Spillovers versus Linkages
April 09, 2007
By Stephen S. Roach (New York)
The global debate is endless (fortunately), but it’s also very simple. The key question is whether the current US slowdown has broader cross-border consequences. For financial markets, which are still discounting relatively sanguine global growth prospects for 2007-08, there is great enthusiasm for the ever-optimistic decoupling scenario – whereby the rest of the world miraculously untethers itself from the US. That remains a real stretch, in my view.
On the surface, the latest global trends seem quite consistent with a decoupling scenario. America has slowed but the rest of the world has picked up. In particular, there seems to have been a meaningful shift in the mix of growth in the industrial world. The US economy has downshifted from 3.4% growth over the 2003-05 period to only about 2% over the past year while trend growth in Europe and Japan has accelerated from around 1.5% to 2.5%. Never mind that the improved pace in Europe and Japan is only a scant faster than the weakened trend now evident in the US. The decoupling crowd rests its case on the “second derivatives” – the juxtaposition of a deceleration in the US compared with acceleration elsewhere in the industrial world. China and India are the icing on the cake – emblematic of a seemingly open-ended boom in the developing world that remains unscathed by the US slowdown. The case for global decoupling concludes that world GDP growth – which surged at a 30-year high of 4.9% over the past four years – will barely skip a beat in 2007. Little wonder that financial markets are priced for a continuation of what many call the best global economy in a generation. The fly in the ointment in this debate is that it may well be that an increasingly integrated world economy has yet to face a legitimate decoupling test. The US may have slowed but the downshift hardly represents a major derailment of the world’s major growth engine. Moreover, the deceleration has been concentrated in one of the least globalized pieces of the US economy – homebuilding activity. Over the final three quarters of 2006, a steep contraction in residential construction expenditures knocked an average of 1.0 percentage point off real GDP growth in the US – a swing of -1.5 percentage points from the positive growth contribution of 0.5% over the preceding three years and enough of a drag to have accounted for all the downshift in real GDP growth over the same period. While the housing recession has undoubtedly reduced US demand for foreign sourced construction materials, this is hardly a major challenge to growth elsewhere in the world economy. So far, the rest of the US economy has been relatively resilient in the face of this steep contraction in residential construction activity. That’s especially the case for personal consumption – more than 70% of US GDP and the one sector of aggregate demand that has the tightest linkages to America’s trading partners. During the final three quarters of 2006, when homebuilding activity hit the skids, annualized real consumption growth still averaged 3.2% -- down only 0.2 percentage point from the growth pace of the preceding three years and fully 33% faster than overall GDP growth over the final three quarters of last year; moreover, in the first period of 2007, our latest tracking estimates suggest consumption growth held at this same impressive 3.2% pace. Business capital spending has started to weaken a bit in recent months. But the weakening has been concentrated in the equipment piece – only 7% of US GDP, or one-tenth the size of the personal consumption sector. Needless to say, as long as the American consumer continues to hold its own as a source of relative resilience, the US economy can shrug off a capex hit – and the global economy will hardly be tested. This outcome underscores a major source of confusion over the global decoupling call – the distinction between internal spillovers and external linkages. The former, in my view, pertain to the interconnectedness within an economy – the relationships between sectors. An obvious case in point is the lack of any spillovers between homebuilding and consumption in the US – at least, so far. I would define linkages as more of a cross-border phenomenon – in effect, the transmission of shifts in one economy to the broader global economy through global trade flows. Internal spillovers are a necessary – but not sufficient – condition for cross-border linkages. But if there have been no internal spillovers, the external linkage debate – and therefore, the global decoupling call – is all but meaningless. That remains very much the case today, in my view. This same point recently has been made by the research staff of the IMF in the prepublication of one of the chapters in the April 2007 issue of the World Economic Outlook (see Chapter 4 on the IMF website, “Decoupling the Train? Spillovers and Cycles in the Global Economy”). Notwithstanding erroneous press accounts of this research, the IMF staff throws cold water on the notion of a global