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Outside Tokyo — Green Shoots of Optimism
March 30, 2007

By Robert Alan Feldman | Tokyo

In recent weeks, I have criss-crossed Japan, meeting with a diverse set of investors. Some were regional institutional investors, such as banks and foundations. Others were individual investors — who came to large-scale seminars and panel discussions in order to get hints for their next investments. Attitudes among regional investors were surprising:  Unlike the jaded investors in Tokyo, the regional investors are becoming more optimistic: Until a few weeks ago, their attitude was ‘Wait and see’. Now their attitude is ‘Buy on dips’.

The change of atmosphere is all the more remarkable in the context of recent events. Volatility in Japanese financial markets has risen, particularly in equities and foreign exchange. New concerns have arisen about the sustainability of US growth, in light of the sub-prime lending problem. China is attempting to slow its economy. And oil prices have risen again, in light of new tensions in the Middle East. Nevertheless, regional investors in Japan seem more optimistic. Why?

One factor behind the more constructive attitude is the opportunity for buying cheap, in the wake of the equity market correction. However, this is far from the only reason. Indeed, questions and comments from the regional investors suggest three main sources for the tentative shift toward optimism:  Demographics, corporate news and reform policy.

The weight of demographics

Compared to regional seminars in earlier years, the turnouts now are high. A key factor in the increased turnout and in the change of attitude is the reaching of age 60 by the first wave of baby boomers, approximately 2.2 million people born in 1947. Another wave of about 2.2 million retirees will follow next year, and yet another wave the year after that. These levels of new retirees contrast to the average births of the 1940-46 period of about 1.7 million/year. Indeed, the population in the age group 60-64 is likely to peak only in 2011 at about 10.8 million, and not return to its current level of about 8.5 million until 2016.

Those hitting or nearing retirement are naturally more interested in managing their assets. This is particularly true in light of the ongoing reforms of both the pension system and the medical system. These reforms will inevitably raise the burden of income support and medical care, and thus are already raising concern among new retirees, not to mention prospective increases in the consumption tax.

So why would all the demographic changes and fears about disposable income lead to a more constructive attitude toward equities? The basic reason is, I believe, the experience of these baby-boomer population cohorts over the last five years. These cohorts have watched economic reforms lead to better equity market performance. In addition, the prospect that interest rates will remain low is well entrenched in these cohorts, and thus the search for yield is intense. Increased dividends are another enticement for these cohorts into the equity market. Indeed, perhaps one of the reasons for corporate dividend hikes (in addition to the use of dividends to keep shareholders away from hostile bidders) is the knowledge that a growing pool of investors will find income-producing equities more attractive.

Corporate news

Just as interest in financial markets from the retiring cohorts is rising, the M&A news from corporations is becoming more aggressive. Recently, major merger, business tie-up, and take-over-bid announcements have come at a rapid pace. Moreover, the sector distribution of such announcements is broad, from retail to beverages to finance, and even to steel. Although the nature of the tie-ups sometimes leaves questions as to how much restructuring will occur, and thus how much productivity gain is likely, there is a large psychological impact from merger announcements involving household names.

Not all the corporate news comes from corporations, either. There have been several decisions on corporate merger policy that increase the likelihood of an acceleration of activity. First, the triangle merger method has become more credible, in light of favorable tax rulings. Yes, there are several strings attached to use of this tool, and this type of merger is a friendly method — and thus requires a long lead time. That said, there has been a rise in the likelihood that Japanese firms will be approached by foreign firms for friendly merger talks. Even if very few such mergers take place, the potential will act as a catalyst. Even more important will be the new ‘safe harbor’ rules (i.e., automatic approval rules) announced by the Japan Fair Trade Commission. Based on the Herfindahl-Hirschman Index, the global standard for measuring concentration in industries, the new JFTC standard is actually more liberal in granting safe harbor to merger proposals than the standards in Europe and the US.

Reform policy

The new safe harbor rules are only one example of progress in the reform policy. Yes, PM Abe’s popularity rates are languishing, but recent actions should bolster the sense of reform momentum. In particular, PM Abe has forced acceptance of tougher rules on bureaucrat jobs after retirement from the civil service (amakudari). Until now, individual Diet members were able to lobby for their favorite bureaucrats when decisions on top jobs were made. PM Abe has insisted — against the wishes of a large number of ruling party members — that such lobbying be banned. The PM has instructed that all post-retirement jobs be set through a government job bank. This would lower the likelihood of collusion between bureaucrats and Diet members, when contracts are granted or when projects are decided.

