Japan
Policy Watch: Smiles and Enthusiasm
April 16, 2007

By Robert Alan Feldman | Tokyo

Contrary to the impression in the Western press, policy momentum is moving in favour of the Abe government. This disconnect was highlighted in a recent speech by Cabinet Secretary Yasuhisa Shiozaki. He was all smiles and enthusiasm. Two factors lie behind this attitude — major progress on Japan-China relations and on civil service reform. The policy progress will bring new momentum to the Abe government in other fields, and will help the ruling party’s prospects in the Upper House election in July, in my view.

Chinaand Japan play cards

Premier Wen Jiabao visited Japan this week and — in a speech to the Japanese Diet televised in both China and Japan — thanked the Japanese people for their support of Chinese economic development. Premier Wen’s speech showed that China is playing its Japan card. China is eager to accelerate progress on environment and energy issues, on which Premier Wen admitted difficulties in recent speeches to party leaders in China. He needs Japanese technology.

PM Abe was just as gracious, and showed that Japan is playing its China card. By making progress in relations with its big neighbour, PM Abe raised his credibility as a leader. A little noticed fact, pointed out by Mr. Shiozaki:  China has agreed to put references to the abduction problem (North Korean abductions of Japanese citizens) into the communiqué of the recent Six Party Talks on denuclearization of the Korean peninsula. Until now, China had refused to do so.  The two sides are trying to help each other.

Civil service reform: Far from boring

Civil service reform is a boring issue to foreign observers, but a popular one among domestic voters. Therefore, it is a key political issue for Abe. He is forcing through a means to prevent influence peddling by Diet members and bureaucracies, when civil servants take cushy jobs in industry after retirement. He accomplished this by finding an intelligent, forceful, TV-friendly minister in Yoshimi Watanabe.

Moreover, the implications of PM Abe’s success (so far) in this issue are wider than first meets the eye. So far, the Abe government has lacked a ‘star’ in the Cabinet, i.e., a minister who could capture the imagination of the public. This element was key for PM Koizumi, as seen in the way that Koizumi deployed Minister Heizo Takenaka on controversial issues. The momentum suggests that Mr. Watanabe could play the Takenaka role in PM Abe’s government.

 

Deeper implications

There was also an important overlap between domestic and foreign issues in the agreements with Premier Wen:  China agreed to open its market to Japanese rice imports. Although limited to 25 tonnes for now, the rice agreement with China kills three birds with one stone. First, it shows progress in relations with China, and thus wins China some points in the Japanese popular mind. Second, it demonstrates that Japanese agriculture can have markets abroad. Third, it shows that Japan has the potential to be a much larger agricultural exporter, if competitiveness improves. (The rice for China will be a luxury food there.) Indeed, PM Abe has said that he wants agriculture to be a strategic industry of Japan. The agreement with China shows the proto-credibility of this vision.

Apart from relations with China, Mr. Shiozaki also stressed the Abe government’s attack on the silo mentality of Japanese policymaking. In the security area, Japan will start a Japan National Security Council; heretofore, the Foreign Ministry, Defence Ministry (formerly Agency), PM Office and other agencies would jealously guard secrets. Now, a cross-ministerial conference will improve coordination. This model is being copied in other areas, such as environment policy. Such bodies can be very effective, when used properly, as shown by the Council on Economic and Fiscal Policy. Such silo-busters give a platform for policy entrepreneurs to push cross-ministry issues, and allow more coordinated policies.

On economic policy, Mr. Shiozaki said that the key element in PM Abe’s economic vision is raising productivity, especially in services. In this regard, the government will start organizing national and regional consultation committees, including members from labor unions, companies and government. Such task forces are expected to bring ideas for better use of resources. Shiozaki mentioned several specific measures, such as 24-hour operation of Haneda Airport (the close airport in Tokyo) to Shanghai, enhanced function of the Tokyo Stock Exchange, pay-for-performance in the civil service, and energy security research.

Out of the doldrums

Mr. Shiozaki’s smiles and enthusiasm suggest that PM Abe and his inner circle have escaped the doldrums that hurt them from mid-December through the early spring. They now have a few victories, and are learning the techniques that bring positive momentum. One such technique is using entrepreneurial politicians like Mr. Watanabe to fight the old guard in the LDP.

Domestic investors are beginning to feel this enthusiasm and momentum. Foreign investors, however, are behind. If the news on better reform momentum permeates foreign investors as well, then overall market sentiment is likely to improve, if gradually. Note that the press will likely try to sell papers with Abe-bashing through the summer, in the run-up to the July election for the Upper House. It is important for investors to distinguish between the views of voters and those of the media.

Risk of ‘milqutoastitude’

The main risk is that PM Abe fails to ignite enthusiasm. Retrenchment politics, which Abe must practice if he is to succeed, require direct contact with the population (often through the media). The Abe Cabinet has not been particularly strong in this regard. True, he has maintained PM Koizumi’s practice of a direct email magazine. However, Economics Minister Ota hardly ever appears on television, unlike her predecessor Mr. Takenaka. Even PM Abe described himself as “Chinese medicine” (kampo-yaku), compared to “shock therapy” (gekiyaku) used by his predecessor.

Another risk is personnel decisions. The recent appointment of two new members of the Monetary Policy Committee at the BoJ does not inspire confidence. The two new Board members have no experience in monetary policy-making, and were approved by the Diet with no discussion. Although Mr. Shiozaki said that the government wants to encourage personnel transfers in and out of the public sector, the standards and procedures for such transfers do not exist. Nor does sufficient pension portability. Investors will be watching to see whether such systems are developed (e.g., by Mr. Watanabe’s new Government Job Bank) and applied to important upcoming appointments.

