United States
Perfect Storm for the US Consumer?
April 02, 2007

By Richard Berner | New York

Eight years ago, I described a “golden age” for the US consumer.  Arguing that consumers’ health was enhanced by strong job and core income gains and improving balance sheets, I saw few clouds on the horizon (see “A ‘Golden Age’ for The US Consumer,” Global Economic Forum, April 14, 1999).  And when storms arrived — a bursting equity bubble, the recession of 2001, the terrorist attacks on 9/11, a jobless recovery, a five-year surge in energy prices, and now the housing recession — our call regarding the American consumer’s resilience held up well.  Annualized growth in real consumer spending during that period averaged 3.4%, essentially equal to the average of the past 50 years, and such outlays never contracted on a quarterly basis.

That was then.  Now, strong pressures appear to be mounting on the US consumer on four fronts: Adjustable-rate mortgages (ARMs) are resetting, consumer lending standards are tightening, housing wealth is decelerating, and surging energy and food quotes threaten to drain more than $100 billion from purchasing power.  If sluggish economic growth begins to erode job and income gains, do these dark clouds finally and ominously herald the perfect consumer storm?  I’ll concede that US consumers face their toughest challenge since the recession of 2001, and the result likely will be only sluggish growth for a while.  Nonetheless, I believe that fears regarding some of these tests are overblown, and others likely will be temporary.  Even a more protracted combination of these trials in my view will not trigger outright consumer retrenchment as long as job and income growth don’t seriously falter.

To assess their impact, it’s important to dimension the extent of each of these challenges.  That’s hard in some cases, like lending standards, that defy quantification.  And the interplay among the first three — the “ARM squeeze,” tighter consumer lending standards, and decelerating housing wealth — could be a triple threat to so-called “liquidity-constrained” consumers, and I don’t want to overlook that possibility.

Let’s look at the ARM squeeze first.  Pessimists have long argued that as a large volume of adjustable rate mortgages begin to reset, the drain on consumer discretionary spending power would be crippling.  Indeed, the Mortgage Bankers Association estimates that between $1.1 and $1.5 trillion of adjustable rate mortgages (or about 10% of the overall mortgage market) will reset this year.  Resets will be painful for certain borrowers, but we estimate that the resets in the aggregate will add only about $15 billion to household debt service in 2007 — representing less than 0.2% of personal income.  The impact of ARM resets will rise further in 2008, to perhaps 0.4% of household disposable income.  That is consistent with the results of a careful new study by Christopher Cagan.  He estimates that the difference between initial monthly payments and the payments when the loans are fully reset averages $42 billion per year over the next few years (see Christopher L. Cagan, “Mortgage Payment Reset: The Issue and the Impact,” First American CoreLogic, Inc., March 19, 2007). 

Reset isn’t the whole story, however.  Some loans — and not just subprime loans — are likely to face the double whammy of a significant reset while simultaneously having insufficient equity to permit a sale or refinance.  Cagan’s analysis suggests that as a result, over the next six years or more, lenders will foreclose on about 1.1 million of such loans amounting to losses of about $112 billion, or about 1.1% of mortgage debt outstanding.  Teaser-rate and subprime mortgages originated in the past three years are most vulnerable; Cagan estimates that 32% of teaser loans (including Pay Option and similar ARMs), 7% of market-rate adjustable loans, and 12% of subprime loans will default due to reset.  However, it is critical to know who are the borrowers in such cases.  Revealingly, Cagan estimates that 11.1% of the properties purchased or most recently refinanced with adjustable-rate first mortgages in 2005 have negative equity, while a whopping 23.9% of the such borrowers in 2006 have negative equity.  Some of these borrowers, seeing the coming deceleration in home prices, probably cashed out as much equity as they could and ran with the proceeds, never even making the first payment.  That kind of fraud suggests much more pressure on the lender than on the consumer.

Not surprisingly, against this backdrop, lenders have already begun to tighten lending standards, which will constitute a second headwind for the would-be extractor of home equity to finance spending.  However, we believe that fears that a credit crunch in combination with mortgage resets will choke off borrowing are overblown.  To be sure, the subprime meltdown continues, lenders began tightening mortgage-underwriting standards last fall, according to the Fed’s survey of senior loan officers, and lending standards will continue to tighten, albeit less for prime borrowers.  And regulatory changes are afoot that may further tighten availability.  The guidelines proposed by regulators on March 2 include a proposal designed to eliminate predatory lending to borrowers who cannot qualify for an ARM when it fully adjusts.  But as we see it, the combination of lender and regulatory actions will likely at most simply reverse the loosening of lending standards that occurred in the past three years.  As a result, it is unlikely to make mortgage credit availability tighter than the average of the 1999-2005 period (see David Greenlaw’s “Subprime Will Hurt, But Affordability Is the Key,” Global Economic Forum, March 23, 2007).  That leaves affordability as the main question for housing demand, and the outlook for housing wealth and income the main issues for consumer spending.

We’ve long thought that the coming deceleration in housing wealth would prompt consumers to boost the share of saving and reduce the proportion of spending out of current income; the real issue is whether the current pace of job and wage growth is sufficient to allow consumers to do so while also maintaining their lifestyles.  I’ve argued that home prices likely would stagnate for a few years, but even if home prices decline nationwide by 5% from current levels, the hit to consumer spending is unlikely to be crippling.  Based on rules of thumb like those in the Fed’s econometric models and those we use, such a hit to wealth (about $1 trillion, or 1.9% of overall household net worth) might promote a $40-50 billion decline in consumer spending, or about 0.4-0.5% of the total.  That’s essentially what we’ve built in to our forecasts. 

An immediate concern is that the combination of surging energy and food quotes threatens to drain more than $100 billion from purchasing power, and would correspondingly further depress spending.  The recent jump in refined product and crude oil prices — for example, retail gasoline quotes rose by 21% in the past eight weeks to levels not seen since Labor Day 2006 — probably isn’t over.  It reflects low inventories, OPEC production cuts, refinery downtime and renewed geopolitical tensions, and could take nationwide gasoline prices just below $3/gallon before it ends.  The good news, in our view, is that these hikes will prove temporary as the demand-supply balance eases (see “Oil Price Spike: Sharp But Temporary,” Global Economic Forum, March 30, 2007).  The bad news is that it will have drained as much as $80 billion at an annual rate from consumer purchasing power in the first half of 2007. 

