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Necessity’s Granddaughter Is Goldilocks
February 23, 2007

By Robert Alan Feldman | Tokyo

Our new macroeconomic forecast for Japan remains aggressive on the outlooks for both growth and prices. (For details, see Getting Springlike, Takehiro Sato, February 16, 2007). We see growth accelerating in both 2007 and 2008, while prices remain virtually stable. How can Japan extend growth for two more years, in the face of a shrinking population, and still have such stable prices? The only possible answer is continued high productivity growth. We think this is the most likely outcome for macro and micro reasons. The implication for bond and equity markets is highly supportive.

The macro part

The macro story concerns the composition of demand. While many investors focus on a shift to consumption as the leader of growth, we see business investment as continuing to lead. Profits are high and rising, and the rates of return on investment are good. Replacement demand is strong, and demand for Japanese machinery to support growth in Asia requires more investment in capital-intensive Japan. Demographics in Japan also require capital deepening. Thus, the macro incentives for high investment remain strong.

While the macro case is strong, however, investors get worried when the micro incentives for investment come up. Macro needs and micro incentives do not appear aligned. Has this changed? Is this about to change more?

The micro part

I think that the answers are “yes” and “yes”. The evidence on the “has changed” part is clear. The new Corporation Law and stricter governance have helped keep the incentive for higher returns in place. As my colleague Naoki Kamiyama points out, total dividend payments in Japan are up to an estimated Y6.5 trillion in the current fiscal year (ending 3/07), from a very stable Y3.0 trillion prior to FY02. And the number of M&A cases rose again in 2006 to 2,775, compared with an average of about 1,700 in the 2000-03 period, and about 500 in the mid-1990s.

The evidence on the “about to change more” part is less clear, but signs are encouraging. First, the Japan Fair Trade Commission, which is the competition watchdog, has recently changed the rules on merger approvals. The new system adapts the Japanese rules to the world standard, the so-called Herfindahl-Hirschman Index, but sets looser standards than the US or Europe for easy merger approval. (see Not only will approvals be easier, but firms will be less hesitant to make proposals, in my view.

Another hurdle, the ministerial rules on triangle mergers by foreign firms, seems more likely to be cleared. Heretofore, Japan’s largest business organization has been cool on the idea. One of Keidanren’s objections has been that local investors could not be protected if holdings were no longer listed in Japan. This objection has now been ended by the move by a major foreign financial institution to issue Japan Drawing Rights (JDRs). The latter are modeled on American Drawing Rights, an innovation in the US many years ago that allowed US investors easy access to Japanese stocks. The JDRs would be listed in Japan, easily approved by listing authorities, and denominated in yen.

Recently, there have been several cases that augur well for more corporate activity. A major brewery has been the target of a friendly takeover proposal, but other suitors are now being discussed in press reports. Two large department stores recently announced a merger. And a listed personnel agency announced that it has acquired a non-listed competitor. M&A should accelerate even more, with the combination of increased ‘threat’ of foreign takeovers and easier domestic takeover rules.

The link to productivity

Both macro and micro developments suggest that productivity will rise. If business investment continues to lead GDP growth by a margin exceeding depreciation, while employment growth remains moderate, then the ratio of output to labor will rise — the very definition of higher labor productivity. At the micro level, M&A means that higher-return firms will take control of the resources of lower-return firms, and reallocate those resources to better use. This is precisely how M&A creates value. If resources are released, they are likely to find other uses, given the tightness of labor markets. Creating more output with the same resources (or the same output with fewer resources) is the very definition of microeconomic productivity

Market implications

For investors, both the macro and micro trends are important. If successful, they herald a permanently higher level of return on assets in Japan, and thus higher asset valuations. True, as Kamiyama-san has said, the current level of the equity market seems to be at the higher end of its fair value range. That said, any retreat of equity prices is likely to have a higher floor than in the past. For the bond market, there are two conflicting effects. On one hand, higher productivity means that real yields should be higher, reflecting the higher efficiency of capital. However, high productivity growth also means that inflation will continue to be low, holding nominal yields down.

In the economy, necessity is the mother of invention. In financial markets, invention is the mother of Goldilocks.

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Clearing the Decks for IG Metall
February 23, 2007

By Elga Bartsch | London

Metalworkers’ wage round to kick off …

This coming week, the powerful metal workers’ union, IG Metall, will table its official demand for the upcoming wage talks in the capital goods, electronics and car industries. Historically, IG Metall has acted as the pacemaker in the annual German wage round. The official demand is unlikely to be very different from the guidance given by the national trade union board earlier this month. The national trade union board had indicated on February 6 that it would advise demanding a pay rise of 6.5%. Two days later, ECB President Trichet stepped up the hawkish tone of the introductory statement. So, do we need to clear the decks for a big wage battle in Germany?

… but shouldn’t see much momentum before May

The actual negotiations will get underway when trade unionists meet with employers’ reps in mid-March. Due to the regionalised structure of the German wage negotiations, the official demand and the subsequent negotiations will take place on a regional basis. But the negotiations are unlikely to gain much momentum before the so-called peace period ends in late April, i.e., four weeks after the expiry date of the current wage contract on March 31.  This is because, during the peace period, trade unions are not allowed to hold any strikes. Only afterwards can unions hold warning strikes and ballot members on an all-out strike, if the negotiations have failed. Typically, only when a strike looms large are wage agreements reached in the German metal sector. Hence, the talks are unlikely to gather much momentum before May. After the official wage demand, the next event is the employers’ offer. It will give us a better understanding of the respective bargaining positions.

