Colombia
An Abundance of FDI
June 26, 2007

By Daniel Volberg | New York

Colombia presented two surprises last week: a warning from a central bank board member that more tightening might be necessary, and then, the next day, a much stronger than expected first quarter GDP report.  Both events should cause Colombia watchers to rethink their interest rate and currency views.  As we highlighted recently, we suspect that the consensus has underestimated both the extent to which policy interest rates are likely to be raised in Colombia this year and the gains that are still possible for the Colombian peso (see “Colombia: Dealing with Abundance” in Global Economic Forum, June 12, 2007).

Higher Growth, Higher Interest Rates
First quarter GDP was up 7.98%, the third quarter of growth near 8%.  While it might be tempting to argue that first quarter data are little more than history, the magnitude of the growth rate, combined with signs that there has been very little slowdown since the beginning of the year, can be expected to put pressure on the central bank.  Indeed, the upside surprise in the first quarter, when combined with our reading of activity in the second quarter, has prompted us to move our estimate for 2007 GDP up to 7.0% from 5.6% and our 2008 forecast to 6.2% from 5.3%.  We expect others, including the central bank, to follow suit.

And while much of the uptick in inflation since the beginning of the year has been due to the impact of bad weather on produce prices, with inflation moving from 4.5% to over 6% in just a matter of months, it is not hard to imagine that the central bank would be concerned.  After all, whatever the source of the initial jump in prices, with growth running well above trend, the risks are high that we see a persistent element in the current inflationary shock emerge.  And, indeed, we have already seen ex-food inflation moving up from 3.6% to 4.3% in the past six months.

Higher interest rates—we continue to expect the central bank to end up hiking rates to at least 9.5% this year—which in turn are likely to play a role in providing for more currency strength.  But our call for a stronger Colombian peso is not based solely on higher interest rates. A strong economy is also generally associated with exchange rate appreciation.  Indeed, the peso started on its long appreciation trend in July, just as the growth rate of the economy picked up in the second half of last year.  And perhaps one of the clearest manifestations of the new found confidence in Colombia, and a clear driver of the currency strength as well, has been foreign direct investment.

An Avalanche of Foreign Direct Investment
We have heard a great deal of debate over the strength of foreign direct investment (FDI) in Colombia this year and thought it was worthwhile to review the record to date. 

First, the pace of inflows of FDI this year has been significantly higher than what we saw in the same period last year.  According to preliminary data from the central bank, inflows of FDI in the first five months of the year have been $3 billion, with the sale of Bancafe and Ecogas alone having generated near $2 billion.  Therefore, FDI inflows so far this year are double the $1.5 billion of inflows that these data recorded in the same time period last year.   Meanwhile total inward investment (including both direct, portfolio and other) has reached $6.4 billion, while the preliminary current account deficit has reached only $ -1.4 billion in the same period.  It is clear that, but for the central bank buying nearly $5 billion in currency markets this year, the Colombian peso would have been even stronger.

Second, the avalanche of FDI inflows is not over yet.  While some may question whether the pace of FDI inflows seen so far this year can be sustained, we are optimistic.  As we tally the projects already announced this year against the funds likely to have already entered, we expect that there is plenty of FDI to come.  There is always a risk that expected projects do not materialize—but unless the global environment takes a sudden turn for the worse, we doubt that events in Colombia are going to cool interest among foreign investors.

Summing up the major FDI projects for this year we expect FDI inflows could be on the order of $7-8.5 billion.   If we calculate FDI to date based on our list of projects, the amount of FDI that has likely already entered is roughly $3.4 billion—slightly above the central bank data.  That leaves $3.8-5.3 billion of FDI still to come.

However, it is possible that we are underestimating the amount of FDI that has entered Colombia already.  We have to admit that the preliminary figures which show $3 billion of FDI inflows this year may be underestimating the true amount of FDI.  The true amount of FDI inflows is recorded in the quarterly Balance of Payments which is calculated using a different accounting methodology from the preliminary, but more frequently published, figures we have cited so far.  The balance of payments, which report that FDI reached $6.3 billion last year, is constructed on an accrual basis, while the preliminary figures showing $3 billion (actually $2.99 billion) of FDI inflows so far this year are done on a cash basis.