Soaring food prices also threaten consumer budgets as well as headline inflation.  Courtesy of a drought in Australia and strong demand for ethanol, overall food prices are rising — at a 3.1% rate in the year ended in February — and could feed through to inflation expectations.  The jump in animal feed quotes has begun to hike beef and poultry prices following flat to declining prices last year.  A California freeze also hiked citrus quotes and damaged orchards.  If food prices rise at a 5% annual rate between February and June, it could siphon about $30 billion from consumers’ shopping baskets over the December-June period.  But the perceived inflation and budget threat from soaring food prices could be transitory and overblown.  The impact of the California freeze will fade.  Persistently higher feed prices could eventually trigger lower beef quotes as ranchers bring more of their herds to slaughter when profitability slips.  The recent USDA report that corn planting would hit a record triggered a 5% plunge in wholesale corn quotes.  Indeed, my colleague Hussein Allidina believes that corn prices will fall as low as $3/bushel (see “Record Production Expected to Send Corn Prices Lower,” March 18, 2007). 

My colleagues Jim Caron and Joachim Fels believe that the yield curve likely will continue to steepen bearishly for now, and I couldn’t agree more.  One factor, in my view, will be rising term premiums, fueled by the less-certain economic outlook and the Fed’s decision to provide less forward-looking guidance for monetary policy; Chairman Bernanke stressed both in his Congressional testimony last week (see “More Clarity, Less Guidance From the Fed,” Weekly International Briefing, March 30, 2007).  In addition, the combination of sluggish growth, slow productivity gains and rising headline inflation creates a whiff of stagflation that may last through the spring (see “Yet Another Whiff of Stagflation?” Global Economic Forum, March 19, 2007).  If, as we expect, energy quotes decline and inflation ultimately subsides, the yield curve might continue to steepen — but bullishly as markets anticipate eventual Fed ease.

The key risk is that these pressures may last longer or are more intense than anticipated, threatening the consumer in particular and thus the economy.  That’s not all: Another old stagflationary ghost is stalking the halls of Congress again — the threat of protectionism.  Like my colleague Steve Roach, I think the threat is real (see his accompanying dispatch, “The Ghost Stirs”).  The direct impact of the current tit-for-tat with China will be small, but even a small trade war will trigger ripple effects in the currency and inflation expectations that could endure.  Even if the outcome of all these factors is no more dire than I expect, corporate earnings, which are leveraged to growth, likely will disappoint.  But strong overseas economic growth and results for the foreign affiliates of US companies seem likely to cushion the blow for both top-line growth and the bottom line.

 

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Global
Oil Price Spike: Sharp But Temporary
April 02, 2007

By Richard Berner | New York

Oil prices are surging again as geopolitical risks fuel fears of supply disruptions.  IPE crude futures for the end of this year jumped to $69 on March 30, up 6.5% in just the past week as escalating tensions over UN sanctions on Iran’s nuclear programs boiled over with the capture by Iran of 15 British sailors in the Gulf.  But supply fears have merely intensified a rally under way for the past ten weeks; the reality is that refined product and crude energy prices have been on the rise since mid-January.  In US markets, wholesale gasoline quotes are up 50% and crude prices up by 24% in the last 50 trading days, and retail gasoline quotes rose by 21% in the past eight weeks — to levels not seen since Labor Day 2006.  The product price hikes are most pronounced in the United States, but aren’t just US-centric; in Europe, for example, diesel (the most popular fuel for cars) quotes increased by 15% over the last four weeks.

The culprits for this broader rally include several of the usual suspects: Strong global demand, a surge in cold weather, OPEC production cuts, refinery downtime and now the escalation of tensions between Iran and the Western world.  The questions now are: Is this jump in prices a replay of the spring 2006 march to $3 gasoline? And given the weaker state of the US economy, could this price spike trigger consumer retrenchment? Conversely, could a weaker US economy and somewhat cooler Chinese growth help bring crude prices down below $60?

In our view, these hikes will prove temporary as the demand-supply balance eases.  Global demand won’t slacken much, especially with the Asian economies still running hot and Europe growing faster than expected.  But refinery downtime will end soon and production runs should get back to normal in a month or so.  And if prices continue at this level or rise further, it wouldn’t surprise us to see OPEC restore some of the production the oil ministers cut last fall.  Already, OPEC sailings have started to increase.  As a result, this price surge should be short-lived and we expect that Brent crude will revert to a range of $50-$60 in the next 18 months.

Fast growing Asian economies have boosted demand

Global demand for oil remains robust, with China’s booming industrial economy playing an ongoing important role.  For example, the US Energy Information Administration (EIA) forecasts that global oil consumption will rise by over 1.4 million bbl/d in 2007, compared with an increase of 1.2 million bbl/d last year.  The EIA assumes that China will account for roughly one-third of incremental demand.  Given our belief that refineries have increased their middle distillate yields in the past two years, those increases in crude demand likely understate the growth in the demand for refined products. 

Less supply side improvement at the margin?

Those improvements in refinery efficiency are one factor that has, over the past year, begun to produce a better balance between supply and demand and thus to bring the five year uptrend in both product and crude prices to an end.  However, at the margin, further boosting the middle distillates yield of existing refineries might prove more difficult than it was over the last two years.  A second factor that we have documented previously is the growth of non-OPEC supply.  But oil markets are still tight compared with several years ago, because production growth has not completely caught up with demand, and so are vulnerable to demand or supply shocks.

Four consecutive supply shocks

Three such shocks occurred in rapid succession beginning in mid-January.  First, the weather, which had been unseasonably mild in both the US and Europe, suddenly turned bitterly cold.  The demand shock from that cold snap, which extended into March, increased the demand for heating oil and related products. 

Second, seasonal downtime maintenance and outright refinery problems have hampered production.  Some US refineries are out of action because of technical or safety problems at a time when many are, in any case, undergoing seasonal maintenance.  US refinery utilization was at 86.3 percent of capacity as of March 16, the lowest for this time of the year since 2002, according to government data. The latest snafu: A fire at BP PLC's giant oil refinery in Whiting, Ind., which is expected to shut key gasoline-producing units for between four and six weeks. The BP problems follow a mid-February fire at Valero Energy Corp.'s McKee refinery in Sunray, Texas, which put the 158,000 barrel-a-day refinery off line completely until April. The refinery will only be able to ramp up to about 70 percent capacity, where it will stay until the end of the year.

Third, imports are near two-year lows.  Unlike in 2005 following the hurricane-induced refinery shutdowns, strikes in Europe are limiting the supply of refined products from that source.  A French port-workers' strike has led some refiners to cut back on production and could affect seven refineries with a total of nearly 1 million barrels a day of refining capacity, or 7 percent of Europe's total.  Unhappily, the strike comes at the start of Europe's refinery maintenance season, which could cut spring capacity significantly.  In fact, the timing of this industrial action was carefully chosen: just three weeks ahead of the first round of the French Presidential election, unions bet that the government will not send in the police to unlock the port.  As a result, the tensions may continue to escalate until the polling day.