 

Global
The Next Asia
April 16, 2007

By Stephen S. Roach | New York

Asia is entering a new phase of its dynamic growth story.  It is a phase that is likely to be dominated by an increasingly powerful pan-regional integration.  The first stage of this transformation saw the emergence of the China-centric Asian supply chain.  The next stage is likely to be driven by new linkages between the region’s two powerhouses — China and Japan.  Asia — to say nothing of the world economy and global competitiveness — may never again be the same.

The seeds of this dramatic transformation were sown in the depths of the Asian crisis of 1997-98.  Collectively, the region took this dark episode as a major wake-up call — reacting with a determination to build new safeguards that would prevent such a wrenching upheaval from ever recurring.  Yet formidable structural impediments complicated this strategy.  Lacking in solid support from self-sustaining private consumption, Asian economies were still heavily dependent on foreign trade as the sustenance for economic growth.  According to the Asian Development Bank, the export-to-GDP ratio had risen to nearly 55% in 2005 — essentially double the world average.  Ironically, that left the region still vulnerable to external shocks — albeit more in the trade sector than from international capital markets, as was the case in 1997-98.  Nevertheless, Asia moved aggressively to insulate itself from external shocks — not only by reducing its vulnerability to the vicissitudes of world financial markets but also by forging new intraregional linkages through trade flows and cross-border investment. 

The good news is that Asia’s persistent dependence on external demand masks a growing and significant reliance on pan-regional trade.  Indeed, the share of Developing Asia’s intraregional exports went from 26% in 1985 to 37% in 2005.  Particularly important was the emergence of a China-centric Asian supply chain.  That was especially the case within Greater China.  According to IMF data, fully 22% of Taiwan’s total exports went to China in 2005 — nearly eight times the 2.8% share of 2000; at the same time, 45% of Hong Kong’s exports went to China in 2005 — up significantly from the 34% share of 2000.  It is a similar story elsewhere in developing Asia — especially in Korea, where the Chinese share of exports went from 10.7% in 2000 to 21.8% in 2005, and even in India, where the portion of exports going to China surged from 1.8% in 2000 to 6.6% in 2005.  Moreover, during the same five-year period, the Chinese export share for the Philippines rose more than five-fold, whereas it essentially doubled in Indonesia, Malaysia, Thailand, and Singapore.  And these figures probably don’t capture the full extent of Asia’s new China-centricity; in particular, there is good reason to believe that an increasing portion of third-party trade linkages — like between Korea and Taiwan — ultimately flow into the Chinese assembly line.

Up until recently, Japan has been on the outside looking in insofar as pan-Asian trade integration is concerned.  According to the Asian Development Bank, the Japanese share of Developing Asia’s exports fell to 9.9% in 2005, almost half the 18% portion prevailing in 1985.  Nevertheless, like the rest of the region, Japan has tilted significantly toward China; shipments from the PRC and Hong Kong, combined, have surged from 5% of total Japanese imports in the early 1990s to close to 21% today.  Its overall trade volume with China has doubled over the last five years.  This trend, in my view, may well be an important precursor of the second stage of pan-Asian economic integration — a new set of linkages between China and Japan.  Collectively, these two nations — the world’s second and fourth largest economies — account for 82% of pan-Asian GDP as measured by the IMF’s purchasing-power-parity metrics.  If they come together, as I now suspect, the implications for Asia — and quite possibly the world — would be profound. 

The possibility of such a new thrust to pan-Asian economic integration is more than just idle curiosity.  In fact, that very potential was in the air during the discussions I had last week in Japan.  My visit overlapped with that of China’s Premier Wen Jiabao — the first such mission of a senior Chinese official in over six years.  Premier Wen’s visit, of course, follows last October’s trip to China by Prime Minister Shinzo Abe – the first foreign excursion of the then newly elected head of the Japanese government.  Both leaders appear to be putting great personal stake in cementing a new future for one of history’s more volatile relationships.  Premier Wen’s speech to the Diet – the first time a Chinese leader has ever addressed the Japanese legislature – put the economic relationship between the two nations in an important context.  Wen’s stress on complementarity and interdependence spoke of a China that appears willing to embrace Japan as a strategic economic partner rather than as an adversary — especially in the areas of the environment and energy.  I agree with Robert Feldman that China and Japan are now “playing each other’s cards” — not just on the economy but also with respect to their painful history, as well as important regional security issues pertaining to North Korea (see his 13 April dispatch, “Policy Watch – Smiles and Enthusiasm”). 

Japan has certainly come a long way in the past five years in rethinking its approach toward China.  As recently as 2002, leading Japanese government officials were still casting China in the role as a major source of Asian instability — accusing the PRC of not only exporting deflation but also being responsible for a “hollowing out” of Corporate Japan (see the 12 December 2002 op-ed piece in the Financial Times, “Time for a Switch to Global Reflation,” jointly authored by Haruhiko Kuroda, then Vice Minister for International Affairs at Japan’s Ministry of Finance, and his deputy, Masahiro Kawai).  The Koizumi government subsequently turned that attitude around — pushing for proactive strategies of corporate restructuring that welcomed offshore efficiency solutions for high-cost Japanese manufacturers.  China was a prime beneficiary of this approach — not just through cross-border trade but also from increasingly aggressive foreign direct investment by Japanese multinationals.  Japan’s FDI into China hit US$6.5 billion in 2005 — greater than China-bound flows from all of Europe ($5.6 billion) and more than double those of the United States ($3.1 billion).