A key difference between the two sets of figures is that FDI inflows made by a foreign entity in the form of materials for projects in Colombia do not get recorded in the preliminary, cash basis, figures but do appear in the final balance of payments analysis.  For example, most of the Refineria de Cartagena project, worth $630.7 million last year—largely new investment in materials and machinery—did not show up in the cash basis monthly foreign direct investment data.

We have tried to recalculate what FDI so far this year would look like using the accrual method as reported in the balance of payments.   We look at capital good imports as a proxy for part of the underreported FDI. Last year, for example, the gap between cash and accrual direct investment, roughly $2.5 billion, was equal to roughly one-quarter of all capital good imports.  The previous year, the gap between cash and accrual direct investment was roughly equal to one-tenth of all capital good imports and in 2004 it was only 6%.  If we assume either the 2004, 2005 or 2006 fraction of capital good imports this year is likely to be counted as FDI, then based on the available data for capital good imports, there is an additional $ 320 million to $1.4 billion of FDI that has not been reported, bringing total accrued FDI to between $3.3 to $4.4 billion. 

Given our expectation of $7-8.5 billion of FDI in 2007 it means that in the first five months of this year we have seen at most roughly half of the overall likely FDI inflows.  Given that half the FDI inflows were accompanied by peso appreciation of 19% from the beginning of the year to the strongest point in the first days of June, another 4-5% appreciation from current levels of 1,940 to 1,850 by the end of the year is likely to be a conservative assessment.

Bottom line
Stronger growth and a deluge of FDI are setting up Colombia for higher interest rates and a stronger peso this year.  As Colombia takes advantage of supportive global economic conditions and a dramatic improvement on the security front to revamp its infrastructure and upgrade its capital stock, it seems surprising to us that many expect the currency to sell off.  While the recent bout of global re-pricing of risk hit the Colombian peso, as well as currencies throughout Latin America and the emerging markets, we suspect that the Colombian peso will gain further ground.   And despite short run inflationary pressure from supply shocks and a roaring economy forcing the central bank to hike interest rates, we suspect that strong growth—and strong capital inflows—are set to continue.

 

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Turkey
Voting for the Future
June 26, 2007

By Serhan Cevik | London

Turkish voters will not just choose a new government — they will also decide the country’s future. Less than a month from now, Turkey will have a new government that will not only shape the next five years but will also determine whether Turkey will become a member of the European Union. Hence, Turkish voters will be voting, on July 22, for a mandate to remove institutional bottlenecks that have kept the economy below its true potential. Indeed, as recent developments have clearly shown, institutional uncertainties remain the biggest obstacle for faster, welfare-enhancing economic growth and progress towards liberal democracy compatible with European standards. Unfortunately, the degree of uncertainty has become far more distortionary, with the military’s venture into politics and constitutional confusion about the presidential election process. Of course, if you just focus on financial markets, you would not notice even a grain of unpredictability, thanks to the lure of carry trades making the lira extremely attractive in the sea of global liquidity. However, that does not change the disturbing fact that Turkey now faces new institutional constraints and political risks that may possibly deepen fragilities in the political landscape, disturb accession negotiations with the EU and weaken the economy.

Strategic voting is likely to become widespread and alter political preferences. One of the side effects of instability in the past decades is the emergence of “swing voters” with no strong party affiliation. Studies show that more than a quarter of Turkish voters changes party preferences in two consecutive elections, leading to election surprises (see “Changing Lanes — Strategic Voting and Election Results”, November 1, 2002). Although measuring political attitudes is difficult (due to the lack of comprehensive polls), recent developments (including failed attempts to engineer a merger between centre-right parties) possibly will amplify strategic voting, especially among undecided voters and those without strong political attachments. Indeed, if voters abandon their first preference with a poor chance of winning for a less preferred candidate with a better chance of winning, we may see yet another surprising result this summer. The latest opinion polls suggest more fragmentation, compared to political consolidation in the 2002 elections, albeit the ruling AK Party is still leading with a wide margin that would be enough to keep it as the leading party. However, we need to be cautious about extrapolating opinion polls to estimate the distribution of parliamentary seats. Since there is a 10% threshold for parliamentary representation, even a small margin of error could lead to unexpected results. In fact, all the opinion polls bring to light the likelihood of at least three parties (AKP, CHP and MHP) in the next parliament, unlike the previous elections when only two parties qualified for parliamentary representation. Having two other parties (GP and DP), with each getting around 10% of the votes, and more independent candidates, implies a more fragmented outcome in the coming elections (see “Black Swans and the Surprise of 2007”, May 24, 2007).

