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United States
Risks to the Outlook
May 07, 2007

By Richard Berner and David Greenlaw (New York)|

Forecast at a Glance





Real GDP




Inflation (CPI)




Unit Labor Costs




After-Tax “Economic” Profits




After-Tax “Book” Profits




E = Morgan Stanley Research Estimates


Risk appetite is steadily rising among market participants amid hints that neither recession nor stagflation is likely for the US economy.  While US equity markets have lagged some of their global counterparts, with gains of 6-6.6% year to date, their performance has caught many investors by surprise.  And the slight widening in credit default swap spreads since the February correction has hardly moved beyond rounding error.  Although the great economic debate is far from over, incoming data suggest that the tepid 1.3% advance in first-quarter US GDP may be the trough of the growth slowdown.  Indeed, for the first time in four months, we’ve slightly increased our forecast for 2007 growth (by 0.1% to 2.1% on a year-over-year basis).  The whiff of stagflation may also be ebbing with good news on core inflation, the prospect of more slack in labor markets, and somewhat stronger productivity growth. 

All three factors are good news for our cautiously optimistic outlook for both growth and inflation.  Pessimists declare that exuberant stock markets don’t square with a tepid economy.  We’d turn that around: Rising asset prices anticipate improved growth and earnings that may not materialize, but generally favorable financial conditions — higher stock prices, lower interest rates, and a weaker dollar — likely will contribute to an improvement in growth.  Moreover, the current period of subpar growth is exactly what the Fed has wanted to see, in order to create some slack in both product and labor markets to reduce inflation.  With a lot of good news in the price of risky assets, however, we’re inclined to take a hard look at what could go wrong. 

First, let’s revisit the key themes underpinning our baseline view.  As we see it, both fundamentals and incoming data imply a gradual improvement in US growth.  Strong global growth has created a positive backdrop for US exports.  And while we don’t believe in the ‘strong’ decoupling story — that the rest of the world is somehow immune to a US recession — we think that faster growth abroad will support US output and thus job gains.  A key reason is that overseas growth has become less dependent on what’s happening in the US economy and is increasingly driven by domestic demand abroad.  More challenges lie ahead, but we think improving US net exports may add up to half a point to US growth and help promote global rebalancing (see “The Decoupling Debate: US Implications,” Global Economic Forum, April 16, 2007).  Moreover, we believe that the fundamentals remain positive for a moderate recovery in capital spending (see “Explaining the Capex Conundrum,” Global Economic Forum, April 23, 2007).  In turn, we expect sufficient growth in jobs and income to support both moderate gains in consumer spending and a gradual rise in personal thrift — a cornerstone of our view. 

Incoming data are mixed but generally do support that baseline.  Global growth continues to surprise higher; together with overseas inflation risks, this has triggered slightly tighter monetary policies or the prospect of policy firming in several European, Latin American, and Asian economies.  That improvement did not show up in US exports in the first quarter, which contracted at a 1.2% annual rate, with industrial supplies, capital goods, and services all declining.  But past gains in exports, along with an improved tone to capital goods deliveries and an end to the inventory correction in Detroit, have ended the manufacturing recession.  As evidence, the upturn in the ISM manufacturing index and a firmer tone to factory output in the past three months already signal improvement.  Looking ahead, the upturn in March capital goods bookings and ISM respondents’ April reports of firmer orders overall and for exports signal that a gradual improvement lies ahead.

However, the dichotomy between weak output and firm labor markets seems to be resolving in favor of slower job gains and earnings and a rising unemployment rate.  Against the backdrop of rising energy quotes and decelerating home prices, that appears to undermine the case for continued gains in consumer spending.  April payroll growth slowed significantly to just 88,000 from an average of 143,000 in the first three months of 2007, and from 189,000 per month for all of 2006.  April’s was the smallest monthly gain in two and a half years, with declines in manufacturing, retailing, finance, and construction subtracting some 67,000 from the total.  A six-minute decline in the workweek, a 0.2% gain in hourly earnings, and rising energy quotes imply that real wage and salary income turned down in April.  We do think slower job growth lies ahead, especially as construction layoffs multiply.  But April’s result in retailing was probably distorted by the early Easter, and with stronger growth in both exports and capital spending, job gains in coming months likely will average 100,000-125,000.  And with labor markets still firm in this ‘two-tier’ economy, we expect pay gains to rebound.

Yet a further potential supply-induced hike in energy quotes and a deeper housing recession would each pose downside risks to the growth outlook.  Since January, US pump gasoline prices (an average of all grades) soared by 36% to $3/gallon and now seem likely to linger at that level for a while.  Assuming they do, we estimate that higher gas and food prices will take more than $100 billion annualized from consumer budgets in the first half of 2007 (see “Gasoline Prices: “Déjà vu,” Global Economic Forum, May 4, 2007).  But shocks to the gasoline supply chain could push prices higher still. 

We believe that our slightly weaker baseline outlook for housing activity this month captures the downside risks.  Indeed, that is one reason the trajectory of our projected second-half recovery remains uneven and a couple of tenths of a percent weaker than a month ago.  Even if demand begins to stabilize soon, as we expect, we are wary that tighter lending standards, especially on subprime loans, will limit the upturn.  Too, there is still a sizable inventory of unsold homes to work off, and that adjustment could occur abruptly.  The deceleration in home prices — which could turn into small nationwide declines — has trimmed the gains in household wealth and will limit growth in consumer spending.  We believe that this wealth effect will play out slowly, but there are some downside risks here as well.

Likewise, contained inflation expectations and emerging economic slack imply a gradual decline in inflation.  We think that core inflation has peaked, and March’s good inflation news reinforces that belief, with core inflation measured by the personal consumption price index (PCEPI) dipping to 2.1%.  Inflation expectations are still low.  The housing recession should help by reducing the increases in rents and owners’ equivalent rents — although both are running over 4%, recent data suggest a sharp deceleration.  Increased economic slack will also help.  We estimate that GDP growth will average just 2.2% over the six quarters ended in the third quarter of 2007, below anyone’s estimate of potential growth.  However, we also think that the dispersion of inflation risks has risen and declines will come slowly.  Labor markets are only beginning to evince growing slack.  A looser and less-certain relationship between slack and inflation than in the past implies a slow decline. 

