China
Monetary Conditions Justify Reserve Requirement Hike
April 13, 2007

By Denise Yam | Hong Kong

Money growth remains above target in March

Though slowing from the 17.8% rate in February, M2 growth in March, at 17.3% YoY, remained above the central bank’s target (16%) for the year.  New renminbi loans made in March dropped 18% YoY to Rmb442 billion, but loan creation in 1Q07 rose 13% YoY to a total of Rmb1.42 trillion, nevertheless off the explosive growth pace in 2006 (+35%).  YoY loan growth slowed to 16.3% YoY, from 17.2% in February.  All in all, there appeared to be some slight slowdown in money growth in March, but the pace continued to exceed the government’s targets.

US$136 billion balance of payments surplus versus Rmb1.4 trilion intended liquidity withdrawal

China’s foreign reserves shot past expectations and reached US$1,202 billion at the end of March, implying an approximate balance of payments surplus of US$136 billion in 1Q07 (+141% YoY), after US$250 billion in 2006.  The surplus was well in excess of the trade surplus (US$46.5 billion) in the quarter, implying significant capital inflows in the period.  We have been following the size of the BoP surplus versus the extent of the PBoC’s quantitative tightening as an assessment of the tightness of the monetary policy stance.  Specifically, we attributed persistently strong loan growth and reacceleration in economic growth to incomplete sterilization of the BoP surplus over 2H04-3Q06 (see Soft Patch in 4Q but Friendly Liquidity Cushions Landing, November 17, 2006).  The large BoP surplus figure just revealed for 1Q07 helped justify the aggressive liquidity withdrawal we have seen in the last few months.  Bond issues net of maturing papers, together with the one percentage point hike in the reserve requirement ratio in 1Q07, were intended to withdraw Rmb1.4 trillion (US$182 billion) of liquidity from the banking system, larger than the BoP surplus.  Nevertheless, we do not yet have updated data on the actual change in financial institutions’ reserve deposits with the PBoC in the same period, so we cannot yet quantify the actual achieved sterilization in 1Q07.  Given that financial institutions increased their reserve deposits with the PBoC significantly towards the end of 2006 to a level well in excess of the required ratio, it is likely that the reserve requirement hikes did not result in a corresponding actual increase in the reserve deposits, and so the ‘achieved’ sterilization was likely smaller than what was ‘intended’.

How effective is the recent tightening?

Monetary tightening has, in the last three years, focused on liquidity management through sterilization of the balance of payments, and less so on raising interest rates (only four rate hikes of 27bp each since tightening began).  While this sterilization, together with administrative controls on lending, seem to have cooled loan and investment growth from their peak in 2003-04, low interest rates and hence the low cost of capital relative to the pace of economic growth have fostered speculation in asset markets and contributed to the government’s concern over the steep rise in the stock market.  This is evident in the apparent diversion of funds from household savings deposits to stock market investment (or speculation).  Savings deposit growth continued to lag other monetary aggregates, up 12.9% YoY in March, versus 15.9% in total deposits.  Low funding costs have continued to support the performance of the A-share market, which continued to set new highs of late, now 18% above the ‘peak"’ reached in January 24 that was followed by a two-week (12%) correction.  M1 growth, which remained high at 19.8% YoY (+21% in February), far outpaced that of M2, also demonstrating how depositors have allocated funds towards more liquid forms.

The latest reserve requirement hike —our interpretation

The PBoC announced, on April 5, yet another 50bp hike in the reserve requirement ratio to 10.5%, effective from April 16.  Similar to the previous reserve requirement hikes, the 50bp hike theoretically withdraws Rmb170 billion in liquidity from the banking system.  Nevertheless, reserve deposits held by financial institutions at the PBoC stood at 14.4% of total deposits at the end of December 2006, nearly four percentage points higher than the new requirement, so it remains uncertain whether this latest reserve requirement hike will have much of a tightening impact.  Besides, this Rmb170 billion incremental withdrawal is much smaller in size than bond issues in recent weeks.

Bond issues and reserve requirement hikescontinue to work, to a certain extent, as substitutes to each other as monetary policy instruments.  Bond issues are generally perceived to be more ‘flexible’ because the size of the issues are determined weekly in response to market conditions, and the effect on liquidity can be reversed by not issuing new bonds when they mature.  However, with the revival of the issuance of 3Y bonds since late January, and Rmb504 billion of such bonds issued so far, the PBoC has also resolved to a less flexible form of the traditionally more flexible instrument, suggesting that the PBoC’s concern over the persistence of such excessive supply of liquidity.  Meanwhile, the PBoC pays 1.89% on required reserves (0.99% on excess reserves), versus 2.6-3.3% on bond issues.  So, reserve requirement hikes are a cheaper way of sterilization.  In other words, the latest reserve requirement hike could be interpreted as a message that the PBoC sees a meaningful portion of the excess liquidity in the banking system as persistent, therefore substituting the more flexible, yet more costly, bond issues with a hike in the reserve requirement.

Fine-tuning interbank rates with bond issues

The PBoC has continued to work hard on guiding interbank rates through varying the size of its bond issues on a weekly basis.  With the interbank rate plunging again following the Chinese New Year seasonal squeeze, the PBoC had withdrawn Rmb900 billion since the week of February 26, net of maturing bonds.  2.7% seems to be roughly the level of 7-day SHIBOR that has been triggering the PBoC to switch between net injection versus net withdrawal of liquidity since November 2006, hence our interpretation that this is where the PBoC wants to target interbank rates.

What’s ahead?

We believe that the government is trying to bring loan, investment and overall economic growth down a notch this year, so a tightening bias is maintained.  The latest data for March and low-lying interest rates suggest more room for tightening ahead.  The reserve requirement and interest rate hikes so far this year have only brought the 7D interbank rate up from the trough of 1.4% to 2.4% currently, in our view, still below where we believe the PBoC is targeting.

Should the latest reserve requirement hike help lift interbank funding costs and halt the steep ascent in the A-share market (not quite the case so far), the PBoC could soften on bond issues, mitigating the impact of the reserve requirement hike.  We stand by our view that the sharp increase in commercial banks’ reserve deposits with the PBoC (+Rmb1.2 trillion in 4Q06) should weaken loan growth in the remainder of the year.  If it does not, more tightening is to be expected.

