Taiwan
NT$ Appreciation Reflects Reversal of Market Expectations
May 30, 2007

By Sharon Lam | Hong Kong

NT$ has appreciated roughly 1.2% against US$ since the middle of last week.  It is not too big a move, but it is catching attention as it stands in contrast to initial market expectations of a continued weak NT$ trend.  Meanwhile, this appreciation also appears to be a Taiwan-specific story, rather than driven by any external forces.  We believe that the NT$ appreciation has stemmed from a reversal of market’s wrong expectations on Taiwanese interest rates and growth. 

Market expected CBC to be done with rate hikes, but this appears not to be the case   
Weak sentiment, low inflation and market expectation of slower growth has been driving speculation that the CBC (Central Bank of China) is done/pausing with this rate hike cycle following its last rate hike in March.  In contrast, we have noted a high likelihood of another rate hike in the next quarterly meeting in June (see In Search of Higher Returns, May 21, 2007).  The market now appears to have sensed the prospect of further central bank tightening, and money market rates have shot up since last week.  There is also speculation that the CBC could be intervening in the FX market to support the NT$.  We do not attempt to estimate whether or not the CBC is intervening, but we think that most pundits’ earlier arguments that the CBC prefers a weak currency may not be entirely correct.  After all, the balance between growth and asset allocation should be considered.  We look for mild and gradual rate hikes and NT$ appreciation, after the initial sharp corrections brought about by the recent sudden reversal in expectations.

In contrast, we have been expecting more rate hikes to normalize the rate level and to slow capital outflow and carry trades
We believe that the central bank attaches a high priority to normalizing the interest rate level, which is deemed too low now that it is causing capital outflows from Taiwan in search of higher returns.  Outward portfolio investment (including both equities and debt) totaled US$11.2 billion in 1Q07, compared with US$41 billion in 2006 and US$34 billion in 2005.  At the same time, the NT$ is already an attractive funding currency for carry trades, with its interest rate level being the second lowest in the region after Japan.  NT$-funded carry trades could become even more popular if Taiwanese rates stay low, while Japan begins its rate hike cycle.  Any significant increase in NT$-funded carry trades will likely form expectations of NT$ depreciation, which will further hurt domestic sentiment, while it goes without saying that the speculative carry trades pose risks to the economy in the event of a sharp unwinding.  We believe that it is therefore important to discourage NT$-funded carry trades from becoming widely popular.

Gradual rate hikes and mild NT$ appreciation won’t hurt recovery
As seen in the 1Q07 GDP data, the Taiwanese economy did not slow as expected but rather accelerated to growth of 4.2% YoY in 1Q from 4% in 4Q06.  Although the 2Q softening is likely due to weaker demand from the US, we expect a solid recovery to come in 2H07 amid stable external demand, while the wealth effect and improving sentiment should support consumption and construction investment is likely to firm up.  The stronger-than-expected growth should give the central bank room to raise interest rates, yet we believe that the pace of rate hikes will remain mild and gradual.  We look for a 12.5bp rate hike at the meeting in June and do not rule out the chance of another hike of the same magnitude at the September meeting.  While the market is now reversing its expectations from rate freeze to rate hike, we believe that the likelihood of a gradual pace is not altered as CBC meetings are conducted quarterly, not monthly like most other central banks, and consequently NT$ appreciation is also likely to mild.  NT$ has been underperforming other currencies in the region, and we believe that mild appreciation going forward will not hurt Taiwan’s export competitiveness.

 

 

 

Turkey
The Power of Patience
May 30, 2007

By Serhan Cevik | London

Consumer price inflation will have declined to 9.8% in May, on our estimates. Even though we are deeply concerned about the consequences of political tensions and uncertainties, we must not turn our back on economic trends. One of the key figures we have to keep watching is inflation. The latest data suggest that inflation is coming down — slowly but steadily, after surging ahead because of supply shocks and the lira’s sudden depreciation last year that has disturbed expectations and pricing behavior. According to our forecasts, the consumer price index will have posted an annual increase of 9.8% in May, down from 10.7% in April and 10.9% at the end of the first quarter. Though encouraging, that would be closer to the upper bound of our forecast profile and certainly inconsistent with the central bank’s target. Indeed, inflation expectations are still getting worse, not better, as market participants look for a year-end reading of 7.8% (up from 7% in the January survey). However, given the extent of multiple shocks and political uncertainties, the slow fall of inflation and the inertia in inflation expectations are not surprising and do not change our more constructive assessment over the medium term (see The Rise and (Slow) Fall of Inflation, April 24, 2007). Albeit higher than our projections, even the consensus estimate for inflation in the next two years has improved, marginally, from 5.6% in April to 5.4% of late.

Disinflation will become more pronounced, but there are still potential obstacles. We expect to see a more pronounced correction in inflation dynamics in the coming months, thanks to base effects, and further disinflation towards the 4% target in 2008, thanks to the lagged effect of monetary tightening. However, even though the latest figures confirm the beginning of a new disinflation phase, there are still a number of potential obstacles that could dominate the behaviour of inflation. For example, similar to what happened in April, seasonal adjustments in clothing prices will have likely had an overwhelming influence over the headline inflation rate in May as well. Likewise, the volatility in unprocessed food prices remains a source of unexpected outcomes. On the other hand, the lira’s strength should continue exerting a disinflationary influence, probably even enough to limit the fallout from higher oil prices. However, the biggest risk to disinflation is the inertia in expectations and pricing behaviour. We have long become accustomed to backward-looking pricing in services, but there is a new, more disturbing type of inertia showing up in tradable prices as well.

Domestic pricing behaviour is inconsistent with the states of the economy, in our view. Currency pass-through is usually asymmetric — more powerful and immediate on the upside but less pronounced and gradual on the downside. Nevertheless, there is still a disconnect between the lira’s behaviour and domestic goods prices, especially considering tighter monetary conditions and the resulting correction in domestic demand. For example, after growing by 14.2% in real terms in the first half of last year, consumer spending on durable goods dropped by 8.3% in the third quarter and then 6.3% in the subsequent period. These were in fact the first negative year-on-year readings in the past five years and point to a significant retrenchment in discretionary consumer spending. The behaviour of domestic demand has hardly changed since then and, judging from survey results and retail sales, has probably weakened even more. Passenger car sales, for example, kept declining by 34% year on year in the first four months of this year. Even so, we still see a painstakingly slow correction in (core) inflation dynamics. In our view, one of the key reasons behind such downward price stickiness is a ‘just in case’ mark-up, reflecting a higher exchange rate assumption.

Maintaining tight monetary conditions will help bringing inflation lower over the medium term. Turkey suffers from a series of distortions and faces several risks, especially in light of recent political developments. And this is why the Central Bank of Turkey will maintain its current monetary policy stance, at least until the end this summer, even though underlying trends point towards slow but steady disinflation. According to our baseline projections, inflation will ease below 7% by the end of the year and closer to the 4% target in the first half of next year, as long as we do not wake up in the middle of a night with the noise of ‘black swans’.