Israel
Testing the Speed Limit
March 20, 2007

By Serhan Cevik | London

The Israeli economy is powering its way to its most robust expansion in years. Even against all sorts of shocks, Israel’s economy has kept growing at an above-trend pace in recent years. And the latest national accounts confirm the continuation of the country’s new growth trend. Real GDP growth accelerated to an annualized rate of 8% in the fourth quarter of 2006, from -0.7% in the third quarter and 5.9% in the first half. In other words, the Israeli economy recovered quickly and strongly from the conflict with Lebanon that led to an abrupt slowdown in the third quarter. Thanks to fiscal consolidation, the private sector has remained the leading engine of economic growth, posting an annualized output increase of 12.8% in the final quarter of last year and an average of 6.4% in the whole year. On the production side, high-technology sectors of the economy achieved an output growth of 23.5% and thereby pushed the overall rate of increase in industrial production from 3.7% in 2005 to 10.5% in 2006. On the expenditure front, both consumer demand and business investment spending leapt upwards — by 4.8% and 6.4%, respectively — and helped to boost real GDP growth to 5.1% last year. This is indeed an astonishing growth performance, especially following a 5.2% increase in the previous year and 4.8% in 2004. No wonder the central bank is once again concerned about the output gap and its inflationary consequences throughout the economy.

The steady decline in unemployment is an indication of the narrowing output gap. According to the Bank of Israel’s estimations, the narrowing of the economy’s output gap contributed 40bp to the annual rate of inflation last year. In our view, the latest macro figures point to an even narrower output gap and a greater contribution to underlying inflation pressures. Take, for example, the steady decline in unemployment from 10.9% of the civilian labour force in 2003 to 7.7% at the end of last year. This is in fact the lowest unemployment rate in the past ten years and confirms the broadening of economic expansion in Israel. Although the strength of productivity growth and a manageable increase so far in real wages keep unit labour costs under control, low interest rates will continue fuelling domestic demand and eventually lead to more pronounced inflationary pressures, in our view.

Deflation is a result of currency strength and will soon disappear, according to our estimates. The consumer price index posted a monthly drop of 0.3% in February, as expected, due largely to seasonal factors, lower energy prices and the strength of the shekel. On a seasonally adjusted basis, however, the CPI increased by 0.3% and at an annualized rate of 3.3% over three months. Nevertheless, the headline inflation rate still eased from a year-on-year reading of 0.1% in January (and 3.8% last April) to -0.8% last month — well below the central bank’s target range. The sudden shift in inflation dynamics is simply a result of the shekel’s appreciation, especially against the dollar, which pushed exchange rate-sensitive prices lower. For instance, the housing sector (which represents 22% of the CPI basket) experienced a 5.5% drop in prices because of the currency pass-through effect and thereby made the most significant ‘deflationary’ contribution to the headline figure. Of course, this is just technical deflation and should soon normalize, as the shekel’s appreciation becomes less influential over pricing decisions (see Technical Deflation, November 20, 2006).

Deflationary readings are not a justification for more interest rate cuts, in our view. The Bank of Israel lowered short-term interest rates by 150bp in a matter of a few months to 4%, as inflation turned into deflation. But, in effect, the central bank is responding to exchange rate movements that may not be necessarily be affected, at least in the short run, by changes in interest rates. Unfortunately, this makes monetary policy less potent and, at the same time, increases the risk of volatility in the future. Even though we expect the shekel to remain strong (thanks to fundamental improvements) and do not foresee an abrupt increase in inflation, economic developments will gradually bring consumer price inflation within the central bank’s target range. This is why we do not believe that deflationary readings resulting from the shekel’s appreciation are a justification for further monetary easing.

 

Mexico
No Hike, No Comfort
March 20, 2007

By Gray Newman and Luis Arcentales | New York, New York

When Mexico’s central bank meets this week, we expect it to keep interest rates unchanged.  More importantly, however, we expect it to back away from the rigid rule it put in place in its February 23 communiqué and replace it with new hawkish language giving it maneuvering room to hike in the future.  The March communiqué — set for release this Friday — is unlikely to resolve the debate in the market on whether Banco de Mexico will be prompted to hike this year, but it is likely to push out the date of any possible hike.