decoupling from the US. To the contrary, they stress that the “…potential size of spillovers from the United States has increased with greater trade and financial integration.” They underscore the same point I stressed above – that as long as the US slowdown remains confined to sector-specific developments such as housing, the less the chances of a more severe stalling out of the American growth engine and, as a consequence, the lower the probability of a more broadly based global slowdown. The IMF research also provides a comprehensive ranking of the cross-border linkages to the US. Based on export exposure to the US, America’s NAFTA partners – Mexico and Canada – are at the top of the vulnerability list; for both of these economies, goods shipped to the US account for around 25% of their GDP. China’s exposure, while considerably less than the NAFTA bloc, has increased dramatically in the past five years; by IMF estimates, US exports accounted for an average of 5.9% of Chinese GDP over the 2001-05 period – seven times the 0.8% share 20 years earlier from 1981-85. US exposure remains quite high in Asia ex Japan; for the newly industrialized economies of Hong Kong, Korea, Singapore, and Taiwan, in conjunction with the ASEAN-4 (Indonesia, Malaysia, the Philippines, and Thailand), US exports accounted for an average of 10.3% of their combined GDP over the 2001-05 period. By contrast, Japan has reduced its dependence on America, with US-bound exports averaging just 2.9% of GDP over the 2001-05 interval – well below the 4.0% portion some 20 years earlier. For the Euro area, US dependency ratios remain quite low, although they have inched up from 1.5% in the first half of the 1980s to 2.4% in the first half of 2000s. Similar modest increases in US exposure have been evident in Brazil and Argentina, and because of oil and resource linkages, US dependency ratios have also risen for Sub-Saharan Africa – from 3.0% in 1981-85 to 5.9% in 2001-05. The results of the IMF staff research are not surprising. They are, in fact, nearly identical with similar conclusions that I and others have stressed in considering the repercussions of a US slowdown on the broader global economy (see my 30 October 2006 dispatch, “The Fallacy of Global Decoupling”). As I noted at the time, the “decouplers” – economies that can stand on their own in the event of a major growth shortfall in the US – must satisfy three conditions: They need to have a broadening base of self-sustaining domestic demand, a diversified export mix, and policy autonomy. In my view, progress is still quite limited on all three counts. Private consumption continues to lag in Europe and Asia. Moreover, the US is still the dominant global export destination; by IMF estimates, the US accounted for 20% of global merchandise exports over the 2001-05 period – a record high for the US and larger than the Euro area as the biggest portion of global trade. Nor is there much leeway for global policy makers to ride to the rescue in the event of a US growth shock; that’s especially the case in developing Asia, which is constrained by currency considerations, but it is also true in Japan, where policy rates are still very close to “zero.” In the end, this debate boils down to the one big call that has always weighed most heavily on the macro outlook – the fate of the American consumer. If US consumption growth remains brisk in the face of pressures building elsewhere in the economy – especially housing, but also business capital spending and autos – then a globalized world will, in effect, have nothing to decouple from. The surprisingly strong March labor market surveys – brisk employment and falling joblessness – underscore the ongoing resilience of labor income generation and consumer purchasing power. Yet as Dick Berner, our resident consumption bull, recently conceded, consumers will need all the help they can get in the face of higher energy and food costs, decelerating housing wealth creation, adjustable-rate mortgage resets, and a tightening of lending standards in the aftermath of the sub-prime mortgage fiasco (see his 2 April dispatch, “Perfect Storm for the US Consumer?”). But if the US labor market continues to display extraordinary staying power in the face of adversity elsewhere in the economy, the overly-indebted, saving-short American consumer could squeak by once again – and so, too, would the rest of a still-coupled world. I remain highly dubious of such an outcome but concede that the burden of proof remains on me. I have long been struck by the inherent inconsistency of a macro call that extols the virtues of integration and globalization, on the one hand, while celebrating the resilience of a decoupled world, on the other hand. Don’t kid yourself – if the lead engine of the global growth train goes off the tracks, the rest of the world will be quick to follow. So far, that hasn’t happened – underscoring my basic conclusion that there has yet to be a meaningful test of the global decoupling thesis. It’s up to the American consumer as to whether that test will ever occur.
