China
PBoC 2Q Survey Results Strengthen the Case for Imminent Tightening
June 21, 2007

By Qing Wang & Denise Yam | Singapore

Summary and conclusions

The People’s Bank of China (PBOC) published the results of its 2Q survey of depositors, entrepreneurs and bankers on Wednesday, June 20.  The results show that: a) depositors are strongly dissatisfied with the pace of price increase; b) entrepreneurs are concerned about the risk of overheating; and c) bankers have strong expectations for rate hikes.  The survey also found that: a) households have a strong desire to invest in the stock market, with a corresponding decline in their willingness to save money in banks or to purchase durable consumer goods; b) exporting enterprises have become increasingly capable of coping with renminbi appreciation pressures; and c) commercial banks have been able to develop fee-based revenue sources to offset the impact of the narrowing spread between lending and deposit rates.

Both the survey results and the PBoC’s interpretation of them point to the need for monetary tightening.  This, together with Premier Wen’s call last week for monetary policy to turn “appropriately tight”, makes a strong case for imminent monetary tightening, we believe.  In view of the risk of overheating and inflationary pressures, and with the domestic A-share market starting to test new highs, we now see a need to hike both the deposit and lending rates.  An effective deposit rate hike could take the form of reduction/removal of the tax on interest income earned on bank deposits.

Depositors’ survey: Dissatisfaction with price rise

The survey shows that: a) depositors’ current income sentiment is high, and they expect future income to rise continuously; b) depositors are unsatisfied with the current pace of price increase, and the degree of dissatisfaction drops to a historical low; c) depositors’ reaction to the most recent rate hike has been relatively calm, which, according to the PBoC, is in part due to the decreasing share of bank deposits in households’ total financial wealth; and d) depositors have a strong desire to invest in the stock market with a corresponding decline in their willingness to save money in banks or buy durable consumer goods.

Entrepreneurs’ survey: Concern about overheating

The survey shows that: a) entrepreneurs’ confidence weakened markedly to a yearly low, as they have become increasingly concerned about the risk of economic overheating; b) entrepreneurs are strongly feeling the pressures of rising prices for their inputs and the need to pass on these higher costs to downstream sectors; c) sales orders — from both domestic and external sources — remain very robust, and, according to the PBoC, this suggests that enterprises have become increasingly capable of coping with renminbi appreciation pressures; d) overall corporate profitability and the financial situation are good; e) investment growth remains at high levels, especially in the energy-intensive sectors, underscoring the challenges to achieving the energy conservation target; and f) past interest rate and RRR hikes are starting to have a cumulative impact, with substantially more entrepreneurs now viewing the current level of banking lending rates as “a bit too high” and, at the same time, expecting additional rate hikes in the coming quarter.

Bankers’ survey: Strong expectations for rate hikes

The survey shows that: a) the proportion of bankers who consider the economy “somewhat overheated” has risen sharply and, as a result, their confidence level has declined to a historical low; b) the banking sector climate index remains at a high level, suggesting that the sector’s overall business situation is good.  In particular, banks’ financial indicators are healthy, despite narrowing of the lending-deposit interest rate spread, supported by fast growth in fee-based revenues; c) the proportion of bankers who regard the current monetary policy stance as “moderate” has declined, and banks have strong expectations for rate hikes in the next quarter; and d) the index of loan demand reached its highest level since 1Q04, when signs of general overheating were evident.

Bottom line

The results from the PBoC’s 2Q survey of depositors, entrepreneurs and bankers point to rising risk of overheating, growing inflationary pressures, and firm expectations for rate hikes.  Both the survey results and the PBoC’s interpretation of them point to the need for monetary tightening.  This, together with Premier Wen’s call last week for monetary policy to turn “appropriately tight”, makes a strong case for imminent monetary tightening, we believe.  In view of the risk of overheating and inflationary pressures, and with the domestic A-share market starting to test new highs, we now see a need to hike both the deposit and lending rates.  An effective deposit rate hike could take the form of reduction/removal of the tax on interest income earned on bank deposits.