The significance of further momentum in the economic cooperation between Japan and China cannot be minimized.  These two economies — one a surplus-labor behemoth and the other a labor-short island — are a formidable combination.  As China now faces the imperatives of migrating from a long-standing fixation on the quantity of growth to a newfound focus on the quality of growth, what better partner could it ask for than Japan to offer the technological capabilities of energy conservation and pollution abatement?  As a rapidly aging, high-cost Japanese economy faces increasingly intensive competitive pressures, who better could it turn to than China to offer offshore options to both the scale and the quality its production model needs?  China needs Japan just as much as Japan needs China — precisely the complementarity that Wen Jiabao alluded to in his recent address to the Japanese Diet.  Of course, there are also important questions for the rest of Asia — especially for those who worry about being marginalized by the growing integration of the region’s two largest economies.

Asia’s global potential is hard to minimize.  Home to more than 55% of the world’s population, the region collectively accounts for nearly 37% of PPP-based world GDP and almost 27% of global exports.  Moreover, Developing Asia is leading the charge in the global productivity sweepstakes; recent IMF estimates place the latest three-year average for Chinese productivity growth at close to 9% and that for the rest of Emerging Asia at nearly 5% — both trends well in excess of the 2% productivity pace in the developed world.  Adept in new technologies and endowed with increasingly modern infrastructure, the region’s new synergies with Japan can only add to Asia’s already impressive competitive prowess.

The asymmetries of the Asian growth model remain its greatest shortcoming.  Its strengths have long been focused on the production side of the equation.  Its weaknesses remain dominated by a glaring deficiency of private consumption.  By our estimates, the consumption share of Developing Asia has fallen from over 60% in the early 1980s to below 50% today — less than the 55% share currently going to exports, as noted above.  Moreover, at 55% of GDP, Japan’s private consumption share remains at the low end of the range in the developed world.  Without greater support from internal consumption, a production-focused Asian growth model will always face sustainability questions.  With protectionist pressures now bearing down on a consumption-deficient Chinese economy, the asymmetries of the Asian model loom all the more problematic.

New synergies between Japanand China do not change the balance of Asia’s asymmetrical growth model.  Asia still has an internal consumption problem that must be addressed — no matter what.  The good news is that China is focused on precisely this challenge.  The bad news is that it will take time — quite possibly a good deal more time than most suspect.  In the meantime, Asia seems increasingly determined to reap the benefits of pan-regional economic integration.  Not only are there new signs of progress in that direction between China and Japan, but there continue to be whispers by advocates of a pan-Asian financial architecture — complete with the trappings of a common currency, integrated capital markets, collective management of a vast portfolio of foreign exchange reserves, and sharply reduced intraregional trade barriers. 

Asia is all about change.  A key question for the rest of the world is how it copes with that change.  The more the West resists the rise of Asia — precisely the risk in light of recent developments in Washington — the greater the chances the region will go its own way.  In either case, whether the region draws support from within or from the rest of the world, the next Asia looks unstoppable to me.

 

Middle East/North Africa
Is Dubai the Future of the Middle East?
April 16, 2007

By Serhan Cevik | from Istanbul

Dubaihas achieved an amazing transformation into a global economic hub. Like a mirage in the middle of a desert, Dubai has emerged from oil dependency and transformed itself into a global economic hub. After growing at an annual rate of 13% in the last six years, Dubai shows no sign of slowdown in its efforts to become a gateway to international trade. In fact, with projects worth over US$200 billion, it remains a huge construction zone designed to create a diversified economy (see our chief economist Stephen Roach’s dispatch, The Cranes of Dubai, February 23, 2007). As a result, Dubai enjoys a strategic position from logistics to financial transactions.  Further, it has also attracted a cluster of innovative, technology-intensive international companies in a variety of sectors that helped ranking the United Arab Emirates the 14th most innovative country (out of 107) and well ahead of India (23rd) and China (29th), according to the World Business/INSEAD Global Innovation Index. It is tempting to dismiss Dubai’s success as a mere by-product of petrodollars, but the story is far more complicated. Even though petrodollars have certainly played an important role in financing the development of non-oil sectors, no other oil-rich country has so far come close to Dubai’s unique status in the region and beyond.

The rest of the Middle East could not easily replicate Dubai’s model. In our view, one of the key factors setting Dubai apart is the leadership’s willingness to take the risk of pursuing the vision of a diversified economic structure that would cushion the emirate as its oil reserves become exhausted within 20 years. Thanks to the oil windfall and the recycling of petrodollars, other countries in the region have also channelled more funds into a wide spectrum of projects to diversify their economies as well as to increase the value-added in hydrocarbon sectors. However, it is still not clear whether bigger countries could easily replicate the development model of Dubai on an economical basis. In other words, just like Hong Kong may be an example for Shanghai, but not for greater China, a country like Saudi Arabia needs, at least, significant modifications in the Dubai model to make it applicable. Nevertheless, Dubai’s progress sends an unambiguous message that the rest of the Middle East should follow to create productive businesses and employment opportunities for a growing working-age population.

The Middle East has a wide productivity gap with the rest of the world. According to the International Labor Organization, the Middle East and North Africa region has the highest unemployment rate in the world — 12.2% versus the global average of 6.2% and 9.8% in sub-Saharan Africa. And the future looks even more challenging, as the regional workforce will grow by about 60% to 185 million in the next 15 years. That would of course require as many jobs as have been created in the last five decades. Moreover, the challenge is not just about boosting growth to create new jobs, but also improving productivity growth to make it more sustainable. A recent study by the Conference Board shows that the rate of labor productivity growth in the Middle East has been close to zero over the last two decades, widening the productivity gap between the region and the rest of the world. Although these are complex problems, the underlying factors limiting employment and productivity growth are the same and quite simple. State-dominated development strategies have resulted in distortionary bureaucracy and incentives that restrict the development of competitive private enterprises.