Geopolitical risks have resurfaced

The fourth supply shock is not a tangible one; it is about the threat of supply disruption.  The capture of 15 British sailors who were patrolling in the Shat Al Arab on a mission mandated by the United Nations has significantly increased the market risk premium for products and crude, for fear of further military escalation that might cut Iranian supply of light crude.  Although we think that the odds are still for a non-violent end to this dangerous confrontation, markets are legitimately hedging against a less peaceful outcome.  As we have already pointed out, an embargo on Iranian oil would reduce global supply by around 2 mb/d (in this matter only Iranian exports matter), which is more than the current spare capacity in other OPEC countries, such as Saudi Arabia.  That markets are quite nervous each time tensions with Iran escalate is thus rational.

These supply shocks should be temporary

While the timing is uncertain, we think these four factors will dissipate going forward.  Refinery maintenance and industrial action in Marseilles are likely to end in the next few weeks.  As for geopolitical tensions, it wouldn’t be wise to bet on any precise calendar.  However, Iran is so heavily dependant on imports of refined oil products and food that its leaders, however aggressive they may appear, have no interest in letting the escalation go to the breaking point.  A face-saving stand-down on both sides is the most likely outcome.

Listen to Saudi Arabia

In addition, we believe that Saudi Arabia is not interested in letting crude prices go much above $70/bl for two reasons. First, Saudi policy makers in general and King Abdullah in particular are well aware that excessively high prices could kill the golden goose of hearty demand for their product.  The big worry is not that high prices could cause a recession and thus cut oil demand — the experience of the last five years would rather suggest that the global economy is less sensitive to oil prices than it was thirty years ago.  Rather, it is that high oil prices are the best imaginable incentive to increase energy conservation and invest in substitutes.  The new focus on the strategic imperative to reduce dependence on imported oil and the sudden interest in preserving the environment, carbon cap and trade schemes, and alternative fuels in Western countries is at least partly a by-product of the rise in gasoline and diesel prices, especially the $80/bbl spike last August.  As a result, higher prices will likely prompt the Saudis to pump more crude.

Second, as we have often stressed, the interests of Saudi Arabia and Iran are divergent in the long run, as they have been in the past.  Only Saudi Arabia could exert a credible pressure on Iranian leaders by increasing crude production and thus bringing down the price of crude.  As the driving season approaches, we would not be surprised if Saudi Arabia started to talk about a seasonal production increase.

In price elasticity we trust

In the medium to long term neither demand nor supply are insensitive to prices.  Ironically, the most eloquent evidence of the power of price elasticity on the supply side was the drop in OECD demand for crude oil last year (-0.5%), despite strong GDP growth (3.2%).  As our consultant Norwegian Energy consultant documented, oil companies reacted to the rise in margins by upgrading refineries in order to increase the supply of middle distillate products (diesel and jet fuel) for a given input of crude oil.  In addition, new refinery capacity able to crack heavy sour crude and produce the most wanted products, i.e. middle distillates, will start coming on stream in 2008 and 2009.  As prices rise to $70/bl again, we would expect refiners and other investors to commit more capital to this lucrative business.  On the demand side, car makers are all rushing to produce more fuel efficient products such as hybrid or ‘clean diesel’ engines, and governments are subsidizing substitutes such as ethanol and bio-diesel.  We would also expect more of these actions following the current price spike, if it were to last.  By coincidence, the US Government Accounting Office, a bipartisan body, has just released a thoughtful report hinting at the risk of a worldwide recession if the peak in oil production is reached in the coming years (Crude Oil: Uncertainty about Future Oil Supply Makes It Important to Develop a Strategy for Addressing a Peak and Decline in Oil Production, GAO-07-283, February 28, 2007).  For these very fundamental reasons, we have kept unchanged our end of 2008 price target at $55/bl for Brent and WTI, the long term normalized price outlook retained by our oil team.  According to our colleagues Doug Terreson and Lloyd Byrne, the marginal price to produce oil while earning an acceptable return on investment is close to $55/bbl WTI.

Watch the shape of futures curves

We’ve often noted that futures prices aren’t reliable predictors of energy quotes.  So far this year, the contango in the crude curve was more on the mark than were we.   And for once, futures markets may yet partly be telling the right story: Gasoline is backwardated, and we think prices and crack spreads are headed lower.  In contrast, we would bet against the slight contango still visible in the crude curve, but nevertheless note with interest that it is much less marked than a few weeks ago, a signal that markets might not see the current price rise as permanent.

Risks are balanced; volatility is of the essence

We’re mindful of the high level of uncertainty in this scenario but believe that the upside risks to prices will likely dominate for now.  The likely culprits: Geopolitical risks, stronger global growth, and a potentially powerful 2007 hurricane season.  Last year, it is worth noting, energy prices tumbled as the highly touted hurricanes never came.  That may happen again, but the vagaries of the weather are always a wild card in the energy outlook.  Nonetheless, the downside risks to prices ultimately could be equally strong if US and Chinese growth slows, as a new rush of supply comes on stream.  One thing is for sure: volatility in energy quotes isn’t going away, and forecasting energy prices will always require a tolerance for being wrong

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United States
Review and Preview
April 02, 2007

By Ted Wieseman | New York

The big curve-steepening move that started after the FOMC statement was released on March 21 was somewhat further on net over the past week, but only after what had seemed a relentless move to new highs through Wednesday saw a least a temporary partial reversal to close out the week. Main focus during the week was on Fed Chairman Bernanke’s testimony Wednesday, in which he attempted to clarify the FOMC’s outlook after investors were apparently a bit confused by the FOMC statement.

Although there was a lot of market volatility surrounding the testimony, from our perspective, the Chairman’s message seemed quite clear — the Fed’s economic outlook has not materially changed and policy remains on hold for now waiting for inflation to gradually recede to more acceptable levels. He acknowledged that uncertainties in the outlook have increased and said that the FOMC therefore wanted more ‘flexibility’ in its official policy stance and wanted to move away from providing explicit future policy guidance but rejected the idea that the Fed had adopted a ‘neutral’ policy stance, stressing that it continues to see inflation as the main risk to the outlook. The past week’s economic data certainly did not make the Fed’s job any easier, with the growth outlook continuing to deteriorate even as inflation reaccelerated. We cut our 1Q GDP estimate to +1.6% from +2.0%, based on yet another bad durable goods report that continued to raise worrying questions about the capital spending outlook and an upward revision to 4Q growth that was centered on inventories and thus seemed likely to borrow from 1Q output. These negatives saw only a small positive offset from a slightly stronger trajectory for 1Q consumer spending implied by upside in the personal income and spending report and better-than-expected construction spending numbers, with the upside concentrated in the business sector even as the residential collapse continued. Meanwhile, the core PCE price index posted its strongest monthly advance since 2001 in February, lifting the annual pace right back to the cycle high of +2.4%. We’re now going on a year of subpar growth averaging little better than 2% and yet core inflation has actually accelerated since the slowdown started.

