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Budget Preview
March 16, 2007

By David Miles | London

Treasury’s outlook consistent with meeting fiscal rules

Next Wednesday (March 20), in his final Budget as Chancellor, Gordon Brown is likely to sound confident about meeting the ‘golden rule’ — to balance the current budget — over this cycle (which the Treasury currently forecasts will end in 2007). Brown will emphasise that the economy is experiencing relatively strong and stable growth, despite volatility in energy prices and — more recently — in financial markets, and that he expects this to continue.

At the Pre-Budget report, last December, the Treasury revised its GDP growth assumptions used in the fiscal projections. Their latest economic forecast for 2.75% GDP growth in 2007/8 still looks optimistic to us; our central forecast is that GDP growth this year will be slightly sub-trend and at about 2.4%. But despite being less optimistic about near-term growth than the Chancellor, our assessment is that the government is likely to meet its fiscal rules — in part because of tax increases announced over the past couple of years and also because the projected increase in current government spending over the next few years will be set at a significantly lower level than seen over the past five years.

Scope for announcements of higher capital spending

The Chancellor may well have some scope to announce a faster pace of capital spending in some areas. Capital spending does not impact the current balance — and in that sense falls outside the scope of the first fiscal rule. But it can be constrained by the rule to keep net debt under 40% of GDP. Our own forecasts have suggested that there was little headroom on that debt limit. But it looks likely that the Chancellor will announce plans to securitise a significant part of the student loans owed to the government. That could generate several billions over the next few years — potentially as much as £16 billion. This would mean that capital spending over the next few years could be higher while allowing the Chancellor to say there is still a safety margin between projected debt and the 40% ceiling.

It is plausible that if the Chancellor uses securitisation proceeds to finance more capital spending, it will be channelled significantly into education; conceivably part could be used to finance the Crossrail project, which has an estimated capital cost of £16 billion and where government funding of perhaps a third of that capital cost might be needed to get the project underway.

Looking further ahead, it is likely that revisions to the estimated level of GDP that will come in 2008 will give further scope to increase borrowing to finance capital spending.

The Office for National Statistics (ONS) has announced that it will be modernising the systems and methods used to construct the UK National Accounts, which is planned to come into effect in time for the September 2008 Blue Book. The ONS hopes that these changes will enable it to provide early GDP estimates that are less susceptible to the often substantial blue book revisions each year. It has been suggested that this new method could lead to a 4% or so increase in the level of GDP. That would allow the Treasury to raise additional funds for public-sector investment and keep net debt in line with the 40% limit. If the estimated level of GDP were to be 4% higher, the stock of debt could rise by about £20 billion while keeping the net debt ratio steady.

It is not easy, however, for the Chancellor to pre-judge the results of the ONS review of the national accounts.

Corporation tax reform unlikely, given forthcoming review

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

But in light of the recent announcement by Treasury minister Ed Balls of a review into the use of debt by thinly capitalised private equity firms, we do not believe that there will be any changes announced in this year’s Budget.

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On Tour with the MoF
March 16, 2007

By Takehiro Sato | Tokyo

We went on tour with the MoF for its IR campaign

We had the opportunity to tour with the MoF on its European IR campaign in early March, just as the stock and forex markets were gyrating. The presentations covered the government’s economic and fiscal policies and debt management policy initiatives. The main points concerning economic and fiscal policies were as follows:

1) Overall improvement in the economy: The officials mentioned, for example, the buoyant 4Q GDP, led by private domestic demand, the elimination of the three post-bubble excesses in the corporate sector (capacity, labor and liabilities), the stabilization of the banking system, the gradual improvement in employment and income conditions for the household sector, and the prospects for the end to deflation.

2) Fiscal consolidation measures: The officials provided a roadmap for achieving a primary surplus and mentioned the likelihood of doing so, in light of the improvement in economic trends and pension reforms.

The main points that came up in the presentation on debt management policy initiatives are as follows:

1) The F3/08 budget draft calls for an increase in tax revenues, a reduction of expenditures, the largest reduction in issuances of refunding bonds from the normalized amount by issuing longer-maturity debt and a greater variety of debt, and ways to reduce the total outstanding balance of debt. 

2) The average term to maturity of JGBs is likely to lengthen to seven years (based on the initial F3/08 budget draft), versus five years and eight months in 1993. The weighted average coupon declined from more than 5% in 1993 to 1.4% in 2005. Accordingly, national debt service has not risen as much as the outstanding amount of JGBs has.

3) Foreign investors already have quite a substantial presence in the yen interest rate futures and derivatives markets.

4) Market efficiency has solidly improved thanks to flexible issuance plan changes in response to market needs, consideration of 40-year JGBs, and the enhancement of market liquidity through flexible buybacks and liquidity-enhancing auctions.

5) Although a sizable share of cash JGBs are owned by the broadly defined government sector and financial institutions, the household sector’s holdings have steadily risen as a result of major promotional efforts. In other words, the MoF has been trying to diversify the base of JGB investors because of the lessons learned from experience, namely that concentrated ownership by financial institutions tends to exacerbate one-way yield moves due to bandwagon-type sentiment.

6) Tax disadvantages have been eliminated. The MoF is doing its best to publicise the withholding tax exemption for foreign investors.

7) IR initiatives are being expanded. A system similar to the forums held by US prime brokers has been solidly established (The Meeting of JGB Market Special Participants and the JGB Investors Roundtable). Information is provided on the ministry website in Japanese and English at the same time.  In addition, the MoF is responding to e-mail queries and stepping up its IR efforts for overseas investors.

