South Africa
South Africa’s Current Accounts: Negative Headline, Positive Detail
March 26, 2007

By Michael Kafe | Johannesburg

The South African Reserve Bank March Quarterly Bulletin released on Thursday showed that South Africa’s headline current account deficit widened to a record R143 billion or 7.8% of GDP in 4Q06. This was a great deal higher than our forecast of 6.2% and consensus expectations of 6.9%. However, the SARB was careful to point out that the reading was seriously distorted by a one-off jump in excess oil imports accounting for more than 2% of GDP.  Essentially, this means that the ‘true’ current account deficit was less than 5.8% of GDP, signaling virtually no deterioration from 3Q levels.  Details elsewhere in the Bulletin on the deficit composition, capital accounts and gross domestic expenditure suggest that South Africa may have already gotten over the worst patch.  We therefore maintain our cautious optimism, leaving our currency, inflation and interest rate forecasts unchanged.

Understanding the oil factor

Although South Africa meets a third of its daily energy needs through the use of local coal and natural gas to produce synthetic fuels, the country nevertheless remains a net importer of oil, with oil imports accounting for just over one-fifth of the country’s import bill.  During 3Q06, oil imports fell 17%, as a number of the country’s major refineries were shut down for routine maintenance. This led to a drawdown on (oil) inventories and contributed in no small way to the overall improvement in the country’s trade balance and current account deficit – despite the fact that oil prices rose to record levels that quarter. Things turned, however, in 4Q for two reasons: First, refinery activity resumed during the quarter and imported intermediate oil inputs were stepped up to ensure maximum possible throughput at the country’s refineries.  Some refined petroleum products were also imported. Second, local oil companies embarked on a significant stockpiling exercise with the view to averting a repeat of December 2005, when they failed to make adequate provision as South Africa switched over to lower octane fuel. The combination of these two factors led to a record 78% increase in the oil bill.  This was what swelled the country’s current account deficit figure that was released on Thursday. According to the SARB, had oil imports in 4Q progressed at their normal pace, the deficit ratio would have been reduced by more than 2 percentage points.

If truth be told, while Morgan Stanley had expected the one-off jump in oil imports to distort the 4Q06 current account number (see our January 26 piece, South Africa: Oil Imports and One-Off Customs Union Transfers May Push Current Account to New Highs – Will the SARB Act Again?), we did not expect the impact to be as huge as 2% of GDP. 

 

Unpacking the detail

The detail is even more encouraging:  Stripping out two percentage points of GDP from the published trade deficit of R65.6 billion takes the 4Q06 trade deficit down to no more than R27 billion. This is actually less than the revised R32.6 billion trade deficit that was reported in the previous quarter.  Keeping net invisibles unchanged, the overall current account deficit also drops to less than 5.8% of GDP, implying that there was in fact no deterioration in the like-for-like current account deficit. 

The SARB must have taken the view that the current account deficit, having printed a revised high of 6.1% of GDP in the first two quarters of 2006, has now gotten over its worst patch – hence the decision to keep rates on hold in February.

And it gets even better:  Not only was the visible trade balance distorted by a one-off item, there was also a rather conspicuous deterioration in net invisibles, thanks to a huge jump in net income payments. A close investigation of the detail here shows that this was entirely due to a rather awkward R14.3 billion fall in dividend inflows on South African non-direct investments abroad. We find this awkward, not least because of the sheer magnitude of the decline – in fact, 4Q dividend inflows have not been particularly encouraging lately – but because this happened at a time when the currency was actually weaker. Positively, however, we are thankful that the deterioration here was a result of a reverse-protuberance in dividend receipts rather than an increase in dividend outflows from South Africa.  Although the mathematical impact of the two is the same, market psychology tends to regard dividend outflows more negatively than a dry-up in dividend inflows.

Improving capital account mix can only get better

The balance of payments on the financial account also shows a huge improvement in the quality of capital flows. South Africa had relied heavily on portfolio flows, net ‘other investments’ and ‘unrecorded transactions’ – the latter two being de facto glorified balancing items – to fund the current account deficit as foreign direct investment (FDI) swung into deep negative territory in 3Q06. However, the latest data show that, although there was still some reliance on portfolio flows and unrecorded transactions, there was virtually no reliance on ‘other investment’ flows to fund what was a much larger current account deficit in 4Q06.

What’s more important, the hemorrhage on the FDI line appears to have ebbed significantly, and with lots of private equity money now knocking on the country’s doors as foreign investors seek to position themselves ahead of the 2010 World Cup games, one can only expect FDI flows to head in one direction from here – and it’s not south.  In fact, were it not for the US$1.5 billion Goldfields acquisition of Barrick Gold’s stake in the South Deep mines, the FDI line would have been very close to printing a positive reading already.

Meanwhile, portfolio investments in both bonds and equity investments continued to pour in: Bond inflows were strong, thanks to the ‘sweeter’ carry, while the country’s strong growth outlook continued to attract equity investors.  In all, net portfolio inflows rose from R21.4 billion in 3Q06 to R27 billion in 4Q06. Against the above solid background, therefore, we leave our ZAR forecast unchanged at 7.5 for end-2007 and 7.9 at end-2008.

Strong capital formation helps lift GDE

Elsewhere, the Quarterly Bulletin also shows that gross domestic expenditure re-accelerated from 1.4%Q, saar in 3Q06 to 12.3%Q, saar in 4Q06, thanks largely to 16.6% growth in gross domestic capital formation, a turnaround in government consumption expenditure and a strong build-up in inventory accumulation. We couldn’t help but notice that capital formation in the mining and quarrying sector, which was down 33% between 2003 and 2004, and remained flat in 2005, appears to have now turned the corner. This portends a likely pick-up in export performance in coming quarters.

Weak link between credit and consumption spend?

Interestingly, household consumption expenditure growth appears to have plateaued at just below 8%, after reaching a peak of 8.3% in the first quarter of the year. This is despite the fact that credit growth rose from an average of 27%Y in 4Q, versus 25%Y in 3Q, further supporting the thesis that the link between credit growth and household consumption that was observed earlier in the year may have weakened.  A number of anecdotes are beginning to suggest that most of the growth in private sector credit extension is going to mortgages and capital goods, as opposed to consumption goods, and this should help calm the SARB’s earlier fears that private sector credit growth was fuelling consumer spending and taking the current account into deeper deficit.  In any case, the ratio of household debt as a percentage of disposable income now appears to be plateauing around the current level of 73.8%, having risen only marginally from 73% in 3Q06.