Apart from the amakudari problem, there is steady progress in other areas, especially financial system reform. Moreover, the political calendar — with regional elections coming over the next three weeks and an Upper House election in July — is forcing the finalization of policy proposals in many areas. These areas include education, road tax reform, agriculture, consumer finance, social security agency reform, corporate tax reform, labor market reform, innovation policy, etc. If PM Abe can repeat his gains from the amakudari issue in other areas, then investor sentiment is likely to improve further.


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Negative Downturn Merely the Beginning
March 30, 2007

By Takehiro Sato | Tokyo

Nationwide core beats our projection, but all else weak

The February nationwide core CPI and the mid-March Tokyo metropolitan core CPI (Japan-style) were down 0.1% YoY, and both fell by 0.1ppt YoY versus in the previous month, with the nationwide core marking the first negative margin in 10 months (since last April).  The figures were mostly bleak, save for a stronger-than-expected showing by the nationwide Japan-style core, and the sluggish Tokyo metropolitan core suggests that the negative margin in the nationwide core will widen ahead in March. 

Core index and the main variables: 1) Core-of-core, 2) US-style core, 3) Trimmed mean estimator

With the YoY impact from rising prices of crude oil one year ago finally dissipating, growth in the nationwide core (Japan-style) is nearing that in the US-style core, where negative price growth continues.  Summarizing the current state of other core measures, the so-called ‘core-of-core’ remains negative, and the 10% trimmed mean estimator that the BoJ tracks carefully turned negative again, sparking fresh concerns.

(1) Core-of-core (baseline): This excludes special factors such as broadly defined public charges and energy prices.  In February, the nationwide core-of-core fell 0.10% YoY, for an improvement of 0.09ppt over the previous month (January: -0.19% YoY), but the Tokyo metropolitan core-of-core CPI worsened by 0.09ppt to -0.15% (February: -0.06%); the performance of the nationwide and Tokyo metropolitan baselines contrasted remarkably.

In the March Tokyo metropolitan, apparel, transportation charges and cultural/entertainment-related prices, not to mention imputed rents, made the most conspicuous negative contributions.   Although we do not include them in our core-of-core calculations, mobile phone charges also declined at a sharper rate, as in February.  Although rents and apparel won’t necessarily translate to the nationwide figures in the following month, other factors mentioned above may do so, with mobile phone charges a likely candidate.  As such, the March nationwide core will quite likely show a larger margin of decline, of at least 0.2% YoY, urged down by the impact of falling crude oil prices and downward factors in the March Tokyo metropolitan core-of-core.

(2) US-style core CPI: The US-style core CPI fell 0.3% YoY in both the February nationwide and March Tokyo metropolitan. The YoY negative margin expanded by 0.1ppt in the nationwide and by 0.2ppt in the Tokyo metropolitan.  While the nationwide US-style core appeared to come through the worst with a fall of 0.5% last September, the pace of improvement is struggling. 

(3) Trimmed mean estimator: Among core price indices, along with the Japan-style core (excluding fresh foods), the 10% trimmed mean estimator that the BoJ carefully monitors fell for the February nationwide, at -0.06% YoY (January: +0.14%), unexpectedly dipping into negative territory (gasoline prices were untrimmed in January but reintroduced into the calculation in February, making a negative contribution, but city gas prices were untrimmed this month after making a positive contribution in January). 

In contrast to the recently weak Japan- and US-style core indices, the growth rate of the trimmed mean estimator had climbed — gradually — since the start of 2006. If the BoJ began to use this measure rather than the standard core index as support for supplementary rate hikes, this could have be seen as convincing to some. Yet the trimmed mean estimator is hardly a widely accepted concept, and that it turned negative this month partly undermines the BoJ’s basis.  

We still expect a negative core inflation rate, even if crude oil price increases rekindle

Since falling oil prices will start to have an effect on the Japan-style core, unless the core-of-core improves noticeably, core CPI will likely be -0.1% YoY in the January-March quarter and in the April-June quarter. With negative growth widening to 0.3% in the July-September quarter, the index is likely to remain negative throughout 2007.

The above forecasts depend to a large extent on the outlook for the oil price and forex rates, and the trend in the core-of-core; while visibility on the former is poor, the latter at least has been stuck at around -0.1-0.2% YoY for the past six months. There has been anecdotal news of a number of upcoming price hikes for the new fiscal year from April, but it is hard to find catalysts for a sharp rebound in the core-of-core. For example, April is expected to bring revisions to a range of service charges, starting with taxi fares. In the case of taxi fares (21/10,000 weighting), however, even if an approximately 20% increase in the basic charge was applied evenly across the whole country, the maximum effect would still be only +0.04ppt.

