Japan
Misconceptions on Consumption
May 25, 2007

By Takehiro Sato | Chicago

Can an increase in deposit interest rates lead to a self-sustaining consumption path?

There are some quite enthusiastic adherents to the hypothesis that an increase in deposit rates, due to an interest rate hike, will stimulate spending. But consistent increases in deposit rates are a must for such income gains on bank deposits to have a steady stimulatory effect on spending.  This type of view just is not logical, however, when you stop to think about it.

Let’s look at a basic example.  The BoJ’s cumulative 0.5% policy rate hike has resulted, overall, in a 0.2% demand deposit rate currently.  Money supply data indicate that individual bank deposits total ¥450 trillion (as of March 2007), and assuming a parallel shift in all durations of deposit rates as well means that a 0.2% deposit rate increase would create full-year income gains of ¥90 billion (or about 0.3% of disposable income).  The assumption is that this flows entirely into consumption.  However, this type of interest income cannot be expected to stimulate spending additionally in the following year without consistent increases in deposit rates, and results in basically no marginal increase.  Basically, rate hikes of 0.5% annually are needed to reap this degree of income gain.  While verifiable analysis is still necessary to tell whether such income gains can be fully passed on to consumption, this argument does not intuitively hold water for us. 

Income from deposit rates a zero-sum, macro-wise

Besides the example above, we must also inject macroeconomic elements into this debate.  For starters, the income gained on deposit rates simply represents transfer income from other economic entities, and is not newly created value appearing in the national accounts. In essence, higher deposit rates are basically a zero-sum from the macro perspective, since they come at the sacrifice of other economic entities. 

More crucial than this in sparking consumption is the normalization of lending rates to move up the deposit rates to an adequate level. Some signs of this have emerged.  The newly contracted interest rate on short-term bank loans has risen relatively smoothly (up in February 2007 by 45bp from 1.16% in April 2006), tracking closely with short-term market rates as they include short-term prime-linked assets and spread loans. But the newly contracted rate on long-term loans has not climbed to the degree that the policy rate has, due to a sluggish response in the long-term bond market.  Although newly contracted rates swing wildly each month, with growth in the extreme case of 42bp over the rate floor of 1.21% in August 2005, the six-month moving average rate is only +26bp.  The reaction in the contracted loan rate on stock-base including existing loans (equivalent to asset management yields on overall long-term loans) has been even more limited, with an increase of only 15bp from the bottom in March 2006, and has even lagged the marginal rise in floating deposit rates.  The obvious suspects for this are demand for capital at companies that are struggling with abundant cash flow, and excessive competition (i.e., ‘over-banking’) resulting in discounts on lending rates. 

If, on the other hand, we examine companies’ ability to pay interest in the context of RoA, we find that returns have recovered to a level in line with the Bubble Era at the mid-4% level, so that companies should now have some slack in coping with rate hikes. Hence, companies are arguably not justified in objecting to lending rate hikes in terms of their capacity to pay interest. The reason why loan interest rates are nevertheless not rising appears to rest more with the conservatism of corporate behavior, rather than borrowers’ finances. In other words, asset price deflation has largely run its course, and although we are now at a stage when companies ought to be turning from de-leveraging (reducing debt ratios) to increasing leverage — in turn raising RoE and market cap — in fact they are reluctant to take on borrowing. This may be because appealing investments are scarce, or perhaps because the preference for balance sheet contraction during the past 15 years-plus of asset price deflation remains ingrained in them. Or else it is that, at a time when much of the focus is on dividend policy, current levels of loan interest rates are in many cases below companies’ cost of capital, so that even though there are instances when the share price impact would be greater if companies increased debt to buy back their own shares as part of capital policy, they seem resistant to do so.

The jury is still out as to whether this conservative company behavior will reach a turning point in the near future, but if there was to be a catalyst, it might be rising demand for funds for M&A. Indeed, according to the BoJ, large-scale M&A undertakings have pushed up the figure for aggregate bank loans since December by about 0.3-0.4 percentage points. In the sense that it not only supports acquisitions but also enables companies worried about being bought out themselves to raise debt ratios and make it harder for a buyout to occur, this kind of demand for funds points to a promising means of using funds for the future. Of course, it is likely to be some time yet before this kind of trend becomes the norm in Japan.