Moreover, higher energy, food and import prices, a potential surge in protectionism, and slowing productivity growth each pose upside risks to that baseline inflation view.  There’s no mistaking the impact of higher energy quotes on headline inflation; indeed, following a 0.6% rise in March, we expect that the CPI rose by 0.5% in April and may rise by another 0.6% in May.  Some of the energy price hikes may also boost core inflation.  And they have already pushed up inflation expectations; measured by the University of Michigan’s canvass, 5-10 year inflation expectations rose to 3.1% in April.  Likewise, the jump in animal feed quotes is hiking beef and poultry prices following flat to declining prices last year, and the effects on citrus quotes of this winter’s California freeze linger.  The acceleration in non-auto consumer import prices to a 1.8% rate in March has just started to show up in consumer inflation gauges, and more is coming, especially if the dollar weakens further (see “Inflation: The Latest US Import?” Global Economic Forum, April 20, 2007).  And we agree with Steve Roach that an outbreak of protectionism would pose further upside inflation risks (see his dispatch, “Protectionism and Inflation”).

The slowing in productivity growth, to 2.1% over 2005 and 1.6% over 2006, raises questions of whether trend productivity and thus potential output are lower than previously thought, implying a more inflation-prone economy.  Indeed, some still fear a return to stagflation.  We don’t.  We still think that trend productivity growth is roughly 2½%, which is good news for long-run inflation prospects.  In the past two years, we think that a below-trend, cyclical productivity undershoot has been underway as job growth was catching up with the economy.  That was then: Following the recent slowing in labor inputs, this month we boosted our forecast of productivity growth by 0.3% in 2007 to 1.6%, and we forecast a return to 2½% productivity growth in 2008.  

The third set of risks revolves around earnings.  Earnings have beaten low first-quarter expectations, but even with some top-line improvement, there remain downside risks to the bottom line.   Analysts slashed their forecast for Q1 S&P operating earnings to just 3.8% — and sure enough, the bar was set low enough so that the estimated 8.9% outcome beat it handily.  Strong global results may have made an even bigger contribution than the 200 bp we expected.  Don’t bet on further strong earnings growth, however; even if top-line growth begins to improve later this year, as we expect, we still think that the risks for earnings lie to the downside.  Earnings are highly leveraged to both US and global growth.  Continued sluggish domestic growth likely will promote margin compression as operating leverage fades.  Pricing power seems to be cooling as operating rates have leveled off.  And credit quality is deteriorating, suggesting pressure on earnings at lenders. 

While we’ve tweaked our baseline economic and inflation forecasts, the basic themes and outlook remain intact.  Concurrently, we expect the Fed to tweak the language of their post-meeting statement this week, but Fed officials have consistently indicated that there are high hurdles to changing monetary policy in either direction.  It’s worth repeating that financial conditions have become more, not less favorable, and global growth has become stronger since the Fed left policy on hold last summer.  Thus, we continue to expect a steady Fed through year-end.  Although investors have trimmed their expectations for Fed ease, there is still more and quicker easing in the price than we think is likely.  Likewise, we expect ten-year Treasury yields to trade in a 4½-5% range, a gradual decline in the dollar, and a pickup in volatility.  TIPs have cheapened further over the past week, making them more attractive. 

This note has focused on several of the downside risks to growth and earnings and on the upside risks to inflation — all of which could undermine the benign outlook priced into risky assets.  Might there also be upside risks to growth and earnings, and downside ones to inflation?  In our view, it’s a question of timing, because our 2008 baseline involves such an outcome.  Hearty global growth, favorable financial conditions, lower energy quotes, and a stronger dollar likely will contribute. 


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An Inconvenient Truth
May 07, 2007

By Serhan Cevik (London)|

The correction in inflation is in line with our estimates and should continue in the coming months. The consumer price index posted a month-on-month increase of 1.2% in April, a tad higher than our projection of 1.1% but much above the consensus estimate of 0.8%.  As a result, with favorable base effects, the annual rate of inflation eased from 10.9% in March to 10.7% last month.  Market participants may not be pleased, but we see no disappointment in the latest figures and even find a glimmer of hope.  Of course, recent political developments may strengthen the inertia and limit the extent of disinflation, but we are still likely to witness further correction in the year-on-year inflation rate in the coming months (see “The Rise and (Slow) Fall of Inflation,” April 24, 2007).  We have long argued that Turkey’s inflation troubles are a result of supply-side shocks and then the lira’s sudden and sharp depreciation last year.  Although higher commodity prices remain a serious challenge, tighter monetary conditions and the return of global risk appetite have strengthened the lira, while moderating domestic demand.

Seasonal adjustments in clothing prices determined the April reading.   It is not surprising to see seasonal fluctuations in economic figures, but the magnitude of such adjustments in clothing prices has widened since the introduction of the new CPI in 2003.  In our view, methodological issues and changing business practices are behind this interesting development.  With that in mind, we were expecting a 9.8% increase in the clothing and footwear component, which actually turned out to be 11.3% in April. Although this is an acceptable degree of deviation, the recent increase in the year-on-year rate of change in clothing prices — from -0.2% in 2006 to 6.2% last month — suggests the influence of factors beyond seasonality.  A higher exchange rate assumption embedded in consumer prices since last summer may be a factor, but we think that the rise in import prices due to higher production costs in China and the reminbi’s appreciation have also played a role in determining domestic prices.  Given its disinflationary features in the past, an upward shift in the clothing category could really become a drag, albeit the moderation of consumer spending suggests otherwise.