Efforts to normalize fiscal policy could encourage overseas investors to own JGBs

Whether the MoF’s IR efforts lead overseas investors to increase their JGB investments depends on not only economic and price trends but also policy trends, in our view. In this regard, budget reform has been moving forward solidly. Public investment declined from a peak of 9% of nominal GDP in F3/97 to 3.6% in F3/06. The indexing of benefits and a reduction in the target pension benefit-to-wage ratio by 9ppts, as part of the pension reforms, make it likely that the increase in the government’s share of costs will be kept down. Major banks have essentially finished repaying public capital, as part of banking system reforms, and financial system problems no longer weigh on the budget.

Looking forward, the government has committed to achieving a primary surplus by F3/2012, which it needs to reduce the government debt to GDP ratio by the middle of the next decade. This commitment is based on the well-known equivalency between the primary balance/GDP ratio and (r–g)*(D/Y). This means that the difference between the nominal cost of debt and nominal growth, times the proportion of government debt. If r–g is 0, the exponential-type of divergence of government debt can be avoided when the primary balance is controlled to 0.

In contrast with what happened during the deflation years in the past, nominal growth ‘g’ is higher than the government’s cost of debt ‘r’, and is likely to remain so for the time being. There is not necessarily a particular relationship between nominal growth and long-term rates, an issue that the former minister for internal affairs, Heizo Takenaka, and the former economic and financial minister, Kaoru Yosano, disagreed on last year. However, we do not see much significance in directly comparing nominal growth and long-term rates, the way these two did; instead, the subject of comparison should be the government’s cost of debt. In this case, r–g is likely to work out favorably for the government because the redemption of relatively high-coupon JGBs issued in the past makes it likely that the average rate on JGBs will rise only very slightly as the economy pulls out of deflation and normalizes and nominal GDP growth is likely to exceed real GDP growth as a result of the GDP deflator turning positive. Incidentally, we forecast F3/08 real growth of 2.4% and nominal growth of 2.7%, but the figures could be stronger because domestic private-sector demand such as private consumption looks to have been stronger than expected so far in January-March, which would likely raise the base effect for F3/08.

Nevertheless, we think that a lack of vigilance would be risky. Fiscal reform success hinges on economic reform, in our opinion, because of the urgent need for economic policies that allow for sustained productivity increases even as the population ages. Otherwise, it may be tough to reel in the tax revenue needed to sustain living standards for an aging population.


In the wake of the market volatility, many of the questions during the seminar concerned yen carry trades and the BoJ’s latest rate hike. The next most frequent topic was the outlook for tax reform. There were also some technical questions on the specifics of the 40-year JGB issuance plan, but not many asked about the details in the seminar session. The seminar participants already have a certain understanding of and experience with the JGB market, and appeared more interested in the grand design of the government’s macro policies.

The MoF’s views on the yen carry trade have already been publicized to some extent in media reports on the post-seminar press conference. Ministry officials appear to believe that the yen’s recent volatility stems not from an unwinding of yen carry trades but rather an evaporation of interest in establishing short-term, speculative yen short positions. In other words, they do not think that the yen selling and yen short positions related to the carry trades — in the form of yen-denominated housing loans overseas and external portfolio investment by domestic investors (individuals and institutions) to take advantage of domestic-foreign interest rate differentials — are affected by short-term market trends, have not been substantially unwound, or will not be easily unwound. 

On forex market volatility, the officials reemphasized the dangers of heavily one-sided positions because risks are always symmetrical, as the finance ministers and governors pointed out at the recent G-7 meeting in Essen, Germany. Generally, the MoF officials appear to be coolly assessing the halt in the yen’s slide.


We do not think that the next step for JGB investing will come from past glory. Japan needs to continue with the next phase of economic and fiscal reform, in our view. Risks are always present, of course.

For example, if the ruling coalition struggles in the upper house elections this summer, the outlook for fiscal reform would become less certain and investors would be likely to demand an appropriate risk premium for holding JGBs. The ruling coalition might struggle in the elections because of its pursuit of the grand goal of a revision of the Constitution as an election issue. Probably what the public is more concerned about is the financial base for the social security system, in light of the aging population. We think the upper house elections could be an opportunity for an acceleration, rather than a slowdown, of fiscal reform due to serious requirements from the general populace.

Some ruling coalition executives appear to believe that fiscal reform is possible without tax increases, thanks to the recent rise in tax revenue, but we think that this is a risky assumption. In fact, we would not be so sure about the prospects for achieving a primary surplus, considering the effects of the aging population. Although such a surplus may look comparatively easy to achieve at a glance, in many cases the expectation is based on a static model that does not include the effect of built-in increases in expenditures stemming from an aging population. Even if a surplus is once achieved, our dynamic model indicates that it will be difficult for the surplus to be maintained constantly without further spending cuts or tax hikes. We think the government will need to ensure some sources of financing by F3/2010, when the government’s share of costs of the basic public pension is expected to start rising.

Foreign investors are unlikely to demand too much of a risk premium for holding JGBs if the government continues to seriously address these issues, and we believe that the government will do. We expect the structure of interest rates in Japan to normalize as deflation ends, and the JGB market to deepen further.

(Unless otherwise noted, opinions in the text are ours, and not the government’s.)

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Tracking the Tectonic Shift in Foreign Reserves and SWFs
March 16, 2007

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

Summary and conclusions

We have highlighted the importance of the tectonic shift from foreign official reserves to sovereign wealth funds (SWFs).  While this issue is not as urgent as the risk-reduction that is taking pace in the market right now, in the long run, the evolution of these funds will have monumental implications for financial markets, in our view.  We have been tracking the rapid growth in both the official reserves and the SWFs.  We now present an update on this issue. 

