United States
Corporate Profits: Downside Risks
April 05, 2007

By Richard Berner | New York

It’s hardly news that corporate profits have begun to decelerate.  Following 18 quarters of double-digit gains, S&P 500 operating earnings rose at an 8.9% annual rate in the fourth quarter compared with the last quarter of 2005.  And with the earnings-reporting season upon us, analysts have completed the quarterly ritual of marking down near-term earnings forecasts.  The outcome: The bottom-up consensus forecast for Q1 S&P operating earnings has been slashed to just 3.8% — a bar probably set low enough so that results will almost surely beat those reduced expectations. 

Investors thus fully recognize that the slowing economy has produced a striking deceleration in corporate results, and that’s in the price.  But I think there’s far more to the story than just slower economic growth.  Even if top-line growth begins to improve later this year, I still think that the risks for earnings lie to the downside.

Now, investors might regard my earnings pessimism cynically.  After all, I’ve been too optimistic on the economy and too bearish on earnings — way too bearish as measured by “economic” profits in the National Income and Product Accounts (NIPAs).  By that metric, corporate profits jumped by 21% in the fourth quarter.  Contrary to my claims that flatter margins would constrain earnings gains, it appears that most of the earnings slowdown has resulted from slower economic growth.  Logically, investors reason, if the economy improves at all from the dismal showing in the first quarter — when year-over-year nominal growth likely fell below 5% — earnings gains should also pick up. 

I disagree for several reasons.  Most important, I still think the margin story is the right one because earnings are highly leveraged to growth both at home and abroad.  Continued sluggish domestic growth likely will promote margin compression as operating leverage fades.  Moreover, I think pricing power will fade, unit costs and interest expense are rising, and credit quality is deteriorating. 

Analyzing profit margins helped isolate the factors behind our bullish earnings call through much of this expansion.  Measured as the quotient of “economic” profits to corporate GDP, margins exploded by 550 basis points from late 2001 to the third quarter of 2006.  At work were five domestic factors: First, companies were able to exploit the high levels of operating leverage in their business.  High fixed costs — primarily for depreciation —gave Corporate America significant operating leverage.  When spread over a broader base in recovery and expansion, such costs decline significantly and contribute to a surge in margins.  Over the past five years, depreciation charges as a share of GDP have declined by 230 basis points.  In addition, corporate interest expense has declined as a share of corporate GDP by 190 basis points in the past five years, the product of both declining interest rates and CFOs’ efforts to clean up their balance sheets.  Third, for financials, better credit quality went straight to the bottom line.  For example, bank analyst Betsy Graseck estimates that reduced provisions for loan losses accounted for 37% of the earnings growth at large-cap banks from 2004-06, and more than half the earnings gains at mid-cap banks.

Fourth, record productivity gains kept unit labor costs either falling or subdued.  Over the past five years, productivity in nonfarm business rose by an annual average of 2.6%, restraining the rise in unit labor costs to an annual rate of 1.5%.  That helped keep compensation charges declining as a share of GDP.  Fifth, pricing power has improved over the past three years as corporate capital discipline has boosted operating rates.  The improvement is far from ubiquitous, but a host of industry segments such as hotels, rails, construction, insurance, healthcare, and even airlines demonstrated improving pricing power.  Finally, two global factors helped.   Rising energy quotes promoted a strong lift to energy-company earnings.  And strong overseas growth has lifted results from US affiliates abroad.  Such earnings (which include multinational oils) accelerated to an 18.7% rate in the year ended in the fourth quarter.

The five domestic factors all seem likely to fade in the coming year, flattening margins and bringing earnings growth down.  Earnings are highly leveraged to growth both at home and abroad.  That leverage is now working to the downside at home, as the slowing in domestic growth from above to below trend is promoting a flattening or even compression in margins as operating leverage fades.  While hardly visible, profit margins so measured dipped by 46 bp in the fourth quarter.  In the S&P universe, US equity strategist Henry McVey notes that after 13 straight quarters in which earnings outstripped revenues, fourth quarter results showed them neck-and-neck, with half the ten major industry groupings in the S&P nonfinancial universe showing declines.   And consensus estimates show margins dipping in the first quarter. 

Interest expense is now rising, both because rates are higher and CFOs have begun to re-lever the capital structure.  Credit quality is starting to deteriorate, so the environment is shifting from one of reserve releasing to reserve increasing (see Betsy Graseck’s “Credit Monitor: Weaker Credit in 2007,” February 12, 2007).  In addition, productivity growth has slowed to 1.4% in the year ended in the fourth quarter, and we expect no improvement in the year ahead.  Concurrently, firmer labor markets have promoted an acceleration in wages and compensation; that trend has moved solidly to 4% over the past year.  And finally, pricing power — a key investment theme for me and for our equity strategy team’s call in 2004-2005 — has cooled as capacity growth has caught up with the advance in output. 

The two global factors — changes in energy prices and overseas growth coupled with a weaker dollar — likely will be a significant offset to this domestic earnings slowdown, and operating leverage may still work to the upside for earnings from overseas operations.  While the 8% decline in energy quotes in the first quarter trimmed overall earnings from a year ago, recent gains in prices will provide a lift.  And with non-US growth likely to remain above the US pace, those results should rise more strongly than domestically-generated earnings.  The upshot: While the first five factors that have lifted margins are now likely to fade, we expect that overseas growth will limit the margin compression. 

