Policy Pitfalls in an Asset-Dependent World
May 21, 2007
By Stephen S. Roach | New York
What do these three developments have in common: Washington-led protectionism, China’s equity bubble, and a dollar-exposed Middle East? They are all unsustainable outgrowths of the same imbalance – America’s historic saving shortfall. Around the world, authorities are having an increasingly difficult time coping with the repercussions of this problem. The endgame remains exceedingly treacherous.
Never before has the world’s leading nation experienced such a paucity of saving. America’s net national saving rate – the depreciation-adjusted saving of individuals, businesses, and the government sector, combined – averaged just 1% of national income over the 2004-06 period. Lacking in domestic saving and unwilling to forego the growth such a saving shortfall might normally entail, the US has been aggressive in importing foreign saving from abroad. The funding of such inflows has given rise to America’s massive current-account and trade deficits – very visible manifestations of the world’s most profound imbalance. US officials, especially Federal Reserve Chairman Ben Bernanke, have been quick to pin the problem on others – bemoaning the glut of global saving and extolling the virtues of a US that is willing to step in and consume this excess. An alternative interpretation charges the United States as guilty of excess consumption – leaving export-dependent economies elsewhere in the world with no choice other than to keep funding saving-short Americans. Either way, this is turning out to be a very dangerous cocktail for an increasingly integrated global economy. In the United States, it has raised the risk of a protectionist response – especially a potentially virulent strain of China bashing. The Congress, of course, sees it quite differently – linking a decade of stagnation of median real wages to America’s massive trade deficit. With China accounting for the largest portion of this deficit – some 34% in the final quarter of 2006 – Congress mistakenly believes that China bashing is fair game. This approach completely ignores the macro context of America’s saving shortfall – pointing the finger at a bilateral piece of a much larger multilateral imbalance. As I asked in recent congressional testimony, what about the other $600 billion of the US foreign trade deficit in 2006 that arises from America’s non-Chinese trading partners? If this were merely a “China problem,” I daresay the other pieces of the US trade deficit would be a good deal smaller. Consistent with the diagnosis of a macro saving shortfall, America’s trade problem shows up in the form of deficits with many economies – not just with China. Contrary to Washington’s political spin regarding China’s unfair competitive advantage brought about by a cheap currency, the large Chinese bilateral imbalance is more a reflection of the tastes and preferences of saving-short American consumers for low-cost, high-quality goods made in China. As Stanford Professor Ronald McKinnon put it, “China is merely the face of a worldwide export surge into the saving-deficient American economy” (see McKinnon’s March 2007 paper in International Finance, “Why China Should Keep Its Dollar Peg”). China’s equity bubble is an offshoot of this same problem. Washington’s China bashers appear to be drawing on the same game plan of forced currency revaluation that wreaked havoc on the Japanese economy in the 1990s. As was the case with the endaka (strong yen) of the late 1980s, RMB appreciation is now taken as a given by domestic and international investors – only questions of degree and timing remain unanswered. There is an eerie similarity between currency-driven outcomes in the two equity markets. In both cases, one-way currency bets turned equities into the asset of choice for the “hot money” of liquidity-fueled investors. Is it a coincidence that China’s A-shares began their recent run only a few months after the pegged-currency regime was abandoned in July 2005. Similarly, was it a coincidence that the Japanese equity bubble emerged in the late 1980s in the aftermath of a Plaza accord that steered the yen/dollar cross rate from 254 in early 1985 to 145 in early 1990? Given the lack of alternative assets in a still undeveloped Chinese financial system, the equity bubble may be even more of a foregone conclusion in China than it was in Japan. In the Middle East, it’s a story of dollar-concentration risk. Oil producers in the Gulf not only price their one commodity (oil) in dollars, but their currencies for the most part are dollar-pegged and, largely as a result, their foreign exchange reserves are massively overweight dollars. In a high oil price environment, the more the United States relies on external lenders to fund its saving-short economy, the more the Gulf region fills the void – and increases its dollar-concentration risk accordingly. This outcome does not sit well with asset allocators in the Middle East. In fact, in my two most recent visits to the region in early 2007, I detected a growing unease with these concerns. The region worries increasingly about excessive exposure to a chronically weak dollar scenario as an unavoidable outgrowth of a prolonged US current account adjustment. Nor is this situation stable. The longer the US suppresses its domestic saving, the greater the risks the Gulf region may face as a levered play on the dollar. Kuwait’s just announced decision to end its dollar-pegged currency regime may well be the first step in a regional diversification strategy that attempts to temper such risks. All the above is subtext to an even deeper plot: In one sense, America’s saving and current account problems are really nothing more than symptoms of the consumption excesses of an asset-dependent US economy. Drawing comfort from asset-based saving – first from equities, then from residential property – the rational consumer has had little reason to save out of current income. Not surprisingly, the income-based personal saving rate moved below zero in 2005-06 – the first back-to-back years of negative saving since the early 1930s. This doesn’t mean households aren’t saving. What it does point to is an important shift in the mix of saving – away from that generated by income toward that which can be funded through wealth creation. Rational or not, this puts tremendous pressure on an economy with already deficient income-based domestic saving – forcing the US into the international capital markets to close the funding gap. In other words, America’s gaping current account deficit is a direct outgrowth of the wealth-based saving tactics of the Asset Economy. So, too, are the global repercussions of America’s gaping external imbalance – including those bearing down on China and the Middle East, as noted above. A key problem with wealth-related global imbalances is the lack of resolve in policy circles to address the excesses in asset markets that have given rise to the disequilibrium in global saving. In the US, this is the essence of the so-called “Greenspan put” – hands off on the upside of asset markets and quick to provide support on the downside. The jury is out on whether Ben Bernanke will break this daisy chain – especially in light of his strong statements to the contrary during America’s post-bubble deflationary scare in 2001-02. That puts dollar-pegged economies, such as those in China and the Middle East, in the uncomfortable position of having to accept America’s agnostic stance on asset markets. Again, it’s hardly a coincidence, in my view, that in recent years both regions have been afflicted with asset bubbles of their own – not just the current Chinese equity bubble but also those evident in Middle East equity markets in 2005 and early 2006. It will be interesting to see if China’s May 18 monetary policy package – a combination of modest hikes in interest rates and bank reserve ratios, along with a wider intra-day currency band – arrests the open-ended buying in domestic A-shares. Inasmuch as these actions don’t alter future expectations of RMB appreciation, it’s hard to believe there will be a lasting deflation of China’s equity bubble. We’ll know soon enough. On the surface, the world economy appears to be doing just fine. After four years of the strongest global growth since the early 1970s, the consensus forecast is for two more years of the same. The problems lie beneath the surface – largely an outgrowth of profound saving imbalances stemming from the excesses of an asset-dependent US economy. As always, the unintended consequences of these imbalances pose the greatest challenge to the global economy and world financial markets. The combination of Washington-led protectionism, a Chinese equity bubble, and Middle East dollar-concentration risk is especially worrisome in that regard. In days of froth, it never pays to worry. But when the tide goes out, it could be a different matter altogether. That could be especially the case in the current climate. Watch out for a crack in the dollar, a related increase in real long-term US interest rates, a widening of credit spreads, and a pullback in global equities. Only then will the long-overdue rebalancing of global saving have begun in earnest.