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The Employment Conundrum
April 09, 2007
By Richard Berner and David Greenlaw (New York)
Rising uncertainty has become the defining characteristic of the economic outlook over the past two months. We argued in our forecast update a month ago that uncertainty was rising, but if anything, developments since have widened the confidence band around our baseline prognosis, and the mix of growth and inflation has again turned less favorable (see “Despite Uncertainty, Fed Ease Still Unlikely Until 2008,” Global Economic Forum, March 12, 2007). Once again, we’ve marked down our forecast for growth, reflecting still-higher energy prices, a deeper housing recession, and additional weakness in capital spending. Over the first three quarters of 2007, we now see growth at a 1.8% annual rate compared with 2.6% in our March update; that’s a full percentage point below our prognosis of two months ago. With growth below trend and operating leverage fading, margins are flattening and earnings growth will be weaker. And once again, reflecting higher prices for energy, food, imports, and medical care, we’ve marked up our outlook for headline and to some extent core inflation. But simply marking down the growth forecast and raising the inflation outlook is the easy part. Although we’ve long expected that job gains will remain firm, the strength of labor markets in the face of a decelerating economy has surprised us. Indeed, the dichotomy between weak output and firm labor markets raises critical questions about the fundamentals in the outlook: Can strong job and income growth continue to sustain consumer outlays? Has the trend in productivity and potential output growth declined? Even if the productivity slowdown is cyclical, will it push up inflation and prolong the whiff of stagflation? And will slowing growth and rising unit costs squeeze profit margins? We don’t pretend to have all the answers, but here are our guesses: Job gains have already slowed, and payrolls will continue to decelerate, but not fast enough to undermine consumer wherewithal. The housing recession is far from over, but strong global growth likely will sustain both output and employment. The productivity slowdown is cyclical, but the trend may also have slipped. We still think core inflation has peaked, but inflation risks are rising again. And margin compression implies that profits likely will stall in 2007. That combination will likely leave the Fed on hold and steepen the yield curve. Importantly, however, neither those conclusions nor the weaker baseline presented here imply serious trouble for the economy. Details follow. There’s no mistaking the weakness in incoming data and the fundamentals that point to downside risks in three key areas. First, the housing recession continues to deepen. Although housing starts bounced by 9% in February, we think that increase simply represents noise in the data (see “Does Volatility in Housing Data Mark a Turning Point?” Global Economic Forum, March 23, 2007). Indeed, we believe that the 10% plunge in new single-family home sales in January-February (although depressed by brutal weather) and a new cycle high for new home inventories point to a tepid spring selling season and aggressive further cuts in supply to realign supply with demand. And the incipient further tightening in mortgage lending standards in the wake of the subprime mortgage meltdown will likely delay until 2008 any meaningful recovery in demand (see “Subprime Will Hurt, But Affordability Is the Key”, Global Economic Forum, March 23, 2007). Consequently, we now forecast that the level of housing starts in the summer quarter will be about 5% lower than we expected a month ago — and that was already the second-lowest forecast in the Blue Chip Economic Indicator Survey — and to levels last seen in 1992. Second, the weakness in capital goods bookings and shipments now points to a second consecutive quarterly contraction in real equipment and software outlays, for the first time in four years. Back then, the bust in telecom equipment and post-9/11 cutbacks in airplanes and rental fleet outlays accounted for much of the downturn. Today’s weakness appears to be more widespread. Deliveries of construction equipment and heavy truck shipments (as new emissions requirements took effect) have plunged — by a stunning 76% and 68% annualized over the three months ended in February, respectively. In addition, CFOs generally appear to be both disciplined and cautious, and still more focused on buying capacity through deals than building it themselves. Also, past investment incentives borrowed from today’s demand (see “The Capex Conundrum,” Global Economic Forum, March 9, 2007). Finally, rising energy prices are again hobbling the consumer. Moreover, higher quotes for food are now adding to the squeeze in discretionary spending power. In fact, we estimate that the latest surge in energy and food prices may drain more than $100 billion (at an annual rate) from consumer purchasing power over the first half of 2007. Inflation-adjusted consumer spending has already slowed and likely will remain sluggish for a while. We estimate that real outlays will rise by just 1.7% annualized in Q2, following an estimated 3.0% advance in Q1 and the sharp 4.2% jump seen in Q4. Nonetheless, we believe that these pressures will eventually abate and that even a more protracted slowdown does not necessarily mean outright consumer retrenchment (see “Perfect Storm for the US Consumer,” Global Economic