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Still Going Strong, but Mind Global Risks
March 02, 2007

By Thomas Gade | London

The Swedish economy is still going strong following the 4Q GDP report, despite growth being lower than we had anticipated. Following an expansion of 1.2%Q (5.0% SAAR) in the fourth quarter, the Swedish economy expanded by a total of 4.4% in 2006 — one of the highest growth rates in Europe last year. Productivity growth may be slowing, but supply-side factors should remain strong going forward, we think. We are revising up our growth forecast for this year from 3.3% to 3.8%, but a number of more global risks are worth highlighting. First, the equity market sell-off — should it be sustained — will start to work through the traditional wealth channel into lower consumption growth. Second, the Swedish economy is sensitive to the global capex cycle. A possible marked slowdown in capital goods demand from China therefore has the potential to hamper export growth going forward. Should these downside risks to demand manifest themselves in the supply-driven Swedish economy, then inflation and short-term interest rates could remain low for longer.   

Volatile, but slowing productivity growth

The Swedish economy has been driven to a large extent by strong supply-side dynamics, which has kept inflation and interest rates low during recent years. Despite a rebound in productivity growth in 4Q to 3.0%Q annualized, there are signs that productivity growth is slowing gradually from the environment of high productivity growth during the last decade. Part of this is explained by the cyclical pick-up in the labour market. The number of hours worked continues to grow at a robust pace. Going forward, we expect a more significant pick-up in hours worked as a result of increased hiring intentions in the industry as well as a result of the introduction of lower taxes on labour income. Increased payrolls and hours worked will likely slow productivity growth going forward. At the same time, the increase in labour supply following lower taxes on labour income as well as through high immigration will ease otherwise increasing pressure in the labour market. Recently, Swedish companies have been investing in increased capacity as a result of record-high utilization rates. In other words, investment in new capacity and technologies also means investment in productivity. Therefore, productivity growth could again surprise on the upside. Hence, mind the upside risk, although sustained productivity growth it is currently not our baseline case.              

Robust demand, but mind downside risks

On the demand side, household consumption (0.7%Q) and investment spending (2.4%Q) were the main drivers of growth in the fourth quarter of last year. Going forward, household consumption will likely be sustained on strong income dynamics driven by rising real wages and employment growth. These will also likely outweigh the negative wealth effect from the recent equity market correction, we estimate. So far, Swedish equities have sold off by close to 6% since the start of the equity market correction on February 27. Should the equity market correction be sustained, this could shave off around two-tenths of consumption in the short term and as much as 0.8 ppt over the full year, we estimate.

In the industry, operating rates are record high. Although operating rates in the Swedish industry traditionally have been higher than in the euro area, increasing capacity pressures and low financing costs are boosting investments and should support investment spending growth going forward, we think. On the external side, the growth contribution from net export growth was flat on the quarter, despite increasing exports and imports. Going forward, the contribution from net trade will likely remain low or possibly negative during the first half of this year. As growth in the euro area recovers from the fiscal tightening implemented in Italy and Germany, we expect export growth in the Swedish economy to pick up again. With an export to GDP ratio of 52% — higher than most other economies — Swedish exports are more sensitive to global demand than in most other economies, and to capex demand in particular. Around 2% of Swedish exports are shipped to China and, given the high capital goods share in Chinese imports, a significant slowdown in investment spending in the Chinese economy could therefore have repercussions on Swedish exports and GDP growth, which are greater than the effect for instance on the euro area (see Europe: Testing Europe’s Resilience to Real and Financial Shocks earlier on the forum). A Chinese investment spending slowdown remains a risk scenario on our forecast, but we will be watching how it plays out carefully.   


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Testing Europe’s Resilience to Real and Financial Shocks
March 02, 2007

By Eric Chaney, David Miles, Thomas Gade, Vladimir Pillonca | London

This week, stock prices across Europe fell sharply in the wake of a major sell-off in China and a very substantial fall in US stock prices. Factors behind the Chinese and US sell-offs were widely seen to be a drop-off in demand for durables and concerns about mortgage debt (in the US) and government reactions to frothy and perhaps poorly regulated domestic stock markets (in China).

Here we briefly aim to assess what the potential impact upon the real economies in Europe might be from stock market falls triggered by worries about the US and Chinese economies; we also consider the more direct link between potential weakness in the US and China and economic demand across Europe. We do so by looking at the strength of two mechanisms. First, we make some educated guesses — back of the envelope calculations — about what changes in stock prices might do to demand for goods and services across Europe. Probably the main element of that transmission is the potential effect upon consumer spending of financial wealth being eroded. Another channel is through knock-on effects to investment if companies perceive that the cost of capital changes as equities tumble. But the evidence of any link between stock price changes and investment is too shaky to give us much confidence in the importance of that link; we suspect that it is weak in most European countries.

Second, we consider more directly the potential for weakness in the US and in China to hit export demand across Europe.  The scale of both effects differs across Europe, and so we look at different regions before drawing some overall conclusions.

The UK: Households are sensitive to stock prices…

The overall value of the UK stock market, as measured by the capitalisation of the FT all share index, is a little under 1.5 times the size of annual GDP. A significant part of the value of the overall index is held outside the UK. But UK households’ ultimate ownership of stocks is also boosted by very significant investments in overseas stocks. Overall, is it reasonable to assume that the value of stocks owned by UK households is about 150% of GDP — most of those stocks are held indirectly by pension funds and life insurance companies, and probably a third are holdings of overseas companies.

A rough guide to the knock-on effect of a change in stock market values to consumption is to assume that it changes consumption by roughly the product of the rate of return and the change in the value of wealth. (This is based on the simple idea that people with a long-time horizon who want to preserve wealth across generations would want to keep the real capital values steady, which means they can consume the real return on the assets.) Taking 4% as a central guess for the real rate of return would suggest that the impact on consumption of a given fall in the market value of equities is about 4% of the fall in market value. The UK market fell about 4% between February 26 and 28, which is about 6% of GDP. Using that rule of thumb would suggest a hit to consumption that will eventually be around 25bp of GDP. This is probably an upper bound on the likely impact, since many households will only be loosely aware of fluctuations in the value of stocks held on their behalf by pension funds and life insurance companies.