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The Conundrum Unwinds
May 21, 2007
By Richard Berner | New York
Despite slowing US growth, declining core inflation and a steady Fed, US real yields are on the rise again. US real growth has decelerated to 2.1% over the past year and to only about 1% in the first quarter, from 3.1% in 2005 and 2006, and significant headwinds for growth persist. Yet US real 10-year yields have risen by 30 basis points (bp) in the past two months to 2.45% — a level close to the upper end of the range prevailing over the past two years. That has pushed nominal 10-year yields to 4.8% — the highest level since February. Is the bond-market “conundrum” of 2004-05 finally unwinding? And if so, why? I think the conundrum is unwinding, although the yield curve is likely to remain relatively flat. The main culprits for this increase in US yields, as I see it, are more global than domestic: Strong global growth — manifest not just in GDP or industrial output but also in domestic demand outside the US — is one key factor. The improvement in non-US domestic demand implies that the strength of global growth is not entirely dependent on US developments. Concurrently, therefore, global real yields are rising; for example, yields on 10-year index-linked UK gilts have jumped by 35 bp in the past two months — and twice that amount since December 2006. In turn, the global domestic demand improvement likely means that the world’s saving-investment balance is tipping away from support for US bond prices. With those overseas trends sustainable, in my view, global real yields seem likely to put a floor under those in the US. Details follow. It’s always difficult to disentangle the forces acting on yields, and this time is no different. For example, at the start of the year, I expected that a combination of five forces would lift real US yields: US ‘core’ inflation would peak and move lower; US growth would rebound towards trend; and US saving imbalances would shrink — the last two courtesy in part of strong growth abroad. In addition, I thought liquidity would dwindle, and term premiums and volatility would rise slightly (see “Critical Macro Investment Themes for 2007,” Global Economic Forum, January 3, 2007). Those forces now all seem to be in play. But two of the factors that I think are important drivers of US real yields originate abroad, and they are right now making the difference. First, strong growth combined with upside risks to inflation abroad have promoted monetary tightening in several economies and increased the likelihood of further policy actions. For example, European growth has consistently turned out to be stronger than expected. Although Eurostat’s flash estimate suggests that EMU GDP decelerated to 0.5% (not annualized) in the first quarter (a rate of 3.1% year over year) from 0.9% in the final quarter of 2006, Eric Chaney believes that this estimate is conservative and that the economy is reaccelerating in the spring (see “A Misleading Deceleration,” Global Economic Forum, May 18, 2007). Elsewhere in Europe, neither the UK, the Scandinavian, nor the eastern European economies show fundamental signs of weakening. In North America, there are signs of slower growth in Mexico, but the Canadian economy is probably growing at a 3½-4% clip. And the ongoing Chinese economic boom continues to fuel Asian growth in both output and incomes, plus hearty gains in domestic demand. As a result, central banks are acting or talking hawkishly in many of these theatres, and markets are pricing in the likelihood of more rate hikes. A second important global factor is also tipping away from support for US yields, namely the global saving-investment balance. Three or four years ago, that balance, coupled with slower global growth, may have contributed to lower global and US real yields. True, global growth was beginning to improve significantly, but it was largely the product of strong US demand and Chinese production. US monetary tightening encouraged the recycling of the resulting surplus saving from abroad into strong US capital inflows from both official and private sources, a stronger dollar, and healthy demand for US yields. That was then. Today, the balance is shifting in the context of strong global growth. More of the income generated from strong growth in output abroad and from the favorable “terms of trade” in commodity-producing economies is showing up in overseas final demand. For example, in both Latin America and Asia excluding Japan and China, strong growth has encouraged booming capital inflows and currency appreciation. With many global yields close to or even above those in the US, and global investors looking abroad for investment opportunities, it’s hardly a stretch to think that rising global yields will put a floor under those back home. Put differently, these shifts mean that some of the flow of saving from abroad that has so far helped to finance the US current account deficit on attractive terms will now be diverted to finance demand growth in many of our overseas trading partners — and in this context, that may contribute to somewhat higher US real interest rates. Reinforcing that tendency, if Asian and Middle Eastern central banks allow their currencies to appreciate against the dollar at a faster pace, or de-peg them from the dollar, they will accumulate dollar-denominated reserves more slowly. That now seems to be happening, because rising inflation pressures are forcing them to abandon their exchange-rate policies, as in Kuwait (see Serhan Cevik’s “Middle East and North Africa: The Case for Revaluation,” Global Economic Forum, May 15, 2007). And China’s latest move to raise rates and broaden the trading band for the yuan is also a step in that direction. Indeed, the gradual diversification of global foreign exchange reserves away from the dollar and liquid fixed-income securities through the growth of Sovereign Wealth Funds seems likely to boost US real rates. As I see it, the combination of relatively healthy growth and the shifts in saving make such a rise highly likely. To be sure, domestic US factors are also important. US real rates are getting a lift from an evident pickup in second-quarter US growth, which precludes Fed ease for now. Indeed, we believe that the first quarter likely marked the trough for US growth at just under 1% annualized, and estimate that the second quarter pace may rebound close to the 3% trend. Among the contributing factors: Stronger growth in capital goods orders, upward revisions to retailing results, surprisingly strong housing activity, lean inventories, and the presumption that hearty global growth will again shrink US net exports. Certainly, it’s too soon to say that this rebound is sustainable, but it is occurring in the face of significant headwinds to growth from rising gasoline quotes and the ongoing housing recession. A second domestic factor also matters: I believe that “term premiums” — the compensation for moving out the risk-free yield curve — and volatility are both poised to rise at least slightly as uncertainty about the global economic and monetary policy outlook increases and liquidity dwindles. Term premiums are close to all-time lows: Based on a model developed at the Fed, the 10-year zero-coupon term premium stood near zero at the end of March (see Don Kim and Jonathan Wright, "An Arbitrage-Free Three-Factor Term Structure Model and the Recent Behavior of Long-Term Yields and Distant-Horizon Forward Rates," FEDS Paper 2005-33). I think a rise in term premiums will boost long-term yields and help to re-steepen the yield curve over the next few months, as my colleague David Miles and I thought it would — and did — in the first half of 2006 (see “The Term-Premium Case for Higher Yields,” Global Economic Forum, January 20, 2006). Although it may have further to go, much of the strong global growth news is already in the price for global real yields. In fact, the price action over the past few days suggests that European yields may have peaked, at least for the time being. In contrast, US yields seem still to discount substantial pessimism about growth. Consequently, transatlantic spreads may stop narrowing for now and could even widen again if the US growth pickup proves sustainable, as we expect. Where are the risks in this scenario? Sustained strong global growth could lift global and US real yields further and narrow transatlantic spreads. Correspondingly, if stronger real growth is the source of the rise in global yields, I don’t think that such a yield backup will represent a threat to risky assets. It may hobble multiple expansion, but strong earnings growth and cash flow would be a powerful offset. On the other hand, rising US inflation risks — related to the threat of protectionism, a weaker dollar and rising energy quotes — could widen US-European spreads in nominal terms. And if they entail the threat of Fed action, such risks may eventually menace risky assets.