Benchmark Treasury yields ended the past week 0- 5bp higher, with the curve continuing to bear steepen, though correcting a bit off the peaks hit Wednesday. The old 2-year yield rose 1bp to 4.62%, the 3-year yield was unchanged at 4.53%, the old 5-year yield rose 3bp to 4.54%, the 10-year yield rose 4bp to 4.65%, and the 30-year yield rose 5bp to 4.84%. The new 2-year ended Friday at 4.58%, well off Wednesday’s auction level of 4.514%, while the new 5-year closed at 4.54%, just marginally worse than Thursday’s auction level of 4.535%. TIPS outperformed slightly on the week, but given the jump in oil prices and upside surprise in the inflation figures, their performance was pretty poor. The 5-year TIPS yield ended the week unchanged at 2.03%, causing its inflation breakeven to rise 3bp to 2.51%, while the 10-year TIPS yield rose 2bp to 2.21%, causing its inflation breakeven to rise 1bp to 2.44%. This combination left the 5-year/5-year forward breakeven based on the benchmark issues unchanged at 2.38%. Fed pricing in the futures market ended the week little changed, with a marginally less dovish near-term view, slightly more dovish late this year and in early 2008, and a bit less dovish further into 2008. The July fed funds contract was unchanged on the week at 5.18%, continuing to price about a 30% chance of a rate cut by the June FOMC meeting. The August contract lost 1bp to 5.125% and the September contract fell 0.5bp to 5.075%.

In the eurodollar futures market, the Sep 07 contract gained 0.5bp and the Dec 07 contract rose 1bp, while the Mar 08 contract was off 0.5bp and the June to Dec 08 contracts lost 2bp, with the low-rate Sep 08 contract ending the week at 4.635%.

A lot of data bearing on GDP growth the past week combined to reduce our estimate for 1Q to +1.6% from +2.0% after the surprising upward revision to 4Q to +2.5% from +2.2%. Another weak durable goods report continued to point to ongoing weakness in the equipment and software component of capital spending and accounted for the bulk of the downward revision. In addition, the upward revision to Q4 was concentrated in inventories, pulling growth forward from 1Q. Based on this 4Q mix shift, we reduced our estimate of the contribution to inventories in 1Q a couple of tenths (to just +0.1pp). Coming into Friday’s numbers, our 1Q estimate was at a new low of +1.4% and we were sweating on the possibility of a zero handle if the recent string of negative surprises continued. But the personal income and spending report showed slightly stronger-than-expected consumer spending in February and led us to up our estimate for the quarter a bit, and the construction spending report was also a bit better than expected overall. The upside in construction was in private non-residential spending, indicating that a reacceleration in structures investment is providing some offset to the continued weakness in equipment spending.

Durable goods orders jumped 2.5% in February, reversing a small part of the 9.3% January plunge, but all the upside was accounted for by the volatile non-defense aircraft component. Underlying orders remained weak, with the key core gauge, non-defense capital goods ex aircraft, down 1.2% on top of a 7.4% plunge last month. This was the fourth drop in five months for core orders that has cumulated to a 10% decline. Weakness in February was led by machinery (-0.4%) and electrical equipment (-5.5%), with a rebound in high-tech equipment (+6.4%) providing some positive offset. Non-defense capital goods ex aircraft shipments only rebounded 1.2% after a downwardly revised 3.3% drop in January, pointing to another decline in equipment investment in 1Q. We now project a 4% drop in 1Q equipment and software investment after the 5% decline in 4Q.

From our perspective, this continued weakness in capital spending is a more worrisome development than the subprime mortgage meltdown. The subprime debacle is certainly likely to deepen and extend the housing recession to some extent, but housing is already in severe recession and we certainly were not assuming that any near-term improvement would suddenly start providing support to the economy. The capital spending downturn, on the other hand, is removing for now a source of offsetting support for the economy that we had expected to be there. Frankly, we remain puzzled about just why the capital spending numbers remain so soft.

Unfilled orders for non-defense capital goods ex aircraft have been surging for some time, having risen 17% over the past year, but for some reason have not been showing up in actual shipments. Certainly, weakness in selected areas of capital spending most directly impacted by the housing and auto recessions is to be expected, but the fairly broad-based nature of the downturn is puzzling, given the pristine state of corporate balance sheets, near-record profit margins, and what would seem to be significant pent-up demand by a variety of measures, probably most notable being the ongoing decline in the economy’s capital/output ratio.

Despite this, the sharp deceleration in equipment and software investment seen over the final three quarters of 2006 can be seen clearly in such varied areas as telecom equipment, fabricated metals, metal working machinery, light trucks, cars, aircraft, ships and boats, household furniture, construction machinery, mining and oilfield equipment, and household appliances.

The most obvious recession scenario at this point would seem to be that the weakness in capital spending is the start of a broader retrenchment by businesses that will soon spill over into job cuts. Without the support currently being provided by strong job and real income growth, it’s impossible to believe that consumption could be running at anywhere near the robust pace it has been recently in the face of the collapsing housing market, particularly given the recent run-up in gasoline prices.

Fortunately, job market indicators remain quite positive at this point, which we expect to see confirmed in Friday’s employment report, where we look for a solid 175,000 gain in March non-farm payrolls, rebounding from the weather-depressed February report. Jobless claims in the latest week extended the big, steady improvement since the weak run of readings during the harsh February weather, with initial claims hitting a ten-week low in the latest week. And consumers continue to view job market conditions quite favorably. Although the Conference Board’s overall consumer confidence index showed a 4-point drop in March, all of the weakness was in the expectations index. The current conditions index improved to a new cycle high on further improvement in views of the jobs situation. The percentage of respondents describing jobs as ‘plentiful’ rose 2.7 points to 30.5%, more than offsetting a 1.2 point rise in the percentage describing jobs as ‘hard to get’ to 19.1%. This was the most positive net view of the current job market since August 2001.

And apparently buoyed by good job and income growth, based on the February personal income and spending report, consumption to this point remains on a robust track. Real spending gained 0.2% in February, a bit better than we expected, and there were no material revisions to prior months. The upside surprise in February, however, was concentrated in a bigger spike in utility output than we expected, with real spending on gas and electric utility services up 9.5%. We’re assuming that about half of this will be reversed in March, tempering the impact of the upside in overall February real PCE on our quarterly estimate. Still, we upped our 1Q consumption forecast to +3.2% from +3.1%.