Meanwhile, oil prices are still trending above our assumptions (US$54/bbl in Jan-Mar) with re-heightened geopolitical risks, and petroleum-related product prices in end-March are trending marginally higher than in February.  We expect these to show up in price indices from April. As a result, we have separately calculated forecasts for the Japan-style core CPI using spot prices rather than our assumptions of oil price and exchange rates. We have left our outlook on the core-of-core CPI almost unchanged, meanwhile. In this case (using spot prices), the drop in the core CPI narrows slightly to -0.1% for F3/08 (-0.2% for C2007). It remains possible, however, that prices will not merely dip temporarily heading toward the summer as the BoJ is indicating, but instead stay in negative territory throughout 2007.

The above calculation brings the core-of-core index to nearly +0.3% YoY in Jan-Mar 2008; however, given the weak current trend in the core-of-core, this assumption may still be too optimistic.

Implications for monetary policy

This price trend takes off the pressure for a third rate hike. The near-term headache for the BoJ is likely to be how to handle price forecasts in the April Outlook Report. Realistically, it seems quite likely that the nationwide CPI for March, due to be announced on the same morning as the BoJ’s next Outlook Report on April 27, will move deeper into negative territory, which we think would be a symbolic event in terms of monetary policy for F3/08. We also think it inevitable that in the Outlook Report the BoJ will revise down its price outlook for the year, as to achieve the current core CPI target (+0.5%) would require the core-of-core improving by 0.09ppt in every month from the level of about -0.2% YoY where it is currently languishing, and frankly we think this is out of the question. Moreover, while the consensus outlook is for a rate hike after the Upper House elections, i.e., in August-September, it is possible that by then the core CPI YoY readings for June and July will have subsided further. Therefore we think the target policy rate could stall at 0.50% during F3/08.

Risks in monetary policy outlook

One risk factor in the scenario described above is that it relies heavily on the oil price holding flat. If the oil price were instead to bounce further, or the yen to weaken further, the BoJ could become more optimistic and this could influence the pace of future rate hikes. Though even then we estimate that it would take an extreme — and in our view improbable — level for the oil price (assuming this was the only factor) of more than US$80/barrel, say, to push the core CPI inflation rate into positive territory YoY.

The second risk factor is that amid a tendency towards adopting ‘second perspectives’ in the policy framework, as indicated at the time of the recent rate hike announcement, the BoJ could try to justify a rate hike even when prices were falling. In fact, Governor Fukui has repeatedly commented that a drop in prices brought on by the falling oil price could result in better terms of trade and so be positive for the economy. To be sure, as with tax cuts, a fall in the oil price would not necessarily lead to deflation as it could raise real purchasing power. However, terms of trade generally deteriorate when the economy is strong and vice versa, and this is simply an outcome rather than a cause. And although it was mainly a positive turn in the CPI resulting from rising oil prices that was seen when quantitative easing was scrapped in March last year, the BoJ justified a rate hike on the basis that high oil prices reflected strength in the global economy. Since the BoJ’s explanations are not always consistent, if it were to attempt an unprecedented tightening while prices are falling, there would likely be renewed pressure from the political side for clarification of the BoJ’s responsibility to account for its actions.


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The Ghost of Reed Smoot
March 30, 2007

By Stephen S. Roach | New York

The label on the photograph sent a chill down my spine: “Reed Smoot, Republican of Utah, Senate Finance Committee Chairman, 1923-33.”  Along with photos of other past chairmen, it was hung in the anteroom to the Senate Finance hearing chamber.  The formal high-collared pose of the dapper mustachioed senator was the last thing I saw before I entered the hearing room on 28 March to testify on US-China currency policy before the Senate Finance Committee.  The legislator from Utah was, of course, the co-sponsor of the notorious Smoot-Hawley Tariff Act of 1930 – a policy blunder of monumental proportions that played a key role in sparking a global trade war and the Great Depression.  Some 77 years later, his spirit was very much in evidence as the Senate Finance Committee gathered to debate the “China threat.”

Over the years, I have participated in several congressional hearings on US-China economic relationships.  Just six weeks ago, I testified on this same issue in executive session in front of the Subcommittee on Trade of the US House Ways and Means Committee (see my 13 February statement, “The Politicization of the US-China Trade Relationship”).  This latest hearing in front of the all-powerful Senate Finance Committee was different.  I left the Dirksen Senate Office Building convinced that trade sanctions against China are now inevitable.  Support is deep and bipartisan.  And the experts tell me that the margin of support appears broad enough to be veto-proof in the event that President Bush objects.  After years of talk and bluster, protectionism no longer seems like an empty threat.  This time, it looks like the real thing.  I suspect a protectionist trade or currency bill could become law by year-end 2007.