Unusual weather conditions have pushed unprocessed food prices higher. Our projection for the headline CPI implied a monthly increase of 0.1% in food prices last month, which would have been consistent with seasonal patterns. However, we ended up with yet another ‘surprising’ reading, as the food component increased by 0.9% and pushed the annual inflation rate from 9.7% in April 2006 to 13.3% this year. Once again, the rise in unprocessed food prices is the culprit, as the year-on-year rate of change jumped from 2.9% in 2005 to 14.3% in 2006 and 17.8% so far this year. But what is behind this trend shift? In the past year, we have written a series of reports on the effect of non-economic factors on inflation dynamics, especially as climatic fluctuations have become far more volatile (see “The Mysterious Vegetarian Demand Bubble,” June 19, 2006 and “Stay Tuned to the Weather Channel,” August 4, 2006). As the latest figures confirm, global warming is no longer science fiction and has direct economic consequences. The whole world is going through the warmest and lowest precipitation period on record, and the situation in Turkey is no different, with a marked increase in temperatures and a 70% drop in rainfall compared to the long-term average (see “No Rain, No Gain,” February 5, 2007). Therefore, coupled with an increase in agricultural exports and higher transportation costs, Turkey will remain exposed to high and volatile changes in food prices.

Underlying inflation trends are gradually becoming supportive for the medium term. Inflation is high and will not decline much in the near future, but underlying changes in inflation dynamics are gradually becoming supportive for a sustained disinflation phase over the medium term. Even though a ‘just in case’ mark-up — mainly reflecting a higher exchange rate assumption — limits the extent of correction in inflation implied by the moderation of domestic demand, there are indeed encouraging signs. For example, the prices of durable goods (excluding gold) declined by 0.8%, lowering the annual inflation rate from 7.2% in March to 5.8% last month. Likewise, the stubborn inertia in service price inflation showed the first sign of easing, as the 0.6% increase last month lowered the year-on-year inflation rate to the lowest level since last September. Moreover, despite the distortion caused by seasonal changes in clothing prices, core measures of inflation have also pointed towards a slow, but steady decline in inflation in the coming months.

We expect inflation to come down to 10% next month, but no monetary easing any time soon. Our projections suggest that consumer price inflation will decline to 10% in May, even against yet another seasonal adjustment in clothing and footwear prices. Of course, that would not support a change in the monetary policy stance in the near future. Nevertheless, we expect the annual inflation rate to move below 7% by the end of 2007 and then closer to the central bank’s 4% target in the first half of next year. It may sound, to many observers, as wishful thinking, but macroeconomic developments support such a trend shift. Apart from exogenous shocks, the only obstacle is political fragility and the resulting ‘risk premium’ in pricing decisions.


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Protectionism and Inflation
May 07, 2007

By Stephen S. Roach (New York)|

Disinflation is at risk as the US Congress rushes headlong down the path of protectionism.  The cross-border arbitrage of costs and pricing – one of the unmistakable hallmarks of globalization – could well turn unfavorable if China bashers get their way.  This could be a recipe for the dreaded stagflation scenario – an awful outcome for financial markets and the functional equivalent of a tax hike on an already beleaguered American middle class.

The US economy has benefited greatly from an outbreak of “imported disinflation” over the past decade.  Researchers from the IMF have estimated that the so-called import-price effect has lowered the US CPI inflation rate by an average of about one percentage point per year since 1997 (see “How Has Globalization Affected Inflation?” Chapter III in the IMF’s World Economic Outlook, April 2006).  Such an externally-driven reduction in domestic US inflation is basically an outgrowth of rising import penetration from the low-cost developing world.  US import penetration – purchases of foreign-made products as a share of domestic goods consumption – has risen from 22% in the early 1990s to about 38% today.  At the same time, our calculations suggest that developing economies have accounted for 58% of the surge in total US imports over the past decade.  China and Mexico have led the way – making up nearly 60% of the cumulative increase of imports to the US from developing economies since 1995. 

Nor have currency swings or business cycles altered the disinflationary forces of globalization.  Over the past 12 years, prices of non-petroleum imports into the US have been basically unchanged, punctuated by brief cyclical breakouts that never exceeded 4% and that were, in turn, followed by periodic declines of approximately equal magnitude.  This compares with a cumulative increase in the so-called core CPI of 31% over the 1995 to 2007 interval.  Even during periods of modest cyclical acceleration in import prices, spillovers from foreign to domestic inflation have been limited.  That’s due in large part to the still-wide disparity between price levels of foreign and domestically-produced goods – a disparity which has continued to open up in recent years.  According to the US Bureau of Labor Statistics, prices of nonagricultural US exports, a good proxy for inflation of internationally-competitive products produced within the United States, have recorded a cumulative increase of about 10% since early 1995 – hardly a major rise but one that nevertheless stands in contrast with the stability of nonpetroleum import prices noted above.  That only adds to the compelling arithmetic of imported disinflation for the US.

I suspect there is an equally important productivity angle to this as well.  Globalization and the record expansion of world trade it has engendered have played a new and important role in the execution of global efficiency solutions by US businesses.  This arises from increasingly powerful synergies of cross-border supply chains available to US multinational corporations, as well as from the arbitrage between relatively antiquated high-cost facilities at home with newer vintages of low-cost production platforms abroad (see a June 2006 speech by Federal Reserve Vice Chairman Donald L. Kohn, “The Effects of Globalization on Inflation and Their Implications for Monetary Policy”).  Similarly, there is compelling evidence of innovation-driven productivity spillovers from inward foreign direct investment (see “Does Inward Foreign Direct Investment Boost the Productivity of Domestic Firms?” by Jonathan Haskel, Sonia Pereira, and Matthew Slaughter, CEPR Discussion Paper No. 3384, May 2002).   To the extent that “imported productivity” growth dampens overall cost pressures in the domestic economy, globalization has created yet another powerful headwind holding back US inflation.