The key conclusions are as follows.  (1) Total global official reserves have breached the US$5 trillion mark, as they grew by US$86 billion in the latest month and by US$832 billion in the past 12 months.   (2) The SWFs could have reached US$2.3 trillion, and will grow very rapidly.  (3) China’s State FX Investment Corporation (SFEIC) will be a massive entity.  (4) Notwithstanding some implementational constraints, these funds will have important structural implications for the financial markets. 

Tracking official reserves and SWFs

• Observation 1.  Global official reserves are massive, and still growing.  The world’s official reserves have just breached the US$5 trillion mark (US$5,130 billion, to be exact, for gross reserves and US$5,078 billion for the currency component).  The world’s official reserves are growing at roughly US$75-80 billion a month, with China accounting for about 30% of these increases.   While oil exporters and the Asian countries have roughly the same absolute size aggregate C/A surpluses (around US$400 billion a year), so far the Asian countries have accumulated these balance of payments (BoP) surpluses in the form of official reserves, while the oil exporters tend to channel their export proceeds into SWFs.  In any case, compared to the total official reserves that prevailed at end-2005 of US$4,175 billion, the world’s official reserves have risen by close to US$1 trillion in a little more than a year: this is a major increase.

• Observation 2.  The SWFs could be as big as official reserves in five or six years’ time.  As of now, the total size of the SWFs may be as big as US$2.3 trillion — already close to half the size of the gross official reserves.  We believe this ratio will rise in the coming years.  If we are right that these funds will grow by roughly US$500 billion a year, at the expense of official reserve growth, the total size of the SWFs should be as big as the official reserves in only 5-6 years’ time.  The top three funds, in terms of size, are ADIA, GIC and Norway’s GPF.  However, we expect China’s SWF to quickly become the second-largest SWF in the world. 

• Observation 3.  China’s SWF is the fund to watch.  In our opinion, Beijing’s decision to establish the State Foreign Exchange Investment Corporation (SFEIC) outside the PBoC was the right decision, as it minimizes the ‘reputational risk’ of having the central bank managing low-risk reserves and a higher-risk investment fund.  But the decision to merge the Central Huijing Holding Company and this new SFEIC was somewhat of a surprise to us. 

First, we always thought of the Central Huijing Holding Company as more like Singapore’s Temasek and the SFEIC modeled after the GIC.  Temasek tends to hold more domestic assets and more private equity, while GIC holds only foreign assets, most of which are publicly traded company shares.  Organizationally, China’s lumping these two types of investment entities together really should not raise major problems, as long as the two branches under the State Council are run separately. 

Second, partly due to the merging of these two types of funds into one, we suspect that China will follow Singapore’s practice of not releasing detailed and timely information on the size of the funds or the composition of these funds’ asset holdings.   In other words, these funds, in terms of transparency, will be more like the ADIA than Norway’s GPF. 

Third, critically, these funds will likely eventually be ‘equity-heavy’.  Specifically, we expect the SFEIC to hold a substantial share of its assets in equities, not sovereign bonds.  Using Norway as the benchmark, massive equity purchases by China are likely in the coming years.  In his speech from last November, Executive Director of the Norwegian Pension Fund, Mr Knut Kjaer, argued that a 40% allocation to equities may be too low.  If the SFEIC is to start with US$300 billion or so of seed capital, the demand for equities should be substantial, if the SFEIC has an equity allocation anywhere near that of Norway’s GPF.  Further, as the SFEIC grows over time, the incremental demand for global equities will no doubt be immense. 

Fourth, in the near term, there will be implementational constraints to China, and other countries, fully executing their new investment plans.  For one thing, keeping equity investment in-house will require a wholesale build-up of staff; this will take time. 

• Observation 4.  Korea’s KIC could eventually grow to US$100 billion in size.  Currently, only US$1 billion out of the entire US$20 billion worth of assets held by KIC is fully invested.  It is the government’s intention to invest the full US$20 billion by the beginning of next year.  It is important to keep in mind that the funds under KIC’s management will likely rise drastically in the coming years.  It is likely that ‘only’ US$150 billion or so will be ‘needed’ for liquidity purposes for Korea.  This means that possibly up to US$90 billion of the existing official reserves could eventually be transferred to the KIC for less restrained investment.  In other words, in theory, KIC could be as large as US$100 billion.  

Impact on financial prices

The evolution from official reserves to SWFs will have several important implications for financial markets.  We highlight the following.

1. Positive for JPY.  Currently, only 3.2% of the world’s official reserves are in JPY.  However, the Nikkei’s market cap is more than 10% of the world’s total.  A wholesale move from bonds to equities by the world’s central banks should be structurally positive for the JPY. 

2. Not too negative for the US Treasuries.  The central banks with the greatest capability to move away from US Treasuries are also the ones with the largest exposures to them.  It would not make sense that these major reserve holders would shift their investment strategies in a way that would undermine themselves.  Retrenchment in supply of the USTs could further help stabilize the UST market. 

3. Not too negative for the USD against the majors.  The US still commands the deepest risky asset markets.  As central banks move up the risk curve, there is no reason to expect that this should lead to more dollar-selling. 

4. Positive for risky assets.  Structurally, this evolution from official reserves to SWFs should be positive for emerging market assets and positive for risky assets in general. 

Bottom line

We will keep tracking the evolution of the official reserves and the sovereign wealth funds.  Both assets are expanding rapidly.  While in the near term, implemental constraints could hold back some of their new investment plans, the longer-term implications for financial markets are immense. 

