Who Will Cure the Sick Man of Europe?
April 25, 2007
By Eric Chaney | London
Five years ago, Germany was ‘the sick man of Europe’; three years ago, Italy took the baton. Today, France has the highest unemployment rate in the euro area and is underperforming other euro members in terms of GDP or exports. It owns the title now. The French disease is serious: to cut a long story short, France is having a harder time coping with globalization than Germany, the UK or even Italy. This sombre background makes the presidential election all the more important. Sunday’s first round might have signaled a starting point of the long-overdue reforms the French economy needs to regain competitiveness and prosperity.
The good news from the first round, won by centre-right candidate Nicolas Sarkozy (with 31.2%) and Mrs. Ségolène Royal (moderate left 25.6%), is that the French people have endorsed the necessity of reforms. By voting for young candidates who made their way against old guards within their own camps, and pledged to change French political habits, they have closed the book of 20th century politics, recently embodied by President Chirac and former PM Jospin. By rejecting protectionist and isolationist songs from the far right and the far left and invading polling booths as had not been seen since 1965, the French said: We want changes and this is a job for government, not for street demonstrators. And by clipping the wings of the ‘neither-right-nor left’ third man, François Bayrou (18.6%), who would have been at the mercy of an Italian-type coalition if elected, they have expressed their will to entrust a strong executive backed by a clear parliamentary majority in order to change France. The less good news is that the French have not yet chosen between two strategies: giving more freedom to businesses and workers to innovate, work and make money, or further regulating the economy to try to reduce the collateral damage from globalisation. Before looking at the platforms of the two contenders, let’s fully understand the French symptoms. Three weaknesses prevent France from benefiting from globalisation: insufficient labour market mobility, low return on innovation and excessive government spending. First and foremost, an ‘insider disease’ is choking the labour market. A majority of employees, civil servants or beneficiaries of open-ended job contracts are highly protected by labour regulation — the insiders. Here, labour mobility is very low. Elsewhere, a growing minority only gets temporary jobs, short-term contracts or internships — the outsiders. The burst of violence that erupted in late 2005 came from outsiders: many of them change jobs often and have lost hope of getting a ‘good’ job. Attempts by the outgoing government to implement small-scale or partial reforms have failed miserably. Second, French companies innovate less than their German or Swedish competitors, according to the 4th Community Innovation Survey (Eurostat). This is due, in my view, to a low rate of innovation from government-sponsored research bodies and a low return on innovation for private firms. Let me take an example: suppose a young computer scientist wants to run his own business. If successful, he would have to hire, and this is where negative returns may deter him; problems include unknown potential firing costs or higher payroll taxes and social regulation for companies having more than ten employees. Third, the size of the government, as measured by the share of public spending in GDP, which goes together with the heavy hand of the state in the management of the economy, is a major hurdle for companies based in France. As of 2006, public administrations spent 53.7% of GDP, thus distracting an enormous amount of resources from going to higher-return projects. The weight of public spending has declined in all EU countries but France over the last ten years. As for the labour market, Mr. Sarkozy wants to replace all existing work contracts with a simplified one, allowing companies to lay off employees with severance payments linked to seniority but without legal hurdles. He would also make unemployment benefits conditional to job seeking. Mrs. Royal favours enhanced conditionality for job seekers as well, but she also wants to generalise the 35-hour working week and to increase the net minimum wage to €1,500 a month — a 50% increase, which would price thousands of small companies out of business and increase structural unemployment dramatically. As for innovation, both candidates pledge to increase public spending on R&D. But only Mr. Sarkozy links this promise to an in-depth reform of French universities and other research bodies. Specifically, universities would become autonomous, including setting their own tuition fees, as early as this year. Both