Economic performance supports the AK Party, but there are other factors influencing voters. Judging from the economy’s performance in the last five years — with real GDP growth reaching to 7.4% a year and inflation declining below 10% for the first time in ages, the AK Party should enjoy strong support from the voters. However, the macro picture alone is not enough to shape voting behaviour, particularly in rural areas and urban peripheries. While even socioeconomic indicators have shown encouraging improvements, there are still deep-seated structural constraints that result in opportunity and income differentials across regions and social groups. Take, for example, rural voters who account for more than one-third of all voters and therefore can have overwhelming political clout. Since the beginning of the stabilization programme in 2000, structural reforms have led to a significant reduction in transfer income to (small) farmers. This adjustment is certainly necessary for economic well-being in the longer term, but also creates a disgruntled voter base. Likewise, although non-farm employment increased from 13.9 million in 2002 to 16.2 million last year, there are still millions of discouraged workers, which will make the behaviour of 4 million new voters even more critical in the coming elections (see “The Politics of Misery and Expectations”, May 16, 2007). Of course, in addition to economic issues, we think that recent political tensions will likely bring ideological stances back in vogue, as well.

A single-party government is still possible, but the likelihood of coalition is not negligible. Estimating the distribution of parliamentary seats is subject to a high margin of error, but it still seems that a single-party government is possible, as long as there are three parties in the next parliament. However, we should not ignore the possibility of a coalition government, which is likely if another party qualifies or there are more than 50 independent members in parliament. Even though there is nothing wrong with a (strong) coalition government, the Turkish economy has always recorded below-potential performance (with widening imbalances) under coalition governments. The question is whether the voters will remember the past before casting their votes on July 22.

 

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Japan
Japan: Psychology Picking Up, Lingering Issue is Catalysts
June 26, 2007

By Takehiro Sato | Tokyo

Japan: Psychology Picking Up, Lingering Issue is Catalysts

Below we record our impressions from meeting with investors in Europe over the last week. With stocks having broken out of their May trading range and a 7-year high, we believe investors have a somewhat more constructive stance on Japanese equities than at the time of our US visit. There is also some sign of expectations of return reversal with the continuing slide in the yen. In other words, investors are looking at Japan with a certain eye toward investment. The lingering issue is catalysts.

What are the catalysts?

Investors are on the lookout for opportunities for Japanese markets to catch up with the global markets, including forex. However, many investors give as a condition solid expansion in Japanese domestic demand. And as a condition for growth in domestic demand, what is being watched is the timing of a clear effect on wages from a tight supply/demand balance in the labor market. Indeed, most of the investors that we met asked why wages continued their long-term stagnation despite tight labor supply/demand, and for the outlook for wages and prices. Despite being discounted by the rally in the second half of 2005, the current pace of escape from deflation is much lower than equity market hot expectations, and thus it is natural for investors to have a growing interest in prices and wages, which are at a low ebb.

However, we do not much expect an early improvement in transmission of wages to consumption, which is of greatest concern. Considering steady growth in employment, wage prices continue to lack momentum. The main reasons are as follows.

1) Moves to hold down labor cost in the public and semi-public sector have only just begun, and we expect total labor cost to be suppressed by 5% over the next five years.

2) Although wage restructuring has progressed in the private sector, the wage curve still remains tilted in favor of older workers at the expense of the young. In other words, assuming the shape of the wage curve stays unchanged, there is likely to continue to be downward pressure on average wages over the next 3-5 years as senior staff continue to retire in large numbers.