 

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UK
The Evolving Outlook for UK Monetary Policy
June 21, 2007

By David Miles | London

The Bank of England’s MPC voted 5-4 to leave rates unchanged at its June meeting. The minutes reveal that many members of the MPC — including the Governor — see significant risks of inflation being above the target on a 1-2-year horizon and are in favour of raising rates now to reduce the need for sharper rate rises later. Yet the majority were not convinced that this was the right course. They saw no clear signs that the inflation outlook had deteriorated and saw some signs that past rate increases were beginning to slow consumer spending. Should the inflation outlook brighten a little, and much clearer signs emerge of consumer spending slowing, it is likely that many MPC members — indeed quite possibly a majority — may continue to see no need for a rate rise. Whether those signs emerge in the very near term is the key factor in determining whether rates stay where they are. With another meeting of the MPC now very close — just two weeks away — it does not seem very likely that enough signs of a slowdown in demand in the UK will emerge to prevent a majority thinking that a rate rise is needed. So it now seems more likely than not that in the very near term — quite probably at the July meeting — rates will be increased to 5.75%.

But things could look very different by the end of the year. It seems likely that consumer spending will slow, and we have argued that this is likely to mean that inflation pressures by the end of the year will look much less threatening than they do today. That is why a serious discussion about unwinding some of the tightening in monetary policy could be on the agenda by the end of the year. Nonetheless if, as we now expect, rates are increased in the very near term, the outlook for the level of rates at year-end is now a little different. I expect that the most likely level of rates for year-end is that they are at around today’s level — 5.5%.

Of course, all this is hard to be confident about — hence the sensible way to express a view on the rate outlook is via a probability distribution over outcomes and not with a single ‘call’.

Judging the path rates might take from here to year-end is also subject to much uncertainty, in part because differences in opinion on the MPC now seem quite significant. It is likely that we may see split votes for some months. The minutes that summarise the discussion at the June meeting give some clear signs of the differences:

Those voting for no change in rates in June would have seen the strength of the following points:

“There were some tentative signs of an easing in household spending and the housing market. Although the slowing had not yet been particularly pronounced, there might be more to come. Previous tightening cycles had suggested that consumption took some time to weaken. That should give the Committee reason to think carefully about the downside risks to near-term consumption growth. Additionally, higher household debt levels might have increased the final impact of interest rate changes, which suggested raising interest rates at a measured pace. The labour market had remained subdued. Employment growth was weak. That was puzzling in light of the capacity pressures that firms were reporting. Moreover, pay growth appeared to be muted. Survey measures of the general public’s inflation expectations had remained stable, despite the pick-up in actual inflation over the winter…and surveys of pricing pressures in service sector businesses had eased”.

The inflation pessimists pointed to the following:

“The economy was still growing robustly despite the rise in official interest rates since August 2006. A slowing of demand growth to below potential was probably necessary if inflation was to hit the target in the medium term. It was not clear what would precipitate that slowing without a further rise in the bank rate. The easing in the household spending numbers was at best tentative, as these data were volatile from month to month. House price inflation was higher in 1Q07 than in 3Q06 in nearly every region of England and in all the other countries of the United Kingdom. The rapid growth of money and credit in part reflected the easiness of credit conditions, and posed an upside risk to spending and inflation. That would need to be offset by a higher level of the bank rate.  Business investment showed strong year-on-year growth and investment intentions were still very positive. The evidence pointed to a confident and buoyant corporate sector. Survey measures of capacity pressures were generally high and increasing. The world economy was also strong.  Oil prices had risen, which could give some unexpected upward impetus to CPI inflation in the near term. Goods price inflation was still high, and contrasted with falling prices earlier in the decade.  In order to meet the inflation target, there had to be some offsetting weakness in service sector price inflation. Though service sector inflation had eased back in the short term, those lower rates of price increase might not persist if demand remained strong”.