We believe that quantitative tightening will continue to dominate policy moves in the short term.  The PBoC is expected to carry on with sterilization of the BoP surplus through open market operations and more reserve requirement hikes.  However, we continue to advocate that quantitative monetary tightening should be combined with interest rate increases.  The cost of capital in China needs to rise over the medium term to achieve better allocation of financial resources.  We continue to expect more interest rate hikes in the next 12-18 months.

 

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Italy
Will Italy Spoil the EMU Growth Party?
April 13, 2007

By Vladimir Pillonca | London

We recently inched up our forecasts for euro area GDP growth to 2.5% for this year, after the exceptional 2.8% reached in 2006, which was twice the average growth rate recorded in the 2001-05 period.  Our US GDP growth forecast for 2007 now stands half a percentage point below our estimate for the euro area — a rare occurrence.   As discussed by Eric Chaney in A Perfect Landing (March 28), the upward revision of our euro area 2007 GDP forecast was prompted by positive survey evidence suggesting strong demand, both domestic and foreign, while inventories are running low.  There is little sign of the soft patch we were expecting in 1Q, despite tighter fiscal policy in Germany and Italy, Germany’s dreaded VAT hike, euro appreciation and high energy prices.  Instead, evidence so far this year points towards a remarkable resilience.

Soft or hard?

And it is not just survey data that are encouraging.  This week, economic (‘hard’) data surprised on the upside.  Both in Germany and in France (which jointly account for over 50% of euro area GDP), industrial production growth was surprisingly strong, defying any notion of a soft patch, at least in 1Q.  In contrast to the continued uncertainty afflicting the US outlook, the euro area seems to be doing just fine.  The biggest question mark revolves around Italy (which accounts for 18% or so of EMU GDP), which is emerging from a rare year of strong economic growth.

Thank you resilient global economy

There are positive external factors.  Notwithstanding slower growth in the US, global growth should remain robust, underpinning demand for Italian exports.  Our estimates for global growth are for 4.5% for this year and next, while the IMF’s latest projections are even more optimistic (see Steve Roach, Rosy Goes Global, for a more sombre assessment).

Besides, we expect Germany, Italy’s single largest export market, to grow strongly this year.  This should help to compensate for the restrictive effects on Italian growth of domestic fiscal tightening, a stronger euro, rising interest rates and elevated energy prices.  The net impact of these forces will ultimately help to determine how long it will take for Italian GDP growth to revert towards its sustainable rate of (potential) growth, which we estimate to be in the 1.1-1.3%Y range.

On some measures, the near-term outlook for Italy is not looking bad at all (for example, tax revenues were strong in the first two months of this year), but uncertainty remains high.  For starters, there is not yet much ‘hard’ business cycle data out for Italy.  In terms of surveys, the ISAE business confidence index predictably declined in 1Q, though it remains at a high level (0.8 standard deviations above its mean).  In terms of timely hard data, only industrial production is available.  While this variable is volatile and prone to revisions, it is also highly correlated with GDP, and its preliminary indications are not encouraging.  Industrial output posted two large consecutive falls in the first two months of the year (-0.5%M in February after the -1.7%M recorded in January) while industrial orders also fell in January (-2.1%M), especially from abroad.  The numbers for February will help to clarify the assessment, but the underlying trend, though moderating, remains positive.

On the sidelines in 1H, before embracing the party in 2H

Right now, we are inclined to believe that the risks are that the Italian economy will slow fairly sharply in 1H07, and growth will gradually pick up thereafter.  However, different data tell different stories.  Industrial production numbers suggest a very sharp slowdown, and even flag the distinct possibility of negative QoQ growth in 1Q.  In contrast, data on tax receipts for January and February and survey evidence seem to point towards a much gentler deceleration.  We think that economic growth will probably turn out somewhere in between these two extremes, with marginally positive growth in 1Q (not much above the 0.1%Q mark).

Looking beyond the first quarter, this year’s economic performance will benefit from some simple arithmetic: even flat QoQ growth throughout this year would result in GDP growth of 1.2% for 2007 as a whole — twice Italy’s average growth over the previous five years.  More formal (statistical) analyses also reinforce the idea that the growth shock that we experienced in 4Q06 will have a positive impact on growth for this year as a whole, as there is a fair amount of persistence in GDP growth. 

Specifically, the simulations we performed suggest that a positive shock to GDP, such as the one we experienced in 4Q, does not disappear instantaneously — but takes up to six quarters to unwind — and the one-year impact of a positive shock is positive though not that large.  Basically, this means that positive shocks tend to be associated with smaller but still higher-than-usual growth in later quarters.

Late maybe, but not a party spoiler

Overall, things seem to be looking up, especially beyond 1Q, though risks have not evaporated, and even a negative GDP reading 1Q is not out of the question.  This would not be a tragedy, but merely a correction after the growth jump recorded in the final quarter of last year.  Continued robust growth across the euro area and beyond will make Italy’s recovery easier to achieve, notwithstanding the likelihood of some near-term growth turbulence.  However, we continue to expect a gradual pick-up in the final two quarters of this year and a further improvement in 2008.

The biggest single risk to growth for the second half of this year and 2008 remains that of a domestic political crisis, especially ahead of the tricky discussion of electoral reforms and pensions (see One Government Crisis, Three Scenarios, February 23, 2007).  Major progress on these areas would be a significant step forwards, brightening the prospects of investing in Italy, both for equity and bond investors. 

In the absence of major setbacks, however, Italy should gradually join the growth party later this year, albeit at its own more sedate pace.