As a result of these trends, the sourcing of domestic consumption in the United States has shifted increasingly away from high-cost goods made at home to cheaper and increasingly high-quality products produced by low-cost developing economies.  In one sense, these impacts are temporary – they reflect globalization-driven impacts on the US economy that have taken it from one state of “openness” to another.  Consequently, as import penetration eventually levels out, the impacts of imported disinflation could ebb.  At the same time, should forces come into play that arrest globalization – namely an outbreak of trade protectionism – there could well be a reversal of the external pressures of disinflation, thereby boosting overall inflation.

Unfortunately, that is precisely the risk today.  As Washington moves to contemplate policies that could lead to trade frictions and protectionism, America’s global sources of disinflation would be very much at risk.  Tariffs and non-tariff duties are the functional equivalent of a tax on low-cost imports.  Depending on pricing leverage, such taxes could be directly passed through to American consumers.  At a minimum, they would boost cost pressures on US multinationals, with the potential to interrupt the shifting of high-cost domestic production to cheaper offshore locations.  Moreover, such frictions might also diminish the productivity dividend offered by global supply chains.  This latter possibility could well be reinforced by ongoing efforts of the US Congress to tighten up the so-called CFIUS (Committee on Foreign Investment in the United States) approval process for foreign direct investment into the United States – a development that has gathered considerable momentum in the aftermath of the aborted 2006 acquisition of US port facilities by Dubai Ports World. 

Furthermore, the cyclical timing of all these developments is far from ideal.  The imposition of trade and investment barriers could lead to the return of the closed-economy inflation dynamic at just the time when slack has diminished in America’s labor and product markets.  And, of course, the dreaded dollar-crisis scenario – hardly a trivial consideration in a protectionist climate – could lead to a much sharper spike in import prices than has been evident in a long time.  All in all, such an unfortunate confluence of circumstances could exacerbate domestically driven inflationary pressures at the wrong point in the business cycle – in sharp contrast to a globalization that has acted increasingly to offset such cyclical pressures over the past 15 years. 

There is great irony to congressional attempts to “fix” globalization: The odds are that the most extensive damage will be inflicted on the very constituency in the US economy that the politicians are trying to assist – America’s middle-class.  One of the most important lessons of the 1970s is that inflation is the cruelest tax of all.  And yet that lesson now seems all but lost on Capitol Hill today.  There is no refuting the reality of pressures already bearing down on American labor.  In the current economic upturn, our calculations suggest that the cumulative gains in private sector worker compensation remain about $430 billion (in real terms) below the trajectory of the typical expansion.  Moreover, according to the US Bureau of Labor Statistics, the median wage – inflation-adjusted weekly pay for the worker in the middle of the wage distribution – has risen a cumulative total of just 0.9% over the seven years ending in the first quarter of 2007; that’s an especially disturbing development in a period of accelerating productivity growth – very much at odds with the long-standing conclusions of economic theory and experience.  As an outgrowth of these developments, the labor share of America’s national income has fallen sharply in recent years and remains near its post-1970 low of 56%.  Sadly, Congress now appears to be contemplating a response to these pressures that would impose the functional equivalent of an inflation tax on US workers at precisely the time when they can least afford it.

America’s beleaguered middle class deserves better.  Due to under-investment in education and human capital over the past 25 years, American labor is lacking in many of the skills required to face the new competitive challenges of an IT-enabled globalization that are bearing down on white- and blue-collar workers, alike (see my 3 February essay, “Unprepared for Globalization”).  Moreover, by failing to save or to embrace pro-saving policies, the US has set itself up for chronic current-account and trade deficits.  This is a lethal political and economic combination that has injected a new sense of urgency into the globalization debate.  And Washington politicians, rather than taking a hard look in the mirror, have embarked on a dangerous course of “scapegoatism” – blaming China for all that ails the American worker.  That has taken the Congress to the brink of moving beyond the rhetorical bluster of the past few years and enacting legislation that would impose severe trade sanctions on China

None of this is to say that there shouldn’t be active and direct negotiations with the Chinese on more legitimate conflicts over trade policy – especially those issues that bear directly on broad constituencies of the US workforce.  The area of intellectual property rights (IPR) is especially important in that regard, particularly since it directly affects the core competencies of America’s knowledge workers – the professionals, managers, executives, sales workers, and office support staffs who, by our calculations, collectively account for 61% of total US employment.   The US Trade Representative’s recent decision to initiate IPR complaints against China with the WTO is a far more appropriate course of action than misdirected congressional scapegoating over the currency and bilateral trade deficit issues.   Unfortunately, Washington politicians are having a hard time making this critical distinction.

In looking back over the past quarter century, few accomplishments in the economics sphere match the successes of the battle against inflation.  Globalization and trade liberalization have become important in insuring the post-inflation peace.  Yes, for many, this has been a mixed blessing.  There is no question that workers in the developed world have borne a disproportionate share of the cross-border arbitrage that lies at the heart of globalization.  At the same time, I have little doubt that the ensuing disinflation has been key in fostering improvements in purchasing power that boost living standards of the same hard-pressed workers.  Protectionism raises the risk of squandering this critically important disinflationary dividend – thereby eroding inflation-adjusted purchasing power.  That is the very last thing America’s middle class needs. 

By going after China and embracing protectionist remedies, the US Congress is reacting to symptoms of much deeper problems – especially skillset disadvantages of workers and an extraordinary shortfall of domestic saving.  Absolutely nothing is gained on either front by blaming China for problems such as these that originate at home.  To the contrary, much could be lost – in the US, the global economy, and world financial markets – if Congress makes a major blunder on US trade policy.  Unwinding the disinflationary benefits of globalization would borrow a painfully familiar page from the stagflationary script of the 1970s. 


