France
The New Sick Man of Europe (Part 2)
March 06, 2007

By Eric Chaney | Paris

  [This is an excerpt from 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.]

Is it serious, doctor?

The macro and micro diagnosis detailed in Part 1 are serious.  If France wants to avoid economic marginalisation, a decrease in standards of living and political troubles — confrontation between the haves and the have-nots, such as in 2005 — I believe that the next president will have to address four key issues: labour market, size of the government, role of the government in the business environment, and innovation.

1. Labour market(s)

Currently, the labour market is split between ‘insiders’ (civil service, state-owned companies, indefinite contracts) and ‘outsiders’ (temporary and short-term contracts, internships). The former is excessively rigid, which discourages companies from hiring on a permanent basis, because of high ‘shadow’ firing costs (legal battles, negotiations with unions, regulatory uncertainties).  The latter is highly flexible and used by companies, but it is negative for human capital accumulation and is generating intense frustration in the workforce.  Access to the insiders’ market looks like an unrealistic dream for outsiders.  The 35-hour working week and the tax wedge (gap between cost and labour income) are making things worse.

Desirable reforms: Simplify the long list of legal labour contracts and make layoffs easier.  Help the unemployed to find jobs.  Make unemployment benefits conditional to active job search.  Reduce payroll taxes for all wage earners.  Abandon the concept of legal working hours.  Remove progressively all ‘threshold effects’ (for instance, the obligation to set up a social council for companies having more than 50 employees). 

2. Government size

France is the only country in the euro area which has not reduced the financial weight of the government over the last ten years.  At close to 54% of GDP, public spending and social transfers reduce the incentive to work and innovate and generate inefficiencies. 

Desirable reforms: Take advantage of retirements to cut the civil service headcount (note that this implies more flexibility: there are areas, such as justice or employment search, where more, not fewer, civil servants are needed).  Allow civil servants to work and earn more.  End the free-lunch principle, which is the foundation of the medical insurance system.  Cut inefficient employment subsidies (government-sponsored jobs).  Use each euro saved in welfare spending to cut payroll taxes in order to initiate a virtuous employment circle.

3. Government role and business environment

The government (central and local) remains highly involved in the economy, not only through large stakes in various companies, public utilities in particular, but also through heavy regulation and by erecting legal or political obstacles to foreign ownership of French companies.  The latter (‘economic patriotism’) is negative for restructuring and innovation.

Desirable reforms: Full privatisation of companies where the government still has minority stakes. Privatisation of public utilities (EDF-GDF, post office and railways).  Liberalisation of excessively regulated sectors such as retail and services, including healthcare (entry barriers, opening hours, weekend shopping, quotas).  Commitment to avoid interfering with businesses regarding management and ownership (except strategic sectors such as defence).  Commitment to cut obstacles for start-ups: cut average time to set up a new company to 48 hours, with one single administrative counterpart.

4. Innovation

Innovation is probably the most important single factor explaining long-term growth.  Pr. Aghion and Acemoglu (Harvard-MIT) show that the marginal product of innovation is higher for economies close to the technology frontier than for those still far from it.  In this regard, the EU lags the US and the gap seems to be widening.  Within the EU, French performance is relatively good (measured, for instance, by patents), although it is well behind Germany.  Obstacles to innovation are multiple.  Fundamental and applied scientific research is bureaucratically managed, both in specialised research bodies (CNRS) and Universities: seniority is often more important than quality, public funding is not efficiently allocated and private funding dramatically insufficient, for lack of incentives and flexibility.  Successful tech start-ups, although more encouraged than before, have been experiencing serious difficulties achieving growth after the initial stage.  Corporate (national and local) taxes and capital gain taxes for individuals reduce the incentive to grow businesses in a world of high capital mobility.

Desirable reforms:  In-depth reform of CNRS and similar research bodies in order to stimulate competition, to reward talent rather than seniority and to let private capital flow in public laboratories.  More autonomy to Universities, including setting tuition fees.  Cut red tape for start-ups.  Progressively cut the corporate tax rate and capital tax gains (for individuals) to 20%.