 

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Vietnam
Strong Macro Story but Market Running Ahead of Itself
April 13, 2007

By Chetan Ahya | Mumbai

Summary

Vietnam is one of the most impressive growth stories in the Asian region, with average GDP growth of 7.1% over the last ten years. The sharp rise in FDI commitments to US$10.2 billion in 2006 from US$6.8 billion in 2005 reflects the attractive growth opportunity emerging in the country. We believe that Vietnam can sustain 8%-plus GDP growth over the next five years, supported by positive demographics, availability of natural resources, accelerated pace of reforms and benefits from globalization, as it continues to open up its trade and capital accounts. However, in our view, the opportunity for portfolio investors is limited in a relatively underdeveloped domestic capital market. Indeed, we believe that the stock market is overheated and has probably run ahead of itself. The real stock market, with the listing of large blue-chip businesses, has yet to emerge. With the government committed to implementing the privatization program more aggressively going forward, we believe that the depth and breadth of Vietnam’s stock market will improve significantly by 2008.

Transition to market-oriented economy

Since the government first initiated major reforms (termed as Doi Moi) in 1986, the country has been steadily transformed from a completely inward-looking, centrally planned economy to a globally integrated, market-oriented economy. As in China, we believe that a stable political environment has played a key role in enabling this major transition without disruption. The government has spearheaded reforms in the following three broad areas: a) modernising and improving the efficiency of state-owned enterprises (SOEs); b) encouraging private sector participation; and c) strengthening the financial sector.

Modernization and privatization of SOEs: In the first stage, the government focused on improving the efficiency of the SOEs by introducing a greater degree of autonomy in decision-making and allowing SOEs to retain a certain portion of their profits. In the second stage, the government initiated privatization (commonly referred to as ‘equitization’ in Vietnam). Privatization has resulted in increased autonomy and helped improve efficiency and financial performance further. The influence of the government in the SOEs’ operations is still high, but its 2006-2010 socio-economic development plan (SEDP) indicates that the government will continue gradually to reduce its influence in SOE operations. To effectively separate its ownership from management, the government has started transferring its ownership rights into a separate company — State Capital Investment Corporation (SCIC). This entity will guide the restructuring process of the SOEs, primarily by helping improve the competency of top management, addressing financial issues (such as bad debt), streamlining the workforce and entering into an alliance with strategic partners for financial and technical support. As of early March 2007, SCIC owned equity in about 426 companies with a fragmented presence in a vast number of business areas. The government plans to consolidate the small companies and continue with aggressive privatization plans over the next five years. SOE reforms will continue to play an important role in the government’s liberalization efforts as the state still accounts for 40% of GDP.

Private sector participation: The introduction of the Enterprise Law in 1999 triggered accelerated development of the private sector. The 1999 Enterprise Law simplified the procedures for setting up businesses though the removal of licenses and permits issued at different government levels. The number of enterprises registered in 2000-2005 was 3.3 times that in the previous ten years. Indeed, industrial production growth in the private sector has markedly surpassed that of both the state and the foreign sector during this period, and the share of the domestic private sector in industrial output rose to 19.2% in 2005 from 6.4% in 1995. More recently, the 2005 Unified Enterprise Law (which supersedes the 1999 Law) and the Common Investment Law will bring all domestic and foreign players under the same governance rules by 2010 and further aid the development of the domestic private sector.

Strengthening financial sector: The government has implemented several measures since 2001 with broader reforms beginning only in 2006. Reforms so far have focused on restructuring banks, reducing their non-performing loan (NPL) ratios and improving capital adequacy ratios to meet with the Basel I requirements. However, the Vietnam banking sector still suffers from NPL problems. While NPLs by Vietnam accounting standards are very low, the ratio is believed to be relatively high according to international accounting standards. Risk management systems are still lacking, and the government’s influence on lending decisions is considerable.

The government is working towards implementing the following reforms to strengthen the banking sector: (a) increase independence of the central bank and reform of the supervisory function; (b) improve monetary policy management through development of money market and a secondary bond market; (c) restructure and improve the efficiency of the banking sector. The government also plans to strengthen the institutional capability of state-owned commercial banks (SOCBs) particularly in the area of risk management. It plans to divest its stakes in large SOCBs to significantly reduce its influence on these banks. In addition, it plans to get a strategic investor in each of the large SOCBs.

With underdeveloped financial markets, the country’s investments are still largely funded through the banking system. Over the last three years, the government has started implementing measures to increase the breadth and depth of the financial markets. It intends to privatize more than 50 SOEs during 2007, and the focus will shift towards listing larger SOEs to improve the supply and liquidity of the stock market.

Likely to sustain 8% GDP growth over the next ten years

The recent announcement of large foreign direct investment (FDI) projects in Vietnam only confirmed the country’s long-term story. Foreign investments registered and implemented have already picked up to 16.7% and 7.0% of GDP, respectively, in 2006 from 8.5% and 7.4% in 2002. This is not surprising, considering that Vietnam has achieved an average GDP increase of 7.1% over the last ten years, with the economy doubling in that period. Indeed, this growth compares favorably against 3.5% in the ASEAN Five, 6.5% in India and 9.2% in China. Economic growth so far has been well-balanced, supported almost equally by investments and private consumer spending. We rank Vietnam very high on our typical emerging market potential growth analysis framework of demographics, reforms and globalization — what we call DRG factors.

First,Vietnam is witnessing a favorable demographic trend, with the ratio of working to dependent population rising rapidly. In 2005, the median age of the population was 25 years; it will be 29 years in 2015 compared with 37 in China, 41 in Korea, 30 in Indonesia and 34 in Thailand, according to United Nations’ estimates. More importantly, the adult literacy rate in Vietnam is high at 90.3%, ensuring a good supply of skilled workers for the manufacturing sector.

Second,over the last few years, the government has implemented structural reforms at an accelerated pace. Structural reforms have improved the utilization of the working-age population, a key resource. A positive demographic trend may be a necessary condition for strong growth, but it is not a sufficient one. Favorable demographics need to be converted into a virtuous cycle. A critical step in this direction is the opening up of productive job opportunities through reforms. The Doi Moi (reforms) process that the Sixth Congress of the Vietnam Communist Party kick-started in 1986 laid the foundation for economic revival. The reform process has gathered pace recently with Vietnam’s efforts to integrate further into the international community through bilateral trade agreements and accession to the World Trade Organization.

