand them all. I know — he was my tutor (a teaching assistant) in Gov 1when I was a college freshman. The first part of the answer involves initial conditions. The Fed has been aiming at growth below trend — enough to create some slack in the economy in order to push inflation lower. But in my view, there isn’t a lot of slack in the economy or labour markets yet. For example, if potential growth is 3%, the so-called output gap may have widened over the past year by half a percentage point to as much as 1%. With the unemployment rate at 4.6%, that growing gap hasn’t been mirrored in labour markets, at least not yet, leaving upside risks to inflation. The second part of the answer involves uncertainty. Officials not only don’t know how much slack there is, they don’t know how much slack they must create to coax inflation down, because the relationship between slack and inflation is looser— the “Phillips curve” is flatter — than in the past. The third part involves Fed credibility and inflation expectations. Core inflation has run above the Fed’s 1-2% preferred “comfort zone” for more than three years, so officials are concerned that the public will come to believe that the Fed will tolerate the current level of inflation, and thus that inflation expectations could drift higher. In his testimony, Chairman Bernanke understandably demurred from pinning himself down on how much slack exists in product or labour markets or on the slope of the Phillips curve: “There’s no specific level of … unemployment that is a trigger … for inflation. The main concern is to make sure that the overall spending in the economy … doesn’t exceed the underlying productive capacity for sustained periods. That seems to generate inflation. But …it’s not easy to determine exactly where that balance should be struck. You need to look at a wide variety of indicators, including price indicators, to get a sense of when the economy is overheating and when it’s more or less in balance.” Now I suspect that Mr. Bernanke shares my belief that potential growth is about 3%, and the slack-inflation relationship is looser than before. Ironically, the Fed’s own success in anchoring inflation expectations has probably been a key reason for that change. It’s ironic because it means that cyclical forces are now less potent in pushing inflation higher, but it also implies that if inflation does rise, the amount of slack required to get inflation back down — the ‘sacrifice ratio’ — is now higher than before. If so, the Fed must tolerate lower growth for longer to bring inflation down. Risk management dictates that the Fed will be reluctant to ease unless that extra slack really materializes and/or they are confident that inflation will fall. But how much and how fast does inflation need to fall? After all, inflation is low: Measured by the PCE price index, core inflation declined to 2.2% in December, or just above the upper end of the comfort zone. With a higher 'sacrifice ratio,’ the cost of bringing inflation down quickly is also higher, so it would be perfectly reasonable for a patient Fed to let inflation drift lower gradually. But as Richmond Fed President Jeffrey Lacker's dissents last year remind us, whether we live with modestly higher inflation depends on what the Fed chooses implicitly for its inflation target. It is in that deeper sense that Chairman Frank’s question really matters. If the Fed is to be accountable, they should say what they mean. Unfortunately, I think the presumed 1-2% comfort zone — a range for which the midpoint of 1½% has become the Fed’s de facto inflation objective — conflicts with such accountability. Such an objective should be low enough to ensure policy credibility, but high enough to allow a cushion both for disinflationary shocks and for measurement bias. Perhaps paradoxically, I think that the midpoint of the comfort zone is a bit too low to be a credible objective, for two reasons. First, the Fed seems reluctant to try to hit it, perhaps because the cost of achieving even a modest decline in inflation is now higher. But the longer the Fed misses its objective, even one that is just presumed, the less credible that objective becomes. Second and related, the cushion it affords for shocks is probably too small. In contrast, in my view, a 2% objective would be a credible number entirely consistent with price stability. It would allow a larger cushion for “unwelcome” declines in inflation from shocks and for measurement error. When core inflation gauged by the PCE price index drifted to and below 1% in 2003, policymakers eased aggressively to avoid even a small threat of deflation. They recalled the lessons from Japan’s deflation and understood the threat of the “zero bound:” If inflation fell lower than nominal interest rates, which cannot go below zero, it would inadvertently make policy restrictive. A higher objective would reduce the need for such an asymmetrical policy response. And if the next ‘benchmark’ national income accounts revision pushes core inflation gauged by the PCE price index slightly lower, with a 2% objective no one would presume a policy response. Together, I think these factors legitimize the argument that the appropriate long-term target could be 2% and