I still like equities over bonds, but challenges abound: Near-term overall growth risks tilt to the downside and earnings still seem likely to slow faster than the economy.  Sticky inflation likely will preclude any near-term interest rate relief.  And a less-certain outlook implies higher volatility and risk premiums.  That unappetizing combination is promoting a bearish steepening of the US yield curve.  As a result, I share my strategy colleagues’ caution on equities. 

Hopes are high that the current earnings deceleration will soon give way to stronger growth.  Those hopes aren’t complete unfounded.  If economic growth improves, Corporate America’s ability to exploit operating leverage may once again surprise to the upside.  And the combination of hearty overseas growth and a weaker dollar could prove to be a bigger offset to domestic earnings weakness.  This time, however, I think the earnings surprises will come in on the downside. 

 

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Euroland
An ECB with a Spring in its Step?
April 05, 2007

By Elga Bartsch | London

This coming week the ECB Governing Council will meet to debate the stance of its monetary policy and whether or not any changes need to be made to it.  Having just hiked interest rates at the previous Governing Council meeting in March, in our view, the outcome of Governing Council’s deliberation will most likely be a holding operation.  But it is possible that the press conference immediately following the announcement of the interest rate decision will deliver a more hawkish message than the markets are currently prepared for.  In our view, it is conceivable that the ECB re-introduces “strong vigilance” to its rhetoric this coming week, thus hinting at another upward adjustment in interest rates already at the May meeting.  In fact, we would place a subjective probability of around 20-25% on such a surprise. The market currently places what is essentially close to 0% probability on a move in May.  That said, our main case scenario is still for a move in June.  But we will be watching out carefully whether the ECB still believes that the risks to price stability warrant “very close monitoring” (meaning that it can afford to wait until June) or whether these risks require it to “exercise strong vigilance” (meaning that the ECB is ready to pull the trigger already in May).

So, what are the pros and cons of a move in May? Recent activity indicators out of the euro area (again) surprised us and the market on the upside. In fact, our reading of the latest batch of business surveys out of the euro area is that there is unlikely to be a meaningful deceleration in growth in early 2007. As a result, we upgraded our growth forecasts for this year from 2.3% to 2.5% (see Eric Chaney’s Perfect Landing, March 28, 2007) and brought forward into the remainder of this year the 50bp of tightening that we had previously pencilled in between now and spring 2008 (see EuroTower Insights, Tweaking the Timing of our ECB Call, March 29, 2007). Rising crude oil prices and higher quotes for agricultural commodities suggest that input price pressures are on the rise again. Furthermore, the latest set of money supply and credit data show little sign of a slowdown, thereby likely adding to the ECB concerns about the risks to price stability over the medium-to-longer term.

In addition, the advantage of an earlier move is that the ECB could potentially act before the wage deal in the German metal sector is sealed.  While an agreement would clearly be reached by June, there is a good chance that the talks are still ongoing in early May. This is because the period in which the trade unions need to keep peace, i.e., cannot go on strike, only ends at the end of April. In the past, it often took a serious threat of an all-out strike to get an agreement in the metal sector.  This wouldn’t be Germany if there weren’t some procedural rules about how to organise an all-out strike. First, the negotiations have to fail and, in the event, any mediation process needs to prove fruitless as well. Second, trade unions have to ballot their members and the regional trade union board has to decide to call a strike. All of this might very well take time until early May.

One drawback of an early move is that May tends to be a busy month in European politics.  While the ECB meeting on May 10 is taking place after the second round of the French presidential election, it will likely take place in the run-up to the parliamentary election in Ireland.  Incidentally, the meeting — one of the ECB’s regular ‘out-of-town’ meetings — will be held in Dublin. The date of the Irish election has not been set yet at the time of writing. Government minister Brian Lenihan suggested last November that the election would take place in May 2007. Subsequently, the Taoiseach, Bertie Ahern, who will set the election date, has been reported to be eyeing May 24 as an election data. While the fireworks surrounding a general election can — and in the case of France already have — created some unwanted attention from politicians to the ECB’s policy-making, the election calendar is unlikely to make big impression on the ECB, we think. Otherwise the Governing Council, now representing 13 European countries, might regularly find its hands bound by a local political agenda.

Another drawback of a move in May is that it would come at a time when the ECB is gradually inching towards an ‘intermezzo’ in its tightening campaign; a renewed acceleration in its pace of tightening would probably send the wrong message to financial markets about the ECB’s inflation worries and its likely future course of action.  It would also pre-empt the June staff projections on growth and inflation, which could potentially paint a somewhat different picture from the ones published in March, depending on futures movements of oil prices and currencies until the time of the forecast. In addition, the assumptions made for growth in the rest of the world, notably in the US, might need to be adjusted to the downside, if the incoming data for the first half of this year are anything to go by.

Bottom line: Anything but a decision to keep the refi rate on hold at 3.75% this coming Thursday would be a major surprise. If anything, the potential for a surprise lies in the press conference.

 

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UK
Inflation Expectations — Is it All Getting a Bit Worse?
April 05, 2007

By David Miles | London

Since the start of the year there has been a significant rise in yields along the gilt curve in the UK. Yields on 10-year bonds are up by about 50bp — from near 4.5% in December to very close to 5%. At the long end, yields are up by not much less: 30-year gilts had yields that were only a little over 4% at the back end of last year and now yield only marginally under 4.5%.

Real yields have risen too — though not by quite as much. It is easy to conclude from this that expectations over inflation have worsened. And that is a natural interpretation in an environment where the actual rate of inflation has risen to levels that are significantly above the target rate and are also higher than the Bank of England expected last year. If there has been a marked erosion in market expectations of the medium-term rate of inflation, this would be a severe worry for the Bank of England. And taking the figures at face value, it look like there is something to worry about.