Rate hikes impacting discretionary expenditure 

What’s more, the little credit that is finding its way to consumers appears to be largely constrained to non-discretionary items, with recreation and entertainment spend being the exception. The Bulletin points out that although durable goods consumption was up from 7%Q, saar in 3Q06 to 8.4%Q, saar in 4Q06, thanks to a strong growth in recreational and entertainment spending, the interest rate-sensitive components such as furniture, household appliances and medical equipment slowed in 4Q.  Semi-durable goods consumption also slowed across the board, from 24% to 7.9%. Non-durable goods consumption accelerated from 3.3% to 6.4%, driven by strong spending on non-discretionary items like household fuel and power, medical and pharmaceutical products and petroleum products. The relatively more discretionary sub-sectors like food and beverages, tobacco and household consumer goods were all down from their 3Q levels.

Looking forward, our view is that, although household spending remained firm in the final quarter of the year, the momentum is fast plateauing, and is likely to swing into negative territory over the course of this year as the full impact of last year’s 200bp of tightening affects overall consumption spending. Our view therefore remains that the SARB keeps rates on hold throughout this year.   

 

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United States
What the Fed Didn’t Say
March 26, 2007

By Richard Berner | New York

Fed officials surprised markets by dropping their bias to tighten monetary policy last week.  In place of “the extent and timing of additional firming that may be needed to address [inflation] risks will depend on the evolution of the outlook,” officials substituted the more neutral phrase: “future policy adjustments will depend on the evolution of the outlook...”  The change itself made sense and wasn’t out of step with market thinking — or ours.  We still think the Fed will remain on hold for the balance of 2007 as officials patiently wait for inflation to drift lower.  However, the Fed’s previous warnings of a possible policy tightening appeared less and less appropriate.  After all, inflation is below its peak, recent economic indicators have been soft, and the potential economic spillovers from the subprime mortgage meltdown still loom ahead.  But the Fed’s terse explanation of the change left market participants confused. 

What didn’t the Fed say?  At his testimony this week, Mr. Bernanke will have the opportunity to clarify three key issues: 1. Have the downside risks surrounding the economic outlook materially increased?  2. Is the Fed’s de facto inflation objective now around 2%?  3. How will the subprime meltdown and market volatility affect monetary policy?  The likely answers — downside growth risks are somewhat higher, inflation is stuck above 2% for now, and market developments may influence policy, but only to the extent that they affect the outlook for growth and inflation — may leave investors unsatisfied. 

In fairness to the Fed, the statement issued immediately following the FOMC meeting is an awkward medium through which to convey nuanced changes to the Committee’s thinking about the outlook or the appropriate policy stance.  Yet the statement is confusing in three respects and requires further explanation.

First, the Committee acknowledged the obvious softer tone to economic and especially housing data since the January 30-31 meeting, when the Committee’s central tendency forecast for real growth over 2007 was a range of 2½-3%.  But the language in the statement did not convey a material change in Fed thinking about risks to growth.  Perhaps the Fed staff marked down their growth forecasts, but policymakers did not want prematurely to signal a change in monetary policy. 

Second, although they forecast that “inflation pressures seem likely to moderate over time,” the FOMC noted that their “predominant policy concern remains the risk that inflation will fail to moderate as expected.”  That seems in sync with recent data and previous statements that core inflation is above the Fed’s presumed 1-2% comfort zone.  But it seems out of step with the shift in the policy risk assessment. 

Third, Fed officials have stated that financial conditions are supportive of growth.  But market participants are wondering what will be the Fed’s response to the subprime mortgage meltdown and to market volatility.   Talk of a “Bernanke Put” is already surfacing. 

Growth uncertainty

Regarding uncertainty about the growth outlook, we sympathize with the Fed because our growth prognosis is evolving in what we suspect is a similar way.  Our baseline view of the economy is qualitatively the same as a few weeks ago, but the downside risks are a bit larger and the uncertainty surrounding that baseline is higher.  For example, two weeks ago we downgraded our near-term forecast for growth by about half a percentage point compared with our February outlook (see “Despite Uncertainty, Fed Ease Still Unlikely Until 2008,” Global Economic Forum, March 12, 2007).  Despite tepid retail sales and higher inflation in February, our “tracking estimate” for first-quarter growth is essentially the same (2%) as what we published then. 

We’ll concede that immediate risks tilt to the downside.  Despite favorable February readings on housing starts and home sales, the likely fallout from the tightening in mortgage lending standards bodes ill for a quick end to the housing recession (see “Does Volatility in Housing Data Mark a Turning Point?” and “Subprime Will Hurt, but Affordability Is the Key,” Global Economic Forum, March 23, 2007).  Moreover, the uncertainty surrounding the outlook for capital spending underscores additional growth risks (see “The Capex Conundrum,” Global Economic Forum, March 9, 2007).  And the uncertain magnitude of weather-related paybacks in economic activity clouds the outlook.

Inflation comfort zone

Confusion about the Fed’s de facto inflation objective is a different story.  Some might say “What inflation objective?”  Indeed, despite extensive discussion, officials haven’t specified a numerical objective for price stability.  However, several Fed officials, notably Chairman Bernanke, have talked about a 1-2% ‘comfort zone’ for core inflation measured by the personal consumption price index (PCEPI), and they haven’t dissuaded market participants from the perception that it is a reasonable facsimile of an “objective.” 

However, since last summer, I have suspected that the Fed was implicitly choosing a slightly higher inflation objective than the midpoint of the presumed comfort zone — perhaps the midpoint of a 1½-2½% range (see “A Higher Inflation Objective?” Global Economic Forum, August 11, 2006).  Inflation outcomes are one reason: If the Fed’s 2007 central tendency inflation forecasts are on the mark, as seems likely, core inflation will have been above the 2% upper bound of the comfort zone for the fourth year in a row. 