Third, the backdrop of a strong trend of globalization in trade and capital has accelerated growth in these job opportunities. As Vietnam opted to be a part of the globalization trend, this proved to be a key trigger for a surge in its ratio of exports to GDP in the late 1980s and early 1990s. Manufacturing exports, particularly in textiles & garments and footwear, have been the country’s strongest segments.

We believe that continued support from the interplay of demographics, reforms and globalization will ensure a sustained acceleration in Vietnam of the virtuous cycle: faster growth in productive job creation — income growth — savings — investments — higher growth. Vietnam’s savings and investments have increased to 30% and 35% of GDP, respectively, in 2005 from 18% and 27% in 1995. We believe that the investment to GDP ratio will cross 40% over the next five years, supporting sustained 8%-plus GDP growth.

Limited immediate opportunities for portfolio investors

Vietnam’s capital markets are among the most underdeveloped in the region. The country’s first stock exchange was started in 2000. Since then, the government has initiated a number of measures to improve the depth and breadth of the market, but we believe it is still way behind other regional markets. The exciting macro story has enticed a large number of investors to Vietnam, but without the matching supply of fresh issuances and listings, the stock market has become overheated, with market capitalization to GDP rising to 35% at end-March 2007 (combined for the Ho Chi Minh VN-Index and Hanoi HASTC-Index), without the large blue-chip companies being listed as yet.

The government has so far privatized and listed only the small SOEs, most of which are currently trading at a valuation of 30-70 times 2006 earnings. Some of the large SOEs in the areas of banking and insurance, telecom, oil & gas, electricity and other infrastructure areas have yet to be listed. In addition to the rising foreign interest in the stock market, the excitement among residents has played a key role in overheating the stock market. Residents have resorted to direct and indirect borrowing from the banks to partially fund their investments in the stock markets. There are also suspected cases of companies investing in the stock market out of funds raised through IPOs.

The government is conscious of the potential challenges of an overheated stock market and has decided to initiate market-based measures to improve the stability of the stock market. In our conversations with policymakers, there was a clear message that they do not intend to initiate any direct measures to stop foreign capital inflows into the stock market. The government and the stock market regulator, the State Securities Commission (SSC), intend to initiate the following measures: (a) increase supply in the stock market by encouraging the large state-owned enterprises to list and through further divestment of government stakes in cases where SOEs are already listed; (b) increase supervision; (c) increase disclosure requirements; (d) impose restrictions on use of bank loans for funding investment in stock market by residents; and (e) ensure greater adherence to corporate governance guidelines.

Challenges and risks

The government needs to address a number of challenges to ensure sustained 8% GDP growth:

First, the most immediate challenge is to cool the overheated stock market without causing a major set-back to confidence in the domestic market and among foreign investors. Any major shock in the stock market could drive away the providers of risk capital for a prolonged period and affect the investment trend.

Second, Vietnam’s banking system still lacks the required robustness. A strong banking sector is a key ingredient of faster and stable economic growth in transition economies. An efficient financial sector can promote savings and enable the flow of a larger share of savings into productive investments. The efficiency of the banking sector will be important for systemic stability of the financial system.

Third, while Vietnam’s infrastructure spending (at 9-10% of GDP) has been picking up, the current state of its infrastructure is still poor. Vietnam must continue this high level of incremental spending, but, increasingly, building modern infrastructure will require technical as well as financial support from the private sector. The government needs to initiate measures to strengthen the legal and policy framework for private sector participation.

Fourth, Vietnam is facing the bigger challenge of building the soft infrastructure — economic and political institutions required for effective management and monitoring of a liberalized market-oriented economy. It needs to strengthen the overall institutional framework, including its judiciary systems, the presence of independent media, regulatory agencies for capital markets and industries like telecom, electricity and oil & gas.

Fifth, rising income and wealth inequality are likely to increase discontent among the lower- and middle-income population. As per the World Bank’s Gini coefficient measure, inequality in Vietnam was relatively high at 0.37 in 2004. We believe that this number has deteriorated further over the last two years. To ensure social stability, in our view, the government must initiate adequate policy measures to provide a safety net for the lower-income population.

Bottom line

Vietnam’s growth story has decidedly taken off. The country’s recent effort to participate in globalization through increasing openness on trade and capital accounts will provide more opportunities for the rest of the world. However, we believe that, in the near term, Vietnam will remain a more attractive play for foreign direct investors than for portfolio investors. In our opinion, the stock markets have yet to offer the depth in size and quality of the companies and are already overheated. However, the government is conscious of this aspect; we expect a number of large state-owned enterprises to be listed on the stock market over the next two years, providing the real investment opportunity.

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Korea
The Travellers
April 13, 2007

By Sharon Lam | Hong Kong

Koreans’ expenditure on overseas services (with travel as the biggest component) has been expanding rapidly in recent years.  Globalization is one factor driving Koreans to travel abroad in search of business opportunities.  Meanwhile, wealth accumulation, coupled with global visions, have led many Koreans to proactively improve their lifestyle.  Koreans have thus become the biggest travellers in the region, and we believe that this is only the beginning of a long-term trend.  Outbound travel businesses will continue to boom in Korea, in my view.  To a certain extent, this could help ease appreciative pressure on the currency. 

Koreans’ desire to travel abroad is not a concern itself.  It only indicates that underlying purchasing power of the economy is solid — i.e., Koreans have money to spend.  However, it becomes an issue when Koreans appear to be keen on spending abroad more than at home lately.  Sluggish domestic sentiment is one reason that I believe is causing many Korean consumers to feel more comfortable opening their purses in overseas countries.  Nonetheless, the upside is that as we know Korean consumers have the ability to spend, and we can expect a meaningful domestic consumption recovery again once sentiment revives.  I believe that sentiment will rebound soon as corporates in Korea appear to be investing again, the housing market is stabilizing and not crashing, the jobless rate keeps declining, North Korea seems to be pacifying, and a change in government is coming with the upcoming election.  Meanwhile, talk of a possible credit rating upgrade from Moody’s also indicates that economic fundamentals are on upside.  There are many good reasons to believe hat sentiment in Korea can only improve soon.  However, things could change if external conditions, particularly a US housing market recession, turn out to be worse than expected. In this case, it would not be just a Korea story, but non-Japan Asia would also be challenged.