The bank’s own estimate of the implied 20-year forward rate of inflation — that is, the implied expectation of where the rate of retail price inflation will be 20 years from now — averaged almost exactly 3% over the past year. But the current reading is about 25bp above that (3.24% as at March 30). Something similar has happened at the 10-year horizon: the implied 10-year forward inflation rate is now around 3.3% — about 15bp above the average over the past year.

But what is significant here is that there has been virtually no change in the implied forward inflation rate five years ahead. The average implied inflation rate at the five-year horizon has stayed very close to 3%, which has been the average over the past year. The current reading of 3% is pretty much where it was in the middle of last year, before the sharp run-up in actual inflation that we have seen since over the past three months was widely anticipated.

It seems rather improbable that the average investor should have grown rather significantly more pessimistic about inflation 10 years and more down the road while not more pessimistic about inflation five years down the road. To put it another way, it strains credibility to see the very recent rise in inflation above the target level having done little to dent people’s belief in the ability of the Bank of England to control inflation for the next five years while at the same time making them believe that the longer-term inflation outlook has worsened.

So what is going on? The answer, I think, reflects the way in which inflation expectations are inferred from the gap between yields on conventional (nominal) debt and yields on real (inflation-proof) debt. It is the gap between the two which drives the implied forward rates of inflation constructed by the Bank of England. The gap between yields on nominal and real debt is also what drives breakeven inflation rates. But that gap reflects more than just expectations of inflation. It also reflects factors that shape the preferences of investors between real (inflation-proof) bonds and nominal debt. There are many such factors at work, including: the willingness to take inflation risk; perceptions of the amount of inflation risk; the degree to which liabilities that some investors seek to match are fixed in real terms; the perceived need to hedge such liabilities; and the relative supplies of real and nominal debt. None of those factors has much to do with the expected (or average) rate of inflation at some point in the future. Furthermore, few of these factors can be expected to remain fixed from one quarter the next. My judgement would also be that this range of factors is more significant the further ahead one looks. If that is true, a measure of inflation expectations based on the difference between a conventional and a real yield is a rather more unreliable indicator of actual inflation expectations the further down the yield curve one goes.

If that is right then we would do well to pay rather more attention to shifts in implied inflation rates at a five-year horizon than to shifts at a longer horizon. That is why I am doubtful that there has been any significant deterioration over the past few months in investor perceptions about the extent to which the Bank of England will control inflation.

That does not mean that inflation risks are small and that the recent rather sharp rise in UK inflation will definitely pass. Our judgement remains that the most likely outcomes are indeed that inflation comes down and returns to target levels quite rapidly — but risks most certainly exist. Our view is, however, that such risks are broadly symmetric. Cost pressures on UK firms may pick up and be passed on, and that poses an upside risk to our central forecast of inflation soon moving back close to 2%. But we also see a significant risk of a sharp and protracted slowdown in the pace of consumer spending; if that happens, inflation pressures will fade.

 

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Currencies
Big Potential for Further Japanese Retail Outflows
April 05, 2007

By Stephen Jen | London

Summary and conclusions

In this note, I highlight a simple point, that Japan’s holdings of risky assets, including foreign assets, as a percentage of its total liquid financial asset holdings, are still very low.  This implies that there is great potential for further retail outflows.  Whether or not these outflows will persist is a difficult call for me to make now, but investors should be aware that the origin of the pressure expelling capital out of Japan may be quite powerful and structural in nature.  Though important in their own right, the ‘JPY carry trades’ are a coincidental story. 

In my recent writing, I have highlighted the cyclical vulnerability of the USD, particularly in 2Q.  However, the risks to USD/JPY are biased to the upside, as the JPY carry trades and structural capital outflows are likely to keep the JPY weak.  I reiterate our call that USD/JPY will reclaim 120 and EUR/JPY will breach 160 in 2Q. 

Two schools of thought on why the JPY is weak

There are two broad schools of thoughts on the JPY.  Outside Japan, investors and commentators seem to be fixated on the so-called ‘JPY carry trades’.   In Japan, the view on the JPY straddles both a structural and a cyclical aspect.  The cyclical part is related to the ‘JPY carry’, but the structural part is connected with a fundamental and structural shift in Japan’s ‘home bias’.  My view is more in alignment with the mindset in Japan. 

Like many in Japan, I believe that the JPY is weak partly, not wholly, because of Japan’s low interest rates.  What has been a key development since late 2005 is a gradual decline in Japan’s ‘home bias’ (i.e., its long-standing preference, possibly driven by cultural or risk preferences in the past, for JPY-denominated assets).  The positive interest rate carry has encouraged this structural shift, but the structural shift would probably have occurred even if Japan’s interest rates were higher than they are now, I suspect. 

This is the ‘capital outflow’ story I’ve tried to emphasize to clients in recent months, to try to draw them away from the simple ‘JPY carry trade’ fad.  While ‘JPY carry trades’ have indeed been a powerful force in keeping the JPY under-valued, structural capital outflows are also critically important.  Further, I believe that the latter is a bigger story — not only because Japanese flows into foreign equities may have accelerated, but also because a similar trend may be occurring in Korea right now and may occur in China in the coming years. 

The BoJ’s Flow of Funds data

The Bank of Japan recently released the 4Q06 Flow of Funds data.  In this release, the BoJ documents the stocks of financial asset holdings of different types of investors in Japan.  In this note, I am focusing on the Japanese HHs. 