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United States
Business Conditions: Both Payback and Genuine Weakness?
March 16, 2007

By Shital Patel and Richard Berner | New York, New York

Echoing the “payback” in recent official economic statistics, the Morgan Stanley Business Conditions Index (MSBCI) retraced much of February’s increase, declining 10 points to 41%.  Given the suspected weakness in financial services businesses in the wake of the subprime mortgage meltdown, it’s hardly surprising that much of the early-March weakness in our analyst canvass of business conditions seems to be concentrated in services industries.  The services sub-index declined 13 points to 37%, while the manufacturing sub-index declined only five points to 50%.  In hindsight, we were premature in judging that the improvement in the MSBCI in February would last.

We weren’t alone: The business outlook and some fundamentals have changed dramatically since February’s survey.  Over the past month, we slashed our current quarter tracking estimate for Q1 from 2.9% to 1.8% following a dismal January durable goods report and tepid retail sales in February.  Moreover, the subprime mortgage crisis and associated fears of a credit crunch have tightened financial conditions.  Both the S&P 500 and the Dow Jones industrials indexes tumbled by more than 4% over the past month.  Our own credit conditions index decreased four points to 49%, the first sub-50% reading since last September.

Given the noise in the data, however, it’s impossible to tell how much of this reversal is simply “payback” for the weather-induced strength in late 2006 and how much is fundamental weakness.  We believe it’s a mix of both, and disentangling the two will be crucial in coming months. There’s no mistaking the downside spillover risks from tighter financial conditions on growth and other asset prices.  But if we’re right that the payback ends and the housing recession begins to bottom, we still expect a gradual return to trend growth in the second half of the year. 

Modestly supporting that view, forward-looking indicators in the early March MSBCI canvass were mostly positive.  The advance bookings index increased three points to 48%, the highest level since last October.  Our business conditions expectations index remained above the 50% threshold, edging down two points to 52%.  Hiring and capex plans only edged lower.  Analysts expect conditions to improve over the next six months for the industrials, materials, energy, and utilities sectors.  Analysts in the consumer discretionary group turned pessimistic, expecting deteriorating conditions. 

However, the breadth of survey results across industries tilted again towards weakness in early March.  Only 14% of analysts reported improving conditions compared to last month, down from 22% last month, while 29% reported deteriorating conditions, up from 18% last month.  Conditions continued to improve for the consumer staples and materials sectors, but deteriorated for the financials, consumer discretionary, industrials, and telecom services sectors.  The IT sector had mixed conditions while conditions were unchanged from improved conditions last month for the healthcare, energy and utilities sectors.

We think that this backdrop should reinforce the deceleration in earnings we’ve long expected.  Accordingly, we asked analysts this month whether the risk to their earnings estimates is at the top or bottom line.  Fully 71% of analysts said there were downside risks to their estimates; 39% of analysts noted downside risks to the top line, mostly from fears of weak domestic growth.  Higher input costs, pricing pressures, and higher compensation costs are risks to bottom-line estimates for 32% of the groups.  Only 29% of analysts bravely ventured that their estimates might be too low, but few because of better than expected top-line results.  Analysts expecting upside risks to the bottom line most often cited lower-than-expected input costs; that held for the 20% of groups.  Higher domestic and/or foreign growth could help top-line results for 10% of the groups.

Nonetheless, there’s an important disconnect in expectations about earnings fundamentals: Although more than two-thirds of the analysts believe there are downside risks to either top- or bottom-line estimates, 60% expect margins to expand in 2007, up from 42% last month.  Analysts covering the consumer staples and industrials sectors continue to believe that margins will grow in 2007, while those covering the materials and utilities groups became more positive this month.  Given dismal business conditions, declining margins over the last three months, and a pessimistic balance of risks for 2007 growth, it is surprising that analysts continue to get more optimistic about margins.  Indeed, in contrast with this canvass, Street analysts generally are going in the opposite direction; they expect margins to rise for only 64.1% of S&P 500 companies, down from 67.5% last month and 74.1% at the beginning of the year. 

In our view, especially as slowing growth compresses operating leverage, the only way that margins could expand is for costs to plunge faster than revenues.  Past performance is no guarantee of the future, but it certainly does not augur favourably; the margin picture over the last three months has not improved.  Small wonder: Prices charged at companies rose faster than unit costs for only 18% of the groups, the lowest percentage in the history of this question and down from 25% last month.  Material and/or labor costs outpaced prices charged for nearly half of the industry groups surveyed. 

Don’t get us wrong; a collapse in earnings is unlikely.  And there are bright spots in that regard.  First, our strategy team’s earnings revision factor has rebounded to 4.5% from the low of 0.7% on January 24.  Second, analysts in our survey report that pricing conditions improved again in March; the pricing conditions index increased another three points to 61%.  The percentage of groups that raised prices by 1-3% from a year ago stood at 31%, nearly triple the 11% recorded last month.  However, the percentage of groups increasing prices by 3% or more was only 14%, down from 27%.  The percentage decreasing prices remained virtually unchanged at 24%.  As in the past, prices declines were concentrated in the IT and telecom services sectors.  Prices were also lower for retail hardlines, US homebuilders, non-life insurance, and large-cap banks.

We wrote recently that growth in net investment in this economic expansion has been subpar, although we still believe that sooner or later corporate capital spending will reaccelerate (see “The Capex Conundrum,” Global Economic Forum, March 9, 2007).  This month’s survey results support an eventual moderate reacceleration, as capex plans held up relatively well in March.  Half of the groups plan to increase capex over the next three months, compared with the historical average of 47%, although down from 56% last month.  More than one-third plan to keep capex spending unchanged and just 5% of the groups plan to decrease capital spending by 6% or more.  The industrials, materials, consumer staples, energy and utilities sectors have the most robust plans to increase capital spending.

