The World Drops Its Guard
February 26, 2007
By Stephen S. Roach | New York
A new level of complacency has set in. It’s not just a financial-market thing -- extremely tight spreads on risky assets and sharply reduced volatility in major equity and bond markets. It’s also an outgrowth of the increasingly cavalier attitude of policy makers. That’s true not only of central banks but also -- and this is a major concern of mine -- by the global authorities charged with managing the world financial architecture. Meanwhile, by flirting with the perils of protectionism, politicians are ignoring some of the most painfully important lessons from history. After four fat years, convictions are deep that nothing can derail a Teflon-like global economy. That’s the time to worry the most.
I am especially concerned about a new lax attitude that has crept into the mindset of the so-called stewards of globalization -- namely, the IMF and the broad collection of G-7 finance ministers. Last spring, in an uncharacteristically bullish lapse, I became more optimistic on the global economy than I had been in a long time (see my 1 May 2006 essay, “World on the Mend”). I was especially encouraged that the Wise Men had finally woken up to the perils of ever-mounting global imbalances -- namely, the widening disparity between America’s gaping current account deficit and large and growing surpluses in China, Japan, Germany, and the major oil producers. With great fanfare at the April 2006 G-7 and IMF meetings, institutional support was thrown behind a new framework of multilateral surveillance and consultation -- in my view, materially raising the odds of an orderly, or benign, rebalancing of an unbalanced world. Unfortunately, the multilateral approach is now rapidly losing momentum. The first joint consultations between the US, Europe, Japan, China, and Saudi Arabia were held last summer, and there was a noticeable lack of “deliverables” following this effort. IMF Managing Director Rodrigo de Rato’s mid-November 2006 report on the “work program” of the Fund’s executive board was a further disappointment, relegating the problems of global imbalances to just one paragraph of a 49-paragraph document. And in the past few months, many of the individual participants at the various G-7 finance ministries and central banks have admitted privately to a lack of progress and conviction in the multilateral approach. With the global economy and world financial markets turning in yet another good year, suddenly, the urgency to act is now seen as less critical by the stewards of globalization. Complacency has claimed an important victim -- thereby undermining the major rationale for my bullish change of heart on the global prognosis. Meanwhile, central banks -- basking in the warm glow of success on the inflation-targeting front -- are pouring more and more fuel on the global risk binge. America’s Federal Reserve seems to settling for a long winter’s nap -- likely to keep monetary policy on hold through at least the end of this year, according to our US team. While the Fed has expressed repeated concerns about last year’s minor upside breakout of inflation, it has also been quick to stress the coming deceleration on the price front. We could well be in the midst of a period like that which prevailed in the early 1990s, when the US central bank left the federal funds rate unchanged at 3% for a 17-month stretch from September 1992 to February 1994. Unfortunately, that experiment did not end well for the financial markets, as one of the Fed first “normalization campaigns” led to the worst year in modern bond market history. An inflation-targeting Bank of Japan seems to be of a similar mindset. That’s mainly because of the distinct possibility of a minor deflationary relapse, with year-over-year comparisons in the CPI likely to move from being fractionally positive (+0.1% in January) to slightly negative by March. Moreover, with the economy still judged to be on shaky foundations -- especially the ever-cautious Japanese consumer -- political pressure on the BOJ to refrain from any policy action has been intense. After having succumbed to that pressure in January, Governor Toshihiko Fukui appears to have expended great political capital in orchestrating the BOJ’s second baby step away from its anti-deflationary ZIRP campaign. In the end, a one-party Japan has little tolerance for central bank independence -- especially in light of a still very fragile state of affairs on the inflation front. I suspect, as does our Japan team, that the mid-February policy adjustment will be the last move of the BOJ for a long time. That leaves the European Central Bank as the only one of the three major central banks that is likely to make any type of a policy adjustment in 2007. Elga Bartsch, our resident ECB watcher, puts the upside at 50 basis points of rate hikes. This suggests that European monetary authorities -- the most dogmatic of the inflation targeters in central banking circles -- believe they are now only two policy moves away from their own normalization objectives in a still low-inflation world. This view, of course, is predicated on the belief that the European economy continues to surprise on the upside. Should that view be drawn into question for any reason -- hardly a trivial possibility in light of the recent increase in the German VAT tax, the lagged impacts of euro appreciation, and the ripple effects of Italian fiscal consolidation -- the risks to the ECB policy path could quickly tip to the downside. There’s nothing wrong with this picture from a strict inflation-targeting perspective. But that’s just the point, in my view. At low levels of inflation -- and persistent risks of deflation in Japan -- inflation targeting produces an exceptionally low level of nominal interest rates. That, in turn, continues to fuel the great liquidity binge that underpins an extraordinary degree of risk taking still evident in world financial markets. Central banks have circled the wagons in taking an agnostic position on this state of affairs. As a former senior central banker put it to me indignantly the other day, “Who are we to judge the state of markets?” That’s indicative of what I believe is a very narrow perspective of the role and purpose of central banking. Most importantly, it relegates financial stability to a secondary consideration at precisely the time when financial globalization and innovation could be inherently destabilizing. The orthodox view of modern-day central banking is premised on the belief that hitting the narrow target of CPI-based price stability is sufficient to address anything else that might come along. Never mind that this approach has produced a most unfortunate string of asset bubbles -- first equities, now property, and next those that may well be bubbling up to the surface in the form of a tightly correlated compression of spreads on a host of risky assets (i.e., emerging market debt and high-yield corporate credit). Never mind the explosion of worldwide derivatives, whose notional value has now reached some $440 trillion (OTC and listed, combined) -- over nine times the size of the global economy. Central bankers will tell you that the liquidity and risk-distribution benefits of derivatives far outweigh the lack of transparency and limited information they have on the incidence and concentration of counter-party risk. Never mind the power of the carry trade, which has been given a new lease on life by the politically-compromised Bank of Japan. Never mind the potential “canary in the coal mine” that may well be evident in America’s sub-prime mortgage market. All in all, increasingly complacent central banks are telling us that these concerns are not actionable issues for monetary policy. That could well be a blunder of tragic proportions. A similar complacency is evident on the political front. As the pendulum of economic power in the developed world has swung from labor to capital, the pendulum of political power is now swinging from the right to the left -- not just in the US but also in France, Germany, Italy, Spain, Japan, and Australia (see my 8 January 2007 dispatch, “Power Shift”). As pro-labor politicians now move into action, trade protectionism is increasingly getting the nod as a legitimate policy response. Nowhere is this more evident than in Washington D.C. I have spent a good deal of time in the US capitol the past couple of weeks and sense that Congress’s anti-China sentiment is most assuredly intensifying. The new Democratically-controlled Congress is not in a rush -- its momentum on trade policy, in general, and China, in particular, is methodical yet increasingly contentious. I have taken the other side in the debate at several forums in Washington -- but to little or no avail. This takes complacency to an even more worrisome level. US politicians feel completely justified in ignoring some of the most painful lessons of history. And, ironically, the broad consensus of investors feels equally justified in ignoring the possibility of a protectionist outcome. Such an inconsistency is yet another example of a world in denial. I’ve been relatively constructive on the global outlook over the past 10 months. The call didn’t work out all that badly -- the world economy turned in another great year and, after a brief bout of risk-aversion last May, the markets did fine as well. That was then. New and worrisome political forces are coming into play at precisely the time when the stewards of globalization have gone back into hibernation. Meanwhile, central banks are refusing to take away the proverbial punchbowl when the party is getting better and better -- instead, egging on the risk-takers when risky assets are priced for all but the absence of risk. Enough is enough -- from where I sit, it no longer makes sense to maintain an optimistic prognosis of the world. This is more of a structural call than a cyclical view. I remain agnostic on the near-term outlook, and certainly concede that the Goldilocks-type mindset currently prevailing could put more froth into the markets. But complacency is building to dangerous levels — always one of the greatest pitfalls for financial markets. And yet that’s precisely the risk today, as investors, policymakers, and politicians all seem to have dropped their guard at the same point in time. The odds have shifted back toward a more bearish endgame. I have a gnawing feeling we’ll look back on the current period with great regret.