Bottom line

Unless there are some clear signs that the strength of demand in the UK is slowing in response to past rate increases, I would expect a majority to vote for a rate rise — quite probably at the next meeting.  

My view is that the 100bp hike in the bank rate since mid-2006 will start to hit consumer spending fairly soon. Possibly the first tell-tale signs of this have been picked up by supermarket chain Tesco, which this week warned of more “challenging conditions” in the months ahead.  But whether the signs of a consumer slowdown will be clear enough in the very short term — over the next month or so — is not at all obvious. We are now only a couple of weeks from the next MPC meeting, and so a near-term rate rise is likely. But we expect the slowdown in consumer spending to be significant enough for rate cuts to be back on the agenda by year-end.

 

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China
China Makes a Broad-based Cut on Export Tax Rebates
June 21, 2007

By Qing Wang & Denise Yam | Singapore

The Ministry of Finance announced on Tuesday, June 19 that the export tax rebates on a wide range of exports — covering 37% of the total number of commodity items on the custom tax schedule — will be cut or eliminated effective July 1.  In previous rounds of export tax rebate cuts, the commodity items affected have been in those sectors considered to be suffering from “overcapacity of production” or “consuming too much energy”.  In this round, such traditional export items as apparel, shoes and toys are also included, as fast expansion of exports of these items could “easily cause trade frictions” with China’s trading partners, according to the announcement.  At this stage, it is difficult to estimate the exact magnitude of the tax rebate cut or quantify its impact on exports; however, the MoF considers that the magnitude is “appropriate” and “should not have a significant impact on normal trade flows”.

This is the first concrete policy action taken by Chinese government agencies in response to Premier Wen Jiabao’s policy statement made last week (see China Economics: The Authorities Appear Poised to Initiate a New Round of Macro Tightening, June 13). We think that more policy announcements by the relevant government agencies (e.g., the PBoC, the NDRC) will likely be made in the coming weeks in line with Premier Wen’s call.  In particular, with the domestic A-share market having completely rebounded from its lows reached in the aftermath of the stamp duty increase and starting to reach new highs in recent sessions, the case for monetary tightening has become even stronger, in our view (see China Economics: Pork Crisis and Timing of the Next Rate Hike, June 4).  We reaffirm our call for imminent monetary tightening, perhaps as early as by the end of this week.

Implications:Given that the cut in export rebates is broad-based, the impact on the export sector should be equivalent to allowing the renminbi exchange rate to appreciate by the magnitude of the export tax cut.  In response, export growth will likely slow in the coming months, in part reflecting some exporters frontloading their exports in recent months in anticipation of this policy change.  This policy move demonstrates once again the authorities’ preference of sector-specific over price-based policy measures (e.g., the exchange rate) to tackle the external imbalances (e.g., the trade surplus).  We would expect more similar measures, aimed at containing the rapid expansion of exports, if the policy actions taken so far fail to produce any tangible results.  This policy move would also likely lower the probability of a much faster appreciation of the renminbi exchange rate in the remainder of the year, in our view.  We expect the authorities to stick to their current strategy of allowing only a gradual appreciation over time, with 4-6% cumulative appreciation against the US dollar likely over the course of 2007.  This policy change does not change our outlook for China (see China Economics: Upgrade Our GDP Growth Forecasts, June 18).

 

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Turkey
Heat Wave
June 21, 2007

