Is Inflation Monetary?
April 03, 2007
By Gray Newman | New York
It’s an election year in Argentina, and the current administration has an impressive track record to back up what opinion polls suggest is a towering double-digit lead over the opposition. Since taking office in May 2003, the administration can point to significant success — whether it’s one of the fastest rates of economic growth in the world, a largely successful debt restructuring, creation of over two million jobs, or progress against poverty that has restored dignified living conditions to more than eight million people. But is Argentina’s high inflation problem this administration’s Achilles’ heel? Even after two years of high inflation, monetary policy remains accommodative, and the overall mix of economic policy measures is contributing to the current inflation mess.
The current bout of high inflation appeared towards the end of 2004 and the beginning of 2005, depending on what one considers the threshold for ‘high inflation’. The devaluation and crisis in 2002, which resulted in inflation near 40% that year, gave way to a period of low inflation in the second half of 2003 and most of 2004. In year-on-year terms, inflation was 3.7% in December 2003, and it had moved up to 6.1% by December 2004. By February 2005, inflation had risen past the 7% mark, and it was in double digits by September. At the end of 2005, the authorities finally acknowledged that inflation was becoming a problem, posing risks to the viability of the current administration and the Argentine economy as a whole.No Consensus on Causes
While almost everyone recognizes that high inflation is a problem, and that includes the current administration, there is little agreement on its underlying causes. Three arguments stand out. First, some private economists have argued that the current inflation problem is the result of insufficient investment. According to many private economists, and confirmed by our estimates, the output gap closed some time around September 2004. The output gap measures the difference between long-term sustainable output and actual output. However, determining the long-term sustainable rate of growth is difficult. Moreover, the classic relationship of cyclical fluctuations translating into inflation has become weaker around the globe as world trade and financial markets have opened up. It’s unclear whether insufficient investment and the closing of the output gap is indeed the major cause of current high inflation. What is clear is that more work needs to be done to understand the investment dynamics and their impact on inflation in Argentina. Second, the official line appears to be that the current bout of high inflation is largely caused by delayed pass-through from the devaluation in 2002. The authorities argue that the dire economic crisis of 2002 produced significant spare industrial capacity and a large pool of cheap labor. Furthermore, they argue that these factors contributed to the rebound in economic activity without significant pressure on margins, as businesses simply ramped up production at minimal cost. This, in turn, delayed the full inflationary effects of the devaluation by three years. We see a number of problems with this line of reasoning. It is difficult to square the data for investment and capacity utilization in Argentina with the timing of the inflation problem. Capacity utilization has hovered around 70% from October 2003 to the present, while the inflation problem surfaced more than a year later. It may be that the effects of tight capacity translate into higher prices with a significant lag, but the twin facts that inflation kept falling after capacity utilization stabilized and that the lag period necessary was so long make the argument less credible. Additionally, investment spending has been strong in Argentina throughout the high inflation period — investment, in real terms, was nearly 18% of GDP in 2004, close to 20% in 2005 and almost 22% of GDP in 2006. Moreover, to further complicate the difficulty in making a connection between capacity utilization and inflation, the slack on the labor front has been ample throughout the high inflation period. Argentina posted double-digit unemployment rates until the fourth quarter of 2006, suggesting abundant supply of relatively cheap labor that should have minimized production costs. Finally, the severe dislocation produced by the 300% devaluation and the economic crisis resulted in inflation around the 40% mark in 2002. The implied pass-through of 13% compares reasonably well with estimates for other economies in the region. For example, most analysts agree that the exchange rate pass-through in Brazil is around 10%. Thus, it is not clear whether there was significant inflation pressure from the devaluation that was not already passed through in 2002. Finally, the third argument for the causes of inflation centers on the government’s economic policy mix. According