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Credit Crunch Watch
February 26, 2007
By Richard Berner | New York
The subprime loan meltdown is still in full swing, and fears persist that it will usher in a broader credit crunch, spreading first to prime mortgages and ultimately to corporate credit. Two weeks ago, I opined that the subprime crash is an idiosyncratic event unlikely to morph into a systemic crunch (see “Will the Subprime Meltdown Trigger a Credit Crunch?” Global Economic Forum, February 12, 2007). I haven’t changed my view. But I also believe that investors should watch indicators of credit quality and credit availability to assess the coming deterioration in credit quality, the reactions of lenders, investors, and policymakers, and the potential implications for financial markets. A guide follows. The carnage in the subprime mortgage market seemed to intensify late last week, promoting a flight-to-safety bid for Treasuries as investors began to worry about spillover and contagion into prime loans and other asset classes. According to Markit, the source for quotes on the ABX indices (the synthetic asset-backed benchmark indices referencing US sub-prime residential mortgages), the price of the lowest-rated on-the-run ABX 07-1 BBB- index plunged to as low as 68 on Friday, representing a 30% collapse in the last five weeks and roughly consistent with spreads of 1300-1400 bp over Libor. This slide began to pressure the highest-rated ABX 07-01 AAA index, which lost about a point in price on Friday afternoon; previously that index had been essentially immune. Likewise, while subprime lender bankruptcies triggered a bloodbath in the share prices of even the better subprime lenders beginning in November, only last week did concerns begin to spill over into the share prices of prime lenders. Those worries are understandable, given soaring subprime defaults and the widely-publicized explosion in mortgage lending over the past few years. But there’s no evidence yet of a broader deterioration in consumer credit quality or of spreading lender restraint. Given healthy income growth, as I see it, aggregate consumer debt-servicing capacity remains healthy. Nonetheless, the tails of the credit quality distribution are getting fatter, and consumer delinquencies and chargeoffs are rising. According to Federal Reserve data, delinquency rates on residential mortgage loans have drifted up by 30 basis points since the end of 2004 to a still-low 1.71% at the end of the third quarter of 2006. In addition to the deterioration in lower-rated mortgages, some of that increase likely is traceable to the shock to many borrowers from the Gulf Coast hurricanes in 2005 and to the seasoning of mortgage portfolios as footings slow from growth in the mid-teens to mid single digits. Mortgage chargeoffs have edged up 4 bp to 11 bp. By comparison, they rose as high as 44 bp in the 2000 recession. Fed data indicate that delinquencies on non-mortgage consumer loans at commercial banks have risen about 15 bp from their record lows at the end of 2005; most of this is traceable to a rise in credit-card delinquencies of about 60 bp to 4.11% over the same period. S&P data for securitized card portfolios show virtually identical results. This is hardly surprising, given the “adverse selection” in cards resulting from better-quality borrowers switching from credit card into mortgage credit over the past several years. Seasoning of card portfolios as lending growth slowed also unmasked the underlying delinquency characteristics in such credit. New bankruptcy laws effective in October, 2005 triggered a rush to file before more stringent criteria took hold, distorting the credit card chargeoff statistics, but it appears that chargeoffs will rise in line with delinquencies. So far, lender restraint seems limited to mortgages. Banks aren’t the primary originators of subprime loans, but the deterioration in subprime mortgage credit quality may have already triggered sharply tighter bank lending standards to individuals, judging by the Fed’s January Senior Loan Officer survey. Sixteen percent of responding banks on net reported tightening lending standards for residential mortgages — the biggest surge since 1990. There’s no question that some would-be subprime borrowers will not get access to credit in coming months or years, and indicators of credit availability bear close scrutiny. Small wonder: That tightening move followed three years of easing lending standards at a time when regulators have been warning banks about risky lending. In contrast, bank lenders have merely stopped loosening standards for non-mortgage loans, and a diffusion index of willingness to lend has dropped sharply but remains positive. Meanwhile, corporate credit fundamentals are extremely favorable, although earnings growth is slowing sharply. Nonfinancial corporate balance sheets were pristine at the end of Q3 2006: Credit-market debt in relation to net worth stood at 34-year lows, while long-term debt in relation to the total and “quick ratios” stand close to record levels. Earnings growth, according to consensus estimates, is slowing from the double-digit clip of the past four years to mid single digits in the first half of 2007, but interest coverage ratios are still close to record high levels. And delinquencies and chargeoffs at banks are still close to record lows despite a deceleration in lending, while junk and leveraged-loan default rates are at eight-year lows. CDS, loan and bond spreads continue to tighten and lending standards remain loose. The CDX default swap index of 125 investment-grade names narrowed to just 32 basis points last week, while BB/BB- leveraged loan and high-yield spreads have narrowed to record tights. Lenders, understandably against that backdrop, have stopped loosening their lending standards to corporate borrowers, according to the Fed’s Senior Loan Officer Survey. Morgan Stanley bank analyst Betsy Graseck and I agree that corporate credit quality is as good as it gets, and there are some signs of weakness. She reports that in 4Q 2006 the share of commercial and industrial loans 90 days past due rose 10% year over year. She is expecting chargeoffs to remain flat this year, but loan provisions to rise 30% as falling recoveries spell the end to the long improvement in credit quality. For their part, regulators seem to be watching credit quality issues intently. They’ve been warning against lax underwriting for several years, but unaccompanied by penalties or sanctions, those warnings haven’t deterred lenders from extending credit. In part, that’s because liquid capital markets are enabling banks to sell down any positions in stressed loans. That may now change. The intensity of those warnings may rise as the subprime meltdown continues. Even a slight reduction in market liquidity will make it more difficult efficiently to lay off risk, so lending standards will likely tighten further. And while I think a regulatory overreaction to the abusive lending practices sometimes accompanying subprime lending is unlikely, regulators will press lenders to find the right balance. The financial market implications of these developments are straightforward. Driven by performance imperatives, market participants may worry about spillovers from subprime woes into other asset classes, but they probably will take comfort from the resilience of markets to past shocks and continue to invest as if spillovers are unlikely. The reality is that with still-favorable fundamentals, credit quality should deteriorate only slowly. But the tails of the distribution are getting fatter, and investors should use the metrics just described to assess those increasing risks and move up the quality scale. In these circumstances, investors should not confuse the resilience of consumers or businesses with ongoing stable credit quality. For years, I‘ve argued that rising debt levels and credit risks would not trigger consumer retrenchment, but that the causality wouldn’t