China Squeeze
February 28, 2007
By Stephen S. Roach | New York
Like nearly everything else in the world these days, it now appears that global stock market corrections are made in China. I have no idea if the rout that began in China was just a brief flash or the start of something big. But I have long felt that something has to give in China. This may well be the beginning of an important venting process.
The basic premise of this story is that China — despite its remarkable successes on the economic development front — now has a seriously unbalanced economy. The main problem is a runaway investment boom. By our estimates, in 2006, fixed asset investment exceeded 45% of Chinese GDP — a record for China and, in fact, a record for any major economy in the world (see accompanying chart). By comparison, Japan’s investment ratio in the 1960s — the period of maximum rebuilding from the destruction of World War II — never exceeded 34% of GDP. China’s annual growth in fixed asset investment has averaged 26% over the past four years. Should the investment boom continue at this pace, the odds of capacity excesses and a deflationary endgame will only increase. That’s the very last thing China wants or needs. The Chinese government recognizes the perils of just such a possibility. For nearly three years, it has conducted an on-and-off tightening campaign aimed at cooling down its overheated investment sector. Following relatively limited actions first implemented in the spring of 2004, Chinese authorities have upped the ante in the past eight months. The People’s Bank of China has raised its short-term policy rate twice by a total of slightly more than 50 basis points, and beginning in mid-2006 the central bank boosted bank reserve requirements five times in increments of 50 bps from 7.5% to 10% — the last such action taking effect on 25 February. The problem for China is that it is still very much a blended economy —both state and market driven. As such, market-based policy actions — especially interest rate adjustments — have had only limited success, at best. Two additional factors compound this problem: First, Chinese banks run chronic excess reserve positions; reserves amounted to 14% of total deposits by year-end 2006 — well above the mandated 10% requirement set by the latest policy action. That means, of course, that recent increases in bank reserve ratios are not a binding constraint on the banking system. Second, much of China’s bank lending remains outside the scope of the central control of its monetary authorities; dominated by a vast and highly fragmented system of autonomous local banks, there is only limited traction between monetary policy adjustments and broad trends in Chinese bank lending. In light of that disconnect, together with only limited development of a domestic corporate bond market, Chinese macro officials have had to rely largely on “administrative controls” — namely, a case-by-case project approval mechanism — to rein in the excesses of a runaway investment boom. The results of this effort have been mixed. Courtesy of the administrative edicts issued by the National Development and Reform Commission — the modern-day counterpart of China’s old central planning bureau — investment growth slowed from near 30% at the start of 2006 to around 14% at the end of the year. Unfortunately, bank lending went the other way — actually accelerating from 13% y-o-y growth in mid-2006, when the latest tightening campaign began in earnest, to 16% by December. That, in a nutshell, could well be the key to this story: China’s central bank has been unable to get traction on bank credit expansion at the same the central planners have succeeded in achieving traction in prompting the investment slowdown. This has resulted in an excess of bank-induced liquidity creation that is undoubtedly spilling over into the financial system. As a doubling of the Shanghai A-share index over the past six months suggests, the Chinese stock market appears to have been a major beneficiary of this mismatch. Here’s where the story gets especially interesting — and, admittedly, somewhat conjectural. In China, stability is everything. The Chinese leadership believes it cannot afford to lose control of either its real economy or its financial markets. Pure market-based systems can rely on interest rates, currencies, fiscal policies, and other macro stabilization instruments to contain the excesses. A blended Chinese economy does not have that option. The quasi-fixed currency regime compounds the macro control problem — making it difficult for China manage its currency in a tight range without fostering excess liquidity creation. That puts the onus on Chinese policymakers to opt for non-market control tactics. Just as China has moved to bring its central planners into the business of containing the excesses in the real economy through administrative measures, I suspect it now feels compelled to rely on a similar approach in order to deal with excesses in its financial system. All this puts the onus on China’s financial regulators to face up to the risks inherent in any asset bubble — in the current