Far from being troubled by such a choice, however, I think there are legitimate analytical reasons why an inflation objective should be higher than 1½%.  First, in my view, a 2% objective is entirely consistent with price stability, given what we know about measuring inflation.  In contrast, the midpoint of the comfort zone does not allow sufficient margin for measurement error.  Most inflation gauges still have some upward bias, so actual inflation may be 20-60 bp lower than today’s indexes suggest, and one of them — the “market-based” PCEPI — puts core inflation at 2%.  So actual inflation could be lower. 

More important, in my view the midpoint of the current comfort zone does not allow a sufficient cushion against any shock that would push inflation lower.  For example, if core inflation did fall to 1½% during an expansion, “unwelcome” declines in inflation might occur in any future economic downturn — unwelcome in the sense that they threatened deflation, as policymakers feared in 2003.  Policymakers then believed they faced the threat of the “zero bound” — a real problem if inflation falls lower than nominal interest rates, which obviously cannot go below zero, and which would inadvertently make policy restrictive.  That “zero bound” for rates is why central banks should never choose zero as the lower bound for an inflation objective.  Taking to heart the lesson of the Japanese experience, Fed officials in 2003 countered the risk of too-low inflation with aggressive monetary ease. 

But as I see it, the real lesson of the 2003 experience is that the 1½% midpoint of the current comfort zone builds an unwanted asymmetry into monetary policy.  Why aim at a target that requires über-aggressive policies if inflation falls 25 basis points below it?  Indeed, recognizing these issues, Chairman Bernanke has suggested that 2% might be the optimal long-run inflation rate — the rate that strikes a balance between price stability and the need to avoid the zero bound (see his Remarks at the 28th Annual Policy Conference: “Inflation Targeting: Prospects and Problems,” Federal Reserve Bank of St. Louis, St. Louis, Missouri October 17, 2003). 

Last, the cost of reducing inflation — the famous ‘sacrifice ratio’ — seems to have increased.  Today’s flatter Phillips curve implies that policy must create an appreciable degree of slack in the economy to reduce inflation.  Of course, in theory, such a change by itself is no reason to prefer a higher inflation objective; Milton Friedman taught central bankers in 1968 that there was no long-run benefit to cheat in favor of extra output by tolerating permanently higher inflation.  A flatter Phillips Curve (in the short run, of course) and a higher sacrifice ratio in isolation simply mean that policymakers may have to tolerate a cyclical overshoot in inflation for longer in order to spread that cost out over time.  Investors could view the Fed’s forecast of 2-2¼% core PCEPI inflation over the four quarters of 2007 as a reflection of that temporary tolerance, especially because the Fed’s February central tendency projections have inflation back in the comfort zone in 2008.

But by anchoring inflation expectations, the Fed is ironically a victim of its own success:  Inflation is still relatively low, and at a 2¼% core rate, the Fed will find it hard to explain to Congress and the public why it should put a million people out of work for two years to reduce inflation by half a point.  Fed Governor Mishkin seems to agree.  Looking at a variety of evidence, he reasonably concluded last week that the anchor seems fixed at about 2% — good news for those worried that inflation might drift higher even if the Fed remained credible.  But it is not such good news for getting to the midpoint of today’s comfort zone.  He noted:

Looking to the medium term, I am less optimistic about the prospects for core PCE inflation to move much below 2 percent in the absence of a determined effort by monetary policy.  This assessment…flows from my view that long-term expectations appear to be well anchored at a level not very far below the current rate of inflation.  If so, a substantial further decline in inflation would require a shift in expectations, and such a shift could be difficult and time consuming to bring about, as I noted earlier (see his “Inflation Dynamics,” March 23, 2007).

Bernanke put?

Last, what are the implications of the subprime mortgage meltdown, tighter mortgage lending standards, and market volatility for monetary policy?  Tighter mortgage lending standards will probably prolong the housing recession, and the Fed will try to take that change in financial conditions into account in revising their forecasts — as have we.  In contrast, however, I think investors who suspect that Chairman Bernanke will exercise a new “put” to bail them out will be disappointed.  Market volatility will affect policy only insofar as it affects the outlook for inflation and growth.  But the line is a fine one, and investors may suspect that a new Bernanke Put is alive and well.  Time will tell.

For now, investors seem to have concluded — correctly, in our view — that moving to a neutral policy stance doesn’t signal an ease at the next FOMC meeting.  However awkward the evolving FOMC statement, future policy actions will depend on the evolving outlook.  But a less-tough inflation stance and less clarity on policy objectives may equal higher term premiums, especially for inflation.  Indeed, the yield curve steepened bearishly last week, and breakeven inflation in the TIPS market rose slightly in recognition of the Fed’s shift.  And investors in risky assets should be careful of what they wish for: The circumstances triggering Fed ease may involve scant earnings growth.

Risks seem evenly balanced between weaker growth and higher inflation, but other combinations are also possible.  Courtesy of the likely weakness in housing, the near-term risks to growth do seem tilted lower, and the Fed has the flexibility to respond if needed.  Likewise, some fundamentals create lingering inflation risks.  Although much less likely, markets seem completely unprepared for stronger growth.

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United States
Review and Preview
March 26, 2007

By Ted Wieseman and David Greenlaw | New York, New York

The Treasury curve saw a significant bear steepening move over the past week after major volatility surrounding an FOMC statement that the market (and we) found somewhat confusing. Ultimately investors decided that the Fed did not signal a notably more dovish policy stance, as expected Fed easing in the futures market was eventually scaled back a bit on the week, but did show slightly lessened inflation vigilance, reflected in both the relative weakness in the long end of the market and also in a rise in inflation breakevens in the TIPS market. We expected the Fed to be on hold through year-end before the FOMC’s moderation (elimination?) in its tightening bias in Wednesday’s statement and continue to now and viewed the change in the statement more as a cleaning up of the language, removing a warning of a near-term rate hike that at this point seems very unlikely, rather than a signal of a meaningfully dovish change in the Fed’s outlook. Still, the Fed certainly knew that the tightening bias language was being intensely focused on by investors as a signaling mechanism, so we’re not sure why it felt the need to adjust it at this time. Certainly, given the huge back and forth swings in the market Wednesday and Thursday, investors were confused as well, and all eyes will be on Fed Chairman Bernanke’s Wednesday testimony for some clarification. It was a very quiet data week, but what was released was better than expected and further tempered the market’s brief post-FOMC enthusiasm for more rate cuts.