 

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Poland
NBP in Data-watching mode, as Labor Market Tightens
March 06, 2007

By Pasquale Diana | London

The recent economic data flow in Poland has surprised the analysts and the NBP on the upside, with IP and retail sales both showing booming growth at the start of 2007. Together with a stronger end to 2006, the activity data have prompted an upgrade in our 2007 GDP forecast from 5.3% to 6.1%. As the NBP notes, favorable weather conditions at the start of the year likely played a role, and some payback in the coming months is on the cards. That said, there is little doubt that this is going to be yet another year of above-potential growth in Poland. Strong FDI and investments, whose contribution to GDP growth has been rising steadily and reached an impressive 5.1%pts in 4Q06, have expanded the economy’s supply side and increased its growth potential. Even so, there are signs that pressure on resources is intensifying. Capacity utilization in industry is running at an all-time high, and businesses are having trouble finding qualified labor.

Looking at the labor market in particular, the latest LFS quarterly data show that the jobless rate dropped to an all-time low of 12.2% (note that this is around 3% lower than the monthly stats office rate, due to methodological differences)[1].  As we pointed out in previous research, employment creation on its own is not sufficient to explain the steep drop in unemployment. The data show a steady increase in the number of people that have left the labor market and become inactive, which has lowered the unemployment rate more than the employment numbers alone would have suggested. This is likely because many Poles left the labor market due to migration abroad. On that note, anecdotal evidence suggests that migration flows to Western Europe are underestimated. If that is the case, and more people have exited the labor market than the statistics suggest, the job market might be even tighter than the official figures suggest.

A tighter labor market is translating into higher wage pressures. Private-sector wage growth stood at 7.8%Y in January, down from December’s bonus-related spike of 8.5%Y, but still much faster than analysts’ expectations of a drop to 6.6%Y. According to NBP calculations, wage growth ex-bonuses continued on its uptrend, from 6.2%Y in December to 6.5%Y in January. Looking at the trend, private sector wage growth has been rising steadily since mid-2005. The acceleration is particularly evident in sectors such as construction (which has seen the highest outflow of labor to Western Europe), where labor shortage has reached record-high levels.

NBP in data-watching mode, but on hold throughout 2007

The NBP has sounded understandably alarmed about the pace of wage growth for a while now. As it noted in its last statement, strong wage growth can only be sustained on the condition that it does not outpace labor productivity growth. Strong productivity in the industrial sector (latest: 13%Y in January) over the recent period has resulted in negative unit labor cost (ULC) growth. In the rest of the economy (mainly services), where productivity is admittedly harder to measure, ULC has been rising. For the economy as a whole, the central bank estimates that ULC rose by 2.4%Y in 4Q06, after 3%Y in 3Q06.

Negative ULC growth in manufacturing has contributed to keeping overall price pressures in check. Yet, the steady acceleration in private sector wage growth represents a risk that ULC growth might pick up in the industrial sector, which would provide ammunition for the MPC hawks (Filar, Noga, Wasilewska-Trenkner), who argue that cost pressures have already built up and it is time to increase interest rates. The latest NBP communication shows a continued tightening bias, and suggests that the central bank will keep an eye on activity data in the coming months.

In the face of tighter labor markets and rising cost pressures, our call that the NBP will remain on hold throughout this year seems aggressive at first blush (note that the market is pricing in around 60bp of hikes this year). Yet, although we expect inflation to rise in the near term (and in 2007 on average, compared to 2006), our inflation forecast sees near-term inflation capped at 2% in 1Q, then down in the mid-1s in the summer, and up again to 2% by year-end. This is far lower than the latest NBP inflation projection, which shows inflation exceeding the 2.5% target in 1Q07, and then reaching 3% by end-2007. Our forecast rests on the assumption that global price pressures remain benign and a vibrantly competitive domestic environment will force domestic firms to absorb part of the rise in wage pressures via reduced margins, rather than passing it onto consumer prices. While the NBP is likely to remain biased towards tightening this year, we still feel that this year’s inflation profile will not be high enough to trigger rate increases. We would feel inclined to change this forecast only if the middle-ground MPC members (Slawinski, Wojtyna and Owsiak) move to the hawkish camp, concerned by rising cost pressures. Although recent comments by Mr Slawinski suggest that he might be moving a bit closer to the hawks, we still think we are quite far away form a rate hike.