I make the following observations:

• Observation 1.  Japanese HHs have massive financial holdings: close to US$13 trillion in gross terms and US$10 trillion in net terms.  Japanese HHs now hold close to US$13 trillion worth of financial assets, with a net asset position of US$9.6 trillion, which is roughly equivalent to around 220% of GDP.  While the economy as a whole, including all seven key sectors, owns nearly US$80 trillion of assets, the Japanese HHs have the largest net asset position of all.  Thus, the HH sector is most important for the purpose of thinking about the capacity of capital outflows from a sector that is most likely not bogged down by concerns about asset-liability mismatch. 

• Observation 2.  Japanese HHs have a cash-rich portfolio.  Incredibly, 50.5% of Japanese HHs’ assets are held in currency and deposits; the comparable figure in the US is around 10%.  Direct JGB holdings account for 2.1% and equities account for 11.9% of retail investors’ portfolios.  Another 25.9% are held in insurance and pension reserves, which, in turn, are mostly invested in bonds and equities.  In any case, Japanese HHs’ cash holdings are still meaningfully larger than the total holdings of securities at around 40.0%, excluding investment trust beneficiary certificates.  (The comparable figure for the US is 83%, based on the Fed’s Flow of Funds data.)  This suggests to me that the current level of risk-tolerance of Japan’s HHs is still extraordinarily low, and has scope to increase in the future. 

• Observation 3.  Japanese investors’ direct holdings of foreign currency assets are very low.  Japanese HHs’ direct holdings of foreign securities account for only 0.5% of their total wealth.  Even the economy-wide average of 5.5% is rather low.  Adding on top of these figures the foreign currency cash deposits, the Japanese HHs hold less than 1% of their financial wealth directly in foreign assets, and the economy as a whole has only about 6.1% directly held in non-JPY assets. 

Financial institutions may have raised their non-JPY asset holdings, on behalf of the Japanese HHs.  The BoJ’s Flow of Funds data don’t offer new information on the non-JPY asset holdings by Japanese financial institutions.  What is reported is that investment trust funds have grown by around US$300 billion in size (¥33.6 trillion) in the last two years.  A good portion of this increase may have come from the foreign currency component, I suspect. 

Demographics and risk-taking in Japan

The ‘JPY carry trades’ became especially popular toward the end of 2005, when it, ironically, became clear that the BoJ was preparing the market to terminate QE (quantitative easing) and ZIRP (zero interest rate policy).  While ‘JPY carry trades’ are clearly an important factor keeping JPY weak now, it is not clear why they were not a factor prior to 2005, when the JPY’s yield deficits were also quite large against several currencies.  I suspect that there have been both cyclical and structural factors that triggered such a shift in risk-taking.  One of the possible explanations of a structural shift in risk-taking could be demographics, whereby Japan’s ageing population has finally realized that a relatively straightforward way to help finance their lengthening retirements (as longevity improves and workers retire as scheduled) is to deploy cash to riskier assets.

Bottom line

There is significant potential for Japan’s retail sector to continue to raise its investment in risky assets in general and non-JPY assets in particular.  The sector’s cash holdings of 50% and securities holdings of 40% of its total financial wealth are very puzzling (the figures are 10% and 83%, respectively in the US) and could potentially rise sharply.  The possibility that the Japanese investor base may be undergoing a structural shift may pose a lingering threat to the JPY.  Capital outflows from Japan could continue to over-rule economic fundamentals and keep the JPY under-valued. 

 

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Currencies
Protectionism Poses Another Risk to the Dollar
April 05, 2007

By Stephen Jen | London

Summary and conclusions

Protectionism now poses yet another downside risk to the dollar.  Trade or financial protectionism is almost always bad for the dollar, because the US, like China, has been a major beneficiary of trade and financial globalization. 

Our view is that protectionism is a genuine risk to the dollar and that investors should be positioned accordingly.  However, it is a tail risk, not our central case view, that protectionism will prevail in the US, for the simple reason that a protectionist policy path would prove to be too costly for the US.  Similarly, China is unlikely to want to see an escalation in protectionist tensions, and will, we guess, take a soft-line approach to the US Department of Commerce’s recent preliminary ruling. 

Our reactions to the latest developments in the US

The risk of protectionism is genuine.  Our Chief Economist Stephen Roach has, for a while now, underscored this as one of the key risks on the horizon that many investors may not have taken seriously enough.  The preliminary ruling by the US Department of Commerce last Friday against Chinese coated paper is seen by Steve Roach and others as a dangerous first step down the path of protectionism, as other industries could, in principle, pursue similar protectionist measures if China is no longer afforded the ‘non-market’ status. 

We share Steve Roach’s view that protectionism poses a risk to the US and the global economy, as well as the dollar.  This protectionist sentiment has indeed gained momentum on Capitol Hill and, in the coming period, is likely to become even more politicized.  From the currency perspective, the obvious trade is to short the dollar against most currencies. 