Trade unions proclaim the end of wage moderation

After an extended period of wage restraint, the pendulum seems to be swinging towards higher wage increases in Germany. Not only are trade unions becoming more demanding in terms of pay packages as the economy continues to recover, as the labour market turns around and as profits are posting record gains. Across the board, trade unions are stepping up their demands compared to last year’s pay rises. But also, several leading politicians seem to be supporting higher wage increases. This is unusual, for two reasons. First, bilateral wage negotiations between employers and employees are sheltered from political influence under the German constitution. Historically, it has been regarded bad form for politicians to comment on the desirable outcome of the deliberations. Second, the support seems to come across all political parties, suggesting that there is broad consensus in favour of abandoning wage moderation.

Companies get generous on profit surge and pricing power

Furthermore, a recent poll of German business leaders by the financial daily Handelsblatt suggests that managers feel considerably more generous this year. Today, a majority view a settlement of between 2-3% as acceptable, whereas last year most thought that less than 2% was appropriate. It might be that managers feel somewhat more generous because contributions to the statutory unemployment insurance scheme were reduced by 2.3 percentage points of gross wages at the beginning of the year. Cutting these contributions, which are equally shared between employers and employees, creates some extra room for manoeuvre. On the one hand, net pay has increased at the beginning of year, possibly taming trade unions’ need to go for a sizeable settlement. On the other hand, non-wage labour costs have been lowered, thus raising the limit for non-inflationary wage increases.  Historically, IG Metall has settled for 48% of its initial demand. But due to the reasons outlined above, they might cut a somewhat better deal this time round. We would therefore not rule out a pay-package, which totals close to the 4% mark. In judging the outcome, the split between a raise in base salaries and one-off bonus payments will be key.

Metalworkers to settle close to, but below, 4%

On balance, a settlement close to 4% in the metal industry by itself would probably not warrant a meaningful upward revision of inflation in Germany or a downward adjustment of employment and growth projections.  But it would likely raise a few eyebrows at the ECB, especially if such a settlement occurs against a background of strong employment growth, falling unemployment and generally rising wage increases across the euro area. It is worth bearing in mind that the metal sector typically settles about half a percentage point above the total economy (2.25%). In addition, Germany has seen a negative wage drift for more than a decade, causing effective pay to rise on average 1.4%, three quarters of a percent less than the negotiated pay. The gap underscores the rapid erosion of the trade unions’ grip on the labour market, which can be witnessed in the falling share of companies and employees covered by traditional sectoral wage contracts.

But the metal workers aren’t Germany

Ahead of IG Metall, the more pragmatic IG Chemie, representing 550,000 workers in the chemical industry, is likely to settle. Similarly, the battered IG Bau, which has demanded 5.5% for its 700,000 construction workers, might sign beforehand, further reducing the upward pressure on wages. The overall cost pressures will depend crucially on the development of the wage drift, which tends to show a cyclical pattern. We assume in our forecasts that the wage drift gradually vanishes. If the wage drift were to instead become positive, it would be an important signal on labour market bottlenecks. Other factors that will determine potential labour cost pressures include the ongoing discussion about the extension of the existing minimum wage legislation to additional sectors and/or the introduction of a nationwide minimum wage. Assuming a cyclical slowdown in labour productivity growth, unit labour costs dynamics are still likely to remain favourable (mainly due to the reduction in unemployment insurance contributions). But they will become less favourable than before and for the first time since 2003, as unit labour cost growth could be moving back into positive territory. Part of this increase in labour cost pressures will likely be absorbed in profit margins. But German manufacturers, especially in the capital goods industry, also report a steep rise in perceived pricing power.

Implications for the euro area and the ECB

Looking at the implications for the euro area and the ECB, Germany is likely to be an important tipping point (see EuroTower Insights: Whither Euro Area Wages? October 20, 2006). This is because Germany’s relative wage deflation is what kept wage increases in the euro area close to 2% in recent years. Other potential tipping points for euro area wage developments include the French presidential election, where one candidate, Segolene Royale, is promising to raise the minimum wage by around 20% and the other, Nicolas Sarkozy, is musing on a potential VAT increase like the one just implemented in Germany. While the negotiated wage is currently increasing to the tune of 2.0%Y, compensation per employee by 2.0%Y and unit labour costs growing at merely 0.8%Y, there is little inflationary pressure from the labour market. But against a backdrop of robust employment growth and rapidly falling unemployment, the ECB is unlikely to wait until inflationary pressures actually materialise.

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Tax Deductibility of Corporate Interest Payments in the UK
February 23, 2007

By David Miles | London

Until relatively recently, the UK had one of the lowest rates of corporation tax in Europe. This is no longer the case. The value of deducting interest payments on debt against the liability to pay UK corporation tax is now higher in the UK than in most European countries. One reason why the German rate of corporation tax is planned to fall marginally below the UK rate is that a set of proposed tax reforms looks likely to be implemented — including limiting (though not removing) the tax deductibility of interest payments (see Germany: A Compromise on the Corporate Tax Reform, by Elga Bartsch, November 7, 2006). In the light of these changes in relative corporate tax rates, raising debt in the UK to finance activity in other European countries is becoming a more attractive strategy — especially if the flow of repatriated profits that might come back to the UK is not taxed further (as in practice is now generally the case). This is one reason why the issue of the tax deductibility of debt has come back on to the agenda in the UK. A further reason is the perception by some that tax deductibility of interest payments seems to particularly favour the highly levered buyouts by private equity companies of — usually less highly geared — publicly quoted companies.