3) Due to the tight supply/demand balance for labor, we expect some increases in wages in some places such as large firms, but though hourly wages for part timers and dispatched personnel are indeed rising, due to a tight supply/demand balance for part timers and such, there is the possibility of the quality of labor continuing to deteriorate. In other words, part-time workers newly taken on because of demand from firms have been discouraged workers, but there is also the possibility that those workers are choosing for instance to work for only 20 hours a week rather than full time (we call these ‘marginal’ part-time workers). In that case average wage growth would be statistically depressed despite an expansion in normal employment.

Considering structural factors (1) and (2) above, we expect average wages to continue to lack upward momentum despite tight employment. Furthermore, current unit labor cost continues to stagnate under a rapid rate of real growth and a very gradual rise in nominal employee incomes, thus the year-over-year rate of decline is expanding. Gauging from these wage conditions, we must conclude that it is likely to be some time before there is a spread to asset prices.

The above-noted scenario could easily invite mild disappointment among investors, who have started to take a positive view of the Japanese market. Indeed, the investors we spoke with seemed less happy with our scenario. In that context, if we were to look for items positive for Japan, these would be improvement in price-related measures such as the CPI and the GDP deflator over the course of 2008. In other words, even we who are highly conservative in our price forecasts are looking for these indicators to turn up slightly over the course of 2008. As standards used in making a judgment about an escape from deflation, the government uses (1) core CPI, (2) the GDP deflator, (3) the output gap, and (4) unit labor cost. There is the possibility of at least three of these four passing the test in the second half of 2008 (according to Cabinet Office calculations, the output gap has already turned positive). Under current conditions the government is not positively disposed to making pronouncements on an escape from deflation, but an announcement would become more likely as price measures continue to improve over the course of 2008.

This gradual improvement in the deflator is taking place at a glacial pace, disappointing investors, but this kind of rate of change is what you would expect for economic indicators, particularly price indicators. In addition, if not only market participants but also firms/employers increasingly believe that there has been an escape from deflation, then employees might seek higher wages of their own accord, and management might have no choice. Our visit emphasized that this gradual change in the macroeconomic environment is stimulating gradual change in wages.

Low expectations for political events

Keeping in mind the possibility of political realignment after the Upper House election, we have maintained that if there were dips caused by political events in the shape of the election, then it would be an opportunity to buy. However, we find few investors agreeing to the possibility of a market rally due to political events. Clearly, given the growing opacity of the political situation after the Upper House election, where pension issues have weakened the ruling party, we believe it is only natural for investors to be cautious, keeping in mind the risk of political gridlock after the elections. Overseas investors do not appear to understand that domestically there is a slight panic about record-keeping for pension contributions. However, in this case there is room for both positive and negative surprises relative to the consensus scenario.

Considering the risk profile here, negative news in the form of a minority by the ruling party in the Upper House has likely already been discounted to an extent, while the possibility of a re-realignment of politics including the DPJ (Democratic Party of Japan) if the LDP and the Komeito actually dropped below half of the seats apparently is not taken seriously by investors because of a lack of clarity. Thus concerns about a drop in share prices due to event risk do not appear particularly great. For all that, at present investors do not have the confidence to sketch out share-price rise scenarios due to political re-realignment at this stage.

BoJ policy valuation

Investors are split between approving and disapproving of the BoJ’s efforts to raise rates before deflation is completely over. On June 18, during our trip, we relinquished our previous view that the BoJ would skip an interest rate hike during the summer with a reported entitled ‘Forecasting Policy Mistake’. Investor response was also mixed to this. Investors agreeing with an early rate hike expected improved bank deposit rate spreads, and did not agree with our use of the phrase “policy mistake”, while some agreed with us that a rate hike while prices were falling was not desirable. Even investors who agreed with a rate hike found it difficult to understand the BoJ’s putting bubble concerns to the fore in raising rates. We noted that the financial authorities were each strengthening monitoring of real estate finance and were warning asset markets by raising rates under conditions of disinflation. In addition to concerns about reigniting a bubble, the authorities are concerned that if they interfere too much with the expansion of asset markets, they may send a negative message to investors, and many investors agreed with this. In any case, with raising rates under conditions of disinflation, there is the strong possibility of the yield curve further flattening, and it is likely to be banks that are hurt the most. Demarcating this from our house sector views, my personal inclination is still to be cautious on banks and bullish on real estate.