Simple regression analysis based on the past link between GDP changes and stock market changes across Europe suggest that the impact is probably lower for Europe as a whole than for the UK. But evidence from countries with a higher-than-average ratio of stock market wealth to GDP (e.g., Sweden) is broadly consistent with this estimate for the UK.

What about the more direct link between a sharp slowdown in the US and China and demand for output produced in Europe? Again the impact will differ across countries.

…but the economy is not heavily exposed to the US

For the UK, exports to the US make up about 2.5% of GDP; exports to China and to India are very much lower — about 0.25% and 0.2% of GDP, respectively. (In contrast, exports to the rest of Europe make up about 12% of GDP.)  So, it would take a very sharp slowdown in economic activity in the US and Asia to have a big effect upon demand for UK goods. A 10% fall in demand for UK goods from Asia and the US might knock no more than 30bp off aggregate UK demand.  In fact, the effect is likely rather smaller than that because some portion of exports to China and the US is really re-exports of goods with a heavy import component.

A worst case scenario for the UK

We conclude that a combination of a significant slowdown in US and Chinese demand, and a simultaneous fairly significant stock market sell-off, is not likely to have a dramatic impact upon the UK. But neither is the effect trivial; it is certainly possible to see UK growth coming in 0.5-0.75% weaker if we see a sharp (10%) fall in export demand from the US and an even sharper fall (say 40%) in exports to China, as a result of the recent stock price falls. Such a hit would come at a time when we believe that the growth of the economy is moving back from its recent slightly above-trend rate to slightly beneath trend. Were that to happen, the chance of further rate rises, which we already judge to be lower than is implied by money market prices, would fall much further.  

Euro area fundamentals are healthy

Circumstances matter: shocks hitting an economy already at the peak of its cycle or still in an early recovery stage are different.  In this regard, the euro area is in a relatively robust position.  The recovery started in 2005 and has gathered steam since then.  It is driven both by domestic demand (Spain, France and now Germany) and overseas exports, especially to Asia and oil exporters.  The spontaneous growth rate (that is, eliminating the impact of oil price changes and monetary tightening) of the euro area GDP was around 3.5% last year and seems likely to be similar this year.  The main headwinds are the restrictive fiscal policies implemented in Germany (VAT rate hike and other measures) and Italy (higher taxes, spending cuts).  So far, companies remain positive, because demand has not significantly slowed since the end of last year.  Nevertheless, we expect GDP growth to be weaker in the second quarter, as final demand in Germany suffers from a payback after the spending boom at the end of last year, due to advanced purchases of durable goods ahead of the VAT rate hike.  Going forward, we anticipate a re-acceleration of growth in the second half of the year, when the negative impact of fiscal retrenchments starts to fade away.  Depending on the resilience of domestic demand, which so far has been more robust than expected, euro area economies seem relatively insulated against external risks.  To what extent?  We look at each of the three risks mentioned above.

A 40% drop in Chinese imports would cut euro area GDP by 0.1-0.2%

Although EU exports to China have doubled over the last five years, they still take only 5.4% of EU exports, or 0.55% of GDP.  Data are in fact quite similar for the euro area alone.  Because the Chinese government is willing to slow fixed capital formation, currently absorbing 45% of GDP, what would happen if Chinese demand for European products, mostly capital goods, dropped by a large amount, say 40%.  At face value, GDP could be cut by 0.25%.  In fact, because exports have a high import content, the impact on GDP would probably be a fraction of this gross impact, between 50% and 80%, depending on which products would be most affected.  Accordingly, the net impact on GDP would be between -0.1% and -0.2%.  Not all countries would be equal in this regard.  For Germany the pain would be twice as high, compared to the average of the EU, given that German exports to China take 3.1% of all German exports, or 1.2% of German GDP.  A 40% drop in Chinese imports could thus cut German GDP by as much as -0.3%.

A 10% drop in US imports would cut the euro area GDP by 0.1-0.2%, too

The pattern of exports to the US is the mirror image of exports to China: US demand for European goods slowed in 2006, a consequence of the Fed action on domestic demand, but also of the depreciation of the US dollar.  Conversely, exports to the US continue to take the lion’s share of EU exports (23%, 14.5% for the euro area).  As a result, EU exports to the US generate 2.3% of EU GDP, on a gross basis, the ratio being practically the same for the euro area.  Calculations similar to those made about China show that the cost of a 10% drop in US imports for the EU or euro area GDP would be a cut by 0.1-0.2%.

In the euro area, the equity wealth effect is limited but not negligible

A permanent rise or decline in equity prices should have a temporary impact on GDP, via households’ wealth effects and changes in the cost of capital for companies.  A generally accepted rule of thumb for the euro area is that a 10% decline in equity prices would cut GDP by around 0.25%.  Given that overseas investors own a large share of the euro area market capitalisation (roughly half of it in Germany or France), this rule is probably at the upper limit of a realistic range.  Taking a more agnostic angle, we have performed a VAR simulation, that is, simulated the reciprocal statistical influence of GDP and real equity price changes on each other.  This simulation suggests that the actual sensitivity could be only half of the previous rule, that is, a 10% drop in equity prices would cut GDP by ‘only’ 0.15% after one year.