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Israel
Tech Support
March 06, 2007

By Serhan Cevik | from New York

Israel’s technology-intensive economy supports the shekel’s appreciation. From whatever direction you look at it, Israel’s economic and financial performance has come out much better than expectations. Growth is running at around 5% for the fourth consecutive year; there is practically no inflation; nominal interest rates and spreads over American bonds are at historical lows; the stock market just passed the 1,000 threshold; and the shekel has appreciated against the trade-weighted currency basket. So far, so good. But could this be also as good as it gets? We think not. Nominal interest rates may no longer be as striking as they were just a few months ago, but growth and real interest rate differentials still make an attractive investment case, especially considering the shekel’s undervaluation. Even after appreciating by 4.5% last year, the real effective exchange rate remains 23.8% below the 2000 peak and 15.2% lower than the average of the 1990s. Of course, if you base the analysis purely on interest rate differentials (which are at an all-time low), the case for further strengthening of the shekel does not look compelling. But our call is based on economic fundamentals and structural factors, which justify sustained appreciation. We can list numerous factors — such as fiscal normalization, productivity growth and low inflation — supporting a higher valuation for the shekel, but the heart of the matter is Israel’s technology-intensive economy, which generates higher value-added exports and a structural current account surplus.

With greater specialization in high-tech sectors, Israel benefits from the global investment cycle. Sectors specializing in high-technology goods and services now account for almost one-third of Israel’s GDP and 75% of its industrial exports. With such an extraordinary link to the global investment cycle, Israel has benefited from strong growth all around the world in the last couple of years (see Tech Nation, February 13, 2007). Although the US-China-India axis — accounting for more than half of Israel’s total exports — has obviously played a crucial role in increasing exports and accelerating GDP growth in the past four years, growth dynamics have become more balanced and therefore resilient to cyclical changes in the global economy.

The composition of human capital and economic sectors is a major source of productivity growth. Despite another burst of volatility in financial markets, Morgan Stanley does not foresee a recessionary rebalancing in the world economy. There are of course risks stemming from cyclical variables and changes in risk appetite, but our optimism about Israel’s economic prospects and the shekel’s valuation depends more on structural factors that will not disappear just because of market jitters. The economy’s shift to higher value-added technology-intensive sectors is a structural move that goes beyond usual business-cycle fluctuations, in our view. With the highest number of engineers and PhDs per thousand in the world, Israel has a stock of human capital that will keep supporting its comparative advantage in high-tech manufacturing industries and services. Moreover, this is not idle capacity, but is being actively used in R&D investment (reaching 5% of GDP a year) and entrepreneurial pursuits. As a result, the positive feedback loop — from technological orientation of human capital and economic activity to total factor productivity and income growth —  enhances the economy’s growth potential (see Salem Abo Zaid, The Trade-Growth Relationship in Israel Revisited: Evidence from Annual Data, 1960-2004, Bank of Israel, December 2006).

Positive externalities of technology-intensive production support the shekel, in our view. Thanks to higher value-added exports of goods and services, Israel enjoys a current account surplus of 5% of GDP, even against the burden of higher commodity prices. This is yet another reflection of structural changes in the economy, and unlikely to fade away in the foreseeable future, in our view. Furthermore, in today’s global system of supply chains, the composition of human capital and economic sectors is an important point of attraction for foreign investment flows. We believe that Israel is already at the forefront of the global technology trends and will gain a prominent role in the coming wave of life sciences and nanotechnology. And that is only good news for the shekel.

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Mexico
Banco de Mexico’s Ultimatum
March 06, 2007

By Gray Newman | New York

It has been a difficult start of the year for Mexico’s central bank.  Not only did Banco de Mexico have to announce in January that inflation ended the year at 4.05% — outside the target of 3% plus or minus 1% — but the specter of soaring tortilla prices threatened to spill over into wage negotiations and upset inflation expectations as well.  The new Calderón administration, cognizant of the risk of being portrayed by the opposition as being aligned with powerful agro-industrial interests against the wellbeing of Mexico’s poorest families (for which tortillas are often a mainstay of their diet), acted swiftly with price agreements and an opening of import quotas for corn.  Last month, the police even began to raid grain storage facilities of some of Mexico’s largest agro interests with the kind of fanfare usually reserved for drug busts.

Averting tortilla turmoil

The administration’s measures seem to have worked.   Tortilla prices, while still high relative to last year, are no longer adding to monthly inflation.  Indeed, tortilla prices fell quickly in the second half of January — dropping by nearly 10% — and since then have been largely unchanged through the first days of March.  A protest march organized by various worker groups against price hikes drew large crowds at the end of January on the same day just blocks away from where Banco de Mexico was releasing its monetary program for 2007, but not much has been heard from labor since then.  Indeed, wage talks in January yielded average nominal wage increases of 4.0% — in line with the average of 2006. And it appears that labor agreements in February have averaged near 3.9% to 4%. 