the monitoring range around it could be +/- 50 bp — or even wider (see “A Higher Inflation Objective? “ Global Economic Forum, August 11, 2006). All this discussion may seem moot, because in other respects the Fed communicates clearly about its objectives and policy strategy. Moreover, Mr. Frank opposes a specific numerical inflation objective because it might conflict with the Fed’s employment objective as part of its dual mandate. For their part, financial market participants are content to await the Fed’s deliberations on an inflation objective and related communication issues. My hunch is that they suspect that the midpoint of the comfort zone is already 2% — or at least higher than 1½% —and they aren’t particularly bothered about it; the Fed has plenty of ‘Street cred’ now. As a result, markets once again are romancing the notion that the Fed will ease before year-end, and further signs of economic weakness and moderate inflation could inflame that belief. Unless the economy stumbles meaningfully, however, we think the Fed will stay on hold until 2008 and ten-year yields should continue to trade in a 4½-5%+ range. As always, a seemingly benign backdrop carries hidden risks. Near term, the risk is that economic data may continue to look weak. Fundamentals could also appear riskier. For example, fears are rising that the so-far-idiosyncratic bust in subprime mortgage lending will morph into a broader, systemic credit crunch as foreclosures rise, lenders grow cautious, and Congressional efforts to rein in predatory lending further choke off supply. I think such fears are dramatically overblown, but perceptions of a wider spillover into prime loans and other asset classes could escalate (see “Will the Subprime Meltdown Trigger a Credit Crunch?” Global Economic Forum, February 12, 2007). And as Chairman Bernanke and we agree, declining energy prices and decelerating rents could feed through to even lower core inflation readings. Beyond the payback, however, I think the risks lie in the other direction, and both the economy’s resilience and inflation risks may once again resurface. For example, prices for imported consumer goods excluding autos and parts rose by 1.5% in January year/year — the largest annual rise in such prices in a decade. Perhaps the disinflationary impetus from Chinese exports is waning. These crosscurrents in activity and inflation may finally push up volatility in financial markets. From the Fed’s standpoint, that may not be such a bad thing. At a time when low volatility has encouraged risk taking, perhaps to excess, a pickup in volatility might remind investors that higher risk usually accompanies higher returns. And if it simultaneously increased term premiums at the long end of the yield curve, higher volatility would modestly add to financial restraint, perhaps relieving the Fed of some of that inflation anxiety.
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Pegged Pains
February 20, 2007
By Serhan Cevik | London
With currencies pegged to the dollar, oil exporters are importing inflation. The global commodity boom has provided oil-producing countries in the Middle East with massive current account surpluses. Thanks to surging oil and natural gas prices, export revenues increased from US$251 billion in 2002 to about US$900 billion last year, raising the cumulative current account surplus from 5.4% of GDP to 25.8% over the course of this unusual period. The resulting flood of liquidity has, of course, stimulated domestic demand and led to the sudden acceleration in growth — from an average of 3.7% a year in the 1990s to 6.3% in the past five years. However, this economic boom has already exhibited signs of overheating, with higher inflation rates across the region (see A Dutch Disease in Arabia, October 18, 2006). According to official statistics, consumer price inflation in the Middle East accelerated from 3.9% in 2001 to 7.7% in 2005 and over 9% last year. Even though liquidity-driven pressures have certainly contributed to the rise in inflation, exchange rate regimes pegged to the US dollar have also turned into a channel for importing inflation. Measurement errors in official price indices underestimate inflation. Consumer price indices show a clear upward trend in inflation in all oil-producing countries, but we believe that measurement errors in outdated official figures understate the degree of acceleration in inflation. For example, in the United Arab Emirates, independent surveys point to an inflation rate of 15-25%, as opposed to 10% according to the official index. Given the extent of liquidity abundance and the mix of extremely accommodative macroeconomic policies, the behaviour of non-tradable prices is the obvious culprit. But we should not overlook the role of imported inflation. Pegged to the dollar, the currencies of oil producers in the Middle East have tracked the dollar’s sustained depreciation since 2002, even as their export earnings have soared to record levels. And since the majority of imports come from Europe and Asia, the dollar’s weakness has become a major source of inflation by pushing up the price of imported goods and services. Oil exporters need to revalue their currencies to bring inflation under