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Review and Preview
May 21, 2007
By Ted Wieseman | New York
Treasuries posted big 5-year-led losses over the past week, sending yields across the curve to their highs since February, as evidence continued to build that the economy may be seeing a decent pick-up in the second quarter from what is increasingly looking to be the trough of the mid-cycle slowdown in 1Q. Even a second straight much better-than-expected inflation report provided no support to the market — though it did help keep the sell-off confined to real rates, with TIPS performing terribly — as the growth upside forced investors to increasingly scale back expectations for near and medium-term Fed rate cuts. Incorporating the lower-than-expected headline CPI result, which boosted our real consumption estimate slightly, a very surprising third straight gain in housing starts, which, while ultimately a seriously unhealthy development, in the near term at least implies a smaller drop in residential investment than we previously expected, and a slightly stronger trajectory for investment spending but lower add from inventories implied by the annual revisions to manufacturing shipments and inventories, we boosted our 2Q GDP forecast marginally to +2.8% from +2.7%. We continue to see 1Q being revised down to +0.9% from +1.3%. Early indicators for the key upcoming employment and ISM reports provided some important early confirmation for this expected 2Q growth pick-up. Based in part on the much better-than-expected jobless claims report, we look for a significantly improved May employment report after the weak April results and project a 175,000 rise in non-farm payrolls. Meanwhile, the factory sector appears to be on the mend after the recent inventory correction, with a recovery in the auto sector playing a key role. Manufacturing output in the IP report posted a second straight robust gain in April, and upside in the key early regional manufacturing surveys suggested that the surprising surge in the ISM in April could be sustained in May. Our preliminary May ISM forecast is 55.0, up slightly from 54.7 in April. Benchmark Treasury yields rose 11-15bp over the past week, taken as a whole making for the market’s worst week of the year and leaving yields at their highs since February. The 2-year yield rose 11bp to 4.82%, the 3-year 13bp to 4.74%, the 5-year 15bp to 4.73%, the 10-year 13bp to 4.80%, and the 30-year 11bp to 4.96%. The sell-off was more than accounted for by a surge in real yields, as TIPS actually underperformed significantly on the week — a rather amazing occurrence during such big losses in the nominal market, a meaningful rise in energy prices, and, even after the slightly lower-than-expected headline CPI result in April, still very positive carry going forward. The 5-year TIPS yield surged 20bp on the week to 2.38% and the 10-year 16bp to 2.45%, sending respective benchmark inflation breakevens down 5bp and 3bp, both to 2.35%. The very short end of the TIPS market in particular continued to get absolutely destroyed, with the yield on the Jan ’08 issue now up about 60bp in the past three weeks. The losses in the broad market and underperformance in TIPS were accompanied by a major further scaling back of Fed rate-cutting expectations in the futures market. In the fed funds futures market, after having been recently flipping narrowly back and forth between the October and December FOMC meetings, the timing of the first expected rate cut was shifted out clearly to December — and even December is not seen as nearly a sure thing — as the November contract lost 4.5bp on the week to 5.16%. On a medium-term basis, nearly a full rate cut was removed from the — now very shallow — expected rate-cutting cycle in the eurodollar futures market, as the low-rate Dec 08 and Mar 09 contracts plummeted 20.5bp each to 4.955% and 4.95% to lead losses in that market. So essentially barely more than just one-and-a-half total rate cuts are now expected in total. What had looked to be the key release coming into the week was seemingly quite market-friendly, but had no lasting positive impact. The consumer price index rose 0.4% in April for a 2.6% year/year gain, boosted by upside in both food (+0.4%) and energy (+2.4%). The core, on the other hand, continued to moderate, rising a less-than-expected 0.2% for a 2.3% year/year increase, down from +2.5% in March and +2.7% in February. The core was largely restrained by smaller gains in owners’ equivalent rent (+0.2%) and rent (+0.2%) that partly offset a rebound in hotels (+1.9%) after the big drop that helped hold down core inflation in March, leaving the key overall shelter gauge at a restrained +0.3%. Core goods prices (-0.1%) also posted a second straight small decline, with clothing prices (-0.3%) falling again and new and used car prices both flat on the month. Translating these results into core PCE inflation, we look for a 0.16% gain in April, which would leave the year/year rate right between +2.0% and +2.1% after the drop from +2.4% to +2.1% in March. For headline PCE prices, we estimate a 0.3% gain, lower than the +0.4% rise we previously assumed, which boosted our estimate of real consumption in 2Q to +2.2% from +2.0%. The small upside in consumption was added to by a likely smaller drop in residential investment after a surprisingly strong housing starts report. Housing starts rose 2.5% in April to a 1.528 million unit annual rate. This marked a third straight gain, a very surprising development that will likely further exacerbate the housing inventory overhang, increase downward pressure on prices, and delay the end of the housing recession. Both single-family (+1.6% to 1.225 million) and multi-family (+6.3% to 303,000) starts posted gains. Single-family starts have now fallen a cumulative 33% from the January 2006 peak, trailing a 37% decline in new home sales since the July 2005 peak, while multi-family starts have been range-bound for more than a decade. We estimate that starts will need to fall about another 25% from here to bring supply and demand back into balance. In the near term, however, the surprising strength in April points to a smaller drop in residential investment in 2Q than we previously expected. We raised our residential investment estimate to -14% from -18%. Our take on the implications of the annual revisions to manufacturing shipments and inventories data released Friday had a small further impact on our growth estimates. We still see 1Q growth being revised down to +0.9% from +1.3%, but we now see final sales being held steady at +1.6% instead