Indeed, all signs would suggest that the risk of a more serious inflation spiral has been averted.  While some worker groups continue to call for emergency salary increases, the administration’s actions to help stabilize tortilla prices have helped to neutralize the issue.  Meanwhile, as the central bank noted in both its communiqué released on January 26 as well as in its quarterly inflation report, the disappointing headline and core inflation readings seemed largely the consequence of a small number of items (tortillas and sugar) which had not contaminated other prices, nor wages nor medium-term expectations. 

Indeed, the central bank underscored the lone nature of the tortilla and sugar price hikes, noting in the opening pages of its most recent quarterly inflation report the fact that tortillas and sugar alone accounted for 70.8% of the increase in core inflation in the second half of 2006.  The entire line of reasoning was consistent with the central bank’s decision in January to keep rates unchanged even while noting that if it saw a “negative effect” from the recent supply shocks on other prices or medium-term expectations that could in turn have an “impact on wages”, it would be ready to act.  

Case closed?

We thought the case was largely closed.   In late February, the central bank released its inflation report for the first half of February, and while year-over-year readings of both headline (4.06%) and core (3.95%) were high, that was largely to be expected.  After all, the year-over-year readings reflected the jump in December and January and would likely remain elevated for much of the year.  The central bank had already warned in late January that headline inflation could fluctuate between 4% and 4.5% for the first half of the year and that core could remain between 3.5% and 4% through the end of the year. 

In contrast, the important news from the first half of February report was that the risk of a spiral appeared to be behind us.  Not only did inflation come in for the first 15 days (0.14%) below what the market was expecting (0.20%), but the principal driver of core inflation — namely processed foods — appeared to have turned the corner.  Processed food inflation had nearly doubled in just over half a year — going from 3.4% in the second half of June 2006 to 6.3% in the second half of January — but had begun to ease in the first half of February to 6.1%.  

Banxico’s surprise

Then it happened: Banco de Mexico suddenly seemed to redefine the nature of the inflation debate on February 26 when it released a communiqué with an ultimatum: either core inflation would begin to show a reversal in March in both year-over-year and monthly terms, or the central bank would act.

It is not clear what triggered the change in the central bank’s thinking in late February, but we would argue that the March ultimatum is unfortunate for two reasons.  First, it runs the risk of shifting attention away from what really should drive central bank policy, namely whether or not the current supply shock — the latest in a string that last year included steel and jitomate prices — is contaminating other prices, expectations or wages.  Second, it introduces an artificial deadline.   If other prices, wages or expectations begin to show a worrisome trend, we would expect the central bank to consider acting regardless of what happens to March’s core readings.  And, alternatively, if Mexico suffers an unexpected supply shock in the second week of March which monetary policy is particularly unsuited to deal with, we hope that monetary policy is not on autopilot, thus forcing the central bank to hike rates. 

We suspect that three things are taking their toll on the central bank.  First, as much as Banco de Mexico does not like to talk about bands, the fact that core inflation is bumping up against 4% and that headline inflation could hit 4.7% (our forecast) in May, June and July has left the board uncomfortable.  The bands are not popular at the bank.  You won’t find a single graph in the latest quarterly inflation report with a line indicating the plus or minus 1% ‘interval’ around the target, but we suspect that there is some unease that inflation is likely to continue to show readings outside the ‘intervals’. 

Second, we suspect that there is a new discussion going on regarding the central bank’s credibility.  The argument goes as follows: the longer that inflation remains this far from the target, the greater the risk that it begins to contaminate expectations or wages.  The central bank does not need to wait until such contamination takes place; indeed, it could prove much more costly to do so.  The fact that wages or expectations have not moved is a sign of the credibility that has been gained from past actions and which the central bank must jealously guard.  In a vacuum, the argument has a lot of validity.  Our problem is that after Mexico’s experience of the past three to four years, in which supply shock after supply shock has failed to have any meaningful or lasting impact on trend inflation (which remains near 3%), we are not sure why today’s episode is likely to be any different.  That, in turn, leads us to our third suspicion. 

Finally, we can’t help but wonder what, if any, impact the turmoil over the nomination of a new member to Banco de Mexico’s board is having on monetary policy.  We don’t want to overplay this last point, but it is somewhat surprising that the post — one of the four vice-governor positions which along with the governor decide on monetary policy — has not been filled.  In the rough-and-tumble world of Mexican politics, we have learned never to say never, but the administration appears to have miscalculated the depth of the opposition to its nominee.  And that, in turn, makes us wonder just how strong the case is for the politically sensitive reforms that the administration hopes to deal with in 2007 and beyond.  A failure on the Banco de Mexico nominee is hardly fatal for reform, but would suggest that the political landscape in Mexico remains as challenging as ever.  That fervor may be causing Banco de Mexico to worry that the combination of above-target inflation in the near term along with an uncertain political environment is just steps away from an inflection point on wages and expectations.  We don’t see the latter point as a serious risk, but can’t help but wonder if it is influencing policymakers at the central bank.