Hiring plans in our survey also held up well, supporting our thesis that healthy gains in consumer income, along with sustained foreign growth, will help restore trend growth in the second half of this year.  An equal percentage of groups plan to increase hiring over the next three months, although 17% plan to cut payrolls, up from 11% in February.  Other surveys of employment have weakened recently, however.  According to the National Federation of Independent Business Small Business Optimism Index, a net 13% of respondents planned to increase employment, down from 17% in January.  Net hiring strength, as reported by the Manpower Employment Outlook survey, fell one point to 18% for 2Q07.  The industrials, consumer staples, energy and utilities sectors along with some groups in the financials and IT sectors plan to increase hiring.

Note: Beginning with our next MSBCI report, we are making a minor change to the methodology we use to calculate the MSBCI.  We have nearly five years of history for the MSBCI, enough to adjust the series for normal seasonal variation using the X-11 Arima seasonal adjustment technique.  Previously, we had used seasonal factors from the Institute for Supply Management (ISM) manufacturing diffusion index.  Unlike that ISM index, our survey also covers non-manufacturing industries, so we prefer our own idiosyncratic seasonal factors.  The pattern of the data remains essentially the same, although in the new series, the decline in March was only eight points, to 42% from 50%, while the 3-month moving average was unchanged at 44%.  In future reports, we will only publish the new seasonally adjusted series, and the complete adjusted data set is available on request.

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The Great Unraveling
March 16, 2007

By Stephen S. Roach | from Beijing

From bubble to bubble – it’s a painfully familiar saga.  First equities, now housing.  First denial, then grudging acceptance.  It’s the pattern and its repetitive character that is so striking.  For the second time in seven years, asset-dependent America has gone to excess.  And once again, twin bubbles in a particular asset class and the real economy are in the process of bursting – most likely with greater-than-expected consequences for the US economy, a US-centric global economy, and world financial markets. 

Sub-prime is today’s dot-com – the pin that pricks a much larger bubble.  Seven years ago, the optimists argued that equities as a broad asset class were in reasonably good shape – that any excesses were concentrated in about 350 of the so-called Internet pure-plays that collectively accounted for only about 6% of the total capitalization of the US equity market at year-end 1999.  That view turned out to be dead wrong.  The dot-com bubble burst, and over the next two and a half years, the much broader S&P 500 index fell by 49% while the asset-dependent US economy slipped into a mild recession, pulling the rest of the world down with it.  Fast-forward seven years, and the actors have changed but the plot is strikingly similar.  This time, it’s the US housing bubble that has burst, and the immediate repercussions have been concentrated in a relatively small segment of that market – sub-prime mortgage debt, which makes up around 10% of total securitized home debt outstanding.  As was the case seven years ago, I suspect that a powerful dynamic has now been set in motion by a small mispriced portion of a major asset class that will have surprisingly broad macro consequences for the US economy as a whole.

Too much attention is being focused on the narrow story – the extent of any damage to housing and mortgage finance markets.  There’s a much bigger story.  Yes, the US housing market is currently in a serious recession – even the optimists concede that point.  To me, the real debate is about “spillovers” – whether the housing downturn will spread to the rest of the economy.  In my view, the lessons of the dot-com shakeout are key in this instance.  Seven years ago, the spillover effects played out with a vengeance in the corporate sector, where the dot-com mania had prompted an unsustainable binge in capital spending and hiring.  The unwinding of that binge triggered the recession of 2000-01.  Today, the spillover effects are likely to be concentrated in the much large consumer sector.   And the loss of that pillar of support is perfectly capable of triggering yet another post-bubble recession. 

The spillover mechanism is hardly complex.  Asset-dependent economies go to excess because they generate a burst of domestic demand that outstrips the underlying support of income generation.  In the absence of rapid asset appreciation and the wealth effects they spawn, the demand overhang needs to be marked to market.  The spillover is a principal characteristic of such a post-bubble shakeout.  Interestingly enough, in the current situation, spillovers have first become evident in business capital spending, as underscored by outright declines in shipments of nondefense capital goods in four of the past five months.  The combination of the housing recession and a sharp slowdown in capex has pushed overall GDP growth down to a 2% annual rate over the past three quarters ending 1Q07 – well below the 3.7% average gains over the previous three years.  Yet this slowdown has occurred in the face of ongoing resilience in consumer demand; real personal consumption growth is still averaging 3.2% over the three quarters ending 1Q07 – only a modest downshift from the astonishing 3.7% growth trend of the past decade.

Therein lies the risk.  To the extent the US economy is now flirting with “growth recession” territory – a sub-2% GDP trajectory – while consumer demand remains brisk, a pullback in personal consumption could well be the proverbial straw that breaks this camel’s back.  The case for a consumer spillover is compelling, in my view.  A chronic shortfall of labor income generation sets the stage – real private compensation remains over $400 billion below the trajectory of the typical business cycle expansion.  At the same time, reflecting the asset-dependent mindset of the American consumer, debt and debt service obligations have surged to all-time highs whereas the income-based saving rate has dipped into negative territory for two years in a row – the first such occurrence since the early 1930s.  Equity extraction from rapidly rising residential property values has squared this circle – more than tripling as a share of disposable personal income from 2.5% in 2002 to 8.5% at its peak in 2005.  The bursting of the housing bubble has all but eliminated that important prop to US consumer demand.  The equity-extraction effect is now going the other way – having already unwound one-third of the run-up of the past four years.  In my view, that puts the income-short, saving-short, overly-indebted American consumer now very much at risk – bringing into play the biggest spillover of them all for an asset-dependent US economy.  February’s surprisingly weak retail sales report – notwithstanding ever-present weather-related distortions – may well be a hint of what lies ahead.