instance, an equity bubble. That’s especially the case in the weeks just before the annual early March meeting of the National People’s Congress — always a critical and delicate point in the Chinese policy cycle. In that context, there were countless rumors of government intervention in the markets on 27 February. The only such action our China team has been able to verify — and it’s an important one — pertains to State-directed sales of its massive holdings of so-called reformed shares. Apparently, yesterday (27 February) it became public information that various local affiliate holding entities under the SASAC (State-owned Assets and Supervision Administration Commission) have been reducing government stakes in about 15 listed Chinese companies by close to the annual limit of 5% of total outstanding shares. Following the equity market reforms of 2005, these previously unlisted shares have since been classified as market tradable shares — thereby opening the door for actions such as those which became evident on 27 February. The 9% one-day plunge in Chinese A-shares could certainly be interpreted as a sign that “inside sellers” played a key role in sparking the decline — either acting at the explicit request of the government or out of fiduciary conviction that the end was close at hand. Inside selling or not, the bottom line is that China’s macro control imperatives are a critical ingredient of its overall stability objectives. And in recent years, risks have been multiplying on the control front. Just as China cannot afford an overhang of excess capacity, it cannot afford a major equity bubble. Lacking in market-based mechanisms to address these problems, the administrative option remains a very important tool in the Chinese policy arsenal. So far, that’s mainly been true on the real side of the economy. The near-parabolic increase in the Chinese equity market over the past six months is good reason to believe this strategy is about to be tested on the financial side of the economy. In the last five years, China has emerged as a major engine on the supply side of the global economy. But with that achievement has come a new set of risks — especially an overheated investment sector and an equity bubble. These two problems are related in that they are both very visible manifestations of China’s control problem. The sharp break of share prices on 27 February may well be symptomatic of China’s increased determination on the macro control front. Ultimately, this is good news for China and the broader global economy — it sets the stage for balanced and sustainable growth. But for those counting on open-ended Chinese growth, any such slowdown could come as a rude awakening. The China squeeze now appears to be on in earnest.
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Reading the Monetary Tea Leaves
February 28, 2007
By Luis Arcentales and Daniel Volberg | New York
Does Chile’s central bank know something we don’t? That seems to be the key question burning in the minds of most Chile-watchers today. The saga began when the central bank unexpectedly cut its target interest rate by 25bp to 5.00% last month after holding rates at 5.25% since July 2006. The move caught markets — including ourselves — completely off-guard. Given the prevalent consensus that the economy is poised to accelerate back to at least trend this year, Chile watchers immediately began to wonder if the central bank’s move meant that there was something wrong with Chile’s growth prospects. Rather than signaling mounting risks of a potential growth relapse, January’s rate cut seemed largely aimed at addressing persistently low inflationary pressures. We believe that an additional factor that likely prompted the central bank to act without previously preparing markets is a seemingly subtle yet likely meaningful redefinition of its inflation target at the beginning of the year. New-found activism? The January rate cut came on the heels of a shift in the central bank’s inflation target. On the surface, the changes seemed minor; however, if the January move is any guidance of what is to come, then we suspect that the new target and policy horizon will have meaningful implications for how the central bank will act in the future. First, the new objective for monetary policy is to keep inflation “around” 3% (+/- 1%) from the previous range of 2-4%, which had been in place since 2001. To be fair, authorities have always aimed explicitly at keeping inflation near the mid-point of the 2-4% range, which could make this change seem rather trivial. However, in our view, in practice the new target reduces authorities’ tolerance for shifts in expected inflation away from 3%. The second move involved a change in the relevant policy horizon to around two years out from 12-24 months previously. At the core of this adjustment is a positive effort, in our view, to shift market agents’ focus towards more relevant medium-term inflation dynamics and, in turn, give authorities additional degrees of freedom to look beyond what might seem to be temporary shocks. The result of the redefined target is likely to be a more activist central