Turning the demographic threat into a gift would improve the region’s growth potential. Albeit daunting, we are in favor of treating the Middle East’s demographic composition as a gift, rather than a threat. An increasing number of countries have already moved ahead with comprehensive reforms to deal with institutional shortcomings. For example, Turkey’s stabilization efforts have helped to rationalize economic incentives and accelerated the shift away from unproductive sectors to modern business opportunities. Likewise, Egypt’s ambitious privatization program and bureaucratic restructurings have created a more rational platform for the private sector. Of course, oil-dependent economies face even greater structural challenges, but diversification efforts could still lead to higher growth, as so far shown by the Dubai model.

United States
The Decoupling Debate: US Implications
April 16, 2007

By Richard Berner | in Milan

A key question for the global economic debate is whether the US slowdown will have broader cross-border consequences, hobbling growth in our trading partners, and with consequent implications for risky asset markets.  I agree with my colleague Steve Roach that the US slowdown won’t leave the rest of the world unscathed; indeed, the world’s economies are more closely coupled than ever, courtesy of ever more tightly-integrated global supply chains, closer financial linkages and consolidation among major services industries (see his “Spillovers versus Linkages,” Global Economic Forum, April 8, 2007).  And the US economic slowdown clearly continues, with the ongoing housing recession, weakness in capital spending and challenges to consumer spending a triple-barrelled threat to US domestic demand. 

But I think a different aspect of the decoupling debate was partly settled last year:  Stronger growth abroad is providing a sustainable boost to US output, earnings and jobs, and I believe that this dynamic will continue to offer a moderate offset to the tepid character of domestic spending.  A key reason is that overseas growth is less dependent on what’s happening in the US economy and increasingly driven by domestic demand abroad.  Thus, while the world hasn’t faced a legitimate decoupling test, America has already passed one.  More challenges lie ahead, but I think improving US net exports may add up to half a point to US growth and promote global rebalancing.  Moreover, stronger growth abroad than at home could add 200 bp to US earnings growth, offsetting the incipient compression in domestic margins.  Unfortunately, it may also boost US inflation.  Here’s why.

Analysts have watched the US economy generally grow faster than those of its major trading partners for nearly two decades, so it’s hardly surprising that there is significant scepticism about such a role reversal.  To be sure, booming global growth in the three years ended in 1989 helped net exports contribute about half a percentage point to overall US output growth.  And the real-estate-induced US recession in 1990-91 (made worse by the oil shock associated with the Gulf War) accentuated that contribution; in the year ended in 2Q91, the contribution from net exports reached 0.9 percentage point.  Of course, that was then.  Globalization, outsourcing, the US role as consumer of last resort during the Asian financial crisis, and most important, faster growth in US domestic demand than comparable demand overseas yielded massive global imbalances and a drag on US growth from net exports averaging 0.6 percentage point in the decade ended in 2005.  Indeed, the deficit arithmetic remains daunting: So large is our inflation-adjusted net export gap that real exports must grow 44% faster than imports merely to hold it constant. 

That is now beginning to change, for three reasons.  Most important, the growth in domestic demand in many of our major trading partners has improved relative to that in the US, promoting brisk growth in US exports, and the slowing in US demand has depressed gains in imports.  For example, over 2006, real domestic demand in Canada and Mexico grew by about 4%, or a bit faster than their collective GDP.  In Europe, domestic demand picked up to 2.8% over the four quarters of 2006.  Hearty capital spending gains, running half again to twice as fast as overall demand, paced the strength in all three economies, which account for half of US exports.  In non-Japan Asia, which accounts for about 18% of US exports, real domestic demand growth ranged from 3% in Taiwan to 7½% or more in Malaysia, China and India.  In Latin America, which accounts for about 7% of US exports, real domestic demand rose by 6-7% last year, again paced by capital spending.  The result: Real US exports of goods and services rose by 9.4% over 2006, while imports gained only 3.3%, and net exports contributed 0.5 percentage point to growth in GDP.  Moreover, in varying degrees, these gains appear sustainable, because employment growth is improving, providing healthy gains in consumer wherewithal.  That is likely one reason why Europe seems to be weathering the fiscal tightening in Germany a bit better than expected. 

The second factor changing the picture is that — with China a notable exception — to the extent that these regions depend on export-led growth, the US is a less important export destination than previously.  For example, in 2000, according to the IMF, many non-Japan Asian economies excluding China shipped 20-25% of their exports to the US market (see World Economic Outlook, April 2007, Chapter 2 “Country and Regional Perspectives”).  Today, for many economies including Korea, Taiwan, Philippines, Thailand, Hong Kong and Singapore, that share has slipped to 10-15%, and exports to Europe, Latin America and interregional trade have taken up the slack.  The result is that while slower US growth will clearly affect these economies by curbing their export growth to the US, the impact on output and employment may be smaller than it would have been in the past.  

The last factor altering the equation is that, adding to the declines from the peak in 2002 or 2003, the dollar has declined somewhat further on a real trade-weighted basis over the past two years, and it seems likely to move lower still.  The two-year time frame allows for some of the lags between the time currencies change, when this affects relative prices, and when it begins to alter sourcing and investment decisions.  While the Fed’s real trade-weighted currency index (TWI) against major currencies has actually moved slightly higher over that period, the real TWI for ‘Other Important Trading Partners,’ including Mexico, China, India and other emerging economies, has declined by 5.3%.  Over the past five years, the broad TWI has declined by about 16% — comparable to the five-year decline by late in 1988 when the combination of booming global growth and a weaker dollar fuelled the three-year surge in US net exports.

