Global
The News and the Future(s)
May 04, 2007

By Manoj Pradhan | London

US 10-year Treasury futures respond strongly to non-farm payroll (NFP) announcements — this is no surprise. What is intriguing, however, is that Bund futures show a response to this number that is over half as strong as the response of Treasury futures, and much stronger than the response that Bunds show to Ifo announcements. The response is measured by analyzing futures prices 10 minutes before and after payroll and Ifo announcements against the surprise in each of these numbers. Economic links between the US and the euro area cannot account for such a strong response from Bunds, implying that a possible decoupling of the euro area economy may weaken this effect somewhat but is unlikely to reduce it by very much.

Results show that NFP surprises elicit a stronger response from Treasury futures and Bunds futures than Ifo surprises. A one-standard-deviation NFP surprise produces a 0.34% change in Treasury futures prices and a 0.19% change in Bunds futures prices. Ifo surprises produce a response of just 0.05% in Bunds futures prices while Treasury futures produce a statistically significant but economically insignificant price response of 0.01%. Using an approximate price of 108 and a duration of 7.9, the 0.33% price change corresponds to a 4.6bp change in yields — a significant size.

The reaction of Treasury futures to NFP announcements is well in line with the importance and information content of the payroll numbers. The reaction of Bund futures, however, is intriguing. First, they show an overwhelmingly greater reaction to US news than to domestic news. Second, the response of Bund futures to NFP announcement surprises is nearly 60% as strong as the response of US Treasuries.

As a rule of thumb, the business cycle and the policy cycle of the euro area lags the US cycle by about six months. As we move further out on the yield curve, the tyranny of the policy rate weakens so that bond yields have more freedom to respond to other stimuli. Thus, Bund yields may be interpreting events in the US as harbingers of things to come in the euro area, justifying their instantaneous response to US news. But what about the magnitude of the response? A 1% increase in US GDP is estimated to increase euro area GDP by 0.36% (source: OECD Interlink model). This number would have to be nearly twice as high to fully account for Bund futures showing a reaction. If evaluated on economic fundamentals alone, the response of Bund Futures seems to be in the right direction but ‘excessive’.

But economic channels are not the only way in which these financial markets are linked. US and euro area bond markets are linked by cross-region trades. Structural factors like greater financial integration and more cyclical factors like greater risk appetite and liquidity have localized global financial markets. Sovereign benchmarks are likely to be the most affected as a result of these cohesive forces. Traders looking to exploit heightened correlation levels across assets and regions might induce greater correlation than these markets would normally show. If markets are indeed efficient, then these conditions must account for the ‘excess’ response — which would constitute more than half of the observed reaction of Bund futures.

While longer-term movements in 10-year Treasury yields and Bund yields have followed broader economic trends, short-term movements in these yields have been well correlated. A 90-day correlation between the two shows downward spikes around large movements in the exchange rate (which are themselves responses to economic events). Interestingly, the response of Bund futures even in times of weak (or negative) correlation consistently reacts to surprises in US payrolls numbers.

Treasury futures should continue to react to NFP surprises, but what of the response of Bunds? If the response was based on economic factors alone, then a genuine decoupling of the euro area from the US would imply that Bund futures would respond minimally to NFP numbers. As it stands, we have argued above that factors specific to financial factors probably play a larger role in explaining the response of Bund futures than economic factors.

Decoupling itself is not a foregone conclusion. Right now, decoupling is difficult to distinguish from the euro area economy simply lagging behind the US. Weak US GDP and homes sales data and strong IFO numbers have bolstered the decoupling argument, but it is still too early to make the call in a decisive manner. Monetary policy works with lags and rates in the euro area still have to work their way through the economy. In addition, a strengthening euro should work to accentuate this trend (see Doubts about Decoupling, Joachim Fels, April 24, 2007). The upshot is that whether Europe decouples from the US or is simply lagging, Bund futures should continue to react strongly to US news.