This conclusion quickly became evident in the opening minutes of the hearing.  An ominous and well-coordinated warning was delivered by two of America’s leading China bashers – Senators Chuck Schumer (Democrat from New York) and Lindsey Graham (Republican from South Carolina).  Their bipartisan teamwork over the past five years has been key in elevating the China debate in the US Congress.  They were the co-sponsors of the infamous bill that would have imposed a 27.5% tariff on China as a penalty for maintaining a currency that they believe was undervalued by a like amount.  Senator Schumer now admits this proposal was nothing more than a stalking horse to galvanize support from his fellow senators.  In his words, “We never intended the original bill to become law.  It was a shot across the bow.”  Yet both he and Graham admit to being stunned when 67 senators voted to support their measure on a procedural action in 2005. 

Emboldened by that response and empowered by the results of last November’s mid-term elections, Schumer and Graham have now embarked on a far more serious course of action.  They have joined forces with Senators Max Baucus (Democrat from Montana and Chairman of the Senate Finance Committee) and Charles Grassley (Republican from Iowa and ranking minority member on Senate Finance) with a united pledge to present a new China currency bill by midyear.  Unlike the tariff bill, which the senators now admit was not “WTO compliant,” they have promised to make their new proposal fully compliant with WTO rules and provisions.  The Senate Finance Committee hearings of March 27-28 were the first step in what I believe will be a methodical and very deliberate legislative process.  In the end, Senator Graham said it all: “We are in the middle of a defining moment right now.  This is one issue where Republicans and Democrats are together, and we are going to act.”  I’m afraid it doesn’t get any clearer than that. 

There were four of us on the panel of so-called expert witnesses that followed Senators Schumer and Graham – myself, Cornell Professor Eswar Prasad, Morris Goldstein of the Petersen Institute, and John Makin of the American Enterprise Institute.  I went first and was quick to criticize the Schumer-Graham approach (see my 28 March statement, “The China Fix”).  The others, however, were far more sympathetic to the anti-China sentiment expressed by the senators.  My comments essentially rang hollow in this two-hour hearing.  I attempted to make three basic points: One, America’s extraordinary saving shortfall sets us up for chronic trade deficits with China and a host of our other trading partners.  Two, China is focused on a major rebalancing of its own economy that, over time, will provide structural relief to its trade surplus.  And three, America’s middle-class angst – which is driving the politics of China bashing – reflects a US economy that failed to prepare its workforce for the pressures of an IT-enabled globalization.  There was little or no response to anything I said. 

Don’t get me wrong.  I am not naïve enough to believe that my arguments would bring the senators to their senses and turn this debate on a dime.  After all, this is politics – not analytics.  But I took the opportunity to underscore what I believe are several serious inconsistencies in the very structure of the China debate.  I reminded the senators that by boring in on the currency angle, they were framing the debate on the relative price between two nations – an approach that needed to consider strengths and weaknesses of both the US and China.  Yet, apart from my testimony, no one made the slightest mention of America’s saving problem and the key role it plays in driving current account and trade deficits.  I also warned of the hypocrisy of the “asymmetrical phasing” implicit in the Congressional fix – putting pressure on the Chinese to move immediately on the currency front while allowing the United States ample time to address its saving shortfall.  I concluded by asking the senators if they really thought that an adjustment in the bilateral exchange rate between the US and China would improve America’s saving position, redress US income disparities, or accelerate the pace of structural change in China?  My answer was “no” on all three counts.  The senators never even answered the questions.

Over the past two years, 27 separate pieces of anti-China legislation were introduced in the 109th Congress.  None of them passed.  This year, it’s likely to be different.  In just the first three months of the 110th Congress, at least another dozen such actions have been introduced.  But the big one has yet to come.  Senators Baucus, Grassley, Schumer, and Graham are about to swing into joint action and come up with what I believe will be a very serious piece of WTO-compliant legislation.  Despite the political acrimony that pervades Washington these days, these four senators are united on this one issue – as are most of their colleagues in the upper chamber of the US legislature.  Chairman Baucus closed the hearing with a very clear statement on where the four-senator collation is headed on the China currency bill over the next couple of months.  In his words, “We want to do it right. We want to be effective.  We want to be firm.  And we want to act.” 