We maintain our forecast of no hike in interest rates in Mexico in 2007 and still expect interest rates to have room to fall in 2008, but concede that Mexico watchers are unlikely to be given much comfort that our forecast of the rate path is the correct one.  Both the inflation readings in the months to come and the central bank’s statements are likely to keep the debate over interest rates alive at least through the third quarter.  That does not mean we cannot have positive reports with lower-than-expected readings; indeed, that could take place this week. Only that the improvement on the inflation front in Mexico is likely to be bumpy, with conflicting signals between core and headline and between month-over-month and year-over-year readings.

Reversing the February rule

The February communiqué was one of the most unfortunate statements made by Banco de Mexico in recent memory, in our view.  The communiqué issued an ultimatum: either core inflation would begin to show a reversal in March in both year-over-year and month-over-month terms or the central bank would move to hike interest rates (see “Mexico: Banco de Mexico’s Ultimatum” in This Week in Latin America, March 5, 2007).

We suspected that Banco de Mexico never intended to jettison its long-stated focus on whether the current transitory uptick in inflation was beginning to contaminate wage agreements, inflation expectations or other prices.  Instead, we suspect that the central bank wanted to accomplish two things in February:

• First, Banco de Mexico wanted to send a strong signal that interest rate cuts were now out of the picture.  In January, the central bank first suggested that a hike could be necessary, but the language was almost a line of central bank boilerplate that simply stated that the central bank would act if it needed to.  The February statement was designed to prepare the market in the event that a hike was needed.  Recall that the central bank has been sensitive to concerns that it may have mislead the market with its relatively benign statements in November and December, which did not suggest the sharp uptick in inflation that took place in January.  

• Second, the central bank wanted to signal that the longer inflation remained significantly above its targets, the greater the risk that expectations, wages and other prices could be contaminated. We suspect that the February communiqué was meant to convey that Banco de Mexico would not necessarily have to wait until wages or medium-term expectations or other prices began to move up to act.  The central bank was trying to avoid a rigid rule limiting when it could hike rates.  But by avoiding that rigid rule, it set itself up for a much more rigid precept that, if read literally, was even worse: the February communiqué risked shifting attention away from what really should drive central bank policy, namely whether the current supply shock was threatening the medium-term trend of inflation. In addition, it introduced an artificial deadline. If other prices, wages or expectations began to show a worrisome trend, we’d expect the central bank to consider acting regardless of what happens to March’s core readings.  And, alternatively, if Mexico suffered an unexpected supply shock in the second week of March which monetary policy is particularly unsuited to deal with, we’d hope that monetary policy wouldn’t be on autopilot, forcing the central bank to hike rates.  

March’s communiqué

Banco de Mexico’s statement on March 23 is likely to contain three elements.  First, we expect it to note that core inflation is showing an improvement in the first half of March, but to warn against extrapolating from such limited data.  Second, we expect the central bank to argue that it will continue to watch core carefully in the months to come and will remain ready to act if deems it appropriate — either because some contamination is being seen or because it fears that such contamination is likely.  Finally, we expect the central bank to note that the Mexican economy is slowing sooner and at a somewhat more pronounced pace than the central bank thought at the beginning of the year.

While the statement on a slowing economy might provide some relief to those worried that Banco de Mexico is ready to act, that comfort is likely to be offset by the statement that the central bank reserves the right to act in the months ahead even if it does not see any contamination.  The risk of contamination may be enough to provoke Banco de Mexico to move. 

The good news on Mexico’s inflation front is that we are not seeing any generalized pressures on prices.  Medium-term expectations remain well-anchored, other prices have not suffered an uptick and wages remain consistent with a move towards the target of 3% inflation.  This past week, one of the most contentious wage negotiations ended with the electricity workers union accepting a 4.25% increase in wages.  While you can debate what the pace of productivity growth is within Mexico’s electricity sector, there is little doubt that with modest productivity growth in the broader economy, a 3% inflation target is not put in jeopardy by wages growing near 4%.

Our concerns are two-fold: while core is likely to improve in the months to come, the path is likely to be bumpy; and headline readings could easily move above 4.5% and closer to 4.6% or 4.7% in May, June and July before turning down.  Of course, much of the uptick is due to little more than a difficult base of comparison, and should not matter.  Still, it is likely to attract attention and provide cause for concern at the central bank. After all, with a bumpy core and high headline year-over-year numbers, there is some risk that they could begin to contaminate expectations and wages.  If enough economic agents think inflation is on the rise and act accordingly, it will likely turn up.  We suspect that this will not be the case, in part because we see the economy slowing in 2007, which is likely to take off some of the pressure that was building last year.  

Bottom line

We are much less concerned about inflation in Mexico than we are about the prospect for reforms to move forward.  On that front, the authorities have made some progress this past week with a bill in congress with broad political support to stem the fiscal losses associated with Mexico’s ‘pay as you go’ public workers pension system.  But while that is positive, we are concerned that convincing the broad policymaking class to take politically costly steps in other areas while facing an abundance of convergence inflows will be difficult.  That, and not the temporary inflation scare at the beginning of this year, remains Mexico’s greatest challenge, in our view.

 

Eastern Europe
What Risk from Baltic Contagion?
March 20, 2007

By Oliver Weeks | London

Concerns about unsustainable credit booms in Eastern Europe continue to build, with the Bank of Latvia intervening last week in support of the lat for the first time since 2001.  Although speculative activity in the Baltics is low and the cost build-up is relatively recent, Latvia does look to us to be overheated and potentially vulnerable.  Wider sell-offs in the past have had their origins in small countries, Thailand and Iceland among others.  If the Latvian government remains slow to react we think that any loss of confidence could put pressure on Estonia, Lithuania and feasibly Bulgaria, all also seeing credit booms supported by fixed exchange rates.  However, we think that fears of contagion to the rest of Eastern Europe, where FX regimes are more flexible and external positions far stronger, are greatly exaggerated.  Slovakia’s ERM parity revaluation underlines the very different dynamics of export performance across the region.

Latviaclearly overheating.   Strong growth expectations, weak fiscal policy, negative real interest rates and a perceived absence of exchange rate risk have fuelled a boom in Latvia that does not look sustainable to us.  Real GDP over the past three years has averaged 10.3%, led by real private consumption growth of 11.5%.  Under pressure from labour emigration, nominal wage growth in 2006 was 23.0%, the fastest in the EU, even before public sector and minimum wage hikes in January.  House price growth in Riga has topped the Knight Frank global index of 32 countries in both of the past two years, rising by 39% in 2006 and 66% in 2005.  With the economy also facing more aggressive energy pricing from Gazprom, headline inflation accelerated to 7.3%Y in February and the current account deficit to 20.9% of GDP in 2006.  FDI amounted to 7.0% of GDP in the same period, leaving the bulk of financing (28.5% of GDP) related to lending from foreign banks.  Credit growth to the private sector has averaged 63% over the last year, taking the stock of private sector credit to 76% of GDP.  Both bank credit and FDI have been focused more on the real estate market than on future export capacity.  Over 70% of the stock of loans is in EUR, boosted by the removal of capital charges for foreign exchange risk on EUR-denominated lending in 2005.  If such confidence in the equivalence of EUR and LVL risk is not maintained, the risk from a reversal of inflows looks significant to us. 

Anti-inflation plan not yet convincing.  Under market pressure, the Latvian government has belatedly come up with a plan to combat inflation, promising a shift to a balanced budget in 2007, capital gains tax on real estate held for less than three years, requirements to lend only against proof of income, and as yet unspecified measures to improve energy efficiency and labour market flexibility.  While the agenda looks appropriate, we are not convinced that this will prove enough to turn inflation around.  The four-party governing coalition is disparate and fragile.  Previous promises by PM Kalvitis to balance the budget have not been fulfilled.  We do expect the central bank to continue for now to resist the recent pressure on its 1% tolerance bands.  Unit labour cost data suggest that the cumulative wage and inflation acceleration is not yet prolonged enough to make competitiveness clearly unsustainable.  Official FX reserves stand at EUR 3.4 billion, 21% of GDP and four months of imports — of which only EUR 65 million was spent last week.  The central bank raised policy rates by 50bp to 5.5% last week but a higher rate differential looks likely to be necessary.  Gross external debt stands at 104% of GDP, of which 70.5% of GDP is held by commercial banks (55% of it classified as short term).  These banks are overwhelmingly Scandinavian-owned, financially robust, and have made a long term strategic commitment to the region.  Nevertheless, the pace of inflows at least looks unlikely to be sustained.  Unless the government quickly gives teeth to its anti-inflation program, export competitiveness may deteriorate sharply and a disorderly adjustment under pressure from further rating agency downgrades is a realistic risk. 

Risks for other Baltics, but not Central Europe.  Pressure on Latvia would likely have implications for Estonia and Lithuania, where fiscal policy has been stronger but similar issues of fixed exchange rates, banking booms and external deficits are prominent, and where the same Scandinavian banks dominate the market.  Estonia’s current account deficit stands at 12.6% of GDP and Lithuania’s at 10.4%.  Bulgaria’s fixed exchange rate and 16.3% of GDP current account deficit also stand out in this context, though fiscal policy has been tighter, there are fewer signs of overheating, FDI is stronger, and different foreign banks are involved.  In Romania, we remain concerned by plans to loosen fiscal policy, despite a 10.3% of GDP current account deficit, but here a floating exchange rate would allow a calmer adjustment if necessary.  Importantly, however, we see no contagion risk for Central Europe, or indeed for Kazakhstan and Russia, despite their rapid credit growth. While Hungary has seen high external imbalances and a fast build-up of FX credit, the current fiscal squeeze has slowed domestic demand growth almost to zero.  We continue to see the current account deficit falling well below 5.0% of GDP this year.  In Slovakia, where the 2006 current account deficit was 7.9% of GDP, the turnaround from car exports is set to be spectacular this year, as both the NBS and ECB have now implicitly acknowledged with the ERM parity revaluation.  In Poland, as in Latvia, emigration is tightening the labour market, and political obstacles to euro qualification remain substantial in both the Czech Republic and Poland.  Yet, here too the rise in export capacity from recent and planned foreign direct investment in the car and electronics sectors looks very powerful.  With sub-5% current account deficits, the 3% of GDP net capital inflows likely to come from the EU next year also look more significant.  Further east, while Kazakhstan may move into current account deficit in the short term, and Russia in the longer term, the external positions here look very robust under almost any plausible commodity price scenario.  Wider risks from pressure in the Baltics look strictly limited to us.

 

Japan
The Moment of Truth Looms — Tankan Preview
March 20, 2007

By Takehiro Sato | Tokyo

External conditions clouding the outlook, but…

The previous December Tankan headline number was solid, despite slowdown concerns on the global economic front.  The key to the March Tankan is whether confirmation arrives of continued improvement in corporate sentiment, even as the outlook on the US economy grows hazier.  We think the headline will strengthen sufficiently. If corporate sentiment again bucks the tough environment that we expect and recuperates, this would be a minor pleasant surprise.  But with the outlook assessments increasingly bleak, we look for a mixed Tankan.

The general trend in our economist industry has become that the BoJ Tankan forecast is announced sooner after the Reuters Tankan, but this time there will again be a gap of over ten days between the two.  Sudden changes in the market could shift corporate sentiment somewhat in the next ten days while the BoJ is conducting its survey.  Therefore, we could still revise our forecasts, depending on market trends.  The January-March Business Outlook Survey (TBA: March 22) and the February Index of Industrial Production (TBA: March 30) are the relevant economic indicators coming out before the Tankan. 

Forecast for business conditions DIs

We expect a +1ppt QoQ improvement over the December Tankan in the current DIs for business conditions at large manufacturing (to +26) and non-manufacturing (to +23) enterprises. 

Despite increasingly uncertain external conditions, we look for the following to hold sentiment steady in manufacturing industries: (1) in general, corporate sentiment is somewhat buffered from short-term market changes, and swayed more by past performance, including production trends from the quarter before; (2) despite a let-up in yen weakness, in real effective terms the yen remains exceedingly cheap; and (3) corporate profits are easier to turn thanks to lower breakeven points now that companies have streamlined fixed costs.  Likewise, we expect non-manufacturing sentiment to benefit primarily from relatively strong sales in retail industries, as was the case in October-December, with the mild winter accelerating sales of spring seasonal apparel. 

Meanwhile, the outlook assessment DIs should again turn more cautious.  The forward assessment DIs often weaken as the current condition DIs climb.  This time as well, we think the outlook assessments for large manufacturers will come in at +21, 5ppt behind the current assessments.  This is not entirely bad, however.  Still, the corporate outlook of market participants seems to be clouding over, in contrast to the sunny headline figures.

Our rough estimates of the BoJ Tankan forecasts based on the Reuters Tankan offer a mixed bag, with manufacturing dipping 2ppt from the December survey and non-manufacturing improving 1ppt.  But because the Reuters Tankan survey period (February 28-March 14) coincided with the wave of equities sell-offs globally, possibly introducing bias into the survey, we would recommend not reading too much into the Reuters Tankan result.