of being revised up to +1.7%. Relative to our prior assumptions, a downward adjustment to investment should be offset by a smaller (though still substantial) reduction in inventories. For 2Q, on the other hand, we now project slightly stronger investment spending, but, with the smaller expected downward adjustment to 1Q inventories, we now see a slightly smaller add in 2Q. Combining the modestly stronger trajectories we now see for consumption, residential investment, and business investment, we raised our forecast for 2Q final sales (GDP excluding inventories) growth to +2.3% from +2.0%. But with the smaller expected downward revision to 1Q inventories, we now look for a slightly smaller add in 2Q, +0.5pp instead of +0.7pp. Netting these, we raised our 2Q GDP forecast marginally to +2.8% from +2.7%. Even with this smaller expected inventory add, a rebound in production after a big prior inventory correction still remains a key driver of the expected acceleration in growth in 2Q, and this was reflected in more positive data on the manufacturing sector released the past week, with the industrial production report confirming the jump in the ISM in April, and improved results from the initial May regional surveys pointing to further improvement. Industrial production jumped 0.7% in April, the second best rise in the past year, boosted by a second straight significant gain in manufacturing (+0.5%) — indeed, the best back-to-back gains since last summer — and a weather-related rebound in utilities (+3.5%). A solid advance in motor vehicle output (+3.3%) accounted for a good part of the manufacturing advance, as light motor vehicle assemblies rebounded 5%. The motor vehicle sector appears likely to add significantly to 2Q growth. Excluding autos, factory output gained 0.3%, with most of the upside reflecting another sharp gain in high-tech output (+2.6%). Excluding both motor vehicles and high-tech, manufacturing production ticked up 0.1%, with mixed results across major sectors. The overall capacity utilization rate rose 0.4pp to 81.6% and the manufacturing rate 0.2pp to 80.2% — both moderately above their long-term averages. Looking ahead to May, results from the initial regional manufacturing surveys indicated that the pick-up in the factory sector continued. On an ISM-comparable weighted average basis, the Empire State survey rose to 53.6 from 52.7 and the Philly Fed to 52.8 from 50.2. Based on these results, we look for a further small improvement in the national ISM in May after the 4-point jump in April, preliminarily projecting a rise to 55.0 from 54.7. The May employment report also seems likely to be robust. Initial jobless claims in the week of May 12 — the reference week for the May employment survey — fell 5,000 to 293,000, a four-month low, dropping the 4-week moving average 12,000 to 305,500, a low in over a year. Continuing claims in the prior week also posted a sharp decline, falling 78,000 to 2.473 million, a low since late January. Based on these results, the favorable weather conditions during the May survey week (in contrast to the unusually cold weather seen in April), and continued strong underlying growth in withheld tax receipts, we look for a much improved May employment report after the weak April results. Our preliminary forecast is for a 175,000 gain in non-farm payrolls. The upcoming week should be very quiet, with an almost completely empty calendar through Wednesday and then just a few notable releases late in the week before Friday’s early close ahead of the Memorial Day Weekend. There are a number of public appearances by Fed officials scheduled through the week but only one on a topic that appears likely to have any potential to move the market, a speech on inflation by Richmond Fed President Lacker Tuesday night. We’ll get some supply news Thursday when the Treasury announces the 2-year and 5-year notes that will be auctioned the following Tuesday and Wednesday. In our view, the Treasury should be cutting coupon sizes to help ease the squeeze on the rapidly shrinking bill market, but if it didn’t do so in April when tax receipts were flooding in, there’s no good reason to expect it to do so now, so we look for unchanged US$18 billion and US$13 billion sizes. The debt managers appear to believe that these sizes are about as small as they can go without impairing liquidity. The only economic data release of any significance in the first part of the week will be the Richmond Fed manufacturing survey on Tuesday. We’ll update our ISM forecast after the release of that report and the Dallas and Kansas City Fed reports the following week. There are a few key releases late in the week, durable goods and new home sales Thursday and existing home sales Friday: * We look for a 0.2% dip in April durable goods orders. Although aircraft bookings remained quite elevated again this month, we look for a slight pullback in overall orders, with softness in a few of the capital equipment components more than offsetting an expected rise in the motor vehicle category. Indeed, the key core gauge of underlying order activity — non-defense capital goods excluding aircraft — is expected to inch lower following a strong performance in March. This would follow a pattern that seems to have developed in recent year, whereby the first month of a new quarter shows some moderation following strength at the end of the previous quarter. Finally, core capital goods shipments are expected to post a solid 0.8% rise in April. * We forecast April new home sales of 825,000 units annualized. The recent deterioration in the homebuilder sentiment index points to some renewed slippage in sales of newly constructed residences following on the heels of the modest uptick seen in March. Our April estimate implies a sequential decline of about 4%. Over the past year, the fall-off in the sales pace has just about matched that of new starts. Thus, we believe that starts will have to move significantly lower over the next several months in order to help absorb the excess inventory of unsold new homes. * We forecast April existing home sales of 6.08 million units annualized. The pending home sales index posted an unusually severe fall-off in March. However, the normal relationship between the PHSI and resales appears to have broken down considerably in recent months. For example, the PHSI fell sharply in January, but sales rose in February. Moreover, the PHSI ticked up in February, but sales plunged in March. So, we suspect that some portion of the latest move may reflect a catch-up, and thus look for only a very modest 0.6% downtick in April sales.