necessarily run in the other direction. For example, two years ago, Dave Greenlaw and I wrote: “Record levels of consumer debt in relation to income have raised anew concerns that rising rates will undermine home and asset prices, forcing consumer retrenchment and increased thrift. Rapid growth in subprime mortgage lending, much in adjustable-rate form, has seemingly heightened the risks. But in our view, concerns over consumer leverage are overblown and misplaced; we think that lenders to the consumer are more at risk than are consumers themselves [italics added]. Our colleague David Miles and we agree that the UK and US mortgage markets are quite different: Unlike their UK counterparts, for example, most US consumers have paid up for insurance against rising interest rates with fixed-rate mortgages (see “Markets at Risk, Economy Resilient,” Global Economic Forum, January 10, 2005).” “In contrast, US consumer lenders are exposed to rate and credit risks. The consumer has three puts back to the lender, and we believe that lenders typically underprice those puts in their eagerness to book income. There is an interest-rate put: Lenders (including investors) profit from the premiums that consumers are willing to pay to finance with fixed rates. But the value of those options falls, and financing costs rise, when rates go up. There is a “refi” put: Consumers can refinance at low cost, but lenders bear the optionality risk in both directions when rates change. And there is a credit put: Overleveraged consumers may suffer financial consequences, but the average consumer suffers little. But for the lenders, the tails matter; they suffer the income loss on nonperforming assets and the principal loss on default. And lenders suffer from adverse selection when better credits pay down debt.” Likewise, there is an important dichotomy between the risks to markets and those to the economy from a deterioration in credit quality. Financial innovation such as the structured credit and ABS markets have dispersed risk more broadly, thus increasing the resilience of the financial system and increasing the apparent resilience of markets to shocks. The risk is that if liquidity ebbs, that apparent market resilience will also dwindle. So while the subprime meltdown is likely to remain idiosyncratic, it should remind investors to carefully reassess lender credit quality and monitor risk-free spreads closely for any signs of distress selling or inability to roll over maturing paper, as well as the tone of rating-agency commentary that may affect ability to finance.
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Review and Preview
February 26, 2007
By Ted Wieseman | New York
Treasuries posted marginal gains over the past quiet, holiday-shortened week, extending the market’s recent winning streak to four weeks after a significant rally Friday more than reversed moderate losses posted through Thursday. In the earlier part of the week, supply in the form of the US$18 billion 2-year auction and US$13 billion 5-year auctions weighed on the market, and what little economic data there were led investors to scale back the significantly more dovish Fed path that was oddly priced into futures after Chairman Bernanke’s unsurprising testimony the prior week. In particular, in the week’s only major release, the core CPI accelerated to +0.3% for the first time since June after three straight +0.1% gains, leading the YoY rate to rise a tenth to +2.7% and pointing to a similar uptick in core PCE inflation (to be reported Thursday) to +2.3%. The market also initially reacted badly to a jobless claims report that, while significantly improved from the abysmal report the prior week, was still quite soft in absolute terms. This appeared to turn around on Friday as investors looked forward to upcoming key data covering the late arrival of winter, notably the employment report due in a couple weeks where we look for only a 50,000 gain in payrolls based in part on the recent weak trend in claims, notwithstanding the sequential improvement in the latest week. The weather-related payback in the economic data we have been warning of recently (see Dick Berner’s articles, Paybacks Ahead? January 29 and Beyond the Payback, February 20) and that first showed up in a big way in the collapse in January housing starts reported a week prior now looks set to begin appearing more broadly in key data to be released over the next month or so. Expectations of the big upcoming month-end index duration extension also appeared to help the market Friday. More important to Friday’s rally than the possibility of an upcoming soft patch in the data or expected month-end buying, however, was focus on the continued carnage in the subprime mortgage market, which provided Treasuries a notable flight to safety bid. The subprime collapse had been continuing all week, but only appeared to become a major focus in the Treasury market on Friday when some modest, early signs indicated that what had been a blow-up essentially confined to this small section of the mortgage market might lead to broader spillovers, as corporate credit spreads generally and mortgage-related companies in particular showed some widening and higher-rated mortgage default swap indices came under some pressure. According to Markit, the lowest-rated on-the-run ABX 07-1 BBB- index plunged in price from 82.82 at the close of the prior week to 74.19 at Thursday’s close. The freefall intensified Friday, with the price plunging to around 68 mid-afternoon. Just five weeks ago, this index closed at 97.47, making for a 30% collapse in little more than a month. This blow-up remains mostly confined to this small part of the mortgage market, but there were some signs of possible spillover Friday. The highest-rated ABX 07-01 AAA index, which had been barely moving during the collapse in the BBB- index, dipping only marginally from January 19 to February 22 from just above par to just below, came under some pressure Friday. After closing near 99-22 Thursday, it was being quoted at 98-24/99-24 Friday afternoon according to Morgan Stanley traders. After a 5-6bp rally Friday, benchmark Treasury yields ended the week mostly marginally lower. The old 2-year was flat at 4.83%, but the 3-year, old 5-year, 10-year and 30-year yields all dipped 1bp to 4.71%, 4.67%, 4.68%, and 4.78%, respectively. After mixed auction results — strong demand and a high indirect share at the 2-year, significantly weaker results at the 5-year — both of the new issues ended the week in positive territory, with the new 2-year closing at 4.804% and being auctioned Wednesday at 4.830% and the new 5-year at 4.662% after being auctioned Thursday at 4.719%. Helped by the CPI surprise and upside in energy prices, TIPS had a very strong week, with the 5-year TIPS yield plunging 11bp to 2.28% and the 10-year 6bp to 2.30%, resulting in the benchmark inflation breakevens rising 10bp and 4bp, respectively, to three-week highs. The big move in the 5-year breakeven versus the 10-year, however, led to a marginal decline in the 5-year/5-year forward that the Fed focuses on. A somewhat less dovish near- and medium-term Fed path had been priced into futures through the first part of the week, but this was largely reversed Friday, with the net result being little change on the week — a marginally less dovish nearer-term path and marginally more dovish longer-term path. In the shorter term, the July fed funds contract was flat at 5.215% and the August contract lost 0.5bp to 5.19%, while the Sep 07 eurodollar contract lost 0.5bp to 5.20% and the Dec 07 contract 1bp to 5.055%. Starting with the June 08 contract, however, eurodollar futures posted small gains on the week, with the low-rate Dec 08 contract improving 1.5bp to 4.825%. The economic calendar was very quiet the past week, with the only key release being the CPI report. The consumer price index rose a larger-than-expected 0.2% in January for a 2.1% YoY gain. A gasoline-driven 1.5% drop in energy prices was largely offset