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Yet Another Whiff of Stagflation?
March 19, 2007

By Richard Bener | New York

Disco music and platform shoes anyone?  As if the subprime mortgage meltdown and its threats to economic activity and financial markets weren’t troubling enough, another specter may start to haunt investors again, namely suspicions that 1970s stagflation may try to make a comeback.  Among the feared ingredients: A prolonged period of tepid growth, made worse by a deepening housing recession; a new epoch of slower US productivity growth, rising unit labor costs and import prices, chronic bouts of surging food quotes, and renewed increases in energy prices that keep both headline and core inflation elevated.  These factors certainly do mean that the dispersion of inflation risks has risen, and that further declines in inflation will come slowly.  But I think there are other forces at work that will ensure a gradual decline in inflation and a reemergence of stronger growth. 

Most important, while the current malaise may feel a bit like stagflation, appropriate monetary policy and underlying healthy productivity gains likely should ultimately banish any incipient bout of stagflation.  As I see it, despite a looser relationship between economic slack and inflation, the combination of declining inflation expectations and increased economic slack will gradually bring inflation down.  I think a slightly restrictive monetary policy has begun to reverse the cyclical rise in inflation expectations that began in 2003, and, as inflation expectations decline, policy restraint is increasing through a rise in the real federal funds rate.  

Moreover, I think the current productivity undershoot is cyclical, not secular, as employment gains have caught up to the economy.  In addition, in my view, neither the surge in food quotes nor the latest rise in energy prices likely will last.  Finally, I think moderate income and employment gains and healthy global growth will sustain consumer wherewithal, exports and output.

To some it may seem ironic, given that I’ve warned about upside inflation risks for the last few years, that my rhetoric today sounds a bit more sanguine — if less certain — about inflation than in the recent past.  But I believe that the inflation process starts with inflation expectations and the balance between aggregate supply and demand, i.e., the slack in the economy.  While unit costs and inflation shocks are also part of the picture, falling expectations of inflation and increasing slack in the economy will offset those other factors (see “Inflation Model Uncertainty” Global Economic Forum, June 3, 2005). 

Encouragingly in that regard, for the first time in four years, two measures of longer-term inflation expectations are turning lower at the same time.  The 5-10 year median inflation expectation measure from the University of Michigan’s consumer sentiment survey has edged lower, moving to an average 2.9% over the past three months.  And distant-forward inflation compensation (5 year, 5 year) has moved down by about 15 bp since the start of 2007 (and by 25 bp since late November) to 235 bp.  To be sure, near-term inflation expectations — measured both by the Michigan survey and by TIPS spreads — either have remained elevated or have risen slightly.  For example, 10-year TIPS spreads have risen by about 10 bp over the past month, reflecting the rise in energy, food and commodity prices.  But I think the longer-term metrics are the key for inflation analytics.  In addition, the economy has grown at a 2¼% annual rate over the last three quarters of 2006, or about ¾ point below trend, and prospects are good for more of the same in the first half of 2007.  Relative to a 3% trend growth rate, such subpar growth is exactly what the Fed was aiming at to help reduce inflation pressures.  “Speed” effects also matter; inflation tends to move in sympathy with the change in operating rates as well as their level.  Just as rising operating rates boosted inflation between 2003 and mid 2006, so too will falling operating rates trim it.

However, the slowing in productivity growth, to 2.1% over 2005 and 1.4% over 2006, raises questions of whether trend productivity and thus potential output are lower than previously thought.  As we see it, trend productivity growth is roughly 2½%, which is good news for long-run inflation prospects.   But a below-trend, cyclical productivity undershoot is underway as job growth finally catches up with the economy.  Such an undershoot is actually typical as the business cycle matures.  But in this expansion, it is taking longer.  Corporate America’s hiring discipline, aimed at correcting the hiring excesses of the 1990s, yielded a 3.1% average annual gain in productivity in the first three years of this expansion — or 0.6% above the trend.  In our view, the current undershoot is showing up in the productivity performance of years 4-6, averaging 1.9% — or 0.6% below the trend.  Indeed, we forecast a return to the 2½% trend rate in 2008.

The productivity deceleration has contributed to an acceleration in unit labor costs of 3.4% over the past year — the fastest clip in six years.  But if the trend in productivity is what matters for underlying unit costs, the recent data overstate their contribution to inflation.  Moreover, quirks in the compensation data — the inclusion of strong bonuses in the fourth quarter at the time of accrual — added measurably to 2006 compensation growth.  In our view, there will be a payback in the first quarter that brings unit labor costs down to 2½% by the end of this year. 