to this line of reasoning, the combination of accommodative monetary policy and looser fiscal policy is driving inflation. Looser fiscal policy creates artificially high demand by pumping fiscal resources into the economy. At the same time, the weak currency policy of the current administration translates into inflationary money creation. The dynamics for monetary inflation are as follows. To prevent the appreciation of the currency and keep the peso weak, the central bank builds up its stock of international reserves as it buys up dollars entering the country. To buy the dollars the central bank, which controls the monetary base, must print money, increasing the money supply. Increasing the money supply beyond what is demanded by the economy is inherently inflationary. To counter the inflationary effects of excess money creation, the central bank must sterilize the dollar purchases by selling local-currency bonds to soak up liquidity. A way to neatly capture the dynamics of sterilization and reserves buildup is to look at net domestic credit — the difference between the monetary base and international reserves. The central bank of Argentina has in fact been sterilizing its intervention, but has the amount of sterilization been sufficient? Both the low level of net domestic credit and a negative real interest rate on deposits since the end of 2002 suggest insufficient sterilization efforts by the central bank. A Monetary Phenomenon
While it is difficult to make a definitive call on the underlying causes of the current high inflation problem, we suspect that accommodative monetary policy is a contributing factor. We are not arguing that the current weak peso policy is the cause of the high inflation, but all indications are that reserve accumulation and insufficient sterilization that result in excessive monetary base growth are a contributing factor behind the current inflation mess. Since the middle of 2005, monetary base growth has exceeded the pace of real GDP growth and the pace of inflation. Money growth in excess of the pace of real GDP is inflationary according to the quantity theory of money. Except for the transition period around the deep crisis of 2002–03, this theory has applied quite well in Argentina. Thus, I find it difficult to argue that the current money creation binge has not contributed to inflationary pressure. Beyond signaling the upward direction of inflationary pressure, the current pace of money growth is a good indicator of the magnitude of inflationary pressure resulting from the partial sterilization policy. The calculation of money base growth is not straightforward because of regulatory changes imposed by the central bank. In August of 2006, the central bank raised reserve requirements on demand and savings deposits to 19% from 17%, and also decreed that only two-thirds of the cash in vaults would count for reserve requirement calculations, implicitly raising reserve requirements a further 50%. Since the demand for money in the economy is measured by the M2 aggregate, and if we assume that the demand for M2 remained largely unchanged, then the regulatory change allowed the central bank to step up money creation and expand the monetary base, which the central bank controls directly, by nearly Ar$6 billion, without raising inflationary pressure. That is because raising reserve requirements decreases the money multiplier effect and, if M2 is kept constant, is equivalent to an increase in demand for the monetary base. The logic for this regulatory change is that it amounts to the purchase of nearly US$2 billion without a sterilization cost for the central bank in that period. However, according to our estimates, even after adjusting for the regulatory changes, monetary base growth was near 20% at the end of 2006, exceeding real output growth of 8.5% by 10–12%. Thus, it is not entirely surprising that inflation has been in the neighborhood of 10–12% as well. Bottom line
Accommodative monetary policy poses grave and unnecessary risks in a high inflation environment. Last year marked the passing of Milton Friedman, a great economist. One of his most famous insights concerns inflation — “inflation is everywhere and always a monetary phenomenon.” We think the current administration in Argentina, and those in charge of the country’s economic management, would do well to heed those words, for inflation could unravel the many impressive achievements that the administration can point to in recent years. An accommodative monetary policy is not helpful in a high inflation environment. The authorities have adopted a set of highly charged political measures, such as semi-voluntary price agreements that look more like price controls, in an effort to control inflation. However, if the fundamentally inflationary money creation is not curbed through increased sterilization or a strengthening of the exchange rate, political leverage is unlikely to prove an effective policy tool.