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A Misleading Deceleration
May 21, 2007
By Eric Chaney | London
EMU GDP growth decelerated to 0.5%Q in the first quarter (3.1% from one year ago), after 0.9%Q in 4Q, according to Eurostat’s flash estimate, which I take as conservative. Nothing particularly exciting, except that, six months ago, most economists starting with ourselves thought that tighter macro policies would cause a standstill, if not an outright contraction in early 2007. So, this ‘perfect landing’ that we had anticipated when we raised our full-year GDP growth forecast to 2.5% two months ago, is in fact a surprising event. I see four interesting lessons in this misleading deceleration: 1. There are upside risks to 2007 GDP forecasts for the euro area; 2. The underlying momentum of euro area economies is strong and not merely cyclical; 3. Global rebalancing seems to work nicely so far; 4. Rising operating rates may imply inflationary risks. Eurostat was cautious Germany and France posted similar growth rates (0.5%Q) despite the VAT hike which has pushed inflation 0.6pp higher in the former, while a payback took place in Italy (0.2%Q), after the 4Q boom that took markets by surprise. Spain experienced only a modest slowdown to 1.0%Q, after 1.2%, while the Netherlands and Belgium continued to cruise at 0.6%Q. Aggregating the known GDPs gives 0.54%Q, which indicates that Eurostat took a conservative stance regarding countries which have not yet released their GDP (Greece, Finland, Ireland and Slovenia). Hence, first quarter GDP data are likely to be revised upward in the next releases. In addition, our survey-based GDP indicator is estimating growth at 0.74%Q in the second quarter, significantly above our bottom-up forecast (0.5%Q). Even if the economy decelerates in the second half under the effect of higher interest rates and a stronger currency, our current 2.5% GDP growth forecast for this year, which happens to be close to consensus, looks very conservative. The underlying growth momentum is strong, above 3% Euro area economies are facing powerful macro headwinds: bold fiscal stabilization plans in Germany and Italy, a 150bp tightening by the European Central Bank since the end of 2005, and a 7% appreciation of the euro since early 2006, on a trade-weighted basis. Also, crude oil quotes have not dropped as much as we thought, from their August 2006 peak. Overall, these adverse macro shocks are likely to cost one full percentage point to GDP growth this year. Given that our 2.5% forecast looks conservative, the underlying momentum of euro area economies, i.e., the spontaneous GDP growth rate that they would achieve if macro policies and exchange rates had not changed, is at least 3.5%. This was already our estimate for last year. I find hard to believe that such punchy growth rates are only the result of cyclical forces. Two structural factors come to my mind: the revival of construction investment in Germany, after a 12-year-long slump, and the revival of productivity, itself the result of in-depth corporate restructuring, investment in IT, and ongoing outsourcing in Central and Eastern Europe and elsewhere. President Trichet said that “2.25 or 2.3 per cent would be an appropriate proxy” for the euro area potential growth in a recent interview with the Financial Times. Once the cyclical and statistical dust settles, he might have to revise his judgment up. Global rebalancing is working nicely, so far Ironing out quarterly fluctuations, GDP growth has been accelerating in the euro area since mid-2005, while it has steadily decelerated in the US. On an annual basis, growth is now hovering above 3% in the euro area and the EU in general, while it has decelerated to 2% in the US. A visual analysis of business cycle linkages between the US and Europe over the last ten years shows three different periods: before 9/11, Europe was lagging the US by 6-9 months. A view largely spread among investors was that it wasn’t worth spending time on cyclical developments in Europe, since they had already seen the movie six months ago on the other side of the Atlantic. 9/11 re-synchronized the business cycles, first on the downside then on the upside, as a result of co-coordinated actions by central banks. The third phase started in late 2005, with opposite trends in the US and Europe. A part of the explanation is indeed cyclical: since initial output gaps were different in both economies, the Fed initiated the tightening cycle earlier than the ECB. However, as mentioned before, I believe that there are more than desynchronized monetary policies in the current decoupling. This is good news for the global economy: Europe is contributing to re-balance global demand more evenly. Mind cyclical inflationary pressures Stronger growth has helped cut the unemployment rate to close to 7%, without triggering a significant acceleration in wage inflation so far — testimony that euro area labour markets are more flexible then they were in the 1990s. Simultaneously, operating rates are rising. Our heat map, which crosses normalized operating rates and their change over the last four quarters, shows that the UK, Germany, Italy and, to a lesser extent, France are in the ‘hot and heating up’ zone (‘warm and heating up’ for France), while the US economy has entered the ‘cooling’ region. The impact of tighter labour markets and high and rising operating rates on inflation is so far benign: despite a 3pp hike in the German VAT rate and higher-than-expected oil product prices, inflation is still slightly below 2% in the euro area. However, cyclical inflationary pressures are probably building up. Over the next 12 months, two opposite forces will shape inflation in the euro area: rising cyclical pressures on the one hand, and the appreciation of the euro and cooling housing markets in countries such as Spain and France on the other hand. Against this uncertain backdrop, the ECB may want to take bolder insurance against inflation risks, at least as long as real demand remains robust. So what about real demand? GDP details out next week will quantify the correction in real demand that took place in the first quarter, and which was mostly a payback after the fourth quarter boom, spurred by advanced purchases of durable goods in Germany. Looking forward, monetary policy and exchange rate gyrations may have a negative impact on real demand, we think. Yet, a slowdown is not yet in the offing, according to the business surveys that we trust (Ifo, Insee, Isae…). The second half of the year could turn weaker than we had previously thought, but, for the time being, this is a possibility, not yet a probability.
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Unprecedented Move by the PBoC
May 21, 2007
By Denise Yam, CFA | Hong Kong
The People’s Bank of China has made an unprecedented announcement of a three-pronged package of measures regarding FX and monetary policy: 1. The daily bilateral trading band for the renminbi against the US dollar is to be widened from +/-0.3% to +/-0.5% from next Monday, May 21. 2. Deposit and lending rates are to be raised, effective from May 19. The 1-year deposit rate is hiked by 27bp to 3.06%, while the 1-year lending rate rises by 18bp to 6.57%. 3. The reserve requirement ratio is to be raised by another 50bp to 11.5%, effective from June 5. The FX band – a symbolic and political gesture: In our view, this is a symbolic and political gesture just before the US-China Strategic Economic Dialogue, due to commence next week. The current 0.3% band had been far from used fully since the system was introduced in July 2005, except recently, on April 30, when a sharp rise in the daily variability hit the limit for the first time. While it is possible that China is ready for faster appreciation in the renminbi, this latest announcement does NOT necessarily imply faster appreciation, as the trading band only applies to intra-day fluctuation, and provides limited guidance on inter-day changes of the central parity. Asymmetric rate hikes serve two purposes: Deposit interest rates are being raised more than the lending rates at the latest tightening move. At the 1-year tenor, the latest asymmetric hikes narrow banks’ net interest margin by 9bp, undoing only one-third of the 27bp widening from the April 2006 rate hike, when the PBoC raised only lending rates (by 27bp) and left depositrates unchanged. Moreover, the deposit yield curve has to be relatively more attractive to deposits in order to slow the diversion of bank deposits to the stock market, amid recent concerns over slowing savings deposit growth and the sharp rise in the stock market (see April Monetary Conditions Call for More Tightening, May 14, 2007). Meanwhile, we believe that this first step to narrow banks’ net interest margins serves as an incentive to encourage banks to develop non-interest fee-based revenue sources and financial product innovation. Reserve requirement hike – one more step closer to the binding level: The PBoC has certainly sped up the pace of reserve requirement hikes, with the last one announced only three weeks earlier, and effective only three days ago (see Another Tightening Move Before Golden Week, April 30, 2007). The latest hike takes the required ratio to 11.5%. Though still nearly 2 percentage points short of the 13.2% average ratio achieved by banks at the end of March, it is nevertheless a further step towards a binding level that will require banks to set aside more deposits with the PBoC. Sending a message ahead of the US-China Strategic Economic Dialogue: In our view, the Chinese government is eager to demonstrate – especially to its US counterparts right before the US-China Strategic Economic Dialogue – that it is increasingly employing market-friendly policy measures to manage the economy, instead of heavy-handed administrative ones. Limited impact on the real economy, but the stock market could react negatively: Because the hike in lending rates was actually smaller than expected, at only 18bp, the impact of the latest rate hike on the real economy will be limited, in our view. Nevertheless, the stock market could react negatively in the short term, as this is the first time that the PBoC has announced a combination of monetary measures in one go, and it may strongly signal the authorities’ unease with the fast pace of economic growth and the rampant speculation and sharp ascent in the stock market. More to come in the remainder of the year: In our view, China continues to face excess liquidity from its balance of payments surplus, while the cost of capital remains too low relative to its pace of economic growth, thereby fostering speculative economic activity. We continue to expect more monetary tightening moves in the remainder of the year. Specifically, we believe that the reserve requirement ratio will be raised further to a binding level, and interest rates will be hiked twice more in 2H07.