Forum, April 2, 2007). The key reason: Income gains and the job growth fueling them likely will continue to provide powerful support for the consumer. Indeed, we have long maintained that over time, real income growth will be sufficient for consumers both to defend lifestyles and gradually rebuild saving. While job gains are gradually slowing, this hearty job dynamic is evident in incoming data. Nonfarm payrolls jumped by 180,000 in March, and together with upward revisions to prior months, have averaged 152,000 over the first three months of 2007. That’s 20% slower than last year’s average, but coupled with a firmer workweek and a 3.6% annualized gain in average hourly earnings over the quarter, it is still enough to imply a 5¼% annualized gain in wage and salary income. The jump in energy and food quotes will turn that into a real gain roughly matching the one in outlays. But — given the yearlong economic slowdown — surely this pace isn’t sustainable. We think that job gains will continue to slow, but despite tepid output gains, not by enough to undermine consumer confidence or wherewithal. Among the reasons: While significant job losses are likely in housing-related industries, the ‘two-tier’ economy, evident in the benefits of strong global growth for exports and output, likely will sustain employment. Job opening rates, which hit a new cycle high of 3.2% in December and sustained that level in January, suggest that companies are still looking to fill the ‘pent-up’ demand resulting from the hiring discipline of the first three years of this expansion. And the tightening of labor markets, evident in the decline in the jobless rate to a new cycle low of 4.4% in March, hints that employers’ anecdotal complaints about the difficulties in finding skilled workers have some validity. However, the slowing in productivity growth, to 2.1% over 2005 and 1.4% over 2006, raises questions of whether trend productivity and thus potential output are lower than previously thought. As we see it, trend productivity growth is roughly 2½%, which is good news for long-run inflation prospects. Indeed, we think that a below-trend, cyclical productivity undershoot is underway as job growth finally catches up with the economy, and we forecast a return to 2½% productivity growth in 2008. Such a cyclical undershoot is typical, but in this expansion, both the overshoot and undershoot have taken longer to play out. Corporate America’s hiring discipline, aimed at correcting the hiring excesses of the 1990s, yielded a 3.1% average annual gain in productivity in the first three years of this expansion — or 0.6% above the trend. In our view, the current undershoot is showing up in the productivity performance of years 4-6, averaging 1.7% — or about 0.8% below the trend. Shifts in the mix of output and employment may contribute to declining output per hour, if, for example, companies are now hiring less-skilled workers. And the plunge in housing may have trimmed nearly a percentage point from productivity growth over the past year: Although real housing outlays have tumbled by an estimated 16.3% over the past year, builders have cut residential construction payrolls by a mere 3.3%. Nonetheless, there is also evidence suggesting that the slowing in productivity growth has a significant secular or trend element. Business capital spending has been subpar, implying slower growth in the stock of business capital; that may have reduced gains in labor efficiency. Some have found evidence of slower growth of total factor productivity (TFP) in recent years, reflecting less rapid technological advances in both IT and low-tech industries (see “Reassessing Trend Growth: The Role of Total Factor Productivity in the Recent Slowing of Labor Productivity,” Macroeconomic Advisers, March 22, 2007). Many have thus revised down their estimates for trend labor productivity growth to 2¼% or a bit less. That’s logical, but the cyclical story also makes sense. Perhaps the truth lies in a blend of the two. Perhaps too, annual revisions will show that current data understated growth in output over the past three years. Even if the productivity slowdown is entirely cyclical, it may act temporarily to push up unit costs and inflation. We still think that core inflation has peaked but that the dispersion of inflation risks has risen and declines will come slowly. The housing recession should help. Rents and owners’ equivalent rents, which account for 38% of the core CPI, likely will decelerate as would-be home sellers put houses up for rent (decelerating rents will reduce the personal consumption price index (PCEPI) by less since they account for 17% of the core rate). Increased economic slack will also help. We estimate that GDP growth will average just 2.1% over the six quarters ended in the third quarter of 2007, below anyone’s estimate of potential growth. Such subpar growth is exactly what the Fed was aiming at to help reduce inflation pressures. “Speed” effects also matter; inflation tends to move in sympathy with the change in operating rates as well as their level. Just as rising operating rates boosted inflation between 2003 and mid 2006, so too will falling operating rates trim it. Still, a looser and less-certain relationship between slack and inflation implies that inflation will recede slowly. And the employment conundrum complicates the analysis; tight labor markets hardly evince growing slack. Moreover, some factors imply that inflation risks are rising again. The news on longer-term inflation expectations has tuned