Increases in import prices, food quotes and energy prices are also plaguing the near-term inflation outlook.  The acceleration in non-auto consumer import prices to a 1.4% rate in February has just started to show up in consumer inflation gauges.  Gains were especially strong for prescription drugs (3.1%) and household appliances (4.7%).  The former may simply reflect a rebound from falling drug prices in the first several months of 2006, while the latter seems unsustainable in the face of the housing slump. 

Food prices also represent an inflation challenge.  Courtesy of a drought in Australia and strong demand for ethanol, overall food prices are rising — at a 3.1% rate in the year ended in February — and could feed through to inflation expectations.  The jump in animal feed quotes has begun to hike beef and poultry prices following flat to declining prices last year.  A California freeze also hiked citrus quotes and damaged orchards.  But the perceived inflation threat from soaring food prices may be overblown.  While subject to both supply and demand shocks, grains are not exhaustible resources like energy.  Persistently higher feed prices could eventually trigger lower beef quotes as ranchers bring more of their herds to slaughter when profitability slips.  And while food is a bigger share of consumer budgets than is energy, food’s share has shrunk by one-third since the inflation-prone 1970s, and grains and sweeteners made from them represent a relatively small share of food costs.

Finally, energy quotes have jumped by $8-10/bbl for crude over the past two months.  At work were OPEC’s production cuts and the return of cold winter weather in North America.  The combination sharply trimmed crude and product inventories and boosted spot prices for crude oil and natural gas.  Refinery downtime has contributed to a jump in crack spreads from roughly $5/bbl to as much as $20, boosting gasoline prices by 25 cents/gal. since the start of the year.  While energy markets are tighter again, we think the increase in non-OPEC supply will allow prices to drift lower.  

Although the combination of slow growth and lingering inflation feels painful, the recipe for monetary policy is clear.  The policy stance is only slightly restrictive, in part because a low level of term premiums has added slightly to financial stimulus, offset by the incipient further tightening in mortgage lending standards.  Given the fact that core inflation does seem to have peaked, that it is relatively low, and the concerns that a flatter Phillips curve and thus a higher “sacrifice ratio” mean that reducing inflation may be more costly than before, the Fed will patiently wait for the forces now bringing inflation down to do their job.   

Nonetheless, given the fact that core inflation has been above the Fed’s 1-2% presumed comfort zone for three years, the Fed’s critics believe that there is more work to do.  And some think that the Fed’s focus on inflation expectations as a determinant of inflation could produce complacency about inflation prospects.  That’s especially because the inflation expectations, which aren’t observed, may simply reflect past inflation (see “Understanding the Evolving Inflation Process” by Steven Cecchetti, Peter Hooper, Bruce Kasman, Kim Schoenholtz, and Mark Watson, US Monetary Policy Forum, March 9, 2007). 

As the discussion above suggests, however, I agree with Fed Vice-Chairman Kohn.   He noted that “Inflation expectations are critical: Increases in expectations of inflation elevate the cost of returning to price stability, and unanchored expectations make it very difficult to understand where the economy is and where it is going.”  Moreover, Mr Kohn and his colleagues clearly understand that inflation expectations won’t stay anchored all by themselves if monetary policy gets off track.  Ultimately, it is the Fed’s responsibility to control them.

For market participants the combination of subpar growth and lingering inflation risks likely will continue to put pressure on risky asset markets for now.  Slower growth and the turn in the credit cycle will hurt earnings, while stubbornly high inflation will force the Fed to stay on hold.  But based on the recent widening in near-term breakeven inflation and similar upside in one-year inflation expectations, the near-term inflation risks seem largely to be in the price. 

Near term, the growth risks to our scenario are biased to the downside.  Indeed, the combination of tightening financial conditions and higher energy quotes could prolong the housing recession and consequent spillovers into the broader economy.  Conversely, relief on inflation and energy prices, when they come, could provide a parallel boon for economic activity.


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Unstable, Unbalanced, Uncoordinated, and Unsustainable
March 19, 2007

By Stephen Roach | New York

Those were not my words – at least not when I heard them firsthand in Beijing, last Friday, 15 March.  In uncharacteristically blunt language, China’s Premier, Wen Jiabao, used the occasion of his annual press conference following the conclusion of the National People’s Congress to send a very clear message about the state of the Chinese economy.  He explicitly characterized macro conditions as “unstable, unbalanced, uncoordinated, and unsustainable.” I have never known a senior policy maker or political leader anywhere to leave it like that without rising to meet his own self-imposed challenge.  Premier Wen has put his reputation firmly on the line.  China, in my view, now has no choice but to continue tightening as it attempts to bring its rapidly growing and unbalanced economy under control. 