Forecast revision

The uptick in inflation in recent months does little to our long-term forecast of inflation in the 3-3.5% range, but has required us to revise upward our end-2007 forecast to 3.6% from 3.2% previously.  We are also adjusting our 2008 number slightly to 3.4% from 3.2% previously.  And with the central bank’s current dilemma unlikely to be resolved in short order, we suspect that the first rate cuts are not likely until the end of 2007 or early 2008. 

Accordingly, we are eliminating any rate cuts in 2007, leaving rates at 7% by year-end versus the 6.25% contemplated in our previous forecast.   We still believe that interest rates can move much lower once the market realizes that inflation is not rearing its head in Mexico, and thus we see rates at 6.0% by end-2008.  

Bottom line

We are much less concerned about inflation in Mexico than we are about the prospect for reforms to move forward.  On that front, the authorities have a daunting task of convincing the broader policymaking class to take politically costly steps even while facing the abundance of convergence inflows that are currently providing Mexico’s public sector with a near unprecedented level of resources.  That remains Mexico’s greatest challenge, in our view.

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Thailand
4Q06 GDP Growth Decelerated
March 06, 2007

By Chetan Ahya | Mumbai

Growth decelerated in 4Q06: GDP expanded at 4.2% YoY in 4Q06 (versus 4.7% YoY in 3Q06).  This is above our and market expectations of 3.9% YoY.  Accordingly, the growth for 2006 stands at 5% YoY, compared with 4.5% YoY in 2005.

Domestic demand weakened significantly: Domestic demand slowed to 0.3% YoY in 4Q06 (versus 4.8% YoY in 3Q06), undermined by domestic political uncertainty and slipping consumer and business confidence.  Private consumption expenditure decelerated to 2.5% YoY and 1.3ppt contribution to growth (versus +2.8% YoY and +1.5ppt in 3Q06).  Government consumption contracted to -4.2% YoY following an increase of 4.3% YoY in 3Q06, thus subtracting 0.3ppt from the headline GDP growth number.  Growth in fixed investment decelerated to 2.4% YoY (versus +3.2% YoY in 3Q06), in-line with the softness seen in the private investment index. 

External balance rebounded in 4Q06: Exports accelerated to 6.8% YoY and 4.5ppt contribution to growth (versus 4.7% YoY and 3.4ppt in 3Q06).  Imports on the other hand decelerated to 1% YoY (versus 5.2% YoY in 3Q06).  The net external balance contribution to growth expanded to 3.9ppt from 0.5ppt in the previous quarter.

Agriculture and services sector growth decelerated: On the supply side, growth in the agriculture and services sectors slowed sharply to 0.9% and 3.6% YoY, respectively (versus 4.0% YoY and 4.1% YoY in 3Q06).  Growth in the industry sector improved marginally to 5.5% YoY, compared with 5.3% YoY in the previous quarter.

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Indonesia
Another 25bp Cut
March 06, 2007

By Chetan Ahya | Mumbai

BI cuts rate by 25bp: Bank Indonesia cut interest rates by another 25bp today, bringing the BI rate down to 9.0% from 9.25%.

February inflation surprised on downside despite floods: The better-than-expected inflation number was likely the reason why the central bank continued with consecutive rate cuts despite earlier comments of a pause.  February inflation released earlier this month stayed flat to January at 6.3%, despite the Jakarta floods.  Key segments such as the food and transport segments rose at a slightly slower pace of 10.8% YoY (versus +11.2% YoY in January) and 1.0% YoY (versus +1.2% in January).

Currency remains range-bound; portfolio inflows still favourable: The rupiah remained fairly stable for the most part between the monetary policy meetings, though the pace of depreciation picked up slightly towards the end of February.  Between meetings, the rupiah depreciated 1.7%.  However, net foreign equity buying in Indonesia remained mostly unaffected by the recent global correction, with the 15-day trailing sum still on an uptrend.

Monetary loosening cycle near end: We believe that the central bank is now near the end of its monetary loosening cycle.  Real rates are now standing at about 3.0%.  We believe that this is at the upper end of the BI’s preferred 2.5-3.0% range.  We reiterate our central case of the benchmark rate reaching 8.75% by year-end.

 

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