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Three Scenarios for the Landing of the Spanish Economy
May 07, 2007

By Eric Chaney (London)|

Not by coincidence, the Spanish construction boom started in 1998-1999, when Spanish short term interest rates converged toward much lower German rates and markets removed the currency risk premium on Spanish assets.  On top of bigger capital inflows attracted by high returns without currency risks, Spain benefited from the injection of structural funds from the EU budget.  As a result, GDP and inflation accelerated above EMU average, and inflation-adjusted interest rates fell further, fuelling even more the housing boom.  From 1997 to 2006, the share of investment in construction (housing, commercial property and public works) rose from 11.4% of GDP to 17.7%.  This vertiginous rise probably added some 0.7 percentage points to GDP growth, on average, over the last 10 years.  It was also the main cause of the impressive immigration flows which have radically changed Spain’s demographic trends.  In the early nineties, the Spanish population (39.3 million in 1994) was stagnant and its age structure rapidly worsening.  From 2003 to 2006, population growth averaged 1.7%, thanks to a net immigration rate as high as 1.5%, raising the number of people living in Spain to 43.7 million.

In order to better understand the importance of the construction boom for the whole economy, it is interesting to make a comparison with the construction boom that followed the German unification.  There are some similarities: the German boom was fuelled by both housing (including refurbishment) and public works, as massive public and private financial transfers from Western Germany funded the construction of new houses, the rehabilitation of existing ones and the upgrade of deficient infrastructures in Eastern Germany.  From 1998 to 1994, the size of the German construction sector grew from 11% to 15% of GDP in 1994.  As a reminder, the population of the Federal Republic had increased from 60 to 77 million in 1990 and, initially, the value of the stock of construction investments in Eastern Germany was close to zero. 

By comparison with Spain, the German boom looks relatively small: in the former, the share of construction has increased by more than 6% of GDP while, in the latter it had increased by ‘only’ 4%.  And yet, the correction in Germany was particularly long and painful: it was only after a 10-year-long decline that the share of construction, which had dropped to 9% of GDP, started to rise again.  The correction was bigger than the boom.

We have used the German case to build three scenarios of what could be the normalization of the Spanish construction sector over the next ten years.  Although the peak may not have been yet reached, we believe that this is imminent and our simulations assume that the ebb starts in 2008 and would be over ten years later, in 2017.

Main case:  back to the 1985-99 average

In our main case scenario, we assume that the share of construction would drop to 12% at the end of the period, that is, to the average level of this sector between 1985 and 1999.  GDP growth would be cut by 0.5% per year, employment and consumption by 0.4% per year, and the budget balance would worsen by 0.2% of GDP per year.  On the supply of labour side, we assume that immigration would be the adjustment variable.

Bull case: strong immigration flows continue

Because immigration trends are also linked to structural factors, such as strong pressures to emigrate from low income EU countries or countries closely associated to the EU, and a relatively flexible labour market in Spain, our bull case differs from the main scenario by stronger immigration trends fuelling the fast growing services economy in Spain.  The construction sector would nevertheless shrink, but less: our 2017 target would be 14% of GDP, close to the peak reached in the early 1990’s.  In that case, GDP growth would be cut by 0.4% per year only.

Bear case: a German-type contraction

Our bear case scenario is directly inspired from the German experience: the construction sector would shrink considerably, undershooting its long term share to 9% of GDP, exactly as it did in Germany.  The impact on GDP growth would be quite substantial, a loss of 0.8% of GDP per year, which would worsen the budget balance by 0.3% per year.  Soon, Spain would run ‘twin deficits’.

In each of these scenarios, we have assumed that fiscal policy would be neutral.  Given the strong starting point of Spanish public finances, this assumption looks restrictive.  It might be hard for Spanish policy makers to resist the temptation of using the ammunitions (budget surpluses) accumulated over the past few years.  Accordingly, we have explored another version of the three cases described earlier, with, in each case, a fiscal stimulus calibrated so that Spanish public accounts would remain ‘Maastricht compliant’ (a deficit not exceeding 2.5% of GDP at the end of the simulation, so that some room would be left for unexpected negative shocks).  A well known paradox, if not a serious flaw, of EMU fiscal rules is that the worse the negative shock, the less governments may use fiscal instruments to stabilize demand.  In our simulations, fiscal policy would be quite instrumental to weather the construction wreck in the bull scenario: The net impact on GDP growth of these two opposite macro forces would be neutral.  On the other hand, in our bear scenario, the fiscal room for maneuver would be more limited and the negative impact on GDP growth soothed by only one-tenth of percentage point.

The two main lessons we draw from our three scenarios are:

1. In all cases but one (a mild recession in construction and a large fiscal stimulus), the growth rate of the Spanish economy should be slower in the next ten years than it was in the last decade;

2. A hard landing, i.e. a full blown recession of the Spanish economy caused by the downsizing of construction, looks improbable.  In our worst case scenario, GDP growth would be trimmed by almost one percentage point, but, given that average GDP growth was 3.7% over the last ten years, this would still leave the economy growing at a robust pace.

For Spain, the party’s over, but this is not necessarily bad news: a continuation of the construction boom would increase, maybe not linearly, the probability and the potential macro disruptions of the unavoidable downsizing of the construction sector.  At this stage, investors should take notice of the change in Spanish fundamentals but they should not panic: The Spanish economy may lose its star status but should not become a lame duck either. 


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Sarkozy’s Victory - A Vote for Reforms
May 07, 2007

By Eric Chaney (from Paris)|

Exit polls give a 53% victory to Nicolas Sarkozy vs. Ségolène Royal. This is slightly less than the 54% implied by Friday polls but could be revised upward later on.  Nicolas Sarkozy will become President as soon as this coming Wednesday, immediately after Jacques Chirac has stepped down. The turnout, estimated at 85%, was as high as in the first round, i.e. the highest since General De Gaulle was elected in 1965.

Who is the new French President?