Sadly, I am not all that surprised by this turn of events.  I have been warning of a rising backlash against globalization for the past couple of years, and now the moment of truth finally seems to be at hand.  Ironically, this is all playing out when the US unemployment rate is hovering near its cycle low of 4.5%.  Yet with downside risks to the economy building by the day, the jobless rate has nowhere to go but up – a development that will only further inflame the bipartisan politics of trade protectionism. 

I was drained at the end of two hours of grilling.  I guess it’s one thing to write abstractly about a problem like protectionism and another matter altogether to become physically immersed in the risks.  I could have sworn that Reed Smoot winked at me as I left the Senate Finance Committee hearing room and staggered out into the unseasonably hot Washington sun.


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‘Asset Shortage Hypothesis’ — Geographical Dimension
March 30, 2007

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

Summary and conclusions

In this note, we follow up on our note last week that introduced the ‘Asset Shortage Hypothesis’ by examining in greater detail the geographical dimension of this idea.   Specifically, we examine the availability of financial assets by region, and highlight some implications for global imbalances, the EUR’s ascent as an internationalized currency and the corporate bond markets. 

We have the following thoughts:

• Thought 1.  US C/A deficit is not difficult to finance.  For years, structural dollar bears have been fretting over the financing sustainability of the US C/A deficit, but have been disappointed as the dollar crisis they predicted has never materialized.  Both Fed Chairman Bernanke and ourselves have proposed the excess savings/inadequate investment hypothesis.  The Asset Shortage Hypothesis is complementary of this relatively sanguine view on the dollar, particularly if we look at the supply of financial assets (sovereign bonds and equities) by geography. 

Sovereign debt issuance by the AXJ countries has declined sharply as a percentage of GDP since the Asian Financial Crisis a decade ago.  In absolute dollar terms, total AXJ sovereign bonds outstanding currently stand at only US$830 billion, compared to US$8.4 trillion for the US, US$9.7 trillion for the EU and US$8.2 trillion for Japan.  The annual total C/A surplus of AXJ is equivalent to around 40% of its own stock of sovereign bonds outstanding. 

Setting aside the question of the ‘desirability’ of holding these bonds, there are simply not enough AXJ bonds for the AXJ investors to purchase.  To the extent that capital flows from ‘East’ to ‘West’ are predominantly fixed income in nature, large market caps in the sovereign bond market in the West have made capital outflows from AXJ (mostly official) a fairly natural trend to expect. 

While net new equity issuance in most parts of the world has declined since 2000, the US still has by far the largest net new issuance of equities.  Asia, surprisingly, came in second, close to the EMU.  Net equity issuance in the UK, Japan and Latam has been very low.  In fact, it has been negative in Latam in recent years. 

Since most of the net new equity issuance in the past two years has taken place in Hong Kong, it would be reasonable, for our purposes, to consider the US and AXJ as a de facto dollar bloc.  Capital flows into HK to acquire these new shares have to be ‘converted back’ into US dollars by the HKMA.  This means that, from the perspective of the available size of net new equity supplies, the dollar bloc offers by far the greatest opportunity for global investors. 

Therefore, looking at the lack of supply of financial assets by AXJ and the opposite for the US and the dollar bloc, we are not surprised that the US has had a relatively easy time financing its C/A deficit. 

• Thought 2.  The EUR is gaining status as an internationalized currency.  Thinking about exchange rates from the perspective of the quantity of supply of financial assets can also help explain the up-trend in EUR/USD in the past five years.  The value of all traded  debt (sovereign, corporate and others), compiled by the BIS, issued in dollars and euros shows that the total stock of all types of debt issued in EUR exceeded that in USD back in December 2003.  At present, all EUR-denominated bond instruments total US$8.3 trillion, compared to US$6.4 trillion for all USD-denominated debt. 

This chart is a validation of the EUR gaining its reserve currency status and the view that it is becoming more internationalized in recent years as entities outside the Eurozone have become more willing to issue new debt in EUR. 

• Thought 3.  Corporate bonds and their derivatives:  demand for them fuelled their supply Ttotal corporate bonds outstanding, as a percentage of GDP, have stagnated in the US, and are rising from a very low level in Euroland.  This is remarkable, given that some corporations have issued debt to finance share buy-backs or leveraged buyouts.  Also, they are relatively small in absolute terms:  US$2.7 trillion in the US and US$1.0 trillion in Euroland.  Low new corporate bond issuance reflects the cash-rich position in which most corporations find themselves. 

  Households, not corporations, have been the primary borrowers in the global economy in recent years.  Since households mainly borrow through banks rather than the capital markets, the shift in demand for credit from corporations to households should restrain the supply of credit instruments while increasing bank loans.  In any case, the supply of corporate debt is not enough to satisfy investors’ demand. 