A worst case scenario for Euroland

A common factor, such as a credit crunch in the US caused by the meltdown of the sub-prime loans market, combined with the Chinese leaders’ policy goal to check fixed investment in their booming economy, could align the three negative factors we have just mentioned.  On our estimates, a sharp correction in Chinese productive investment, a credit crunch in the US and a further fall in equity markets (say -20%) would cut euro area GDP by 0.5-0.9% in the one to two years following the shock.  This would obviously be a tough test for the recovery and, with GDP growth likely to drop significantly below trend and deflationist risks rising, the European Central Bank would probably cut interest rates.  We are very far from there.


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Structural Capital Outflows from Asia Ex-Japan
March 02, 2007

By Stephen Jen and Charles St-Arnaud | London, London

While investors and commentators tend to focus on capital inflows when thinking about emerging markets, there has been a significant increase in capital outflows from AXJ countries.  In this note, we document this relatively recent trend, and argue that these outflows are likely to be structural in nature, and that over the medium term, these outflows will likely become a very significant factor, helping to support USD/AXJ.  In fact, 2007 may very well be the last opportunity to sell USD/AXJ as these outflows will likely grow in size, making it less necessary for the AXJ central banks to intervene and more difficult for investors to predict an unambiguous downward trend for USD/AXJ. 

Securities outflows from AXJ have increased sharply

Gross portfolio outflows from AXJ have risen drastically over the past decade.  From close to nil in 1996, portfolio outflows are now around 1.5% of GDP, and growing rapidly.  In fact, the four-quarter moving averages points to these net portfolio outflows being almost as large as net portfolio inflows, and shows that the rising trend in these outflows is more steady and definitive than that for capital inflows.  Simple extrapolation suggests that in the next two years, these portfolio outflows will become a very meaningful counter-weight to capital inflows. 

To the extent that most investors have been conditioned to think only about foreign portfolio investment in AXJ, they will likely be surprised by the inability of USD/AXJ to trade lower over the medium term if these portfolio outflows continue to rise, as we suspect they will. 

This trend is, however, not witnessed uniformly across the AXJ economies.  Korea and Taiwan stand out, as they have shown a particularly strong trend outflow.  Specifically, gross official outflows from Korea and Taiwan are currently averaging around 3.0% (1.5% bond outflows and 1.5% equity outflows) and 13.5% (2.5% bond outflows and 11.0% equity outflows) of GDP, respectively. 

Compared to the unweighted regional averages, which capture the divergence across countries, the weighted average outflows are still at a relatively modest 1.5% of GDP. This is due to the low level of outflows from China.  The rest of the AXJ countries have much stronger outflows.  The size of unweighted regional average outflows has reached 4-5% of GDP, implying that many AXJC countries are already experiencing net securities outflows.  On the other hand, the fact that the weighted and the unweighted regional average inflows have been quite similar in the past two years suggests that there has not been much of a divergence across AXJ countries on the inflows, but a lot more divergence on the outflows. 

Our theses for this structural trend

There are several possible factors behind this powerful trend.  We suggest the following hypotheses: 

Hypothesis 1.  Financial globalization.  As we argued in a previous piece (KRW: No Instant Satisfaction from Liberalization of Outflows, January 17, 2007), Korea and China have extremely low levels of private sector holdings of foreign assets.  In the case of China, this is clearly due to the legacy effect of it having been a communist country with a relatively closed capital account for much of the relevant past.  Capital account liberalization on outflows in China is a relatively recent event, and will likely have an impact on outflows only over time.  For Korea, we believe that the low level of foreign asset holdings by the private sector is the result of a combination of (i) Koreans’ intrinsic preference for Korean assets, i.e., the so-called ‘home bias’ that Japanese investors have until recently also demonstrated and (ii) restrictions on capital outflows.  However, as the Korean authorities rapidly liberalize these restrictions, and as Korean investors start to have an increasingly global view on asset holdings, commensurate with their real economy’s exposure to the global economy, we expect private capital outflows to steadily increase. 

Private sector capital outflows are already high in Taiwan (RoC), but will likely stay high.  The Central Bank of China (CBC) in Taiwan now has US$266 billion in foreign exchange reserves, and does not have a particularly strong desire to raise this figure.  Similar to other central banks in Asia, Taiwan is likely to already possess more reserves than it needs for liquidity purposes.  What is different from the rest of Asia is that the CBC has stringent restrictions on personnel that are a serious obstacle to the CBC setting up a GIC-like institution to invest the ‘excess reserves’ in more creative ways.  This limitation has forced the CBC to encourage private sector capital outflows.  The bulk (85%) of these outflows, as we indicated above, are equities, not bonds.  This is important, as Taiwan has the second-lowest interest rate in Asia, yet the massive outflows are equity-centered.  Those who are fixated on ‘carry trades’ should take note of the fact that the outflow story in Asia, including Japan, is about much more than just ‘carry trades’.

Hypothesis 2.  The low-return environment forcing greater risk-taking.  The low-return environment has forced not only Japanese but also other Asian investors to adopt riskier investment strategies, including increasing their investment exposure to foreign assets.  The same motivation has also affected the AXJ central banks’ investment strategy, as low returns on sovereign bonds is one of the reasons behind the emergence of the sovereign wealth funds, in our view. 

Hypothesis 3.  Demographic reasons.  This is a theme that we have also discussed with regard to capital outflows from Japan, that the combination of ageing and longevity has led to savers seeking higher-return portfolios in order to (i) retire on time or retire early and (ii) still be able to fully protect their lifestyle, even with a higher life expectancy.  We note that this hypothesis is in stark contrast to the widely accepted view in academia that an ageing population should lead to a rise in risk aversion and a preference for bonds over equities, and therefore an increase in the equity risk premium.  However, what has actually happened in practice is precisely the opposite.  In fact, there has been a broad-based increase in risk-taking around the world, not just from the private sector investors in AXJ.  We suspect that the combination of ageing, the low-yield environment and persistent upside surprises on life expectancy over the past decades has led to a fundamental shift in investment behaviour from a group of investors traditionally considered risk-averse.  The low-volatility environment has further encouraged riskier investment strategies. 