The ink was barely dry on the Premier’s observations when China’s central bank followed the next day with a rare Saturday announcement of an immediate monetary tightening – the third interest rate hike in 11 months, which reinforces five increases in bank reserve ratios implemented over the past nine months.  The latest 27 basis point hike in the policy lending rate came only a day after Zhou Xiaochuan, Governor of the People’s Bank of China, sent a crystal-clear warning, “…(F)rom a macro perspective, after serious study, we decided to place further controls.”  In central banking circles, it doesn’t get any more direct than that.  Suddenly, China’s once opaque policy authorities are amazingly transparent – owning up to the seriousness of their macro control problems and setting in motion what I believe will ultimately be a much more determined shift to policy restraint than has been evident in a long time.

To some extent, this shift has been data driven.  While China’s January-February statistics are always hard to read because of Lunar New Year’s distortions, there can be no mistaking the reacceleration of economic and financial activity in early 2007.  Over the first two months of this year, export growth surged to 41.5% y-o-y – a dramatic acceleration from the still rapid 27% pace of 2006.  Similarly, average growth in fixed asset investment came in at 23% in January February 2007 – little changed from the 24% pace of 2006 and far from the long-sought slowdown of this overheated sector that now makes up over 45% of Chinese GDP.  At the same time, industrial output growth reaccelerated to 18.5% in the first two months of this year – reversing the deceleration to sub-15% readings in late 2006 and close to the peak comparison of 19.5% evident last June.  Moreover, despite a seemingly determined monetary tightening campaign, bank lending growth reaccelerated to nearly 17% over the January-February period – well above the 13% pace in 2006; RMB loans in February, alone, were nearly three times those extended in the same month a year ago.  Finally, on the heels of the spike in export growth, the trade surplus ballooned to nearly $24 billion in February – fully nine times levels hit a year earlier; that signals what most senior Beijing officials believe to be a very rapid accumulation of foreign exchange reserves in early 2007, which only further complicates China’s already daunting liquidity management challenge. 

In short, the data flow in early 2007 depicts a Chinese economy that is once again defying the efforts of a three-year tightening campaign.  With the exception of a few soft months over the past three years, a white-hot Chinese economy has largely been unresponsive to the current off-and-on tightening efforts that were first initiated in the spring of 2004.  Beijing has talked tough on the macro control front, but this talk has not achieved satisfactory results.  Persistent excess liquidity, in conjunction with a still highly fragmented banking system and an investment decision-making process that is driven mainly by provincial and local considerations, have undermined policy traction.  As Premier Wen Jiabao indicated at the conclusion of the National People’s Congress on 15 March, this is a major challenge to the Chinese leadership.  He left little doubt as to his intent by adding this is “…not the time for complacency with respect to the economy.”  Quite simply, the Chinese leadership cannot afford to let the world’s fourth largest economy lapse back into the boom-bust pattern of yesteryear.  In my view, Beijing seems quite focused on delivering on the macro control front in 2007.

These concerns were very much the focus of the just-completed China Development Forum – an annual gathering in Beijing that follows immediately on the heels of the National People’s Congress and provides official China with an opportunity to clarify and expand its message.  I have been privileged to attend all but one of these Forums since its inception in 2000 and find it to be invaluable in getting a read on the Beijing agenda.  This year’s theme said it all – “China: Towards New Models of Economic Growth.”  It is a clear recognition by the State Council – China’s cabinet and whose Development Research Center is the official sponsor of the event – that the Chinese economy is at a critical juncture.  The Old Model – dominated by a recycling of massive domestic saving into an equally massive investment boom that then supports an all-powerful export machine – has outlived its usefulness.  Official China not only concedes the twin perils of excess capacity and a protectionist backlash to open-ended exports but also worries increasingly about the negative externalities of the current model – namely widening income disparities, excess resource consumption, and environmental degradation. 