by a broadly based 0.7% gain in food prices. The core rose 0.3%, the largest increase in seven months, leading the YoY rate to rise a tenth to +2.7%. Much of the upside in the core was attributable to the largest rise in medical care (+0.8%) in 15 years on big increases in drug prices, hospital charges and doctors bills. Significant rises in hotel rates (+1.1%), airfares (+2.1%), and tobacco (+3.1%) also contributed. These upside surprises offset moderation in the key owners’ equivalent rent (+0.2%) component and the smallest gain in education (+0.1%) in six years. Based on these results, we look for the headline and core PCE price gauges to both rise 0.2%. Note that while the core PCE price index has a much higher weight for medical care than the CPI, the PCE price index uses PPI indices for medical and not the CPI gauges, and so the surge in CPI-based medical prices does not have any direct implications for the core PCE. Still, the high +0.2% we expect for core PCE in January would lift the YoY rate a tenth to +2.3%, back to just marginally below the cycle high of +2.4% hit from August to October, leaving the Fed that much further away from considering the possibility of rate cuts. The upside we expect in headline PCE prices after the CPI surprise had a meaningful impact on our growth estimates. Incorporating a higher inflation assumption, we cut our forecast for January real consumption to +0.2% from +0.4%. Early reports also point to a bigger drop in motor vehicle sales in February than we had assumed. Building in the cut to January real spending and a slightly lower assumption for February based on a lower autos estimate, we reduced our 1Q consumption forecast to +3.4% from +4.1% and our GDP forecast to +3.0% from +3.4%. There will be a lot of data bearing on this estimate in the coming week, so it could change significantly in the days ahead — in particular the details of the 4Q revision, inventories and capital goods shipments figures from the durables report, new and existing home sales, motor vehicle sales, and the personal income and spending report. The late February survey week and shortness of the month mean that the employment report will be delayed a week. But at this point, based in part on the significant deterioration in jobless claims since the first part of January, we expect to see a significant weather-related payback and forecast a 50,000 rise in February non-farm payrolls, which would be a three-year low. Note that the survey week for the January employment report fell during the period of unusually warm weather seen in the early part of the winter, so the February employment report will be the first to reflect the late arrival of cold weather. The surprising 22,000 gain in construction jobs posted in January and 10,000 rise in December almost certainly were helped in a big way by the unusually late start to winter, which delayed to some extent the big seasonal layoffs seen around this time each year. A drop in construction payrolls of 100,000 or more in February as these delayed layoffs come through and the underlying weakness in the sector shows through would not be a significant surprise. Even without the usual first Friday release of the employment report, the economic data calendar is very busy in the coming week. Releases due out include durable goods, Conference Board consumer confidence, and existing home sales Tuesday, revised GDP and new home sales Wednesday, personal income and spending, ISM, construction spending, motor vehicle sales, and the OFHEO house price index Thursday, and the University of Michigan consumer confidence index Friday: * We forecast a 4.8% plunge in January durable goods orders. Company data point to a sharp pullback in the volatile aircraft category, which has been quite elevated in recent months. Meanwhile, core order activity is expected to post a modest rise — in line with recent ISM survey results. And core shipments are expected to show a solid gain, reflecting the recent upside in unfilled orders. * We expect the Conference Board’s consumer confidence index to dip slightly to 110.0 in February. The University of Michigan survey showed some deterioration in early February. However, that gauge had experienced more upside in January than was evident in other indicators — such as the Conference Board and weekly ABC sentiment indices. Indeed, the latter has held within a relatively narrow range of late. So, we look for little change in the Conference Board gauge versus the 110.3 reading seen in January. * We forecast January existing home sales of 6.20 million units annualized. Home shopping activity during the early part of the month was likely supported by milder-than-usual weather conditions across many parts of the nation. However, we look for a very slight dip in resales, consistent with the recent performance of the NAR’s pending home sales index. * We look for 4Q GDP growth to be revised down significantly to +2.3% from the initially published figure of +3.5%. The expected adjustment is about equally split between inventories and final sales. In particular, the actual reading for wholesale inventories in December was well below the Commerce Department assumption. The foreign trade deficit for December was also wider than had been assumed. Finally, the downward adjustment to November retail control is expected to shave a few tenths of percent from consumer spending. * We forecast January new home sales of 1.08 million units annualized. Sales of newly constructed residences appear to be due for some moderation following the surprising increases seen in both November and December. Still, with new construction undergoing a significant correction, the inventory of unsold new homes appears to be moving toward a healthier balance point. * We look for personal income and spending to both rise 0.4% in January. The employment report pointed to some softness in both hours worked and wage rates, which would normally imply a subpar outcome for personal income. However, the strength in personal tax payments seen over the course of the month implies that there was another spike in non-wage income (such as stock options). On the spending side, the retail sales data suggest a modest overall rise. However, the headline CPI came in higher than anticipated in January, which cut into the expected rise in inflation-adjusted terms. Indeed, we now see real consumption on track for only a 3.4% rise in 1Q — down from our prior estimate of better than 4%. Finally, our translation of the core CPI data points to a ‘high’ +0.2% for the core PCE, with the YoY rate ticking up to +2.3%. * We expect the February ISM to rise a point to 50.5. The regional surveys that have been released to this point have been mixed, with Empire and KC both pointing to strength while Philly showed notable deterioration. We believe that this points to a slight uptick in this month’s ISM, reflecting a bottoming out in motor vehicle production and a better inventory situation in some other sectors. The price index is expected to tick lower but remain well within its recent range. * We forecast a 0.5% decline in January construction spending. Mild weather prevailed across much of the nation during the first half of the month. However, the housing starts data point to a further decline in the residential category, which is expected to more than outweigh gains in the non-residential and public components. * Following two consecutive months of modestly above-trend motor vehicle sales results, we look for some pullback in February to a 16.0 million unit annual rate. In particular we suspect that a decline in fleet sales — part of the industry’s strategy to enhance long-run profitability — will become increasingly evident as we move through 2007. The severe winter storms that hit some parts of the nation around mid-month are also likely to have at least temporarily slowed showroom traffic. Note that we will update our estimate for February if the Big 3 provide some sales guidance in the days ahead.