Particularly surprising were significant gains in both housing starts and home sales, the combination of which led us to boost our 1Q GDP estimate a couple of tenths to +2.0% on a somewhat smaller expected plunge in residential investment. Meanwhile, initial jobless claims continued to improve, as expected, further suggesting that the March employment report will see a good rebound from the weather-depressed February results.

Benchmark Treasury yields rose 2-10bp over the past week and the curve steepened significantly after backing up 9-10bp from the highs briefly hit Wednesday in the initial reaction to the FOMC statement. The curve initially bull steepened sharply Wednesday as the market surged higher but then kept moving a bit steeper Thursday in the reversal. For the week, the 2-year and 3-year yields rose 2bp each to 4.61% and 4.53%, the 5-year 4bp to 4.51%, the 10-year 7bp to 4.61%, and the 30-year 10bp to 4.80%. The slight disinversion of 2s-10s was the first since August, while 2s-30s hit its highest level since last May.

An initial move to price in significantly more near and medium-term Fed easing on Wednesday was more than reversed Thursday and Friday as the meaning of the Fed’s rhetoric was reassessed and more positive housing data drew into question just how bad the broader fallout from the subprime debacle, on which hopes for an early rate cut hinge, might be. For the week, the July fed funds contract lost 0.5bp to 5.18%, pricing about a 25% chance of a rate cut by the June FOMC meeting, the August contract 3bp to 5.115%, pricing in about a 75% chance of a rate cut by the August FOMC meeting, and the September contract 4bp to 5.07%, just about fully pricing in a cut by the September meeting. Among the medium-term eurodollar futures contracts, the biggest losers were Sep 07 and Dec 07, which lost 3 and 3.5bp. The 2008 contracts swung significantly back and forth, but wound up little changed, losing 0.5-1.5bp. Eurodollar futures are now pricing a likelihood, but not a certainty, of a second cut to 4.75% by year-end and an eventual move to 4.50% by mid-2008, but nothing beyond that. Along with the curve’s bear steepening, the performance of the TIPS market suggested some unease with the Fed’s perceived slightly softer inflation fighting stance. Both the 5-year and 10-year benchmark inflation breakevens rose 4bp, to 2.48% and 2.43%, respectively, highs since August. This also resulted in the 5-year/5-year forward inflation breakeven, which the Fed has indicated it monitors as an important measure of market-based inflation expectations, rising 4bp to 2.38%, up about 10bp from the lows hit a couple weeks ago to the highest level in over a month.

In an otherwise very quiet week, the Fed’s surprising decision to at least significantly moderate and perhaps eliminate — it really wasn’t quite clear — its long-held tightening bias resulted in significant market volatility and, it would seem, investor confusion over just what message policymakers were trying to convey and whether there really had been any significant change in the policy outlook signaled. Inflation is still seen as the main risk to the outlook — “the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected”. But instead of again warning that this could lead to “additional firming” in policy, as it has since going on hold in June, policymakers left the direction of the next policy move open — “Future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information”. We mostly see the change as reflecting a cleaning up of the risk assessment language that carries limited policy significance.

We saw the Fed on hold for an extended period before this announcement and continue to now. FOMC members probably feel the same way and may have just decided they should more accurately reflect this in their official language instead of continuing to warn of a near-term rate hike that they didn’t really think had much likelihood of happening. Still, the Fed certainly knew that the risk assessment was being viewed as a key signaling mechanism, so we were surprised that it would risk generating market confusion about its near-term intentions by messing with it at this point and thus can’t be sure that it didn’t perhaps really intend to signal a more fundamental shift in the policy outlook.

Fortunately, Chairman Bernanke will have an early opportunity to clarify the Fed’s views when he testifies Wednesday on the economic outlook before Congress.

The past week’s very quiet economic calendar was focused on housing market data. Incoming numbers were much stronger than expected, though the homebuilders’ survey pointed to a more cautious outlook for future data based on expected fallout from the tightening in subprime lending conditions.

Housing starts surged 9.0% in February to 1.525 million units annualized, reversing more than half of a 14.3% plunge recorded the prior month, which had left starts at a near ten-year low of 1.399 million. The bulk of the upside was in the key single-family category (+10%); multi-family starts (+4%) posted a smaller gain. The regional breakdown suggested some negative weather impact, with sales down sharply in the Northeast and Midwest. But this was easily offset by surges in the South and West. Despite the rebound in starts this month, past weakness still pointed to moderating supply that should help to bring inventories into line, with housing completions down 9.4% on the month and houses under construction dipping 0.7%.

Home sales were also considerably better than expected. Existing home sales gained 3.9% in February on top of the 2.7% rise in January to reach 6.69 million units at an annual rate, a high since last April. By region, the biggest gains were in the Northeast and Midwest, suggesting that the unusually mild weather in the early part of the winter may have continued to help boost sales. On the other hand, the upside in sales relative to the pending home sales index debunked the notion that homebuyers are having major trouble at this point closing on purchases because of tighter lending conditions. The number of homes available for sale rose 5.9%, leading the months’ supply to tick up a tenth to 6.7.

These data are not seasonally adjusted and inventories almost always rise significantly this time of year ahead of the key spring selling season.

Incorporating the housing starts and home sales figures into our GDP estimates, we boosted our 1Q residential investment estimate to -18% from -22% and our overall GDP forecast to +2.0% from +1.8%. The upside was about evenly divided between a positive impact on our estimate of the predominant homebuilding component of residential investment (which we currently see running at -29%, little changed from 4Q) from the housing starts results and the positive impact on our estimate of the brokerage commissions component from the home sales results.