The Beijing Consensus is clear on the broad outlines of the New Model.  As underscored by the 11th Five-Year Plan enacted a year ago, the goal is a more balanced economy that draws increasing support from private consumption and a more rational market-based allocation of saving and investment.  The emphasis on the shift from the quantity to the quality of the growth experience permeated the discussions at this year’s China Development Forum.  Resource conservation and environmental concerns were at the top of the agenda as defining characteristics of the coming regime change.  Major disappointment was expressed by senior Chinese officials over the failure to hit the energy conservation and emission-reduction targets that were announced with great fanfare a year ago.  This was ascribed to what the Chinese leadership now refers to as “structural pollution” – the environmental degradation that is a painfully natural outgrowth of the structural disequilibrium of the old manufacturing-intensive growth model (see my 9 March dispatch, “Two Birds with One Stone,” which reaches a similar conclusion).  The debate was not over the endgame of the shift from the Old to the New model, but on the tactics required to manage this daunting but increasingly urgent transition.  There was broad agreement that there has been too much talk and not enough action in recent years in the areas of macro management and rebalancing.  As one senior official put it to me, “2007 must be a year of action – the stakes are too high to do anything else.” 

The give and take with senior Chinese policy makers is always the highlight of the China Development Forum.  Minister Ma Kai, Chairman of the National Development and Reform Commission (NDRC) and the nation’s leading macro manager, acknowledged in response to a question that I raised that Premier Wen has “…increased our awareness of China’s problems.”  While he hinted at more administrative measure to come – underscoring likely increases in the area of land control and higher project-approval hurdle rates with respect to environmental impacts and energy consumption – he did not pound the table in favor of restraint.  His confident, but generally relaxed, demeanor over the state of the Chinese economy stood in sharp contrast with the far more determined tone expressed by China’s Premier.  I suspect Minister Ma is about to change his tune.  To the extent Chinese authorities are likely to up the ante on tightening, and to the extent that monetary policy traction remains very much in doubt, the burden of restraint should fall increasingly on the central planners at the NDRC.

This conclusion became all the more evident at the closing session of the China Development Forum – the annual audience with the Premier.  I have watched Wen Jiabao grow into his job over the past four years.  Today, he speaks with much greater conviction and confidence than he did several years ago in framing the China macro debate.  It’s not just the way he states the problems but it is also a new sense of command over the challenge and solutions.  He welcomed the opportunity to elaborate on his worried characterization of the state of the Chinese economy.  By unstable, he was referring to overheated investment, excess liquidity, and a sharply widening current-account surplus.  By unbalanced, he was voicing concerns over urban-rural and east-west disparities.  By uncoordinated, he was drawing attention to the regional fragmentation of the macro economy, to the sharp contrasts between excess manufacturing and an undeveloped services sector, and to the disparities between excess investment and deficient consumption.  And by unsustainable, he was highlighting the twin perils of environmental degradation and excess resource absorption, as well as persistent tensions in the income distribution.  Collectively the “four uns” – as they became known in our discussions this week in Beijing – made a compelling case for the growth-model change that was the theme of this year’s China Development Forum.  As Columbia Professor and Nobel Laureate Joseph Stiglitz put it in our discussions, “China always adopts new models at key transition points in its development journey.  This is one of those times.”

As I sit back and reflect over the message from this year’s Forum and try to benchmark the discussions to those I have heard in each of the previous six years, I am struck by one major shift – that there is greater determination than ever to get on with the transition to the new model.  There is a new and important sense that time is growing short.  Official China’s frank admission of failure in hitting its energy conservation and environmental remediation objectives in 2006 only underscores the sense of urgency.  So does the renewed spurt of rapid growth in early 2007.  Premier Wen left no mistake of the significance of this new focus.  He went out of his way to stress, “This is a strategic shift for China.”  It doesn’t get much clearer than that.

For those of us in the West, this is a strong signal we need to update our perceptions of China.  Think less of open-ended unbalanced growth and more of a somewhat slower and better balanced expansion.  Think less of an industrial-production dominated model with destabilizing implications for natural resource consumption and the environment.  Think more of a shift to consumption and “greener” growth.  Think also of macro stabilization policies – not just those of central bank but especially those of the central planners at the NDRC – that will be used increasingly to up the ante on the tightening required to achieve these objectives.  But don’t think for a moment that China will back down on the reforms that have driven nearly three decades of its extraordinary transformation.  Time and again, China has used the reform process to spark key transitions in its development journey.  I suspect a similar transition is now at hand.  In the end, Premier Wen Jiabao said it all as he brought the 2007 China Development Forum to a close, “Our plan is in place.  What is needed is action.”  And I suspect that is exactly what will happen over the course of this year.