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Striking Contrasts
February 26, 2007
By Eric Chaney | London
There is a striking contrast between a surprisingly robust economy and growing political uncertainties in continental Europe. French politicians competing for the presidency remain vague about the cost of their platforms and none of them is showing a great trust in market mechanisms. Despite talks at the highest level, the tensions between German and French interests about Airbus are hampering restructuring plans. In Italy, a confidence crisis shook up the cabinet, casting doubts on the process of reforms. On the other hand, the real economy is robust; tell us the February business surveys. Although announcing a slowdown in the next three months, companies are more upbeat than our upwardly revised GDP growth forecast for this year (2.3%). Will politics spoil the party? To some extent, the answer to this question is in the resilience of the real economy. Smooth transition scenario validated Although the Ifo index came out below market expectations (but in line with our forecast, as in January), the German and the other similar surveys are consistent with the ‘smooth transition’ scenario we had described in the December issue of the Business Cycle Watch. In short, production has not (yet) significantly slowed, demand is robust and companies are paring production plans in order to keep inventories as low as possible, which is likely to translate into a temporary slowdown in real activity in 2Q, but not to a downturn. Our Compass model is now at the border between the Strong and Steady region (robust growth, no acceleration, and no deceleration) and the Grey zone. Our GDP indicator is upbeat for 1Q (+0.7%Q), even marginally more than one month ago, delaying the correction to the second period (0.4%Q). Are we missing something? A benign VAT-related boomerang effect? It is indeed possible to see a half-empty bottle in February surveys. Most of the acceleration in Europe at the end of last year came from Germany. For instance the demand indicator in the German survey rose to 2.6 standard deviations (s.d.) above average in November, a level not even reached in the aftermath of the German unification, while the same indicator was ‘only’ 1.1 s.d. above average in other euro area countries. We thought that the acceleration of demand reported in Germany was a mix of buoyant overseas demand for capital goods and advanced purchases of durable goods by domestic consumers. While global demand does not seem to weaken, a domestic correction seemed unavoidable. When and how severe, not if, were the right questions. No miracle Now, we have the answer, at least part of it. First, neither German nor producers from neighbouring countries have signaled a sharp correction in demand. As for Germany, the demand indicator just softened to 2.4 s.d. while for the euro area as a whole it is stable at 1.5 s.d. Should we conclude, as some politicians are tempted to do, that the VAT rate hike did not matter, by the virtue of some macro miracle? Probably not: German producers have trimmed production plans, by a full point of standard deviation. Also, German retailers see a significant correction in retail sales just around the corner. Although these indicators are based on expectations, not on hard evidence, we take their warning seriously. However, the broader picture still looks relatively benign: at the euro area level, production plans decelerated from 1.1 s.d. to 0.7 s.d., indicating that companies are firmly willing to keep inventory costs in check — this is why they are paring production plans — but at the same time that they expect the underlying demand trend to remain healthy. A significant upside risk to our 2007 GDP growth forecast Let’s try to put some numbers on this analysis with the help of our survey-based quantitative indicators. Our manufacturing indicator was hit by the correction in production expectations: after 0.8%Q growth in 1Q, it is now anticipating a hard landing in 2Q, at 0.2%Q. However, thanks to more stable business conditions in services, which were not subject to the same gyrations as the manufacturing sector was, our early GDP indicator, which is quite upbeat for 1Q, at 0.7%Q (significantly above-trend), is pointing to a soft landing in 2Q, at 0.4%Q. There is a caveat: because our GDP indicator was too conservative for 4Q, estimating 0.6%Q GDP growth whereas the actual data was 0.9%, it might be too strong for 1Q. But even if the 0.2pp forecasting error is subtracted from the 1Q estimate, we are left with 0.5%Q GDP growth, still 0.2pp above our baseline GDP growth forecast. Practically, 2.5% GDP growth this year in the euro area seems achievable. A benign slowdown, despite powerful headwinds In my view, these numbers show that euro area economies are more resilient to shocks and headwinds than generally thought. Consider this: Germany and Italy — almost 50% of the euro area — are both in the midst of large fiscal stabilisation plans, the euro is super strong and the ECB has already raised the refi rate by 150bp. Despite all these hurdles, the economy’s underlying growth rate is above-trend, even assuming a faster potential GDP growth (2.25% would be my best guess, but it is clearly at the top end of reasonable estimates). The contrast with unhelpful politics is all the more striking. Although there is no doubt in my view that structural reforms must be the result of the democratic political process — which makes them more difficult but less subject to U-turns due to popular discontent — it is tempting to tell to politicians: “Why don’t you look at European companies’ performances? There must be some interesting lessons there about the life post-restructuring.” In the meantime, the risk in the financial markets is to shrug off political uncertainties and become excessively complacent about the economy.
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Heads Up for a Possible Growth Surprise
February 26, 2007
By Thomas Gade | London
Sweden could be in for another big growth surprise, which could even beat our above-consensus GDP growth forecast of 1.5% QoQ (6.1% SAAR). In fact, the Swedish economy could have expanded by as much as 1.9% QoQ (7.8% SAAR) in 4Q06. We will know this coming week when the data are released by Statistics Sweden. With consensus significantly lower, markets may therefore be in for another growth surprise. If our forecast proves to be correct, we may need to revise up our 2007 GDP forecast to close to 4% from our current 3.3% forecast. Strong growth, low inflation and low rates Financial markets could react to a growth surprise with a knee-jerk reaction of curve flattening, currency strengthening and equities rising. However, this could prove to be the wrong reaction, at least for the first two. This is because the strong growth is to a large extent driven by supply-side factors, a fact emphasised by the Riksbank. The Riksbank could therefore possibly be right in projecting a very flat trajectory for monetary policy rates, a projection that is doubted by the much more hawkish financial market expectations. Should the supply-side surprises be sustained, it would be too soon to call an end to the current environment of high growth, low inflation and low interest rates, despite increasing demand. As a result, the yield curve should remain steep or even steeper, and the currency could be range-bound. Meanwhile, higher equity valuations could be sustained for longer. Strong, balanced demand across the board … The demand side of the possible growth surge in 4Q06 will likely have been driven by strong external demand as well as sustained high growth in consumer spending and investment spending. On the external side, the nominal trade balance surplus has surged in 4Q06. Interestingly, German exports also surged in 4Q. Part of this may be related to the ongoing global capex expansion, which benefits both Germany and Sweden. As industrial capacity utilization rates in the euro area are rising and nearing record levels, the capex expansion will likely continue to support Swedish exports going forward. Domestically, consumer spending growth will likely have been sustained on the back of robust employment growth and supportive income dynamics. Survey evidence points towards sustained hiring intentions going forward. Finally, investment spending growth is sustained by industrial operating rates at record levels as well as the continued favourable financing conditions. Adding to that, construction activity is significantly above its long-term average. Summing up, demand appears to have surged in 4Q06, with foreign demand likely outweighing otherwise balanced domestic demand. … but mind strong supply-side effects Bear in mind that growth in the Swedish economy during the last decade is largely a result of favourable developments on the supply side. Competitive forces have been at play as a result of a series of deregulations and privatisations during the last 20 years. Further, the economy is benefiting from a high degree of IT penetration as well as possibly also from a more stable macroeconomic environment following the financial crisis at the beginning of the 1990s. Following the crisis, monetary policy switched towards inflation-targeting, and fiscal policy was made subject to expenditure ceilings and budget surplus targets. In total, the structural changes in the Swedish economy are likely to have been behind the productivity growth surge. Although we do expect productivity growth to slow going forward as payrolls increase, there are still a number of supply effects at play that markets should be mindful of. In particular, rising labour supply could prove significant in the years ahead due to lower taxes on labour income and higher net immigration. Further, the high investment spending suggests that although utilisation rates in the industry are high, capacity is being increased as well. All of these factors raise the potential rate of growth. Going forward, a rising domestic labour supply as well as further labour sharing and increased capacity at the global level should contain wage growth and labour cost pressures. Dovish Riksbank and hawkish markets As a result of the supply developments and in particular the surge in productivity growth during the last decade, growth in the Swedish economy has remained high, while inflation and interest rates have remained low. This coming week, markets may respond by stacking-up on SEK, sending equities higher while flattening the yield curve on the back of the 4Q growth surprise. In the medium term, there are risks that market participants, including ourselves, could be proven wrong in betting against the very flat profile for monetary policy rates forecast by the Riksbank in its latest Monetary Policy Report. The very favourable supply-side factors and high structural productivity growth could prove them wrong, we think. The 4Q GDP report will only give some hints as to the supply factors, but these hints may be just as important as the demand components the markets typically focus on.