Having said the above, we think there are some reasons to believe that protectionism is likely to remain a threat rather than reality, that there will be ‘more bark than bite’, and more heat than fire.  Recognizing that facts are scant, we offer our thoughts:

• Thought 1.  US Commerce Department: loud bark, uncertain bite.  The Commerce Department issued a preliminary ruling.  While the final ruling is scheduled to be announced on June 13, in reality it may not be rendered until October.  The time gap is intended to give Beijing time to react to this announcement and to negotiate to remove the alleged subsidies.  At a press conference this Monday, Under Secretary of Commerce for International Trade Mr F. Lavin discussed this issue.  He listed a range of trade and economic practices in China that many would consider unfair.  By listing these specific examples, Mr. Lavin effectively gave Beijing the opportunity to respond to the Commerce Department’s announcement.  Mr Lavin also laid out the ‘Five-Pillar Framework’ the US follows in dealing with trade-related issues.   Of these five pillars, bilateral negotiations — mainly the Strategy Economic Dialogue led by Secretary Paulson — is the US’ primary pillar, and the preferred way of dealing with China. 

The US Commerce Department does not want to start a ‘war’, we suspect. 

• Thought 2.  Beijing is unlikely to play hardball.  We do not see Beijing wanting to retaliate against the US in kind, particularly when only a ‘preliminary’ ruling has been rendered and no action has been taken by the US.  In other words, the US Commerce Department has incorporated a great deal of room for China to maneuver in response.  There is no clear need for Beijing to retaliate.  Further, from a longer-term strategic perspective, China may not yet see itself as being in a position to challenge the US on issues such as this one. 

As a result, we believe that there will likely be much give and take between the US and China on the issue of trade.  A quick escalation of hostile trade actions does not really make sense to us. 

• Thought 3.  The shifting political tide will be countered, however.  Having expressed our rather optimistic interpretation and prediction regarding the latest Commerce Department announcement, we fully concur with Steve Roach that ‘the train has left the station’ as far as the politicians on Capitol Hill are concerned.  No doubt, the situation is less tractable than before.  But there will be important counterbalancing forces that may still keep this protectionist trend in check.

First, most of the technocrats in the Bush Administration are still pro-trade and anti-protectionism.  The benefits of globalization are still very compelling.  Necessary ‘micro’ measures to improve the fairness of trade will be endorsed by the Bush Administration, but not tolerated at the expense of the ‘macro’ strategy of pro-market and pro-trade. 

Second, there are powerful lobbying forces on Capitol Hill representing groups that would want to restrain the protectionist movement (e.g., US multinationals who have invested in China and are benefiting from outsourcing must not want this trend to pick up pace). 

Chinese RMB

The pace of crawl of USD/CNY has declined sharply in recent months, for unknown reasons.  We still believe that there is ample room for Beijing to allow the CNY to appreciate at an accelerated pace.  The economy is growing too rapidly and the PBoC continues to tighten.  The argument that China’s exports (volume or profits) are too sensitive for USD/CNY to decline at a faster pace is no longer compelling, in our view.  We believe that the risk of the rate of crawl of USD/CNY accelerating again in the near future is rising. 

Bottom line

Rising protectionism is a genuine risk to the US economy and the US dollar, in our view.  We believe that investors should respect this threat, and be positioned defensively regarding the dollar.  Having said this, we tend to view protectionism as a tail risk, not our central case assumption.  It will remain more of an irritating threat rather than something that will undermine globalization, in our opinion. 

 

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Ukraine
Capital Flight and Elections
April 05, 2007

By Oliver Weeks | London

While the outcome of Ukraine’s latest political stand-off remains unclear, early elections look increasingly probable to us.  The impact on the economy and balance of payments looks limited, barring a descent into violence that still seems highly unlikely. 

Capital flight was already high.  Even before the current uncertainty, the very high level of outward capital flight in Ukraine’s balance of payments is striking.  Taking the net outflow of deposits, short-term capital, non-repatriated export earnings and fictitious transactions as an indicator of capital flight, outflows are already at record levels.  On this measure, cumulative annual capital flight in the run-up to the Orange revolution surged to US$10.8 billion, 16.6% of GDP.  These outflows slowed to an annual US$5.5 billion as political and re-privatization risk receded by the end of 2005, but returned to just above 2004 levels as coalition negotiations dragged on after the March 2006 parliamentary elections.  Amid the current uncertainty, we would expect capital flight to pick up again, but the scope for a significant further deterioration seems limited.  Note that in Russia the continuous private sector capital outflows of the post-transition period have shown a spectacular reversal, with a US$42 billion net inflow in 2006.  In Ukraine’s case, while we expect a continuing widening of the current account deficit with further gas price rises, the steady increase in long-term lending, portfolio and direct investment inflows looks likely to remain resistant to political uncertainty. 

Elections likely but export outlook robust.  Early elections now seem more likely than not to us.  The Constitutional Court is under intense pressure, but is split and may prefer to continue its recent practice of avoiding difficult decisions.  Yushchenko’s complaints about MPs defecting to the governing coalition appear to have a reasonable legal basis.  While the Socialist government faction will be scared of falling under the 3% election threshold, the Regions party may hope to do well despite sharp falls in the latest opinion poll, and appears to be gearing up to campaign.  Yushchenko’s own Our Ukraine bloc is set to lose support but Yulia Tymoshenko’s bloc looks likely to gain, as would the Communists.  The major entrepreneurs backing both of the largest parties seem unlikely to take the risk of intensifying east-west confrontation and testing the split loyalties of army and interior ministry forces.  Clearly, there is little prospect of a stable majority emerging from a new vote, and a risk of the unpredictable Ms Tymoshenko returning to government.  Uncertainty looks likely to continue, but this has been the case for a long time already and there is no active reform agenda currently at stake.  Meanwhile, monthly GDP growth has accelerated to 8.6% year on year in the first two months of 2007.  Industrial metals account for 43% of Ukrainian exports, while the Goldman Sachs industrial metals index is reaching new all-time highs.  Unless the stand-off turns violent — and public apathy appears dominant at the moment — the economy should prove relatively resilient. 

