Playing with Fire
April 30, 2007
By Stephen S. Roach | New York
The US Congress seems more determined than ever to tighten the noose on China. The issue is trade policy – and the legislative response to America’s outsize bilateral trade deficit with China. The way things look today, bipartisan support for such efforts is deep enough to assure veto-proof passage of tough trade sanctions on a broad array of Chinese products shipped to the US. I continue to believe this could be a policy blunder of monumental proportions. By going after China, the US Congress is playing with fire.
For starters, this legislative “remedy” is based on seriously flawed macroeconomic analysis. China bashing doesn’t address the real problem that Capitol Hill believes is bearing down on American workers – a multilateral trade deficit that hit a record $836 billion in 2006. Since the Chinese bilateral deficit of $232 billion amounted to the largest slice of the overall trade gap – 28% for all of 2006 and fully 34% in the final period of the year – Congress has concluded that China is the major culprit behind the trade-related squeeze on middle-class American workers. That overlooks one key point: The United States runs trade deficits not because it is victimized by unfair competition from China or anyone else but because it suffers from a chronic shortfall of domestic saving. That’s right, lacking in saving – as evidenced by a net national saving rate that plunged to a record low of 1% of national income over the 2004-06 period – the US has no choice other than to import surplus saving from abroad if it wants to keep growing. That means running current account and trade deficits in order to attract the foreign capital. China turns out to be the biggest piece in this equation not because it is unfairly undercutting American-made products but because its menu of products satisfies the tastes and preferences of a chronically saving-short US economy. China bashers continually overlook the macro context of America’s bilateral trade deficits at great peril. Consider the consequences if Congress gets its way and US trade with China is significantly curtailed: The immediate impact would be a tax on US multinationals like Wal-Mart, which sourced some $18 billion of goods from China in 2006. That would either squeeze profit margins or, if passed through to retail prices, raise the cost of living for American consumers. Over time, if the sanctions were onerous enough, the impact would be to redirect US trade away from China. But here’s where the problem gets especially thorny: Unless America increases its domestic saving, sanctions on Chinese products will do nothing to alleviate the overall trade deficit. The outcome would follow the “water balloon analogy” to a tee – squeezing the Chinese piece would simply reallocate the deficit elsewhere. And most likely that would redirect saving-short America’s multilateral trade deficit away from low-cost Chinese producers toward higher-cost foreign sourcing. Again, that would be the functional equivalent of a tax increase on American consumers. Of course, by going after China the US Congress is also biting the hand that feeds it. China is one of America’s most important external lenders. To a large extent this is an outgrowth of the same currency policy that has US politicians so up in arms – a “managed peg” that has allowed the renminbi to increase by only about 7% versus the dollar since July 2005. To keep the RMB in this range, China must recycle a disproportionate share of its massive build-up of foreign exchange reserves into dollar-denominated assets. As of February 2007, China held $416 billion of US Treasuries – second only to Japan and up nearly $100 billion from the level a year earlier. And there is good reason to believe that the Chinese hold another $300-400 billion in other dollar-based assets, such as agencies and corporate bonds. By continuing to allocate at least 60% of its ongoing reserve accumulation into dollar-denominated assets, China remains an important source of demand for American securities – thereby helping to keep US interest rates lower than might otherwise be the case. In effect, Chinese currency policy is subsidizing the interest rate underpinnings of America’s asset economy – long an important driver of the wealth effects that support the US consumer. Congressional pressure on China could put its bid for dollar-denominated assets at risk for two reasons: On the one hand, if China accedes to US pressure and allows the RMB to appreciate a good deal more against the dollar, there would be less of a need to recycle such a massive amount of FX reserve accumulation into dollar-based assets. Absent such buying, US interest rates could rise. On the other hand, if Washington enacts onerous trade sanctions on China, there is a good chance that the Chinese government could retaliate and order its reserve managers to diversify incremental reserve accumulation out of dollars. In that case, the dollar could plunge and longer-term US real interest rates could rise sharply – a crisis-like scenario that could tip an already weakened US economy quickly into recession. Either way, by imposing sanctions on one of its major foreign lenders, the Congress could be putting a saving-short US economy in a very precarious situation. Nor does the Congress appear to be all that sensitive to the internal pressures that trade sanctions might impose on China or the broader Asian economy. Despite its rapid growth and increasingly important role as one of America’s major suppliers of goods and financial capital, China is still a very undeveloped economy. That’s especially the case with respect to its financial system, dominated by four large banks that are only just starting to go public. Banks and China’s other international borrowers need to be able to hedge their currency exposure – especially in the face of the large exchange-rate fluctuations that Washington lawmakers are seeking. Lacking in well-developed capital markets, such hedging strategies are very difficult to implement in China. A large RMB revaluation could, as a consequence, deal a lethal blow to China’s embryonic financial system Moreover, there is the distinct possibility that Washington-led China bashing could inflict major collateral damage on the rest of Asia. Contrary to popular folklore, China has not become the world’s factory. Instead, it is functioning