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Anticipating a Windfall
February 26, 2007
By Oliver Weeks | London
The latest attempt to slow the explosive growth of bank credit in Kazakhstan is meeting inevitable resistance but looks likely to be implemented in April. However, we are unconvinced that the proposals to limit banks’ foreign borrowing will have a significant impact on inflows and lending at the macro level, and we expect further restrictions including hikes in reserve requirements later this year. Assuming Brent oil around US$54, we expect a sharp widening in the current account deficit to around 5.0% of GDP this year, but this is likely to remain well funded. We expect the National Bank to tolerate around 5% further nominal appreciation this year, though it may once again use slightly weaker inflows in 2H to try to introduce some two-way risk. In the longer term, despite signs of delays to major oil field projects, the outlook for exports and the balance of payments remains formidable, suggesting that significant real appreciation is inevitable. Credit restrictions still likely to be implemented. A resumption in acceleration of credit growth at the end of 2006 is likely to have reinforced the resolve of the supervisory agencies to tighten policy. After slowing temporarily in mid-2006 as coverage of reserve requirements was extended, bank credit growth to the private sector picked up to an all-time high of 85.5% year on year in 4Q06, led by credit to households at 131%Y. Booming credit demand is unsurprising, given the strength of medium-term economic prospects, and real wage growth running at 10.6%Y. However, even by emerging European standards, the pace of private sector credit growth — 61% per year over the past three years — is unprecedented. From just 10.6% of GDP in 2000, domestic credit to the private sector reached 45% of GDP in 2006, well above Poland and Russia and on track to overtake Hungary in 2007. The implied threat to macro stability still seems manageable, given the strength of export revenue and shrinking government debt, now at 11% of GDP. The Kazakh banking system is less restrained by government crowding out than central Europe, and more competitive than Russia’s. It is nevertheless reasonable for regulators to raise concerns about credit culture and capacity during a rush for market share. Housing prices rose 39% during 2006, to an average of US$1,040 per square meter nationally, and an alarming 76% to US$1,860 per square meter in Almaty. South Korea’s 2002-3 credit card crisis points to the risks of poorly supervised and structured household credit even without a macro shock. Beyond a couple of small banks, there are few signs of such problems yet in Kazakhstan, but NPLs are a lagging indicator of trouble and banks have been clearly warned that tighter policy is likely. We do not expect the current proposals to be the last of new restrictions this year. Current tightening proposals unlikely to be enough. Indeed, while we expect the current proposals to be pushed through, we are not convinced that they will have a significant tightening impact at the macro level. Reasonably enough, the latest proposal focuses on foreign borrowing, given its prominence as a source of funding — commercial banks’ gross liabilities to non-residents rose by US$ 14.2 billion in 2006. The latest draft, from February 20, sets a table of ratios of regulatory capital to liabilities to non-residents, slightly looser than the previous version and due to come into effect on April 1 with a one-year grace period for those not already compliant. The first impact has thus been to accelerate the rush to foreign markets. So far in 2007, local banks have raised US$4.5 billion worth of Eurobonds (not counting private loans), with further large offerings in the near-term pipeline. We expect the next result of the proposals to be to accelerate equity issuance. After a rush of IPOs in 4Q06, KKB has already raised another US$0.95 billion of equity locally this year, and we expect several more IPOs this year. The proposed limits also appear to leave open the option of bond issuance to foreigners directly from banks rather than via SPVs, technically difficult in FX but possible as private placements and/or in KZT. Even excluding this, our estimates based on the end-2006 equity capital of the ten largest banks suggest that the restriction would still technically allow for around a further US$14 billion of bank foreign borrowing. Clearly, however, room for borrowing is unevenly distributed. Assuming that Halyk and KKB do not take up their whole allocation, likely gross borrowing this year falls to around US$9 billion, but this may be conservative as it does not allow for new equity issuance or for loans completed before April. We expect further restrictions on bank lending, notably further hikes and broadening of reserve requirements, later this year. Current account likely to move sharply into deficit. The National Bank is unsurprisingly keen to talk up the negative impact of FX borrowing restrictions on the KZT. In 2007, we do expect both the current account deficit to widen and the financial account surplus to shrink. Minerals and metals accounted for 89% of goods exports in 2006 (with another 4% from chemicals). Oil revenue is likely to fall sharply, given negligible planned production increases this year. In 2006, oil and gas condensate accounted for US$24.8 billion, 65% of exports, up 4% by volume and 35% by value on 2005. At the Morgan Stanley economics team’s average Brent forecast for 2007 of US$54.4, we would expect this to fall to around US$22 billion in 2007. We see income from copper close to 2006’s US$2.4 billion. On the positive side, given a planned 31% increase in uranium output and Morgan Stanley’s US$86 per lb forecast, the value of uranium exports could double to around US$1.3 billion. We also expect lower income outflows as foreign investors in the oil sector slow amortization payments of FDI liabilities — most FDI in the oil sector is recorded as debt, but has no fixed repayment schedule. Nevertheless, we expect the current account deficit to widen from 1.3% of GDP in 2006 to around 5.0% of GDP in 2007, the largest deficit since 2001. But is still likely to be well funded. While a (temporary) shift back to a substantial current account deficit may cause some alarm, we still expect the deficit to be overwhelmed by financial account inflows. A slowdown in gross bank borrowing is likely to be partly compensated by ongoing investment in the oil sector and rising borrowing plans in non-financial sectors. Among portfolio investment, we expect further large IPO inflows, both from banks and from other sectors including real estate, mining, telecoms and transport. We also expect slower net FX purchases for the National Fund as tax revenue growth slows and pressure builds to spend oil revenue. Since July 2006, the National Fund has received all government oil revenue, boosting portfolio outflows on the financial account. The Fund was due to transfer KZT 77 billion back to the budget “for development purposes” in 2006, but none was drawn due to the over-performance of