Even with this upward adjustment to our 1Q estimate, clearly the 18% drop we project for overall residential investment and 29% plunge in the new homebuilding component imply that the housing recession is far from over, and this was reflected in a more pessimistic view on activity in the latest homebuilders survey. The National Association of Homebuilders’ Housing Market Index turned down again in March after having rebounded somewhat over the prior few months. The composite index fell to 36 in March (on a 50-breakeven scale) after having risen to 39 in February from the 16-year low of 30 hit in September, with all three components down — present sales, expected future sales and floor traffic. The NAHB attributed the pullback to worries about the impact of the subprime mess —“Builders are uncertain about the consequences of tightening mortgage lending standards for their home sales down the line, and some are already seeing effects of the subprime shakeout on current sales activity.” Our baseline case remains that housing starts will trough near 1.2 million units around mid-year, which would be a further 20% decline from February’s level and a nearly 50% peak to trough drop. This would substantially exceed our baseline case of a roughly 20% peak to trough decline in combined new and existing home sales. This combination would allow inventories of unsold homes to come into a more normal balance over the summer, helping put a floor under home prices.

In the week’s only other notable data release, jobless claims continued to improve in the latest week, further pointing to a decent rebound in the March employment report after the weather-depressed February results. Our preliminary forecast for March non-farm payrolls is +175,000. Note that the employment report will be released on April 6, which is Good Friday, resulting in one of the oddest trading sessions on record, with the BMA recommending the bond market close at 10:30 in the morning. The stock market will actually be closed on employment Friday.

Main focus in the coming week will clearly be on Fed Chairman Bernanke’s Wednesday morning testimony. Otherwise, there will be a number of data releases and supply to deal with. On the supply front, the Treasury will announce 2-year and 5-year notes Monday for auction Wednesday and Thursday. We expect unchanged sizes of US$18 billion and US$13 billion, respectively, but a continuation of the recent run of coupon size cuts would not be a major surprise. Key data releases include new home sales Monday, Conference Board consumer confidence Tuesday, durable goods Wednesday, revised GDP Thursday, and personal income and spending, construction spending and University of Michigan consumer confidence Friday:

* We forecast February new home sales of 960,000 units annualized. Since hitting a 15-year low of 30 back in September, the homebuilder sentiment gauge moved up to 33 in December and to 40 in February before pulling back in March. So, even factoring in the unusually severe weather conditions across much of the nation during the month of February, we look for a 2.5% uptick in sales of newly built residences. Moreover, since new construction has now been pared back a good deal more than sales, the backlog of unsold new homes should continue to gradually drift lower.

* We expect the Conference Board’s measure of consumer confidence to drop to 106.0 in March. The recent run-up in gasoline prices, together with the turmoil in financial markets, poses a potentially significant double whammy for consumer confidence. This was evident in the early March readings from the University of Michigan and ABC surveys. We look for a 6.5-point decline in the Conference Board gauge, taking it back near the level that prevailed throughout much of 2006.

* We look for a 3.2% gain in February durable goods orders, a partial rebound in bookings following on the heels of the very disappointing results seen in January. Based on company reports, we expect to see a sharp jump in the volatile aircraft category, and this is responsible for much of the anticipated gain in overall orders. Meanwhile, the key core gauge — non-defense capital goods excluding aircraft — is expected to be up 1%, led by a partial rebound in the high-tech component, which may have been temporarily depressed by the introduction of the new Vista operating system. Core capital goods shipments are also expected to bounce back after a fall-off in January.

* At this point, we see no revision to the previously published 4Q GDP reading of +2.2%, as a small downward adjustment to retail control should be about offset by a slightly narrower trade gap. Note that this report will also include the initial read on 4Q corporate profits. We look for after-tax economic profits to post a 14% rise from the same quarter a year ago.

* We expect February personal income and spending to both rise 0.4%, as the employment data and the retail sales figures point to modest gains in both income and spending. The level of income should again receive a boost from the assumed US$50 billion of special bonus payments and stock option exercise that showed up as accrued income in 4Q (note: it appears that the Commerce Department statisticians intend to spread the US$50 billion of disbursements evenly across the first quarter). Also, note that although we downgraded our assessment of spending growth in response to the latest retail sales report, it still looks like real consumption is running at a relatively solid +3.1% in the current quarter. Finally, the core PCE price index is expected to match the +0.2% recorded by the core CPI, with the year/year rate holding at +2.3%.

* In the wake of the much stronger-than-anticipated housing starts report, we now look for only a 0.1% decline in overall construction spending in February. The residential component is expected to be down just 1%, which would represent its best performance since last April.

Meanwhile, unusually severe weather conditions across parts of the nation are expected to help restrain the anticipated gains in the non-residential and public components.

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Europe
The EU Is Younger Than You Might Think
March 26, 2007

By Eric Chaney | Paris

While officials gather in Berlin to celebrate the 50th anniversary of the European Union, which started modestly with a Community of six countries willing to share coal and steel resources, the future of Europe is still hotly debated.  Feeling profoundly European and being convinced that the values we built in the Renaissance and Enlightenment periods on the foundations provided by Greek mathematicians and philosophers (by choosing this order, I humbly follow Immanuel Kant, not my own instinct) are the best things Europe brought to the world, I am not going to add my own romantic spin.  Rather, I’d like to offer a couple of views about some in-depth economic changes that have taken place and still going on in this part of the world. 

Change #1.  Productivity is accelerating in Europe

There is no doubt that productivity is accelerating in the EU in general and the euro area in particular since 2003.  In the latter, productivity per capita accelerated to 1.9% on our estimates in 2006, more than 1 percentage point above the average of the previous five years.  This is not contested.  What remains ambiguous is the nature of the improvement; cyclical or structural?  I believe that it is structural for several reasons.  First, employment policies aiming at opening labour markets to low-skilled workers, arguably less productive, by means of labour tax cuts, are coming to an end.  Second, European companies have massively invested in IC technologies over the last 15 years precisely to improve productivity and cut costs.  Third, corporate restructuring has accelerated, as a consequence of globalisation, and resulted into large-scale outsourcing of labour-intensive and thus less-productive activities.  The last two factors are still in full swing and have an impact on the growth rate of productivity. 

Change #2.  The labour force is growing faster than expected

In practically every single EU country, statisticians are upgrading population estimates (things remaining uncertain in Germany, unfortunately), in some cases because of higher fecundity rates — after Sweden, this is now the case of France, where the fecundity rate has reached the magic 2.0 level — and everywhere in the Western part of Europe because of immigration flows.  Among large countries, Spain, Italy, the UK and France are all revising up estimates and projections of immigration trends.  Spain is welcoming more than 400K immigrants per year and will probably upgrade its population estimates soon.  In France, INSEE recently doubled its by definition conservative assumptions for immigration flows from 50K to 100K per year until 2050.  The interesting thing about immigration is that it coincides with declining unemployment rates, suggesting that labour markets are progressively becoming less rigid.  In this regard, the Spanish performance is the most impressive: with immigration flows adding 1.5% per annum to the labour force, the unemployment rate has nevertheless halved over the last 10 years.