much more as the final destination of a huge pan-Asian supply chain – directly involving inputs and supplies from the region’s other major economies like Korea, Taiwan, and Japan. China is, in fact, the largest export market for the first two of these externally-led economies and is rapidly closing in on the US as Japan’s largest export market. Professor Lawrence Lau of Stanford and the Chinese University of Hong Kong has estimated that domestic PRC-based content accounts for only about 20% of the total value of Chinese exports to the US (see Lau’s 2003 paper, “Is China Playing by the Rules?” presented as testimony in September 2003 before the US Congressional Executive Commission). More recent research by economists at the central bank of Finland underscores how shifts in the RMB would reverberate throughout a vertically integrated pan-Asian production platform (see Alicia Garcia-Herrero and Tuuli Koivu, “Can the Chinese trade surplus be reduced through exchange rate policy?” Bank of Finland, BOFIT discussion paper #6, 2007). The US Congress is operating under the false presumption that trade sanctions would be a surgical strike on China. That is unlikely to be the case. Instead, there would undoubtedly be major cross-border spillovers that could quickly put pressure on the rest of a China-centric Asian supply chain. There is a final misperception about the oft-feared Chinese exporter. It turns out that China has become an important efficiency solution for many of the world’s multinational corporations. China’s so-called foreign-invested enterprises – basically, Chinese subsidiaries of multinationals – have accounted for more than 60% of the explosive growth of overall Chinese exports over the past decade. That raises serious questions about the real identity of the widely feared, all-powerful Chinese exporter. It may be less of a case of the indigenous Chinese company and more an outgrowth of conscious decisions being taken by Western companies. Who is the new China – is it them or us? Unfortunately, the US Congress is seeing the China problem from a very narrow perspective. At the root of Washington’s approach are understandable concerns about increasingly acute pressures bearing down on American middle-class workers. But the link between this painful problem and China is based on flawed macro analysis – mistakenly focusing on the bilateral piece of a major multilateral imbalance of a saving-short US economy. As is often the case, one error can beget another, and the real risk is that Washington-led China bashing could trigger a host of unintended consequences – not only taxing American consumers and US multinational corporations but also triggering currency and real interest rate pressures that could tip the US economy into recession. But the biggest tragedy could come from a United States that squanders an historic chance to engage China as a strategic partner in an increasingly globalized world. And if Washington pushes China away, I fear the rest of an increasingly China-centric Asia won’t be too far behind. Globalization isn’t easy. It puts pressure on developing and developed countries, alike. As the world’s leading economic power, it falls to the United States to assume the special role as a steward of globalization. China bashing is tantamount to an abdication of that role. Globalization may have an exceedingly tough time recovering
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Review and Preview
April 30, 2007
By Ted Wieseman | New York
Treasuries posted small losses across the curve the past week. Positive reactions through the week to some softer data — notably existing home sales, new home sales and GDP — were offset by strength in stocks, a rethinking of the initial positive reaction to the 1Q GDP downside based on positive forward-looking implications of the report and concerns about an acceleration in nominal growth, and supply pressures, as there were decent intraday sell-offs leading into each of the week’s three coupon auctions from Tuesday to Thursday that totaled a substantial US$38 billion in new Treasury issuance. It didn’t get much reaction as investors focused on predictably bad housing numbers instead, but the most important release of the week from our perspective was the durables report, where a recovery was badly needed after a string of dismal reports to reduce the possibility of a potentially recessionary growth outcome in 2Q. And although the market only briefly took notice, we certainly got that, with the key core gauge of capital goods demand surging in March, posting its sharpest gain in nearly three years and providing a good basis to expect a further pick-up in capital spending in 2Q after the surprising small rebound in 1Q. Meanwhile, 1Q growth came in lower than expected, but it now looks increasingly likely that this will mark the trough of the current period of sub-par growth. We came into the week forecasting +1.7% 1Q GDP growth, took this down +1.5% after the home sales and durables results, and then the actual outcome was slightly weaker at +1.3%. But all of the net downside relative to our forecast was in inventories. Final sales were actually a bit better than expected, and the inventory shortfall should be made up in 2Q. In addition, the extremely volatile federal government component posted a surprising decline (at least as much as we can be surprised at this point by the puzzling results BEA has been coming up with here recently) to move into negative territory on a year-on-year basis. Federal government spending has certainly slowed, but not that much, and a rebound seems likely in 2Q. Building in the likely upside to 2Q capital spending implied by the surge in March orders, the expected reversal of the 1Q inventory drag, and a likely rebound in federal government spending, we boosted our early 2Q GDP forecast to +2.4% from +1.7%. On the week, benchmark yields rose 3-4bp, with just a marginal underperformance at the long end. The old 2-year, 3-year, old 5-year, and 10-year yields all rose 3bp to 4.68%, 4.61%, 4.59% and 4.70%, respectively, while the 30-year yield rose 4bp to 4.885%. All three of the week’s auctions — US$8 billion 5-year TIPS, US$18 billion 2s and US$13 billion 5s, almost certainly more total supply than we will see at the upcoming quarterly refunding — went well, with good covers and above-average participation from final investors. But the heavy