Low interest rates in some ways a necessary evil under asset price deflation

With regard to the need to raise interest rates in order to stimulate consumer spending, even the BoJ has not stood up to be counted by putting this forward as justification for raising interest rates. However, occasional public statements in the Diet and elsewhere have referred to a specific figure of ¥200 trillion for the effect of the transfer of revenue from low interest rates from the household sector to the banking system during the period of asset deflation that followed the Bubble Era. We agree that there was a certain amount of revenue transfer from the household sector to the corporate and public sectors, and that the effect of this inverse transfer of income in some ways dampened consumption activity by older people with a particularly high level of cash assets. At the same time, however, low interest rates also had advantages for the national economy as a whole, as they acted as a sort of lifesaver for the banking system. The banking system might have been on the very brink of collapse, and in most cases it was thanks to lowering interest rates that actual collapse was averted. Moreover, to some extent low interest rates on deposits are symbolic of low levels of asset efficiency in the economy, and to overemphasize the disadvantages alone would probably not present a balanced picture.

What can we hope for from income gains and capital gains from outward investment?

That said, in the asset markets, there are moves to attract income from the household sector, and changes are clearly afoot in the deposit bias, and home bias, we have seen up to now in the household sector, which has become dissatisfied with domestic deposit interest rates. In other words, while the authorities responsible for setting and implementing monetary policy naturally support household sector income with rate hikes, individual investors also look for income gains and capital gains, and emerge as active investors in overseas instruments. Moreover, plentiful domestic savings rule out the need for concern about a classic crowding-out of the fiscal deficit due to a rising risk premium, so at present such side-effects of outflows of funds do not go beyond weakening the home currency (i.e., yen depreciation) and establishing something of a distance between the Japanese stock market and individual investors’ risk money.

So, is the answer ‘Yes’ or ‘No’ when it comes to the question of whether income gains and capital gains from such risk money will provide support for personal consumption? The overall balance of investment trusts involved in investments such as sovereign bonds which are popular with individual investors has risen sharply since 2004, and now stands at about ¥41 trillion (as of April 2007). However, as discussed above, in order for income gains from such investments to provide continual stimulation for personal consumption, income gains must remain above year-earlier levels. Moreover, the extent to which such gains will flow into consumption is unclear. Also, income gains from interest rate gaps differ from domestic deposits in that they involve the transfer of income from overseas, so although the sum is not zero, they do come accompanied by forex risk. If we combine the interest-rate parity theory — which decides forward rates — with the rational expectation theory, the yen rate going forward should be decided by differentials between domestic and overseas interest rates. For this reason, yen weakness due to the gap between domestic and overseas rates is destined at some stage to correct to yen appreciation due to the same differential between domestic and overseas rates. Accordingly, in the longer term, expected rates of return from financial transactions of this nature should work out at levels in line with domestic deposit rates. When all is said and done, it seems almost unrealistic that the burden of kick-starting personal consumption is left with such items.

 

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Taiwan
More Upside to Come
May 25, 2007

By Sharon Lam | Hong Kong

Taiwan’s 1Q07 GDP growth was in line with our expectations at +4.2% YoY in real terms, representing an acceleration in growth from +4.0% in 4Q06.  This beat the market’s initial expectation, which looked for a further slowdown in the economy on weak domestic demand.  Indeed, the headline domestic demand number in 1Q was not encouraging, as it gives a negative contribution to overall GDP growth of 0.4 percentage points, yet this was dragged down by sluggish government spending and also inventory changes.  If not because of a large dip in inventory (which in a way illustrates that demand came in stronger than initial production plans), Taiwan’s GDP growth in 1Q would have come in significantly above trend.  Nevertheless, growth in fact remained export-driven, as net exports accounted for the entire growth, contributing 4.6 percentage points to overall GDP growth in 1Q. 

We expect the Taiwanese economy to continue to recover, and domestic demand is likely to account for a larger share of growth in the coming quarters.  2007 GDP growth is likely to end up higher than current consensus forecasts, in our view.  The stronger-than-expected growth should provide room for the central bank to raise interest rates again.