candidates want to make life easier for smaller companies, but they both miss the point: small companies need to grow, and a willingness to help only smaller companies will not address the lack of innovation. Last, Mrs. Royal wants more intervention from the central and local governments. She has made so many spending promises that overall government outlays would almost certainly shoot up under her rule. By contrast, Mr. Sarkozy is determined to cut the tax pressure by four points of GDP over ten years, which would imply a similar decline in public spending. He would do so by replacing only one out of two retiring civil servants and by closing inefficient bureaucracies. As for interfering with business, both candidates claim that they would protect ‘strategic’ French businesses from falling into foreign hands. To be sure, ‘economic patriotism’ will remain alive and well in France no matter who is at the head of the new regime. Mrs. Royal’s platform, although so far the most reformist platform I have read coming from socialist ranks, would not deliver the fresh oxygen France needs to heal its triple disease, in my view. Of course, like Gerhard Schröder in Germany, Mrs. Royal might understand the need for in-depth economic reforms after one or two years of unsuccessful trials. Unfortunately, I believe that her massive proposed rise of the minimum wage — a concession to the far left in the last few days of the campaign for the first round — would inflict largely irreversible damages on the economy. Mr. Sarkozy’s platform is the most reformist and pro-market of the two. He has a carefully conceived strategy, such as letting employers and unions negotiate labour market reforms for a given period of time before the government steps in, or starting all the reforms together, so that they will reinforce each other. In a perfect democratic world, the debate between the two camps would be about platforms and strategies, rather than on individuals and ideologies. A reading of the first round that the French are ready for reforms would give a clear edge to Nicolas Sarkozy. Of course, we don’t live in this perfect world, and Mr. Sarkozy’s poll lead is no guarantee of victory on May 6. [This is a slightly edited version of an Op-Ed in the April 24 edition of the Wall Street Journal Europe]
Important Disclosure Information at the end of this Forum
No Rate Hike, but Tightening Mode Indicator Still On
April 25, 2007
By Chetan Ahya | Mumbai
Taking a pause The Reserve Bank of India (RBI) today decided to take a pause in monetary tightening, leaving its policy rates (repo and reverse repo rates) unchanged as compared with our expectation of a 50% probability of the RBI taking a pause. The central bank also left the cash reserve ratio unchanged. The move was not surprising, considering that the RBI had hiked both the policy rate and the cash reserve ratio just 24 days back on March 30. The other significant measures announced by the RBI were related to capital flows — it reduced the interest rate ceiling on non-resident Indian remittances by 50bp and further liberalized regulations related to capital outflows (outward remittances by resident individuals, corporate investments and overseas investments by mutual funds). Tightening policy stance maintained The monetary policy stance, which has transitioned to a clear tightening mode (as indicated in the March 30 statement), has been left unchanged, implying that the RBI is not yet finished with its effort to moderate demand pressures. Since October 2006, as the RBI has become more concerned about overheating, it has shifted its policy stance from an equal emphasis on price and growth to a bias towards price stability at the cost of growth. On March 30, the RBI stated that the “…stance of monetary policy has progressively shifted from an equal emphasis on price stability along with growth to one of reinforcing price stability…” Today’s policy statement reiterated this view, stating that “…the policy preference for the period ahead is strongly in favor of reinforcing the emphasis on price stability and anchoring inflation expectations.” Overheating concerns intact The RBI has in today’s policy statement reiterated its concern about overheating, citing inter-play of both demand pressures and supply-side constraints. It stated that “demand pressures appear to have intensified alongside robust growth and there are increased supply-side pressures in evidence”. On the demand side, the RBI highlighted the usual overheating indicators — high credit growth, a widening trade deficit, accelerating inflation (as reflected in the “steady increase in prices of manufactures” and “indications of wage pressures in some sectors”) and elevated asset prices. The RBI also cautioned against supply-side constraints, as