There has been a much more long-standing view among many academics that there is no good reason to create a tax advantage to corporate debt financing by allowing interest payments to be deducted from gross operating surpluses before corporation tax is levied. (One reason for considering this is that the ability of the UK government to levy extra taxes on income repatriated to the UK from overseas subsidiaries is threatened by rulings by the European Court of Justice. The issues involved, and the link between this and interest tax deductibility, are explored in Chapter 10 of the IFS/Morgan Stanley 2007 Green Budget.) Companies are not able to deduct dividend payments on equities from their profits in calculating taxable income and there is no clear case for favouring debt financing over equity financing. (For a thorough and recent review of the case for withdrawing tax deductibility of corporate interest payments, see M. Devereux, S. Mokkas, J. Pennock and P. Wharrad, Interest Rate Deductibility for UK Corporation Tax, 2006 (

So what are potential impacts of removing the tax deductibility of interest payments? And how likely is this to happen in the UK?

Removing interest tax deductibility in itself would generate substantially more tax revenue. Such a policy could hardly be applied to financial institutions — most clearly in the case of banks for which debt liabilities are largely offset by debt assets. So it is likely that if a policy of levelling the tax playing field between debt and equity were to be applied, financial institutions would either need to be exempted or else the rules structured so as to reflect their unusual position.

A revenue-neutral way of implementing a change would be to offset the removal of interest deductibility for non-financial companies with a cut in the corporate tax rate. We estimate that the UK corporate tax rate could come down from 30% to around 20% and still generate tax receipts at around the current level.

What might be the implications of a cut to 20% in the rate of corporate tax and a removal of deductibility of interest payments (all applied to non-financial companies)? To get some idea, it is helpful to look at the existing way in which companies finance their operations. We looked at the proportion of capital investment that has been financed from retained earnings (operating surplus after interest paid, tax and dividends), from issuing new equity and from issuing debt. The proportion of corporate spending financed from equity issues and from debt can be, and very frequently has been, negative as share repurchases can exceed new share issues, and repayment of existing debt can exceed new loans raised from banks and from new issues of corporate bonds. Companies find it harder to pay dividends in excess of post-tax equity profits, so retained earnings (or gross corporate saving) are rarely negative.

Over the past 20 years, on average, new issues of equities and debt have hardly contributed to the aggregate financing of corporate investment. Share buybacks have more than offset new share issues. Debt issues have exceeded debt repayments in most recent years, though the share of corporate spending financed out of debt has only averaged around 20-30%. Retained earnings — a form of equity financing — have consistently financed by far the largest part of corporate spending. That might make it seem that any adverse consequences upon corporate spending from removing a tax advantage to debt might be small.

But looking at the flows of net debt (which is appropriate in looking at the overall contribution to financing investment) does not tell one much about the importance of the stock of corporate debt in the economy. That is better measured by gross corporate gearing — the ratio of gross debt to the sum of gross debt plus equity. Aggregate gearing for UK non-financial companies is now just under 45%.

It is likely that reliance on bank lending and upon debt issuance would be lower without interest tax deductibility — potentially so much so that corporates would embark on a strategy of buying back bonds and repaying loans on a substantial scale. Would that be a problem? What might be the impact on bond yields?

We offer the following thoughts:

  • Internationalisation in portfolios of financial assets in recent years has meant that trends in the real yields on bonds issued by governments (in different currencies) across the world have looked very similar; there has certainly been a substantial internationalisation of holdings of gilts. That suggests that the knock-on impact of any change in the supply of corporate debt from UK companies on the cost of government debt might be limited.
  • There would be winners and losers: companies that have had small amounts of debt will find that the benefit from lower corporation tax more than offsets the cost of losing tax deductibility; firms that have had unusually high gearing would be net losers.
  • At a time when companies are looking to better match their portfolios of assets held within DB pension plans against liabilities whose values are calculated by reference to the yield on an AA sterling corporate bond, a move that plausibly reduces the stock of such debt is hardly helpful.
  • Finally, there would be some scope for companies to re-create the tax advantage of debt deductibility by other means. A company can finance the purchase of materials using debt which it might choose to repay in, say, six months when revenues from the use of the materials flows in. The interest on that debt is currently deductible from the corporate tax bill. A company which arranged to pay its supplier of raw materials in six months at a price which reflected six months of gross interest would be able to deduct the whole cost against its tax bill even if interest was no longer tax deductible.

The last three points make this potential reform of the system of corporation tax problematic. So while we expect the issue to generate continuing debate, it is unlikely to be implemented by any government for some time.

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Low Investment Is the Main Source of Global Liquidity
February 23, 2007

By Stephen Jen | London

Summary and conclusions

I believe that the source of global liquidity is real, not nominal. 

In contrast to the popular view that central banks’ irresponsibly easy monetary policy has led to the bloated asset prices in the world, I believe that the more important source of global liquidity is the (curiously) low capex/capital stock in the world.  Until the global economy’s capex accelerates to absorb much of the savings, real long bond yields in the world should remain low and risky assets should be supported. 

This type of ‘real’ liquidity will only be withdrawn when the global economy becomes capex-led.  By then, risky assets could come under some modest pressures.  I say ‘modest’ because a capex-led global economy will be a low-inflation, high-growth economy, much like we have seen in China in the past few years.  This should provide some support for risky assets. 

In the currency space, the key implication is that ‘greed’, not ‘fear’, will drive investments.  Exchange rates will move gradually (i.e., trends are possible) and no currency, not even the dollar, can crash, if there is no fear (i.e., volatility will remain low).  Asian and other emerging market currencies should perform well, at the expense of the USD, EUR and GBP.  The tug-of-war between the dollar and the euro will be much less exciting than it has been for the past four years. 

The source of global liquidity is real, not nominal

The Fed being the manager of the proverbial ‘punch bowl’ at the proverbial ‘party’ is no longer an appropriate description of what is going on, in my view.  In fact, the traditional view that the center and the driver of the party is the punch bowl, and that the fate of the party is predicated on the size of the punch bowl, is not a view I find compelling. 