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Europe
Spain and the UK: Similarities and Differences in the State of the Housing Market
May 04, 2007

By David Miles | London

 A few months ago we produced an analysis of what had driven UK house prices up so much in the period since the mid-1990s, and asked whether this was sustainable (UK Housing: How Did We Get Here? David Miles and Melanie Baker, November 2006). There are few European countries that have seen prices rise as much as in the UK — but Spain is one of them. In fact, the Spanish and UK experience over the past decade has been — in many respects — very similar. What we do here is use the same framework that we developed for analysing movements in UK house prices to look at the Spanish market in order to assess how stretched valuations might have become.

First, the facts. In both countries house prices are now about three times higher than they were ten years ago. In real terms — after allowing for the rise in the general price level — house prices are up by about 130% in Spain, somewhat more than in the UK. But mortgage debt has increased dramatically faster in Spain than in the UK. The aggregate stock of mortgages in Spain is now around six times as great as it was ten years ago. Since the mid-1990s, mortgage debt relative to aggregate household income in Spain increased from levels below those in the UK to levels significantly above them.

Both population growth, and particularly the numbers of new houses built, have been greater in Spain than in the UK. Interest rates over the ten-year period have also fallen faster in Spain than in the UK.

So, some of the fundamental factors that one expects to drive house prices — population growth, movements in interest rates — would make one expect that Spanish house prices should have risen more than in the UK. Other factors — particularly the much greater scale of house-building in Spain — work in the opposite direction. We use the framework developed in the recent analysis of the run-up of UK house prices to assess the impact of the drivers of the demand and supply for housing upon house prices in Spain. We aim to estimate the impact of population growth, changes in interest rates, movements in disposable incomes and the effect of shifts in expectations of future returns on housing. We might term the latter a speculative factor — one which we might expect to be volatile and to create the potential for sharp movements in prices and construction activity if expectations of future price rises are scaled back.

We assume that the impact of incomes and population on demand in Spain is similar to that in the UK and that the sensitivity of demand to perceived changes in the effective cost of housing is also similar. We find that the impact of lower real interest rates and higher populations would indeed have been expected to raise house prices in Spain over the past ten years by significantly more than in the UK. But the very much larger scale of house-building roughly offsets this so that the net impact of a lower cost of debt, rising populations and house-building is roughly comparable in the two countries.

We find that in accounting for the very great increase in house prices in the two countries, a major role is played by changes over the past ten years in the expectations about likely future capital gains. This force — which one could describe as a speculative factor — is as important in Spain as in the UK. This means that the demand for housing is significantly exposed to shifts in sentiment about future house price increases in both countries.

Conclusion: We estimate that a substantial part of the more than doubling of UK and Spanish real house prices over the past ten years is due to income growth, population growth and falling real interest rates. However, one-third or more is likely to reflect changes in expected house price inflation — this is a speculative element of demand, and one which is likely to be volatile.

The key question is whether, starting from here, we are likely to have significant falls in real house prices and/or construction activity once those expectations come down. We think this is quite likely — but our simulations suggest that the timing is very hard to fathom.

In Spain, adjustment will probably come relatively more in the form of a supply adjustment (less construction), while in the UK it would come proportionately more in the form of price adjustments.

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Currencies
The World Is Indeed De-Coupling
May 04, 2007

By Stephen Jen | London

Summary and conclusions

We reaffirm our view that the global economy is successfully de-coupling, and that the US economy is indeed experiencing a mid-cycle slowdown and not a cycle-terminating recession.  These are the critical assumptions behind our constructive view on risky assets and our cyclically bearish view on the dollar. 

In this note, we take a closer look at the issue of economic de-coupling, which is curiously still a subject of debate among investors and commentators, despite data that overwhelmingly support this view. 

The verdict from the IMF’s World Economic Outlook

The IMF’s World Economic Outlook (WEO) published on April 11 had a chapter devoted to this issue.  The key points made there were as follows.   First, since 1970, mid-cycle soft landings in the US economy (e.g., 1986 and 1995) have usually been accompanied by healthy growth in the rest of the world.  Cycle-terminating hard landings in the US (there were five recessions in this period), however, had significantly negative effects on the rest of the world.  Second, on two occasions, there was particularly tight coupling between the US and the global economy, but the main reason for this was that the world was hit by common shocks.  These two episodes were the oil shock in the early 1970s and the bursting of the IT bubble in 2000.  Since the current US slowdown is driven by a US-specific factor, the spillover effects to other countries are likely to be limited.   Third, the US has become progressively less dominant as a trade partner for most countries in the rest of the world.  Fourth, countries that had already suffered from large negative shocks at the beginning of US recessions actually performed better than countries that were in the more mature phase of their growth cycle. 