Better-than-expected construction spending results also helped offset a bit of the negative growth impacts of the durables and revised GDP reports. Overall construction spending results for February (+0.3%) were better than expected (though downward revisions to prior months were partly offsetting), led by a surge in private non-residential spending (+2.3%) that pointed to a reacceleration in business investment in structures in 1Q that should provide a bit of offset to the continued weakness in the equipment and software component. Overall residential spending fell 1.0%, the best reading since March 2006. The result was boosted by a 2.7% gain in home improvement spending, however. If you believe these figures, home improvement spending has surged 16.5% over the past year, which seems plain wrong to us. These numbers are of little importance, however, since they are not used by the BEA in estimating the improvements component of residential investment in GDP. The key components that do feed into GDP, new single and multi-family homebuilding, fell a combined 2.0%. This was an improvement from the 3.4% plunge in January but was obviously still grim and continued to point to a drop in residential investment in 1Q similar to the 20% plunge in 4Q. Continued weakness in home sales suggests similar weakness should extend at least into mid-year. New home sales fell 3.9% in February on top of a 15.8% plunge in January to reach a near six-year low of 848,000 units annualized. Homes available for sale rose 1.5%, which, combined with the drop in sales, led the months’ supply to rise to 8.1 from 7.3, a high since 1991 and way above the long-term average near 5.5 months. The further upside in inventories points to a bigger correction in starts and more pressure on prices being required to bring the market back into better balance.

With a deteriorating growth outlook for 1Q and a reacceleration in inflation, we seem to be in the middle of at least a mild stagflationary episode. The core PCE price index rose 0.33% in February, the biggest gain since 2001, lifting the year/year rate to +2.4% from +2.2%, matching the cycle high previously seen in August and September. Upside was led by the physicians services price index (which has a 5% weight in core PCE), which spiked 3.0%, by far the biggest monthly increase ever in this category. The combination of a year of sub-par GDP growth little better than 2% and core PCE inflation actually having accelerated a bit over this period to remain stuck at an unacceptably high level must be a source of significant frustration and puzzlement for the Fed. Barring a notably more pronounced downshift in growth than we currently expect — and certainly downside risks, centered, in our view, more on the capital spending outlook than housing, do seem to be rising — this core inflation stickiness reinforces the likelihood of the Fed staying on hold, patiently waiting for a continued period of sub-par growth to eventually bring inflation down to more acceptable levels.

The economic calendar in the coming week is not especially busy but contains a number of key releases, with main focus on Friday’s employment report. Friday will certainly be an odd day, with stock and commodities markets closed for Good Friday, but the bond market open for a very short trading session ending at 10:30. Investors will also be watching Monday’s ISM report and Tuesday’s motor vehicle sales results.

There will be a bit more supply, with Thursday’s announcement of the 10-year TIPS reopening (which will not actually be auctioned until a full week later, making for a strangely early announcement). We expect an unchanged US$8 billion size. The Fed calendar is quite light, but St. Louis Fed President Poole will be speaking Monday. Poole is typically very straightforward in laying out his views on the economy and policy and is always worth listening to. Other less notable data releases due out include pending home sales Tuesday, factory orders and non-manufacturing ISM Wednesday, and wholesale trade Friday:

* We forecast a 51.0 reading for the March ISM. The regional results were mixed, but overall a bit on the softer side, with Empire and Kansas City down, Philly up and Richmond and Dallas virtually unchanged.

This was also reflected in a pullback in the Morgan Stanley Business Conditions Index. So, we look for the ISM to post a decline of a little more than 1 point, but to remain above the 50 breakeven threshold. The price gauge is expected to move up to its highest reading since last August.

* We look for a very slight downtick in motor vehicle sales in March to a 16.5 million unit annual pace from the 16.6-16.7 million unit levels seen in the first two months of the year. While declining deliveries to rental fleets remains a source of restraint, some automakers have recently introduced new rounds of incentive offers. We will update our estimate if the Big 3 offer any last-minute sales guidance.

* We forecast a 2.9% gain in February factory orders. The significant gain in the durables component, which was entirely accounted for by the volatile aircraft component, combined with what we expect to be an even bigger jump in the non-durables component, led by an anticipated sharp rebound in petroleum products after the plunge last month, should lead to the biggest rise in overall factory orders in nearly a year.

* We look for a 175,000 gain in March non-farm payrolls. The recent improvement in the unemployment claims data would appear to confirm that much of the softness seen in the February employment report was related to unusually severe weather in parts of the country. So, we look for at least a modest rebound in categories such as non-residential construction and transportation along with continued advances in sectors such as leisure, healthcare and business services. And while there have been widespread indications of significant layoffs in mortgage-related businesses tied to the subprime debacle, company reports suggest that the cutbacks are not likely to show up in the employment figures right away (because many workers received 60-day notice). Finally, we look for a steady 4.5% unemployment rate, a weather-related rebound in the workweek, and another slightly above-trend advance in average hourly earnings.

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Turkey
Breakeven Odds
April 02, 2007

By Serhan Cevik | London

Inflation will rise, once more, in March, but then converge towards the target. Among all the data releases market participants follow, none creates as much excitement as inflation figures, usually published on the third of every month. The release of the March data is no exception, especially with upside risks stemming from a few specific categories. While the consensus estimate for m/m inflation stands at 1% according to the latest surveys, we are just a bit more optimistic, expecting a 0.9% increase that would bring the annual inflation rate from 10.2% in February to 10.8% in March. Although the rise in inflation so far this year may seem disappointing, it is well within our forecast profile (see Turkey: The Return of Disinflation, November 9, 2006). Even if inflation increases by more than we expect due to volatile subcomponents or administered price adjustments, the underlying trend should remain intact and lead to disinflation in the coming months. Indeed, we are likely to see a turning point in April and a more pronounced deceleration in the remainder of the year. In agreement with the central bank’s thinking, such an outlook — shaped by one-off factors in the short term but fundamentals in the medium term — would support the current policy stance and then a gradual, measured easing later in the year.

The real yield curve points to a marked increase in the risk premium. Like macroeconomic fundamentals confirming the secular nature of disinflation, survey measures of inflation expectations show a steady decline to 5.5% within the next two years, and that should lead to an inverted yield curve. But the current shape of the yield curve is virtually flat, with the spread between short-term rates and 2-year bond yield standing at 83bp. While there has been an improvement from 190bp since our last report on this subject (see Turkey: A Tale of Two Curves, March 16, 2007), bond prices still do not reflect fiscal fundamentals and the coming disinflation. Real yield curves based on domestic bond yields and survey measures of inflation expectations clearly show the distortions caused by global volatility shocks. With an across-the-board rise in real interest rates, the inverted curve turned into an upward-sloping shape and only recently showed a slight inversion. In our view, changes in the shape of the yield curve reflect a rise in the term premium, compared with the behavior prior to the eruption of volatility and monetary tightening.