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Opening Up for Growth
April 03, 2007
By Sharon Lam | Hong Kong
Korea-US FTA Coming at the Right Time – A Catalyst that Korea Needs: The Korean economy has been suffering from a lack of catalysts for a while. The positive trade impact from the Korea-US FTA may take time to realize, but should serve as an immediate confidence booster. Coupled with the recent strong performance in capex and domestic demand, this leads us to believe that the Korean economy is on the road to recovery. Upside of FTA – Increased Exports and Service Sector Development: As Korean and US trading patterns complement each other, we believe the tariff reduction will help to motivate further trade creation. At the same time, it gives Korea advantages over major competitors such as China, Japan and Taiwan that do not have free trade agreements with the US. We perform a competitive advantage analysis to pick the industries that will benefit from the FTA. Our analysis suggests that the main beneficiaries over the medium term will be food & beverage manufacturing, automobiles, telecom equipment, textiles, rubber and plastics and some electrical machinery. The FTA should also help to speed up the opening of Korea’s service sector, lifting Korea’s growth potential. Downside of FTA Likely Limited: In our view, primary agriculture will suffer the most from cheaper agricultural imports from the US, if the FTA eliminates import tariffs on agricultural products in Korea. Pharmaceuticals and cosmetics may also see increased competition. Nevertheless, these are not pillar industries in Korea and therefore the negative impact on the overall economy should be minimal, in our view. The trade surplus with the US may be reduced, but, if Korea imports more from the US than Japan, it could help Korea alleviate its huge trade deficit with Japan. We think the upside from the FTA outweighs the downside. The long negotiations over the Free Trade Agreement between Korea and the US (KORUS FTA) appear to have resulted in broad agreement. At the time of writing, the details of the deal have yet to be finalized, but the representatives of the two countries are optimistic that the deal will be signed very soon. In this report, we attempt to analyze historical trading patterns between Korea and the US and competitive advantages in different sectors. We are confident that the overall economic impact from the Korea-US FTA will be positive. Indeed, since Adam Smith, we have known that open economies deliver more wealth than closed economies. Korea itself has borne witness to the truth of this proposition in the last few decades. We conclude that the sectors that are most likely to benefit include food & beverage manufacturing, automobiles, telecom equipment, textiles, rubber and plastics and some electrical machinery. The sectors that will face challenges, with increasing competition from the US, will be primary agriculture, pharmaceutical products and cosmetics. The Korean economy has been suffering from a lack of catalysts for a while, causing net capital outflows and creating weak sentiment. However, we believe Korea’s fundamentals are very solid with room for growth, and the only element missing is business and consumer confidence. While the FTA’s positive impact on trade and service sector expansion may take time to be realized, the injection of optimism should have an immediate positive effect on confidence. Coupled with the recent strong performance in capex and domestic consumption, reviving sentiment should push up growth this year, in our view. We believe an economic recovery is likely to occur soon, or may already be happening. A Glance at the Korea-US Economic Relationship Korea’s economic ties with the US have declined in the last decade, with China taking over as Korea’s biggest trade partner. The US has been important for Korea historically, not just on the military front, but as the largest foreign investor in the country, committing US$36 billion of FDI (30% of the total) in the last 30 years, double second-placed Japan’s US$18 billion. Based on the latest data, the US accounts for 14% of Korea’s total exports (i.e. 5% of GDP). The trade surplus that Korea enjoyed vs. the US in 2006 totaled US$9.5 billion. China has played a significant role in Korea’s growth since 2002 through trade and the provision of a low cost production base for Korean companies. However, over-reliance on China and the notorious hollowing out of manufacturing are less than ideal for Korea. A revitalized economic relationship with the US, be it meaningful or symbolic, should at least help inject new ideas and hopes into the economy – which is what is needed to boost currently sluggish sentiment, in my view. Benefits of FTA The benefits of FTA are usually two-fold: trade and FDI. The reduction/elimination of tariffs should clearly increase trade flows between the two countries. Increase in Exports The spur to trade should result from substitution of traded goods for higher-priced domestically produced goods. Trade occurs between two countries when their trading patterns are complementary rather than competitive. In our view, Korean and US trade patterns appear to be complementary. The US is Korea’s third-largest export market, accounting for 13% (US$43.2 billion) of Korea’s total exports – trailing the EU’s 14% and China + Hong Kong’s 29%. Automobiles are Korea’s biggest export items to the US (26% of Korea’s total exports to the US), followed by telecom equipment (14%). The US also remains a steady and top market for Korean-made industrial machinery (10%) and metals (7%). The share of Korean electrical working tool and semiconductor exports sent to the US is still significant (13%), but has been declining quite substantially over the years as these items are now shipped mostly to China due to relocation of downstream tech production to China. The US is Korea’s third-largest import destination, accounting for 11% (US$33.7 