Nicolas Sarkozy, 52, will be one of the youngest Presidents of the French Republic. Born in France from a French mother and a Hungarian immigrant, he was trained as a lawyer, and not as a civil servant at ENA where 90% of top French politicians are coming from.  He won the primaries within UMP (neo-Gaullist, moderate right) by arguing that a break in the management of the economy was necessary, that the 'French model' did not work anymore, that France should learn from other European countries which have achieved full employment, and that the election of the President should be a 'referendum for reforms'. This makes his election all the more important for France: if Sarkozy lives up to his promises, this could be the beginning of long overdue structural reforms for the French economy.

On a different note, the defeat of the socialist party as it existed until now is likely to trigger an internal crisis that could result in the emergence of a social-democrat type party, separated from the traditional hard left.

Main economic reforms for the next five years:

• Flexibilisation of the labor market, with one single work contract replacing both highly protective and highly flexible legal contracts. This should be first negotiated by unions and employers, before the government steps in. The process might take up to one year;

• Tax cuts for overtime hours above 35 hour per week), in order to reduce the marginal cost of labor and increase the purchasing power of employees. This is likely to be implemented relatively quickly;

• Autonomy --including financial-- given to Universities, in order to introduce more competition in French academia and boost research and innovation. This should go together with a reform of the large government sponsored research bodies.

• Steady reduction of the overall tax pressure (0.4% of GDP per year)

• Reduction of the civil service headcount: only half of retiring civil servants should be replaced

• Test of a 'social VAT', designed to transfer some of the payroll taxes paid by employers (taxes on labor input) onto consumers

• Further deregulation of pricing rules in the retail sector (removal of floor prices)

In addition, Sarkozy will plead in favor of a carbon tax on products imported by the EU from countries which have not ratified the Tokyo protocol, for a EU small business act, and, in general, for a more pro-active stance in WTO negotiations.  Similarly, he will ask the ECB to pay more attention to the exchange rate of the euro. Practically, it will be very difficult to convince the 26 other members of the EU, or the 12 other members of the EMU to follow France on these grounds.

Consequences for the markets

In the short term, since financial markets had fully priced a Sarkozy win, they are unlikely to react significantly. However, in the medium run, things might turn differently:

• Equity markets are still skeptical about the possibility of reforming France peacefully. If reforms start for earnest, as I believe will be the case, equity markets should progressively anticipate stronger potential growth and better profits for French companies. It might take some time before we get there and, in the short term, markets may pay more attention to the risk of social unrest;

• Bond markets, which are currently pricing a small risk premium on French sovereign bonds vs. German ones, will probably wait until the 2008 budget is unveiled (third week of September) before taking a view on the most likely path of the French sovereign debt. Since Sarkozy made numerous promises implying higher public spending, this spread might remain for some time. In the longer run, stronger growth and a more flexible economy should play in favor of French bonds

• Inflation-proof bonds are likely to price a temporary rise of inflation in France, consequence of a possible 'social VAT'.  Accordingly, the spread between OATis’ and OATeis’ break-even rates (implied expected inflation) should widen.

In conclusion, the election of Nicolas Sarkozy is in my view a landmark event for the French economy, the ‘sick man of Europe’, as I have dubbed it in recent reports.  However, the process of reforms is tortuous and non linear. And even if Mr. Sarkozy has the democratic legitimacy and a carefully thought strategy to undertake the necessary reforms, there will certainly be potholes and unexpected hurdles on the road toward a more efficient and competitive economy.  But at last, the first step is now done.


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European and EMEA Economics
Russia - How to Spend It
May 07, 2007

By Oliver Weeks (London)|

Spectacular capital inflows into Russia look likely to continue in the near future almost regardless of the near term course of oil prices and risks around 2008’s presidential election.  With fiscal policy loosening simultaneously, upside risks to inflation and the RUB are growing while growth should remain well supported.  We expect political rivalry in the run-up to the election to be closely managed, but risks to the investment outlook in the following two to three years remain significant, and further clouded by demographics. 

From capital flight to capital flood.  After almost continuous capital flight since the beginning of the economy’s transition, net private sector capital inflows into Russia have surged and continue to accelerate.   The Central Bank’s 2007 monetary programme was based on an assumption of USD 15 billion in private sector capital inflows.  The CBR now estimates private capital inflows in Q1 alone at USD 13 billion.  Its new full year forecast, USD 35 billion, still looks a vast underestimate to us given the strength of current and planned IPOs and foreign borrowing interest.  Sluggish oil output growth will likely see the current account surplus declining inexorably from 2006’s USD 94.5 billion.  Even in its optimistic scenario the Ministry of Economy forecasts oil output growth of just 7.1% and gas output growth of 9.2% in total between 2006 and 2010.  Yet in the short term the capital account surplus may surge from USD 11.9 billion in 2006 to around USD 60 billion in 2007, pointing to an FX reserve increase to around USD 425 billion. Although spectacular net inflows may also reflect an element of cashing-out, and obstacles to Russian state companies investing abroad, the state’s rapid shift to massive net creditor status and the introduction of full rouble convertibility have sharply reinforced confidence in the domestic economy ahead of next year’s political transition.  The turnaround is also reflected in a long awaited pickup in fixed investment growth, which at 20.4% year on year in real terms in Q1 is growing at the fastest rate this decade.  While the pace of recent wealth gains owes much to terms of trade – projected real gross national income growth averages 10.8% pa this decade, against 6.8% for real GDP – the short term outlook for growth looks robust under any plausible oil scenario.  We expect 7.0% real GDP growth this year.  For the Central Bank, however, the inflow represents a new and serious challenge. 