It didn’t have to be this way.  Were it not for a serious policy blunder by America’s central bank, I suspect the US economy could have been much more successful in avoiding the perils of a multi-bubble syndrome.  Former Fed Chairman Alan Greenspan crossed the line, in my view, by encouraging reckless behavior in the midst of each of the last two asset bubbles.  In early 2000, while NASDAQ was cresting toward 5000, he was unabashed in his enthusiastic endorsement of a once-in-a-generation increase in productivity growth that he argued justified seemingly lofty valuations of equity markets.  This was tantamount to a green light for market speculators and legions of individual investors at just the point when the equity bubble was nearing its end.  And then only four years later, he did it again – this time directing his counsel at the players of the property bubble.  In early 2004, he urged homeowners to shift from fixed to floating rate mortgages, and in early 2005, he extolled the virtues of sub-prime borrowing – the extension of credit to unworthy borrowers.  Far from the heartless central banker that is supposed to “take the punchbowl away just when the party is getting good,” Alan Greenspan turned into an unabashed cheerleader for the excesses of an increasingly asset-dependent US economy.  I fear history will not judge the Maestro’s legacy kindly.  And now he’s reinventing himself as a forecaster.  Figure that!

Greenspan or not, downside risks are building in the US economy.  The sub-prime carnage is getting all the headlines these days, but in the end, I suspect it will be only a footnote in yet another post-bubble shakeout.  America got into this mess by first succumbing to the siren song of an equity bubble (see my 25 April 2005 dispatch, “Original Sin”).  Fearful of a Japan-like outcome, the Federal Reserve was quick to ease aggressively in order to contain the downside.  The excess liquidity that was then injected into the system after the bursting of the equity bubble set the markets up for a series of other bubbles – especially residential property, emerging markets, high-yield corporate credit, and mortgages.  Meanwhile, the yen carry trade added high-octane fuel to the levered play in risky assets, and the income-based saving shortfall of America’s asset-dependent economy resulted in the mother of all current account deficits.  No one in their right mind ever though this mess was sustainable – barring, of course, the fringe “new paradigmers” who always seem to show up at bubble time.  It was just a question of when, and under what conditions, it would end. 

Is the Great Unraveling finally at hand?  It’s hard to tell.  As bubble begets bubble, the asset-dependent character of the US economy has become more deeply entrenched.  A similar self-reinforcing mechanism is at work in driving a still US-centric global economy.  Lacking in autonomous support from private consumption, the rest of the world would be lost without the asset-dependent American consumer.  All this takes us to a rather disturbing bi-modal endgame – the bursting of the proverbial Big Bubble that brings the whole house of cards down or the inflation of yet another bubble to buy more time. 

The exit strategy is painfully simple: Ultimately, it is up to Ben Bernanke – and whether he has both the wisdom and the courage to break the daisy chain of the “Greenspan put.”  If he doesn’t, I am convinced that this liquidity-driven era of excesses and imbalances will ultimately go down in history as the outgrowth of a huge failure for modern-day central banking.  In the meantime, prepare for the downside – spillover risks are bound to intensify as yet another post-bubble shakeout unfolds.

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Minor Miracle — Public Debate on Information Integrity
March 16, 2007

By Robert Alan Feldman | Tokyo

Regrettably, the news that Toshihiko Fukui, the governor, had proposed a rise leaked out while the meeting was in progress. This is the latest in a steady flow of leaks over the months about the BoJ’s supposedly confidential deliberations. Such weak discipline, along with poor signalling in the bank’s official pronouncements, weakens the perceived integrity of policy-making and unsettles the markets. (Financial Times, February 22, 2007, internet edition.)

A new debate has erupted about monetary policy. The new debate concerns not content but procedure. The problem is integrity of information. Once again, an issue of potential information leaks has surfaced. The news is not that leaks may have occurred. The news is that such leaks have now been openly debated in the Diet as a threat to Japan’s competitiveness as a financial market. Indeed, some of the BoJ’s biggest supporters in its quest to ‘normalize’ interest rates are livid about the recent incident at the Policy Board. Now in the open, this debate must lead to reforms, or else the credibility of the entire Diet oversight process — not just that of the BoJ — will drop.

The Diet debate: Bad news comes out

In Diet testimony this week, Governor Fukui was asked whether the BoJ had investigated the incident by going to the TV station that had broadcast the news of an impending rate hike proposal, even before the proposal was made. The Governor’s initial answer was vague, and he opined that the TV report was speculation. The Diet questioner was not placated. Had the BoJ actually gone out to investigate? After repeated questions, the Governor said only that the BoJ should establish internal information accurately before going to question outside parties. In short, no, the BoJ had not gone to the TV station.

The statements of the Finance Minister were even less encouraging. When asked whether reports that the leak might have come from a cell phone connection from the Ministry of Finance observer at the BoJ meeting, Minister Omi ducked the question three times. However, the questioner forced him back to the topic, and the minister said that he had no knowledge of matter of the cell phone.