billion) of total imports, behind China + Hong Kong’s 16% and Japan’s 17%. Industrial machinery takes up a large share of Korea’s imports from the US (23%). Korea depends on the US for food imports (7% of Korea’s total imports from the US) and also semiconductors (16%) other than DRAM and NAND, which Korea specializes in producing. Korea also relies on US for precision equipment (7%), including measuring equipment and equipment for medical use. Since the two countries’ trading patterns are not competitive in nature, the reduction/elimination in tariffs should only help to create and motivate further trade between them. Now, we turn to another analysis to pick out sectors that should benefit from the FTA. In our competitive advantage analysis, we define Korea as having a competitive advantage in a given product in the US market when its share of US imports of that product is bigger than its share of total US imports (i.e. when that ratio is larger than one). We find that Korea has a competitive advantage in exports of textiles, ships, automobiles, semiconductors, telecom equipment, rubber and plastics to the US. We think these sectors will continue to see growth as free trade should make them even more competitive in the US market. Most importantly, Korea’s major trade competitors in the US market – namely Japan, China and Taiwan – do not have FTAs with the US. Korea competes with these countries mainly in automobiles, telecom equipment, semiconductors, electrical working tools and computer parts. The Korea-US FTA will provide advantages to Korea over its competitors by lowering the cost of exporting Korean-made products into the US market. We think this will help offset worries over KRW appreciation hurting competitiveness, as it should reduce the need to increase export prices to avoid losses through currency conversion. By combining the above analyses, we conclude that the sectors that should see an increase in exports from the Korea-US FTA are those that account for a significant share of Korea’s exports to the US, have a competitive advantage in trading with the US and compete directly with exports from countries that do not have FTAs with the US. Hence we see the major beneficiaries as automobiles, telecom equipment, electrical working tools, textiles, rubber and plastics. Increase in FDI and Opening Up of Service Sector Korea has not yet been classified as a mature economy, mainly because of the slow development of its service sector. The country took more than 20 years to achieve a 10% increase in the service sector’s share in national income. Korea’s service industries are not fully opened up and the subsequent lack of competition is the main factor hindering improvements in people’s living standards. In theory, FTAs can attract more foreign direct investment (FDI) into an economy’s manufacturing sector as other countries look to take advantage of easier and cheaper access to the FTA partners of that economy. Yet, this is unlikely to be the case for Korea. First, US import tariffs are not high to begin with. Second, the cost of production in Korea is expensive compared with other countries in the region due to Korea’s rigid labor market. Therefore, the cost for other countries’ manufacturers to relocate to Korea is probably higher than the savings from not having to pay US tariffs. Hence we do not expect the FTA to drive a marked increase in FDI in Korea’s manufacturing sector. However, we do see potential for FDI growth in the service sector, as part of the Korea-US FTA includes requests for Korea to open up its service sector by removing foreign ownership limits in certain industries. Speeding up service industry development is crucial for Korea’s growth prospects, in our view. Korea has experienced a rapid recovery since the financial crisis but this recovery has come from manufacturing and exports. Certainly, Korea is good at high-value-added production, but this can only take the economy so far. Korea has accumulated substantial wealth from manufacturing, and it should therefore represent a promising consumer market. However, the regulated nature of the service sector has hindered growth in this area. With the FTA potentially opening up the service sector, we expect to see an increase in FDI into this segment of the economy. If this happens, we think Korea’s medium-term growth potential could increase from 4.5% currently to 5.5%. Downside of FTA Likely Limited The most oft-cited concerns over the FTA are: 1) it will bring in more imports and damage local producers; 2) it will reduce Korea’s trade surplus; and 3) it will reduce government revenue. In our view, these concerns are only partially justified, and the downside from the FTA is likely limited. The biggest concern over the FTA is if it will increase imports, thereby damaging local industries. We believe this kind of downside risk to Korea should be small because, based on our analysis, the trading patterns between Korea and US are complementary in nature, meaning the countries trade mainly for products that they cannot produce efficiently themselves. Moreover, consumers should gain from cheaper products in general. The Korean economy’s social welfare should increase rather than shrink after the FTA, in our view. After all, this is the spirit of trade. 