reflected in agricultural performance and physical infrastructure. Indeed, it mentioned that, as we have been highlighting, “infrastructure bottlenecks are emerging as the single most important constraint on the Indian economy. Rapid growth in demand for infrastructure with a less-than-proportionate supply response in the prevailing investment climate has resulted in stretching capacity utilization in electricity generation, roads, ports and major airports to overheating”. Indeed, a few recent moves by the government have only added to the potential delay in the supply response (see Supply Response — New Hurdles Are Emerging, April 2, 2007). Inflation targets reduced further In today’s monetary policy statement, the RBI indicated that its policy endeavor will be to contain wholesale price inflation at close to 5%. This compares with its earlier stated comfort zone of 5-5.5% and the current inflation rate of 6.1%. Similarly, the RBI has reduced its medium-term inflation target to 4-4.5% from 5% stated earlier. While explaining this change in inflation target, the RBI indicated that “…the socially tolerable rate of inflation has come down”. We believe that this is a reflection of an emerging consensus among the political leaders in the ruling coalition parties that higher inflation is unacceptable. In this context, the RBI has also highlighted the importance of curtailing money supply growth to 17-17.5%, compared with the average of 21.4% in March 2007. Growth and inflation targets appear inconsistent The RBI is estimating GDP growth for the 12 months ended March 2008 at 8.5%. The policy document continues to focus on inflation as a risk and, in fact, the RBI has reduced its inflation target from 5.0-5.5% to 5.0%. The RBI has also highlighted that recent inflation pressure is an outcome of domestic demand running high relative to supply. Although the supply response is currently under way, its “realization could be constrained over the next two years”. In our view, deceleration in inflation is unlikely without a commensurate moderation in demand growth. The growth for the quarter ended March is likely to be 8.5% and hence, in our view, the RBI’s growth estimate of 8.5% for the 12 months ended March 2008 does not imply any deceleration in demand growth. In our view, achieving lower inflation with a continued strong growth trend will be difficult, given the current macroeconomic conditions in which the supply response (growth in productive capacity) is slow. In terms of the monetary policy and growth outlook, we see three possible scenarios: Scenario (I) — the RBI stops tightening after one more hike: This is our base case scenario. We assume that demand growth will start slowing meaningfully over the next three to four months, resulting in reduced inflation pressure in the second half of the year. In other words, while the rate hikes will stop, the past measures will cause a slower growth trend. Note that lending rates for consumer loans have risen by 250-300bp since December 2006 and by 350bp since April 2006. In addition, the appreciating trend in the currency over the past month (another method of monetary tightening) should result in slower external growth coupled with moderating inflation. As a result, we expect GDP growth to be lower at 7.5% in F2008 versus the RBI’s estimate of 8.5%. Scenario (II) — the RBI hikes rates more than once: If growth remains strong at 8.5%, the negative surprise for financial markets may come from inflation remaining high and the RBI continuing to tighten for longer than our and market expectations. Scenario (III) — the RBI stops tightening: If the RBI decides to let its guard down (no more tightening), two outcomes are possible: (IIIA) Growth slows: Past tightening measures slow the demand growth down meaningfully, leading to a deceleration in inflation pressures. (IIIB) Growth accelerates further: We believe that this would be the worst outcome for the financial markets. Under this scenario, after the initial excitement, the financial markets would likely suffer a rude shock, with the RBI being forced to initiate some very aggressive measures in a short period of time. We believe that this scenario has the lowest probability of materializing. Bottom line We believe that the emphasis on inflation in the monetary policy statement is an indication by the RBI that the monetary policy stance is unlikely to change soon. We expect inflation to remain above the newly defined comfort zone of 5% over the next four months. Hence, the RBI is likely to hike its policy rates at least once more to slow demand growth and reduce inflationary pressure. The wildcard for policy moves, particularly the cash reserve ratio, will be the trend in capital inflows and global risk appetite for emerging markets assets.