Private consumption — still on track to recovery

With the gradual repair in household balance sheets and increase in employment growth, we had expected private consumption growth to improve.  The private consumption growth in 1Q07 at +2.3%, matching that in 4Q06, was slightly below expectations, which could once again reflect stagnant consumer sentiment, in our view.  Nevertheless, we continue to look for upside in consumption growth in the coming quarters as sentiment is likely to bottom out towards the presidential election, while the wealth effect from property price growth and overseas investment gains should kick in.

Capital investment — limited downside

Capital investment by the private sector rose a mild +1.3% in 1Q07 compared to +11% in 4Q06, which was, however, only pushed up by a low base effect.  Political uncertainty and production hollowing-out are to blame for sluggish private sector capex, as usual.  Nevertheless, we believe that downside to private sector capex is likely to be very limited, as robust external demand is already causing Taiwanese manufacturers’ capacity utilization rate to hover above 80%.  Meanwhile, capex by public enterprises should be solid this year, with projects in power supply, water supply and railway reconstruction, etc.  Already in 1Q07, capex by public enterprises has gone up 22.9%, albeit partly caused by a low base effect.  The other component of capital investment – construction – will also see more upside in the coming quarters, in our view, as illustrated by the recent pick-up of leading indicators such as building permits granted and construction loans.

Net exports — expanded on steady exports and weak imports

Exports jumped again at +6.3% in 1Q07 compared to +3% in 4Q06, helped by resilience from China and Europe.  On the other hand, imports declined by 1% in 1Q07 compared to +1.7% in 4Q06, dragged down by a lower intake of capital goods.  We believe that this can be attributed to manufacturers’ initial weak expectations on demand in 1Q, which caused them to adjust production and bring in fewer capital goods.  Yet, demand turned out to be better than expected, and this may also explain why inventory levels were slashed significantly in 1Q, in our view.  We expect external demand to remain steady for the rest of this year, while a weak currency is also helping the Taiwanese exporters.  Yet, the contribution from net exports to GDP growth is likely to weaken going forward, as we are expecting a pick-up in domestic demand and hence imports.

Bottom line 

The 1Q07 GDP data illustrated that the Taiwanese economy was not as sluggish in the last quarter as the market had thought.  Consensus forecasts Taiwan’s GDP growth this year to be at 4.2%.  With 1Q07 already in at 4.2%, and more upside likely to come, we expect to see upward revisions to 2007 GDP forecasts for Taiwan. 

The rebound in growth, coupled with the recent pick-up in import and wholesale prices, should provide room for the central bank to continue to normalize interest rates.  We see a high likelihood of a rate hike by another 12.5bp at the next monetary policy meeting in June.  We believe that Taiwan’s interest rate level is still below neutral, and thus gradual and mild rate hikes will not hurt the economy.  Meanwhile, the expected pick-up in inflation means that real rates will remain steady, or even lower, in the coming months, in our view.  We believe that interest rate normalization will help to slow, but not reverse, capital outflow in search of higher returns.

 

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India
Back to Goldilocks?
May 25, 2007

By Chetan Ahya | Mumbai

Overheating concerns appear to be receding

The financial markets appear to be pricing in reduced overheating concerns on the back of favorable weekly inflation data.  More importantly, there have been no fresh tightening measures announced by the central bank in the past two months.  This compares with back-to-back measures announced by the central bank every month for the four months beginning December 2006.  Given the pause in tightening measures, coupled with reduced headline inflation, we believe that the market may be going back to pricing in the goldilocks environment.

Financial markets confused on policy stance?

In its last statement (announced on April 24, 2007), the Reserve Bank of India (RBI) clearly highlighted that it is maintaining its policy stance of being “strongly in favour of reinforcing the emphasis on price stability and anchoring inflation expectations”.  In other words, the official statement has indicated that monetary policy is still in tightening mode. However, the confusion in the market is justified to some extent.  After back-to-back surprise and strong tightening measures on concerns over banks’ aggressive lending to property and related sectors, the central bank announced a reversal in risk weighting for small mortgage loans to 50% from 75% (limited to loans of up to IDR 2 million).  In conjunction with its decision not to hike the policy rate, this move raised hopes among market players that there would be no further rate hikes.  While the RBI governor later clarified in a television interview that the move to reduce the risk weight was an exception and that the overall policy stance remained unchanged, the message does not appear to have been factored in by the financial markets.