1. Which sectors will suffer from more US imports? The sector that is likely to suffer most from the Korea-US FTA is primary agriculture, as it will compete head on with cheaper US imports. While the potential loss of income is likely to hurt Korean farmers, we believe the impact on the overall economy should actually be positive. The agriculture sector is a shrinking industry in Korea, accounting for only 3% of GDP, and is rather insignificant next to the potential for increased manufacturing in exports and development of the service sector. Meanwhile, cheaper agricultural imports will be good news for consumers in Korea and should also help to lower inflation. Most importantly, Korea’s key competitive advantage is not in primary agriculture, but in food and beverage manufacturing, which will now benefit from cheaper imports. Among the producer manufacturing sectors – i.e. raw materials, components, machinery and equipment – Korea and the US do not appear to be competing against each other. In the consumer manufacturing sector, however, there will be increased competition after the FTA and the impact will be determined by a combination of cost and brand preference. The US is a top import source of pharmaceutical products and cosmetics for Korea, and the US appears to have both cost and brand advantages in these sectors. As a result, we think Korean companies operating in these sectors could be challenged by the FTA. The US also seems to have a competitive advantage over Korea in apparel and footwear, but these products are now mainly outsourced to China hence their pricing should see little impact from the Korea-US FTA. The automobile sector is an area that has raised many concerns – i.e. if the FTA brings in more US cars, this could hurt this pillar industry in Korea. In our view, such concerns are overdone. We believe that automobile consumption in Korea is driven more by brand preference, which is unlikely to be affected by the existence – or not – of free trade. Koreans have tended to show a very strong preference to drive domestic cars. Meanwhile, imported cars are perceived as luxury items whose consumption is not determined by price. German cars accounted for almost 60% of Korea’s total car imports last year, followed by 22% from Japan and 5% from the US. Japanese consumer brands tend not to be too visible in the Korean market, possibly for historical and political reasons. The fact that Korea imports more Japanese cars than US cars underlines the lack of demand for US cars in Korea and, in our view, implies that the domestic producers should not suffer unduly as a result of the FTA. Rather, as aforementioned, we believe Korean automobile producers will benefit from the FTA as it will make Korean cars cheaper in the US market, helping offset recent pricing pressure from currency appreciation. 2. Will Korea’s trade balance be reduced? Some argue that, since Korean’s import tariffs are much higher than those of the US, the Korea-US FTA will benefit the US more in terms of its exports to Korea. However, this can be seen from another angle, too – the larger tariff reduction and thus cheaper goods will benefit Korea’s producers, as they will be able to import cheaper components for the production of food and beverage and consumer electronics goods (including mobile phones). Moreover, the FTA may result in trade diversion – i.e. Korea may import more from the US at the expense of other countries, such as Japan, particularly in areas such as electronics and machinery (currently supplied by both the US and Japan. Whether trade diversion will occur depends on relative prices from different import sources. If Korea substitutes some of its imports from Japan to the US, this could help reduce its large trade deficit with Japan. We believe the impact on Korea’s trade balance will be minimal. 3. Will government finance be affected due to loss of import tax revenue? Korea’s import tax revenue totaled W6.3 trillion in 2006. Since the US accounts for about 11% of Korea’s total imports, we assume the loss of tariff revenue will be around W0.7 trillion, which is equivalent to only 0.3% of the Korean government’s total revenue – an amount too insignificant to result in any fiscal issues. Furthermore, the potential economic benefits from the FTA – including export growth, service sector development and consequent job creation – should only help to boost growth and government revenue over the long term. It would require numerous assumptions to come up with quantitative estimates of how the Korea-US FTA will impact Korea’s GDP growth, and even then the impact is unlikely to be seen imminently. Nevertheless, we feel that the overall upside from the FTA clearly outweighs the downside. The immediate positive impact should be a boost to confidence in Korea. Coupled with the recent strong performance in capex and domestic consumption, reviving sentiment should push up growth this year, in our view. We believe an economic recovery is likely to occur soon, or may already be happening.
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LNY Effect Leads to Slowdown in Exports
April 03, 2007
By Chetan Ahya | Mumbai
February trade momentum remained lackluster: Export growth contracted to -2.8% YoY in February following an increase of 11.3% YoY (revised upwards from 8.9% YoY) in January. This was below our and market expectations. Import growth also declined to
-4.0% YoY (vs. +17.7% YoY in January). On a sequential basis, both exports and imports contracted to -14.4% MoM and -17.1% MoM (vs. -8.5% MoM and -1.3% MoM in January). The trade surplus stood at US$2.2 billion in February, slightly lower than the previous month. In our view, the timing of the Lunar New Year and the general slowdown in export growth seen in other Asian economies contributed to this slowdown. Key trends in export segments: Exports of electrical & electronic products contracted to -5.5% YoY in February, having rebounded to 8.8% YoY in January, leading to a 2.6ppt contraction in the headline number. Export growth in crude petroleum and refined petroleum products remained weak at -12.7% YoY and -35.4% YoY (vs. -27.9% YoY and -34% YoY in January). In terms of market destinations, exports to EU, US and Japan stood at 8.8% YoY, 2.5% YoY and -5.1% YoY in February. Import growth decelerated across all categories: By end-use classification, capital and intermediate goods imports decelerated sharply to 3.5% YoY and 7.7% YoY in February, having accelerated to +23% YoY and +18.1% YoY in January. Consumer goods imports also eased to 15.2% YoY (vs. +17.7% YoY in January).
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