mixed. The 5-10 year median inflation expectation measure from the University of Michigan’s consumer sentiment survey has edged lower, moving to an average 2.9% over the past three months. But distant-forward inflation compensation (5 year, 5 year) has moved up by about 15 bp over the past month, although at 243 bp are well below their mid-2006 peaks of 270 bp. Increases in prices for imports, medical care, food and energy are also plaguing the near-term inflation outlook. The acceleration in non-auto consumer import prices to a 1.4% rate in February has just started to show up in consumer inflation gauges, especially in prescription drugs and household appliances. The former may simply reflect a rebound from falling drug prices in the first several months of 2006, while the latter seems unsustainable in the face of the housing slump. The 3% February jump in doctors’ fees — the biggest one-month gain in the 48-year history of the data — won’t be repeated, but alone added 0.1% to core inflation measured by the PCEPI. Overall food prices rose 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. But the perceived inflation threat from soaring food prices may be overblown and temporary (see “Yet Another Whiff of Stagflation?” Global Economic Forum, March 19, 2007). Energy quotes have soared this spring, with crude jumping by $8-10/bbl the past two months. At work were OPEC’s production cuts, cold winter weather, refinery downtime and rising geopolitical risks. We think that the price spike is transitory, because these factors should fade and the increase in non-OPEC supply will allow prices to drift lower. (see “Oil Price Spike: Sharp But Temporary,” Global Economic Forum, March 30, 2007). And while it won’t cause lasting damage to the economy or inflation expectations, the 55-cent per gallon leap in gasoline prices since mid-January isn’t over, and could filter through to higher core readings. Will slowing growth and rising unit costs squeeze profit margins? Our long-standing caution on earnings is starting to pay off. Following 18 quarters of double-digit gains, S&P 500 operating earnings rose at an 8.9% annual rate in the fourth quarter, and 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. Don’t bet on a rapid rebound; even if top-line growth begins to improve later this year, as I expect, I still think that the risks for earnings lie to the downside. Earnings are highly leveraged to growth. Continued sluggish domestic growth likely will promote margin compression as operating leverage fades. Pricing power seems to be cooling as operating rates have leveled off. And credit quality is deteriorating, suggesting pressure on earnings at lenders (see “Corporate Profits: Downside Risks,” Global Economic Forum, April 5, 2007). Fed officials adopted language aimed at giving them more monetary policy flexibility at their meeting two weeks ago. The change made sense. Inflation is below its peak, and downside risks to growth have increased. Thus, the Fed’s previous warnings of a possible policy tightening appeared inappropriate. Conversely, the Fed made it clear that inflation remains a concern. Balancing those risks, we still think the Fed will remain on hold for the remainder of 2007 as officials patiently wait for inflation to drift lower. The combination of hearty job gains, the decline in the jobless rate to a new cyclical low, uncertainty about the trend in productivity growth and unfavorable inflation readings likely will reinforce the Fed’s resolve. However, the easing moves we expect in 2008 will clearly depend on the inflation outlook, not on the calendar. For market participants, a second Fed change also matters. For the first time in four years, the Fed will henceforth provide less forward-looking guidance about prospective policy moves. The FOMC now agrees that characterizing risks to the outlook is the best way to indicate policy guidance, and that it should use explicit forward-looking language about the policy path only in "unusual circumstances." We think that the combination of rising uncertainty about the outlook — especially for inflation — and reduced forward-looking guidance from the Fed imply that term and other risk premiums will rise further, the yield curve will steepen irregularly and TIPs may outperform. The risks for investors are rising with crosscurrents swirling around the outlook for growth, inflation, profits and monetary policy. That markets have defied these uncertainties lately does not give us comfort because we see neither a rapid improvement in growth, a quick decline in inflation, or relief from the Fed. Forecast at a Glance | 2006E | 2007E | 2008E | Real GDP | 3.3% | 2.0% | 2.9% | Inflation (CPI) | 3.2 | 2.5 | 1.9 | Unit Labor Costs | 3.1 | 3.0 | 2.7 | After-Tax “Economic” Profits | 22.5 | 1.1 | 5.3 | After-Tax “Book” Profits | 19.4 | 1.1 | 2.6 |
Source: Morgan Stanley Research E = Morgan Stanley Research Estimates
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Reform Lives! What the Tokyo Election Meant
April 09, 2007
By Robert Alan Feldman (Tokyo)