Battle of overheating not so easy to win

Overheating symptoms including inflation are a natural outcome of aggregate demand growth running higher than supply (productive capacity growth).  However, as the RBI has highlighted in its recent policy statements, an effective acceleration in supply growth could take about two years.  This lag in supply creation will be particularly high in areas such as infrastructure, where the government's participation is required. 

In our view, the RBI would be comfortable dropping its guard only on evidence of a correction of this underlying demand-supply imbalance between current domestic demand and supply.  Indeed, we believe that the government’s efforts to accelerate supply growth have faced some push-back, as evident in SEZ policy challenges, delays in land acquisition for roads and slow progress on mega power plants.

Domestic demand growth has slowed marginally

With the exception of two- and four-wheel vehicle sales growth, there has been no meaningful slowdown in domestic demand growth in the key indicators.  Overall, bank credit growth has seen a slight slowdown to 27.2% as of end-April from 29.3% in February and 29.8% in January. Industrial production growth has accelerated to 12.9% in March (last available data point) from an average of 11.1% in January-February 2007.  Indeed, the key driver was the acceleration in the consumer goods segment growth to 14.2% in March from an average of 8% in January-February 2007. Cement dispatches growth has accelerated to 10.9% in April from an average of 7.4% in January-March 2007.  Indirect tax collections growth (excise and customs duty collections) has accelerated to 19% in April 2007 from an average of 12.8% in January-March 2007.

Reduced inflationary pressure may be temporary

Headline inflation (WPI) has decelerated to 5.4% as of May 5 and seems likely to decelerate to 5.1-5.2% (close to the RBI’s comfort zone of 5%) over the next two weeks.  This will be the second major dip in the inflation trend after the first phase, which began from mid-March, when inflation decelerated to an average of 5.9% in April from an average of 6.3% in the first quarter of the fiscal year.  For the most part, this deceleration in inflation is not due to a reduced demand-supply imbalance. Analysis of the components of inflation indicates that there are three key reasons for this likely deceleration in inflation: (a) appreciation of the rupee, offsetting the adverse impact of the rise in prices of global commodity-related products; (b) government measures, which have delayed price hikes for metal products; and (c) the continued support of a higher base effect.  In our view, this trend is akin to suppression of the symptom rather than the treatment of the problem.

Downside growth surprise or rate hike next?

In a television interview post the April 24 policy announcement, the RBI governor indicated that the central bank’s actions going forward would be more data-dependent.  The governor mentioned that the central bank has found signals that imply that financial market participants are responding to the measures.  However, he added that the pace of change has to be accelerated and if “it doesn’t happen we will have to review the whole set of measures, but the stance is the same”.  Since then, there has hardly been any slowdown in the credit growth trend.  The credit growth data over the coming few weeks will be critical for monetary policy direction, but we believe that the risks of further tightening remain high.  We see three possible scenarios:

Scenario 1: Growth slows meaningfully and inflation remains contained: This is our base case scenario.  We believe that the lagged effect of aggressive monetary policy tightening will result in slower domestic demand growth.  In addition, the recent sharp appreciation in the exchange rate — at a time when exports have been slowing due to weaker growth in the US — should slow external demand growth. However, to ensure that the domestic demand trend is firmly on the path of deceleration, the RBI may need to keep the tightening pressure on by initiating one more policy rate hike of 25bp and/or cash reserve ratio hike. This would ensure that the banking system remains tight on lending, decidedly taming demand growth.  However, if growth starts slowing very sharply in a short space of time, the RBI may not initiate any more tightening measures.