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Band Widening ≠ Faster Renminbi Appreciation
May 21, 2007
By Qing Wang | Hong Kong
The PBoC announced last Friday (May 18) that the daily trading band for the exchange rate between the renminbi and the US dollar would be widened from ±0.3% to ±0.5%. Our immediate reaction was that this is largely a political gesture and symbolic move that do not necessarily lead to faster renminbi appreciation (see Unprecedented Move by the PBoC, May 18, 2007). This call is based on not only our interpretation of Chinese authorities’ policy intention, but also our understanding of how the trading band works technically.
The current daily trading band, by design, does not constitute a constraint on the pace of renminbi appreciation over time. Specifically, while spot trading is constrained within ±0.3% (now ±0.5%) of the renminbi-US dollar central parity, this central parity rate may, in theory, vary by any magnitude from the closing rate of the previous trading day. In another words, the inter-day changes are not constrained by the band. The daily trading band applies only to intra-day changes.
There appears to be some confusion about the trading band mechanism among some market participants. There is a reason for it. When the Chinese authorities made the historic shift of the renminbi exchange rate regime on July 21, 2005, the central parity exchange rate of the current trading day was made equal to the closing rate of the previous trading day. This mechanism ensures that the daily trading band imposes an effective constraint for both inter-day and intra-day changes. However, this mechanism changed when the market-maker mechanism was introduced on January 6, 2006. Under the new mechanism, the renminbi-US dollar central parity of the current trading day is determined based on the weighted average of the price quotes provided by the market markers. The central parity rate is announced 15 minutes before trading begins each morning. Under the new mechanism, the mechanical link between the central parity rate of the current day and the closing rate of previous day is severed, making the trading band apply only to intra-day changes.
Since widening the band relaxes a non-existent constraint on the pace of renminbi appreciation against the US dollar, it will not necessarily lead to faster renminbi appreciation per se. Although the central parity of renminbi-US dollar exchange is, in principle, determined based on the weighted average of the quotes from market makers, it is still heavily managed by the PBoC, which has considerable discretion over determining the weights when the weighted average is calculated. Thus, the pace of renminbi appreciation ultimately hinges on how comfortable the Chinese authorities are with allowing faster appreciation of the central parity rate instead of the intra-day volatility around the central parity rate. The band widening could, in our view, lead to more exchange rate volatility, both intra-day and inter-day, going forward. Since January 2006, when the new central parity mechanism was introduced, the intra-day trading band has been far from used fully, except recently, on April 30, when the lower boundary of the band was tested. The potential volatility in the future will unlikely be as high as the magnitude of the band widening would suggest. Nevertheless, with a wider band, we expect the intra-day volatility to rise from the current level. Moreover, to the extent that the band widening signals the authorities’ tendency to allow more flexibility in the exchange rate in general, we should expect more inter-day fluctuations as well. We expect the Chinese authorities to stick with gradual renminbi appreciation. As our colleague Stephen Jen wrote in his May 17 note, Dealing with China’s BoP Surplus: Not Straightforward, the Chinese authorities have a ‘Saving-Investment’ perspective on China’s current account surplus and do not believe that renminbi appreciation alone can play much of a significant role in addressing related problems. We therefore do not expect a major shift in the authorities’ current strategy on renminbi exchange, and the accelerated pace of renminbi appreciation (i.e., an annualized pace of 4-6%) against the US dollar since 4Q last year will likely be sustained through 2007. Bottom line: No change in the big picture. China will continue to experience large trade surpluses and rapid FX reserve accumulation. The Chinese authorities will likely opt for other policy measures (e.g., liberalizing administered prices for energy) to help tackle these issues. In the meantime, the strong pressure on the renminbi to appreciate will persist.
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Exporting Services, Floating on Liquidity
May 21, 2007
By Denise Yam, CFA | Hong Kong
Economy grew 5.6% YoY in real terms in 1Q07 Hong Kong’s economic growth fell short of expectations in 1Q07, dipping to 5.6% YoY in real terms, from the revised 7.3% (from 7%) gain in 4Q06 and 6.9% (revised from 6.8%) in 2006. We forecasted 6.5% growth prior to the release, against consensus expectations of 6.4%. The main disappointment came through fixed investment, with private sector expenditure on machinery equipment gaining just 5.9% YoY in real terms, the slowest since 1Q05, down from 14.8% in 4Q06. Public sector investment also remained weak, falling 6.7% YoY (-3.6% in 4Q06). The slowdown in trade growth also contributed negatively to growth in the quarter. Other expenditure components actually met or exceeded our expectations, which we shall discuss in more detail in the following sections. Strengthening the edge as China’s service center Services trade continued to be a major powerhouse for Hong Kong’s growth, offsetting the slack in fixed investment expenditure. Exports of services grew by 11.6% YoY in nominal terms and 8.4% in real terms in 1Q07, led by financial and business services (+18.4%) and travel/inbound tourism (+14.6% in nominal terms), consistent with our outlook that non-trade related services will continue to gain share in Hong Kong’s exports over time. Exports of financial services grew by 57.3% YoY in 2006 after 23.9% in 2005 and 21% in 2004, as Hong Kong strengthened its role as China’s fund-raising center.
Inbound tourist spending grew 14.5% YoY in 1Q07 to HK$25.2 billion, reaching a new record of 6.8% of GDP. This exceeded expectations as visitor arrivals only rose 6.3% YoY in the quarter, implying that each tourist spent 7.8% more in Hong Kong compared to a year ago. The flood of Mainland Chinese tourists since 2H03 has benefited Hong Kong significantly, bringing the net tourism balance into surplus since 2006 (0.3% of GDP in 2006 and 1% in 1Q07). This contrasts with other economies in the region, e.g., Japan, Korea, Taiwan and Singapore, where the relatively high per capita income keeps outbound tourist spending above that of inbound tourism revenues. Korea stands out in particular, with robust growth in outbound travel in recent years. Hong Kong’s unique positioning with inbound tourism from China is therefore particularly well demonstrated when stacked against the experiences of its regional neighbours.