Our view

We fully concur with the findings of the IMF and add the following observations for your consideration.

• Observation 1.  Whether the US landing is hard or soft is important for the de-coupling debate.   We totally agree with the IMF’s finding on this.  Based on our own research, most countries (except Japan) have a lower growth correlation with the US in soft landings than in hard landings, supporting the IMF’s observation that growth correlation with the US is higher in hard landings but lower in soft landings. 

• Observation 2.  Financial markets have continued to do well, despite the soft landing in the US.  Some ‘pessimists’ have argued that the strong evidence of economic de-coupling is not enough to declare that the world is out of the woods, and that financial coupling will take the world down when US equities sell off: there is a presumption made by the ‘pessimists’ that the US equities should not be so buoyant.  While we agree that the level of financial coupling is very high, we argue that equity markets don’t need to be weak if there is only a soft economic landing, and global growth rotation.  If anything, a more balanced global economy, both sectorally and geographically (at a country level), actually reduces overall risk as it makes global growth more sustainable.  Risky assets should perform well.  Indeed, global equity markets fully recovered from the sell-off in February/March in a quarter of the time it took last year, and the Dow continues to set record highs.  Therefore, financial coupling actually helps effect economic de-coupling. 

• Observation 3.  ‘Coupling’ versus ‘synchronism’.   We strongly disagree with the view that the global economy has not de-coupled but is simply ‘out-of-sync’.  The difference between these two concepts is not about the timing of the slowdown in the rest of the world, but the magnitude of the negative spillover effects from the US.  We recommend thinking in terms of the ‘positive alphas’ and the ‘negative betas’, with the latter being the elasticities of the rest of the world’s growth with respect to that of the US.  Describing the current state of affairs in the world economy as ‘out-of-sync’ understates the strong ‘positive alphas’ we are witnessing in many parts of the world, in our view. 

First, as the IMF documented in the WEO, countries that are growing below trend tend to experience self-correcting forces, pushing them to drift toward trend.  This is a point we have made in the past as well, and believe that this is the case in both Euroland and Japan, making them appear de-coupled from the US.  Second, it seems difficult for the ‘pessimists’ to explain away the extraordinary growth in China, despite the slowdown in the US.  Third, not only China, but all of the emerging market space is showing an immense amount of resilience.  Oil prices and metals prices remain buoyant, partly reflecting robust global demand, in our view.  Fourth, and perhaps the best example of all, Canada’s ability to de-couple from the US is most remarkable, despite the fact that 84% of its exports go to the US, and that Canadian building materials and auto parts exports have been hurt by the slowdown in the US.  

• Observation 4.  The US is a less important export market than in the past.  Over the past two decades, exports to the US, as a percentage of total exports, have declined in the EU, Japan, Taiwan, Korea and Thailand.  China is an exceptional case, of course.  In general, the world’s reliance on demand from the US has steadily declined as globalization has led to less of a reliance on the US in general.  Recent data suggest that exports from AXJ (e.g., in China, Taiwan, Korea, Singapore and Malaysia) remain very robust, despite the slowdown in the US.   

Impact on the currency markets

Though the US economy is soft landing, the global economy is in great shape.  This growth rotation away from the US and a generally healthy risk-taking environment have permitted the dollar to descend gradually, and we believe that this will continue until the US economy starts to reassert itself.  We recommend persisting with USD shorts against the ‘usual suspects,’ e.g., the EUR, GBP, AUD and CAD now.  But as the US economy gradually gains momentum, investors should rotate into USD/AXJ shorts, and go short on the over-valued EUR/USD and GBP/USD. 

If anything, the primary risk to the global economy is excessive growth and inflation, not recession, in our opinion.  The biggest risk to risky assets, which may become visible in two or three quarters’ time, is central banks being seen to be behind the curve, and we see a repeat of what happened last May/June. 