From Rugby Sevens to tomb raiders

The last week of March saw an influx of tourists into Hong Kong due to the annual Hong Kong Rugby Sevens tournament.  This year saw a noticeable increase in Korean visitors.  In Central (the main business and shopping district), Korean tourists seemed to fill the streets.  While Mainland Chinese visitors to Hong Kong are typically big spenders, they seemed to be outnumbered by Korean shoppers and tourists during that week. While I was at the checkout counter in a shoe shop, the customers next to me were paying for a stack of Jimmy Choos piled up so high that I could not see the saleslady behind the counter. 

During a visit to Cambodia last week, I was told by many local people that Koreans are not only their major tourists but also among the biggest foreign investors as well.  At Angkor Wat and any major temple, I saw more Koreans than any other ethnic group.  Koreans often came in big groups and their tour guides were typically among the loudest (it was hard not to notice them).  The only areas where I did not hear any Korean were the local villages and the countryside.  After all, riding a motorbike to the countryside under 40C might not be a good idea for many.  Nightlife is scarce in Siem Reap except one small concentrated area, the so-called ‘bar street’, where there are a handful of bars that cater to tourists, while Korean karaoke bars can be found here and there. 

Overseas travel business will continue to boom

Outbound travel, both for business and leisure, is a rising trend in Korea.  This kind of trend typically emerges along with wealth and business opportunities.   Koreans are increasingly travelling abroad for business opportunities — i.e., foreign investment — mainly in the manufacturing sector, in search of a cheaper and more flexible production force.  It is therefore not surprising to see that Koreans now account for a significantly growing share of visitor arrivals in China (18% in 2006), Philippines (20%) and Vietnam (12%); and surely these destinations are also for leisure travel as well.  Other than establishing investment, Korean companies’ aggressive and successful brand marketing around the world is also a reason for the growth in business travel.  Increasingly efficient and profit-oriented Korean companies will only continue to seize business opportunities amid a rising globalization trend.

Leisure travel is another booming business in Korea, and it is likely only the beginning of a long-term trend.  Outbound leisure travel has a direct relationship with wealth growth; thus the surge in outbound tourism is strong evidence that Koreans are becoming ever wealthier.   Looking at Japan’s experience, its outbound tourism took off when PPP-adjusted per capita GDP (in 2005 prices) reached around US$23,000 in the mid-1980s, which was also when Japan became a more developed economy.  Koreans appear to be more eager to travel abroad than the Japanese.  In fact, Koreans are already spending similar amounts on outbound travel as the Japanese, while their income level is 30% less than their Japanese counterparts.  Nevertheless, we believe that the uptrend in outbound travel will only continue in Korea as income rises.  Korean income levels are expected to reach US$23,000 this year (PPP-adjusted GDP per capita in 2005 prices) — i.e., comparable to when Japan’s outbound travel began to soar. This could well be the beginning of another outbound tourism boom for Korea. 

An aging population is also contributing to travel demand due to longer retirement.  Korea’s current life expectancy is 79 years, compared to 70 20 years ago. This figure is expected to increase to 82 years in 20 years, according to data from the United Nations. The increasing number of retirees in an economy should have a direct correlation with the number of leisure travellers. Meanwhile, the younger generation is becoming increasingly exposed to travel due to overseas study and represents another pool of potential frequent travellers.  In fact, the growth in overseas study itself has generated more travel not just for students but for their families as well.  Koreans are expected to spend US$4.6 billion on overseas education this year, a steady rise from US$1 billion in 2000.

Airlines, travel agencies and tour operators are structural bulls in Korea, in my view. 

Inbound tourism in Korea, however, is much less buoyant.  Korea is running a deficit on tourism income, which reached a record high last year of US$8.5 billion.  Korea has been extremely successful in marketing its manufacturing brands, but the country’s tourism industry has lagged.  Korean TV soap operas helped to stimulate inbound tourism for a while in the last two years but it cannot help carry tourism that much.  To boost its tourism industry, Korea needs to invest in infrastructure and further develop and enhance its service sector.  A widening tourism income deficit will remain for some time, in our view.

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Global
Rosy Goes Global
April 13, 2007

By Stephen S. Roach | Seoul

It was inevitable.  Everyone has gone global.  And now it’s Rosy Scenario’s turn — that ever-voluptuous step-child of the 1980s who personified the wide-eyed optimism of America’s Reagan Administration.  In its bi-annual update on the state of the world economy and its prospects, the International Monetary Fund has come up with a baseline view of the world over 2007-08 that would make even Rosy blush. 

The latest IMF prognosis is the single most optimistic official forecast I have ever seen for the global economy.  After four years of 4.9% average growth in world GDP over the 2003-06 interval, the IMF is projecting two more years of the same — average gains of 4.9% over the 2007-08 period.  At first, I thought the “num lock” was stuck on the IMF computer.  Then I pored through the numbers, read most of the accompanying text, and quickly came to the realization they were dead serious. 

How optimistic is this forecast?  The IMF has calculated its official estimates of world GDP as measured on a purchasing power parity basis back to 1970.  Over this 37-year history, there is only one four-year growth spurt that is stronger than that of 2003-06 — the 5.4% average annual growth outcome for 1970-73.  Unlike the current IMF forecast, which calls for another two years of boom-like conditions, the four-year growth surge of the early 1970s was followed by a sharp recession in the global economy, with average gains of just 2.3% over the 1974-75 period.  In the modern post-1970 history of the global economy, there has never been a six-year run along the lines of the 4.9% surge the IMF is currently forecasting through 2008. 