This interchange makes one point very clear: There was virtually no investigation of the alleged leak despite widespread knowledge of the event. (I say “alleged” because it has not been established for sure that there was in fact a leak. Governor Fukui said that, in his opinion, the report was speculative. Perhaps so. If so, however, the TV station would have run a report at a very sensitive time, on the basis of no reliable information. It is hard to imagine that a reputable news agency would do so. In any case, fact finding is clearly necessary.) If it was indeed a leak, it would be a clear violation of the Civil Servant Law. Without reforms, the credibility of government policy on information integrity would inevitably suffer, and fears of inappropriate use of insider information would grow.

Can’t go home again

Now that the matter has been aired in the Diet, it can hardly be hushed up. The problem — and the opportunity — stems from the fact that the issue of information integrity is far more widespread than this alleged leak from the central bank. For example, a recent press report about the potential delisting of a company caused widespread disruption in markets, but the report turned out to be erroneous. Because custom in Japanese press culture does not require citing specific sources, many investors were misled by the report. In such circumstances, there are naturally fears of information manipulation and insider trading. Indeed, the independence of the press from political authorities is questionable, in light of the nature of the press club system and the protection of newspapers through price maintenance laws. The independence of the financial press from its companies is questionable, in light of ‘earnings previews’. These previews that appear in the press are often highly accurate, and thus suggest that material information has been leaked.

Tokyo’s competitiveness as an international market

This matter is a crucial component of the initiative to raise Tokyo’s competitiveness as an international financial market. Ten years ago, when announcing the financial Big Bang, then-PM Hashimoto said that Japanese financial markets would be “free, fair, and global”. With widespread worries about information integrity, the Hashimoto target of “fair” has not been fully achieved yet. Fortunately, there is strong momentum behind the government’s drive to raise Tokyo’s competitiveness. The attention in the Diet to this problem of information integrity is actually good news, since it proves that the system is working to correct a defect.

What to look for

Will the government and media response be sufficient? In light of the long history of collusion between the players, it is hard to be optimistic, but at least a start has been made. Investors can be confident of improvement in information integrity if any of the following measures, or all, or more, are adopted. (a) Abolition of press clubs at ministries. (b) Creation of a ‘financial proficiency’ test for reporters. (c) Require by-lines on financial reports. (d) Abolition of price maintenance for daily newspapers. (e) Abolition of the 1951 law that allows newspapers to restrict stock ownership to their own employees. Such measures would change the incentive structure and governance of the media, and raise the quality of information available to investors.

The press will undoubtedly gag at such suggestions. Indeed, after a recent interview, the reporter promised to report my media reform ideas in his newspaper, but his editors cut the part on media reform. (The reporter was kind enough to send me the exact text of what was cut from his article, as follows: “Feldman is also proposing ‘media reform’ as a method to strengthen markets. The content would include such things as abolishing press clubs, requiring by-lines, establishing a system for financial reporters to have a qualification like the sales representative at securities companies, or criminal penalties for firms that leak market moving information.  These proposals may give us a headache, but foreign investors think that ‘information from Japan is low in quality’. When information quality is low, media reform is necessary, Feldman explains. From the foreign viewpoint, monetary policy may seem odd, but the media are too.  It may sound chic for a reporter to suffer criminal penalties for a scoop that moves markets. However, for myself, with limited experience in financial reporting, it would probably be wise to study for a ‘necessary’ qualification exam.”  Media magnates may also pressure politicians to back off, just as happened in 2005, when political pressure quashed the attempt of the Japan Fair Trade Commission to end the special price maintenance rules for newspapers.

Is there hope? I think so, because conditions today are different. First, the recent BoJ incident has illustrated the dangers of low information integrity. Second, even domestic investors are angry at poor information quality. Third, the Diet debate has brought the issue into the public eye. Finally, there is a genuine sense of crisis about financial sector competitiveness.

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March Madness
March 16, 2007

By Stephen Jen | London

Summary and conclusions

While risks linger, compared to the episode last May/June, I suspect that this round of risk-reduction will likely be much shorter in duration and much less severe in terms of the intensity of the sell-offs.  Therefore, I expect risk-rebuilding be the main driver of exchange rates in the days/weeks ahead.  The second driver will be the familiar ‘Dollar Smile’.  As a result, USD/JPY, EUR/USD and EUR/JPY will likely be biased to the upside, as risk is rebuilt. 

The US economy is still in a ‘benign-and-necessary’ soft patch.  This slowdown, relative to 2006 and relative to the rest of the world, should reduce risk to financial markets.  Further, global liquidity remains abundant.  Investors have no ‘loyalty’ toward either fear or greed.  Once risky assets start to perform again, investors’ sentiment will switch from fear to greed very rapidly, I believe.  

Risk-rebuilding is the next medium-term risk to FX

The turmoil in the sub-prime mortgage market and the possible repercussions from a weakening US housing market are difficult to gauge.  As the various negative factors slowly work through the real economy and the credit markets, investors could in theory remain wary of risks for a protracted period.  Adding to these shocks is the still highly leveraged posture of many investors.  Since global liquidity is partly a function of ‘exogenous money’ (i.e., what central banks create as base money) and ‘endogenous money’ (i.e., all the factors that drive the money multiplier and credit creation, including excess savings, a low term premium and investor risk-tolerance), an endogenous liquidity contraction is possible if investors stay risk-averse.  

To a large extent, the call on the timing of risk-rebuilding is essentially a call on the collective psychology of the market.  However, I believe that risk is heavily biased in favor of investors rebuilding risk much sooner than they did last year. 

At the trough of this current round of risk-retrenchment, the world lost close to US$3 trillion of equity market cap, out of US$45 trillion that prevailed as of February 26.  As of last night, the cumulative losses in global market capitalization were around US$2.0 trillion, which should decline somewhat with the positive equity market performance today.  It took around six months (or 124 trading days) for the global equity markets to fully recuperate the loss in market capitalization.  It will not take nearly that long this time around, I believe. 