Change #3.  Public opinions are disenchanted about the benefits of the Union

While a majority of EU citizens are happy with the Union and unwilling to unravel the process, the French and Dutch popular rejection of the draft EU Constitution in 2005 were in fact the visible part of the iceberg.  Most opinion polls show that, apart from the countries benefiting from large money transfers from the EU (Portugal, Greece, most new EU members…), the public at large does not believe that being part of the Union has significantly increased their welfare and does not count on the Union to do so in the future.  On the first point, the popular answer is understandable — disentangling the impact of the EU, or the EMU, from other factors such as globalisation or cyclical developments is difficult — but likely wrong:  academic studies have shown that intra-EU trade and with it national incomes have blossomed as trade barriers fell one after another under EU rules.  True, some countries were more successful than others: Spain and Ireland are great success stories while Portugal and, until recently, Greece are not.  As for the second point, the popular answer is perfectly correct, in my view: going forward, most of the reforms that need to be undertaken to improve the welfare of EU citizens will have to be initiated at the national level, as demonstrated by those countries which have been successful in doing so, such as the UK, Denmark, Sweden, Spain, the Netherlands and, more recently, Germany.

Change #4.  The EU has become unmanageable

The Constitutional Treaty rejected by the French and the Dutch was trying to kill two birds with one stone:  amending the infamous Nice Treaty, which was an ill-conceived compromise creating huge distortions between countries on decision rules, and introducing a more solemn document bringing together the peoples of the Union.  That was not a wise strategy, obviously.  But while the second objective was neither necessary nor desirable from an economic welfare point of view, the first one was important.  Now that the Union has 27 members and continues to live with rules elaborated for six closely related countries, it has become unmanageable. 

Potential growth is accelerating

There are several important consequences to these four changes.  First and foremost, the potential growth rate of the EU and of the euro area in particular is accelerating, thanks to faster productivity and a more dynamic labour force.  By how much is debatable.  I personally believe that the current potential growth rate of the euro area is around 2.25%, i.e., one quarter of a percentage point above the average growth rate observed since EMU started.  Going forward, I believe that potential GDP growth could accelerate to 2.5% over the next five years but not significantly more.  Afterwards, demography is likely to have the upper hand and curb potential growth.  Yet, I am the first to concede that I would never have thought that Spain, which was supposed to be hampered by a fast aging population, would have such a stellar performance, largely (but not only) thanks to massive immigration flows. Hence, upside surprises are possible in the long run as well.

Reform policies are re-nationalised

Second, peoples of Europe should not count on Europe to improve their living conditions, apart from the very low income countries which have joined recently.  The EU creates friendly conditions to cope with the challenges of globalisation, such as (almost) free competition within a huge internal market (492 millions inhabitants in 2006) and a legal system protecting property rights and enforcing the rule of law.  But reforms will not come from Brussels anymore.  Too often in the past governments told their constituencies that some changes were imposed by ‘European decisions’.  This was cynical (most of the time, governments had endorsed the decision) and has contributed to make the EU unpopular.  The road to reforms is a national highway, not a federal EU freeway, as it was when Jacques Delors launched the Single Market or the Single Currency initiatives. This is a good thing: in the end, national parliaments hold the legitimacy in our democracies.

Two years for a new EU Treaty, modest and effective

Third, amending and simplifying the Treaties ruling the Union should be a top priority on the EU agenda.  Since the reform process is re-nationalised, there is no particular urgency in doing so.  However, leaving the system unchanged raises the risk of an insidious unravelling of the Union, as populist politicians might be tempted to leverage on the lack of popularity of the EU to access to power and make things worse.  The German presidency is very active in this regard, and because Germany has regained its self confidence and is aware of its leading role in Europe, I would bet that Frau Merkel will build solid foundations for a new Treaty.  The job is already 80% done: the ill-fated constitutional Treaty was a good compromise for the management of the EU: A President, elected by all EU citizens, a Foreign Affairs minister, a clear and fair majority rule decision (double majority, i.e., countries and populations), and a green light for enhanced co-operation for countries ready to deepen political and economic ties.  Portugal and Slovenia will then take over and use their relative modest sizes to broker partial deals between bigger countries with diverging interests.  Then, France will take over in the second half of 2008 and I hope I am not over-optimistic in thinking that a deal could be achievable by that time.

 

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Global
Asian Decoupling Unlikely
March 26, 2007

By Stephen S. Roach | New York

As the US economy slows, most believe that Asia’s growth machine will fill the void.  Don’t count on it.  Policy makers in China and India are shifting toward restraint, tilting growth risks in the region’s fastest-growing economies to the downside.  Nor is an externally-dependent Japanese economy likely to provide much compensation.  To the extent the case for global decoupling is dependent on an Asian offset, prepare to be disappointed. 

After years of doubt, convictions are deep that both China and India will stay the course of hyper-growth.  There has been talk for years about the coming Chinese slowdown, but so far the downshift has failed to materialize.  The 10.7% increase in Chinese GDP in 2007 was the fastest since 1995, when the size of the economy was less than one-third what it is today.  Moreover, with India now showing impressive improvement in its macro foundations of growth – especially saving, infrastructure, and foreign direct investment – there is good reason to believe that there may be considerable staying power to the recent acceleration in economic growth that averaged 9% during the 2005-06 interval. 

Incoming data give little reason to doubt the staying power of the Asian growth machine.  Chinese industrial output growth has reaccelerated to an 18.5% y-o-y pace over the January-February period – up from the sub-15% comparison in the final period of 2006 and only a shade slower than the 19.5% gains recorded last June.  While India’s industrial production growth is certainly not as brisk as China’s, the 10% y-o-y comparison in early 2007 remains well above the 7¼% pace that was evident in late 2005 and early 2006.  Needless to say, if China and India stay their present course, the global economy would barely skip a beat in the face of a US slowdown.  Collectively, China and India account for about 21% of world GDP, as measured by the IMF’s purchasing power parity framework – essentially equal to the 20% share the statisticians assign to the United States.  Add in the recent acceleration in the Japanese economy – a 5.5% annualized increase in the final quarter of CY2006 for an economy that accounts for another 6% of PPP-based world GDP – and there is good reason to believe that the impact of America’s downshift could well be neutralized by the ongoing vigor of the Asian growth machine.