These three hypotheses are not mutually exclusive, and we believe at this point that all three will continue to be important propellants behind the trend being discussed. 

Japan: the issue is broader than the ‘JPY carry trades’

There is a great deal of fixation on the so-called ‘JPY carry trades’.  However, we believe that capital outflows from Japan — both equities and bonds — are a structural story, as we have discussed in this note about AXJ.  Carry trades, or the interest rate-sensitive flows, are only a part of the broader, more structural story.  For example, of the investment trust flows that investors track, a sizeable portion are actually equity flows, and therefore have nothing to do with the interest rate differentials.  Often the media and analysts mix up these different types of outflows from Japan and erroneously refer to them as ‘carry trades’.  (For example, we’ve seen estimates of the size of the JPY carry trades that include all foreign asset holdings by Japanese investors.) 

Not acknowledging the distinction between capital outflows and carry trades will lead to (i) an over-emphasis on yield differentials and (ii) an over-emphasis on cyclical rather than structural considerations. 

Bottom line

Portfolio outflows from some AXJ economies are large and rising.  We believe that this is a powerful and structural trend and something that will become an important factor for the currency markets in the medium term.


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United States
Does Market Turmoil Change the Outlook?
March 02, 2007

By Richard Berner and David Greenlaw | New York, New York

Financial conditions — the composite of interest rates, stock prices, credit spreads and credit availability, and the dollar’s value — have been generally supportive of US economic growth over the recent past.  But financial-market turmoil this week spread broadly beyond subprime mortgages, potentially undermining that support for economic activity.  The government–induced selloff in Chinese equities merely provided the match; we agree with our colleague Henry McVey that the kindling more fundamentally included indiscriminate bullishness, weak economic data, a flurry of earnings downgrades, and fears of spreading credit woes.  In our view, while these developments increase the downside risks surrounding the outlook, they don’t materially change it.

Among the reasons: Financial conditions have become slightly more restrictive, but that move only partly reverses conditions that had been supportive of growth.  Beyond the subprime meltdown, more credit dislocations are likely, but the odds of a systemic credit crunch are remote.  In addition, the non-financial supports to growth — including healthy consumer income gains and still-vibrant growth abroad —are essentially intact.  Finally, this shock combined with somewhat weaker growth could be disinflationary.  While that isn’t priced into markets, and inflation probably will only gradually drift lower, marginally reduced inflation risks would help economic performance and eventually allow the Fed to ease monetary policy.

While these developments may increase near-term downside risks to the economy, they slightly reduce risks for financial markets, if only because the sharp declines in risky asset prices have taken some froth out of equity and credit markets.  In turn, reduced market risk could limit the threat to economic activity from tighter financial conditions.  However, investors should not take that as a green light to buy.  Rather, the message is more nuanced: At the margin, credit quality and liquidity will probably continue to deteriorate, and not all the bad news on that score is yet in the price.  It seems obvious now, but the longstanding message from our equity, credit and FX strategy teams that investors should continue to move up the quality scale is as important as ever.  The trade is no longer costless but the risk-reward is still favorable.

Prior to this week’s developments, in our view, rising equity prices, low and declining term premiums and volatility, their beneficial influence on corporate credit spreads, ample credit availability and an ongoing decline in the dollar’s real, effective exchange rate fostered financial conditions supportive of growth.  Those factors more than offset a neutral or slightly restrictive monetary policy and deteriorating subprime mortgage credit conditions.  Logically, a reversal of several of those factors could tip the balance to some financial restraint, certainly relative to the full-throttle support of the past year. 

How do we calibrate that financial stimulus?  Some compile a financial conditions index as a weighted composite of changes in asset prices.  We prefer a combination of models assessing interest rate, currency and wealth effects, and judgment.  Financial conditions indexes do help us cross check our judgment and models; for example, a model-based index from Macroeconomic Advisers was still in positive territory at the end of 2006.  But even such sophisticated indexes may understate the financial prop to growth, because they miss the contribution from tighter lower-rated credit spreads and credit availability. 

Moreover, whatever the metric, gauging the impact on economic activity of financial conditions is problematic because the linkage works both ways: What happens in markets strongly influences growth, but current economic conditions (and more importantly, those expected in the future) materially influence the market’s expected path for monetary policy and asset prices.  Unraveling that interplay is the key conundrum for assessing what’s in the price. 

Fears that a credit crunch in combination with mortgage resets will choke off borrowing in our view are overblown (see “Will the Subprime Meltdown Trigger a Credit Crunch?” and “Credit Crunch Watch”, Global Economic Forum, February 12 and February 26, 2007).  To be sure, the subprime meltdown continues — and lenders have already tightened mortgage-underwriting standards over the three months ending in January, according to responses to the latest Fed survey of senior loan officers.  Lending standards will continue to tighten, albeit less for prime borrowers. 

There will also be regulatory changes.  Regulators will issue subprime lending guidelines soon, and effective September 1 Freddie Mac will stop buying subprime loans with teaser rates.  Congress likely will enact legislation aimed at reducing predatory lending practices.  And the combination of subprime carnage, heightened volatility and reduced liquidity is widening spreads across the board; for example, over the past week, investment-grade and high-yield CDX spreads widened by 3 basis points and 10 bps, respectively, while single-A and BBB-rated cash CMBS spreads widened by 3 bps and 25 bps.  While some rational restraint in mortgage lending may well flatten the trajectory of the eventual recovery in the housing market, it obviously creates a healthier environment over the long run.

And unlike the more broadly based credit crunch of the early 1990s, there has been no sign of any noticeable swing toward restraint in other types of bank loans.  For example, standards for business lending, credit card availability and other types of consumer borrowing are all little changed of late — in sharp contrast to the noticeable tightening that was evident in these products during the earlier period.