Despite these fundamentals, new evidence for the ongoing improvement in US net exports may come in fits and starts.  Courtesy of exceptionally weak imports of petroleum products and industrial materials, net exports added 1.6 percentage points to GDP in the last quarter of 2006 and, given data through February, may reverse one-third of that gain in the first quarter.  An inventory correction in computer accessories, semiconductors and telecom equipment probably temporarily depressed exports in February; strikes and bad weather may have played a role in depressing both exports and imports.  But the fundamentals seem likely to boost exports by far more than imports in coming months.

Stronger growth abroad may also boost US earnings and inflation.  Over the four quarters of 2006, net earnings from US affiliates abroad contributed some 330 bp to overall earnings as measured by so-called “economic” profits in the national income accounts.  Such affiliate earnings rose by nearly 19%.  Although that pace is probably not sustainable, it will likely far outpace domestically-generated earnings as margins flatten at home (see “Corporate Profits: Downside Risks,” Global Economic Forum, April 5, 2007).  Meanwhile, the disinflationary forces from globalization and tightly integrated global supply chains may now be unwinding, as both surging raw materials prices and a sizable acceleration in consumer import prices may add to US inflation.  Strong global demand and refinery downtime have lifted energy quotes.  Compared with a year ago, core crude producer prices surged 7.7%, and consumer goods import prices rose 1.8%; the latter the fastest pace in more than 11 years.  Against the US backdrop of still-high resource utilization, some of these price increases will pass through to the retail level, making more gradual the decline in core inflation. 

These developments will carry with them several key implications for financial markets.  Indeed, some represent themes that are already partly in the price, but they may still be actionable for investors.  A diminished flow of saving from abroad may lift US interest rates — especially if it comes in the context of renewed growth in US capital spending, as we expect.  But despite our call for a further rise in term premiums and a steeper yield curve, transatlantic spreads likely will narrow further.  Strong European growth and tough talk from the European Central Bank narrowed the 10-year Treasury-Bund spread by 12 bp last week to 53 bp — the lowest level in more than two years.  Further declines may be on the way as the dollar may continue to weaken.  Against that backdrop, the Fed has made it clear that the hurdles to easing monetary policy are high, and we continue to expect monetary policy to remain on hold through the end of the year.  US equity markets will probably continue to underperform, while materials and energy stocks — and others benefiting from growth abroad — likely will outperform. 

Risks clearly abound in this scenario.  Perhaps most important, neither the global economy nor financial markets would escape unscathed from a US downturn.  And it’s likely that the weakness of US demand will depress growth in Canada and Mexico.  But critics of the “strong” decoupling thesis have given short shrift to the “soft” form of decoupling — after all, the linkages in a more tightly-integrated global economy run toward the US economy from abroad as well as in the other direction.  That could even provide some upside risks to US growth and risky asset markets. 

 

Korea
Liquidity from BOP to Remain Favorable
April 16, 2007

By Sharon Lam | Hong Kong

Korea’s current account is often closely monitored by investors as it is commonly perceived as a major source of liquidity to the economy.  We, like market consensus, forecast a much lower current account surplus (with some even predicting a deficit) in Korea this year.  Should this be a big concern?  And does this mean an end to liquidity growth in Korea?  We think not.  The current account is just one part of the balance of payments (BOP), and we should not ignore the financial account, which has been showing a much bigger surplus.  We believe that the financial account will continue to generate a considerable surplus this year due to foreign equity inflows and sustained borrowing in foreign currency.  In fact, even the BOP does not tell the whole liquidity story, as the liquidity impact on the market would have to involve asset allocation theory as well.  In this report, we look at a detailed breakdown of the BOP and conclude that at least one important source of liquidity will remain favorable this year.  My estimates reflect our GDP forecast of only 4.3%, and therefore the estimates for the trade balance and foreign equity inflows are rather conservative, in my view.  I see upside risks to my estimates.

Current account reduction …

The current account is broken down into goods trade, services, income and current transfers.  We expect the overall current account to narrow to US$0.5 billion in 2007 from US$6.1 billion in 2006. 

1. Trade balance: Staying resilient. Last year the goods trade balance totaled US$29.2 billion.  In 1Q07, the trade balance likely reached almost US$7 billion, surpassing our expectation.  In 2Q07, however, we may see a decline due to weaker demand from the US and higher oil prices.  However, our US team forecasts consumption growth to pick up again from 3Q07.  Meanwhile, we expect exports to China to remain robust as the Chinese government has encouraged greater consumption and imports of capital goods to alleviate its huge trade surplus.  The Beijing Olympic Games in 2008 should also give positive support to Korean exports as Beijing has been an important market for Korea.  Chinese consumers appear to favor Korean products over Japanese, possibly for historical reasons, while Koreans have also been very successful at brand-marketing their goods.  Korea often benefits from global sporting events due to its production of TV monitors, semiconductors and consumer electronics.  The upcoming Olympic Games in Beijing should provide support to Korean exports from late 2007 into 2008.  Given the above considerations, we expect the trade surplus within the current account to rebound after a temporary easing in 2Q.  We forecast the 2007 trade balance to total US$28 billion, close to the US$29 billion in 2006.  The downside risk comes if Korean consumption turns out to be stronger and lifts imports, but this would be positive for overall economic growth.  Another downside risk is, of course, if the global economy shrinks, a problem for all export-oriented economies in the region.

2. Services balance: Structural downside. Korea’s services account deficit keeps widening due to rapidly rising outbound travel demand (see The Travellers, April 13).  Koreans are also paying for business services employed overseas along with their ongoing international expansion plans.  These are structural trends that we do not believe can be reversed easily.  We expect the services account deficit to widen to US$22.0 billion in 2007 from US$18.8 billion in 2006.