Bottom line

We believe that the global economy is genuinely de-coupling, and that this development has important consequences for risky assets and the dollar. 

 

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Currencies
How Big Could Sovereign Wealth Funds Be by 2015?
May 04, 2007

By Stephen Jen | London

Summary and conclusions

Answer: US$12 trillion. 

How important will the SWFs be over the medium and long term?  According to my calculations, based on several assumptions, the world’s SWFs could grow from US$2.5 trillion now to nearly US$12 trillion by 2015, and could exceed the total size of the world’s official reserves within five years, i.e., by end-2011. 

The calculations I have performed

In the last update on this subject, I reported that, according to my ‘guesstimates’, the total size of the SWFs in the world could be as large as US$2.3 trillion.  This figure does not include the funds from Saudi Arabia, but does include the entire Oil Stability Fund (OSF) of Russia.  Assuming that SWFs of Saudi Arabia may total US$300 billion, and taking out some US$70 billion from the OSF, the total size of the world’s SWFs may now be around US$2.50 trillion. 

I then assumed that, broadly, total oil revenues (including both the quantity and price effects) would rise by around 10% a year for the foreseeable future, and that a portion of each non-oil exporter’s C/A surplus would be diverted either to the official reserves or to their SWFs.  Further, I made the conservative assumption that the annual nominal return on a SWF’s investment is 5.50% (slightly higher than the currency-weighted return on 2Y sovereign paper of 4.30%). 

1.         US$12 trillion by 2015 ... First, I expect SWFs to grow very rapidly, both in absolute terms and relative to the total stock of the world’s official foreign currency reserves.  Starting from US$2.50 trillion now, SWFs are expected to double in size before 2010 and rise to around the US$10 trillion mark before 2014, before reaching around US$12 trillion by 2015.

2.         … surpassing official reserves within five years.  The world’s official reserves, in comparison, are likely to expand at a much slower pace, and are expected to be surpassed by the SWFs by 2011, when both the reserves and the SWFs should reach around US$6.5 trillion. 

3.         Non-oil Asian exporters will play a more important role.  Currently, the SWFs derived from oil and gas export proceeds account for some two-thirds of the total, with the rest consisting of funds mainly controlled by the Asian exporters.  However, going forward, the share of oil-centered SWFs within the total number of SWFs is expected to decline gradually, reaching the 50% mark by 2015 or thereabouts.  China’s SWF, which is likely to be named the ‘Huei Lian Company’, is expected to be the single-largest SWF by 2009, surpassing ADIA. 

Caveats regarding my calculations

At present, SWFs have very low transparency, and they will likely remain opaque for the foreseeable future.  Therefore, I have had to make some educated guesses on their size and the pace at which they will accumulate funds (mostly transfers from the official reserves).  There are two main assumptions driving the results I presented above.  First, I have assumed that most of the incremental balance of payments surpluses will be accumulated in SWFs, rather than official reserves.  Second, the investment return on SWFs is assumed to be a bit higher than that on sovereign bond holdings in the official reserves. 

On the first assumption, my theory may be a bit aggressive, given that if a particular SWF does not perform well, it is quite likely that the nation in question will divert less financial resources to it and will keep them in the form of reserves instead.  In fact, there is nothing to suggest that funds could not be taken from the SWFs and transferred back into official reserves. 

On the second assumption, I have been very conservative, assuming only a 110bp premium on SWF returns, compared to the ‘risk-free’ returns on official reserves. 

Clearly, altering these assumptions would have the logical implications for my results.  But I do think the scenario I have outlined is the most likely one I can think of.

Big impact on the market likely

Given the massive size of these funds, all the market impacts that I have discussed in previous notes (e.g., on the dollar, the US Treasuries and risky assets) will be that much more important.  The shift from the sovereign bond markets in the US, Euroland and the UK will remove an important support for the long-term bond markets, with logical implications that I feel I need not discuss here. 

Rising risk of financial protectionism

I continue to believe that the emergence of the SWFs will fundamentally alter how risky assets trade, but it will also raise important questions, particularly concerning financial protectionism.  Here, I highlight some additional thoughts I have on financial protectionism. 