bank. Instead of using January’s Monetary Policy Report to prepare markets for future easing, authorities instead chose to surprise with a cut. In addition, the cut took place only two months after the central bank clearly shifted to a neutral bias in November by removing any reference to potential rate hikes down the road still contained in October’s policy communiqué. Such a rapid set of actions suggests a break from the past of sorts and, in our view, points to an increased scope for small moves on the part of the central bank aimed at steering expectations towards 3%. Ironically, the Chilean central bank’s own solid track record has been reflected in two-year forward inflation expectations remaining well anchored at 3.0% almost uninterruptedly since mid-2002 — based on its own survey of market participants — thus reducing the informational value of this measure. Thus, the central bank seems now to be increasingly focusing on more volatile market-based readings such as breakeven inflation derived from nominal and indexed instruments. Another implication of the redefined target is the likely need for the central bank to act in a more pre-emptive fashion. One key element cited as a justification for January’s cut was a wider output gap derived from the sub-par growth performance in 2006. Our own projections of core inflation — which better reflects underlying inflation trends — point to muted pressures throughout the year. In addition, our estimates suggest that changes in the output gap tend to be seen in inflation with a lag of roughly two years. Against this backdrop and with the need to shift the market’s focus towards the new policy horizon, we suspect that that policy will take a more pre-emptive tilt going forward. Consistent with our view that inflation pressures are likely to remain muted in 2007, we are revising our forecast lower to 2.2% from 2.9% previously. For 2008, we are adjusting our forecast downwards to 2.7% from 3.0% previously. While we agree with the argument put forward to justify January’s decision, by surprising markets authorities did not take into full consideration one of the two main principles of central banking, in our view. The first tenet is a clear set of objectives and policy instruments – where Chile’s central bank certainly earns high marks. The second is clear communication of the central bank’s reaction function. It is in light of the second principle that the January cut could seem premature and, in our view, should have been preceded by some guidance of the practical ramifications of the changing parameters of monetary policy. Interestingly, January’s was a split decision — something rare for a central bank whose previous 11 decisions were unanimous — with the minutes suggesting that the sole dissenter argued, among other things, for preparing markets before a move. While the central bank has signaled that all policy options remain on the table, our sense is that January’s was not the last cut of what is likely to be a brief easing cycle. The outlook paragraph contained in the January policy communiqué stated that the next rate move would be data-driven. Indeed, the wording was the exact one used in November, December and more recently in the February policy statement, implying a neutral bias. But not only would a lone 25bp cut be out of line with the recent cycles, it would also imply a level of fine-tuning that seems inconsistent with the uncertainties regarding monetary policy. Moreover, the January cut came against a backdrop of two consecutive months of higher-than-expected headline and core inflation readings. February inflation, by contrast, is likely to plunge due to methodological issues related to the new Transantiago transportation system. However, even when the near-term data are sending rather mixed signals, with underlying inflation pressures largely muted it is up to the central bank to signal that there are times when fundamentals could still prompt easing. Importantly, breakeven inflation measures remain relatively low and, if February inflation indeed posts a very low reading, expectations could also trend lower. Bottom line The move by Chile’s central bank to redefine its inflation target is a positive one, in our view. By changing its horizon to two years and stressing that inflation should converge to the 3% level, the market’s focus should shift towards more relevant medium-term inflation dynamics. Against this backdrop, and despite its solid track record, the central bank has to make certain that surprise actions like January’s become the exception rather than the norm going forward. Indeed, the need for certainty as markets adjust to the new redefined targets is higher if, as we suspect, policy is set to become more activist going forward. The good news for Chile watchers is that the prospects for an acceleration in economic activity are intact. While doubts abound over what Chile’s central bank will do next, the case for stronger growth seems more certain as several tailwinds – including higher fiscal outlays, a modest improvement in investment and lower energy quotes – are set to boost the economy this year.