Regarding payment reset shock, the Mortgage Bankers Association estimates that between $1.1 and $1.5 trillion of adjustable rate mortgages (or about 10% of the overall mortgage market) will reset this year.  A reset might be extremely painful for certain borrowers, but we estimate that the resets in the aggregate will add only about $15 billion to household debt service — representing less than 0.2% of personal income.  This is consistent with reports that the subprime problems that have surfaced to this point are largely a reflection of so-called early payment defaults — usually associated with fraudulent activity and inappropriate underwriting — as opposed to a fundamental deterioration in household cash flows. 

In our judgment, therefore, the market selloff and wider credit spreads end for now the easing in those components of financial conditions; and thus are a minor negative for growth — one that could of course grow with further market declines.  Beyond the modest increase in financial restraint, moreover, market volatility creates uncertainty, and uncertainty can be the enemy of growth. 

But in our view, three factors represent critical offsets.  First, courtesy of financial-market deregulation and innovation, the sensitivity of the economy to changes in financial conditions is more muted than commonly thought.  For example, rules of thumb and models such as the Fed and we use suggest that a sustained 100 bps decline in interest rates would, after a year, boost spending on consumer durables by 1.7 percentage points, on housing by 4.8 points, and on equipment investment by 1.3 points.  The influence of changes in stock-market wealth is comparatively small; a 20% increase in such wealth might boost consumer durable outlays by 0.9%.  Those “partial equilibrium” impacts ignore feedback and the interplay among these factors, so their overall influence on growth may be smaller yet (see David Reifschneider, Robert Tetlow and John Williams, “Aggregate Disturbances, Monetary Policy and the Macroeconomy: The FRB/US Perspective,” Federal Reserve Bulletin, January 1999).

Second, changes in financial conditions affect the economy with a lag, and the earlier improvement in financial support is still working its way through the economy.  After all, stock prices are at this writing back to November levels but are 9% above year-ago levels.  Finally, the decline in risk-free rates — albeit one fueled by a flight to quality as investors bail out of risky assets — is a shock absorber that lessens the depressing impact on growth of the widening in credit spreads, the decline in stock prices and the unfolding move by lenders to tighten credit.

The last offset is that this shock and somewhat weaker growth may be disinflationary.  A further stock-market decline could escalate the uncertainty surrounding the outlook, weigh on business confidence and thus depress perceived pricing power and inflation expectations.  More fundamentally, the increase in economic slack resulting from a prolonged period of sub-par growth could reinforce that effect on inflation, even though the slack-inflation linkage is looser (the Phillips curve is flatter) than in the past.  If inflation and inflation expectations come down, that will be positive for market and economic performance.  And this would eventually — and we stress eventually — allow the Fed to ease monetary policy. 

Markets are already pricing in a 60% chance of a Fed move by June, based on fears of weaker growth, hopes for lower inflation and in response to market turmoil.  Don’t expect one.  The markets’ growth fears in our view are exaggerated.  Although fourth-quarter growth was revised sharply lower to 2.2%, Chairman Bernanke noted that the revised data were “more consistent with our view of the economy.”  First-quarter growth now looks weaker than most market participants (including us) expected; we now track it at a 2¼% annual rate.  But the winter weakness does seem to reflect the weather-induced “payback” in home sales and housing activity that we have been expecting, and it is perhaps close to Fed forecasts.  Far from being alarmed by sub-par growth, the FOMC likely welcomes its disinflationary implications. 

Downside economic risks are now marginally higher because financial conditions are slightly less growth-supportive.  Conversely, market risks may now be lower because the price action has taken some of the froth out of the equity and credit markets.  But market volatility will test that thesis: Risk has returned, and it’s far from certain how far the pendulum will swing in the other direction.  Unlike last May, investors seem less likely to buy on the dip and now will probably be more discriminating.


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First Signs of Recovery for Low-Income Groups
March 02, 2007

By Deyi Tan and Chetan Ahya | Singapore, Mumbai


Rising income and wealth inequality combined with the poor per capita income growth trend for low-income households has continued to be one of the most debated subjects in the context of Singapore’s growth trend.  Recently announced household income data hold some positive news in this regard.  Five straight years of economic expansion, including three years of above-trend growth, have resulted in the lowest-income decile group finally seeing its income rise 6.6% YoY in 2006 following a long period of decline.  In our view, the key reason why this group has witnessed an increase in average income is because of more members in lower-income households finding employment, not higher wage growth.  Hence, we believe that this recovery could be short-lived and we could see a reversal in line with the deceleration in growth we expect over the next two years.  Wage growth at the bottom still remains structurally weak.  We see a low probability of a meaningful recovery in private consumption spending.

Bigger pie, but highly unequal distribution

Riding on the support of the unusually strong global growth cycle, Singapore’s GDP growth has risen at an annual rate of 6.1% in the past five years.  However, the income distribution has been highly uneven.  Not only has real wage growth mostly lagged productivity gains in the aftermath of the 2001 slowdown, but income inequality has also been gradually widening. Income inequality, as measured by the Gini coefficient index, has worsened from an already high level of 0.49 in 2000 to 0.52 in 2005.  We believe that wealth inequality would have also further widened sharply over the last few years, considering the large disparity in the property price trend in lower and middle income group residential housing.

First signs of income recovery at the lower deciles

Higher-income deciles saw their incomes rebound almost immediately after the economy suffered in 2001-02.  Middle-income deciles have followed, albeit really picking up pace only in 2005.  However, the good news is that families at the lowest decile, who saw their incomes contract until 2005 despite consecutive years of strong economic growth, finally saw a reversal in 2006.  The lowest income decile saw its income per household member rise 6.6% YoY in 2006, markedly closing the growth gap between the top and lowest sections of the society.  Income in the middle-range sections has also further picked up pace.

Job growth in low income segment is improving...