Scenario 2: Growth stays strong and inflation picks up again: The risk of this outcome coming through is not low.  With the global capital market environment remaining supportive, Indian companies are planning fresh equity issuance worth over US$15 billion in the next six months. Although we are not sure about the success of these IPOs, if they do come through, it will only increase domestic liquidity and, in turn, ensure that growth remains strong despite the recent tightening.  However, we believe that, under such a scenario, the RBI may demonstrate its commitment to reduce inflation via a fresh round of tightening, largely in the form of cash reserve ratio hikes and some administrative measures highlighting these moves as being exceptional and temporary in nature.  These moves could be towards restricting capital inflows and/or restrictions in lending.

Scenario 3: Growth stays strong but inflation downtrend is maintained: We assign a very low probability to this Goldilocks scenario.  It assumes a quick reversal in the underlying demand-supply imbalance, with a meaningful slowdown in demand.  Indirectly, this scenario assumes that the apprehension we share with the RBI about a time-lag supply response proves inaccurate.  In other words, the system’s ability to generate a supply response turns out to be better than our expectation.  However, given the current conditions, this outcome appears to be very unlikely.

 

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Global
China’s Pace, America’s Angst
May 25, 2007

By Stephen S. Roach | New York

Round II of the Strategic Economic Dialog has come and gone.  In just eight months time, this carefully orchestrated consultation between senior officials from the US and China has established a robust framework of engagement between the world’s first and fourth largest economies.  The good news is there is progress to report.  The bad news is that the progress was predictably incremental – insufficient to defuse the political angst now bubbling over in the US Congress.

There were no major surprises coming out of the latest SED.  The Chinese announced market-opening measures in air transportation and financial services, and joint initiatives were established in the areas of environmental protection and energy security.  The all-important issue of intellectual property rights was singled out for special attention in future negotiations.  This is unequivocally good news.  These actions underscore China’s ongoing commitment to market-based reforms and offer yet another demonstration of the open-economy model of Chinese economic development – an approach which provides its trading partners with steadily increasing access to the world’s most populous domestic markets.  China’s open development model stands in sharp contrast to the closed-economy strategy used by Japan during its development, which kept the rest of the world on the outside looking in.  In an era of accelerating globalization, the Chinese strain of open development offers the world considerably greater opportunity than the closed approach long advocated by Japan.

The US Congress could care less.  The economic pressures bearing down on Washington come straight from the American middle class.  And with understandable reason: According to the US Bureau of Labor Statistics, the median real wage – inflation-adjusted wages for the worker in the middle of the pay distribution – has risen a cumulative total of just 0.9% over the seven years ending in the first quarter of 2007.  This is a particularly disturbing development for a US economy that is in the midst of a powerful productivity revival – an outcome that would normally lead to proportionate gains in real wages.  This disconnect between the contribution and the reward of American workers is, in my view, at the heart of Washington’s political dilemma.  The easy answer is to blame someone else – in this case, scapegoating China because it accounts for the largest bilateral piece of America’s record multilateral trade deficit.  The tougher answer is to get to the bottom of the real wage stagnation problem – and put policies in place that could rectify this situation.  Lacking in good answers and unable to muster patience in this era of the quick fix, Congress has opted for the former option – putting China in the cross-hairs of a classic blame game.

I’ve droned on enough over the past several months about what I believe are serious flaws to the Washington response to this problem (see, for example, my latest testimony in front of the US Congress, “A Slippery Slope,” published as a 9 May 2007 Special Economic Study).  My critique can be summed up in three words – trade, saving, and globalization.  First of all, Congress is operating under the dangerous presumption that there is cause and effect between median real wage stagnation and a record trade deficit.  On both theoretical and empirical counts, the jury is very much out on this key issue.  In addition, US politicians have failed to put America’s trade deficit in the broader context of an unprecedented shortfall of domestic saving – refusing to accept the algebraic logic of a multilateral trade deficit as an outgrowth of subpar saving and incorrectly fixating on a bilateral resolution of the Chinese piece of this equation.  Finally, Washington has little or no appreciation of how the IT-enabled hyper-speed of the current globalization has unleashed extraordinary pressures on a broad cross-section of American workers – blue- and white-collar, alike.  In short, the “China fix” does an enormous disservice to these critical macro considerations and, since it also opens the door to retaliatory actions, risks a policy blunder of monumental proportions.  Ask me how I really feel about it!