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Strong GDP Growth in 4Q06
February 28, 2007
By Michael Kafe | Johannesburg
Data released by Statistics South Africa (StatsSA) late this morning show that GDP rose 5.6%Q, saar to deliver a 5.6%Y increase in 4Q06. This was pretty much in line with Morgan Stanley’s forecast of a 5.3%Q growth, but much higher than consensus estimates of 4.8%Q. It is important to note that these are seasonally adjusted and annualized numbers, and minor differences in the base are easily compounded once annualized. Even so, while our headline forecast was broadly in line with the actual reading, a close look at the detail reveals some rather embarrassing disparities between our sectoral forecasts and the actual readings. First is agricultural production. According to Statistics South Africa, agricultural production remained in recession right through the year, although the negative growth rate improved from -29.9% in 2Q06 to -8.4% in 4Q06. Growth in the sector (or the lack thereof?) was apparently driven by a lower harvest of food crops in 4Q06. We find this to be rather strange, given the harvest-led deceleration in general food prices that quarter. Of course, there may have been a run on agricultural inventories as well (e.g., cereals, frozen meat, etc.), which would have helped contain price increases in a quarter where pricing pressure is usually strong. But this is not our view. We had expected a positive contribution from the agricultural sector. Second, mining and quarrying came in at no more than 4.6%. This was much lower than our forecast of a 10% increase, which was largely based on the strong monthly mining production numbers that were reported by StatsSA, adjusted for a slow-down in oil production. According to StatsSA, the growth here was driven by strong coal and metal ore (including platinum) production. But it is also important to note that, in compiling the quarterly data, StatsSA supplements its published monthly data with some information from the Chamber of Mines. Perhaps there were worse data on gold production from the latter source than the 1.9% decline that was published by StatsSA. Third, finance, real estate and business services printed a 7.2%Q growth rate, which was much higher than our forecast of 4.9%. We had expected this sector to show some deceleration from the 5.9%Q that was earlier reported for the third quarter, thanks to rising interest rates. However, the third quarter growth rate was revised a full percentage point lower, giving the 4Q reading a good base to leap from. But this revision alone does not fully explain the difference. The fact is, we got the direction wrong too! Interestingly, StatsSA mentions that the jump here was driven by “...increased activities auxiliary to financial intermediation”. Obviously, the momentum in these auxiliary activities is not in synch with the slowdown in formal lending/borrowing activity. For the third consecutive quarter, we have under-estimated construction activity in South Africa. Perhaps it is time to do a reality check. Although today’s data confirm our view that construction activity likely peaked at 14.5% in the second quarter of last year, the truth is that we have been calling for a faster deceleration in activity than has been the case. We have for a while now been of the view that most of the 2010 World Cup-related construction would be back-loaded. However, the data suggest that this may be happening a bit earlier than we had thought. Other sectors like manufacturing production also reported strong growth in 4Q06. After collapsing from 11%Q in 2Q05 to 1.4%Q in 4Q05, manufacturing activity has since recovered to produce an 8.3%Q growth that topped our bullish forecast of 7%Q. Activity here was broad-based, ranging from textiles and paper, through chemicals and plastic products to mineral products and transport equipment. Surely, this sector must have benefited from the weaker currency in the second half of the year. We expect a slowdown in manufacturing activity as the currency stabilizes and as the 200bp of rate tightening bites. In fact, today’s data show that the wholesale and retail sectors are already showing signs of a slowdown/deceleration, following the move to tighter money last year. We expect manufacturing production to follow suit over the course of this year. On the whole, the GDP data show that South Africa’s enviable growth composition has not really changed over the course of 2006. Manufacturing, construction, real estate and financial services, which together account for some two-fifths of GDP, remain the key growth cylinders, while agriculture, electricity and personal services, accounting for less than 10%, are the sluggards. In the middle are wholesale, retail and transport, which, although decelerating somewhat, are still growing at above-trend rates of about 5.5%. We look for some deceleration in manufacturing and financial services this year as interest rates hurt, while base effects from 2006 combine with higher throughput from more intensive capital formation to help lift annual growth rates in agricultural and mining production this year. On the back of today’s data, we now expect 2007 and 2008 GDP growth to come in at 4.7% and 4.6% respectively. This is slower than the 5% reported in 2006 but marginally higher than our earlier forecasts of 4.5% for both years.