supply still weighed on the market, with decent intraday cheapening moves ahead of each auction that were not reversed in post-auction trading. And continued distribution of all this supply Friday afternoon appeared to contribute to afternoon weakness that left the market very close to the lows for the week at Friday’s close. All three new issues ended the week slightly in the red, with the 5-year TIPS closing at 2.12% after being auctioned Tuesday at 2.114%, the 2-year closing at 4.66% after being auctioned Wednesday at 4.606%, and the 5-year ending the week at 4.59% after being auctioned Thursday at 4.579%. Fed easing expectations in the futures market were scaled back somewhat over the course of the week. In the near term, the August fed funds contract lost 0.5bp to 5.205% and the October contract 2bp to 5.15%, cutting the odds of a rate cut by the August FOMC meeting to about 25% and by the September meeting to 40%, with the first cut not expected until the end of October meeting. Eurodollar futures losses were concentrated in a 7.5bp drop in the Mar 08 contract to 4.89% and a 7bp decline in the June 08 contract to 4.765%. The low rate contract was shifted out from the Sep 08 to Dec 08 contract, which was off 4.5bp to 4.705%. Though weak home sales results — misguidedly, in our view — caused the biggest market reactions of the past week’s fairly busy run of economic data, a recovery in the durable goods report was really the week’s most important number, helping significantly ease what had been growing fears of downside risks to growth from the capital spending outlook. Durable goods orders jumped 3.4% in March. While another spike in civilian aircraft orders (+38%) provided a boost, underlying orders also showed a sharp rebound, with the key core gauge — non-defense capital goods ex aircraft — surging 4.7%. This was the biggest monthly rise in two-and-a-half years and followed declines in four of the prior five months, including an 8.3% plunge over January and February. Big gains in machinery (+4.2%) and telecom equipment (+12.3%) led the rebound in core orders. Non-defense capital goods shipments gained 0.7% in March, the first rise in four months, providing a solid ramp for equipment investment heading into 2Q. Combined with the upside in orders, which led us to raise our assumptions for shipments in 2Q, we look for a further acceleration in the recently soft equipment and software investment component of GDP after the (surprising) small gain in 1Q. Real GDP rose at a 1.3% annual rate in 1Q. This was a bit less than the +1.5% we expected, but all of the downside was in inventories, with final sales at +1.6% coming in slightly better than we anticipated. Inventories surprisingly subtracted 0.3pp, and net exports subtracted 0.5pp, reversing a third of the huge add to 4Q growth. Final domestic demand rose 2.0%, led by another significant rise in consumption (+3.8%) and a surprising gain in business investment (+2.0%), with the equipment and software component (+1.9%) coming in much stronger than implied by capital goods shipments and other relevant data. On the negative side, residential investment (-17.0%) continued to plunge, and government spending (+0.9%) was little changed on a drop in the extremely volatile federal government component. We look for the inventory surprise to be reversed in 2Q, adding 0.3pp to our GDP forecast. Even assuming just a minor rebound from the surprising drop in federal government spending adds another 0.1pp. And the positive implications from the durables report for investment added another 0.3pp to our forecast. Taken together, we boosted our initial tracking estimate for 2Q growth to +2.4% from +1.7%. We expect this pick-up from 1Q to come even as consumption growth slows sharply from the +4% annualized surge recorded over 4Q06 and 1Q. We project just a 1.7% gain in consumption in 2Q as consumers are hit by the 34% run-up in gasoline prices since the end of January. Residential investment should continue to crater; we look for another plunge in the high teens to knock a point off growth again. Offsetting these negatives, we expect to see the further acceleration in business investment implied by the capital goods orders and shipments recovery in March, a return to a positive contribution from net exports — we see the underlying trend here as a roughly 0.5pp add per quarter, which is what we got on average over 4Q06 (+1.6pp) and 1Q (-0.5pp) — a swing back towards inventory rebuilding after the major drag in the past couple quarters, with a flattening out in auto sector inventories after major prior retrenchment expected to be a significant positive, and a pick-up in government spending after the weird drop in the federal component kept this component little changed in 1Q. The overall GDP price index surged 4.0% in 1Q, largely on upside in energy, while the core PCE price index gained 2.2%, as expected and consistent with the flat reading for March, we expect. There was significant focus in the market on the acceleration in nominal GDP growth to a 5.3% annual rate — just above the funds target — in 1Q that this spike in prices caused. Tracking the nominal funds target relative to the trend in nominal GDP is certainly a reasonable alternative to Taylor Rule-type calculations or judgments based on an estimate of the ‘neutral’ real rate to use in assessing the stance of policy. We found it odd, however, that many investors seemed to be so focused Friday on this one-quarter outcome for nominal GDP that was driven by a huge spike in energy prices that is unlikely to be repeated — to the extent that as this result was focused on it resulted in the market’s initial positive reaction to the downside in real growth being quickly reversed. On a year-on-year basis, nominal GDP growth slowed to +4.8% in 1Q from +5.7% in 4Q06, an outcome consistent with the idea that the current 5.25% funds target is modestly restrictive, a similar conclusion that would be arrived at by comparing the current real funds rate to historical norms or computing a Taylor Rule-based estimate. Housing remains weak and looks set to remain a big drag on growth in coming quarters. We’re not sure why this should come as any surprise to investors, but the existing and new home sales reports for some reason caused the biggest market reactions of the week’s various data releases, though in both cases the upside proved short-lived as