The surge in credit derivatives was, in our opinion, a direct result of financial innovation and the originators’ desire to manufacture supply to meet the demand for these instruments.  In other words, investors’ appetite for these securities created its own supply of this class of risky assets.  The growth of credit derivatives raises the issue of ‘indebtedness’ in the US, that much of this type of debt does not really constitute genuine ‘indebtedness’ but rather exactly the opposite: flush liquidity. 

Bottom line

We believe that the world is suffering from a shortage of financial assets.  The geographical distribution of these financial assets (i) helps explain why the US C/A deficit has been easy to finance and (ii) validates the view that the EUR has gained status as an internationalized currency.  Further, similar to sovereign bonds and equities, corporate bonds are also in short supply.  The sharp surge in credit derivatives could be a result of strong demand for risky assets generating its own supply.


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Middle East/North Africa
In the Shadow of Giants
March 30, 2007

By Serhan Cevik and Katerina Kalcheva | London, London

No country can escape unscathed from a synchronized slowdown in the global economy. All the countries have enjoyed, with varying degrees, the unprecedented boom in the past five years, and now face the risk of a synchronized slowdown in the global economy. Even though structural changes support a higher pace of growth and should keep us away from an outright recession, the slowdown is already here and may intensify in the coming months. First, the correction in the US housing market that began last year and reduced the rate of real GDP growth by 0.8 percentage point over the last four quarters is likely to bring more pain as the world’s largest economy moves below its trend growth rate. A weakness in the housing sector is not necessarily a trigger for an economy-wide recession, but the spillover effects could still become a drag on the overall economy. Second, as if the challenges in the US are not enough, China — the world’s other leading engine of growth — may also experience a managed slowdown in economic activity. China’s breakneck speed of growth makes the authorities uncomfortable and will likely lead to the introduction of administrative measures to bring it to a more sustainable path. In our view, no economy can escape unscathed from such a synchronized slowdown and its financial implications, but the Middle East stands to lose even more from a correction made in the US and China.

The Middle East has a significant exposure to the US and Chinese economies. Countries with greater trade exposure to the US and China tend to have highly synchronized business cycles. As exports from the Middle East to America and China soared from an annual average of US$20.9 billion in the 1990s to more than US$100 billion last year, all the countries in the region have become more synchronized with the US and China and thus vulnerable to a slowdown in economic activity. This is, of course, mainly due to America’s leading position in the global economy and China’s exponential growth with high oil intensity. While the US maintains its leadership in oil consumption, China’s imports of mineral fuels increased rapidly from US$6.7 billion in 1998 to US$90 billion in the last 12 months, with more than half coming from the Middle East (see Dragon’s Appetite, March 21, 2007).

Turkey is less vulnerable to a slowdown in the US and China, compared with the rest of the region. Our previous calculations on growth correlations with the US confirmed greater synchronization (see When Atlas Sneezes, October 25, 2006). And when we run our model with the latest (weighted) growth figures incorporating China and the US, the result is even more vivid. With exports to the US and China accounting for 5.6% of total exports, Turkey does not have significant growth interdependence with the US-China axis. Europe is Turkey’s main trading partner, accounting for 65% of its exports, and thereby limits its direct exposure to a slowdown in the US and Chinese economies. On the other hand, with 46.4% of exports going to America and China, Israel is far more exposed to what happens in the US and China and therefore may suffer from a downturn in these countries. However, the most significant vulnerability of the Middle East and North Africa stems from the commodity channel, in our view. As the price of oil surged from an average of US$25 a barrel in 2002 to US$65.2 in the last year, export revenues of oil-producing countries increased from US$250 billion to the US$1 trillion threshold, intensifying the sensitivity to the global growth cycle.

The Middle East’s most significant vulnerability comes through the commodity channel. Correlation coefficients for output growth, for example, in Saudi Arabia and the United Arab Emirates vis-à-vis the US and Chinese economies increased from -0.72 and -0.09, respectively, in the 1990s to 0.79 and 0.83 in the last five years. Greater openness in the region has certainly played a role, but the oil dependency is the main reason for such an unusual exposure, in our view. As a result, a slowdown in the US-China axis would weaken economic performance throughout the Middle East. Indeed, even before the latest jitters in the US, oil producers in the region are set to experience a slowdown in real GDP growth from around 7% last year to about 5% this year. Furthermore, lower growth and changing expenditure patterns in oil-exporting countries may also have unexpected consequences through the petrodollar channel.