The reason for the staggered income recovery is simple.  The labour market has been undergoing a structural shift.  The move towards higher value-added activities has led to a squeeze on jobs in the middle-lower/lower rungs.  Job gains have been primarily concentrated in the PMETs (Professionals, Managers, Executives, Technicians) segment in the past 10 years.  Also relevant is the fact that lower-skilled workers are typically the first to be retrenched during a bad patch but slow to be re-hired when things rebound.  With the economy on a sustained growth path for the last few years, job elasticity with respect to growth has picked up decidedly.  Businesses are getting more comfortable about hiring, and this is especially evident in terms of the increasing job vacancies at the lower tier.  More lower-income section jobs have translated into a recovery in household income at the lower end.

...but wage growth remains weak

While the average monthly income from work per household member recorded growth in 2006, this was primarily on account of more members in the family getting employed rather than an acceleration in wage growth.  Globalisation has led to inevitable repercussions for labour returns as streams of cheap labour flood the global market.  As mentioned previously, wage growth has systematically lagged productivity growth in the past few years to maintain cost competitiveness (The National Wages Council also recommends “that built-in wage increases should continue to lag behind productivity growth in order to be sustainable and to maintain our cost competitiveness”.  Indeed, the wage remuneration share (% of GDP) has fallen to a low of 40.9% from the peak of 47%, even lower than the trough of 41.4% in 1999.

The recovery in job growth is good news.  However, considering that the recovery appears to be more cyclical and also lacks the support of wage growth, it is unlikely to start a major acceleration in private consumption growth in the lower and middle-income sections of the population.  We believe there are structural issues facing the lower-income decile families.  First, job growth in this segment has tended to be weak.  Second, wages have been stagnating.  Third, they continue to face a rising inequality compared with the upper-income sections. 

Government schemes do help, but it’s not enough

Cognizant of the income inequality in the system, the government has taken steps to accelerate income growth for the lower-income segment of the population, starting from the Progress Package[1] last year to making the Workfare system a permanent feature of the social security system this year.  The Workfare Income Supplement Scheme[2] (WIS), recently announced in the budget, will speed up income growth, especially for lower-waged and older employees.  This is achieved through income supplements from the government conditional on regular work, underlining the government’s caution of being too much of a welfare state even as it moves toward some sort of a social security system.  Workfare income supplements will be given in cash and into Central Provident Fund (CPF) accounts.  However, the ratio (1:2.5) is skewed towards the latter.  To that extent, the WIS is aimed at preparing old workers for future needs rather than boosting current spending power.  Also, the amount allocated for this is not much — S$200 million (around 0.1% of GDP).

Conclusion: No major consumption spurt underway

The absence of a full-fledged recovery in the lower-income section of the population is one of the reasons why consumer spending has remained subdued even as GDP growth was very strong.  We believe that a benign change is taking place in terms of the income landscape on the mass market end. However, any effect on spending power will likely be gradual and capped.  Job growth would be limited as cyclical prospects turn less favourable.  Indeed, even as the government tries to improve income for the lower-wage sections, it is likely to maintain its focus on competitiveness.  This is exemplified by the recent amendment in the Budget, which reduces an employer’s compulsory contribution to the Central Provident Fund. 

[1]The Progress Package was introduced in the FY2006 Budget to distribute budget surpluses back to people. It comprises of i) growth dividends - essentially cash handouts, ii) Workfare Bonus - income bonus for old, low-waged workers conditions on regular work and iii) others such as rebates and top-ups to pension funds and healthcare funds for older workers.


[2]The Workfare Income Supplement (WIS)Scheme (FY2007) is a continuation of the Workfare bonus implemented in FY2006. It is targeted at workers aged 35 years and above and conditional on regular work.

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Looking for a Free Lunch Again
March 02, 2007

By Takehiro Sato | Frankfurt

No free lunches, but…

The market has reacted as if it has exhausted all potential monetary policy issues for some time immediately after the February rate hike, but the corrections in asset markets worldwide since the end of last month have changed everything. We had been uncomfortable with the growing speculation even after the rate hike that yen carry trades would continue for a considerable future. We think the exuberance and its reversal, stemming from overblown expectations that yen carry trades would continue to be profitable for an extended period, are a reminder that there are no free lunches. That said, it depends on the timing.

The yen should ordinarily strengthen in a disinflationary environment, but having increasingly deviated from fair value, it was increasingly vulnerable to a reversal based on interest parity theory. In this regard, we find the latest yen appreciation comforting.  Since the rally in TOPIX to above 1,800 set off warnings, in light of our strategist colleague Naoki Kamiyama’s estimate of TOPIX’s fair value of 1,750-1,800, based even on our optimistic corporate earnings forecast, the latest market correction does not change our constructive market outlook, even factoring in the possibility of a slight undershoot.

The two sides of the argument that rate differentials determine exchange rates

What comes to mind as a result of the carry trades is the double-sided nature of Rudiger Dornbusch’s argument that interest rate differentials indicate the absolute level of as well as changes in exchange rates. If rates in Japan are relatively low, for example, the yen should be weak. Yen carry trades are aimed at capitalizing on such rate differentials and are premised on yen weakness in light of rate differentials. According to interest parity theory, however, changes in exchange rates from now until some point in the future are determined by rate differentials; if rates in Japan are relatively low, arbitrage rates should work in favor of yen appreciation. In other words, with rate differentials, the yen should be weak in the short term but strengthen later. Such rate changes should offset the benefits of yen carry trades. In these ways, interest rate differentials mean that exchange rate moves in the short term should be completely different from those in the future, and contribute to sudden shifts in the forex market from time to time.

Rate differentials have so far led to yen depreciation, but the correction in stocks actually led to short-term yen appreciation because arbitrage rates based on the differentials point to yen appreciation. Given the considerable rate differential, the yen could still weaken from the perspective of a grand cycle, and we see the recent decline in USD/JPY as a fairly major speed correction. In this regard, we recommend buying on weakness if the rate pulls back to around ¥115.