pre-auction cheapening immediately set in after the day’s highs were hit at 10:00 Tuesday and Wednesday after these reports were released. New home sales rose 2.6% in March to 858,000 annualized, showing a slight rebound after plummeting 18% over the prior two months as we head into the key spring selling season. Meanwhile, existing home sales fell 8.4% in March to a 6.12 million unit annual pace, more than reversing surprising upside in the prior couple months. Because of the way they are counted, existing home sales lag new home sales, and so this drop appeared to reflect a catch-up to the prior weakness in the latter. The months’ supply of unsold new homes dipped to 7.8 from the 16-year high of 8.1 hit in February. This remains well above the long-term average of 5.5 months and indicates that significant further downside in starts will be needed to bring the market into balance after the surprising recent gains. We look for about a 25% drop in starts over the next six months to an ultimate trough below 1.2 million units around the late summer. Such an outcome would keep real residential investment declining at pace near the 18.5% declines averaged over the past three quarters through 3Q, after which we expect the housing recession to begin moderating and ultimately turning to modest growth over the course of 2008. The upcoming week is very busy, with a number of key economic releases and the Treasury refunding announcement, but trading volumes will be thinned by holidays in Asia. On the refunding, we look for a US$33 billion package, US$14 billion 3s (US$2 billion smaller than last time), US$13 billion 10s (unchanged), and a US$6 billion reopening of the bond. The Treasury will announce the fate of the 3-year at this refunding, and elimination appears very likely, particularly in light of how strong tax revenue growth has been in April and the strain this is putting on the bill market, which is unlikely to see much relief until the summer. Through Thursday, individual non-withheld tax receipts (basically checks sent in with people’s tax returns) so far in April have totaled US$172 billion, up 16% from the comparable period last year. We came into tax season looking for 14% cumulative growth in non-withheld receipts over the April/May period, and we certainly appear to be on track for at least that. This is not the only source of tax strength, however. Withheld income and payroll taxes are on pace to post a 14% year-on-year surge in April and gross corporate taxes 13%. Incorporating these results, we cut our 2007 budget deficit estimate to US$180 billion from US$210 billion, which would be an estimated 1.3% of GDP. If non-withheld receipts continue to surprise on the upside in the remaining week or so in which significant numbers are still to be tallied, this could easily move even lower. With further improvement expected in 2008, there may not be much for the presidential candidates to debate about on the fiscal side next year. Current talk about the need to face trade-offs among fixing the AMT, extending the Bush tax cuts and significantly boosting healthcare spending would certainly seem a lot less pressing with a budget deficit only around a meager 1% of GDP. Key data releases due out in the coming week include personal income and spending and construction spending Monday, ISM and motor vehicle sales Tuesday, factory orders Wednesday, productivity Thursday, and — the week’s main focus — employment on Friday: * We forecast a 0.7% gain in personal income in March and 0.4% rise in spending. The employment report pointed to an above-trend increase in nominal personal income during March. On the spending side, vehicle sales data imply a slight dip in car buying. Moreover, we look for some weather-related softness in outlays for utilities. So even though retail control (including gas stations) posted a sharp 0.7% rise, the gain in overall consumption is likely to be more subdued. And real consumer spending is expected to be flat after taking into account an anticipated 0.4% rise in the headline PCE price index. Finally, the core PCE is expected to be 0.0% (+0.03% before rounding), which should push the year-on-year rate all the way down to +2.1% (versus +2.4% in February). * We look for a 0.5% rise in March construction spending. The housing starts data for March were stronger than anticipated, but we still look for a modest decline in the residential category (-0.5%). Meanwhile, we expect to see further gains in the non-residential (+1.0%) and public (+1.0%) sectors, aided by improved weather relative to the unusually severe conditions experienced across parts of the country during February. * Based on the regional surveys that have been released to this point, we look for a slight deterioration in the ISM to 50.5 in April relative to the 50.9 reading seen in March. The price index is expected to continue to climb — rising 2.5 points to 68.0. We will update our estimate following the release of the remainder of the regional reports. * Our preliminary April motor vehicle sales forecast of 16.0 million calls for a modest pullback relative to the 16.3 million unit pace seen in March. Foreign nameplates are expected to continue to garner market share. Industry reports suggest that some domestic automakers are transitioning from financing-based incentives to cashback deals, which could lead to some late-month improvement. We will update our estimate if the automakers offer any last-minute guidance. * We forecast a 2.5% gain in March factory orders. The sharp jump seen in the durables component, along with some price-related elevation in the non-durables category, should lead to a sizeable advance in overall bookings. Meanwhile, factory inventories are expected to be up 0.4%, with the I/S ratio holding at 1.25. * We look for a 1.0% rise in 1Q productivity and a 1.2% gain in unit labor costs. The GDP data showed 1.4% growth in the relevant measure of output. Adjusting the data from the monthly payroll employment report for the impact of self-employed and supervisory workers, we estimate that hours worked (as defined in the productivity report) rose 0.4% during the quarter. This implies a 1% gain in productivity for the quarter, with the year-on-year rate slipping a bit below 1% (even after factoring in a likely 0.4 percentage point upward revision for 4Q06). Obviously, the recent productivity results show indications of some