3. Income and transfer balance: Remains in deficit. The income account, which captures mainly investment income (from either direct investment or portfolio investment) is likely to be in bigger deficit this year due to higher dividend payments by Korean companies.  Due to the high foreign ownership in the Korean equity market, the dividend payment months (March and April) will often push down the overall current account balance into deficit.  However, the growth in Korea’s overseas equity investment means that there should be higher dividend income inflow this year as well.  Thus, we believe that the income account deficit will not widen as much as the increase in Korean companies’ dividend payments. 

We forecast an income account deficit of US$1 billion in 2007 versus US$0.5 billion in 2006.  Meanwhile, the current transfer account, which includes remittances, should also continue to expand because of increased demand for overseas property and education.  We forecast the current transfer deficit to come in at -US$4.5 billion in 2007 compared to -US$3.8 billion in 2006.

…will be offset by increase in financial and capital account

Last year, total liquidity in the economy rose despite a weaker current account as the financial account surplus was strong enough to bring up the overall balance of payments.  That also explains why the KRW appreciated.  The financial account is broken down into direct, portfolio and other investment.  We forecast that the financial account surplus will climb to US$28.5 billion in 2007 from US$21.7 billion in 2006.

1. Direct investment: Sluggish trend but unpredictable. Korea is seeing declining net direct investment as Koreans are stepping up business investment abroad, while the country itself is losing attractiveness to other low-cost economies while at the same time competing for foreign investment.  It is hard to predict direct investment as it can be volatile due to just one or two big corporate investment plans.  Since this number can easily swing between positive and negative, we take a conservative approach to assume that net direct investment will remain at a record deficit of US$3.5 billion.  

2. Portfolio investment: Reducing outflow. Last year, foreigners contributed to a net equity investment outflow of US$8.5 billion within the balance of payments’ financial account.  Recently, we have seen foreigners becoming more active in buying Korean equities again.  Even if we assume foreign equity investment to be neutral this year, it would still represent an increase of US$8.5 billion in the portfolio investment balance from last year.  In the first two months, we already saw an inflow of US$2 billion.  Meanwhile, we see a structural uptrend of foreigners’ investment in Korean bonds, due possibly to the introduction of longer-term instruments and the improving credit rating.  Net investment inflows into Korean debt securities totaled US$8.4 billion in 2006, and in the first two months of 2007 this had already risen to US$4.8 billion.  We forecast total portfolio inflow of US$15 billion this year (US$5 billion in equity and US$10 billion in debt), up from US$0.03 billion last year, which is again a rather conservative assumption, in my view.

The concern, however, is that Koreans are actively investing in overseas equity investment.  This could be both a cyclical drive and a structural demand for a more diversified investment portfolio.  Koreans are mainly investing in the Chinese and Indian equity markets.  Assuming that these two markets remain hot this year, we forecast total portfolio investment outflows to jump to -US$28 billion this year from -US$23 billion last year.

Combining the above, we expect portfolio investment to remain in deficit in 2007, but this should narrow to -US$13 billion from -US$23 billion last year.

3.  Other investment: Cheap foreign currency loans remain an important source of liquidity. The investment account captures loans between countries.  In 2006, foreign currency loans totaled US$43 billion, with two-thirds being Korean exporters’ forward sales of USD/KRW.  We expect these forward sales to remain as the trade surplus will stay resilient this year, while the weak US dollar still dominates.  The other one-third of foreign currency loans represents the pure borrowings in foreign currencies by Korean banks/companies/individuals, which are mostly converted into local currency for investment purposes.  Individuals took advantage of cheaper borrowing costs to invest and to also bet on further KRW appreciation, i.e., to a certain extent KRW appreciation has been a self-fulfilling prophecy.  We thought this type of borrowing could be less active this year as expectations of currency appreciation seem more divided than last year.  Nevertheless, the low cost of borrowing and the resistance of JPY to appreciate turn out to still be favorable factors for borrowing in JPY.  A considerable amount of foreign currency loans will be maintained this year, in my view.  In fact, even with the KRW having depreciated sharply against JPY in February and March, it did not stop foreign currency borrowing, which totaled US$6 billion in the first two months of this year.  We therefore forecast a not-so-significant decline in foreign currency loans to US$40 billion this year from US$43 billion last year, reflecting some discouragement from the central bank on foreign currency borrowing to a certain degree.

Domestic Economic Conditions Outperforming Expectations

We had emphasized that the current economic slowdown would be mild, yet it turns out to be even milder than we thought.  In fact, indicators across all categories are outperforming expectations, including liquidity, export, capex, private consumption and construction investment.  While we are still concerned about 2Q weakness due to softer US growth, we believe that the Korean economy is holding up stronger than our initial predictions.

 

United States
Review and Preview
April 16, 2007

By Ted Wieseman and David Greenlaw | New York, New York

Treasuries ended the past largely uneventful week little changed as what appeared to be a back and forth fight between bullish overseas, especially Asian, investors and more bearish domestic investors ended with minor front-end-led losses on the week. After foreign markets fully reopened Tuesday, the market was bid up overnight every day, largely by Asian buying, but with long Treasuries versus short European government bonds trades also contributing significantly as the 10-year Treasury/bund spread plunged on the week to a more than two-year low.