'First, we have the money.’  Fiscal policy appears to be loosening rapidly ahead of next year’s election.  Insulated from popular pressure, fiscal policy has been impressively conservative in recent years, with external government debt falling to 4.5% of GDP.  The Finance Ministry’s resistance to spending the Stabilisation Fund surplus, now at RUB 2.92 trillion (USD 114 billion) against an original target of RUB 500 billion, has been tenacious.  The new oil fund reform will safeguard most of the past gains, establishing a Reserve Fund to be set at 10% of GDP, with oil and gas transfers to be fixed in the budget and surpluses to go to a new and more aggressively invested fund for longer term investment.  However the pace of spending growth is accelerating.  The latest federal budget revision for 2007 has nominal spending up 31%Y, against flat revenue.  From a federal budget surplus of 7.5% of GDP (and a final consolidated government surplus of 8.4% of GDP) in 2006, the federal surplus is most recently planned to fall to 2.1% of GDP this year and 0.5% of GDP in 2008.  This reflects conservative Urals oil prices forecasts of USD 55 and 53 respectively, but oil revenue is no longer massively underestimated, and the new oil and gas transfers to the budget appear flexible upwards.  Most recently President Putin’s final state of the nation address has allocated at least an extra RUB 650 billion in spending to pensions, infrastructure, science and development banks, to be funded by Yukos windfalls and tapping the new Future Generations Fund.  Indeed, Putin’s renaming of the latter – now the Fund for National Well-being - underlines a new inclination to spend on current social challenges.  (In Putin’s words ‘first, we have the money’.)  Certainly the government does have the revenue available, and is keen to suggest to economists that much of the announced spending will take years to materialise and focus on productive domestic investment.  The slow pace of bureaucratic reform suggests this may be optimistic however. 

Inflation resurgence a growing risk.  The combination of resurgent capital inflows and government spending points to further upside risks both for inflation and the RUB.  While year on year CPI growth has fallen 6 percentage points in the last two years, to 7.4% in March, further falls seem unlikely.  Recent rapid falls in food prices are unlikely to be sustained, both due to European weather conditions and a temporary surge in sugar imports to beat an expected tariff hike.  Official restrictions on hikes in municipal services bills helped meet the 2006 inflation target but other state monopolies have more aggressive plans.  The Ministry of Economy’s latest forecasts have electricity price rises for end users accelerating from 10.3% in 2006 to 12-13% in 2007, and averaging 15-16% a year in 2008-10, reflecting a combination of regulated price rises and an expansion of the liberalised section of the market from 5% to around 70%.  Gas price growth, both wholesale and retail, is seen accelerating from 11% in 2006 to 15% in 2007, and an average of 26.8% pa over the following three years.  With the Rosstat consumer confidence index at its highest level since compilation began in 2000, and real wage growth up 18.4%Y in Q1, demand pressure is bringing a gradual rise in labour activism, with the relative success of the Ford strike in February encouraging unions elsewhere.  Our own simple measure of core inflation, excluding food and petrol prices, is already at 9.4%Y, against 6.6% for the official core index (which excludes administrative and seasonal prices although the former are well below market levels and a source of future inflation).  While there may clearly be selective administrative pressure on price setting, for example on petrol prices, in the run-up to the election, the official 8.0% target for end-2007 CPI and more importantly the preliminary 7.0% target for 2008 both look at risk to us. 

Nominal appreciation likely despite policy inertia.   The National Bank and government’s joint 2007 monetary projections, assuming Urals oil at USD 61, have M2 growth slowing to 19-29%, from 49% in 2006.  So far M2 growth has accelerated to 53%Y in March.  The latest official comments suggest a new M2 growth forecast of 24-32% but with no change in inflation or real appreciation forecasts.  The Bank’s preliminary 2008 monetary forecasts look equally optimistic, with M2 growth at 21-23%, and FX inflows slowing from USD 35 billion to 30 billion.  Certainly growing confidence in the domestic economy has its upside too for the CBR.  Apart from temporary relief on food prices the main factor keeping inflation under control has been a sharp fall in velocity of circulation as growing confidence in the RUB and fading memories of the 2004 banking crisis raise people’s willingness to hold roubles for longer.  The share of cash in M2 has fallen to 29% in March, from 32% a year earlier.  Among bank deposits the share of the RUB has risen to 79% in February, from 71% a year earlier.  M2/GDP velocity was down 19.8%Y in Q1.  At the same time the CBR is stepping up efforts to sterilise recent interventions, announcing an unprecedented RUB 350 billion of 6 month OBR auctions in June.  While aimed to anticipate the VTB sale, this is still well below the USD 30.3 billion increase in international reserves in April alone.  Further sterilisation still risks attracting further inflows.  Even the current (and unlikely sustainable) pace of declines in velocity seems inadequate to constrain inflation at current monetary growth rates.  With no one institution accountable to the President for inflation, and political pressure against nominal FX appreciation rising, the CBR is unlikely to risk aggressive use of the FX tool in response.  Nevertheless it may wish to be seen to be responding.  We see little evidence still of harm to the real economy from over-appreciation.  The monetary guidelines target 4-5% real effective appreciation with Urals at $61, but allow for a maximum of 10%.  With an inflation differential likely around 5%, nominal effective appreciation of around 2.5% (a further 2.1%) seems feasible in 2007 even without further rises in oil prices. 

Investment outlook improving in parts.  In the longer term both the Central Bank’s plan to clarify current dilemmas by a move to a clear inflation targeting regime and hopes for sustainable investment-led growth will require deeper local markets.  Here there has been some progress.  Although pension reform has been a failure so far, part of the oil surplus seems likely to be invested in local markets with the aim of rescuing the system.  The state will offer matching funding up to a yet-to-be-defined ceiling for additional voluntary contributions to individual pension accounts.  With the President opposed to raising the retirement age, the average ratio of pensions to wages already down to 27%, and demographic ratios deteriorating rapidly, such injections are likely to be large.  (Ex-PM Gaidar has called for an injection of 70% of GDP from the sale of state owned firms, though this is politically improbable.)  Meanwhile inflows into local mutual funds have accelerated sharply, reaching a record RUB 21.4 billion in Q1 (85% into equities).  Recent progress towards establishing a single central depositary may help too in this regard.  It is also worth noting the RUB 267 billion in ‘silent’ pension fund assets held at negative yields in sovereign paper by Vnesheconombank, which would be transferred to private pension fund managers if government liberals get their way.  With commodity output growth weak and interest outflows on private foreign debt rising, the economy may move into current account deficit around 2011 (in sharp contrast to Kazakhstan).  The new fiscal regime will see the government gradually moving to a non-oil deficit, to be funded in domestic markets and further stimulating their growth.  While pressure of inflows will continue to keep real interest rates negative in the short term, gradual upward pressure on rates looks likely over the next few years.  The upside of the end of the oil boom will be greater monetary control, but remains several years off. 