underlying moderation — likely due to cyclical forces. Meanwhile, the calculation of unit labor cost will be distorted by the unwind of US$50 billion in stock option exercising and other special payments which BLS statisticians plugged into the accrued compensation data for 4Q06. Moreover, the inconsistent treatment of the timing of these payments should lead to a sharp pullback in the year-on-year rate of growth in unit labor costs. We will have more of an apples-to-apples comparison for the year-on-year change in 2Q, and unit labor costs should rebound to a growth pace that is above the underlying rate of core inflation at that point. * We forecast an 80,000 increase in April non-farm payrolls. Declines in the residential construction and retail trade categories are expected to lead to a below-trend rise in payrolls this month. The expected pullback in construction jobs represents a catch-up for some upside surprises in recent months as we move into the part of the year in which the seasonal adjustment factors anticipate some significant increases in hiring. Meanwhile, the retail trade category appears due for a pullback since it has been unusually strong in recent months and because some of the elevation that was evident in March might have been attributable to the Easter calendar shift. The government sector is also expected to flatten out following some above-trend readings in recent months. We look for the unemployment rate to reverse the downtick seen in March. Finally, the average workweek is expected to unwind the small gain seen last month, while average hourly earnings are likely to continue to show signs of some underlying acceleration.
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The ECB and the Euro
April 30, 2007
By Elga Bartsch | London
This week’s batch of business surveys has failed to show any skid marks from the German VAT hike, US slowdown or the marked strengthening of the euro. In fact, feeding the April business surveys into our proprietary early GDP indicator signals small upside risks to our official near-term GDP forecasts (see Eric Chaney’s Business Cycle Watch: Ignoring the Euro (So Far), April 27, 2007). Furthermore, the first April CPI report out of the euro area signals upside pressure from energy and food prices. If this trend persists, thanks to heightened geopolitical tensions and the unusually warm and dry spring weather, the decline in HICP inflation this summer could be less pronounced than previously assumed. Incoming data thus underpin our view that the ECB is highly likely to raise the refi rate by another 25 basis points at the June meeting, bringing its key policy rate to 4.0%. This widely expected move will likely be pre-announced at the May Governing Council meeting by a statement that the upside risks to price stability warrant “strong vigilance”. Beyond June, the course of the ECB’s monetary policy action has become much more controversial. Some observers argue that the ECB will soon find its tightening campaign being brought to a halt by a rapid deterioration in the incoming activity data. Others highlight that a further rise in the euro will rein in the hawks on the Council. This past week, even a nose-diving Spanish economy was cited as a reason for the ECB not to hike beyond 4%. Of these arguments, the potential repercussions of a rallying euro on the ECB’s monetary policy deliberations is the most convincing one, I think. Nonetheless, I believe that we should bear in mind a number of factors that will likely limit the ECB concerns about the euro’s ascent. First, like an oil price shock, an appreciation in the currency essentially has a one-off dampening effect on the price level. Unless the currency continues to appreciate on an ongoing basis, it should not affect meaningfully the underlying inflation pressures. It’s only the so-called second-round effects caused by lower import prices that the central bank should be concerned about. These second-round effects are more likely to stem from changes in wage and price-setting behaviour. Here the ongoing wage talks in the German metal industry are probably more relevant for the ECB’s inflation outlook, and we still have to see trade unions lowering their wage demands because of the stronger euro. Of course, a stronger currency — like a higher oil price — can have negative repercussions on export demand. Contrary to overseas economic activity, which tends to affect export demand almost immediately, there is typically a time lag of 6–9 months before exchange rate moves affect export demand. Hence, we might still see the negative impact of the recent rise in the euro on the Euroland manufacturing sector. Thus far, business sentiment has not been dented by the stronger euro. Second, the impact of the stronger euro on growth and inflation over the medium term crucially depends on the degree of pass-through. Pass-through into import prices, however, seems to have fallen consistently globally due to a number of factors, including the rising credibility of central banks and changes in the pricing behaviour of companies. Pricing-to-market implies that exchange rate gyrations tend to show up in profit margins rather than market shares. Together with increasingly globalised production structures, the latter implies that stated corporate profits can become more sensitive to unexpected, and hence unhedged, exchange rate movements. Underlying corporate profitability, by contrast, tends to be less affected by exchange rate swings than quarterly results would sometimes suggest. The third — and in my mind, the most important — point is that financial globalization might make central banks become more tolerant of currency appreciation. This is because the way in which monetary policy decisions are transmitted to the economy changes as a result of global financial market integration. In globalised financial markets, individual central banks seem to have less control over the medium to long end of the yield curve. Therefore, the exchange rate might have to play a bigger role in transmitting monetary policy tightening to the real economy. Much has been said and written about the limited reaction of bond yields to global monetary policy tightening, and I don’t want to elaborate further on this issue here. I would just like to highlight that — together with the low level of interest rates across the maturity spectrum — the rampant money supply growth