Gov. Shintaro Ishihara won big in the Tokyo governor’s election. His victory had had three parts and bodes well for the future of economic reform in Japan. The three parts were style, organization, and demography. The party that weaves these three factors most cleverly will win the upcoming Upper House election in July. At the moment, PM Abe and the ruling party appear to be leading, but an LDP victory is far from certain. In particular, there are many areas for entrepreneurial politicians to shine. If they do so, and I expect they will, then reform in Japan has only just begun. Style, Organization, Demography The style behind Gov. Ishihara’s victory was his appeal as a strong leader. He defined issues, such as his attempt to bring the Olympics to Tokyo. Although public opinion polls suggest that only a small majority of Tokyo voters actually favor bringing the Olympics, his clear definition of an issue reinforced his reputation for decisiveness. He has created this reputation by forcing some decisions onto a reluctant bureaucracy, even though not all observers would agree with the reputation. The governor’s opponent, Shiro Asano, allowed Gov. Ishihara to define the campaign issues, took a long time to declare against the Olympic bid, and had no defining issues of his own. As has often been the case with the opposition in Japan, Mr. Asano fell into the opposition trap. He opposed, but did not appear to propose. It is ironic that Gov. Ishihara could win with a Olympic bid, since only a few years ago, another candidate, Yukio Aoshima, won the governorship by opposing a similar plan. Voters value a fighting spirit. The organization factor that aided Gov. Ishihara -- and other conservative candidates throughout the country -- was the Komeito Party, the coalition partner with the ruling Liberal Democratic Party (LDP). (Although the LDP did not formally endorse Gov. Ishihara, it supported him, with backing from the Komeito. The opposition Democratic Party of Japan (DPJ) supported Mr. Asano.) The Komeito organization was the key factor in bringing the very large majority to the governor. Gov. Ishihara received 2.8 million votes, compared to 2.7 million for all the other candidates combined, including Mr. Asano’s 1.7 million. The demography factor is the floating vote, i.e. voters with no set party affiliation. According to press estimates, this group was about 30% of the voters in the Tokyo election. This floating vote split evenly between Gov Ishihara and challenger Asano, at about 40% each, with 15% going to the Communist Party candidate. Thus, the DPJ is in trouble with the floaters. TokyoResults Will Boost Economic Reform The Tokyo result is positive for the reform agenda begun under PM Junichiro Koizumi. This is because the style and content of politics that won in Tokyo are precisely Koizumi’s style and content. The next major test in Japanese politics will be the Upper House election in July. (A second round of regional elections, on April 22, is unlikely to change trends.) There is an opportunity for either the LDP or the DPJ to win. To do so, however, a party must show strong leadership, have a good organization, and appeal to the floating voter. The winner will be the party that does better on these three factors. On leadership, PM Abe has the advantage over DPJ leader Ozawa. True, PM Abe’s general popularity has weakened, but that of Mr. Ozawa is lower. Moreover, although low, voter support rates for the LDP are more than double those for the DPJ. On organization, the Komeito is quite strong, as shown in the Tokyo governor race. However, non-LDP candidates did well at the local assembly level in elections around Japan. Moreover, labor unions -- which back the DPJ -- still have strong organizations too. The problem for the DPJ is that the party is much more centrist than the unions, and thus the willingness of union rank and file to work for the DPJ is questionable. On the floating voters, the problem is issues with identity. For the telegenic and articulate PM Koizumi, the identity issue was Reform, with a capital R, especially postal system reform. PM Abe, in contrast, has been vocal on a number of issues, including constitutional reform, education reform, and labor market reform. PM Abe is less telegenic and less forceful as a speaker. However, Mr. Ozawa suffers on these fronts even more than PM Abe. Overall, therefore, it appears that Tokyo results bode well for PM Abe and the LDP in the July election. Do they also bode well for political revival in Japan and for the world economy? Reform Is the Only Road to Victory I think the answer is yes. Strong leadership and large impact of floating voters is precisely the combination that leads to “retrenchment politics,” the politics that allows diffuse interests of the general public to beat vested interests of narrow support groups. Gov. Ishihara’s victory shows that there is huge opportunity for entrepreneurial politicians to win elections on popular, galvanizing issues. Another key issue is free trade agreements. PM Abe faces a hard choice. On one hand, the power of the farm lobby in Japan remains strong. On the other, higher farm productivity -- impossible under current rules -- is needed to raise food self-sufficiency, which is only 40% and falling. Protecting farmers means risking national security and prosperity. Why should the LDP stick with the farmers, if they can win the cities like they won Tokyo, raise productivity, and enhance national security to boot? Thus, the Tokyo election could be another nail in the coffin of Japanese agricultural protectionism. There are many other issues where public appeal against vested interests can force reform. Entrepreneur politicians are emerging, such as Yoshimi Watanabe, who has spearheaded PM Abe’s civil service reform against a torrent of opposition from within the LDP. Other issues: Education. Labor. Innovation. Corporate governance. Media. Finance. If the real lessons of the Tokyo election are learned, then reform in Japan has only just begun.