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Asia Pacific
AXJ’s Excess Liquidity Problem – At a New Level
March 19, 2007

By Chetan Ahya | Mumbai

AXJ’s reserves accretion has accelerated again

Even as Asia ex-Japan’s (AXJ) central banks struggle to manage their existing stock of foreign currency reserves, the annual accretion has started to accelerate again. Over the past 12 months, AXJ’s foreign exchange reserves have increased by US$360 billon to US$2.3 trillion. In the past three months alone, foreign reserves have increased by US$130 billion. China and India, the new tigers of Asia, are the key contributors, accounting for 75% (US$272 billion) of the total increase in the past 12 months. The other two groups — the ASEAN-4 and Industrialized Asia ex-Japan — have contributed US$36 billion and US$54 billion, respectively.

Current account surplus is key driver, not capital inflows

Although the rise in reserves as a proportion of GDP has reached the peak equal to that during the mid-1990s, most of the rise in reserves in the present cycle has been driven by current account surpluses instead of capital inflows. For instance, over the past 12 months ended September 2006, the current account was in surplus of US$315 billion (5.5% of GDP) and indeed there have been capital outflows (US$8.7 billion) due to some of the more developed economies in the region making investments abroad. Over the past five years, the current account balance has accounted for US$0.97 trillion of the total balance of payments surplus of US$1.2 trillion. Compare this with 1996 (right before the Asian crisis) when the current account was in deficit of US$28 billion (0.9% of GDP) and the capital surplus was US$109 billion (3.7% of GDP). Moreover, a large part of the capital surplus during the mid-1990s was due to debt inflows, unlike in the recent period, where a large part of capital inflows has been non-debt-creating.

Structural problem of weak domestic demand

Asia has struggled to revive its domestic demand post the Asia crisis. As reflected in the weak credit growth trend for the top five countries in the region (accounting for 87% of the region’s GDP), domestic demand is still relatively weak (except in India). The aggregate credit-deposit ratio has continued to decline to a new low of 72.8% in November 2006 — from the peak of over 90% in 1996-1997. The region’s savings-investment gap (a mirror of its rising current account surplus) has widened to a new high of 5.9% of GDP (US$348 billion) in 2006 from 3.8% of GDP (US$172 billion) in 2004. To be sure, the region’s investment to GDP ratio (25.8% in 2006) is close to the highs achieved during the pre-Asian crisis levels. However, savings are estimated to have risen sharply to 40% of GDP in 2006 (compared with a peak of 34.3% in the mid-1990s), resulting in the savings-investment gap rising to a new high of 5.9%.

AXJ’s ability to stimulate domestic demand (the major components being fixed investment and private consumption) remains constrained. AXJ’s (excluding India) fixed investments are made with an eye on potential global demand rather than domestic consumption. Hence, the fixed investment trend has tended to follow the region’s export and global growth cycle. The structural dynamics of private consumption also remain uninspiring.

Excess liquidity — reaching unmanageable proportions

Unable to revive domestic demand, the region’s export-dependent economies continue to accumulate foreign reserves by intervening in the FX market. So far, there has been little evidence of the region’s central banks (except Korea and to a small extent India) letting the currency appreciation (on a real effective exchange rate basis) take the pressure in a meaningful manner. This is evident in the recent sharp rise in sterilization efforts. AXJ’s excess liquidity stock (sterilization of liquidity through issuance of bonds) has increased to about US$820 billion (14% of GDP) from US$510 billion (9.9% of GDP) in December 2005 and US$380 billion (8.5% of GDP) in December 2004. Again, China accounts for the bulk of it at US$615 billion. Indeed, the aggregate AXJ excess liquidity stock now accounts for 44% of its total reserves. Moreover, with US short rates at 5% (91-day treasury bill) being higher than the weighted average rates in AXJ (currently at 3%), there are no perceived financial costs associated with building such high stocks of excess liquidity.

Side effects of excess liquidity challenge existing policy

Many of the region’s central banks are in a difficult position, as the side effects of this rising liquidity are affecting the effectiveness of their monetary policy measures. Clearly, two of the region’s standard-bearers — China and India — are now facing major challenges with the continued rise in FX reserves (see India and China: Reigning in Overstretched Growth Cycles, December 22, 2006). While China is suffering from the problem of excess fixed investment and unmanageable asset price inflation, India is facing goods inflation as well a euphoric rise in property prices.