indicates that the impact of past ECB interest rate hikes has been limited. With only a muted reaction in the bond market — and also in the equity market, for that matter — another transmission channel might be needed to ensure that the euro area economy isn’t fuelled too much further. And this channel would be the exchange rate. Naturally, the ECB Council will likely have various views on the euro and its implications for monetary policy. Having a more controversial discussion is exactly what you would expect as the tightening campaign inches towards its end. As a result, the euro area monetary policy outlook will likely become more data-dependent over the summer, and calling the next ECB move correctly will likely become more challenging. In this context, the release of a new set of staff projections at the June meeting will likely be key in shaping expectations. Given the price action in commodity and currency markets, the assumptions underlying the staff projections could change meaningfully compared with March, when a EUR/USD of 1.30 and a crude oil price of USD 60 per barrel this year and USD 63 for next year was assumed. While this year’s growth forecast of 2.5% and this year’s inflation forecast of 1.8% probably still carry some small upside risks, the impact of higher exchange rate assumption would be negative for next year’s staff projections, which stand at 2.4% for growth and of 2.0% for inflation. At this stage, financial markets might very well get excited about the idea of no further tightening from the ECB — unless, of course, the press conference sends a distinctively hawkish message. However, after the summer holidays, when the US economy starts to recover and the USD starts to strengthen again, the situation might again look very different. In my mind, it would therefore be too early to close the books on ECB tightening in June.
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Ignoring the Euro (So Far)
April 30, 2007
By Eric Chaney | London
As the euro was breaking its December 2004 record (USD 1.364), on its way to 1.37, euro area manufacturing companies polled by economic institutes (Ifo, Insee, Isae) are reporting the strongest ever recorded demand indicator, at least since the beginning of our records (January 1988). Although the rise of the single currency is negative for corporate profits, other things being equal, the message from companies that should be the most sensitive to this factor is loud clear: at this stage, they can afford to live with a strong currency. Two factors are providing convenient cushions: strong order books and comfortable profits. The former is helping companies to buy time while the second makes price cuts — signaled by some surveys — less painful than otherwise. None of these shock absorbers will have a permanent effect, of course, but, so far, corporate Europe is still able to ignore the strength of the euro. The demand indicator broke a new record The main surprise for business cycle watchers was the rebound of the demand indicator from 1.4 to 1.6 standard deviation (sd), slightly higher than the December 2006 and June 2000 previous records. The German indicator continued to defy gravity, at 2.3 sd, not only a level unseen since the hottest times of the German unification (end of 1990), but even slightly higher than one month ago. The boomerang effect that we feared after the rise of the German VAT rate did not materialise at all, despite anecdotal (but fragile) evidence that retail sales were down in the first months of this year. Yet, the main improvement in demand trends came from other countries, starting with Italy and including Belgium and the Netherlands. This is important: the euro area recovery is no more a pure German story; instead it is gathering momentum by becoming more broad-based. What could have offset the drop in Chinese imports? On the most recent statistics (February), Chinese imports from the euro area, as recorded by the IMF, dropped by 4.5%Y, after having increased by 19%Y on average over the previous six months. Although they may have rebounded since then, we take seriously the willingness of the Chinese leadership to slow capital spending and, consequently, imports of foreign capital goods. But since euro area manufacturers have not reported any significant deceleration in aggregate demand, we must conclude that the Chinese slowdown was offset by the appetite of other customers. The fact that the recovery is becoming broader based within the continent gives a first clue: internal trade, i.e., within the Union, is probably accelerating faster than final domestic demand itself, a cyclical feature often observed in the past and due to pan-European corporate restructuring. Two other suspects come to our mind: Oil exporting countries such as Saudi Arabia and the Emirates, but also Russia and Kazakhstan, seem to accelerate the recycling of petro-dollars in real goods, as testified for instance by the stunning growth rate of investment in Dubai. Although most oil exporters are de facto in the US dollar zone, the rising income elasticity of their imports is likely to offset its price elasticity. Last, the slight re-acceleration of US imports, up 0.6%Q in the first quarter, according to the advanced GDP report, may have helped, although marginally. Keeping inventories tight is paying off In contrast, there is little evidence that, despite the surprising resilience of demand, companies are rushing to build inventories. It is even quite the opposite. The inventory indicator has been remarkably stable since last December, at -0.9 sd, indicating that companies see inventories as insufficient, given demand trends, but not as dramatically as, for instance, in May 2000, when the index dropped to -1.5 sd. Moreover, the Belgian component, a reliable leading indicator of the euro area inventory cycle, is heading toward a more balanced assessment. This is good news, I believe, because it implies that if demand slowed unexpectedly, companies would not have to slash production as aggressively as they did in June-July 2001 for instance. Decoupling from the US is a reality, for now at least While experts continue to debate about the possibility of the global economy decoupling from the US business cycle, European companies are answering quietly: “We are not concerned by the woes of the US economy; we have more than enough other customers within and outside of