Keeping an eye on the stock market with a buying stance

As for the stock market, other than some overheating in the real estate sector and other asset plays, we did not see much problem with the level of market indices as Japanese stocks started to look like attractive catch-up plays in late 2006 and then played catch-up until recently. The lack of visibility on US durable goods orders and the housing market correction is likely to exacerbate the trend toward risk reduction that started with the plunge in Chinese stocks. However, we agree with our US economics team’s consistently upbeat stance on the US economy. Thanks to fat profit margins, the corporate sector has become better able to weather external shocks. The household sector, meanwhile, has been supported by strong employment and income conditions, including substantial qualitative improvement in incomes. We accordingly do not see any risks of a recession. While recognizing that it would be a stretch to apply this economic outlook to the outlook for the market, we recommend looking for buying opportunities during this correction.

Risks for the above scenario include the trend in US inflation during a temporary slowdown for the economy. In recent testimony before Congress, Fed Chairman Bernanke expressed optimism on inflation, and the market has hardly priced in inflation risk. Instead, the US bond market rallied in the past few days on a flight to quality. Based on conventional economic theory, however, it is inconceivable that inflation will slow down nicely even as wage growth continues to rise because of tight labor market conditions and corporate profit margins continuing to increase. Even with an economic slowdown, albeit a temporary one, we think one risk is that wage growth will lead to an acceleration in unit labor costs and push up inflation. One possible explanation for the previously noted puzzle is that GDP is actually growing at a faster pace or, stated differently, productivity growth is stronger than the data indicate. This is difficult to prove, however. Assuming this is the case, we think the Fed could be behind the curve and risk assets would be subject to further downward pressures. A rise in US long-term yields could ironically put upward pressure on the yen, contrary to the typical assumptions behind the carry trade.

This scenario is not our main one, but by keeping these risks in mind and sticking to a fundamental buy-on-weakness stance, we like to think it is possible to get through this latest meltdown.

Time to anticipate recovery in cash flow dynamics

Finally, we expect the recent rally in the bond market to continue into the new fiscal year. There is no shortage of factors supporting JGB prices. Negative readings for the change in the CPI in Japan look likely. The January nationwide core CPI rate has fallen to 0% YoY, and we estimate that it could be negative for February (to be released on March 30), with the negative margin likely to widen for March. This release, in April 27, will come out on the same day as the BoJ’s April Outlook for Economic Activity and Prices. In its statement on its latest rate hike decision, the BoJ mentioned, as an excuse for doing a premature rate hike, that CPI growth could stay around 0% for some time but the medium-to-long-term perspective remains positive. That said, we think it would be ironic if the CPI’s negative margin widens on the morning the outlook report is released. A downward revision of the BoJ’s CPI forecast looks almost certain for the April outlook report, and if the recent trend toward risk reduction continues, a rate hike would be out of the question.

Given that the February rate hike came right on the heels of the GDP release, the market’s consensus expectation for the next rate hike is August or September, after the upper house elections and the release of the April-June GDP data. However, we think that the BoJ is likely to keep its policy rate at 0.50% for the rest of the year and may not raise rates again until April-June 2008, when prices may rise due to an easy comparison once the negative YoY growth in energy prices dissipates. 

We accordingly believe that JGB investors no longer need to be concerned about another BoJ rate hike, particularly in light of the global correction in asset markets, and with the likelihood of a pick-up in JGB buying to capture the carry ahead of the new fiscal year, they should instead be concerned in the near term about the possibility of long-term yields declining too much. Banks are apparently going back quietly to the bond market because of weak lending growth. We would anticipate a recovery in cash flow dynamics, and would say don’t miss the ride.


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The New Sick Man of Europe (Part 1)
March 02, 2007

By Eric Chaney | Paris

[This is an excerpt of a more comprehensive report co-authored with Morgan Stanley European equity strategist Ronan Carr and including contributions from European equity analysts covering companies sensitive to the French markets.   Entitled “French Elections: A Guide to Investors”, the report is available from your usual Morgan Stanley contact.]

After Germany, then Italy, it’s France’s turn

In 2001, Germany was dubbed the ‘sick man of Europe’.  Two years later, Italy took the baton and pundits started to speculate about Italy kissing goodbye to the euro.  In each case, slow growth, high unemployment and competitiveness issues seemed to be intractable.  Since then, Germany has caught up with its neighbours, regained its #1 rank in global exports and is now at the forefront of EuropeItaly, although not totally out of the woods, posted a GDP growth rate last year almost twice as fast as its post EMU trend.  So which economy is going to wear the ‘sick man of Europe’ shirt now? Among the larger euro area economies, the answer is in my view unambiguous: it is France.  Four macro indicators illustrate the weakness of the French economy: GDP growth, exports, unemployment and public finances.

GDP growth: From middle ranker to underperformer

In the four years before EMU, average French GDP growth (2.2%) was comparable to the average of the euro area (2.3%). In the six first years of EMU, France did slightly better at 2.1% versus 2.0% for the euro area.  However, the underlying picture was deteriorating in relative terms.  With the come-back of Germany and Italy, French GDP growth dropped 0.8pp below the EMU average in 2006, without any particular macro factor explaining this underperformance.  By definition, the exchange rate was the same for all euro area countries, and real interest rates were very close too, since inflation differentials were marginal — 0.3pp lower in France than in Italy and 0.1pp higher than in Germany.  Last, fiscal policies were slightly restrictive in the three countries.  Although losses in structural competitiveness do not appear all of a sudden in growth performances, they constitute a legitimate suspect to explain France’s underperformance.