In my opinion, financial protectionism will be a major problem for globalization.  While many are still worried about trade protectionism, I believe that the next big risk to globalization is of a different type.   Back in the 1980s, Japanese investors bought US properties.  In early 2000, Russian investors bought football clubs and Middle Eastern investors bought race tracks.  The SWFs of tomorrow are likely to have quite a different taste in assets.  Assets that promise solid financial returns may not be as interesting as those that embody technology and techniques that cannot easily be ‘home-grown’ or imitated.  Higher-tech companies and even foreign banks could be primary targets of these funds. 

The US is expected to be defensive on this front.  But what about countries such as Australia and Canada: how will they react if large SWFs show interest in their resource companies?  Also, on the financial services front, while the US’s reaction is predictable, what about the UK?  How will the UK government react to a bid from a SWF for a UK universal or investment bank? 

Financial protectionism is the flip-side of trade protectionism, in my view.  While the arguments in favor of and against trade protectionism are clear, the pros and cons of resisting foreign capital are not yet clear, and how various countries will react is also unclear. 

In any case, I believe that there is a distinct risk that foreign funds turning from creditors to owners will trigger reactions from the recipient countries that will undermine globalization.  

Bottom line

I’ve long stressed the importance of SWFs, and underscored that they are already quite large.  My calculations suggest that they could grow to US$12 trillion by 2015, and surpass the size of the world’s total official reserves within five years (before 2011).  The SWFs will become absolutely massive in size in the not-too-distant future, and will have powerful implications for the financial markets, as I have discussed in the past.   I am increasingly concerned about financial globalization, as a reaction to the emergence of these funds.

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Indonesia
Domestic Demand Recovery to Gain Momentum
May 04, 2007

By Chetan Ahya | Mumbai

Summary

Unlike the rest of Asia, exports have been a relatively weak driver for Indonesia. We believe that domestic demand remains the anchor to Indonesia’s growth outlook. Recent trends in cyclical indicators — such as credit growth, automobile sales, cement demand and non-oil imports and electricity consumption — indicate a sustained recovery in domestic demand. We believe that the recovery in domestic demand will continue to gather pace, driven by a lower cost of capital and improving macro-stability indicators. With banking sector excess liquidity balances rising, we expect a gradual flattening of the banking sector lending risk curve to support a further recovery in credit-funded domestic demand.

Gradual improvement in domestic demand indicators

With the aggressive monetary easing undertaken by the central bank since 2Q06, most cyclical demand indicators are now showing signs of recovery. Some of the key data that point towards recovery are:

Credit growth: After decelerating sharply from the peak of 31% YoY in September 2005 to 9.7% YoY in August 2006, Indonesia’s commercial banks’ credit growth steadily accelerated to 15.3% YoY in March 2007.

Non-oil imports: Momentum in non-oil and gas imports, which is a broad measure of domestic demand, has also improved considerably, accelerating to 24.5% YoY in March 2007 from an average of 12.1% in 4Q06 and 13% in 3Q06.

Auto sales: Growth in both motorcycle and car sales has decidedly bottomed out. In March 2007, domestic vehicle sales (including cars and commercial vehicles) grew 26.4% YoY, compared with an average 9.5% decline during 4Q06 and 41.6% decline in 3Q06. Similarly, domestic motorcycle sales rose by 31.5% in March 2007 compared with 10.3% growth in 4Q06 and an 8.8% decline in 3Q06.

Investment cycle is also improving

Improving domestic consumption, accelerating non-oil exports and a falling cost of capital are also supporting a recovery in the investment cycle. Investment credit growth has accelerated to 15.5% in February 2007 from the bottom of 3.2% in August 2006. Capital goods output has also continued to record a major improvement. Indeed, machinery and equipment output growth has accelerated to a 17-quarter high of 69.9% YoY (3MMA), albeit off a low base. Similarly, electrical machinery and equipment output growth also accelerated to 28.7%YoY (3MMA) in January 2007.