Policy makers in China and India are becoming increasingly aggressive in addressing the side effects of excess liquidity with several measures over the past 12-18 months. Although a direct increase in the cost of capital would be the easiest way to change the behavior of borrowers and slow growth in both these economies, in an environment of exuberance about emerging markets as an asset class, central bank actions to increase domestic interest rates aggressively to slow growth would only result in attracting more capital, in our view. As a result, the focus of the central banks has been to initiate measures other than just raising interest rates. A summary of the administrative and monetary policy related measures undertaken by both countries follows:

India’s measures — focused on slowing credit allocation to consumption and the property sector: The RBI has been concerned about strong credit growth, particularly in select sectors, such as borrowing by individuals and real estate lending. It has initiated some quantitative measures to influence the quality of credit growth (including increasing risk weights on commercial real estate, housing and consumer loans, and increasing provisioning required on standard assets in specific sectors). Aside from these measures, the central bank has raised policy rates by 150bp over the past two years, as well as raising the cash reserve ratio by a cumulative 100bp between December 2006 and February 2007.

China’s measures — targeted at reining in investment: Over the past year, the Chinese government has taken various measures to rein in investment, particularly the rapid real estate development. The property sector has been one of the key areas of concern for Chinese policy makers. The government has also initiated measures to cut capacity and to promote consolidation in certain hard commodity industries. Additionally, it has begun the unification of tax rates for domestic and foreign enterprises. Over the past 12 months, the central bank has raised benchmark lending rates by 81bp (including the 27bp hike announced this weekend) and also resorted to a cumulative 250bp rise in the cash reserve ratio.

What’s the end game?

The substantial amount of FX inflows has not only had an adverse impact on AXJ central banks’ ability to manage their monetary policies, but has also affected their ability to effectively manage such large reserves. Clearly, the solution as G7 Communiqués have been highlighting is to allow meaningful adjustment in AXJ currencies. In addition, a sustainable solution also requires AXJ economies to rebalance their growth models and stimulate domestic demand via effective reform measures.

The policy makers in key economies, particularly China, have made some effort over the past couple of years to facilitate this change. However, in our view, the transition toward a relatively balanced model is likely to be very gradual. In the meantime, it is inevitable that AXJ central banks will look for opportunities to improve returns on their reserve assets. China recently announced its intention to transfer US$200-300 billion to Lianhui, a National FX reserve investment company being set up by the Chinese government. The Indian government has announced that it is considering the use of forex reserves for funding domestic infrastructure spending. A government-appointed committee has given its recommendations for facilitating this move and the government is currently evaluating the options in conjunction with the central bank.


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A Tale of Two Curves
March 19, 2007

By Serhan Cevik | London

Interest rates and inflation expectations tell us different tales about the economy’s future. Asset prices and survey-based market expectations can tell us many things about the future of an economy, but these signals are not necessarily always coherent and pointing to the same direction. Take, for example, domestic interest rates and inflation expectations. Theoretically speaking, we should be able to uncover a link between nominal interest rates and the future path of inflation. However, the shape of the yield curve in Turkey does not reflect the evolution of inflation dynamics all the time. Economic fundamentals and survey-based inflation expectations suggest that the yield curve should be inverted, looking beyond the current monetary policy stance and pricing in the coming decline in inflation and interest rates. But the spread between short-term interest rates and the 1-year yield stands at 145bp and even stretches to 190bp against 2-year interest rates, while inflation expectations point to a marked drop in inflation to 6.8% within a year and to 5.5% in two years from now. In other words, the divergence between inflation expectations and interest rates widens as we move along the time horizon. In our view, this curious phenomenon is a result of the possibility of exchange rate weakness (due to domestic politics and/or global risk aversion) that has become the overwhelming factor in determining the level of interest rates, the term premium and the slope of the yield curve.

Even though market participants expect monetary easing, the term premium remains high. There are various theories explaining the term structure of interest rates and the shape of the yield curve. The expectations theory, for example, suggests that market expectations of future interest rates determine the yield curve. However, the liquidity preference theory is more appropriate for the Turkish case, in our view, as it incorporates a premium for holding long-term bonds. This term — or liquidity — premium is indeed the key factor in determining the shape of the yield curve. For example, after last year’s global volatility shock, not only have interest rates risen, but also the marked increase in the term premium has dramatically altered the shape of the yield curve. However, changes in inflation expectations cannot fully account for this increase in the term premium, even though inflation expectations (which are, by the way, backward-looking and reflect realized inflation in the Turkish economy) point to lower short-term interest rates in the future. Therefore, the term structure of domestic interest rates implies an additional risk premium that by and large reflects the possibility of exchange rate weakness and higher inflation volatility (see Pricing the Unexpected, February 12, 2007).