The new inflation-linked bond shows a breakeven inflation rate of 7% for the next five years. We are used to relying on surveys to assess market expectations about the future path of inflation and interest rates, but recent developments in the Turkish fixed income market offer new instruments (such as inflation-indexed bonds and cross-currency swaps) to narrow the information gap. For example, with a cash flow discount model, we estimate that the Treasury’s CPI-linked 5-year bond yielding 9.9% implies an average breakeven inflation rate of 7% for the next five years. There are not enough data points to allow a comprehensive analysis, but we can use cross-currency swaps to create a synthetic yield curve and approximate the structure of breakeven inflation rates. According to this rough approach, we get a breakeven-inflation curve that ranges from 8.2% for the first 12 months to 7.4% in the following year and an average of 6.5% in the final three years.

Higher currency risk premium is the main source of distortions. Despite our macro optimism, we have always thought that Turkey needs to pay a real interest rate of about 7-8% until inflation moves within the ‘price stability’ range, and an extra 200bp would not be excessive in an election period. So, even though the normalization of economic fundamentals and credit indicators should lead to lower long-term real interest rates, the 1-year real interest rate has moved closer to our assessment. Yet, the breakeven inflation rate for the next five years is still inconsistent with the monetary policy stance and the secular disinflation process. Yes, inflation is high and will not decline much in the near term, but economic fundamentals support faster disinflation over the medium term. The key point keeping the breakeven inflation rate at around 7% is a higher currency risk premium, pricing in an unexpected depreciation of the lira. We think this is just a ‘once bitten, twice shy’ syndrome and should gradually recede, along with political risks.

 

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Japan
Tankan — Non-Manufacturing Impressively Stable
April 02, 2007

By Takehiro Sato | Tokyo

Headline weak, but non-manufacturing industries solid

Although the headline DI was within the market consensus but below our upbeat forecast, the overall impression was sufficient, thanks to solid figures in non-manufacturing industries.  The sense of inventory surplus did not heighten in manufacturing industries, despite concerns over IT-related adjustments, and falling input prices are keeping margins on a soft improvement track.  Labor shortages seem to be escalating, regardless of the industry.  Non-manufacturers underpinned each corporate segment, much as the BoJ’s soft-landing scenario called for, which is positive, but not enough to expedite the timing on the next rate hike, due to current downside in wages and prices, as well as the US economic slowdown. 

Results for major DI values

(1) Business conditions DI: The headline DI for large manufacturing (+23) fell 2ppt, contrary to our forecast.  By sector, the materials industry DI held flat (+24), but the processing/assembly DI fell 2ppt (to +22).  Electrical machinery, precision equipment and autos declines highlighted the latter, hurt by the ongoing slowdown in the US economy, it seems.  Meanwhile, the non-manufacturing DI was solid, holding flat over the previous report (+22).

Meanwhile, for the outlook DIs, large manufacturing dipped 3ppt (+20), while large non-manufacturing climbed 1ppt (+23).  Both materials and processing/assembly industries were down among large manufacturers.  But downward biases in the outlook DIs are a staple of the BoJ Tankan, and not problematic.  Notice the positive instead: that higher outlook DIs in non-manufacturing industries, chiefly in retail and personal services, suggest a pick-up in personal consumption of late.

(2) Supply/demand DIs: Both the domestic and overseas supply/demand conditions DIs for large manufacturers fell, while those for non-manufacturers held steady.  These figures are not a negative surprise though, as such patterns mirror the business conditions DIs.  Meanwhile, the inventory level DI for large manufacturing declined 1ppt to +13.  Despite some worrisome adjustments in IT-related inventories, we doubt an impending risk of inventory adjustment overall as the inventory level DI held stable. 

(3) Prices DIs: The output price DI for large manufacturers (-1) worsened by 1ppt. Input prices DI (+32) also fell 3ppt on weaker energy/materials prices. As a result, the margins DI for large manufacturers (defined as the difference between the output price and input price DIs) improved by 2ppt, to -33. Broken down, the margins DI for the materials industry worsened 4ppt, but the processing industry continued to improve, at +5ppt. Although improvement in the margins DI is positive, a lower input prices DI indicates a slowdown in the global economy, and could be negative. The margin DI for large non-manufacturers was flat QoQ at -15.

(4) Employment and manufacturing production capacity DIs: The employment DI painted an increasing sense of shortage in labor, while the production capacity DI indicated some easing in production resource shortages; the impression is mixed. For all industries/large enterprises overall, the employment DI dropped to -13 by 2ppt and the outlook DI dipped another 1ppt, to -14 (tighter labor conditions spell a lower DI). Meanwhile, the manufacturing production capacity DI edged up 2ppt to -1 (again, tighter conditions spell a lower DI).

Revisions of F3/07 targets and initial plans for F3/08

1) Outlook for sales, recurring profit: For F3/07 large manufacturers now look for sales of +4.6% and recurring profit of +7.1%, after both were revised up. The forex assumption in these forecasts was also raised to around ¥115.01 (previously ¥114.06). The present profit targets still seem conservative, especially in light of robust Oct-Dec earnings.

The initial F3/08 business plan includes sales growth of +1.6% and a recurring profit decline of 0.6%. Generally, companies expect lower profits in 1H followed by a rebound in 2H, implying a virtually flat YoY earnings trend overall. However, we expect some upside to this plan, given that the profit margin is likely to improve incrementally due to lower input prices, and also because wages are likely to remain stable despite the tighter labor market.

While labor’s share of income has stayed steadily low over the past two years, capital’s share of income has continued to rise. In other words, since the benefits of economic growth have gone disproportionately to companies, the growth in workers’ incomes has been lackluster while corporate earnings have been strong. This trend is not likely to change easily as long as inflation expectations are low, and we think there is still decent potential for corporate earnings to be consistently better than the bottom-up aggregate of cautious forecasts. Risk factors include a squeeze on recurring profit from depreciation, as a result of growth in capital investment (cash flow would not be affected, of course).

2) Planned capital investment (F3/07 results and F3/08 initial plan): The outlook for large manufacturers (+15.6%), large non-manufacturers (+9.7%), and overall (+11.9%) was revised down marginally. This is in-line with the typical revision pattern, and was expected. The planned increase for companies of all sizes and in all industries (including software but excluding land purchasing expenses; a basis that is close to nominal GDP basis) was revised down to +8.7%, assuming a flat capex deflator, and matching our outlook for real investment (+8.7% YoY). The YoY change in planned land acquisitions continued to be robust for non-manufacturers at +16.0% YoY. The figure for all enterprises in all industries was +11.5%.

Meanwhile, capex plans for F3/08 were +2.5% for large manufacturers, +3.1% for large non-manufacturers, and +2.9% overall, starting off ahead of our forecasts, thanks mainly to robust figures at non-manufacturers. The current economic expansion has been characterized by an overall capital investment cycle that becomes longer as each driving-force sector is replaced by another as it loses steam. The momentum in capital spending by manufacturers is likely to weaken as the global economy slows, but capital spending demand among non-manufacturers, which generally has little to do with the economic cycle, is likely to increase. For instance, the electric power utilities probably have strong replacement demand, a large amount of railway cars are coming up for replacement, and the communications and financial services sectors look likely to be sources of new demand. Such demand among non-manufacturers for new and replacement capital equipment should bolster capital investment overall in 2007. We expect major upward revisions for both manufacturers and non-manufacturers in the next June Tankan.

