Italy
Too Early for a Rating Upgrade, but Progressing
June 06, 2007

By Vladimir Pillonca | London

Despite the progress made over the last year on Italy’s public finances, a credit rating upgrade later this year looks like a very low probability event, in our view.  However, we think that public finances will take a turn for the better this year and market speculation regarding an upgrade could progressively gather traction, especially if political uncertainty subsides and progress is made on reforms.  We think that some rating agencies might decide to raise their outlooks, if not yet their actual ratings, although we think this is unlikely before the end of the year.  A positive evolution of public finances would also be good news for equity investors because it would lower the government’s financing costs and free up resources to increase Italy’s productive potential (this is an extract from our detailed report: Italy Economics, Speculating on Re-rating Scenarios, June 4).  Further progress on productivity-enhancing reforms, such as those contained in the Bersani decree, is also crucial.

A turn for the better after years of disappointment

In a country where the debt-to-GDP ratio amounts to almost 107% of GDP, and government spending accounts for 50% of GDP, public finances acquire a special importance.  The good news is that we think Italy’s public finances will take a turn for the better in 2007.  Under our central forecast, the budget deficit falls from last year’s 4.4% of GDP to 2.5% this year, and should be 2.8% in 2008, the lowest level since 2000.  Arguably, risks are skewed to a lower outcome for next year if the government’s estimates of €8-10 billion of permanently higher tax revenues prove correct, and no political crises materialise.  In addition, the government has already committed to 0.5% of GDP worth of fiscal consolidation for 2008.  This should help to limit the scope of deterioration next year.  In this sense, the near-term outlook seems encouraging, providing no adverse events materialise, to which we now turn in our scenario analysis.

Scenario #1: A positive outlook, upgrade speculation gathers traction

Our central scenario is what we consider to be the most likely development.  GDP grows by a respectable 1.7-1.8% YoY this year, reflecting a positive contribution of investments and net exports, while consumption grows at a more modest pace (1.1%Y), and unemployment falls further.  The economic recovery becomes more balanced in 2008 as employment rises further, household spending recovers and as tax pressure eases slightly.  In this scenario, anti-tax evasion measures prove effective and help tax revenues to rise at a robust pace this year and hold up relatively well next year.  Under this set of circumstances, by the end of this year/early next year speculation on an eventual upgrade could well start to gather traction.

Key risks: The main risks to this scenario are that the government falls or that the domestic economy relapses to its pre-2006 anaemic growth rate, or a combination of both, which we explore in our final scenario.  A political crisis in the coming months would mostly endanger the path of public finances for 2008 and especially 2009, but the negative impact on 2007 would likely be limited, in our view.

Scenario #2: The case for an upgrade

Real GDP grows by 2.4% YoY in 2007 and 2.2% YoY in 2008, well above our estimates of Italy’s growth potential, against a background of solid growth across Europe.  Under this scenario, the coalition continues to make progress on supply-side reforms, which results in a gradual improvement of productivity growth, and implements much-needed permanent cuts to the path of government expenditure, persuading trade unions of the absolute necessity of these measures.  Just as important, the electoral system is reformed to contain a stronger non-proportional representation in the Upper House, leading to a more stable political outlook.  This would be a major step at resolving Italy’s inherently unstable political system (see One Government Crisis, Three Scenarios, February 23, 2007).

Key risks: While in principle, the government is committed on all these fronts, the complex political balance and the strong opposition of trade unions to cuts to pension expenditure and a rationalisation of social spending more generally means that the joint probability of this set of positive outcomes, though not zero, is small.

Scenario #3: Deep economic stagnation/downgrade

Our negative scenario tries to capture the potential impact of a sharp and prolonged economic slowdown and a long-lasting period of political uncertainty, which drives the reform process to a halt.  This state of affairs could be triggered, for instance, by Prodi resigning and an interim government not making progress on the much-needed new electoral law system, while the reform efforts wane (see One Government Crisis, Three Scenarios, February 23, 2007).  Alternatively, this situation could be caused by a significant domestic economic slowdown, unrelated to political developments.  Under this scenario, economic growth slows sharply for two consecutive years (to 0.9% in 2007 and 0.6% in 2008) — a pattern similar to that experienced in 2002-05 when GDP growth averaged 0.4% YoY.  Against this backdrop, tax revenues growth slows to around 2%.  This set of circumstances would almost inevitably trigger a rating downgrade, and an increase in government bonds spreads.