Not surprisingly, the China perspective is all but lost in the shuffle in the halls of Congress.  China is viewed on Capitol Hill as America’s major economic adversary – a threat to middle-class workers and an affront to the rules and principles of global trade.  Overlooked in this perception is the enormous progress China has made on the road to development over the past 29 years – and the opportunities that presents for the United States, the rest of Asia, and the broader global economy.  Equally ignored is the still very delicate nature of China’s astonishing transition – underscored by Premier Wen Jiabao’s recent characterization of the Chinese economy as being “unstable, unbalanced, uncoordinated, and unsustainable.”  Congress, by contrast, makes little allowance for the serious development challenges China still faces – in effect, treating China like a much more economically advanced trading partner from the developed world.  Such is the classic illogic of politics.

Nor does the Congress seem to have much appreciation of the distance China has traveled in the short span of three decades.  China’s unprecedented development successes are largely an outgrowth of its unwavering commitment to reform – not just the transition from a state-owned toward a privately controlled system but also the shift from a centrally-planned toward a market-based system of resource allocation.  These reforms are far from complete, and the outcome of the just-completed SED promises further movement in that direction.  Over the past 30 years, China has been exceedingly careful to balance the pace of reforms against the risks of instability.  At no point did it follow the shock-therapy approach embraced by states of the former Soviet Union.  “Determined incrementalism” is the best way I would describe the character of three decades of Chinese reforms – no backtracking but steady and unrelenting progress toward private ownership and markets.  This approach is very much at odds with the search for the “magic potion” that always seems to dominate the short-term problem-solving mentality of Washington politicians.  The radical currency-fix option that is now on the table in Washington is very much at odds with the gradualism that has served China so well over the past 30 years.

I had the opportunity to participate in the closing event of SED II – a reception for the 15-minister Chinese delegation followed by a dinner speech from the leader of the China negotiating team, Vice Premier Wu Yi.  Both the Vice Premier, as well as US Treasury Secretary Hank Paulson, who also spoke at the dinner, made the same point: The Strategic Economic Dialog is a framework of engagement on longer-term issues shaping the economic relationship between the US and China.  By definition, that implies it is designed to achieve incremental results rather than come up with grand solutions to short-term concerns such as those currently playing out on Capitol Hill.  This underscores a major mismatch between two sets of forces driving the bilateral US-China relationship – the incrementalism of the SED approach and the more draconian quick-fix mindset of the Congress.  Nevertheless, unlike the first meetings of last December which did not involve the US Congress in any way whatsoever, the just concluded summit included four meetings between the Chinese delegation and key US legislators – one with the House leadership, another with the Senate leadership , and then separate meetings with the House Ways and Means and Senate Finance Committees. 

When asked how the sessions with Congress went, Vice Premier Wu said in perfect English, “Very difficult.”  That reinforced concerns she expressed in her prepared remarks when she warned of the perils of a large RMB adjustment – especially with respect to its potential impact on the Chinese economy.  She also underscored her previously stated concerns that the recent WTO complaints filed by the US on intellectual property rights issues “… runs counter to the understanding between our two leaders and could have a serious impact on our bilateral trade relationship.”  To me, that is a clear and worrisome sign of what to expect in the way of a retaliatory response, should the US Congress actually throw down the gauntlet and impose trade sanctions on China. 

China’s incremental approach to reform has served a stability-fixated nation quite well over the past three decades.  However, the gradual pace of Chinese transition is very much at odds with the “quick fix” of a large currency adjustment that is now dominating the political debate in the US Congress.  Therein lies what could potentially be a fatal flaw of the SED: Judging the outcome of this meeting of the largest group of senior US and Chinese policymakers ever assembled, America’s protectionist politicians could well characterize a predictable incremental outcome as a negotiating failure of the highest order – establishing even firmer grounds for taking matters into their own hands.  SED II did not dissuade me of these concerns.  I stand by my view that there is about 60% chance that a veto-proof majority of the US Congress will pass a WTO-compliant bill by the end of 2007 that will impose broad-based trade sanctions on Chinese products sold in America.

 

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