Risk (1)

Currently there is a 180 degree difference between the bearish consensus on the US economy and a view of the global economy that is even more positive than before. In this context, the greatest current risk is US inflation concerns. For example, if the US core inflation rate were to increase 0.5 percentage points year over year on an energy prices pass-through, reaching the upper 2% range, global asset price conditions might change. In other words, due to increases in US inflation, the Fed, which has to date kept a somewhat higher policy rate relative to economic conditions while entrenching until inflationary pressures have passed, might fall behind the curve, forcing it into a new series of rate hikes. In that case, US long-term interest rates could rise sharply and surpass 5.5%, with the possibility of global asset price adjustment resulting. The above is the worst-case scenario. In such a case Japanese asset markets would naturally be affected. Thus US inflation concerns are not necessarily tied to Japan expected inflation rate increases (however, the above is just a risk, and not our main scenario).

Given the above, it is clear that to the BoJ it is important in its own interest hike strategy for the global economy not to excessively raise inflationary concerns, and allow for continued gradual growth. If the global economy accelerates or decelerates too much, then a strategy of raising rates under conditions of disinflation is unlikely to go well. 

As for the domestic economy we have pointed to the possibility of a slight deceleration during this summer, and signs of this are starting to emerge as Japan enters the rainy season. This appears to be not risk but reality. For example, measures of sentiment such as the Economy Watcher Survey and Reuters Tankan indicated a tepid consumer trend after Golden Week in May. From June, the impact of elimination of special tax breaks on the residents tax and transferring sources of tax to regions, in effect raising taxes, would appear, with this also having somewhat of a negative effect on consumption. In addition, in May the trade statistics for January-March (especially March) showed a rebound off slumping import volume, and with the outlook for a decline in net external demand in April-June, there is the possibility of negative contributions to GDP.  All told, over the medium term we are maintaining a constructive stance vis-à-vis the Japanese economy, but in the short term, we are skeptical about personal consumption and net external demand momentum in April-June and July-September. Naturally, if these concerns can be overcome, for example if, helped by hot weather, summer consumption ramps up, then overseas investors may adopt a more bullish stance on Japan. However, even if all the signs were in place, it would be after the beginning of autumn, and thus some time is likely to be necessary.

Risk (2)

Finally, at least some of the investors we visited expected return reversal from the yen, which is still in decline. This is just our personal opinion, but we believe there is a possibility of this. Catalysts and timing are issues, but unfortunately, currently the yen probably does not have the vigour to turn around its downtrend. For example, even if the BoJ hiked rates in the summer, partly with the hidden motive of defending the yen, what difference would a 25bps rate hike make given the overwhelming domestic-overseas interest rate gap? Indeed, after a hike, with the BoJ’s motives exposed, the yen depreciation trend might actually intensify. However, given current conditions where the yen is inversely correlated to overseas asset prices as a funding currency, asset price procurement, equity/bond/real estate asset price adjustments in high yield countries could act as catalysts for a rebound in the yen. Unfortunately, it is difficult to look for the timing, but one possibility would be tightening by overseas central banks such as the ECB, BOE, or Fed. As such, here too the point is inflationary concerns. However, here too this is not our main scenario.

A more realistic scenario would be a change in Japanese currency policy toward renewed market intervention in Japanese currency policy with a cabinet reshuffle or change of administration after the Upper House election bringing a new Finance Minister or Vice Minister. In Japanese business circles, more than yen depreciation increasing corporate export competitiveness, concerns are appearing about domestic firms becoming targets for acquisition by overseas investors. As such it is hard to completely deny the possibility.

 

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