Domestic consumption buoyed by asset market performance
Private consumption grew 7.8% YoY in nominal and 5.6% in real terms in 1Q07, beating our expectations, as spending was supported by buoyant asset prices, robust job growth and salary increases. Noticeable capital outflows that, in our view, contributed to a weaker HK$ and narrowed the HIBOR-LIBOR spread somewhat in January appeared to have reversed in the subsequent months, maintaining the relatively easy monetary conditions in Hong Kong. Although the initial potential inflows from China’s QDII investments would unlikely be significant enough to take HK$ interest rates lower, in our view (see Can QDII Lead to Lower HK$ Interest Rates? May 14, 2007), it is probable that liquidity conditions and hence asset market performance will remain buoyant this year in light of the positive investment sentiment that helps realize the pipeline of more IPOs.
Our forecasts
We are maintaining our forecast of 5% real GDP growth in 2007. We continue to see some mild moderation in merchandise export growth, from more than 9% in 2006 to just under 7% this year, but in general we have observed resilient demand from Europe and Japan, offsetting the relative sluggishness in the US. Meanwhile, the growth pace of the Chinese economy has also remained stubbornly buoyant of late, showing limited response to the mild macro controls and further pushing forward the deceleration we had been forecasting. Global economic growth, aggregating the forecasts of our team, is expected to stay above 4.5% for the fourth straight year, giving support to Hong Kong’s trade-oriented economy. The growth in service exports is forecasted to sustain in double-digit territory (+11%), a key ingredient to continued gradual employment restructuring and improvement in overall labor market conditions. Combined with accommodative monetary conditions, domestic consumption and investment are projected to have another robust year, with private sector spending growing 4.5% (versus 5.1% in 2006) and 7% (11.3% in 2006), respectively.
With regard to our outlook on inflation, Hong Kong’s headline CPI is being distorted by fiscal concessions this year. More specifically, the waiver on public housing rents in February 2007 and the cut in property rates for 2Q-3Q07 are estimated to slash the YoY inflation rate by more than 1 percentage point in the affected months. Many observers prefer to adjust the data for the distortions, but we caution against such simplistic adjustments because these one-off factors very likely contribute to pricing dynamics of other categories in the CPI basket. Specific discretionary consumer sectors could enjoy better pricing power on the back of the extra purchasing power released from the fiscal concessions, so we should still consider the reported CPI as a reflection of the actual overall cost of living. Meanwhile, the buoyant property market of late, and further appreciation in the renminbi (and hence higher cost of imports for consumption in Hong Kong), also pull the CPI up. We therefore maintain our 2.5% CPI inflation forecast for the year.
Stay alert for volatility and shocks
As we have put forward in our previous reports, Hong Kong’s fixed exchange rate and its small size relative to its asset markets as well as cross-border trade and capital flows leave the economy vulnerable to exogenous shocks and considerable volatility (see From Easy Money to the Volatile Real Economy, November 21, 2006). Ironically, just as we pay increasing attention to how China is experimenting with various means to manage liquidity, Hong Kong’s economic cycles remain dominated by, and often exaggerated by, its passive stance on monetary conditions. While we are optimistic on Hong Kong’s economic prospects over the medium term, believing that the economy is well positioned to leverage on opportunities from China’s multi-decade development, forecasting cyclical turns in the Hong Kong economy is complicated by the volatile fluctuations in global asset market sentiment in response to liquidity conditions. Our updated forecasts assume the maintenance of stable and accommodative monetary conditions in the remainder of the year, but both upside and downside risks remain upon changes in external liquidity conditions.
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Tweaking Our GDP Forecast Higher
May 21, 2007
By Deyi Tan | Singapore
A stronger-than-expected 1Q07 The economy rose 6.1% YoY in 1Q07 (versus +6.6% YoY in 4Q06), beating our and consensus expectations of 5.8% YoY and 5.7% YoY, respectively, as well as the 6.0% advance estimate put out by the government in early April. The government has raised its 2007 GDP forecast from 4.5-6.5% to 5-7%. Where were the surprises? Supply-side: While we were right about the underperformance of the manufacturing sector (+4.3% YoY versus +7.7% in 4Q06) relative to the manufacturing advance estimate of 6.1%, the weakness in the manufacturing sector was offset by stronger-than-expected momentum in the construction sector (+9.7% YoY versus +4.7% in 4Q06), as well as growth acceleration in the services segment (+7.0% versus +6.6% in 4Q06) which includes financial services (+12.9% YoY in 1Q07 versus +11.1% YoY in 4Q06), business (+6.6% YoY versus +5.4% YoY) and transport and storage (+4.4% versus +4.0%). Demand-side: We note three trends. First, consumer spending remained relatively lackluster at 2.3% YoY (versus +2.7% in 4Q06). This is in line with our view that uneven wage growth across different income deciles will hinder a fully fledged recovery in consumer spending. Second, capex growth was stronger than expected, with fixed capex rising 16.0% YoY (versus +17.1% in 4Q06). This is underpinned by two factors: 1) the construction cycle rebounded strongly. Residential construction capex rose 17.4% YoY (versus +3.6% YoY in 4Q06). Non-residential construction capex rose 21.0% YoY (versus +8.3% YoY). 2) There was markedly less inventory destocking in 1Q07. As a result, inventories contributed +3.1%-pt to headline (versus +0.5%-pt in 4Q06). Third, external demand remained weak at 4.8% YoY (versus +3.4% YoY in 4Q06), but import growth was relatively strong at 6.1% YoY (versus +3.9% YoY in 4Q06), leading to a net external balance growth contribution of -1.3%-pt to headline GDP (versus -0.5%-pt in 4Q06). Tweaking our 2007 growth forecasts Given the upside surprise, we are tweaking our 2007 growth forecast from 5.5% YoY to 5.7% YoY. Below, we reiterate the key themes underlying our economic outlook for 2007: 1) Growth will remain healthy, but the mean reversion we are expecting will likely continue to play out in 1H07. However, we agree that despite the level of export-orientation and its high-beta status, the economy is coping well with the soft-landing in the global economy. To be sure, external demand has been relatively weak compared to several quarters ago, and this continues to be reflected in the export numbers. However, as indicated by the US ISM new orders leading indicator, export weakness could trough out at the earliest in 2Q07 before rebounding in 2H07. Soft external demand notwithstanding, the economy has also been riding on the back of the extended global liquidity cycle, which has helped to support the financial services industry. Economic restructuring efforts on the other hand have also led to the development of other segments such as biomedical and marine & offshore — relatively defensive sectors — which have helped to counter the softness in other economic areas. 2) Domestic demand components will see different momentum. On the consumer spending front, we are likely to see only a muted pick-up, despite the improvement in labour markets. As we mentioned previously, the uneven recovery in wage growth among different income deciles will hinder a fully fledged recovery in private consumption, and 1Q07 data bear out this point. Consumer spending trends for the next two quarters will be difficult to read amid the noise from the potential front-loading of big-ticket items ahead of the 2% GST hike in July, the short-term impact when the hike is implemented, and the potential offset from the GST rebates worth S$4 billion announced by the government in its February budget. However, we believe that the underlying trend is likely one of a muted recovery at this stage of the economic cycle, until the benefits of further above-trend global growth filter down more strongly to the lower income deciles. 3) However, construction capex should show a healthy pick-up. Capex trends hinge on two factors. In our view: one part of capex is tied to export cycles; the other part, to construction. For the latter, we are seeing a benign pick-up in the construction cycle following the property upturn. Construction is picking up not only in residential property, but also in other areas such as office space. In addition, aggressive tourism development plans such as the construction of the integrated resorts have started this year. The latest statistics show that momentum in construction has been very strong. Based on the expected supply that is coming onstream, the likelihood is that momentum will stay healthy for 2007 and 2008.