Excess liquidity should help lower lending rates

A continued rise in the balance of payments surplus is resulting in large foreign exchange inflows. Indeed, a large part of the increase in reserves is due to a sharp improvement in the current account. Indonesia’s four-quarter trailing current account surplus improved to a high of US$9.4 billion in March 2007, based on our estimates. Bank Indonesia’s intervention in the foreign exchange market has meant continued injection of liquidity into the domestic money market. Excess liquidity balances (liquidity sterilized by the central bank’s open market operations) has increased to US$30 billion. Banks’ credit-deposit ratio also remains low, at 60%. With the government deficit remaining low, at around 1% of GDP, there is minimal government demand for liquidity.

Credit-funded demand growth to accelerate

We expect both investment and retail credit growth to accelerate further. Although retail credit growth has lagged overall growth so far, we expect this to improve meaningfully over the next six months. With rising excess liquidity within the banking system, banks are likely push through more loans to households. We expect the banking sector’s loan spreads to normalize from current high levels. Currently, banking sector lending rates for investment credit and consumption credit are about 600bp and 850bp above Bank Indonesia’s policy rate of 9% (note that this compares with a one-year time deposit rate of 10.5% and a 10-year bond yield of 9.5%). Moreover, overall leveraging in the system is also relatively low compared with other countries in the region. Indonesia’s total bank credit to GDP ratio was 24% as of end-2006 compared with 44% in India and 115% in China. Indonesia’s retail loan to GDP ratio was 7% at end-2006, versus 18% in China and 14.8% in India.

Faster structural reforms key for further acceleration|

We believe that for accelerating and sustained GDP growth beyond 6.5%, Indonesia needs strong growth in productive capacity; this, in turn, requires active anchoring by the government through structural reforms and the policy environment. Although, with continued political stability, the government has been able to gradually improve the investment climate, the overall supply response in Indonesia remains weak. One of the biggest challenges for country is the low spending on infrastructure investment, at 3% of GDP. However, considering that current capacity utilization in the country is not stretched, we do not expect the improvement in domestic demand to create inflationary pressures for at least the next 12 months.

Risk to domestic demand in near term may come from external environment

A reversal in global risk appetite for emerging market assets in the past has had a significant impact on the domestic liquidity environment. For instance, during the last quarter of 2005, the reversal in global risk appetite significantly affected the domestic liquidity environment as the current account surplus was also minimal during that period. However, the balance of payments surplus mix is very different currently, with higher reliance on the current account surplus. We believe that this should help to reduce the adverse impact arising from any reversal in global risk appetite.

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Eastern Europe
Slovakia - Brussels Sprouts Some Doubts, but Optimism Prevails
May 04, 2007

By Pasquale Diana (London)

On a recent trip to Brussels, we met high-level Commission representatives as well as personnel from the Slovak Permanent Representation in Brussels.   Here are the main findings from our visit:

Case for further FX strength is well-supported.  There seems to be broad agreement in Brussels that a country with rapidly converging growth dynamics should experience real FX appreciation pressures.   In Slovakia’s case, productivity catch-up was the rationale for the 8% revaluation of the central parity on March 16, which was followed by sharp SKK strengthening that prompted NBS intervention. Slovakia looks set to grow by nearly 9% this year, and a further 8% next year, on the back of a phenomenal net export boost.   This will likely result in a sharp reduction of the current-account deficit, from 8.3% of GDP in 2006 to 4.5% in 2007 and just over 3% in 2008.   Given this macro backdrop, real FX appreciation pressures are likely to remain.   With inflation set to fall rapidly to the core European level or below, these pressures should be felt primarily in the nominal exchange rate.

While the European authorities appear comfortable with the above reasoning, they argue that it is far from ideal to want to fix nominal exchange rates when there are such strong appreciation pressures on the currency.   And while it is true that the new FX band (30.13 to 40.76) probably gives the koruna enough scope to appreciate in order to reflect these transformations in the real economy, the basic idea of remaining in ERM II for two years is to show the ability to sustain a period of exchange rate stability, rather than continued strength.   The EU authorities acknowledge that the formulation of the exchange rate criterion offers room for significant interpretation but feel strongly about the need to avoid a ‘crawling peg’, with the Slovak authorities being forced to revalue the parity every few months, under pressure from the FX market.