Except for Tuesday (when domestic investors extended the starting strength), these overnight gains were reversed over the course of the US trading sessions, with the reversals supported by more hawkish-than-expected FOMC minutes Wednesday, strong chain store sales results Thursday and worries about cost pressures in the early stage PPI readings, rising inflation expectations in the Michigan survey and plummeting European markets Friday. The main fundamental focus the past week was on the minutes from the March FOMC meeting, which proved surprisingly hawkish for a meeting that resulted in the significant moderation of the Fed’s previously long-held tightening bias. Downside risks to growth from the subprime meltdown and weak capital spending were acknowledged but largely downplayed, while upside risks to inflation were seen as more threatening and, to some extent, rising. The language shift implemented in March gave the FOMC the freedom to cut rates if the growth downside proves significantly more severe than policymakers think likely, but the discussion at the meeting continued to stress the greater risk of upside in inflation forcing more rate hikes. In response, near-term Fed rate-cutting expectations continued to be significantly scaled back. The economic data calendar was light.

There were several releases impacting our 1Q GDP forecast, but the resulting shifts were small and offsetting, and we continue to forecast +1.4% growth. Meanwhile, inflation measures pointed to rising cost pressures from both surging raw materials prices and a sizable acceleration in consumer import prices. We expect to see similar upside in the upcoming CPI report, which highlights the upcoming week’s data calendar, where we project a +0.3% core reading.

On the week, benchmark Treasury yields rose 0-2bp and the curve flattened slightly. The market was a bit stronger on the week until about 10:00 Friday morning when a decent sell-off took hold that left the market at new recent lows by Friday’s close. Upside in inflation expectations in the Michigan survey, a plunge in European bonds and some technically based selling as the new lows for the week were hit triggered Friday’s weakness. In contrast to the muted showing by Treasuries, the big fixed income story of the week was the continuing major sell-off in Europe, with the 10-year Treasury/bund spread plunging 12bp on the week to +53bp, a low since December 2004. As for Treasuries, the 2-year, 3-year and 5-year yields all rose 2bp to 4.76%, 4.70% and 4.68%, the 10-year yield ticked up 1bp to 4.76%, and the long bond held steady at 4.93%. Massive bill paydowns start this week as tax season kicks off, and the bill market began to feel the squeeze, with the 4-week bill’s bond equivalent yield plunging 13bp to 4.96%. The surprisingly hawkish FOMC minutes fretted about upside inflation risks much more than downside growth risks, and the Fed’s concerns were supported in subsequent data showing upside in raw materials costs, imports prices and inflation expectations, leading to a significant scaling back of near-term rate-cutting expectations in the futures markets. The July fed funds contract lost 0.5bp to 5.235%, the August contract 1.5bp to 5.21%, the September contract 2.5bp to 5.195%, and the October contract 3.5bp to 5.17%. So, roughly speaking, the market now sees almost no chance of a rate cut by the June FOMC meeting, about a one in five chance of a cut by August, and a one in three chance of a cut by September. This was the least amount of easing priced in over this timeframe in two months. The amount of easing expected beyond the September meeting and into the first part of 2008 was also scaled back somewhat, with eurodollar futures losses led by the Sep 07, Dec 07 and Mar 08 contracts, which fell 4.5bp, 5.5bp and 4bp, respectively.

There was little change, however, in the total amount of Fed easing expected — still essentially a 50bp cut in the funds target to 4.75% by the second half of 2008 — as the low rate Sep 08 contract was only off 1bp on the week to 4.82%. TIPS underperformed, with the benchmark 5-year and 10-year inflation breakevens narrowing 4bp each to 2.51% to 2.45%. The 10-year TIPS reopening on Thursday was an ugly auction and certainly didn’t help, but most of the week’s net underperformance actually happened Monday.

A few data releases bearing on 1q GDP released over the past week had small individual impacts that netted out to no change in our +1.4% estimate, though we now see marginally stronger domestic demand offset by a slightly bigger drag from net exports. First, details from the Treasury budget statement — which showed a US$96.3 billion federal government budget deficit in March, up US$11 billion from a year ago but still leaving the deficit through the first half of FY2007 running US$45 billion below the prior year as we head into the key April tax season — led us to trim our forecast for federal government spending to +4.4% from +5.1%. This was offset, however, by stronger-than-expected chain store sales results that led us to boost our consumer spending estimates slightly. An aggregate we compile of the biggest companies showed a 6.3% jump in overall composite same-store sales and a 6.1% rise excluding drug stores. These aggregate March results were considerably better than industry expectations. For example, the International Council of Shopping Centers predicted a 4-5% increase in sales. Although we are cautious about just how these results will end up being translated into official retail sales results — Census sometimes has trouble adequately seasonally adjusting for the timing of Easter, resulting in some big and unpredictable offsetting swings in impacted retail sales components over the March/April period — we still upped our estimate of the key ‘retail control’ component of March sales to +1.1% from +1.0%, which boosted our consumption forecast to +3.1% to +3.0%.

Finally, though ostensibly significantly better than expected, the underlying details of the February trade report relative to our assumptions were a wash, pointing to slightly worse net exports in 1Q, offset by slightly stronger capital spending. The nominal trade deficit surprisingly narrowed US$0.5 billion in February to US$58.4 billion, with both exports (-2.2%) and imports (-1.7%) down significantly. The export weakness was concentrated in a broadly based drop in capital goods that was led by aircraft, computer accessories, oilfield equipment, industrial machinery and generators. Meanwhile, the import drop was more than accounted for by a plunge in petroleum products. While a significant part of this reflected a sharp pullback in volumes (-15%), in line with Energy Department figures, inexplicably the majority of the drop actually reflected lower prices. This weakness was partly offset by a sharp rebound in consumer goods after a plunge last month that appeared to reflect timing issues with the Chinese New Year. With the weakness in imports in large part price-related, the real trade figures were not nearly as favorable as the nominal results. The real goods trade deficit in January was revised up to US$57.0 billion from US$56.7 billion and then widened further to US$57.3 billion in February. These results were marginally worse than we were building into our GDP estimates, and we now see net exports subtracting 0.6pp from 1Q GDP instead of -0.5pp. On the other hand, the figures for net exports of capital goods were a bit better than we assumed because of the bigger-than-expected drop in capital goods exports, pointing to slightly stronger domestic investment. We raised our estimate of overall 1Q capital spending to +1.0% from +0.7% and the equipment and software component to -1.8% from -2.2%.