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CHF Mortgage Loans Ex-Switzerland Are Small
March 30, 2007

By Stephen Jen and Luca Bindelli | London, London

Summary and conclusions

In this note, we make a straightforward observation (which is contrary to popular opinion) that CHF-denominated loans outside Switzerland are rather small and have probably peaked. 

Even though there is anecdotal evidence that CHF-denominated mortgage loans have become more popular in some Eastern European countries in the past couple of years, the absolute size of these loans is still small, and they have actually stabilized since the summer of 2006.  While nominal interest rate differentials still matter for the CHF, we remain skeptical that they have been or will continue to be the dominant factor driving the CHF.  In particular, we challenge the notion popularized by newspaper articles that demand for cheap CHF (and JPY) mortgage loans is ballooning outside Switzerland and Japan

What we have argued in the past about the CHF and JPY

We believe that nominal cash yield differentials have indeed been a major factor behind the weakness in both the CHF and the JPY, both of which remain undervalued.   The risks to EUR/CHF are biased to the upside in the near term since, in our opinion, an inflation-targeting Swiss National Bank will have difficulties justifying urgent rate hikes when inflation is drifting lower, with the latest inflation print being zero.  While we also believe that Switzerland’s neutral interest rate is far above where its policy rate is right now, the positive shock to Switzerland’s aggregate supply (primarily through immigration) should lead to a steepening in the yield curve.  In a carry-dominated environment in the currency markets, this is, all else equal, negative for the CHF. 

For the JPY, the story is a bit different.  Even though Japan is also experiencing a powerful productivity surge, and output growth has been above the long-term potential growth rate for three consecutive years, the confluence of two structural forces — globalization and demographics — has led to a peculiar constellation of macro variables.  (Arguably, Japan has been hit harder by these two structural shocks than most other countries.)  In particular, inflation and wage pressures remaining low with such strong overall real growth is, in our view, a direct result of these two tectonic forces. 

In addition, the JPY has been weaker than justified by economic fundamentals because of (very possibly) a structural decline in the ‘home bias’ by Japan’s retail investors.  These capital outflows have occurred through both foreign bond and equity purchases, and could probably remain strong even if the cash yield differentials are compressed.  This is why we have long challenged the popular notion that ‘JPY carry trades’ are the dominant force keeping the world’s risky assets supported.  The story, in our view, is more complicated, even though capital outflows from Japan have no doubt been one (of several) critical factor behind the under-valued JPY. 

CHF retail loans outside Switzerland

The whole ‘carry trade’ idea has been blown out of proportion by commentators and the press, in our view.  While some of the arguments and claims made on this subject are true, many are not.  One particular example is the claim that CHF and JPY-denominated mortgage loans have exploded in many parts of the world, in particular in Eastern Europe

In a previous note (Type 3 JPY Carry Trades: Fact or Fiction, November 2, 2006), we made an attempt to refute this general notion that JPY-denominated retail loans outside Japan were ballooning.  In this note, we take a closer look at the claim that CHF-denominated mortgage loans outside Switzerland have surged sharply. 

We have the following thoughts:

1. CHF loans may have peaked.  While retail loans denominated in CHF terms have indeed risen sharply since early 2004, this trend has tapered off since the summer of 2006, presumably due to the 50bps rate hikes by both the ECB and the SNB in 2H06. 

Some of these changes in trends in HUF and CHF loans may also be due to the movements in the HUF and CHF (HUF appreciated while CHF depreciated).  We have thus corrected for valuation changes. 

In any case, a flattening in this chart implies that there were no new CHF loans extended since last summer. 

2. The absolute size of CHF loans is small.  Further, if the question is whether CHF-denominated mortgage loans extended in Hungary are big enough to move the CHF market, then the absolute size of these loans matters.  In absolute terms, the size of outstanding loans in Hungary denominated in CHF is around €15 billion, built up gradually over a two-year period.  This does not seem large enough to dictate where the CHF goes, though it was probably one contributing factor to the CHF’s weakness.  

3. We see a similar story in Euroland.   EUR-denominated loans absolutely dominate, as they account for 96.4% of all loans.  Of the remainder, USD loans are the largest, followed by CHF, GBP and JPY loans.  CHF loans account for only 1.1% of the total, or around €111 billion as of end-2006.  While the absolute size of CHF-denominated loans extended in Euroland has grown, at 1.1% of the total, they account for the same share of total loans as they did in early 2003.  Thus, there is no indication that CHF carry trades have gained too much popularity in Euroland at the retail level. 