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FDI Story — Changing Gears
May 21, 2007
By Chetan Ahya | Mumbai
FDI inflows rising sharply
FDI inflows have spiked up to US$14.5 billion (1.4% of GDP, including reinvested earnings) during the 12 months ended March 2007. The headline official estimate is US$19.1 billion during this period; however, this includes US$3.1 of share swap and US$1.5 billion of round-tripping (both related to the IPO of Cairn Energy — explained below). Adjusted for this, FDI was US$14.5 billion (including reinvested earnings of US$ 3 billion) compared with US$7.7 billion in the previous year. On a calendar year basis, India’s share (excluding the Cairn Energy-related transactions) in global FDI flows improved to an estimated 1.0% in 2006 from 0.7% in 2005 and 0.8% in 2004. However, we believe that FDI inflows are still significantly below potential. FDI inflows in India are at 1.4% of GDP (in 2006) compared with the average of 3% of GDP (in 2006) for developing countries. India’s inflows in absolute terms at US$12.2 billion in 2006 were lower than that for other major emerging markets like China (at US$69.5 billion), Russia (US$28 billion) and Brazil (US$16 billion). If India were to receive FDI inflow of 3% of GDP, in line with the developing countries’ average, economic growth would be 0.4 ppts higher (assuming the trend-line average capital output ratio of 4.3). What explains the sharp rise in FDI?
Since company and sector -wise break-ups of inflows for February and March 2007 are unavailable, we have analyzed the trend for the trailing 12 months ended January 2007. During the 12-month period ending January 2007, FDI inflows (including reinvested earnings of US$2.6 billion) have been at US$18.2 billion, compared with US$6.5 billion in the preceding 12 months. Breaking up the components of FDI inflows, we believe that there are three key factors supporting the increase in FDI during the 12 months ended January 2007: I) Cairn Energy-related transactions: The largest FDI investments in the current year were two transactions related to UK-based Cairn Energy and its Indian arm’s IPO. First, the company invested US$1.5 billion in its India arm — Cairn India Ltd. However, this was in the nature of an accounting entry used for an internal transfer of assets (to facilitate the initial public offering) and resulted in a corresponding outflow of investment in the same month. Secondly, there was a share swap transaction of US$3.1 billion (recorded by the Ministry of Commerce in March 2007). This transaction was a swap of shares between two Cairn Energy affiliates (again related to the IPO). Both these transactions resulted in a FDI inflow and outflow of the same amounts. These transactions had no impact on the net FDI inflows, but pushed the overall FDI inflows to the extent of US$4.6 billion. For the purpose of the understanding the underlying FDI investment trend, we would exclude this part of the gross inflows. Adjusted for these transactions, during the 12 month period ending January 2007, FDI inflows (excluding reinvested earnings) have-been at US$13.6 billion, compared with US$6.5 billion in the preceding 12 months. II) Large acquisition of shares of existing companies: This includes three transactions including (a) Oracle’s investment of US$1.4 billion in information-technology company, I-Flex and (b) Merrill Lynch’s acquisition of a stake in DSP. (a) Oracle-iFlex: During this period, Oracle Global invested US$1.4 billion in the information-technology company — I-Flex Solutions. It increased it shareholding in the company to 83% from 53% at the start of the period by purchasing shares from existing shareholders and via a preferential allotment. Oracle Global had first invested in the company in the preceding 12 months ending January 2006, when it purchased Citibank’s stake in the company for US$0.6 billion. (b) Merill Lynch — DSP: Merrill Lynch invested US$0.5 billion to increase its stake in the Indian financial services joint venture with DSP from 50% to 90%. III) Pick-up of FDI in real estate: Post the relaxation of regulations related to FDI in real estate in February 2006, there has been a steady pick-up in foreign investments into this sector. During the 12 months ended January 2007, real estate investments are estimated to be at US$1.5 billion, compared with US$0.1 billion in the preceding 12 months. Services sector continues to be the key attraction for foreign investors
FDI in the services sector increased to US$5.3 billion during the 12 months ended January 2007, compared with US$1.8 billion in the preceding 12 months. Two large transactions — Oracle-I-Flex and Merrill Lynch-DSP — investing in existing shares explain most of this increase. Even excluding these two transactions, there has been an increase in services sector FDI. There have been number of small investments in the IT services and BPO sector for setting up green field facilities. FDI in manufacturing declined
Much to our surprise, the FDI investments in manufacturing have declined during the 12 months ended January 2007 to US$1.5 billion, compared with US$1.8 billion during the preceding 12 months. The largest single investment in the manufacturing sector was only US$79 million, compared with US$1.1 billion in services. Indeed, in these 12 months, FDI in real estate was higher than FDI in manufacturing. We believe that the overall business environment for manufacturing FDI is not yet attractive enough. The challenges and delays faced by POSCO for its US$12 billion steel project are reflective of this environment. POSCO first announced its intention to invest in this project in July 2004. However, the company has not been able to invest meaningful sums due to various hurdles such as acquiring clear mining rights, acquisition of land from local population, approval for setting up of captive port and environmental clearances. FDI inflows should continue to pick up
We expect the underlying FDI inflows trend to continue to improve. First, India is continuing to expand as a major destination for services sector outsourcing. While FDI inflows for services tend to be relatively small as this sector is not very capital-intensive, its contribution is rising. Second, the positive trend of globalization of the capital markets will mean increased acquisition of shares by foreign companies, ensuring higher FDI inflows. Third, there should be a steady increase in FDI focused on growing domestic market opportunities, especially in consumer goods. We believe that FDI in manufacturing will remain a challenge in the near term, but expect an improvement in this area over the next 2-3 years as there is progress on critical issues such as infrastructure and SEZs.
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