the non-oil budget. In 2007, KZT 302 billion is allocated for transfer. Again, not all is likely to be drawn, but, with local spending by development institutions due to accelerate from currently meagre levels, outflows from the National Fund look likely to pick up. The Kazyna state development fund has promised US$10 billion of (much needed) projects to develop the non-oil sector in 2007-9. With new FDI also accelerating, we expect an overall financial account surplus in the region of US$13 billion, down from around US$14.5 billion in 2006 but still leaving an overall balance of payment surplus close to US$5 billion. Short-term FX appreciation still at the discretion of NBK. A smaller surplus in the short term would still leave tolerance of FX appreciation up to the NBK, but would make life slightly easier for the bank. NBK Governor Saidenov has made it clear the bank will continue to intervene in the FX market but hopes to be much less involved than in 2006. The joint statement of the government and NBK on January 24 reiterates that policy remains to intervene against “short term and speculative” flows. So far in 2007 Mr Saidenov’s hopes for inactivity have been disappointed. The bank has seen FX reserves rise another US$2.9 billion in the first six weeks of the year, after a record US$4.0 billion inflow in December, taking international reserves to 28% of GDP (and National Fund assets to 18% of GDP). It has also stepped up its own sterilization activity, more than tripling the amount of NBK notes outstanding in the last three months, to KZT 838 billion. Nevertheless, we expect inflation to intensify pressure for tighter monetary conditions in the short term, even with lower oil prices. The 2007 budget introduced significant tax cuts and public sector wage hikes. Headline CPI picked up to 8.5%Y in January, the highest for three months, with service price growth accelerating to 12.0%Y. The bank’s inflation forecast for 2007 remains quite vague, with 7.3-8.3% seen the central range if oil remains below US$60 per barrel but FX inflows remain strong. With slower inflows, the bank forecasts 6.3-7.2% and with oil above US$60 suggests inflation could rise as high as 9.3%Y. However, the medium-term aspiration is clearly more ambitious, with the joint government-NBK program specifying a target range of 5-7% for 2007-9. The bank denies being influenced by the USDKZT 117 level used in 2007 budget planning. It does however appear less concerned by current KZT levels than by the risk of appreciation attracting more speculative inflow. Given likely continuing inflows and hedging activity in 1H, we think that the bank is likely to tolerate further appreciation towards 118 by mid-year, albeit not in a straight line. A slight slowdown in inflows in 2H and temporarily wider current account releases may give the bank an opportunity to reintroduce some two-way risk but, given the longer-term balance of payments outlook, this does not look sustainable to us. Long-term export outlook strong, if political succession is smooth. Recent news on oil projects has not been particularly positive, with further delays possible at the vast Kashagan field and Tengiz under pressure on ecological grounds. Nevertheless the long term outlook for production, and the balance of payments, remains highly impressive. Official, downwardly revised forecasts are now for oil and gas condensate output to rise from the current 65 million tonnes a year to 90 million tonnes a year by 2010, and 130 million tonnes by 2015, in line with Kuwait’s current output. These seem conservative with Kashagan peak output currently planned at 70 million tonnes a year and Tengiz planning to double annual output from the current 13.3 million tonnes with new investment from 2008. Future north Caspian development could boost peak flow towards 160 million tonnes per annum, above Venezuela’s current level. Natural gas exports are less significant but also set to rise sharply from the current 7 billion cubic meters a year. By 2009, the first phase of the China-Kazakhstan gas pipeline is due to be complete, with a capacity of 10 billion cubic meters a year, worth around US$2.5 billion at current prices. By 2012, capacity is due to be US$30 billion. Overall, we expect annual oil and gas revenue to rise about 2.5 times over the next five years even with no price increases. On top of this, uranium production is planned to triple by 2009. Despite relatively high extraction and transport costs, Kazakhstan looks resilient to adverse commodity price moves. The most significant risk to the long-term outlook would seem to be a disputed transfer of power. This seems a low probability event, while the president remains healthy and living standards keep rising, but a non-negligible factor given the absence of any clear arrangement or mechanism for succession, and the high stakes for the current nomenklatura. Long-term appreciation seems inevitable. In the absence of unrest and redistribution, significant longer-term real appreciation seems inevitable. The absence of complaints from exporters about the exchange rate is already striking (though may also reflect the small size of the non-commodity export sector). While government wariness about appreciation is understandable, given the weakness of the non-commodity sector, recent real appreciation has actually been remarkably limited. Since January 2000, the real effective exchange rate has appreciated only 0.5%, and against Kazakhstan’s largest CIS trading partners (the likeliest potential non-oil export markets) it has depreciated 29%. In 4Q06, the real effective exchange rate depreciated 4.3%. And like most others, we expect significant further real rouble appreciation. With the KZT fully convertible, the bank is unlikely to be able to rely on administrative measures for long to hold back capital inflows. Despite aggressive recent sterilization, growth in M0 and M3 is running at 46% and 80% year on year, respectively. The bank can raise reserve requirements again to contain the feed-through from base money to wider monetary aggregates. However, the scope for further such measures seems limited. The effectiveness of oil fund sterilization is likely to decline as non-oil inflows continue to grow and pressure for local spending rises. Further fiscal policy tightening seems unrealistic, given development needs. The scope for directing inflows towards local capacity-raising investment, upgrading education and infrastructure is clearly very high if properly managed. We expect bank policy to be directed towards developing the local currency market, boosting its regional role and raising interest rates towards positive real levels. The bank already appears determined to extend the maturity of its own notes out to a year. Such measures may attract more speculative inflow and further raise the fiscal cost of sterilization. However, this may be a price worth paying if it contributes to the long-term aim of allowing local markets to intermediate foreign investment in more broadly based growth. Meanwhile, attempts to hold back nominal appreciation seem likely only to shift the channel of real appreciation to inflation.