That doesn’t mean it can’t happen, of course.  Our own baseline forecast at Morgan Stanley — average world GDP growth of 4.5% over the 2007-8 period — is not all that different from the latest IMF prognosis.  The biggest discrepancy is in Developing Asia — especially China, which has a 15% weight in the IMF’s PPP-based metric for world GDP.  The IMF is currently calling for Chinese economic growth to average 9.7% over the 2007-08 period — and that is 0.8 percentage point faster than our 8.9% forecast.  The IMF is also slightly more optimistic on India — another 6% of world GDP by their metric — with a forecast of 8.1% average growth for 2007-08 versus our estimate of 7.6% growth over the same period.  Finally, the IMF is a tad more optimistic on the US (2.2% vs. 2.0% in 2007) and Latin America (4.9% vs. 4.5%).  Other than these differences, we’re both in the same ballpark.

After 35 years in the forecasting business, I’ve learned not to take the precision of the exercise too seriously.  The value of the baseline forecast is less in the detail of the spreadsheet and more in the directional tilt of the expected growth trajectory.  On that basis, there is no mistaking the message from the IMF: They are looking for the strongest global boom in 35 years to be followed by yet another two years of comparable boom-like conditions — an unprecedented development for the modern-day global economy.  This is the global version of Rosy Scenario.

And that’s where I draw the line — largely for two reasons: First, I am much more worried about the downside to the US economy than either the IMF or our own US team at Morgan Stanley.  In my view, the odds of a spillover from the housing recession to consumer spending are high and rising.  I concede it hasn’t happened yet but remain convinced that it’s only a matter of time in a post-housing-bubble climate before the asset-dependent, income-short, overly-indebted, saving-short US consumer pulls back.  The scenario I have in mind envisions US consumption growth, which is currently running at a 3.2% clip year over year, slowing to around 2% over the next year — enough of a deceleration to push US GDP growth from its current 2% clip down toward 1% over the same period.  Should the US economy follow this type of trajectory, I have little doubt that the rest of the world will be quick to follow.  As I have long noted, I am not a buyer of the so-called global decoupling story (see my latest missive on this, “Spillovers versus Linkages,” 9 April).

My second concern pertains to the heightened risks of trade protectionism that are currently being manifested in the form of growing frictions between the US and China.  I remain convinced that the odds are quite high — probably around 60% at this point — that a bipartisan, WTO-compliant currency or trade bill will pass both houses in the US Congress with a veto-proof margin by the end of this year.  This bill will impose far more stringent sanctions on China — either in the form of more broadly based countervailing duties or anti-dumping remedies — than the recent actions initiated on paper products and intellectual property rights.  The possibility of Chinese retaliation to such legislation needs to be taken quite seriously — retaliation that could take the form of restricting US fixed or portfolio investments into China or even reallocating a portion of the new flow of FX reserve accumulation away from China’s historical pattern of dollar-denominated buying.  In the latter instance, dollar and US real interest rate outcomes could be far more severe than those assumed in the IMF baseline — with far more worrisome consequences for the global economy and world financial markets than suggested by Rosy Scenario.

Interestingly enough, if you take the time to read the latest World Economic Outlook of the IMF, both of these risks are given center stage in the analytical chapters that accompany their baseline forecast.  There is a 40-page chapter on global decoupling and an equally extensive effort on the tensions between capital and labor that lie at the heart of the globalization and protectionism debate.  In many respects, these efforts are music to my ears.  The framework laid out in both of these chapters is very similar to the analysis I have been presenting for quite some time.  The difference is in how far the IMF is willing to push the very concerns they highlight.  On global decoupling, they concede a US spillover from housing to consumption would take a serious toll on the global economy; in the end, however, they side with the “containment crowd” – that consumers will remain largely unflinching.  On the globalization debate, they document in great detail the declining share of labor income in the developed world — down some 8 percentage points of developed world GDP since the early 1980s.  They simply don’t believe that this will have actionable consequences in the political arena – a conclusion that is understandable for the world’s official stewards of globalization but one that I very much reject on the basis of my recent experience in Washington (see, for example, my 30 March dispatch, “The Ghost of Reed Smoot”).

Financial markets are currently discounting something quite close to the IMF’s baseline scenario.  Should either of the IMF’s concerns come to pass — possibilities that worry me a good deal — most major asset classes could be hit quite hard.  In the end, I think the biggest disservice done by the IMF’s global prognosis is in the conclusions on risk assessment.  Ironically, after having gone to great lengths to document the major risks and concerns in the global economy, the IMF then dismisses the very analytics it so carefully develops.  In their own words, the “Risks to global growth now seem more balanced than six months ago….”  The siren song of Rosy Scenario has never seemed more seductive.

 

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United States
Business Conditions: Confirming the Mid-Cycle Slowdown
April 13, 2007

By Shital Patel and Richard Berner | New York

The Morgan Stanley Business Conditions Index (MSBCI) improved in early April, increasing two points to 45%.  The less-volatile three-month moving average continued its steady, albeit glacial, improvement from the January low, also increasing two points to 45%.  While this is a welcome increase, business conditions have not meaningfully improved; the level is still below the 50% threshold that separates growth from contraction (more precisely, it indicates whether a majority of respondents is growing or shrinking).  More ominously, forward looking indicators such as advance bookings and business conditions expectations deteriorated this month, suggesting that this improvement may not last.  (As a reminder, this month we are implementing our new seasonal adjustment technique for the headline MSBCI.  Please see note at end for details.)

This month, at least, the dispersion of results tilted slightly towards improvement.  Business conditions rose for 18% of the groups, up from 14% in March, while conditions deteriorated for one-quarter of the groups, down from 28%.  However, it is important to remember that conditions remained unchanged for a full 57% of the groups.  Improvement was concentrated in the materials, consumer staples, and utilities sectors, while conditions deteriorated for the consumer discretionary, IT, industrials, and financials groups.  Nonetheless, the manufacturing sub-index improved two points to 52%, while the services index increased four points to 41%.

However, there is no mistaking weakness in business conditions, echoed in the sluggish tone to economic activity portrayed in official data.  Earlier this week, we marked down our forecast for 1^st half GDP growth to 1.5% due to still-high energy prices, a deeper housing recession, and additional weakness in capital spending; in January, this forecast stood at 2.6%.  Such weakness is often the prelude to a recession, with the trigger being an unexpected shock.  What are the chances that the MSBCI is warning of such risks?

