Gains and Pains
July 12, 2007
By Serhan Cevik | from Istanbul
Turkey’s unprecedented progress in the last five years may not be enough to ensure stability. Since the first multi-party parliamentary elections in 1950, Turkey has had a variety of single-party and coalition governments, with varying degrees of success in terms of economic performance. Under coalitions, the average rate of real GDP growth and inflation were 3.8% a year and 42.5%, respectively. On the other hand, with single-party governments, Turkey’s economic record improved dramatically — growth rising to 6.4% and inflation declining to 26.4% on average. No wonder then, that in the last five years when the first single-party government in over a decade had the opportunity to implement prudent policies and reforms, Turkey started accession talks with the EU and enjoyed its longest stretch of uninterrupted growth and disinflation. Indeed, thanks to the moderation of volatility and greater openness, output growth accelerated to 7% a year and inflation decelerated to 10.3% on average. Holding everything else constant, we would generally expect such exceptional macro progress to increase support for the ruling party. However, although opinion polls put the AK Party well ahead, the likelihood of a fragmented parliament is not negligible. Unlike in the 2002 elections, it seems that at least three parties (AKP, CHP and MHP) will be in parliament, along with 25-50 independent members. Moreover, polls suggest that if the DP and GP parties surprise on the upside, they could qualify for parliament. Since financial markets already price in an AKP government, we scrutinize other possibilities and identify the potential sources of political fragmentation.
Turkish voters have occasionally exhibited symptoms of ‘irrationality’ in voting behavior. We have already published a series of briefing notes on the determinants of voting behavior. Our findings suggest that employment growth, the growth rate of per capita income and consumer price inflation have statistically significant effects on voting patterns. Nonetheless, we also observe systematic voting outcomes that could not be accounted for by the model. For example, throughout the 1970s and 1990s, Turkish voters supported a set of parties that ended up forming weak coalitions and mismanaging the economy (see Are Voters Rational?, July 10, 2007). Consequently, this episode ended with the 1980 military coup; and fragile coalition governments of the 1990s led to the 2001 crisis. In our view, these symptoms of ‘irrationality’ in the electorate’s behavior are a result of distortions caused by the electoral system, non-economic factors influencing political preferences and the distribution of economic gains and pains across Turkish society. Since there has been no material change in the electoral regime, ‘mean reversion’ in voting behavior may once again result in more fragmentation. Likewise, without the devastating shock of an economic crisis, we think that voters are likely to attach more weight to non-economic factors. Opinion polls already show such tendencies, and highlight the importance of political and ideological issues such as the secularism debate and the war in Iraq. Furthermore, despite an impressive macro performance in the past five years, the distribution of pains and gains from stabilization has not been even, and we think that this has created disgruntled voters with a greater tendency to ‘swing’ from one party to another. The uneven distribution of gains and pains creates disgruntled voters. Turkey has enjoyed the benefits of stabilization and even reasonable improvements in social indicators. For example, the poverty rate declined from 27% in 2002 to 20.5% in 2005, while the equality of income distribution (measured by the Gini coefficient) improved from 0.44 to 0.38 over the same period. However, the last five years have represented a period of normalization that was not enough to close the expectation gap. In fact, employment growth lagged behind the increase in working-age population and there was only a limited recovery in real wages. As a result, the share of labor income stagnated at around 26% of GDP, after declining from 30.7% in 1999. Similarly, structural changes in the agriculture sector, albeit very encouraging for long-run growth prospects, have led to a sharp drop in farm employment and widened the gap between rural and urban areas. In other words, the normalization process that makes the Turkish economy more productive has also been a source of dislocation and social frustration. Not every government would maintain institutional and economic progress. Surveys show strong support for AKP and imply a high probability of a single-party government in a parliament with three parties and 30 independent members. Asset prices already reflect this scenario, but we are concerned about divergence between polls and the risk of unexpected swings in voting behavior. In other words, although a single-party government appears the likely outcome, the possibility of a coalition that may not be as passionate an advocate of prudent economic policies and liberal democracy is not insignificant. We have long argued that the Turkish economy rests on stronger fundamentals, but we also realize that the internalization of reforms and fiscal discipline is incomplete. Consequently, a (weak) government with questionable commitment to structural reforms and openness could still disturb the normalization process. This is why we believe that Turkey stands, once again, at a crossroads of sub-optimal performance or faster real convergence.
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Rate Hike Prompts Us to Look Forward to 2008
July 12, 2007
By Sharon Lam | Hong Kong
The Bank of Korea (BoK) has raised its overnight call rate target by 25bp to 4.75%, the highest since 2001. This is the extension of a rate hike cycle that started in October 2005. In my view, the market has mostly priced in today’s rate hike, so it should not have come as much of a shock. I believe that Korea’s interest rate level is already at or very close to neutral, while the economy is only at an early stage of recovery and inflation remains within the central bank’s target range. Rate hikes are unlikely to derail the recovery as export orders look to remain robust, but they could limit further upside in growth revisions this year. The consensus 2007 GDP forecast is at 4.5%, and I think it looks about right under this monetary policy direction. In my view, 5% growth for 2007 is a remote possibility, but looks plausible for 2008 on hopes of stimulus from a potential new government and resilient exports. I believe that the biggest macro excitement will be in 2008, not 2007. In today’s comments, the BoK remains upbeat on economic recovery. It mentioned that recovery would continue into 2008, unlike in the previous month’s statements, when the language was more focused on recovery in 2H07. I see this as a signal that this is not the end of this rate hike cycle yet. I expect one more 25bp hike in the remainder of this year, in late 3Q or early 4Q. The interest rate outlook next year will very much depend on housing market development, in my view, which is dependent on the new government’s housing policy and investment confidence, which I believe are skewed to the upside. