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Middle East/North Africa
Dragon’s Appetite March 22, 2007 By Serhan Cevik | London Oil-dependent economies in the
United States
Refilling the Punch Bowl? March 22, 2007 By David Greenlaw | New York The statement issued by the FOMC on Wednesday afternoon contained one significant surprise. Specifically, the risk assessment language was altered in a way that left the tilt toward inflation concerns in place but removed the tightening bias. A reference to “additional firming” was replaced by “future policy adjustments” as seen below: March 21 statement “In these circumstances, the Committee’s predominant policy concern remains the risk that inflation will fail to moderate as expected. Future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.” January 31 Statement “The Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.” So, the tilt toward inflation concerns remains, but the potential policy response is now two-sided. We see the change as reflecting a ‘cleaning-up’ of the risk assessment language that carries little policy significance. However, we admit that there is one major problem with this interpretation. The Fed knows the risk assessment was being viewed as a signaling mechanism. Why change it now and risk generating market confusion about its near-term intentions? While the adjustment to the risk assessment came as a surprise, the changes to the growth and inflation language in the first part of the statement were very much in line with expectations. The depiction of economic growth was downgraded and the spin on the housing market reflected less optimism than seen in the January statement. This was countered by an expression of a bit more concern regarding recent inflation readings. Most importantly, the Fed still sees the economy expanding at a moderate pace in coming quarters while inflation pressures are expected to gradually ebb. In the immediate aftermath of the statement release, 2-year Treasury yields fell by about 10bp, the 2s/10s curve steepened by about 5bp and the implied probability of a rate cut by the time of June meeting, as measured by the fed funds futures market, rose from 25% to 40%. Credit spreads narrowed by about 5bp and the ABX index rallied. In the equity market, the S&P 500 jumped nearly 1.5%. The bottom line is that we doubt the FOMC was looking to signal a ‘Bernanke put’ to holders of risky assets. But, that is how some appear to be interpreting the message. Admittedly, all this leaves us a bit confused regarding the Fed’s policy message. We’ll be particularly anxious to see the details behind the tweaking of the risk assessment in the minutes of today’s meeting, which will be released on April 11.
UK
The 2007 Budget — No Free Lunch March 22, 2007 By David Miles | London Chancellor Brown had little room for manoeuvre in his eleventh — and almost certainly his last — Budget. In the past few months, tax revenues have been marginally weaker than he had anticipated, and he had limited scope for more borrowing, given his fiscal rules. So, his main changes had to be self-financing. Thus, despite the initial headlines that the Chancellor had managed to find some tax cuts, the reality is that these are matched by (somewhat less obvious) effective tax increases elsewhere. There were no free lunches here. The headline rate of corporate tax has come down — but this is financed by net reductions in capital allowances and a rise in the tax rate on small businesses. He has announced a cut in the basic (or headline) rate of income tax — but this is offset by removing a lower rate on the first band of taxable income and by an increase in the effective rate of national insurance on some earners. A substantial amount (£6 billion) has been found for pensioners employed by companies that went bankrupt and who were not covered by the recently created Pension Protection Fund. Education spending is one of the few elements of overall government expenditure forecasts to rise roughly in line with GDP; most other spending departments have to see their spending fall as a percent of GDP. Overall borrowing is marginally higher over the next few years, but is projected to stay just under the 40% net debt ceiling. Asset sales bring in significant revenues to finance some of the higher spending. The Debt Management Office (DMO) has announced that it will sell around £60 billion of gilts this year; about two-thirds will be long-dated bonds. Looking further ahead, borrowing is little changed from previous forecasts. Not surprisingly, the Chancellor announced that he had succeeded in balancing the current budget, on average, over a ten-year cycle, which he estimated to have just ended. The 2007 Budget: Macroeconomic performance: - Slightly above trend growth is predicted for 2007 at 2.75-3.25%. Thereafter, growth is set at trend. We believe that the Treasury’s forecasts are slightly optimistic. They are based on fairly robust consumer spending. We anticipate that households will want to save more, and so in the near term, spending will be a bit less strong than in the budget forecasts. - The economic cycle is forecast to end in early 2007. This means that the aggregate surplus on the current budget over the estimated ten-year full cycle is approximately +£11 billion. This means that the Chancellor can say he has met the ‘Golden Rule’ over the last