To that effect, European authorities expect Slovak authorities to make a conscious attempt to restrain FX strength.   Our sense is that this implies the rapid elimination of any interest rate differential with ECB rates (or even a negative differential), and if needed market intervention to avoid SKK strength becoming a one-way trade. Interestingly, the authorities noted that the recent aggressive intervention by the NBS to stem the SKK gains by buying euros in the market does not breach the ‘severe tension’ clause of the ERM II regime (a currency should stay within the fluctuation bands for at least two years without ‘severe tensions’).   This clause was intended to refer in practice to tensions on the weaker, not stronger side.

If, as we believe, Slovakia will enter the euro zone at a rate stronger than the current parity of 35.4424, this would be an unprecedented event.   Never before has a euro area member candidate entered at a rate different from the parity at the time of the evaluation.   Yet we believe that in mid-2008 the SKK will have appreciated enough against the euro to fix the parity at a level different from the current parity.   We estimate that the irrevocable euro conversion rate could be EUR/SKK at around 32 (see also Tight Monetary Conditions to Trigger NBS Cuts, March 23).

A wide HICP comfort margin and tighter fiscal policy would help.  Following our trip, we continue to believe that it will be difficult to argue against Slovakia’s euro credentials if it meets all the nominal criteria.   Even so, we acknowledge that there would be risks if the criterion (especially on the HICP front) was met by a very narrow margin (e.g., a few tenths).   In that case, EU authorities might be able to make a convincing case that Slovakia’s inflation performance was helped by currency appreciation or the behavior of regulated prices, but that the country would be unable to meet the inflation criterion in a sustainable manner when the exchange rate is fixed and/or regulated prices are adjusted.  

With interest rates likely to fall at a time of very buoyant growth, our sense is that the European authorities would appreciate a dose of fiscal tightening.   The latest Slovak convergence programme looks for a deficit of 2.9% of GDP, just low enough to qualify for euro adoption.   The EU authorities point out that this objective is roughly the same as the one included in the 2004 convergence program.   Yet, growth over the last few years turned out to be roughly 2.7% per year faster than anticipated, which means that the 2007 deficit target should have been much lower.   Our sense is that a dose of fiscal tightening would go a long way towards showing the EU willingness to comply with the recommendations included in the Council Opinion of January 2007.

Slovak authorities committed to the euro project.  Regardless of what the EC’s proposal is, the final decision on Slovakia’s euro application will rest with the European Council, the heads of state of the 27 EU members.   While in theory a qualified majority would be needed to approve Slovakia’s bid, in practice these decisions are taken by consensus.   Our talks in Brussels suggest that the ability of Slovak authorities to advance their case at the EU has improved over the recent period.   However, recent comments from the PM look far from encouraging.   Mr Fico warned his voters that Slovakia could be left out of the euro area for “political reasons”.   While not entirely unreasonable, this comment leaves the Slovak leader open to the suggestion that he might be looking for excuses and an alibi in case Slovakia’s bid is rejected.

More constructively, we note that the Prime Minister has thus far shown willingness to stay the course, most likely due also to the lobbying of the NBS, which is the staunchest supporter of euro adoption in 2009.   Most likely, the PM understands that a negative reaction to Slovakia’s bid would, at least in the short run, cause significant weakness of the FX markets and a loss of investor confidence.   The NBS would likely have to intervene in the FX market and use FX reserves to stem SKK losses (much as it did in summer 2006), and increase rates as the country’s risk premium rises.   We suspect that the authorities will be aware of the likely negative market reaction and potential negative impact on the government’s popularity.

Look for further SKK gains, but beware NBS intervention.  We continue to believe that the SKK will be under pressure to appreciate in the coming quarters.   The last revaluation accounts for the past productivity catch-up with the euro area (and possibly some future convergence), but we continue to feel that another revaluation is due, around mid-2008.   The conversion rate versus the euro should be set at around 32 (5% stronger than the current level), though we do not rule out a lower level.   That said, investors should be ready to withstand occasional NBS intervention aimed at discouraging speculative inflows.   But in the end, we feel that there are strong macro reasons to expect the koruna to appreciate from here.

 

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