Forecasts and management plans in F3/07 and F3/08

(1) Sales and profit targets: The December Tankan stuck with conservative plans for large manufacturers in all industries in F3/07, with sales projected up 4.0% and recurring profit up 5.5%.  Yet, the October-December MoF Corporate Statistics showed recurring profit growth of 8.9% YoY for large enterprises with over JPY 1 billion in capital (in manufacturing industries +14.9%), and growth currently has not relented.  It seems that companies remain cautious despite the current earnings strength, but it is hard to find rational grounds for forecasting profit declines for January-March when it gets to the stage of estimating actual earnings, and we expect full-term earnings guidance to reflect the true situation.

In F3/06, initial profit targets for F3/07 looked for flat YoY performances but fresh in the memory are upward revisions to 10% growth at the interim, and ultimately profit nearly 20% higher than the previous year. Looking at how targets were revised in F3/06, we think there are ample grounds for expecting forecasts of near-10% growth for F3/07 as well. However, given companies’ conservative stance, we do not expect the sales and profit targets for F3/08 that firms will be publishing shortly to be very upbeat. As a rough guide, we expect targets for both sales and profits to be about flat YoY at best. 

(2) Capex plans: Percentage-wise, the biggest revisions to capex plans by large corporations for the year tend to occur in the June Tankan. This is because few companies make institutional decisions at the time of the March survey, and such decisions on management plans for the business year tend to be taken, along with compilation and publication of the previous year’s results, at the time of the June survey. Moreover, the change up to the September survey is the smallest for the entire business year because few companies review their annual capex targets ahead of interim results. Meanwhile, revisions in the December Tankan basically depend on the economic cycle, and in general are made upwards when the economy is expanding, and downwards when receding. In addition, the usual pattern is for the March Tankan to bear little relation to the economic cycle, and for small downward revisions to be made from December. This appears to reflect the physical lack of time to execute all the plans ahead of the end of the business year, resulting in implementation being put back to the following year.

In the three years since F3/04, these plans have largely been revised down at the March survey. This year we forecast a downward revision of 0.3% by large corporations compared with the Decembers of the past three years (manufacturing -0.5%, non-manufacturing -0.2%). From here, we expect the capex targets of large corporations to increase 12.0% YoY (+16.0% for manufacturers, +9.9% for non-manufacturers).

For F3/08, we have been expecting capex plans, soon to be unveiled for the first time, to start off with a small YoY rise of 2.5% for large manufacturers, and a small dip of 1.0% for large non-manufacturers, resulting in a rise of just 0.3% for large corporations in all industries. For a number of reasons, including because the Development Bank of Japan’s survey of capex plans, a leading indicator, will take place once a year in June beginning this year, in truth there is little to go on in forecasting capex plans for the new business year. Here, therefore, we have taken a stab at estimating such targets for F3/08 based simply on the past pattern.

Policy/market implications

The BoJ finally executed an additional rate hike in February after some bumps along the road, prices are set to veer into negative growth, and the US economic outlook is increasingly opaque.  Considering all this, we doubt that the March Tankan will provide strong guidance for the BoJ’s future monetary policy.  Minus a full-throttle slowdown in the US economy, the market is likely to grow hopeful of another rate hike after the release of January-March GDP data, and once the Upper House elections enter the picture in May-June.  Of course, even then we expect the YoY decline in prices to accelerate gradually, and so in our view the BoJ is unlikely to engage in a rate hike campaign.

Still, many investors have been asking us for a counter-argument for a possible rate hike even with prices falling, in light of the BoJ’s stance of focusing on a so-called ‘second pillar’ (second perspective). However, we have to ask if there is any central bank that would raise rates at a time of negative price growth. For the BoJ to make doubly sure, two things are probably necessary: fresh confirmation that manufacturing production is in a moderate uptrend upon evidence from industrial production and of a tendency for upward revisions in production outlook indicators; and fresh confirmation from the consumer price data that the basic direction of prices excluding special factors (oil price, etc.) is in line with its own scenario. On this point, we think there is bound to be a downward revision at least in the price outlook in the April 27 Outlook Report, even if not in the outlook for GDP growth.  If the BoJ gave a bullish message on the price outlook, the market could simply laugh it off as wishful thinking. We maintain our outlook of no additional rate hike throughout F3/08.