All these small changes to our estimates for government spending, consumption, net exports and investment were offsetting and we continue to project a 1.4% rise in 1Q GDP. There are still a number of releases over the next couple of weeks that could alter that ahead of the April 27 release of the advance GDP estimate, including retail sales and inventories, housing starts, industrial production, existing and new home sales and durable goods (which given its volatility seems most likely to prompt a material adjustment).

Growth remains sluggish, but cost pressures continue to build in this mild stagflationary episode we are suffering through. The producer price index surged 1.0% in March (for a 3.2% Y/Y gain) on top of the 1.3% gain in February, again boosted by significant upside in both food (+1.4%) and energy (+3.6%). The upside in energy was led by gasoline, with another sizable gain likely in April, while food prices have now surged 18% annualized in the past four months, the sharpest rise over such a period since 1980. Excluding food and energy, the core PPI was flat (+1.7% Y/Y), but only because of a drop in volatile motor vehicle prices. Excluding autos, the core rose 0.2%, in line with the recent trend. News at earlier stages of production showed major pipeline cost pressures. The core crude gauge surged 7.7%, one of the biggest gains on record, with spikes in wastepaper (though according to our paper products analyst Edings Thibault, this has started to significantly reverse in April) and steel scrap prices. Also notable on the cost front were details of the import/export prices report. In particular, consumer goods import prices gained 0.2% in March for a 1.8% gain over the past year, a more than 11-year high and up sharply from -0.3% last March.

The significant acceleration in consumer goods prices poses upside risks going forward to core CPI goods prices. There has typically been about a six-month lag between swings in prices for imported consumer goods and changes in the corresponding CPI prices. Certainly, the degree to which businesses have the pricing power to pass through the significant upside in raw material and consumer import prices will depend importantly on the strength of demand and the level of resource utilization in the economy. Recent demand trends have obviously been weak, but the economy continues to operate with little if any slack, so there should be at least some business pricing power to push through rising cost pressures from a variety of sources — unit labor costs, energy, food, industrial raw materials and core import prices.

There is a fairly busy economic calendar in the coming week, mostly packed into Monday and Tuesday, with focus on CPI Tuesday and retail sales Monday. Meanwhile, the Empire State survey Monday and Philly Fed survey Thursday will set early expectations for the April ISM report, and initial jobless claims this week will cover the survey week for the employment report and guide initial forecasts for the April employment report. We think that the jump in initial claims the past week to 342,000 reflected inadequate seasonal adjustment for the typical first week of a new quarter surge in filings and expect a more than complete retracement this week to 310,000. Other data releases due out include business inventories Monday, housing starts and IP Tuesday, and leading indicators Thursday:

* We forecast a 0.6% gain in March retail sales overall and 0.9% ex-autos. The chain store results were considerably stronger than expected.

However, it is very difficult to know how much of this is real and how much is attributable to the Easter calendar shift. Moreover, it is virtually impossible to gauge the accuracy of the seasonal adjustment factors that will be used to smooth the March/April sales pattern. So while we have bumped up our estimates slightly in response to the favorable company news, we have low confidence in the March outcome and believe that it will be necessary to average the March and April data in order to get an accurate read on the underlying sales picture. We continue to look for a slight pullback in the auto dealer category, as implied by unit sales data from the companies, along with a price-related surge in gas station receipts. Indeed, March sales are expected to be up only 0.4%, excluding autos and gas stations. Finally, we now see real consumption spending up 3.1% in 1Q.

* We look for a 0.2% gain in February business inventories. The previously reported results for the manufacturing and wholesale sectors, together with an anticipated fractional advance at the retail stage, point to another relatively modest gain in overall stockpiles. The I/S ratio is expected to hold at 1.29.

* We look for a 0.8% surge in headline CPI in March, one of the biggest gains seen in quite some time, led by a whopping 10% spike in gasoline prices. The food category is also expected to post another sizeable advance. Meanwhile, the core is expected to rise 0.3%, edging up a bit relative to recent months, with upside contributions coming from airfares and hotel rates. On an unrounded basis, the core is expected to be +0.30% — implying that we see about equal upside and downside risk relative to our point estimate. Finally, the core is expected to hold at +2.7% year/year.

* We look for about an 8% retracement in March housing starts to a 1.40 million unit annual rate on the heels of the surprising gain seen in February. While the employment report pointed to some weather-related upside in hours worked within the residential construction sector during March, we are inclined to discount this factor — especially after seeing a significant disconnect between the employment data and starts in the month of February. Indeed, the recent deterioration in the homebuilder sentiment survey would seem to imply a clear pullback in activity.

Moreover, a decline in starts will be necessary to help bring the backlog of unsold new homes into better alignment with historical norms.

* We forecast a 0.1% gain in March industrial production. The employment report showed only the second increase in hours worked within the factory sector since last July. So we look for a solid 0.5% rise in the key manufacturing component of IP. Meanwhile, a weather-related decline in the utility category — offsetting some of the upside seen in February — should lead to a more modest gain in overall production. Finally, the capacity utilization rate is expected to be unchanged at 82.0%.

* The index of leading economic indicators should post a small 0.2% rebound in March on the heels of two consecutive monthly declines. The main positive contributors are jobless claims, the manufacturing workweek and the money supply. Meanwhile, negative contributions are expected from stock prices, consumer confidence and the yield curve.