The Asian offset, in conjunction with a modest cyclical uplift in a long sluggish European economy, is the essence of the case for global decoupling – a world economy that has finally weaned itself from the great American growth engine.  A key presumption of that conclusion is that Asia can stay its present course.  There are two flaws in that argument, in my view – the first being that internal pressures are now building in Asia’s fastest-growing economies that could be sowing the seeds for slower growth ahead.  In particular, both the Chinese and Indian economies are now displaying worrisome signs of overheating.  In China, the symptoms have manifested themselves in the form of imbalances in the mix of the real economy, widening disparities in the income distribution, and a large and growing current-account surplus – to say nothing of the negative externalities of environmental degradation and excess resource consumption.  In India, the overheating has surfaced in the form of a cyclical resurgence of inflation, with the CPI running at a 6.8% y-o-y rate in early 2007 – a sharp acceleration from the 3.8% pace of 2002-05.

In recent weeks, I have met with senior policy makers in both China and India.  It is clear to me that in both cases the authorities are in the process of shifting their policy arsenals toward meaningful restraint.  In China, the direction comes from the top in the form of growing concerns expressed by Premier Wen Jiabao about a Chinese economy that he has explicitly characterized as “unstable, unbalanced, uncoordinated, and unsustainable” (see my 19 March dispatch of the same name).  Since those words were first uttered at the end of the National People’s Congress on 15 March, Chinese authorities have been quick to respond.  There was a monetary tightening the very next day and the securities industry regulators have issued new rules that prevent companies from purchasing equities with proceeds from share sales.  The former move is aimed at cooling off an overheated investment sector while the latter move is addressed at dealing with a frothy domestic stock market that increased by 100% in the six months ending in late February.  I am more convinced than ever that Beijing is now deadly serious in attempting to regain control over its rapidly growing economy in an effort to shift the focus from the quantity to the quality of growth.  This is good news for China but could be disappointing for the decoupling camp that expects rapid Chinese economic growth to remain resistant to any downside pressures.

India is similarly positioned.  The Reserve Bank of India does not take overheating and cyclical inflationary pressures lightly.  I was actually in Mumbai the day the RBI tightened monetary policy last month (13 February), and it was clear to me in my discussions at the central bank that it meant business.  The RBI’s official statement following that action said it all: “(A) determined and co-ordinated effort by all to contain inflation without unduly impacting the growth momentum is not only an economic necessity but also a moral compulsion.”  Our Indian economics team underscores the risk of another monetary tightening prior to the 24 April policy meeting.  At the same time, the government’s annual budget contained measures that would cut tariffs on food and other price-sensitive manufactured products.  Indian authorities are fixated on a mounting cyclical inflation problem and appear more than willing to take a haircut on economic growth to achieve such an objective.  Our current economic forecast reflects just such an outcome – a downshift to 6.9% GDP growth in 2008 following average gains of 8.7% over the 2005-07 period.

There is a second factor at work that is also likely to challenge the view that hyper growth is here to stay in Asia – the region’s persistent reliance on external demand as a major driver of economic growth.  This is less a story for India, with its relatively small trade sector, and more a story for the rest of Asia.  China is at the top of the external vulnerability chain.  Its export sector, which rose to nearly 37% of GDP in 2006, surged at a 41% y-o-y rate in the first two months of 2007.  Moreover – and this is an absolutely critical point in the decoupling debate – the United States is China’s largest export market, accounting for 21% of RMB-based exports.  As the US economy now slows, the biggest piece of China’s export dynamic is at risk.  So, too, are the large external sectors of China’s pan-Asian supply chain – especially Taiwan, Korea, and even Japan.  Lacking in self-sustaining support from private consumption, the Asian growth dynamic remains highly vulnerable to an external shock.  That’s yet another important reason to be very suspicious of the case for global decoupling. 

Decoupling and global rebalancing go hand in hand.  A decoupled world is very much a rebalanced world – and vice versa.  Recent trends admittedly lend some support to the decoupling thesis – especially a booming Asia economy but also a seemingly remarkable cyclical revival in Europe.  The European upsurge is a welcome development, but perspective is key.  At most, it will add 0.2 to 0.3 percentage point to our baseline case for world economic growth.  Asia, especially China and India, is a very different story.  This is a much larger segment of the global economy and is growing at rates that are three times as fast as those in the developed world.  An Asian economy that only barely widens its growth multiple relative to the rest of the world could well drive global decoupling on its own.

That’s unlikely to be the case, in my view.  Not only does Asia remain vulnerable to a US-centric external shock, but the region’s two most powerful growth stories – China and India – are now both very focused on matters of internal sustainability.  The Premier of China has put his reputation on the line in attempting to bring an unstable, unbalanced, uncoordinated, and unsustainable Chinese economy under control.  The Indian government is equally focused on an anti-inflationary policy tightening.  Looking backward, both of these economies have been on an exceptionally strong growth path that – if left to its own devices – could play an increasingly important role in powering a decoupled world.  Looking forward, however, it’s likely to be a very different story.  With growth prospects in China and India tipping to the downside at the same time the US economy is slowing, the global economy is likely to be a good deal weaker than the decoupling crowd would lead you to believe.