To me, the party has moved outdoors, and the ‘good weather’ (i.e., solid real factors) will keep the party going, with or without the punch bowl.  By this I mean that the key driver of global liquidity is real, not monetary or nominal. 

Many, such as some ‘old paradigmers’, paint the image that we are standing knee-deep in liquidity flooded by the G10 central banks, with emerging economies as the accomplices through their currency interventions.  But I believe it is the low level of global investment that has led to excess savings, which, in turn, have artificially depressed the real long bond yields in the world.  This investment (I) and savings (S) framework is a real concept, not a monetary or nominal notion. 

As I have been arguing for some time, the fact that the global yield curves are so flat, with some being inverted, is a confirmation that real factors dominate monetary factors in keeping global liquidity conditions easy.  This is also why I have long argued strongly against the use of monetary aggregates as measures of liquidity, because doing so implies some guilt on the part of the central banks in creating so much liquidity in the world. 

In my view of the world, risky assets will be surprisingly resilient to monetary tightening.  The BoJ could raise the policy rate to 1.00% and that would not undermine risky assets in the world. 

I have these specific thoughts:

• Thought 1.  The world’s yield curve remains too flat.   This is an observation I’ve been making for some time.  Based on the G10 GDP-weighted real interest rates that we compute, the world’s cash rate is now close to its long-run average.  With the BoJ’s latest rate hike, in three months’ time, the market expects the world real cash rate to reach the long-term average.  With goods price inflation being so benign, it is difficult to argue that the world’s central banks are behind the curve.  However, the world’s 10Y real interest rates are at a generational low — currently at 2.14%, compared to the long-run average of 3.20%.  The low long-term interest rate, not the cash rate, is the extraordinary feature of the global economy.

• Thought 2.  Low capital-to-labor ratio.  I think that a key related issue here is that, with the effective doubling of the global labor force in the past 10-15 years, the world’s capital-to-labor ratio has been artificially depressed.  For various reasons, which I will mention later, there has been a curious reluctance on the part of the corporate sector in the world to invest in physical assets, i.e., capex has been surprisingly low, despite the fact that the global capital-to-labor ratio is artificially depressed.  Exhibit 2 shows that in Asia, one of the fastest-growing regions in the world, while the savings rates for NE and SE Asia have not changed that much in the past 15 years, their investment rates have collapsed, even including the massive investment that has taken place in China in recent years. 

• Thought 3.  Why is the world’s capex so low?  The world’s investment in physical assets being so low is remarkable, in light of the fact that the cost of capital, i.e., interest rates, is so low.  There are some possible explanations for this.  First, since 2002, there has been an intense debate on whether there would be a ‘double-dip’ and whether the recovery we began to witness in the US was genuine and sustainable.  The world has been worried about an asset-driven growth model in the US, and growing external imbalances.  It was not until recently that most investors accepted the view that the economic recovery was genuine.  In short, intense uncertainty regarding the outlook of the global economy may have forced companies to restrain their capex plans.  Second, multinational corporations may have attached a certain risk to expanding capacity in emerging markets, due to uncertainties regarding both political and economic policies. 

• Thought 4.  The key implications of my hypothesis.  There are some critical implications of my hypothesis:

1. Global imbalances are not only sustainable, they are the root cause of excess liquidity.  For the past few years, there were commentators who argued that, with such a large C/A deficit, the dollar was at risk of collapsing.  In fact, the investment and savings framework I propose suggests that the C/A surpluses in the rest of the world would provide adequate financing, as long as the US does not make major policy errors. 

2. Global financial conditions will likely remain benign for an extended period.  Though I am arguing that global excess savings/inadequate investment are important, monetary policy still matters.   But as long as central banks don’t push policy rates deep into restrictive territory, and as long as the world does not fully absorb its own savings, global financial conditions will remain stimulative.  Gentle monetary tightening will not likely undermine risky assets, in my view. 

3. Exchange rates will show trends, with low volatility.  In an investment environment driven by ‘greed’ rather than ‘fear,’ cross-border flows should not be too lumpy.  Massive capital flights and panic repatriation flows are not likely in this environment.  This means that exchange rate will show trends, with volatility remaining low.

Bottom line

The origin of global liquidity is at the core of the old paradigm versus new paradigm debate.  Some ‘old paradigmers’ tend to believe that much of the buoyancy in the global economy and the financial markets is a direct result of liquidity arising from monetary stimulus.  They therefore tend to be hyper-sensitive to central bank policies and believe that most of the asset prices will ‘mean revert’ once the extraordinary monetary stimulus is removed.  On the other hand, others such as some ‘new paradigmers’ and myself believe that the main source of global liquidity is real, not monetary, and is a derivative of the world’s capex being too low to absorb its savings.

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February 23, 2007

By Stephen Jen | London

Summary and conclusions

Much has happened since our last forecast round two weeks ago (Slightly Flattening the Paths for EUR/USD and USD/JPY, February 8, 2007).  In this note, I highlight four currency pairs that I find interesting in the near term.  Specifically, I believe that the risks to USD/JPY, EUR/JPY, EUR/USD and EUR/CHF are all biased to the upside.  I am not sure that these will be very powerful trends, but 2-3% moves in each of these crosses would be very feasible in the coming weeks, in my view.  For the time being, I see these as opportunistic trades, and not powerful enough yet to warrant a formal change in our quarterly forecasts. 

Three mini-themes

The real fundamentals of the global economy remain reasonably robust, with growth gradually rotating from the US to the rest of the world.  Inflation is likely to remain benign, and my general view on currencies remains unchanged. 

However, based on the macroeconomic data published in the past two weeks, there are three mini-themes emerging that should lead to some interesting currency movements. 