Important Disclosure Information at the end of this Forum
Disclosure Statement
The information and opinions in this report were prepared or are disseminated by Morgan Stanley & Co. Incorporated and/or Morgan Stanley & Co. International plc and/or Morgan Stanley Japan Securities Co., Ltd. and/or Morgan Stanley Dean Witter Asia Limited and/or Morgan Stanley Dean Witter Asia (Singapore) Pte. (Registration number 199206298Z) and/or Morgan Stanley Asia (Singapore) Securities Pte Ltd (Registration number 200008434H) and/or Morgan Stanley Taiwan Limited and/or Morgan Stanley & Co International plc, Seoul Branch, and/or Morgan Stanley Dean Witter Australia Limited (A.B.N. 67 003 734 576, holder of Australian financial services licence No. 233742, which accepts responsibility for its contents), and/or JM Morgan Stanley Securities Private Limited and their affiliates (collectively, "Morgan Stanley").
Global Research
Conflict Management Policy
This research observes our conflict management policy, available at www.morganstanley.com/institutional/research/management_policies.html
Important Disclosures
This report does not provide individually tailored investment advice. It has been prepared without regard to the circumstances and objectives of those who receive it. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages them to seek a financial adviser's advice. The appropriateness of an investment or strategy will depend on an investor's circumstances and objectives. This report is not an offer to buy or sell any security or to participate in any trading strategy. The value of and income from your investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized.
With the exception of information regarding Morgan Stanley, reports prepared by Morgan Stanley research personnel are based on public information. Morgan Stanley makes every effort to use reliable, comprehensive information, but we do not represent that it is accurate or complete. We have no obligation to tell you when opinions or information in this report change apart from when we intend to discontinue research coverage of a company. Facts and views in this report have not been reviewed by, and may not reflect information known to, professionals in other Morgan Stanley business areas, including investment banking personnel.
To our readers in Taiwan: This publication is distributed by Morgan Stanley & Co. International plc, Taipei Branch; it may not be distributed to or quoted or used by the public media without the express written consent of Morgan Stanley. To our readers in Hong Kong: Information is distributed in Hong Kong by and on behalf of, and is attributable to, Morgan Stanley Dean Witter Asia Limited as part of its regulated activities in Hong Kong; if you have any queries concerning it, contact our Hong Kong sales representatives.
This publication is disseminated in Japan by Morgan Stanley Japan Securities Co., Ltd.; in Canada by Morgan Stanley Canada Limited, which has approved of, and has agreed to take responsibility for, the contents of this publication in Canada; in Germany by Morgan Stanley Bank AG, Frankfurt am Main, regulated by Bundesanstalt fuer Finanzdienstleistungsaufsicht (BaFin); in Spain by Morgan Stanley, S.V., S.A., a Morgan Stanley group company, which is supervised by the Spanish Securities Markets Commission (CNMV) and states that this document has been written and distributed in accordance with the rules of conduct applicable to financial research as established under Spanish regulations; in the United States by Morgan Stanley & Co. Incorporated, which accepts responsibility for its contents. Morgan Stanley & Co. International plc, authorized and regulated by Financial Services Authority, disseminates in the UK research that it has prepared, and approves solely for the purposes of section 21 of the Financial Services and Markets Act 2000, research which has been prepared by any of its affiliates. Private U.K. investors should obtain the advice of their Morgan Stanley & Co. International plc representative about the investments concerned. In Australia, this report, and any access to it, is intended only for "wholesale clients" within the meaning of the Australian Corporations Act.
Trademarks and service marks herein are their owners' property. Third-party data providers make no warranties or representations of the accuracy, completeness, or timeliness of their data and shall not have liability for any damages relating to such data. The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of MSCI and S&P. Morgan Stanley bases projections, opinions, forecasts and trading strategies regarding the MSCI Country Index Series solely on public information. MSCI has not reviewed, approved or endorsed these projections, opinions, forecasts and trading strategies. Morgan Stanley has no influence on or control over MSCI's index compilation decisions. This report or portions of it may not be reprinted, sold or redistributed without the written consent of Morgan Stanley. Morgan Stanley research is disseminated and available primarily electronically, and, in some cases, in printed form. Additional information on recommended securities is available on request.
|