 

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Middle East/North Africa
What Would Mundell Say?
April 05, 2007

By Serhan Cevik | from Stockholm

The GCC should listen to Robert Mundell before launching a currency union. Four decades before the introduction of a single currency in Europe, Nobel-laureate Robert Mundell outlined a theoretical framework for currency unions and identified a set of economic criteria to determine the cost-benefit ratio and sustainability of a common monetary arrangement (see “A Theory of Optimum Currency Areas”, American Economic Review, November 1961). Even though the GCC countries – Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates – share similar socio-cultural values and political institutions, such common features are not necessarily enough to form an optimum currency area and, more importantly, determine the sustainability of such a costly endeavor. This is why the GCC needs to make sure that all the member countries have acceptable scores on Professor Mundell’s analytical tests before moving ahead with greater monetary integration and adopting a single currency.

The long-term benefits may be exciting, but we also need to consider the costs of monetary unification. The advantages of a currency union are well known theoretically and, thanks to the euro experiment, practically as well. The GCC, too, could enjoy a range of benefits like lower transaction costs and greater transparency that would strengthen trade and investment linkages within the region and boost the rate of economic growth. However, before getting excited about the long-term gains, we need to consider preconditions and potential costs that all the GCC economies need to meet for entering the planned currency union. Building upon Mundell’s recommendations, we can identify certain key conditions for a sustainable monetary cooperation: the high degree of economic diversification, factor flexibility and mobility, openness, intra-regional trade and macroeconomic convergence between members.

The lack of economic diversification is the biggest challenge to a successful monetary union. Although oil and natural gas exports distort the degree of openness, the GCC countries have reasonable integration with the global economy and share similar economic structures for the time being. However, with a high degree of oil dependency, all these economies derive most of their earnings from a single category of exports and so remain vulnerable to terms-of-trade shocks. Likewise, mainly because of the lack of economic diversification, the volume of intra-regional trade represents less than 5% of GDP in the GCC, which of course limits potential benefits from the monetary union. The results on factor flexibility and mobility are also mixed. While the high share of expatriates brings a certain degree of labor-market flexibility, the so-called nationalization programs and high share of public employment limit flexibility and mobility across the region. On the other hand, capital mobility within the GCC remains low, not so much because of restrictions, but mainly due to investment preferences to diversify outside the region. Unfortunately, such a limited degree of financial integration could fail to smooth diverse shocks to the exchange rate regime. In the meantime, the synchronization of business cycles has improved with the oil boom, but the correlation of growth rates in the GCC remains far lower than the correlation between European economies prior to the adoption of the euro. Further, despite a long period of exchange-rate stability, inflation differentials have shown no convergence and widened even more in recent years. And on the fiscal front, even though the oil windfall has improved budgetary performance and debt indicators, oil dependency is, once again, a significant long-term challenge, especially considering the divergences in natural resource endowment.

The GCC has a long way to go to achieve macroeconomic convergence and diversification. The launch date for the GCC monetary union is just around the corner, but the authorities are having (publicly available) second thoughts. Oman has already opted out of the currency union, and the rest of the GCC is seriously considering the postponement of the 2010 deadline, if not the entire project. This is not surprising, as the GCC does not yet meet the preconditions for monetary integration and must deal with a set of structural shortcomings that challenge the sustainability of a currency union. These arguments, by the way, differ from those made before the euro’s introduction (and even today) about whether Europe is an optimum currency area or not. The problem with the GCC monetary union is not about macroeconomic convergence or political will to give up policy sovereignty. Although the synchronization of economies in the region is certainly an important issue, the real problem is oil dependency and the sustainability of a currency union in the long run, in our view. But, this is also why these countries would be better off if they keep pursuing the goal of establishing a currency union – a process that could promote prudent policies and structural reforms and thereby accelerate economic diversification (see United States of Petrodollars, March 14, 2007). All in all, we believe that revaluing the undervalued exchange rates and moving, at least, to a peg against a basket of currencies make good economic sense and would even set the stage for the planned monetary union, if they decide to go ahead with it.

 

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Israel
Sweet Spot
April 05, 2007

By Serhan Cevik | from Istanbul

The central bank’s decision to keep interest rates on hold will support stability. After cutting short-term interest rates by 150bp since last October to 4% in March, the Bank of Israel decided to pause the easing campaign and to keep the policy rate unchanged this month at exactly 125bp below the US Federal Reserve’s stance. Our call for the end of monetary easing, however, had nothing (at least, directly) to do with interest rate differentials, to which we have never attached much importance as long as economic fundamentals support a stable outlook. Instead, our focus has always been on the state of the real economy and inflation dynamics beyond the deflationary effect of the shekel’s appreciation. The central bank, too, is now emphasizing the narrowing output gap and the lagged transmission of interest rate cuts throughout the Israeli economy. In fact, the most important factor pushing the year-on-year inflation rate from 3.8% in April 2006 to -0.8% in February 2007 was the shekel’s strengthening against the dollar. Although our currency economics team expects the dollar to remain weak as the US economy continues to experience a temporary slowdown (see Another Bout of Generalized Dollar Weakness in 2Q, March 22, 2007), allowing Israel’s monetary policy to be dominated by exchange rate movements alone would diminish its effectiveness in the long term and expose the entire economy to the risk of higher volatility. This is why we have argued in favor of looking beyond temporary deflation and focusing on the effects of low interest rates on domestic demand.