• Mini-theme 1.  Inflation is drifting lower in many countries.   I am in no way making a blanket statement about the trend in inflation in every country of the world, or dismissing inflation risks arising from tight capacity constraints.  But I believe that inflation in general is likely to remain on a generally downward path until this fall.  Such a scenario will have important implications for inflation-centered central banks and for currencies. 

First, the decline in energy prices last fall will continue to depress inflation statistics until this fall.  Not only will headline inflation be contained, but even core, which includes some spillover/second-round effects of oil price changes, should show this trend.

Further, there are several countries, including, in particular, the Nordic countries, Switzerland and Japan, which have experienced very positive supply shocks: positive labor supply shocks in the first two cases and a total factor productivity shock in the case of Japan.  Strong economic growth in these countries has not been accompanied by high inflation, and the output gap framework hasn’t really been that useful, given the instability of aggregate supply. 

While the trend of declining inflation due to energy prices is purely statistical and temporary, low contemporaneous inflation will nevertheless make it more difficult for inflation-centered central banks to justify rate hikes.  In addition, the countries that are experiencing strong aggregate supply growth will have difficulties staying on the rate normalization paths. 

We have used the terms ‘early cycle’ and ‘late cycle’ for central banks to describe how early they are in the interest rate normalization cycle, or how far their policy rates are relative to the ‘neutral’ rate of interest: the BoE would be considered ‘late cycle’ while the SNB would be ‘early cycle’.  If general inflationary pressures abate as I suspect they will in the coming months, I believe that the ‘early-cycle’ central banks will come under more pressure to delay their rate hikes.  Further, to the extent that there is a view that the ‘early-cycle’ central banks would somehow catch up to the ‘late-cycle’ central banks, a fall in inflationary pressures would be a net negative for the ‘early-cycle’ currencies. 

I don’t believe that the surprise from the Riksbank last Wednesday was an isolated event.  Growth in Sweden has been extraordinarily robust.  However, without inflationary pressures, it is difficult for such an orthodox inflation-targeting central bank to justify aggressive rate hikes in the near future, even though Sweden’s neutral rate of interest may be higher because of the supply shock.   The BoJ is another good example.  Economic growth has been robust in Japan, driven primarily by total factor productivity.  But without inflation, the BoJ will struggle to justify further tightening. 

The next central bank to surprise on the dovish side, in my view, will be the SNB.  In its Quarterly Report from last December, the SNB drastically revised lower its forecast inflation path, which shows a trough at around 0.4% for the first part of 2007 and an increase toward 2.0% by mid-2009.  I believe that the SNB will struggle to justify having two-and-a-half more hikes by year-end.  Just as EUR/SEK has reacted to the low inflation prints, I believe EUR/CHF will head higher. 

Trade: Long EUR/CHF.  The risk to EUR/CHF, therefore, is biased to the upside.  Despite the latest comments from Mr Roth, without high overall inflation or import price inflation, the SNB is likely to follow the path of the Riksbank. 

• Mini-theme 2.  Cyclical growth divergence between the US and Euroland.  Now is not the time to sell EUR/USD.  The growth trajectories of the US and the Euroland are likely to diverge a bit further in 1Q and 2Q, in my view, with the US falling back into a soft patch.  There will likely be a bit of a slowdown in Euroland, but nothing compared to what we are likely to see in the US.  Structural EUR-bears like me need to suppress our prejudices and acknowledge that Euroland is in a genuine, impressive recovery; there is really a lot of momentum in Euroland.  Inflation, however, is already low and is likely to drift lower: HICP has been below 2.0% for five consecutive months and core inflation has been at 1.5% or lower for the past 20 months.  As with Sweden, Switzerland and Japan, I don’t see how the ECB can justify its urgency in tightening beyond March if inflation drifts lower from the current levels. 

Trade: Long EUR/USD and EUR/JPY.  Uncertainty regarding what the ECB might do after its March meeting will help cap EUR/USD at 1.35, in my view, but will not stop it from rising to that level from 1.31.  The risks are biased to the upside for EUR/USD and EUR/JPY.  When the US economy reasserts itself, most likely in 2H, EUR/USD will likely sell off. 

• Mini-theme 3.  Capital outflows from Japan will likely continue to weigh on the JPY.  This latest move by the BoJ will not reverse the trend in USD/JPY, which could reach 125 in the near term.  I have the following thoughts: 

1. Inflation will force the BoJ to be inactive until at least late summer.  In my view, the BoJ has not been as intellectually disciplined as it should have been, as it roamed from inflation to growth, forward-looking to backward-looking, and from expected inflation to contemporaneous inflation.  However, this may have been a communications issue, where the BoJ has not been particularly transparent or predictable.  In any case, going forward, it is likely that the inflation trajectory will dictate the BoJ’s policy stance.  Given that inflation is likely to drift south (from the current 0.1%), the BoJ will almost certainly be inactive for several months, even if growth accelerates.  I’ve long argued that an assertive and hawkish BoJ is a necessary but not sufficient condition for the JPY to rally.  The latest rate hike does not prove that the BoJ is either assertive or hawkish. 

2. Capital outflows from Japan are likely to continue.  There is a lot of hype about ‘carry trades’, but the real issue, in my view, is capital outflows, some of which are interest-sensitive flows.  There is a lot of retail demand in Japan for foreign bonds and equities — a trend that can also be witnessed in Korea and Taiwan.  In my previous write-ups, I put forward my hypothesis that these outflows could be related to demographics, and not just the positive carry.  The cash yield differential between the US and Japan was 6.0% in 2001, yet USD/JPY traded at a low level of 105.  I am inclined to believe that there was a structural shift in the investment philosophy of Japanese investors some time in 2005, and the positive carry helped push capital out of Japan, once this philosophical shift took place.  My hypothesis is that the combination of an ageing population with increased life expectancy drove Japanese retail investors to enhance their investment returns by going overseas.  If the main motivation behind these capital outflows is indeed demographic, it will be difficult for these flows to reverse any time soon.  