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Turkey
Not Even Wrong
March 26, 2007

By Serhan Cevik | London

Fiscal consolidation is the primary driver of Turkey’s macroeconomic normalization. We can easily count — on the fingers of two hands — the number of years in the post-war period that Turkey has enjoyed stability. As fragile, malfunctioning coalitions had become the norm, the country suffered from institutional inertia and populist policies that created a distortionary economic structure based on rent-seeking and resulted in unsustainable imbalances. Unfortunately, despite several attempts, underlying weaknesses — in politics as well as economic areas — were left unaddressed for decades and eventually led to the devastating crisis in 2001. In our view, one of the most important reasons for the crisis and Turkey’s underperformance in the preceding decades was the state of public finances that turned from mediocre into destructive by the end of the 1990s. The public sector borrowing requirement, for example, increased from an average of 5% of GDP in the 1980s to 9% in the 1990s and then to 16.4% in 2001, forcing the Treasury to allocate 103.5% of tax revenues (or 23.2% of GDP) to interest payments. But just like every cloud has a silver lining, the crisis has become a wake-up call, bringing consolidation to Turkey’s fragmented political and fiscal landscapes. And these fundamental changes, not capital inflows or some artificial measures, are behind macroeconomic and financial improvements.

The unprecedented degree of fiscal tightening has helped to normalize public finances. One way or another, the authorities were aware of the approaching storm and even tried to correct fiscal imbalances. But the extent of such attempts remained feeble throughout the 1990s, when the average lifespan of a coalition government was just 14.2 months. All that has changed in recent years, and the degree of fiscal consolidation — measured by primary budget surplus as a share of GDP — increased from an annual average of 1.3% in the 1990s to an astonishing 6.2% since 2000. We may quarrel the issue of quality, but the accumulated effects of maintaining such an unparalleled fiscal correction have nevertheless been more than enough to normalize the country’s budgetary performance and put its debt dynamics on a sustainable path. Indeed, the overall budget deficit declined from an average of 6.1% of GDP in the 1990s and the peak of 16.5% in 2001 to 0.7% last year. Furthermore, the public sector borrowing requirement, our favorite measure of the fiscal stance, moved from 16.4% of GDP in the year of the crisis to a savings rate of 3% last year.

Fiscal discipline has driven debt dynamics from the verge of default towards the Maastricht criteria. Prudent policies and structural reforms — leading to a cumulative budget surplus of 30.5 percentage points of GDP in the last five years — lowered the risk premium and the cost of borrowing for the Treasury in the domestic debt market from an average of 97.7% in the 1995-2002 period to as low as 13.9% in 2005 and 18% last year. As a result, the government’s interest payments declined from an enormous 23.2% of GDP in 2001 to 8.2% last year, normalizing economic incentives and helping to accelerate the rate of real GDP growth to an average of 7.5% in the last five years. Naturally, all these improvements have driven Turkey’s debt dynamics from the verge of default towards meeting the Maastricht criteria. The public sector’s gross debt stock declined from the peak of 107.3% of GDP in 2001 to 62.3% last year; and the net debt- to-GDP ratio fell from 90.4% in 2001 to, on our estimates, 48.5% by the end of 2006. In other words, indebtedness indicators are now even better than those recorded before the crisis, and the maturity and currency composition of public debt has become far less susceptible to market volatility. While the average maturity of domestic borrowing improved from nine months in 2003 to 28 months last year, the share of local currency-denominated instruments increased from 50% of domestic debt to 85% in the same period. This is why, despite higher interest rates and a weaker currency after the volatility shock, we still expect the net debt-to-GDP ratio to decline to 45% this year and 40% by the end of next year. As a result, though Turkey needs to do more to reduce the vulnerability of public finances to exchange rate and interest rate movements and business cycles, debt sustainability is no longer a lingering risk to the economic outlook.

A reasonable election-oriented reshuffling in this year’s budget is not the end of fiscal consolidation. According to preliminary figures, the central government budget posted a cumulative primary surplus of 3.8 billion lira in the first two months of this year, representing 10.6% of the year-end target. Compared with 20.3% recorded in the same period of 2006, the latest reading points to a weaker fiscal performance so far this year. Indeed, the overall budget deficit widened from 0.5 billion lira in the first two months of 2006 to 8.2 billion lira this year. There are several reasons contributing to this ‘disappointing’ picture. First, some of the 2006 expenditures are being accounted for in this year’s budget. Second, higher interest rates since last June increased interest payments by 32.8% to 12 billon lira in the fist two months of this year. Third, the moderation of domestic demand contributed to the 3.1% drop in total revenues, while non-interest expenditures increased by 21.9%, because of higher wages, pension and healthcare spending and, of course, election economics. With the coming elections later this year, the authorities have brought forward some of the public expenditures. Does this bring an end to the abovementioned encouraging developments on the fiscal front? Not at all, in our opinion. A reasonable election-oriented reshuffling in this year’s budget is normal and there will be new measures (amounting to approximately 0.6% of GDP) to keep fiscal performance in line with the targets by the end of the year.

Structural shortcomings are the real challenge for Turkey in the longer term. Although the progress has so far been much better than expectations and helped to normalize the macroeconomic landscape, Turkey still must deal with a variety of institutional challenges to ensure long-term fiscal solvency and support faster income growth on a sustainable basis. The pension deficit, for example, already widened from 0.3% of GDP in 1990 to 4.5% last year, and siphons billions of dollars away from education and infrastructure projects that could give a significant boost to Turkey’s growth potential. Moreover, if the authorities fail to introduce comprehensive reforms, the social security deficit will only get worse with every passing year (see Myopic Judgments, December 21, 2006). Likewise, while breaking all the privatization records in the last couple of years, state-owned enterprises in regulated sectors remain a problem for fiscal performance in particular and economic efficiency in general. On the other hand, modernizing Turkey’s archaic, distortionary tax system is, in our view, as important as the rationalization of public expenditures. The composition of tax revenues has worsened over the decades and become inefficient and quite regressive (see Tax the Rich, August 8, 2006). Therefore, streamlining the tax code and strengthening administrative capabilities are necessary for a more equitable distribution of the tax burden and improving the state’s ability to function properly.

Despite all the remaining challenges, claiming a lack of progress is just not even wrong. In every bout of volatility, we keep hearing about the looming economic collapse and debt default. Nothing really happens for all the reasons we highlighted above, but the band of catastrophists and hypochondriacs is unlikely to disappear from the charts. This is simply a result of living through instability for more than three decades. Therefore, fiscal discipline must remain as an anchor for stabilizing expectations and normalizing economic incentives. It may seem costly, especially to politicians, but it is actually not. As Turkey converges towards Europe, the benefits of fiscal consolidation will keep emerging in every aspect of economic life — from the moderation of volatility and disinflation to the distribution of income.

 

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