There is no inflation today, but underlying trends point to a higher readings in the future. The consumer price index posted a cumulative decline of 0.4% in the first two months of this year, lowering the year-on-year inflation rate to -0.8% in February. From whatever angle you look at it, this is a significant shift from the inflation trend in early 2006 when the CPI was increasing at annual rate of 3.8%. In our view, deflationary readings have come on the back of changes in the shekel’s valuation, which have an overwhelming influence on consumer prices linked to or denominated in dollars. For example, the fully dollarized housing sector (with a 22% weight in the CPI basket) has so far experienced a 5.5% drop in prices and pushed the headline figure into the deflationary territory. Therefore, this is not an episode of deflation written by weak domestic demand. Instead, the pass-through from the shekel’s appreciation has become the leading factor driving inflation dynamics in the short run, but we are likely to see economic fundamentals becoming more and more influential in the coming months (see Technical Deflation, November 20, 2006). Indeed, although the dollar has weakened even more so far this year, the rise in dollar-denominated housing prices has started stabilizing the rate of deflation in the shekel-denominated index. Likewise, domestic prices unaffected by currency movements confirm this trend, rising at annual rate of about 2% versus deflation in prices influenced by the exchange rate. This is not a surprising development, in our view, given low real interest rates and the shekel’s strength at the same time.

The recovery in private domestic demand is far stronger than expectations. The war in Lebanon last summer led to a contraction in domestic demand in the third quarter, but the economy has recovered quickly and far stronger than expectations. Real GDP surged ahead by 8% in the final quarter and brought the average growth rate to 5.1% last year. More significantly, output growth in the business sector reached an annualized rate of 12.8% in the fourth quarter (and an average of 6.4% in the whole of last year). Exports certainly played an important role, thanks to Israel’s growing presence in the global technology cycle. However, the rise in consumer spending has also gained momentum. After increasing by 4.8% last year, the latest indicators point to an even faster rate of growth in private consumption. For example, personal credit card purchases increased at an annual rate of 10% in January and 17% in February, while the rate of growth in chain store sales accelerated from 6.8% in 4Q06 to 9% in the first two months of this year. Clearly, the economy is on an above-trend growth path, and that justifies no further monetary easing, even though we still expect the shekel to remain strong.

Policymakers have an opportunity to keep the Israeli economy on a sweet spot. More than favorable cyclical factors, structural changes in the Israeli economy (such as greater specialization in high-technology industries) have moved the current account balance steadily from an average deficit of -2% of GDP in the 1990s to an average surplus of 3% in the past four years and 5% in 2006. In the meantime, foreign assets held by residents increased by US$86.6 billion since 2000 to US$156.7 billion last year, against a US$50.8 billion rise in liabilities. As a result, Israel’s net international position improved from US$50.3 billion in 2000 to US$14.5 billion in 2006 (see Net Gains, January 10, 2007). Although the decline in home bias has certainly altered the currency composition of residents’ portfolio allocations, we believe that the country’s improving net international position supports the shekel’s valuation and could indeed help to keep the Israeli economy on a sweet spot.

 

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Japan
Looking for Stable Rimban Despite Shrinking Fiscal Deficit
April 05, 2007

By Takehiro Sato | Tokyo

Responding to concerns about a possible cutback in Rimban operations

The F3/08 budget projects ¥25.4 trillion in new-resource bonds, or almost ¥5 trillion less than in the initial F3/07 budget thanks to a recovery in tax proceeds. BoJ Rimban operations for medium/long-term JGBs, meanwhile, are unchanged, at ¥14.4 trillion annually (¥1.2 trillion per month), resulting in covering the bulk of fiscal deficits with BoJ’s purchase operations, despite two policy rate hikes since July 2006 and a shrinking fiscal deficit. Some investors are starting to express concern about the risk of cutbacks in the operations.

Yet there is no reason to worry, in our view. The BoJ cannot reduce JGB purchase operations, even if it wanted to, because the outstanding value of banknotes has not declined, contrary to expectations, since banknotes that fled the financial system are not returning to deposits, despite stabilization. It also faces a technical hurdle from the shortening duration of asset composition on the balance sheet since a balance must be maintained with liabilities’ (banknotes) value and their duration. Although the chances are low, the BoJ might need to increase purchase operations if these conditions become more pronounced.

Capital not returning to deposits, even with higher deposit interest rates

The above view assumes slow progress in getting banknotes to return to bank deposits. Higher savings interest rates might encourage individuals to reduce cash holdings and lower the outstanding value of banknotes, and this could lead to serious talk of reducing (rather than expanding) JGB purchases because of the so-called ‘banknote ceiling’.

However, there are questions about the nature of these outstanding banknotes and there is no guarantee that they will return to the banking system in response to higher deposit interest rates. We think that the bulk of these banknotes accumulated in the private sector will not return to the banking system, as explained below (and previously).

We estimate that banknotes hoarded in the private sector reached almost ¥37 trillion at the end of 2006 judging from the ratio of outstanding banknote value to nominal GDP. The primary reason for hoarding was said to be precautionary demand for cash reserves amid heightened financial instability from the late 1990s. It is widely accepted that rising levels of cash-under-the-mattress savings increased banknote growth during the periods of greater financial system instability in 1997-98 and 2001-02. Yet there is still no evidence of a large-scale return of these savings to bank deposits even though financial system worries faded nearly three years ago, partly due to ultra-low interest rates. We think that another dynamic is helping sustain the inflated level of banknotes.