Policy/market implications

This Tankan suggests solid corporate sentiment, primarily in non-manufacturing industries, despite the US economic slowdown that seems to have hurt the DIs in manufacturing industries.  The report also indicates a widening Tankan DI-based output gap ahead.  But in the month or so since the February rate hike, consumer prices have fallen into negative territory, and wages have lagged even more, even under a tight labor market.  Current inflation rates carry less weight today with monetary policy shifting to a forward-looking scheme based on the ‘two-pillar’ concept in unison with the end of quantitative easing.  However, this Tankan report does not seem to us able to expedite the pace of rate hikes ahead. 

The BoJ will probably also be wary of losing credibility if the Japanese economy contracts, in light of currently weak economic indicators in the US.  The bank secretariat is also well aware that sitting on a rate hike brings much less political costs than hurrying one through, since consumer prices have entered negative turf and real-time land prices are also rising at a slower pace. 

But the market should clamor again for a rate hike towards May-June once solid Jan-Mar quarter GDP figures come out and the Upper House elections draw nearer. Such a period would provide investors buying opportunities in the bond and foreign exchange markets.  Conversely, the stock market will likely feel uneasy during the Apr-Jun quarter due to such an anomaly. 

 

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India
Supply Response: New Hurdles Are Emerging
April 02, 2007

By Chetan Ahya | Mumbai

Policymakers remain worried about overheating as a number of macro indicators such as inflation, the current account deficit, the banking sector and property prices are flashing red. Strong growth in demand at a time when the effective supply creation response (growth in productive capacity) is weak explains this overheating. Over the last three years, while global risk appetite-driven liquidity supported strong demand growth, the government policy response to accelerate India’s production capacity has been slow. Just when it appeared that the supply response was finally picking up, fresh hurdles have emerged regarding the development of special economic zones (SEZ), large industrial projects, organized retail chains and infrastructure. We believe that progress in these areas is critical for encouraging private corporate sector investment and sustaining 9% GDP growth.

Push-back in critical investment

Issues challenging the pace of development are widespread and complex. One of the most contentious issues emerging is the acquisition of agricultural land for the purposes of industrialization. Other common issues delaying investment are questions raised by local groups on inadequate rehabilitation of population displaced due to SEZ and industrial development, and general lack of readiness in the system to accept change. Moreover, these issues are not just restricted to one or two states. Some of the key states that have faced hurdles are Orissa, West Bengal, Maharashtraand Karnataka. The ruling parties in each of these states are also different. 

Special Economic Zones — land locked?

Progress on the development of the SEZ is symptomatic of the typical overall macro supply-side response challenge that India is facing. The policy effort for SEZ development has been very slow until recently, and just when it appeared that the pace was picking up, fresh hurdles have emerged, challenging progress in this area. The trail of events explaining the slow development of SEZ is as follows:

First, the government took a long time to promulgate a policy that could generate the investor response. After some iterations, the government re-enacted the SEZ Act in February 2006 (the law was first issued in 2000), raising hopes for quicker development of high-quality infrastructure in pockets, providing a liberal and supportive business environment, and thus kick-starting the much-needed push for manufacturing exports. The new legislation provided a uniform SEZ policy, comprehensively covered all aspects of establishment, operation and fiscal oversight, and provided a larger tax incentive package.

Second, the new Act faced opposition from within the government as it was relatively liberal in laying down the minimum size restrictions. Lower limits on size in addition to attractive tax incentives resulted in over 400 applicants displaying interest to develop SEZ in a variety of industries, though many of them were very small (the average size of these SEZ is only 4.3 sq. km). This overwhelming response meant that the cumulative tax loss from these investments was likely to be very high, forcing the Ministry of Finance to convey its concerns on the liberal tax incentive package and the minimum size restrictions. The Ministry of Finance is of the view that the ideal approach would be to just initiate 5-6 large SEZ in different regions of the country — an approach we agree with (see India Economics: SEZ Rush: 267 and Counting..., September 22, 2006).

Third, acquisition of agricultural land for SEZ development by various state governments and SEZ investors has caused social and political upheaval, threatening to put the entire program into disarray. The public opposition faced by state governments and companies in acquiring farm land in Nandigaram, West Bengal (for a 40 sq. km chemical SEZ being set up by the Salim Group, Indonesia) and Jagatsinghpur District, Orissa (for a 16 sq. km steel SEZ being set up by POSCO) have forced the central government to halt the entire process of approving SEZ, and state governments have stopped acquiring any further agricultural land. Following these developments, acquisition of land by the Maharashtra State Government for even the largest SEZ — Reliance Industries’ SEZ project in Maharashtra (100 sq. km) — has also been frozen after a senior fact-finding committee warned the Chief Minister that the project could lead to a situation similar to that seen in West Bengal.

The government has stopped giving approval to new SEZ, and the ones that had received preliminary approval but had not acquired land are likely to face setbacks until the government releases the new land acquisition regulations and the rehabilitation policy.

The focus of politicians on this issue is justified, given that 60% of the workforce is employed in the agriculture sector (a large of chunk of which is self-employed). Additionally, 86% of the land is either cultivable or is under forest area. Hence, this issue cannot be circumvented by simply opting to acquire non-agricultural land for industrial activities. Indeed, smaller SEZ may be able circumvent the problem, but larger SEZ, as we have seen in recent cases, will have to face this issue. The development of larger SEZ presents a bigger challenge of rehabilitation in India’s case as it has a very high population density. For instance, population density in India is 2.5 times that in China.

We believe that the real solution for India’s manufacturing would have been large SEZ, which create scale benefits, provide world class infrastructure within the SEZ, and ensure high-quality connectivity to resources and markets via rail, roads and ports. Large SEZ will be critical for creating a globally competitive SME manufacturing sector. However, it is becoming clear that to promote large SEZ in the current political environment will be challenging. In effect, India will be forced to accept a less-than-optimal solution of small- and medium-sized SEZ — we see no major rationale for providing such a high level of tax incentives for these SEZ though.

 

Overstretched infrastructure

The policy response in the area of infrastructure has also remained slow. We have always argued that the single most important macro constraint on the Indian economy is the low spending on infrastructure. Rapid growth in demand for infrastructure over the past four years and a less-than-proportionate rise in infrastructure spend has meant that capacity utilization in electricity, roads, seaports and major airports is at maximum limits.