In our view, the MSBCI and other business cycle indicators do not point to recession.  Rather, they suggest that we are in the middle of a mid-cycle slowdown, as in early 1995, and we think that the odds of recession are still around one in five.  To be sure, we launched the MSBCI in June 2002, so we don’t have enough history to observe its performance in a recession or in a past period of sluggish growth.  But we can look to other past data to inform that judgment.  Real GDP growth averaged 0.9% in the 1^st half of 1995 while the ISM index troughed at 45.9%.  In contrast, our near-term, bearish view involves 1.6% growth in GDP, while the ISM seems to have bottomed at 49.3% in January of this year, at a much higher level than during the 1995 experience.  Unbelievable as it may seem, the economy today is stronger and business conditions are more vigorous than they were 12 years ago.

Even if we are in the midst of a mid-cycle slowdown, how long might it last?  According to our survey results, weakness will persist for some time.  Forward-looking data are tepid.  We asked analysts whether advance bookings for the next 1-6 months have increased or decreased.  After a 13-point increase over the prior two months, the advance bookings index retreated 11 points to 37%, the third lowest reading in the history of the question.  Much of the weakness is concentrated in the IT and financials sectors.  Meanwhile, our business conditions expectations index declined three points to 49%.

Many suspect that easy financial conditions, which have long been a tailwind for the outlook, are tightening and thus becoming a headwind.  Subprime mortgage fears certainly have promoted consumer lender caution.  However, there is scant evidence of caution in business credit; our survey results suggest that financial conditions are only a mild restraint at this point.  The credit conditions index remained unchanged at 49% in early April.  We’ll monitor credit conditions closely as any significant downside could be a cause for concern.

While incoming data point to a Q1 contraction in capital spending, we still believe that pent-up demand for capex remains.  The recent decline reflects CFO cautiousness as well as capex discipline.  Is caution fading? The Conference Board CEO business confidence index increased three points to 53 in 1Q07, but that ray of hope may simply be a lagging indicator since it is a quarterly survey.  Our survey results suggest that capex plans have moderated but haven’t weakened notably: 51% of the groups plan to increase capex over the next three months, above the historical average of 47% and up one point from last month.  35% of the groups plan to keep spending unchanged and only 2% have plans to decrease spending by 6% or more.  The industrials, energy and utilities sectors have the most robust capex plans. 

Although capex plans have held up reasonably well, hiring plans weakened this month.  32% of groups plan to increase hiring over the next three months, down from 38% in March and slightly below the historical average of 33%.  18% of the groups plan to cut payrolls.  The IT, industrials, healthcare, and energy sectors, along with the retail hardlines and REITs, have plans to increase hiring.  Despite weak economic growth, payroll growth surprised to the upside in March’s employment report.  However, our survey painted a very different picture of recent job growth.  Only 18% of analysts noted that companies have stepped up hiring, down sharply from the 33% recorded last month, and the fourth lowest reading on record.  Not surprisingly, as the ADP employment indicator confirms, small firms account for most of the hiring.

Because of slower-than-expected domestic volume growth, it is no surprise that 1Q07 earnings growth estimates have been slashed to 3.4% from 8.0% in the beginning of the year according to our US strategy team.  However, pricing conditions could also depress growth in the bottom line.  Our pricing conditions index decreased five points to 56%, providing some relief to the threat of stagflation.  The percentage of groups that raised prices from a year ago stood at 41%, down slightly from 45% last month, while the percentage decreasing prices increased to 30% from 24%.

While price increases have decelerated, so have costs, which may temper margin compression.  Prices charged have risen faster than unit costs over the last three months for 26% of the companies, up from 18% in March.  Material and/or labor costs outpaced prices charged for 36% of the companies, down from 49% last month.  We also asked analysts this month whether earnings have decelerated faster than sales at companies under their coverage over the last three months.  Earnings have decelerated slower than sales for 30% of the groups, while earnings have decelerated at the same pace for 11% of the groups.  Of the 34% of groups where earnings have decelerated faster than sales, most analysts cited that costs have risen faster than prices (or in one case, prices have fallen faster than costs), while others noted reduced operating leverage and deteriorated credit quality. 

Looking forward, we asked analysts whether there were upside or downside risks to their 2007 estimates and whether they were to the top or bottom line.  Not surprisingly, fully 40% of respondents noted downside risks to their top-line estimates mostly from weak domestic growth.  Domestic growth is a major concern for the industrials group.  There is risk to the bottom-line for 26% of the groups, mostly in the IT sector.  Analysts cited several reasons including higher input costs, interest expense, and a tougher pricing environment.  21% of analysts believe there are upside risks to bottom-line estimates, most expecting lower input costs.  Finally, only 14% of the groups see upside risks to top-line growth.  The margin outlook for 2007 deteriorated slightly in April with only 52% of the analysts expecting margins to expand at companies they cover.  This is down from 60% in March and is significantly lower than Street estimates.  Street analysts expect margins to rise at 62.1% of S&P 500 companies.

NOTE: We have nearly five years of history for the MSBCI, enough to adjust the series for normal seasonal variation using the X-11 Arima seasonal adjustment technique.  Previously, we had used seasonal factors from the Institute for Supply Management (ISM) manufacturing diffusion index.  However, seasonally adjusting the series ourselves will result in revisions to past data, although by not more than one point in either direction.  The pattern of the data will remain the same.  Despite the potential revisions, we still believe using X-11 is the best technique because it will capture idiosyncratic seasonal factors that other methods would miss.

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Japan
Solid Strategy, Unclear Basis
April 13, 2007

By Takehiro Sato | Tokyo

Upbeat scenario and forward-leaning stance to remain in place; impression likely to be somewhat hawkish

A number of the risks identified by the BoJ have recently been materializing, but we expect the Outlook Report coming on April 27 to reiterate the bank’s upbeat assessment of the economy and the prices, as well as a forward-leaning policy stance. Overall, the report is likely to leave a somewhat hawkish impression.