The second factor is an increase in concealed money avoiding taxes. Money is concealed for a variety of reasons such as incurring higher costs than asset value from penalty taxes if caught by tax authorities. We believe that the expansion of underground money with advances in the underground economy might also have supported strong banknote growth in the late 1990s. Our analysis suggests that the value of concealed banknotes was worth at least ¥24 trillion at the end of 2006, though it is uncertain how much of this money enters the real economy, given its secretive nature. Modest increases in savings interest rates are unlikely to pull this money back into the banking system if it has been hoarded for these reasons, preventing a decline in outstanding banknote value.

Technical, though important, point

Higher outstanding banknote value leads to the following technical problems for the BoJ’s daily money market operations. 

The duration of JGBs owned by the BoJ on the asset side of the balance sheet to counter the ¥75.1 trillion in outstanding banknotes (liabilities, as of March 20) is gradually shortening and currently at 4.77 years (4.30-year average duration, after reflecting March purchases and redemptions). Medium/long-term JGB value has dropped below the ¥50 trillion level to ¥49.5 trillion and the short-term asset ratio is rising. Outstanding banknote value and medium/long-term JGB holdings were ¥75.0 trillion and ¥60.5 trillion, respectively a year ago (end-F3/06). The asset-liability gap has expanded by ¥11.1 trillion over one year (from ¥14.5 trillion to ¥25.6 trillion) and is being covered by a higher volume of short-term assets such as short-term bills, promissory notes and the like.

We attribute the downward trend in medium/long-term JGB holdings value to: 1) a change in the BoJ’s rollover practice for expiring JGBs since F3/00 from rolling over the same amount as 10-year long-term JGBs to rolling over to 1-year short-term bills one time and then converting to cash as a result of redemption; and 2) purchasing bonds with shorter maturation periods in recent medium/long-term JGB operations. While the BoJ is purchasing ¥1.2 trillion per month, redemptions are increasing with shorter durations and preventing expansion of total outstanding value.

Yet the BoJ cannot allow excessive shortening of asset duration since banknotes have an indefinite duration. Lengthening duration is also better for short-term market stability and monetary coordination efficiency.

An excessive rise in the short-term asset ratio without progress in getting banknotes to return to bank deposits as explained above expands the range of daily fluctuation of capital supply-demand in the short-term market and leads to higher volatility for the short-term interest rate. The frequency and scale of daily capital supply by the BoJ to control this situation naturally increases. The BoJ might have to expand JGB purchase operations rather than reduce these operations to rectify this type of inefficiency. BoJ officials acknowledge the benefits of lengthening asset duration.

The BoJ must conduct capital supply operations with a period of one month worth more than ¥1 trillion per business day to cover the ¥24 trillion asset-liability gap. The daily scale or frequency would double for operations with two-week maturity. Operation frequency is actually higher than in the past quantitative easing period due to shorter capital-supply operation periods and a wider asset-liability gap.

Possibility of full-flattening at low levels

We conclude that the BoJ will be unable to reduce JGB purchase operations even with moderate normalization of interest rates without progress in getting banknotes to return to bank deposits. It might even be necessary to expand purchase operations in an extreme case (excessive decline in the medium/long-term JGB share of BoJ asset holdings).

We expect continued strong potential demand for long-term bonds with international adoption of mark-to-market accounting at life insurers by around 2010. A move by the Postal Insurance company being privatized this fall to correct its mismatch of asset and liability duration, meanwhile, would have a dramatic impact on the bond market. We think the yield curve could flatten to extreme levels as the BoJ proceeds with policy rate hikes at a very moderate pace in light of these factors. During recent visits, some institutional investors have not expressed much resistance to our outlook for full-flattening of the yield curve at very low levels (1.5%-2%) over the next few years. This flattening might cause problems for investors earning income from the mismatch between short-term and long-term interest rates. Yet it is a favorable environment for asset markets since a flatter curve restricts the actual monetary tightening effect. 

 

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Indonesia
Rates on Hold
April 05, 2007

By Deyi Tan | Singapore

Benchmark rate stays at 9.0%: Bank Indonesia kept the benchmark rate unchanged at 9.0% in its meeting today. This is contrary to our and market expectations of a 25bp cut.

Near the end of the loosening cycle: While we were wrong in terms of the timing of the rate cut, the pause in monetary policy loosening affirms that the central bank is near the end of the loosening cycle, in our view. The central bank is clearly scaling down on its loosening. It has transitioned from a more aggressive pace of 50bp cuts in 2H06 to a more measured pace of 25bp cuts in 1Q07 and now a pause in its meeting today.  

Conditions still favourable: However, conditions that affect monetary policy decisions are still broadly benign, in our view. The currency aspect is supportive despite the lower interest rate differentials. Net foreign equity buying picked up markedly in March and that has led to the rupiah appreciating further since the monetary meeting on March 6. On the other hand, the March inflation data (+6.5% YoY) released earlier this week were lower than expected but accelerated from February (+6.3% YoY) due to base effects. Core inflation was stable at 5.9% YoY. Even so, current inflation readings have stayed consistently at the upper end of the central bank’s targeted range of 5-7%. The pause in this meeting likely reflects the central bank’s concerns on this front.

BI rate to reach 8.75% by year-end: We reiterate our view that the BI rate is likely to reach 8.75% by year-end. This implies one more 25bp cut to go. With the central bank signalling a 8.5% BI rate by year-end, the risk to our forecast appears skewed to the downside.

 

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