Decisive factors for an upgrade

As financial markets are interested in possible turning points, 2007 could be an important year for Italy’s public finances, whose path this year will provide a first assessment of the effectiveness of the new fiscal regime.  Upgrade decisions are based on a longer-term perspective on public finances.  In Italy’s case, the largest challenge — and the biggest obstacle to an upgrade — is to place the debt-to-GDP ratio on a solid downward trajectory.  One major consideration regards the nature of the rebalancing of public finances.  Rebalancing cannot be achieved by raising tax pressure indefinitely, as has been largely done so far (besides, Italian tax pressure is already very high), so evidence that the few spending control initiatives put in place so far are having a restraining impact would increase the possibility of an eventual upgrade.  But, at the end of the day, progress on curtailing government spending in critical areas such as pensions, public employment and healthcare are critical to trigger an upgrade.  Tax revenues cannot do all the adjustment alone.  Ultimately, the re-balancing of Italy’s fiscal position cannot be a one-sided process.

The supply side of the story is critical

In the final analysis, the long-term sustainability of Italy’s recent spell of decent growth will hinge on whether the economy’s potential can rise from its currently anaemic potential growth, which we estimate to be 1.2-1.4% YoY (under a wide series of approaches).  Notwithstanding measurement issues which afflict estimates of productivity (see Eric Chaney’s Enough Italy Bashing, November 2006 for more details), we can safely argue that Italy’s total factor productivity rose only moderately over the last decade (by just over 0.8% YoY on average since 1990, according our estimates).  This is a major longer- and medium-term hurdle for both public finances and corporate profitability growth; and while we do find tentative signs of a recent improvement in total factor productivity growth, we are at a very preliminary stage, and the sustainability of these gains (when the cyclical push fades) remains open to debate.  Raising Italy’s productivity performance means more reforms such as those contained in the Bersani Decree, and more measures to encourage competition, innovation and technological progress (see Flickers of Light at the End of the Tunnel, December 13, 2006, for details).

 

Turkey
Food for Thought
June 06, 2007

By Serhan Cevik | London

Consumer price inflation eased from 10.7% in April to 9.2% last month. You never know for sure what you would get, especially when it comes to monthly inflation readings in the midst of numerous shocks and uncertainties. After a disappointing start this year, consumer price inflation has lately moved into an encouraging downward trend, easing from 10.9% at the end of the first quarter to 10.7% in April and 9.2% last month. Indeed, the most recent reading — a month-on-month increase of 0.5% — was much better than our own estimate of 1% and the consensus forecast of 0.8%. But let’s not get overexcited and look beyond the headline figure. Even though we still expect further correction in inflation dynamics in the coming months — thanks to favourable base effects, the lira’s continuing strength and the lagged effect of monetary tightening — the path towards price stability is full of challenges and likely to take a long time to complete. In fact, consumer price inflation is still running at a rate that is more than twice as much as the central bank’s target, and the major factor behind last month’s better-than-expected reading was a marked drop in food prices.

Inflation in unprocessed food prices declined from 16.6% in April to 11.1% in May. Unprocessed food prices have long been an obstacle in front of Turkey’s disinflation efforts, as annual inflation increased from an average of 2.9% in 2005 to 21.8% last summer, due largely to supply-side disturbances affecting fresh fruit and vegetable prices (see The Mysterious Vegetarian Demand Bubble, June 19, 2006). Unfortunately, the correction towards 10% in the second half of the year turned out to be unsustainable, and unprocessed food prices recorded a year-on-year increase of 20.7% at the beginning of this year. In our view, such a high degree of volatility in fresh fruit and vegetable prices reflects a number of curious factors, like meteorological anomalies throughout Europe (if not the whole world) and the ‘rounding up’ effect of price adjustments on low-cost items (see Coining Disinflation, May 17, 2007). Of course, volatility comes on the downside as well as on the upside. After a wave of inflation pressures in the first four months, the early arrival of summer products lowered unprocessed food prices by 3.5% and thereby the food component by 1.7% last month. However, it is still too early to declare victory over food price inflation for three key reasons: (1) fresh fruit and vegetable prices are increasing at the fastest rates in years; (2) low rainfall and high temperatures may lead to volatility in production and prices; and (3) regulatory changes affecting the distribution of fruit and vegetables may result in higher prices, despite tax cuts.

Core measures of inflation remain problematic, albeit showing a few signs of improvement. The deceleration in inflation is not just about food prices, as a number of other categories (such as entertainment, healthcare and even housing) showed lower readings. Nevertheless, the consumer price index excluding unprocessed food still posted a monthly increase of 1.2%, lowering the annual inflation rate from 9.8% in April to 8.9% last month. Therefore, beyond base effects, there is still no significant correction in domestic prices. This is a curious phenomenon, given the lira’s strength and a far-reaching retrenchment in consumer spending. In addition to a wider spectrum of seasonal price variations and the asymmetric exchange rate pass-through effect, there could be external factors (like higher production costs in China) affecting domestic prices in sectors like clothing. However, we believe that the main reason for inflation inertia — not just in services but also in tradable goods — is a ‘just in case’ mark-up reflecting a higher exchange rate assumption. Indeed, such pricing behaviour could explain the disconnect between economic conditions and expected as well as actual inflation.