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RBI’s Tough Task of Fine Balancing
April 09, 2007
By Chetan Ahya (Mumbai)
Rupee Trading at High end of Trading Band
Large capital inflows over the last few months have caused major appreciation pressure on the rupee against the US dollar. The rupee has appreciated by 8.7% against the US dollar to 42.9 currently from the bottom of 47 in July 2006. However, on trade-weighted basis (nominal effective exchange rate, or NEER) the rupee has been largely stable. Against the euro, the rupee has traded within a narrow range over the last 10 months. Rupee Is Overvalued on REER Basis
Even as the Indian rupee is nearly steady on a trade-weighted basis, with India's inflation running higher than that of its major trading partners, on a real effective exchange rate basis (REER, trade-weighted rupee adjusted for inflation differentials with trade partners), the Indian currency has moved to its highest level in the last 14 years. We believe that the Reserve Bank of India (RBI) has traditionally used the REER trend as an important tool for monitoring the currency. On an REER basis, the rupee is now about 9% above its 10-year mean. The current-account deficit, excluding non-resident Indians' (NRI) remittances (CADEXR), widened to the high level of 5.1% of GDP at quarter-end December 2006. Although from a macro stability perspective one can look at the current account including a sustainable component of NRI remittances, we believe that in the context of assessing the implication for the relative competitiveness and domestic output growth, CADEXR is a better measure. Accelerating Capital Inflows the Key Driver
Rising forex inflows have pushed the REER into the overvalued zone. India's foreign exchange reserves have increased by US$48 billion over the last 12 months to US$200 billion. With the current account continuing to be in deficit, this increase in reserves is driven by strong capital inflows. Twelve-month trailing capital inflows have spiked up to an estimated US$43 billion from US$16.7 billion three years back. The bulk of this rise is due to non-FDI (non-foreign direct investment) inflows — primarily debt and portfolio equity inflows. Although FDI flows have picked up recently, non-FDI flows continue to account for about 75% of the total. Moreover, a large part of the increase in FDI is due to investment in real estate by foreigners. Overheating Limits Ability to Intervene in FX Market
Even as the RBI may be concerned about the overvaluation of the currency and the widening trade deficit, it is forced to let the currency move to the overvalued zone, as excessive intervention in the FX market is resulting in a large injection of liquidity in the banking system. Two years back, when domestic capacity utilization was low, the system could absorb this liquidity. However, with capacity utilization increasing to near peak levels, this liquidity has over the last few months posed a challenge to macro stability. Most macro indicators such as accelerating inflation, a widening trade deficit, a stretch in the banking sector balance sheet and property prices are flashing red. Fighting the Impossible Trinity
The RBI is increasingly facing the complex challenge of trying to pursue an open capital account, an independent monetary policy, and a managed exchange rate. Given that India has gradually opened up its capital account, the Central Bank is being forced to choose between the other two corners of the impossible trinity - i.e., an independent monetary policy and a stable exchange rate. The gradual liberalization of the capital account of the Indian economy coupled with a high global risk appetite over the last four years led to a surge in capital flows into India. As we highlighted earlier, these capital flows are, at the margin, overheating the domestic economy. This overheating has forced the Central Bank independently to pursue a tightening monetary policy in an effort to rein in domestic demand. To improve the effectiveness of its monetary policy, RBI has been sterilizing the large increases in liquidity caused by intervention in the foreign exchange market through the issuance of short-term bonds and multiple increases in cash reserve ratios. However, this effort is complicated by higher interest rates, which, in turn, attract more debt capital inflows (a result of the open capital account). For instance, we estimate that, during the quarter ended March 2007, the foreign debt inflows rose to US$10.5 billion from US$4.4 billion during the quarter ended March 2006. Although, so far, RBI has not taken any measures to control capital inflow, we believe that, if inflows surge further, the Central Bank will consider initiating measures to change regulations to moderate certain types of capital inflows (in effect, choosing an independent monetary policy and a stable exchange rate over an open capital account). For instance, it could reduce the limit on the amount of external commercial borrowings that can be raised by the corporate sector during a year. India's Challenge More Complex than for Other EMs
India's position is more complex than that of other EMs facing the impossible trinity. Unlike many other EMs, India is operating with tight capacity utilization as reflected in a high CADEXR and rising inflationary pressure, forcing it to pursue a relatively high interest rate policy. If RBI allows major appreciation of the currency to reduce inflationary pressure, it will risk further widening in CADEXR. For instance, most of the AXJ countries are running a current-account surplus with a very tame inflation trend. Indeed, India's current-account deficit is one of the highest, and its acceleration in inflation is one of the greatest amongst major emerging markets. Outcome Depends on Global Risk Appetite
Even in 1993-1996, although the Reserve Bank did initiate tightening measures with signs of overheating, we believe that the effective moderation in aggregate demand growth was driven by a slowdown in capital inflows. We believe that, in the current cycle too, while RBI is pressing the brake pedal, increased global integration of the financial markets has made monetary policy measures less effective. In our view, recent aggressive measures by RBI to increase the short-term cost of capital have been relatively successful so far in forcing banks to initiate sharp hikes in lending rates. For instance, the largest private sector bank has increased its mortgage lending rate by about 400 basis points to 12% since January 2006, taking it to a five-and-a-half-year high. We believe this will cause a soft-landing of the growth cycle. However, it is too early to come to a conclusion. If continued global risk appetite for EM assets were to ensure higher capital inflows into India, liquidity conditions could improve, supporting the current high growth rates for a while longer. However, such an outcome would increase the risk of further appreciation of REER and continued deterioration of macro indicators such as inflation, worsening the current-account deficit and asset prices to precarious levels in the intervening period, making the end game more painful. Bottom-line
Given that RBI has been restrained in tampering with the regulations related to capital inflows, it will need to choose between weak to stable currency and hiking of interest rates (to cool overheating in the domestic market). We believe that currently the RBI is focused more on slowing domestic demand growth and reducing inflationary pressure. In that context, even as it may succeed in maintaining the trade-weighted rupee stable, over the next six months, it will have to choose to allow appreciation of the rupee against the US dollar unless there is a meaningful reversal in the global risk appetite for EM assets.