By Serhan Cevik | London

Weather anomalies present a threat as challenging as liquidity-driven capital flows. Nothing seems to bring an end to the Istan-bull’s breathtaking run, pushing the Turkish lira to its strongest level in years, thanks to the lure of carry trades and strong economic fundamentals. In turn, the lira’s strength may have accelerated disinflation, even against strong inertia in certain sectors. On our estimates, consumer price inflation will decline from 9.2% in May to 8.8% at the end of this month. However, with higher energy quotes, weather anomalies present a challenge through the volatility of food prices. Surface temperatures in Turkey have already been 4˚C above the seasonal pattern, while average rainfall is running about 60% below the long-term mean. These dramatic changes in climatic conditions are not just specific to Turkey, but reflect a global phenomenon. According to the Goddard Institute for Space Studies, the average global temperature has risen from 13.9˚C in the first half of the 20th century to 14.9˚C in 2006 and 15.2˚C in the first five months of this year. Such global warming of a few degrees may sound trivial (compared to seasonal or even daily changes), but we are in fact witnessing the most significant trend shift in the last 10,000 years. The rate of deviation from the long-term mean accelerated from an average of 0.06˚C in the 1970s and 1980s to 0.44˚C in the 1990s and 0.90˚C this year (see Warming Up, January 25, 2007).

Adverse meteorological conditions lower crop yields and raise soft commodity prices. Global warming is not just about warmer weather, but also — more importantly — leads to unpredictable changes in variability patterns. One of the immediate consequences of extreme weather conditions is droughts with greater severity that cause agricultural supply shocks and higher volatility in food prices (see Stay Tuned to the Weather Channel, August 4, 2006). And we may now be observing such an event on a global scale, as the ratio of stocks to consumption dropped to its lowest reading on record, leading to a sustained increase in food prices. Indeed, virtually every country around the world has experienced a surge in food prices and consequently pressures on headline inflation rates. This is a significant risk, especially for developing countries where food has a greater weight in consumer price indices. In Turkey, for example, food prices account for 28.5% of the CPI and thereby can turn into a major source of volatility. Over the last couple of years, food price inflation declined from 12% at the beginning of 2004 to 4.9% at the end of 2005, but then surged to 14.6% earlier this year. Although the year-on-year rate of change in food prices eased to 10.6% last month, meteorological data still point to a volatile outlook for (unprocessed) food prices.

Supply shocks, not demand pressures, are responsible for food price inflation. We have long argued that the rise in food prices is not a result of demand pressures, but reflects supply disturbances that influence the behaviour of unprocessed food prices (see The Mysterious Vegetarian Demand Bubble, June 19, 2006). With higher volatility, the annual rate of inflation in unprocessed food prices surged from an average of 1.7% in the first half of 2005 to the peak of 21.8% last summer and then declined to 12.9% at the end of 2006 before increasing back to 20.7% earlier this year. Even though there has been some degree of ‘normalization’ in recent months (lowering unprocessed food price inflation to 11.1% in May, thanks to the early arrival of summer products), the degree of deviation from ‘usual’ seasonal patterns is significant, and the combination of high temperatures and low rainfall could still result in volatility in farm production and prices. Furthermore, despite the recent tax cuts in a number of food categories, regulatory changes affecting the distribution of fresh fruit and vegetable may raise consumer prices. Therefore, the risk of another food price shock is not negligible, especially considering the likelihood of more extreme weather conditions in the future. That said, Turkey’s inflation troubles go beyond the volatility of food prices.

The central bank will maintain its restrictive policy stance in the near future, we think. Thanks to base effects, consumer price inflation eased to 9.2% last month and we expect to see it at around 6.5% by the end of the year. However, the CPI excluding unprocessed food prices is still running at an annualized rate of 11.3% over three months, up from 7.3% at the end of last year. The lack of correction in domestic prices — beyond base effects — is a curious development, especially given the lira’s strength and the retrenchment in consumer demand. A number of factors (such as inertia in services, asymmetric currency pass-through and higher import prices from China) slow the pace of disinflation, but we believe that the most important reason for the disconnect between economic developments and the behavior of core inflation is the ‘just in case’ mark-up on domestic prices that reflects a higher exchange rate assumption. This is, of course, due partly to occasional bursts of volatility in global financial markets and political/institutional risks in Turkey. As a result, we are likely to see slow progress on the inflation front, at least until political risks disappear from the horizon. With such a challenging outlook, we think that the Central Bank of Turkey will maintain its restrictive monetary policy stance in the near future and keep a tight rein on liquidity conditions in the domestic money markets.

 

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