Inflation will keep declining in the coming months, but it is still too early for monetary easing. According to our estimates, consumer price inflation will ease below 8% this summer and around 6.5% by the end of the year. However, there are still a number of risks: the volatility in food prices, higher energy quotes and political and global uncertainties that could weaken the exchange rate. Therefore, we expect the central bank to remain on hold until there is an unambiguous disinflation trend towards its target over the medium term and to lower short-term interest rates by no more than 100bp this year — less than the 150bp implied by bond prices.

 

Israel
Reading the (Early) Signs of Excess
June 06, 2007

By Serhan Cevik | London

Israel is in a sweet spot of strong growth and no inflation, but there are already signs of excess. Thanks to its high-tech orientation creating higher value-added, Israel has a unique position among emerging (as well as industrialized) countries. In our view, the composition of human capital and a high propensity for entrepreneurial activity form the basis for strong economic performance, despite all the obvious challenges stemming from geopolitical risks and security concerns. Indeed, supported by fiscal consolidation and robust global demand, the Israeli economy has kept growing at an impressive pace and enjoyed a structural shift in its current account balance from an average deficit of 2% of GDP in the 1990s to 4.9% last year. As a result, after a long period of undervaluation, the shekel has appreciated towards its fair value against the dollar, creating a wave of deflation in exchange rate-sensitive sectors of the economy. Therefore, Israel is in a ‘sweet spot’ of economic outperformance and lower interest rates — certainly a point of attraction for foreign capital as well as domestic investment (see Sweet Spot, April 5, 2007). However, even though fundamental improvements will keep supporting the shekel and low inflation, we should not ignore the (early) signs of excess that may become a source of volatility in the future.

Technical deflation will prove to be a temporary phenomenon, in our view. Consumer price inflation declined from 3.8% a year ago to -1.3%, as the shekel’s realignment led to a strong pass-through effect on domestic prices linked to or denominated in dollars. Take, for example, the notorious case of housing prices. With the legacy of hyperinflation, residents have long become accustomed to quoting rents and housing prices in dollars, just like many professional services using prices linked to the exchange rate. Unfortunately, this habit of indexation is a major source of inflation volatility. And as the shekel appreciated by 13.5% against the dollar over the past year, housing prices recorded a 6.2% decline and, with a 22% weight in the consumer price index, lowered the headline reading into the deflationary territory. But this is just technical deflation, in our opinion, and will prove to be temporary, as the shekel stabilizes at its new equilibrium.

Israel already has a ‘hidden inflation’ problem, reflecting the narrowing output gap. We expect inflation to move slowly out of the deflationary territory and stay close to the lower bound of the central bank’s target range of 1-3% by the end of this year. However, a closer examination of the data reveals that Israel already has a ‘hidden inflation’ problem behind the veil of currency appreciation. The Bank of Israel estimates that consumer price inflation excluding items affected by exchange rate movements increased to an annual rate of 4% in the first quarter of the year, as opposed to a 4.6% drop registered by currency-linked prices in the CPI basket. We believe that such a degree of divergence is a clear sign of underlying inflation pressures resulting from sustained growth in domestic demand. The latest national accounts show that real GDP growth reached an annualized rate of 6.3% in 1Q07, even after four years of sustained output expansion. More importantly (at least for inflation dynamics), consumer spending grew at an annualized rate of 11.8% in the first three months, up sharply from 4.8% last year, thanks especially to a 95.1% surge in spending on durable goods. In our view, improvements in the labor market (like the lowest unemployment rate in a decade) and the wealth effect of booming asset markets and low interest rates have pushed aggregate demand growth to beyond the economy’s potential growth rate. As a result, the output gap — the difference between actual and potential output — has turned positive and inflationary.

Experimenting with lower interest rates would worsen underlying inflation dynamics. The Bank of Israel has already lowered short-term interest rates by 200bp since last October to 3.5% — the lowest level in history and 175bp below the US policy rate. We are not obsessed about interest rate differentials, but further experimentation with lower interest rates would worsen underlying inflation dynamics and even destabilize financial markets. This is why we believe that Israel is now at a stage of consolidation and the central bank should let the economy absorb the lagged effects of monetary easing.