Longer term outlook still in the balance.  Yet while strong macro-financial management and a developing local market can help boost investment, the longer term preconditions for sustainable growth seem more questionable.  Reform of natural monopolies and the civil service remains strictly limited, while there has been little progress on perceived corruption indicators, demographics or long term political predictability.  In the short term the risks posed by the March 2008 presidential election seem manageable.  Clearly Putin will wish to prolong uncertainty to avoid lame duck status, but his eventual decision, whether for one anointed candidate or two, could be decisive.  The recent prominence of Sergei Ivanov in state media has been striking, while among the reserves the pace of promotion of Sergei Naryshkin stands out.  Ivanov may also prove popular in the event of a straight contest with Dmitry Medvedev, given the currently cultivated climate of nationalism.  He also appears more statist than Medvedev and perhaps more likely eventually to attempt to assert his independence.  With neither side likely to be capable of winning without Putin’s support, a destructive struggle before the election looks unlikely.  The post election environment looks less clear however.  Parliamentary, media and judicial checks and balances remain effectively absent.  As the new President gains backing and confidence, there is a risk of disruptive redistribution, as when Putin turned against the Yeltsin inheritance in 2002-4, though it would seem prudent to wait for Putin’s much stronger public aura to fade before taking him on.  The prospects for reversal of the trend to greater state control seem limited under any approved candidate, and particularly Ivanov.  Suspicion of foreign involvement in infrastructure and natural resources will likely continue to constrain investment, as will state dominance in the banking sector.  Meanwhile the troubling demographic outlook may begin to bite.  As the collapsing birth rate of the mid-80’s kicks in, government projections show the labour force declining by 0.5 million in 2008 and 2009, and over 1 million pa thereafter, for a 25% fall over the next two decades.  A surge in immigration is the obvious answer, but difficult given the strength of nationalism.  Russia’s long term status as a major emerging market rather than a petro-state remains at stake for the next president.

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No Metal Battle
May 07, 2007

By Elga Bartsch (London)|

After a negotiation marathon to avoid an all-out strike, a wage agreement was finally reached in the German metal sector. The agreement, which will be closely watched by the ECB, is broadly in line with expectations showing headline wage increase of 4.1% from June onwards, the highest settlement for more than a decade. The wage agreement, which will expire only at the end of October 2008, foresees a further increase of 1.7% in June 2008. In addition, there will be a bonus payment of 0.7% from mid 2008 onwards subject to company discretion based on the cyclical situation. The pay deal for the 3.4 million workers in the sector (8.5% of employment) marks a noticeable pick-up in the pace of pay rises from the previous 3.0% rise in base salaries.

The effective wage rise is somewhat lower than what headlines suggest. Negotiated wages in the metal industry will likely rise by an average 3.9% this year and an average 2.5% next year, assuming that all companies in the metal sector will pay the one-off bonus. The latter estimate marks the upper end of the likely increase in 2008. If, by contrast, no bonus payments are made at all the effective wage increase in 2008 will average only 2.1%. For the full term of the contract, we calculate an effective wage increase of 3.3%, about half a percentage point above the long-term average in the sector. On the whole, worries that the pay deal would be excessive have not materialized, we think. In the near-term the cost pressure will be limited by a reduction in the contributions to unemployment insurance by 1.3 percentage points of gross wages at the beginning of this year and by the smart pickup in productivity growth to 1.7% last year.

Despite its relatively benign outcome, the agreement won’t go unnoticed at the ECB, we think. This is not because the deal is likely to generate much immediate inflationary pressure. It is because it is an important observation of relative bargaining power of workers and employers in the light of the current labour market situation. With an unemployment rate of only 6.8% of the labour force in Germany and with nearly 60% of German jobseekers being long-term unemployed, a central bank can be forgiven for being vigilant regarding signs of rising capacity constraints. In addition, the metal-sector wage deal might spill over into other sectors, such as the service industry, where such a pay rise would be a much greater concern. Historically, the negotiated wage increase for the total economy has closely tracked the gyrations in the metal sector. Furthermore, given the labour market turnaround, it is likely that the negative wage drift will gradually disappear going forward. This would remove a key driver of the wage disinflation in Germany over the last decade.

The pilot agreement for the state of Baden-Wuerttemberg still needs to be approved by the other regions. Even though an approval tends to be norm, it is not guaranteed. Just this week, the agreement reached for the construction industry back in March for a 3.5% pay rise for the 680,000 construction workers was rejected by a large number of east German and some west German states, causing the deal to fall through and necessitating an ex-post mediation process. We saw something similar in the metal industry in the second half of 1990s when some of the east German regions felt that the pay deals were putting jobs in the region at risk.

The moderate wage increase is good news for the consumer recovery, we think. In our view it is unlikely that companies will scale back their hiring intention on the news of today’s wage deal. Hence, consumers, who currently are the most optimistic about the labour market outlook since 1985, might turn out to be right. We therefore continue to expect a recovery in consumer spending in the course of this year driven by stronger income growth and rising consumer confidence. However, after broad retail sales plunged 7.4%Q in the first three months of this year due to the three-point VAT hike implemented in January, it seems likely that consumer spending will decline by more than the -0.3%Q we had penciled in so far. Instead, a contraction on par with previous VAT hikes of around 0.75%Q seems more likely. Our tracking estimate for 1Q GDP growth isn’t affected by the downside surprise in retail sales, as the main input into the official statistics comes from the supply side.   Here, industrial production out this coming week will provide the final clue.


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