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The Litmus Test for Liberal Democracy
April 09, 2007
By Serhan Cevik (from Istanbul)
The election of a new president will not lead to political paralysis, in our view. Every presidential election in Turkey’s history — from Kemal Ataturk to the current president — has been difficult and even controversial for one reason or another. Although the presidency is a symbolic institution, it has retained a crucial position in the state hierarchy and certain powers (like appointing the top echelons of the government bureaucracy and heading the National Security Council). From a historical point of view, as coalition governments failed to deal with pressing economic and political problems, the political system reached its first nadir in 1979 — among many to follow in the following decades — when the fragmented parliament could not agree on a presidential nominee. That unfortunately turned out to be a critical juncture in the events leading to the military coup in 1980. Since then, every election (presidential or parliamentary) has become a source of uncertainty and speculation. No wonder, as we approach this year’s elections, some observers have pointed out the possibility of military intervention, even attaching no less than 50% probability (see Turkey’s Coming Coup, Newsweek, December 4, 2006). But putting out a number or drawing probability trees does not make such claims more credible than those you could hear everyday in coffee shops across the country. In our view, there is no ground for a traditional or post-modern coup in Turkey, and here is why. Turkish society stands against a change in the country’s secular regime and orientation. Political tradition suggests that Prime Minister Tayyip Erdogan as the head of the largest parliamentary group would become the next president. However, even though the ruling party has enough votes to do so, there is a resistance to Mr. Erdogan’s candidacy in certain circles, arguing that it would threaten the basic principles of the republic. This line of reasoning stems from a theory that Mr. Erdogan’s Justice and Development Party (AKP) has a “hidden agenda” to get rid of secularism and to establish a state based on religious principles, like Iran. Beyond the obvious implications, such a development would destabilize Turkey’s economic and institutional progress and hurt international sentiment towards Turkey. Hence, we need a proper analysis, supported by facts not ideological arguments, to assess the risk. Let’s assume, for argument’s sake, the AKP has such a “hidden agenda” and there are no institutional safeguards against attempts to alter democratic principles. Even so, the question we need to focus on is whether Turkish society is interested in a fundamental change in the country’s secular regime and orientation. Thanks to the excellent fieldwork of the Turkish Economic and Social Studies Foundation, we have the answer in details. The number of Turks who identify themselves as Muslims increased from 35.7% in 1999 to 44.6% last year. But this is not enough to conclude that secularism is under threat. A comparison with international surveys reveals that a stronger sense of religious identity is a global phenomenon, and most likely the result of geopolitical developments around the world. Therefore, focusing on this figure alone, as many observers apparently do, could lead to erroneous conclusions. In our view, the strengthening of Muslim identity is not a sign of religious fundamentalism or the rejection of secular principles, at least in the Turkish case. Indeed, the number of Turks in favor of a state based on Sharia law declined from 27% in 1996 and 21% in 1999 to 9% last year. Put differently, the number of Turks opposing a religious state increased steadily from 58% in 1996 to 76% last year. Even among those who identify themselves as ‘Islamist’, 68% stand against a Sharia-based state structure. Turkeyshares with European countries a similar attitude towards liberal democracy. In our view, Turkey is not on the verge of a shift away from secular principles and will remain on its path towards a truly liberal democratic system. But, just like in many other countries, economic and political reforms lead to a clash between the status quo standing against institutional modernization and the EU accession process driving the country towards liberal democracy. In this environment, some observers give a special importance to the Turkish military’s position (which partly reflects its historical involvement in the establishment of the republic and the influence of the constitution written by the military regime after the 1980 coup). However, the great majority of Turks no longer wants to see the armed forces involved in politics, especially after witnessing a series of military interventions that failed to solve real problems and had unintended consequences. Furthermore, contrary to the conventional wisdom, Turkey already shares with European countries a similar attitude towards liberal democracy (see Jeffrey Dixon, A Clash of Civilizations, or Differences in Economic Modernization? Examining Liberal-Democratic Values in Turkey and the European Union, TUSIAD, September 2005), which supports institutional reforms demilitarizing the political landscape, bringing civilian control over the military, and empowering the rule of law and democratic processes. Therefore, we expect no political dislocation and care about Mr. Erdogan’s decision on the presidency only to the extent it affects general elections later this year.
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