control. Despite all the challenges, flexible exchange rates are still the best tool to achieve sustainable stability and economic growth. The case of oil exporters is no different, in our view. Especially now, with the rise in inflation, the unprecedented level of current account imbalances is a call for real exchange rate adjustment. In theory, this could come through either inflation or a nominal currency appreciation. Obviously, it would far better if the necessary adjustment takes place through exchange-rate revaluation rather than a costly episode of higher inflation. Therefore, we think the best possible course of action is to abandon fixed exchange rate regimes in favor of floating currencies or, at least, pegs to a trade-weighted basket of currencies instead of the dollar. But that is unfortunately unlikely to happen any time soon in the Middle East, and the authorities may instead opt for one-off revaluation of the prevailing dollar pegs. Although that may not be a long-term solution, it would still be a step towards normalizing real interest rates and gaining control of the overheating economies. Pegged exchange rate regimes also hinder rebalancing in the global economy. According to the conventional wisdom of oil exporters, the dollar pegs make economic sense and help minimize exchange-rate risk because oil — their most important source of export revenues — is priced in dollars. In our view, that is a misleading sense of stability, and currency and oil price fluctuations in the second half of the 1990s and recent years are a case in point. Fixed exchange rate regimes (especially those pegged to a single currency) make commodity producers more vulnerable, not less, and distort economic compositions. Moreover, currency misalignments in the Middle East are not just a domestic concern, but have also contributed — even more than China’s well-known effect — to global imbalances. The sustained depreciation of real effective exchange rates has pushed import prices higher and thereby kept import demand well below the increase in exports. This is why we think greater exchange rate flexibility in oil-producing countries is necessary for rebalancing in the global economy as well as their own economic progress.
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What Will Be the Focus of Budget F2008?
February 20, 2007
By Chetan Ahya | Mumbai
Summary The Ministry of Finance is scheduled to present the annual central government budget on February 28. Apart from addressing fiscal management as a broader issue, the government has traditionally used the budget as a platform for relaying the measures it aims to take to address the pressing macro issues. We believe that F2008 budget measures will centre on the three key macro themes: (a) inflation control, (b) infrastructure and (c) enhancing social objectives. Assessing the success of fiscal management In line with the last three years’ trend, the central government’s headline deficit is likely to fall further to 3.3% of GDP during the 12 months ended March 2007, well within the target implied by the Fiscal Responsibility and Budget Management Act. The government has been able to cut its fiscal deficit from a peak of 6.2% in F2002, primarily on account of higher ratio of tax to GDP. We believe that a significant part of the improvement in tax to GDP is cyclical, reflecting a leveraged growth cycle supported by global liquidity and low real interest rates. Indeed, most of the increase in tax to GDP is due to higher corporation taxes because of higher profits. Moreover, if we add the off-balance sheet oil subsidy of 1.1% of GDP, the fiscal deficit would be at 4.5%. We believe that, for a sustainable reduction in deficit, there is a need to reduce non-interest revenue expenditure, which has increased by 0.6 percentage points of GDP since F2002. Indeed, we would rate the improvement in the fiscal management to be less than satisfactory. In the F2008 budget, we do not expect any major progress on expenditure reforms, the long-standing issue that has led to a sticky fiscal deficit problem. Macro themes that will influence budget measures We believe that the government is occupied with working out measures to sustain the current high growth, but at the same time it is also initiating steps to address the needs of the lower and middle income population, making the growth inclusive in nature. In this context, we believe that budget measures will focus on following three macro objectives: (a) Inflation control — through indirect tax rate cuts The wholesale price index (WPI)-based inflation rate (provisional) has accelerated to 6.73% during the week ended February 3, 2007 (from 5.58% six weeks ago), well above the RBI’s comfort zone of 5-5.5%. Analysis of price trends for various WPI components indicates that a major part of the recent acceleration in overall inflation is due to manufacturing products. We believe that the budget will attempt to take short-term measures to reduce the inflationary pressure by cutting customs and excise tariff for manufactured products. We believe that there could be across-the-board cuts in the peak tariff rate from 12.5% to 7-8%, taking it closer to the target of 6-7% (the current ASEAN tariff