Europe”. The fact is that the US economy started to slow below trend in the second quarter of last year (GDP growth down to 0.64%Q from 1.4%) and that, almost one year later, as the economy is close to stall speed (0.32%Q in 1Q), the euro area economy is still growing above trend. The time-honoured six-month lag between the US and European business cycles seems to have lost its predicting power. Our early GDP indicator jumps to 0.74%Q for 2Q More precisely, our GDP indicator, which synthesises the information coming from business services in manufacturing, construction and services as well as from the yield curve, moved from 0.5% to 0.74%, helped by strong readings in the manufacturing sector, but also by fresh and positive news from services. As a reminder, this indicator is estimating GDP growth at 0.7%Q in the first period, but since we suspect that it might have over-reacted after its 4Q undershooting, we stick to our 0.5%Q official forecast for both 1Q and 2Q. It remains that for the first two quarters of this year, our business survey-based tool is more upbeat than our official GDP growth forecast. This is signaling upside risks to our full year GDP forecast, which we revised up to 2.5% one month ago. Mind the lagged impact effects of the euro and rates How strong might be current readings, it would be unwise to believe that currency and interest rates do not matter anymore. Time lags are contingent on the initial state of the economy and are thus uncertain. Sooner or later, real demand will slow. Clearly, we are not there yet.
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Good News: The Party Is Over
April 30, 2007
By Eric Chaney | London
Investors’ positive sentiment about the performance of the Spanish economy was shaken by the collapse of the building company Astroc Mediterraneo, which put a concrete name on investors’ anxieties regarding the housing and construction sectors. Many were quick to draw a parallel with the crash of the US sub-prime lending market and to predict a hard landing for the Spanish economy. We believe that neither this parallel nor this conclusion are solidly founded; yet, questioning the sustainability of the stellar performance of the Spanish economy — 3.7% GDP growth on average since EMU started — is justified. Spain has accumulated large imbalances, such as a current account deficit close to 9% of GDP, that are likely to be unwound in the coming years as the result of higher real interest rates and slower, if not lower, housing prices. In our view, the relevant question is whether these adjustments will trigger a hard or a soft landing of the main Iberian economy. At this stage, we believe that a gradual deceleration, i.e., a soft landing from a macro viewpoint, is the most likely scenario. However, this does not exclude more painful adjustments in the sector where the Spanish exuberance is concentrated: housing and construction. There are several negative factors making the Spanish outlook overcast. First, the construction sector is clearly oversized. In 2006, the whole sector, including housing and commercial investment and public works, absorbed 17.8% of GDP, to be compared, for instance, to 9.7% in France. There are many reasons explaining why the construction sector grew so large in Spain: rapid development of infrastructures funded by EU transfers, strong demand for seashore properties by foreign investors who are no longer deterred by a possible devaluation of the peseta; strong demand for second houses by Spanish households who are becoming richer and strong demand from immigrants. Immigration flows are indeed stunning: on a net basis, 642,000 immigrants (1.5% of the population) landed in Spain in 2005. Second, households’ debt has taken off, reaching 120% of disposable income on the latest readings, and is sensitive to short-term interest rates. Third, previous ECB rate hikes have not yet fully passed through and there is more to come: most mortgage rates are reset after one to three years. Fourth, productivity growth has been sluggish over the last ten years, despite strong growth performance: compared to the EU-15 average, Spanish hourly productivity has lost 4 points since 1995. Fifth, housing prices are probably significantly overvalued, although it is difficult to assess exactly by which margin. There are nevertheless positive variables in the Spanish equation. For instance, migration inflows, which are part of the solution, i.e., are among the supply-side factors that explain both strong GDP growth and buoyant demand for houses, could become part of the problem if reversed. However, they are partially structural, reflecting the relative flexibility of the Spanish labour market: despite massive immigration, the Spanish unemployment rate has declined by 10 points since 1995. Although Spanish inflation has been higher than the euro area average since EMU inception and despite the strength of the euro, Spanish exports have increased in line with euro area exports, suggesting that factors other than price competitiveness are playing in favour of Spain. Last and probably the most precious asset in case of an unexpected demand contraction, the Spanish public budget is running a sizable surplus (1.8% of GDP) and the public debt is one of the lowest in the euro area, at less than 40% of GDP, thanks to prudent fiscal policies from previous governments On balance, we believe that negative factors are likely to have the upper hand in the next few years. The unavoidable downsizing of the construction sector will prove painful, as it has been for Germany after the post-unification boom. Indebted households will see their discretionary income cut by higher interest payments, which will bear on consumer spending, on top of a less positive wealth effect. However, a hard landing looks highly unlikely in a country having powerful fiscal stabilisers and the possibility of contra-cyclical fiscal actions by the government. After several years of above-trend growth, evidenced by the size of the current account deficit but also by the budget surplus, Spain’s GDP growth is likely to decelerate to trend or below trend. Thanks to a strong start this year, helped by buoyant foreign demand, GDP growth is likely to reach 3.7% this year. However, we anticipate a sharp slowdown next year, to 2.4%. Even so, this would still be stronger than the 2.1% average GDP growth of the euro area since EMU started.