cycle. But it also means we begin a new cycle with a fiscal deficit. Government spending: - The Treasury now forecasts slightly higher overall spending over the next few years relative to the December Pre-Budget Report (PBR). Asset sales — more than new tax revenues or more borrowing — raise much of the funds needed to finance this. Borrowing: - Public Sector Net Borrowing is forecast to be slightly higher, and the budget deficit marginally worse. Net debt is forecast to (just) stay on the right side of the 40% ceiling. Tax receipts are predicted to rise by almost 1% of GDP over the next couple of years. What has been given away: - The basic rate of income tax, which will be reduced from 22p to 20p as of April 2008, but this is largely offset by the removal of the lower 10p starting rate. - The rate of corporation tax, which will be reduced from 30p to 28p as of April next year; this is largely offset by less generous capital allowances. - £6 billion of additional funding for individuals who lost their pensions as a consequence of pension fund bankruptcy. Where does the money come from? - Asset sales, including the securitisation of £6 billion of student loans, will generate an additional £18 billion over the next few years. - An increase in the rate of small business taxation from 20p this year to 22p by 2009. - National insurance contributions will be levied on more income. Debt management: - The Debt Management Office (DMO) plans to raise £59.8 billion in 2007/8, £58.4 billion of which is from gilt sales and the remaining £1.4 billion from Treasury Bills. Gilt issuance is marginally down on this year, largely because the debt office will run down its stock of cash. - Just under two-thirds of planned gilt sales will be long-dated in 2007/8. - There is little change in borrowing further ahead as compared to the December Pre-Budget report. Conclusion The budget is, overall, fiscally neutral; there has been little change in the planned level of borrowing. But within a broadly unchanged balance between planned spending and taxing, there have been some significant changes. The corporate tax changes will create winners and losers as the balance between tax rates on smaller and larger companies shifts, and capital allowances change. There have also been some significant changes in the way income tax and national insurance contributions are levied. Asset sales have helped allow the Chancellor make a big one-off contribution to those who had pensions with companies that became bankrupt. As with any broadly neutral budget, this one will create losers as well as winners. It creates a somewhat simpler system of corporate and personal income taxation — removing some of the intricacies Chancellor Brown had introduced in earlier budgets.
Turkey
Subprime Motives March 22, 2007 By Serhan Cevik | London Volatility is in the nature of financial markets and does not necessarily signal bad fundamentals. It never ends. Like fractals, volatility is omnipresent in every tic of data, driven by one reason or another. However, the outbursts of volatility in financial markets are not necessarily a sign of weak economic fundamentals. There are of course imbalances in the world economy, but we need to treat them carefully in the light of institutional developments and structural changes around the world that may well be, at least, partially responsible for the emergence of global imbalances in the first place. Last year, for example, market participants experienced two consecutive panic attacks — first, about the prospect of higher interest rates in the Changes in global risk appetite have become the biggest risk to emerging economies. In the good old days, fiscal problems and structural weaknesses in developing countries used to be the trigger for abrupt adjustments in financial markets. That is no longer the case, thanks to prudent policies and structural reforms adopted by an increasing number of emerging economies. Instead, the abundance of liquidity and changes in global risk appetite present the most immediate threat. Let’s look into this issue from the Turkish perspective, once more. While holding approximately 70% of the free float in the stock market, foreign investors accumulated more than 20 billion lira worth of domestic government debt since last summer and now carry a fixed-income portfolio of 42 billion lira. In other words, non-residents own 35.7% of non-bank holdings of domestic debt, up from last year’s low of 20.7% and 11.5% at the end of 2003. With interest rates at 20%, it is not surprising to see Stronger fundamentals and tighter domestic liquidity conditions shield the Turkish economy. Turkey is — and will remain for a long while — exposed to changes in global risk appetite, but stronger economic fundamentals and tighter domestic liquidity conditions shield the economy against occasional bursts of financial volatility around the world. Take, for example, the VIX index — a widely used measure of global volatility — and the volatility of the Turkish lira. During last year’s volatility eruption, when the VIX increased by 110%, the lira weakened more than 30% in a matter of weeks and its volatility surged by a staggering 1275%. This time around, however, while the VIX jumped by 96%, the lira has remained fairly stable and showed a 56% increase in its volatility.
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