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Serious Problems with the CPI
February 28, 2007
By Takeshi Yamaguchi | Tokyo
Market sensitive to even 0.1ppt changes in CPI’s YoY change With the YoY change in the core CPI close to 0%, the market has become very sensitive to changes in the figure of as little as 0.1ppt. The CPI has long been closely watched for its monetary policy implications, but recently bond investors have been particularly interested in even minute CPI changes because of the implications for CPI linkers. In conjunction with the CPI revisions last August, the YoY change in the core CPI was revised downward by 0.4ppt, and the break-even inflation (BEI: the average expected inflation rate over the next 10 years) implied by the pricing of CPI linkers fell from 0.8-0.9% to 0.6-0.7% and then later slipped to 0.4-0.5% as expectations of inflation staying low took hold. Although the BEI is an indicator of inflation expectations, including the impact of the consumption tax and other indirect taxes, investor interest in the monthly core CPI figures and the market’s consensus expectations is strong because expected inflation is affected to some extent by current price trends. The core CPI for December (announced last month) was up 0.1% YoY, down 0.1ppt from the 0.2% YoY growth in November. However, we believe it is questionable whether this 0.1ppt slowdown can be taken at face value. Core CPI growth may not have actually slowed Japan’s CPI and its YoY change are shown to the first decimal place. Let us review how the YoY change in the core CPI is calculated by the Statistics Bureau & Statistics Center of the Ministry of Internal Affairs and Communications. The December change, for example, is calculated based on the following formula for each item and category. YoY change (%) = (December index/year-ago December index – 1) × 100 The December 2006 index was 100.1 and the December 2005 index 100.0, for a change of 0.1%, as follows: (100.1/100.0-1)×100=0.1 This result matches the announced figure. If the calculated figure goes out to the second decimal place or more, it is rounded to the nearest first decimal place. What is not very well known, however, is that the MoM and YoY changes are based on reported index figures that have already been rounded to the first decimal place. For example, the December 2006 core CPI of 100.1 may have been 100.050 or 100.149; the figure is not released to this degree of precision. Likewise, the December 2005 figure of 100.0 may have been 99.950 or 100.049. The YoY change may have actually been, for example, (100.149/99.950-1)×100=0.199… The result would be an announced figure of 0.1%. Similarly, the YoY change may have actually been (100.050/100.049-1)×100=0.000… The result would also be an announced figure of 0.1%. It should thus be kept in mind that the December YoY change of 0.1% could have actually been 0.1ppt higher or lower, and likewise for the November figure of 0.2%. We thus argue that it is not possible to determine for sure whether core CPI growth actually narrowed based on the released figures of 0.2% in November and 0.1% in December; the YoY changes may have been the same, or the growth may have even accelerated. On our estimates, the probability that the December YoY growth calculated from unrounded index numbers was actually higher than the November growth (i.e., Prob(Dec YoY growth-Nov YoY growth>0)) is relatively small at about 4%, but the probability that the December growth was actually at least about the same as the November growth (i.e., Prob(Dec YoY growth-Nov YoY growth>-0.05)) is about 20%. Revision in calculation of US CPI change To minimize such margins of error, the US Bureau of Labor Statistics is releasing CPI figures to the third decimal place starting with the January data. The announced change in the CPI is calculated based on CPI figures that go out to the third decimal place and then is rounded to the first decimal place, as before. About 25% of the released CPI changes based on the new method are different from the figures based on the old method, using CPI figures rounded to the first decimal place. To be sure, we think it is debatable how significant it is to release CPI figures to the third decimal place, considering that statistics involve various margins of error. In addition, a universal problem with CPI data is the inherent bias from the use of a Laspeyres index, as became keenly apparent when the last August CPI revisions led to a substantial drop in CPI growth. Nevertheless, in light of the growing demand for more precise CPI data for valuing and pricing CPI linkers, we believe that the Japanese government should consider adequately explaining the nature of the data to the market and calculating the change in the CPI based on unrounded index figures, the way the US does, particularly since the costs of making the change would be fairly minor.
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Yet Another Rate Cut
February 28, 2007
By Chetan Ahya | Mumbai
Policy rate lowered to 4.50%. The Bank of Thailand (BoT) lowered the policy rate (1-day repurchase rate) from 4.75% to 4.50% in its meeting today. This was in line with our and market expectations. In its statement, the BoT cited that “risks to inflationary pressures were low and monetary policy could be eased in support of a further expansion of the economy”. Headline inflation moderates further: On the inflation front, January inflation moderated to 3.0% YoY, following an increase of 3.5% YoY in December. However, core inflation came up to 1.6% YoY (versus +1.5% YoY in December). Inflation in the non-food category decelerated to 1.1% YoY (versus 1.9% YoY in December) while that in the food category accelerated to a 13-month high of 6.3% (versus 6.0% YoY in December). The BoT believes that “inflationary pressures were expected to be on a downward trend and core inflation should remain within the target range”. Growth conditions continue to deteriorate: On the macro economy, Thailand’s consumer confidence slipped further to 79.9 in January (versus 82.4 in December). In addition, domestic demand and investment indicators like consumer goods imports, capital goods imports and automobiles sales continued to remain weak. Macro outlook remains unexciting: Despite today’s rate cut, we believe that the growth outlook will remain unexciting until the underlying problem of political uncertainty and its consequent impact on the business confidence are addressed. Indeed, in our view, the political condition has further weakened over the last month. We believe that growth conditions are unlikely to improve significantly in 2007, thus giving the BoT leeway to cut rates further.
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