Everyone is in fear now, but risk-building could happen very quickly, as soon as risky assets start to perform.  In other words, ‘endogenous money’ that has been sensitive to risk tolerance could rebound quickly if investors could find a justification to do so.  Here are my thoughts:

1.         The global economic conditions are very solid.  With the strong 4Q GDP growth prints, the global economy may have grown by more than 5.2% in 2006.  While there should be some modest deceleration this year (possibly toward 4.5% or so), the ‘quality’ of global growth, in terms of sectoral and geographical balance, is superior to any time since 2002. 

The just-released US C/A deficit figure, which showed that the US C/A deficit indeed shrank from 6.9% in 3Q to 5.8% in 4Q06, is a strong validation that the world is on the mend.  The out-of-balance US-led growth since 2002 is finally evolving into a more benign and sustainable growth pattern.  If investors and policy makers at one time genuinely believed that yawning global imbalances had been the number one threat to financial markets, surely a reversal of this trend should reduce the risk of a dollar crash. 

Not only is the recovery in Euroland and Japan immensely encouraging, emerging markets are also increasingly a source of stability, rather than ‘combustible’ regions of the past, ultra-vulnerable to shocks.  This is why I have long had a positive structural view on the dollar, believing that global imbalances were a natural consequence of globalization.  A US-led global recovery would eventually give way to a ‘20% balancing down, 80% balancing up’ scenario, whereby the US slows a bit for the recovering rest of the world to catch up.  In theory, this should reduce risk, not raise it.  A slowdown in the US housing market is an integral part of this script, as a decline in the housing wealth-to-disposable income ratio is a key factor that should support the US household savings rate, and, in turn, help stabilize the US C/A deficit.  Wholesale selling of equities in Turkey and Singapore because of some problems with the US sub-prime market says more about market positioning than economic fundamentals.  Over the medium term, I trust the latter, not the former. 

Further, global inflation should continue to drift lower until this autumn, due to the base effect of oil prices.  Central banks that have paused (e.g., the Fed) should remain on hold, while those that are in motion should slow down (e.g., the ECB, the Riksbank, the SNB).  This dovish bias should reduce the risk of an overly anxious central bank further crimping global liquidity. 

2.         Debt service burden is a function of interest rates and employment.  While the delinquency ratio of sub-prime mortgage borrowers may be drifting higher, the general debt service capability of the US population should remain stable.  This is better measured by the Fed’s Financial Obligations Ratio (FOR), which is defined as debt service plus other expenditures such as automobile leases, rental payments, home insurance and property tax payments.  The Fed’s FOR has been relatively stable for two quarters.  The sharp rise from mid-2004 reflected primarily the Fed’s rate hikes since then.  To the extent that the Fed will remain on hold, and employment and income growth remain reasonably healthy, it is unlikely that the overall FOR of the US will rise significantly to undermine the broader mortgage market. 

3.         Global liquidity is likely to remain abundant.  The ‘real’ sources (i.e., the world’s savings-investment surplus) of global liquidity remain robust:  the Asian countries and the oil exporters continue to generate some US$800 billion worth of combined C/A surplus.  Global long-term interest rates, as a result, have remained near a generational low.  Unless ‘endogenous money’ collapses due to risk retrenchment, which I don’t believe will happen, global liquidity conditions could quickly rebound to support new risk-taking. 

Bottom line

I remain unconvinced that risk aversion will persist much longer, and expect risk-rebuilding to be the main driver of the currency markets in the coming days/weeks.  On the back of strong global economics and ample liquidity, investors could be easily persuaded to re-accumulate risk, in my view.  Fundamental factors holding down risk-taking are not nearly as strong this time around compared to last May/June.  USD/JPY, EUR/USD, and EUR/JPY should be biased to the upside, as risk is re-built over time.

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February Exports Decelerate Amid LNY Effect
March 16, 2007

By Deyi Tan and Chetan Ahya and Tanvee Gupta | Singapore, Mumbai, Mumbai

February trade surplus narrowed to S$3.2 billion: February export growth contracted to -6.4% YoY following an increase of 15.2% YoY in January.  This was well below market expectations of a 3% YoY increase.  Import growth also slowed to -7.5% YoY (versus +11.9% in January).  Consequently, the trade balance stood at S$3.2 billion compared to S$6.8 billion in January.  We believe that the general trend of deceleration was accentuated by the Lunar New Year holidays.

Non-oil domestic exports weakened: Non-oil domestic exports contracted to -6.6% YoY (versus +11% in January).  Electronic NODX growth weakened significantly to -17% YoY after rebounding to 2.1% in January.  Deceleration was observed across all segments.  In particular, exports of disk drives (-30.9% YoY versus -8.4%), ICs (-22.6% YoY versus +0.5%) and consumer electronics (-33.2% YoY versus -4.2%) contracted sharply in February compared to the previous month.

Non-electronics NODX growth decelerated in February: Non-electronics NODX rose 3.2% YoY (versus +18.7% in January).  Exports of petrochemicals contracted to -7% YoY (versus +26.4% YoY in January) while pharmaceuticals decelerated to 0.8% YoY (versus +12.6% YoY in January).

Export momentum weakened across all markets: In terms of end markets, NODX demand from the US, EU and Japan decelerated/contracted to +1.7% YoY,
-15.1% YoY and -10.7% YoY, respectively (versus +44.6%, -8.5% and -6.3% in January).


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