Economic fundamentals will become more influential over inflation dynamics. Inflation seems to be trapped in a tight range, around 10%, after declining from an average of 73.7% in the 1990-2001 period. But this is not a mysterious resistance or a result of domestic imbalances. Instead, Turkey has suffered from a number of supply-side shocks — higher energy quotes, an unusual surge in food prices and the lira’s sharp depreciation. Nevertheless, as the latest figures show, consumer price inflation declined from 11.7% last July to 10.2% in February. It could have been even lower, but food prices (which account for 28.5% of the consumer price index) kept increasing beyond seasonal patterns and limited the correction in headline inflation. Indeed, core measures of inflation confirm the gradual but steady downward shift in inflation dynamics. For example, the seasonally adjusted core CPI posted an annualized increase of 5.3% in February, down from 7.8% in December and 13.4% last summer. Even though we do not expect a sudden drop in the headline figure until the second quarter and there are well-known risks, inflation will start converging towards the central bank’s target. In our opinion, economic fundamentals — such as the composition of growth, fiscal consolidation, the state of the labor market and the output gap — will gain more and more influence over the behavior of inflation. This is why market participants must not ignore underlying fundamentals in determining the term premium. After all, beyond short-term pressures (like political uncertainty or global risk appetite), secular developments are far more important for a country’s credit quality, risk premium and the shape of the yield curve.


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Going Global
March 19, 2007

By Elga Bartsch | London

Germany is the turnaround story in Europe at the moment. This past week, two of the major German economic research institutes raised their 2007 growth estimates for Europe’s largest economy. Other think-tanks might follow before the six main economic research institutes convene later in the spring to produce their joint report on the economic outlook on behalf of the German government.

My former colleagues at the Kiel Institute of World Economics proved most optimistic, raising their GDP growth estimate for this year from 2.1% to 2.8%. In other words, the Kiel Institute’s business cycle experts no longer expect a meaningful slowdown compared to expectations for 2.7% in 2006. This would be remarkable, given the three-point VAT hike and the fiscal consolidation package implemented at the beginning of this year. While we have highlighted potential upside risks to our own full-year estimate of 1.9%, we are holding our fire, at least for now. This is because we take the downward revision to output plans by companies reported in recent business surveys seriously. As a result of these downgrades, we see a risk of softer-than-expected GDP growth this spring (see Business Cycle Watch, Striking Contrasts, February 23, 2007). Needless to say, we are eagerly awaiting the next batch of business surveys out of the euro area. Next week, the first installment of March business surveys will come from Belgium and the Netherlands, but the heavy hitters, such as the Ifo, the Insee and the Isae survey, will not be released until the week after.

The cyclical and structural turnaround of the German economy, dubbed the sick man of Europe not so long ago, is very good news for the euro area as a whole, for two reasons. First, Germany looks set to become more of a locomotive again in terms of domestic demand growth. Second, the German economic revival shows — like the Dutch economy before it — that the adjustment process within the euro area seems to be working reasonably well (see Netherlands: Roundtrip, December 15, 2006). This adjustment process, driven by relative inflation and labour cost dynamics, cools down countries that have started to overheat relative to the rest of the euro area through a loss of competitiveness as long as national inflation stays above the euro area average. Likewise, it reignites growth in those countries that go into hibernation relative to the remainder of the euro area as they start to regain their competitiveness via below-average increases in consumer prices and unit labour costs.

As I have argued before, the main motor of reforms in Germany was the corporate sector (see Macro Reforms Meet Micro Restructuring, August 24, 2005). Globalisation drove the micro-restructuring we saw at the company level in Germany over the past few years. German companies, faced with weak domestic demand and high labour costs, were forced to look abroad for opportunities to get their businesses back into shape. Contrary to domestic policymakers, corporate Germany has embraced the challenges and the opportunities of globalisation. As a result, the degree of openness of the Germany economy has surged.  Today, the share of exports and imports in GDP, a broad measure of the extent to which a country is intertwined with others via international trade, registers 87.5% of nominal GDP (see also Excelling at Exports, February 26, 2007).  This is about one-third higher than what you would find for other larger European economies, such as the UK, France, Italy or Spain, where the share of international trade in goods and services in GDP has broadly stagnated over the last ten years. In contrast, other large European countries have not made much progress in rising to the challenges of globalisation.