rates). In our view, the sustainable solution would be to create the right business environment so that the supply-side response (productive capacity creation) is adequate to meet the acceleration in demand growth. However, addressing this weakness remains a challenge and requires a quick and concerted policy response to bring about a major change in business environment, particularly infrastructure and the overall administrative framework. (b) Infrastructure — particularly for rural areas As we have been highlighting for a while, one of the key reasons for India’s slow response in increasing productive capacity has been the less-than-optimal government response to improve the business environment. In this context, infrastructure development is the most important anchor for a quick response from the corporate sector to add productive capacity. Both the central and state governments have announced a set of measures over the last three years to increase infrastructure spending. This we believe has helped to accelerate India’s total infrastructure to US$34 billion (3.9% of GDP) in F2007 from US$17.8 billion (3.1% of GDP) in F2004. However, we believe that to sustain 8-9% GDP growth, there is a need to increase infrastructure spending to 7-8% of GDP. We believe that the government will move further in the right direction in the coming budget by announcing measures to promote infrastructure investments. Within the overall infrastructure push, the budget is likely to make a bigger push for government spending on rural infrastructure. Although the private sector has been forthcoming in funding urban infrastructure, the rural infrastructure spending (except telecom) has not witnessed any significant improvement so far. We believe that there is unanimous opinion among the policy makers that the rural infrastructure investments by the public sector, which have been woefully lacking, need to increase. We expect the budget to increase allocation for rural infrastructure spend as well as provide tax concessions for the corporate sector investing for this purpose. This measure will also be necessary for addressing the emerging longer-term challenge on food inflation, as a lack of infrastructure investments has caused decelerating farm output growth. (c) Enhancing social objectives — with higher budget allocation to education and health Social development has continued to be among the most important issues gaining the attention of policymakers over the past three years (since the UPA government assumed power). This is reflected in the acceleration in the central government’s social sector spending over the past three years to an annual average rate of 21% as compared with an average 10% in the preceding five years. The key area that has seen acceleration in spending has been education. This acceleration has in turn been aided by the 2% education cess levied on tax collections by the central government. However, our concern is that the state governments, who account for about 80% of total spending, have witnessed much slower growth in their allocation. Their spending on the social sector has grown by 15% in the past three years (just above nominal GDP growth of 14%) as compared with 9% in the preceding five years. We believe that the states need to concurrently accelerate their spending on the social sector to ensure that the government is able to reach its target spending of 8-9% of GDP on education and health as compared with its current spending of 5.9% of GDP. In this year’s budget, we expect the central government to continue its push for spending on social development, particularly with regards to education and health. Expectations on sector-specific measures A bottom-up aggregation of our analyst expectations indicates that the budget will likely have a benign impact on most of the sectors, barring a few tax-related tweaks. The sectors where positive announcements are expected in the budget include banks (incentivizing deposit mobilization via income tax breaks), agrochemicals (thrust on agriculture and reduction of customs duty), automobiles (excise and customs duty cuts), infrastructure (focus on funding, further clarity on key projects) and oil & gas (potential reduction in regulatory uncertainty). The metals sector is the only one where a negative announcement is expected, in the form of customs duty cuts owing to inflation fears. Bottom line On an overall basis, we expect the budget to take a few more steps in the right direction. We expect the government to initiate a meaningful cut in indirect taxes and increase allocation for infrastructure and social development expenditure, such as on education and health. However, we have limited hopes for the introduction of public expenditure reform in the current coalition politics environment. Similarly, on policy reform, we see little likelihood of any major push for privatization and foreign direct investment (particularly multi-product retail business and insurance sector). We believe that many of the critical macro challenges for the country need to be addressed outside the budget; in this context, the budget per se has limited scope for pushing forward structural reforms.
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