3. ‘Carry trades’ likely to be resilient to monetary tightening.  I don’t find convincing the argument that continued monetary tightening by central banks will one day force an unwind of carry trades, as it undermines risky assets.  To me, risky assets are supported by liquidity, and liquidity, in turn, is not driven by easy monetary policy but by the real imbalances in the world savings and investment rates.  This is an idea I have been arguing for some time.  Agreeing on the source of global liquidity is key, since if my thesis is correct, then monetary tightening will do very little to undermine risky assets or force an unwind of JPY carry trades, because it does not remove the true source of global liquidity: excess savings or inadequate investment. 

4. Monetary transparency and predictability encourage carry trades.  I have also argued previously that inflation-targeting may have played a role in nominal yield differentials being such a dominant a driver of exchange rates.  Inflation-targeting central banks, with their frequent reports and speeches, have substantially enhanced the transparency of their communication on how they think and make decisions on monetary policy.  Some central banks (New Zealand, Norway and Sweden) have taken a further step — by announcing the path of the policy interest rates.  Central bank transparency attracts disproportionate attention from investors on monetary policy, and predictability lowers interest rate and exchange rate risk.  Carry trades thrive in this environment.  If this hypothesis of mine is correct, carry trades driving exchange rates is a structural development, not something fleeting.

Trade: Sell JPY.

Bottom line

From where I sit, the stars seem to be aligning for EUR/JPY, EUR/USD and USD/JPY to rise in the weeks ahead.  160 may finally be within reach for EUR/JPY.  Further, I think that the risks to EUR/CHF are increasingly biased to the upside. 

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The Cranes of Dubai
February 23, 2007

By Stephen S. Roach | New York

It has been almost three weeks since I returned from my latest trip to the Middle East, but I am still haunted by the sight of the cranes of Dubai.  According to construction trade sources, somewhere between 15% to 25% of the 125,000 construction cranes currently operating in the world today are located in Dubai.  As a macro person, I am struck by two possible interpretations of this astonishing development: It could be a property bubble of epic proportions or it may be emblematic of a new Middle East that challenges its long-standing role as a financial recycling machine.  Either outcome could have profound consequences for world financial markets and the global economy.

The comparison with Shanghai Pudong -- China’s massive urban development project of the 1990s -- is unavoidable.  I saw Pudong rise from the rice fields and never thought anything could surpass it.  I was wrong.  Based on industry sources, 26.8 million square feet of office space is expected to come on line in Dubai in 2007, alone -- more than six times the peak rate of completions in Pudong in 1999 and nearly equal to the total stock of 30 million square feet of office space in downtown Minneapolis.  Based on current projections, another 42 million square feet should come on line in Dubai in 2008 -- the equivalent of adding the office space of a downtown San Francisco.  There is one obvious and critically important difference between these two urban development projects: Pudong has an indigenous support base of 1.3 billion Chinese citizens.  Dubai’s current population is 1.3 million.  Throw in the entire native population of the UAE and the support base is still only around 4 million domestic citizens.  That's right, a region with less than 0.5% the population of China is out-building the biggest construction boom in modern Chinese history.

That doesn’t necessarily spell trouble.  After all, construction and economic development go hand in hand.  The problems arise when building cycles go to extremes -- fueled by speculation or funded by the easy money of state-directed lending.  The jury is out on Dubai, although it’s hard not to take note of the obvious excesses -- ski-domes in the desert, offshore cities in the shape of palm trees and the “world,” a massive 8-runway second airport under construction, the Tiger- and now Sergio-led golf-course bonanza, Venetian-like canals for the urban cruise, a world record 160-story skyscraper, and on and on.  Dubai aspires to be the premier financial center and destination tourist resort for the Middle East.  It may well get there.  The problem is that other urban centers in the region are vying for the same title.  Take a look at Doha, Bahrain, Riyadh, and even nearby Abu Dhabi.  Far too many are in the same chase.

Bubble or not, the Dubai-led Gulf building boom is not an isolated development.  Throughout the region, it has been accompanied by expanded infrastructure efforts, rapidly growing commitments to education and medicine, increased industrialization, and the growth of domestic capital market activity.  These trends are emblematic of a new and important development in the Middle East that distinguishes the current period of elevated oil prices from the oil shocks of the past -- a massive push toward internal development.  The “Dubai factor” simply was not present in the two oil shocks of the 1970s or in the brief surge of oil prices in 1990.  Lacking in domestic spending commitments, the inflow of elevated oil revenues spun quickly through a revolving door -- reinvested in world financial markets, especially dollar-based assets.  Such petro-dollar recycling quickly became synonymous for the oil shock. 

This shock is different.  As noted above, internal absorption is now very much in focus for oil-producing countries in the Middle East.  As oil prices have surged in recent years, imports of goods and services of the world’s major oil producers more than doubled from around $170 billion in 1999 to $355 billion in 2005.  At the same time, according to IMF estimates, primary government expenditures -- a good proxy for publicly sponsored infrastructure and social spending initiatives -- accounted for fully 15% of GDP growth in 2005 in the GCC (Gulf Cooperation Council, which includes Saudi Arabia, Kuwait, the UAE, Bahrain, Qatar, and Oman); by contrast, this share was basically “zero” in 2002.  Moreover, the region’s fiscal authorities are mindful of the policy mistakes of the past, when mean-reverting oil prices led to substantial government budget deficits for those who had been too aggressive in opening up the spending spigot.  For the developing economies of the Middle East, the IMF is estimating central government surpluses of a little more than 8% of GDP in 2007 -- about the same as in 2006 but a swing of around 11 percentage points of GDP from the 3% average deficits of 2002-03.  This more prudent fiscal response is a very encouraging development that could avoid the boom-bust cycles of the 1980s and thereby set the stage for more sustainable state-led spending initiatives in the years ahead.