4. Retail loans in JPY terms are even smaller.  There has also been talk that non-Japanese residents are taking out mortgages in JPY terms and these have driven the JPY lower.  We have always been skeptical of this idea.  JPY-denominated loans have not risen at all in Hungary (a representative Eastern European country) or the EMU, they have actually declined since 2004.  Thus, one could argue that, at the household level, CHF carry trades outside Switzerland are relatively more popular than JPY carry trades outside Japan.  But the former’s popularity has also been waning for nine months.

Bottom line

Much has been said about ‘carry trades’.  While some arguments are valid, in our view many are not.  One of the popular views that we believe is not valid is the notion that non-Swiss and non-Japanese resident households have significantly increased their mortgage borrowing in CHF and JPY-denominated loans.  Data we could find don’t support this view.  Specifically, CHF-denominated loans outside Switzerland have likely peaked.  JPY-denominated retail loans outside Japan were never a meaningful factor. 


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Income Inequality and Capitalism in the UK
March 30, 2007

By David Miles | London

Income inequality in the UK is once again on the rise. Latest data show that on a range of different measures the distribution of household income — after tax and after the payment of social security benefits — became slightly less equal over the course of the past year or so. What is surprising, and perhaps worrying, about this is not that the scale of the increase was great — in fact it was rather small — but that it happened despite a prolonged and concerted series of policy measures to make the distribution of incomes more equal.

Let’s start with the facts, and then turn to the implications. The most widely used single measure of income inequality is the Gini coefficient. There was a very sharp, indeed almost unprecedented, increase in income inequality in the 1980s. Inequality rose somewhat further in the early years of the Labour government at the end of the 1990s. Since around 2000, inequality first dropped slightly but then resumed its upwards path over the past couple of years.

So over the ten years that Labour has been in power under Prime Minister Blair, the distribution of income has crept up slightly. This is despite a series of major changes to the tax and benefit system which have redistributed incomes towards the less well-off. Without this sustained policy of using the tax and social security system to re-distribute income, inequality would have increased much more dramatically. Here is what the UK Institute for Fiscal Studies — the authoritative and independent research institute — says:

“Labour has introduced a package of redistributive tax and benefit reforms since 1997 …tax and benefit reforms since 1997 have clearly been progressive, benefiting the less well-off relative to the better-off. Given the fact that Labour’s tax and benefit reforms have tended to benefit poorer households at the expense of richer ones, it might seem surprising that income inequality is slightly higher on most measures than it was in 1996–97…While the actual level of inequality as measured by the Gini coefficient is slightly higher in 2005-06 than it was nine years earlier, with an approximate value of 0.347 in 2005-06 compared with 0.333 in 1996-97, our simulations here suggest that the Gini coefficient would have increased considerably, to around 0.378, if the tax and benefit system had remained unchanged”.

There are limits to how much any government can use the tax and social security system to re-distribute incomes. Indeed, it appears as if the UK government may have concluded that those limits have been reached. The budget that Chancellor Brown introduced just last week did make some changes to the tax and benefit system, but these were designed to simplify the system, bring down some headline tax rates and ensure that few people lost out. What they did not do — unlike nearly all his previous annual budgets — was re-distribute incomes to the less well-off.

So, the stark picture is this: after a decade of steady economic growth, in which unemployment has fallen sharply and employment has risen significantly, and during which the government has used all the levers at its disposable to try to engineer a redistribution of incomes towards the less well-off, it has managed to prevent much of a further increase in inequality. But as it has neared the limits of its ability to use the tax and benefit system to re-distribute incomes, inequality has recently started to move higher again.

If it took an enormous effort in using the tax and benefit system — one that pushed it to the limits of feasible redistribution — just to keep income distribution from rising much further, then what next?  Note again that all this has happened in the UK when unemployment has been — on average — falling and the employment rate — the participation rate — rising. Employment has been boosted by a rise in public sector employment as state spending has risen sharply since 2001. In the poorest and most deprived parts of the country, the reliance on public sector jobs is great — there has been little growth in the private sector, the market and jobs. And from here on we are likely to have much slower growth in state spending.

All this has potentially worrying implications for business and for financial markets. For 10 years under the Labour government there has been muted anti-business sentiment in the UK, and to an extent that is unusual. The UK has embraced the global economy in a way that would have been hard to predict based on much of its history over the past 50 years. The UK has been more open to foreign ownership of what were UK companies, more open to trade and more open to flows of migrants than most large developed economies. It is far from clear that there is a powerful link between those things and the pressures driving inequality higher. But in the eyes of many ordinary people and of some politicians there is a much clearer link.

It is easy to become complacent about the relatively pro-business environment in the UK today — something that seems to have the support of the main political parties. Whether that situation is robust to potential further increases in income inequality is far from clear.



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