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Fiscal Mettle in Fine Fettle
February 26, 2007
By Michael Kafe | Johannesburg
Against the backdrop of strong domestic growth, contained inflationary pressures and a supportive international environment, Finance Minister Trevor Manuel showed last Wednesday that South Africa is expected to record an historic fiscal surplus this fiscal year ending March 31, 2007. In addition, the government is looking to reduce its domestic and foreign debt stock, choosing instead to apply its huge cash revenue overruns to fund the ongoing capital expenditure program. Further, the government has provided some R14.6 billion in gross tax relief and unveiled further foreign exchange control relaxation. However, the Minister’s current account forecast for 2006 and 2007 raises more questions than answers. Highlights of the Budget Fiscal health: South Africa’s fiscus is in fine fettle, bursting at the seams with revenues, while expenditure outlays are struggling to catch up. Initial projections were for the 2006/07 fiscal year to record a central government deficit of R26.3 billion or 1.5% of GDP. This was later revised to a deficit of R7.8 billion or 0.5% of GDP in October. The 2007/08 Budget document now estimates a fiscal surplus of R5.2 billion or 0.3% of GDP. Also, the fiscal balance for 2007/08, which was hitherto expected to come in at a revised R9.3 billion surplus (0.5% of GDP), is now penciled in at R10.7 billion or 0.6% of GDP. The strong revenue growth was driven by a R28.5 billion overrun in taxes on income and profits, especially company taxes (R19.6 billion). Personal income tax and VAT proceeds were also quite strong, recording some R6.5 billion and R3.4 billion above initial estimates, respectively. Government spending, on the other hand, is expected to come in marginally below expectations; while a R1.1 billion undershoot in fiscal 2005/06 was blamed on lower debt service costs, the same cannot be said for the R2.1 billion undershoot reported in this fiscal year (2006/07), which was largely driven by an inability to spend, given lack of capacity. The government's capital expenditure budget is now expected to rise to R416 billion over the next three years – an increase of R6.1 billion over the medium-term estimates published last October. The big question is whether the government has the capacity to deliver on these spending requirements. An infrastructure delivery improvement program (IDIP) has been set up to address the issue of chronic underspending of capital infrastructure budgets. Taxes Given the strong fiscal position of the government, a R14.6 billion (gross) tax relief package has been proposed. This includes: · Personal income tax relief of R8.4 billion that compensates for fiscal drag/bracket creep without threatening to overstimulate domestic consumption; · A phased replacement of the secondary tax on companies with a dividend tax and reducing the rate of tax from 12.5% to 10%. This should help broaden the tax base significantly while contemporaneously bringing down the cost of equity financing. This will come at a cost of R2 billion in foregone revenues; · Abolishing the retirement fund tax at a cost of R3 billion to the Treasury; · Treating the sale of shares held for more than three years as capital gains for tax purposes. The government also proposes to introduce a comprehensive social security package over the 2007-10 period. Details including compulsory social security tax recommendations and wage subsidy propositions will be tabled for public discussion later this year. In our opinion, the timing of this social package is propitious, as it should help earn the Mbeki government some much-desired political brownie points ahead of the African National Congress (ANC)’s Economic Policy Conference in June this year, party presidential elections in December, and national elections in April 2009. Those in the Zuma camp will have to produce a credible alternative to sway the marginal populist vote in their favor, in our view. Finally, a synthetic fuels tax that we had expected to feature in this Budget was postponed. According to Minister Manuel, a decision will be made in July and action will only take effect from January 1, 2008. Government funding The government has cut back further on its funding requirement. The total public sector financing requirement was budgeted in October to come in at R8.8 billion, -R10.2 billion, R2.5 billion and R8.9 billion, respectively, in 2006/07 to 2009/10. However, as a result of the revenue overruns, it will now come in at no more than -R4.3 billion, -R11.6 billion, R1.8 billion and R7.5 billion, respectively. On a net basis, the government is looking to buy back domestic debt over the next three years. The amount of domestic government bonds outstanding is expected to decline from R421.4 billion in 2006/07 to R413.8 billion in 2007/08 before rising to R416.4 billion in 2008/09, while the foreign debt stock remains flattish at R83.6 billion over the next three years. This will lead to a decline in the share of domestic debt in the total debt portfolio from 87.4% in 2005/06 to 85% by 2008/09. Conversely, the share of foreign bonds rises from 12.6% in 2005/06 to 15% in 2008/09 before dipping slightly to 14.5% in 2009/10. The government does not intend to continue borrowing in the international capital markets over the next two years and has already made provision for a US$1 billion equivalent capital market loan in 2009/10. In order to maintain a presence in the international capital markets, the National Treasury plans to pursue an active foreign debt management strategy. On the domestic front, no new fixed income bonds will be issued this coming fiscal year. Instead, issuance will concentrate in the medium-to-long-term maturity benchmark bonds. The maturing R198 inflation-linked bond will be replaced with a new 20-year CPI-linker. New inflation-linked retail bonds will also be introduced in the 3, 5 and 10-year space. Exchange controls In line with the government’s policy of gradualism as far as the removal of exchange controls is concerned, some further token relief was given for corporates seeking to invest offshore. The current shareholding threshold of 50% + 1 for all investment outside Africa has been reduced to 25% – in line with restrictions for direct investments in Africa. Also, the range of permissible transactions on customer foreign currency (CFC) accounts has been broadened to allow such accounts to be used for both trade and services-related payments. Finally, permission was granted to establish a rand futures market to help deepen liquidity in the foreign exchange market. We do not expect any of these moves to lead to an immediate outflow of foreign exchange. In fact, at the moment, the flow of direct and indirect investment in South Africa is a lot more inward than outward. Current account forecast is confusing With regards to the macroeconomic outlook, the Minister cut his 2007 CPIX inflation number from 5.5% to 5.1% and raised 2008 forecasts from 4.4% to 4.7%. These revisions bring the Finance Ministry closer to Morgan Stanley’s average forecast of 4.9% for both 2007 and 2008. What is confusing, though, is that the Finance Ministry now expects the 2006 current account deficit to come in at a mere 5.5% of GDP. Mathematically, this is impossible – at least not without significant downward revisions to the first three quarters of 2006. As things stand now, for the 2006 average to print 5.5% of GDP, the 4Q06 deficit will have to come in at no more than 5.2% of GDP – a far cry from our revised conservative estimate of 6.2% of GDP and the SARB’s clear warning last week that the deficit widened significantly from the 5.2% of GDP that was reported for 3Q06. We also think that the Finance Ministry’s forecast of a 5.3%-of-GDP current account deficit for 2007 is rather low, when compared with Morgan Stanley’s forecast of a 5.6% annual average, which will be largely driven by a bullet SACU payment outflow in the final quarter of this fiscal year ending March 2007. Latest data from the Treasury show that, of the revised R25.2 billion SACU payments budgeted for this fiscal year, only R14.8 billion was paid out by December 31, 2006. That means that a whopping R10.4 billion will have to flow out in 1Q07. This ties in with the Treasury’s comment that “...over February and March 2007, the cash requirement for loan redemptions, interest and SACU payments amounts to R60.8 billion” (see the 2007 Budget Review, page 92). Our preliminary calculations show that redemptions (R33 billion) and coupon payments (R16.2 billion) together account for no more than R49.2 billion in February/March 2007 – leaving SACU payments to account for the difference.
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January Rebound: Underlying Strength Mixed
February 26, 2007
By Deyi Tan | Singapore
A slight re-acceleration? Production accelerated to 14.6% YoY (versus +5.6% YoY in December), in-line with the rebound we saw in January exports last week. Excluding biomedical, which tends to be volatile, production rose 8.0% YoY (3MMA) in January. This marks a slight pick-up from the 3.5% YoY (3MMA) trend in December and comes after five consecutive months of deceleration. However, we believe that this is due to the January data being positively affected by the higher number of working days compared with last year since, on a sequential seasonally adjusted basis, January production declined 6.5% MoM. Electronics still in relatively soft patch: Specifically, the electronics segment performed slightly better in January than in December (+4.1% YoY versus -7.9% in December). However, on a moving average basis, the segment is still contracting at -1.5% YoY (3MMA). Key products such as semiconductors were reasonably healthy (+12.3% YoY) but smaller segments such as data storage and infocomms were in negative territory (-13.2% YoY and -5.9% YoY). Transport and biomedical segments are still relatively better-performing segments: Transport and biomedical remain the better-performing segments. Transport rose 45.2% YoY (versus +29.8% YoY in December) on the back of a 55.4% YoY rise in marine and offshore and a 30% YoY increase in aerospace. Biomedical also registered double-digit growth at 24.1% as pharmaceuticals surged 25.0% YoY.
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