During the tenth five-year plan (F2003-2007), the government had targeted 41,000 MW of capacity addition. However, the actual addition has only been 18,400 MW. The lagged supply response has meant that the peak electricity deficit has increased to an eight-year high of 13.9% in April-January 2007, forcing supply outages in various industries. In the roads segment, completion of highway development has been muted during the past two years.

Seaports have seen capacity utilization levels increase to 93% in F2006 from 84% in F2002 despite a 168 million ton increase in capacity over this period. In the airport segment, capacity constraints at the Mumbai and Delhi airports (two key airports accounting for 41% of total domestic air passenger traffic) have forced the government to freeze the number of flights that can be operated during peak hours by domestic airlines from these two airports over the coming seven months at current levels.

A complex set of factors is causing this delayed response in infrastructure development. Key hurdles include weak regulatory framework (particularly in the case of electricity), land acquisition problems, stretched capacity of domestic construction companies and lack of availability of equipment in certain areas.

Organized retail — roadblocks ahead

The emergence of the organized retail sector is likely to benefit two critical and lagging segments of the Indian economy: agriculture and small and medium-sized manufacturing. The rising scale of organized retail distribution network and increasing competition will force players to focus on reforming the whole supply chain (see India Economics: The Retail Revolution, December 7, 2006). While the government was delaying the decision to allow FDI in multi-product retail chains, various domestic entrepreneurs announced their intention to invest more than US$10 billion over the next five years to capture a share of the organized retail sector.

Even these plans by domestic entrepreneurs are facing opposition. In the leftist CPI-M led alliance ruled state of Kerala, the state government launched a unique attack on organized retail players. The state government has decided to launch 5,700 retail shops to sell products at sub-market rates aided by government subsidy. In addition, it has offered an annual subsidy for three years to farmers who will enter into a sale agreement to supply farm-fresh produce. In the state of Tamil Nadu, a group of traders have staged opposition against the entry of organized retailers, and senior political leaders have given Reliance Fresh (which has opened 12 outlets in the state) one month to wind up operations.

Following these developments, the central government has asked the Indian Council for International Economic Research (ICRIER) to conduct a comprehensive impact assessment of the participation of large foreign and domestic companies on smaller ‘mom and pop’ shops in the retail sector. Additionally, the Leftist parties are in the process of preparing a draft bill that proposes to regulate the activities of large domestic players in the retail sector and will present it to the central government for consideration.

Accelerated supply response necessary for aggregate welfare

We believe that there is a need for policymakers to manage these hurdles in a way that they do not slow the growth in productive capacity of the system. India will be adding about 61 million people to its working age population of 719 million over the next four years. Low levels of labor productivity in agriculture and large existing unemployment in the rural economy imply that the government has to create opportunities in manufacturing, construction and urban services market. Large-scale SEZ, major infrastructure development and organized retail are critical spokes of the job creation wheel for this growing working age population.

For sure, these developments will cause some displacement among the existing population. The government needs to play an active role in building capacity within its machinery to execute effective policies targeted towards rehabilitation of the minority. This will be critical for ensuring that efforts to protect a small section of the poor population do not result in a loss of opportunity to a much larger section of poor, unemployed population. When the government was faced with a similar dilemma in the case of privatization of public sector units, coalition politics forced it to address the needs of the minority sector and ignore aggregate welfare by opting to abandon privatization of profitable public sector units completely. The government had to protect the interests of the workforce employed in public sector undertakings of the central government (amounting to only 6 million people, just 1.6% of the total workforce), even though it could have used the proceeds from privatization for rural infrastructure development.

Even in the case of retail, the issue of employment should not only be assessed from the perspective of the welfare of the lower middle-income group (LMIG) population dependent on mom and pop shops, but also from the viewpoint of the welfare of the overall LMIG population. Although a specific section of LMIG already employed in mom and pop shops may be adversely affected, the emergence of the organized retail sector will create new jobs for a different section of lower middle class in low-end modern retailing distribution, small-scale manufacturing, packaging, construction, infrastructure and transport sectors. Moreover, we believe that the lower middle-class also stands to gain from the higher productivity benefit (in the form of lower inflation) that the organized retail sector offers. The quality of employment will also see a vast improvement as larger institutions will be able to provide better social security, training and growth opportunities. Indeed, increased organized sector activity should result in higher aggregate tax to GDP that would allow the government to initiate measures for direct intervention to reduce the adverse impact on any specific section of the population.

Innovative and swift solutions needed

Both central/state governments and private players need to come up with innovative solutions. For instance, in the case of SEZ, the problem of acquiring agricultural land could be addressed by offering equity participation to farmers. In the recent past, the state government has acquired land from farmers at throwaway prices and then transferred it to private real estate developers who, in turn, would make huge returns by developing the land into SEZ.

We believe that this could have been implemented in a more equitable and transparent manner. For example, the central government can suggest a model structure for acquiring farm land. We believe that the central government should provide tax concessions to only 5-6 large SEZ (above 50 sq. km. in size). The central government needs to entrust the task of promoting and developing these SEZ in the hands of a new entity (say SEZ Authority of India), modeled along the lines of National Highway Authority of India (NHAI). Indeed, to kick-start the operations of SEZ Authority of India (SAI), the government could transfer a few of the successful managers from NHAI.

The SAI could take the lead in conceptualizing 5-6 large SEZ companies in terms of the location, its infrastructure linkages and the type of business activities, which would be promoted through those SEZ. SAI could be initially funded by the central government. Each of these SEZ could be floated under the public private partnership (PPP) framework. The SAI and state government could play an active role in acquiring land from farmers through a transparent price determination mechanism and transfer it to the PPP SEZ company. The SAI could own 20%, the state government could own 10%, a 20% stake could be distributed to farmers in the form of equity shares, and the balance could be given to a private sector player through a transparent bidding system. The SAI could later divest its stake in the stock market to ensure that farmers have an exit route as well. The SAI could use the funds collected through divestment to fund the next SEZ.

The success of these solutions will hinge on the ability and willingness of the government’s administrative machinery to implement these changes. All levels of the machinery starting from the top policymakers in central and state governments to the village and district level officials will have to ensure that these solutions are implemented swiftly. In our view, the government is best positioned to protect the interests and needs of the minority. The easy argument against the above-mentioned model would be that the government will not be able to execute it. However, we believe that to ensure a politically and economically viable solution, there is little choice for the government but to build the capability to execute it.

Bottom line: Inevitable slowdown in near-term growth

It appears that the hurdles facing SEZ, infrastructure development and organized retail are indicative of the limitations of generating a swift supply response in India. These issues highlight the need to slow domestic demand in the near term to reduce the macro overheating. In our view, there is little choice for the central bank but to effectively tighten the monetary policy to slow demand growth. While the supply response will eventually raise the potential growth rate, in the near term growth will inevitably slow to below 8%, in our view.

 

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