Notwithstanding the push toward internal absorption, Middle East oil-producing states have not turned their backs on dollar-denominated assets.  Due largely to dollar-pegged currencies, GCC monetary authorities still need to invest a large portion of their outsize portfolio of official foreign exchange reserves in dollar-based assets.  But the combination of new domestic spending programs and reserve diversification strategies challenges the time-honored conclusion that petro-dollar recycling is an automatic outgrowth of rising oil prices.  There is an added and important twist in the current climate: America’s post-9/11 Patriot Act now makes it much more difficult for Middle East portfolio investors to transfer funds into the US.  At the same time, the recent controversy over the purchase of US assets by Dubai Ports World, together with congressional efforts currently underway to tighten up restrictions on foreign direct investment into the US -- the so-called CFIUS approval process -- also discourages dollar-centric buying of Middle East investors.  An offset comes from the sharp corrections in local stock markets since late 2005 -- underscoring the risks of the domestic capital markets option for non-dollar diversifications strategies.  But should these markets start to recover, I suspect local buying will intensify rather quickly -- diverting assets away from lower-return alternatives in the US and elsewhere in the developed world.  In short, there are many reasons to believe that in the current period of sharply elevated oil prices, the petro-dollar recycling story may be far less compelling than it used to be.

This conclusion has important implications for world financial markets.  Most importantly, it challenges consensus views that high oil prices create a natural bid for dollar-denominated assets.  In a climate where dollar risk remains an ongoing concern, that could be an especially important point for the currency debate.  In light of recent dollar-diversification concerns expressed by reserve managers in the Middle East -- especially those in the UAE, Qatar, Iran, and Syria -- that possibility should not be taken lightly.

The cranes of Dubai are emblematic of a much deeper point: We need to update our thinking about the Gulf economy -- especially insofar as its internal development efforts are concerned, but also with respect to its role in world financial markets.  It was only a little over 33 years ago when rising oil prices first came into play.  Since then, the economic development of Middle East oil producers has been nothing short of extraordinary.  Dubai underscores a critical difference between then and now.  Even if it ends up being a bubble, I suspect there will be no turning back for the new Middle East.  In a world where the globalization debate is dominated by China, it is high time to broaden our horizons.


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United States
Home Prices: Still More Rust than Bust
February 23, 2007

By Richard Berner | New York

Home prices continued to decelerate sharply towards the end of 2006 and are now flirting with their first-ever nationwide decline.  All home price measures are telling a similar story: Rust has begun, and bust threatens the once-frothiest markets.  For example, measured by the S&P/Case-Shiller home price index for the top 20 metro areas, prices rose by only 1.7% in the year ended in November, and prices declined in seven of those markets.  Pessimists have long expected that declines in housing wealth would trigger consumer retrenchment, and I think those honey-starved bears are merely hibernating.  They’ll find manna even in home-price stagnation and predictably will argue that it could trigger a consumer pullback with potentially dire consequences for the broader economy. 

I disagree.  I’ll concede that the risks for home prices have escalated but I’m sticking to my guns: I still think that home price stagnation is more likely than a period of outright decline.  The reasons: The housing recession isn’t over, but its intensity is starting to ebb.  Likewise, there are clear signs that the supply-demand imbalance that triggered the deceleration in home prices is beginning to shrink.  Most important for assessing spillover effects, in my view, the linkage between housing wealth and consumer spending is weaker than the bears believe.  Income and job growth are far more important for consumer spending than is wealth from any source, and I continue to think that consumers will have enough income both to maintain their lifestyles and rebuild saving.  Such income gains also preclude a major further decline in housing demand. 

Nonetheless, regional variation is likely for now, with weak economic and housing regions continuing to get weaker.  And the return of winter weather in February likely hobbled job gains, raising questions about the sustainability of income growth.  As a result, concerns about collateral damage from the housing-economy connection could well grab the spotlight again, if only temporarily.

By any metric, there’s no mistaking the deceleration in home prices.  Full year results for 2006 will be released next week, but both nationwide and in many regions, it’s already apparent that the outcomes were the worst since the housing bust of the early 1990s, when annual price increases averaged 2% or less for a four-year stretch.  For the fourth quarter of 2006, both the S&P/Case-Shiller and Office of Federal Housing Enterprise Oversight (OFHEO) home price indexes — two of the more reliable measures — will likely show a further sharp deceleration in price change from the same period a year ago. 

Metrics do matter for assessing price movements, however.  Differences in coverage, weighting and index construction mean that the results from the two mentioned indexes are not identical; the new, national S&P/CS home price index shows much sharper movements both up and down than does the OFHEO gauge.  In the year ending in the third quarter, the former slowed to 3.4%, while the OFHEO index decelerated to 7.7%.  (Documentation for the S&P/CS national index doesn’t clearly indicate its regional scope, but one reason for the growth gap between the OFHEO and S&P/CS Composite 20-MSA indexes is that the former includes the booming Philadelphia and Houston MSAs — respectively the fourth and seventh largest, comprising nearly 12 million people —while the latter excludes them.)