Meanwhile, although the median GDP growth forecast in the Policy Board’s F3/08 outlook will probably stay largely the same, a lowering of the core CPI inflation outlook is inevitable. We think that the F3/09 outlook, due to be released for the first time, will call for a settled growth rate of around 2%, and continuation of measured improvement in prices. The outlook for F3/09, however, is unlikely to be taken realistically. After all, a hawkish overall impression notwithstanding, the markets may remain skeptical about the forward-leaning stance as prices continue to trend below the BoJ’s outlook.

Views on consumption and prices are the centrepiece, but don’t expect surprises

The outline of the economic outlook should remain unaltered, but the delayed recovery in wages will require adjusting the outlook for personal consumption to a more realistic level. Actually this was modified already in the January Monthly Report, in an interim assessment of the biannual October Outlook Report. Having said that, recent consumption data have been increasingly solid, notwithstanding the sharp rebound in October-December, and since the February rate hike the BoJ has upgraded its assessment of the current state of personal consumption half a notch to “has been firm”. In the corporate sector too, the new fiscal year’s capex plans in the Tankan have made for a good start to the year, especially in non-manufacturing, and the BoJ is becoming increasingly confident in the firmness of both the corporate and the household spending. Although some risks are materializing — in Japan, a second straight month below 50% for the coincident index of the business conditions due to worsening production and shipment-related data in manufacturing industry, and widening wage declines; in overseas, sign of real correction in the US housing market — we expect the economic tone of the April Outlook Report to be generally upbeat.

The price assessment should also be fundamentally unchanged, despite the recent slide back into negative territory. The BoJ’s Monthly Report for April reiterated the official view that it is projected to continue to follow a positive trend, as the output gap continues to be positive, and this view is likely to be adopted in the Outlook Report as well. However, the BoJ in its October Outlook Report has already formally recognized that the sensitivity of prices to the output gap is diminishing. With price risks recently coming to the fore and with further deterioration in wages, one of the key props for a stronger price outlook contrary to the BoJ’s initial expectations, the BoJ would be wise to make a convincing restatement of its case for price recovery — though we think that new arguments are unlikely to be forthcoming.

Incidentally, the current outlook for the core CPI in F3/08 (+0.5%) will need to be moderated, but to achieve a forecast of +0.2% would require YoY improvement in the so-called ‘core of core’ index of 0.06 to 0.07pt every month. The recent stably low readings suggest that this is a tough task, and that another undershoot of the BoJ’s price outlook is likely. Indeed, we are taking seriously the possibility that the core CPI could be negative throughout the rest of F3/08. This is a conclusion readily formed through analogy with the shape of the recently flat Phillips curve. Note that even if the output gap becomes more positive (the inflation gap widens), due to the marked lowering of price sensitivity, mechanical application of an econometric model could show absolutely no improvement in the core of core index. In this case, with a constant oil price assumption, it is no stretch at all to conclude that prices will be flat or down slightly throughout this fiscal year.

Market implications

Whether it hits the mark or not, the BoJ’s assessment of the economy and prices is likely to be upbeat, and point clearly towards ongoing normalization of the monetary policy. The recent drop in visibility for overseas economies and domestic price stagnation mean it is unlikely that the April Outlook Report will prompt the market to expect a third policy rate hike any earlier than currently, however.

On the other hand, the January-March GDP data to be announced in mid-May should indicate that the economy is continuing to expand nicely even after the buoyant growth of October-December, driven by personal consumption and capex. If this forecast is correct, expectations for another rate hike could be fanned again in May or June, by which time the aftermath of the Upper House elections will have moved into view.

Risks

A path of steady growth for the economy from the April-June quarter onwards cannot be taken for granted. The onset of a correction in manufacturing industry and negative growth for capex make this crunch time for whether the US economy will miss a soft landing and go into a deeper soft patch, and sub-prime problems have caused financial institutions to rein in lending attitudes to individual borrowers. This could well affect near-term US consumption, with a knock-on impact on the booming Japanese automobile exports to North America. The production rebuilding in manufacturing industry could therefore be unexpectedly limp from the April-June quarter, exacerbating the risks of a slowdown in Japan’s economy from mid-year, as happened in 2004.

If price deflation intensifies towards the summer and April-June GDP is weaker than foreseen, the market’s consensus for a rate hike in August or September could be blown away in a trice. Our main scenario for the economy is basically upbeat like the BoJ’s, but does incorporate some degree of slowdown in the April-June and July-September quarters, and also factors fully for negative prices. For us the ‘risk scenario’ here therefore has a comparatively high probability, and is not just an outside possibility.

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Korea
Stable Interest Rate
April 13, 2007

By Sharon Lam | Hong Kong

In line with expectations, the Bank of Korea left its overnight call rate target unchanged at 4.5% in its monthly meeting today.  I expect the policy rate to remain unchanged in the next six months.

Yields are likely to be up and down in the coming months: We have long been arguing out of consensus that it is too early to expect rate cuts due to solid fundamentals.  The recent spike in yields is a reversal from the market’s wrong previous expectation of a rate cut, in our view.  While we are positive on the overall growth outlook for 2007 in Korea, we still expect a bottom in 2Q as external demand is troubled by the US housing recession.  Speculation on rate cuts could emerge again soon when we see some temporary slowdown in production and exports in the next 1-2 months, causing yields to flatten.  When the economy fully recovers in 2H07 as we predict, yields will rise again.

Why no rate cut?  The current slowdown is very mild, more a normalization of growth rates than any real deterioration in the economy.  Korea’s current interest rate level is still slightly below a neutral level, which we believe should be 4.75-5%.  With strong money supply growth and a solid economy, there is really no need for the central bank to continue its expansionary monetary policy.  Low inflation could seem to favor a rate cut, yet we see low consumer/producer inflation as a globalization phenomenon.  Asset price inflation in Korea, however, is high and needs to monitored. 

Why no rate rise?  The housing market already appears to be stabilizing, and mortgage lending is peaking out.  Korea’s credit profile, both corporate and household, remains healthy, in our view. 

Risks of domestic growth biased to upside: Domestic demand has outperformed expectations lately and we believe that this trend will sustain as sentiment improves towards the presidential election at year-end.  Indeed, encouraging economic prospects are positively attracting the attention of credit agencies.

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