Most economists would argue that deeper integration into the international division of labour is beneficial for any economy. This is because it allows a country to leverage its comparative advantage. Concentrating on producing those goods and services that one produces best and leaving the others to those who have a comparative advantage in producing them goes a long way in explaining the renewed strength of the German economy, I think. In this context, the persistent gap between the Ifo business climate and the ZEW investor sentiment survey is interesting, because the Ifo business climate summarises the views of some 6,000 company captains and the ZEW investor sentiment canvasses some 300 analysts and investors. The persistent discrepancy between the two surveys suggests that the latter has not yet fully taken on board structural improvements.  As the Ifo business climate is the ‘true magnetic North’ for the business cycle, we would expect the ZEW business expectations to make further gains in the coming months after registering a higher-than-expected reading of 5.8 reached in March. At the same time, the Ifo business climate, which still stands more than two standard deviations above its long-term average, should gradually correct to 106.3 in March, we think, after a reading of 107.0 in February.

Notwithstanding the potential soft patch ahead, the broader and deeper integration into the global economy is a win-win strategy for Germany, due to the efficiency and productivity gains it brings. But the higher degree of openness also implies a greater sensitivity to global economic shocks. In this sense, Germany — after all a G3 economy — is in the process of becoming a small open economy. With recent concerns about the US economy and the state of its housing market, the potential repercussions on the consumer and the reluctance of US companies to invest, the greater exposure to the global trade cycle is something worth bearing in mind for forecasters. In the future, Germany may prove a bellwether to gauge the potential impact of the global business cycle on the euro area, provided we find our main scenario of solid global economics fundamentals confirmed.


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Expected Move, Unexpected Timing
March 19, 2007

By Denise Yam | Hong Kong

Chinaraises interest rates ...

In an expected policy move though at an unexpected time, the People’s Bank of China (PBoC) announced a rise in interest rates at 5pm on Saturday, March 17, 2007, effective from March 18. 1-year benchmark lending and deposit rates have been raised by 27bp, to 6.39% and 2.79%, respectively.

... earlier than expected

We had expected China to hold back from raising rates until the 1Q07 economic report (due in the third week of April). January-February data released over the past week demonstrated strong growth momentum, but, in our view, did not suggest that the economy was so overheated to warrant an immediate rate rise. In particular, fixed asset investment and inflation figures, generally perceived as rate rise triggers, were both benign. Upside surprises in the data came through exports and industrial production, which are not the usual triggers for tightening, while fast money and loan growth signalled sustained excess liquidity and led us to expect liquidity withdrawal from interbank market to continue. The latest hike again highlighted the unpredictability of the timing of China’s policy moves.

Combining rate hikes with liquidity management to raise cost of capital

Since macro tightening began in 3Q03, China has relied more heavily on liquidity management tools (i.e., reserve requirement rises and bond issues to financial institutions) than raising interest rates to control loan growth. However, this has mainly served to sterilize the inflows from the ballooning balance of payment surplus, and has only mostly worked on ‘excess’ liquidity rather than lifting the cost of capital meaningfully. The interest rate rises so far have left rates still way below the neutral level consistent with the pace of economic growth, fostered speculation in asset markets, and left China vulnerable to a rebound in excessive investment. We have argued that quantitative monetary tightening should be combined with interest rate increases, to raise the cost of capital in China over the medium term and achieve better allocation of financial resources. The latest rise, though at an unexpected time, is certainly an encouraging move in the right direction.

Economic impact

Although the 27bp rise contributes little to closing the gap between China’s interest rates and their neutral level consistent with the pace of economic growth, it serves to reiterate the government’s determination to gradually slowing and rebalancing the economy. The gradual rise in the cost of capital should lead to a marginal rejection of low-return investments and contribute to improving financial capital allocation. From the household perspective, the marginal rise in deposit rates should do little harm to the robust consumption growth currently underpinned by improving job market conditions, rising employment income and wealth accumulation. Better returns on their savings deposits with financial institutions should also serve to halt the drain of savings deposits of late towards stock market investments.

Further monetary tightening this year and next

China has raised interest rates four times (totalling 108bp on the 1Y lending rate) and the reserve requirement ratio seven times (totalling four percentage points) in the current tightening cycle. We expect further monetary tightening this year and next. Our central case is for a combination of measures that address both the price and quantity of capital. We expect one more interest rate rise and one to two more reserve requirement rises in 2007.


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