Despite their differences, these two indexes are more reliable than are the price measures accompanying monthly home sales reports because they share a common methodological lineage: They reflect so-called ‘matched sample’ price readings that track repeat sales of the same single-family properties.  Those apples-to-apples comparisons mean that shifts in the mix of homes sold will not affect price changes.  But even these gauges may overstate ‘pure’ price appreciation in housing, because they don’t take remodeling into account (although the S&P/CS gauge adjusts price changes for low housing turnover).  That is, owners add to the value of their property by investing in additions and alterations, but OFHEO doesn’t adjust its index for such increases in ‘quality.’  The difference can be substantial: The Census Bureau’s median price composite for new 1-family homes sold rose by 47.3% in the five years ended in 2005, while a similar index adjusted for quality rose by one-third less, or 32.4%.  In addition, ‘appraisal bias’ may inflate the OFHEO measure; a ‘purchase-only’ version of the OFHEO measure shows that home price appreciation peaked at 11.1% in Q3 of 2005 and ran at 6% in the year ended in September 2006. 

In contrast, some of the commonly-cited home pricing metrics are meaningless when looked at over periods less than two years.  For example, the Census Bureau publishes average and median home prices (in dollars) for both new and existing homes sold each month.  Analytically, median prices are superior to average quotes because the upward drift in housing quality biases the average change higher.  But shifts in the size or value composition of sales also heavily skew the median price measures for new home sales because they are not adjusted for quality.  A shift to sales of more expensive houses will boost the median with no underlying change in the price of comparable units.  The index of median prices for sales of existing homes is similarly flawed.  Downshifts in the quality and size mix of new homes sold brought the five-year change in the Census price composite for median new homes sold down to just 30.4% by the end of 2006, while the constant-quality price index rose by 33.7% over the same period. 

Pessimists argue that the bursting of a so-called housing bubble means that prices could decline significantly.  And I’ll concede that prices could decelerate faster than we now expect or even decline — after all, investor and speculative activity in housing has picked up in the past five years, and builders lost the discipline they developed following the housing bust in the early 1990s.  It’s been nearly two years since demand peaked, but so large was the resulting supply-demand mismatch that it still overhangs the market.  Builders are busy cutting their estimates of demand and earnings as they write down the value of properties in inventory on which it won’t pay to build for the time being. 

But I think two factors seem likely to limit downward pressure on home prices: First, builders are slashing starts faster than sales to trim the inventory of unsold homes.  A rebalancing of supply and demand will mitigate the pressure on builders to give concessions and lessen the pressure on sellers of existing homes to cut prices.  January’s plunge in single-family housing starts put new construction down nearly 40% from a year ago, while 1-family home sales in January probably fell by one-third as much.  At that sales rate, the inventory overhang of new homes likely stood at 6.2 months’ supply — down from a peak of 7.2 months but well above the 4½ month norm of the past decade.  Even if sales fall further, an additional 10% decline in starts will eliminate the inventory overhang by next October.  And if the recent stability in homebuilder sales and traffic surveys is sustained, the sales decline may be far more muted. 

A second factor limiting the downside price pressures is that buyers are relatively sensitive to price.  That suggests that weakness in demand won’t clobber prices; in fact, cooling prices may help revive demand.  In other words, even a sizable drop in demand won’t move prices a lot.  And a deceleration in home prices — and declines in some markets in real terms — should begin to improve housing affordability.  Although it is 20% below its 2003 peak, an index of housing affordability rose by 8% in the second half of 2006.  Investors thus should not assume that a bust in housing activity would promote more than rusting home prices.

Nonetheless, regional convergence in home price growth rates — as previously “hot” markets chill and growth rates settle to a low-single-digit pace among most major regions — will continue to be a dominant theme.  Prices may fall in markets that are affected by a weak economy (e.g., Detroit), by high speculative activity (e.g., some condominium markets) or where there is a preponderance of second homes (e.g., in Florida or the Sunbelt).  Ironically, home prices in the Gulf Coast and Florida have fared quite differently in the eighteen months following the destructive 2005 hurricanes: The supply shock that reduced the housing stock and caused a scramble for new places to live in the Gulf Coast has led to price hikes of 15-25% in New Orleans-Metairie-Kenner and Baton Rouge, LA and Gulfport-Biloxi, MS.  Contrariwise, the sharp escalation in insurance premiums and the difficulty in obtaining homeowners insurance at all has added to downward pressure on Florida home prices.  Those disparities underscore the fact that local economic conditions are typically the dominant forces driving home prices.

Still, the current context for the deceleration in home prices may yet trigger fears of broader economic weakness that could send a chill through financial markets — even if I’m right that a nationwide decline in home prices does not occur.  Having been lulled by the weather-induced stability in housing of last autumn, investors may be more cautious now.  Weakness in housing activity and homebuilder earnings are legitimately making investors less sure of where the trough for the housing downturn might lie.  The subprime lending bust is stirring fears of a broader mortgage credit crunch, either because scarred lenders pull back from lower-rated borrowers or because Congress imposes new restrictions aimed at limiting predatory lending that cut credit supply, or both.  Uncertainty over the macro and market effects of those risks may leave investors jittery until greater clarity about the home-price shakeout emerges.  Together with an incipient weather-related “payback” in economic activity, this uncertainty may lead investors to suspect collateral damage to the economy and an increasing chance of Fed ease.  Bonds may thus fare better than risky assets for now. 

Likewise, there are some legitimate downside risks to home prices themselves.  Investor and speculative activity in housing is ebbing fast, lending standards are tightening, and the imbalance between housing supply and demand is still wide.  But if I’m right that self-corrective forces will limit price declines, that the linkage between housing wealth and consumer spending is weaker than the pessimists believe, and that fears of a subprime-induced credit crunch are overblown, then the housing bust scare will turn out to be just that — a scare.

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