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Post-Modern Blues
April 30, 2007
By Serhan Cevik | from Tel Aviv
The military’s involvement in politics undermines Turkey’s case for EU membership. Turks used to wake up to the deafening noise of tanks rolling through the streets, as the powerful military reshaped the country’s political landscape every ten years between 1960 and 1980 and then used ‘post-modern’ tactics in 1997 to remove a government from office. However, just as we thought Turkey is moving steadily towards liberal democracy, Turks went to bed last Friday with a harsh, unexpected statement from the Chief of Staff condemning “endless efforts to undermine the fundamental values of the republic”. Even though reasons behind this blunt declaration are open to debate, there is no doubt that even ‘post-modern’ statements undermine institutional reforms to demilitarize the political landscape and thereby Turkey’s accession negotiations with the European Union. The apparent ‘trigger’ for the military’s burst into the political scene is the parliamentary selection of the new president. In a recent briefing note, we argued that presidential elections have always been controversial and the process would indeed become a test for institutional modernization (see The Litmus Test for Liberal Democracy, April 9, 2007). The military’s reaction is not a coup d’etat in the traditional sense, but it certainly increases the degree of uncertainty in an election year and hurts Turkey’s case for EU membership. The military’s statement puts Turkey in an awkward position. Although presidency may be a symbolic institution, the constitution — written by a military regime — endows the president with important powers (like appointing top bureaucrats and heading the National Security Council). This is why the military feels that it should have a say over the selection process, especially with a lack of trust between the ‘secular establishment’ and the ruling government. However, realizing the problem, Prime Minister Tayyip Erdogan has already opted out of seeking the presidency and instead nominated Foreign Affairs Minister Abdullah Gul as the party’s candidate. Given Mr. Gul’s well-respected standing in domestic and international politics, we thought that his nomination would not destabilize the delicate balance. Apparently, that is not the case (at least, from the military’s point of view), albeit he is one of the leading architects of Turkey’s accession process. The military’s statement does not mention Mr. Gul (or any other politician), but cites the killing of three Christian missionaries and a group of children singing hymns to celebrate the birth of Prophet Mohammed as a threat to secularism. However, it seems that the problem stems from the military’s expectation for a ‘moderate’ presidential candidate (like the defense minister), instead of someone like Mr. Gul with a ‘history’ in political Islam and a wife wearing a headscarf. Of course, this cannot be an excuse for having a stance against the most reform-minded civilian government in Turkey’s recent history, and it sends an awkward message to the EU where no membership candidate has faced what Turkey is experiencing right now. The politics of fear leads to a dangerous polarization in Turkish society. Reliable surveys show that the number of Turks opposing a regime based on religious principles stands at 76%, and 68% among those who identify themselves as ‘Islamist’. Alas, while the society is firmly in favor of the secular state, the politics of fear remains widespread and leads to dangerous polarization. Indeed, the government’s response was as strong as the military’s statement and could escalate the tension in the midst of an election period. However, we believe that all the parties will try to minimize the fallout and find a graceful exit from the impasse. While the AKP is unlikely to change its presidential candidate, the Constitutional Court’s decision on the ongoing election process may clear the way. Mr. Gul received 357 votes, just short of 367 votes required in the first two rounds, and will likely get elected in the third round of voting, when the requirement is only 276 votes. However, the main opposition party (CHP) has asked the Constitutional Court to annul the entire selection process, arguing that there must be at least 367 members of parliament present in the general assembly to start the voting procedure. We may be failing to read ambiguous legal texts, but the quorum requirement seems to be 184 MPs, not 367. Of course, if the court rules in favor of the CHP’s appeal, there is only one option, and that is holding general elections within 90 days. Elections could ease the tension and shorten the period of uncertainty, in our view. Even though there is really no ground for a military coup (which would obviously undermine Turkey’s economic and institutional development), holding elections as soon as possible could ease the tension and shorten the period of uncertainty. In our view, the Turkish economy is strong enough to withstand unexpected events like the military’s statement. Nevertheless, we all know that it has a significant exposure to liquidity-driven capital flows that may not appreciate the peculiar channels of communication between politicians and the military. In the longer term, of course, what matters for sustainable, welfare-enhancing growth is not just economic stability, but also institutional modernization towards a truly liberal democratic regime. After all, foreign as well domestic investors prefer to put their money in a country where the rule of law is unquestionable (see Law and Order, November 26, 2004).
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