Exports: Losing ground since 1999

In a country with a long tradition of mercantilism — imports are vilified; exports glorified — foreign trade data are closely scrutinised by government and private experts.  The sharp rise in the trade deficit in 2005, to €22.9 billion from €4.8 billion in 2004, was not unnoticed.  Of course, it was only partially explained in terms of trade changes, namely more expensive energy products.  Actually, the trade deficit worsened again in 2006, reaching €29.2 billion, or 1.7% of GDP.  By itself, a trade deficit is not a symptom of macro illness (nor is a government budget deficit).  Diverging domestic demand growth between countries having similar productivity and cost trends generates temporary surpluses and deficits, with temporary maybe meaning several years.  That Germany and Japan have large trade surpluses is largely explained by the slow growth rate of their populations and of their domestic demand.  That is why it is more revealing to look at export performances.  In my view, the reality check is given by the relative export performance of each EMU participant in euro terms and on foreign markets, so that domestic demand differentials do not bias the comparison.  On that count, France’s performance is alarming: since the beginning of the monetary union, the share of French exports outside of the euro area, relative to euro area exports, dropped by 18% (as of 4Q06), while the share of Germany’s exports increased by 15% and Spanish and Italian shares were roughly unchanged.  Among the factors possibly explaining the dismal performance of French exports is the deterioration of cost competitiveness vis-à-vis Germany (a long overdue reversal after France’s strong relative performance in the aftermath of the German unification) but not vis-à-vis Italy and Spain.

It’s not exports, it’s globalisation, stupid

Other, more structural factors must have weighted on French competitiveness, such as product and geographical specialisation.  In their comprehensive report to the Council of Economic Analysis, Patrick Artus and Lionel Fontagné found in particular that French exports have a low income elasticity, compared to other large exporters, which is clearly a disadvantage when global trade is booming as it currently is.  Arguably, the disadvantage should turn into an advantage during a downturn.  Unfortunately, France did not perform better during the 2001-03 downturn.  In my view, the poor export performance of French companies is the result of poor, or slow, adaptation to the rapidly changing environment resulting from globalisation.  At this stage of the globalisation process, the challenge for companies in high income countries is mostly the abundance of cheap labour in a context of ever lower trade costs.  Pr. Richard Freeman of Harvard University encapsulated the new challenge in his now famous concept, “The great doubling”.  He calculated that the victory of capitalism in Eastern Europe, Russia, China and India has increased the size of the workforce that is potentially available for the global market economy from 1.5 to 3 billion.  Almost every single industry in the traded economy is affected.  Winning corporate strategies, now well documented, are first innovation, second outsourcing.  Both are intimately linked: outsourcing without innovating makes companies excessively sensitive to cost and political competition in the new markets, while innovation without mass production facilities in new markets reduces the return on innovation.  French companies are lagging on both counts.  According to the 4th Community Innovation Survey recently released by Eurostat, only one-third of French companies have innovation activity, versus 43% in the UK, 50% in Sweden, 51% in Belgium and 65% in Germany, the leading European economy in this regard.  As for outsourcing, France is also lagging, as shown indirectly by the decrease of the share of imports in intermediate consumption in the manufacturing sector (-1.2 pp from 1995 to 2000).  By contrast, Germany (+4.6), Sweden (+3.4) and Italy (+2.0) have all increased imported inputs, which has helped to cut costs and improve competitiveness, although, it is often argued, this has not helped create jobs.

Unemployment: France is champion in the euro area

When unemployment rates are measured with harmonised rates instead of national ones, the verdict is appalling for France: in December 2006, Eurostat ranked France (8.5%) at the bottom of the euro area classroom, together with Greece (8.7%), and I would not be surprised to see Greece outperforming France in the next quarterly labour force survey.  Despite massive government spending (2.7% of GDP in 2004, according to the OECD’s Employment Outlook, December 2006), France has a much higher unemployment rate than Denmark or Italy, which spend about the same amount of taxpayers’ money on employment policies.  Policies aimed at reducing the tax wedge for low wages (that is, subsidies offsetting payroll taxes) have helped to reduce the unemployment rate for unskilled workers, but a significant part of these subsidies are used to offset the consequences of the increase in labour costs consecutive to the reduction in working hours.  With the benefit of hindsight, this particular aspect of the French policy has failed to cut unemployment: France was the only country to use this policy in the euro area and, yet, France has now almost the highest unemployment rate.

Government debt is ballooning …

Since 1990, the gross public debt (general government concept) has almost doubled as a percentage of GDP, rising from 35% to 67% in 2007 (65.4% in 2006, on our estimates).  Stabilising the debt to GDP ratio with a 2% GDP growth rate would require keeping the budget deficit no higher than 2.5% of GDP, or the primary balance at equilibrium, going forward.  This might look relatively easy, in comparison with the challenges facing the Italian government, for instance.  However, past experience shows that it is far from warranted: from 1995 to 2006 (President Chirac’s years), the primary balance averaged -0.3% of GDP.  Yet, the real challenge for policy makers is the demographic transition.  Including gross pension liabilities raises the public debt to roughly 120% of GDP, according to the Pebereau report on public finances.  If policy makers want to increase the room for manoeuvre within budgetary policy, they must invert the debt snowball effect.

… and big government is alive and well

In the 1970s, big governments were the dominant model in Western Europe: the Great Depression and the Second World War had yielded a broad consensus about the role of the government in fine-tuning economic growth and distributing the benefits of fast productivity growth to workers and retirees through social protection and welfare grants.  That was then.  Productivity running at 4% per annum was the result of Europe catching up with the US in terms of technology.  Once Europe got closer to the technology frontier, in the mid-1970s, productivity slowed dramatically.  Because social and political paradigms are much slower to change than supply curves, big governments continued to grow for some time, until, in most countries, the fiscal pendulum started to move in the opposite direction.  There was one exception: France.  Since 1995, the share of the government, measured by government outlays as a percentage of GDP, was roughly constant at 54%, while it declined by 4% in the euro area.

[In the second part of this piece, I identify four key areas for reforms, which I think should be at the top of the next president’s agenda.]


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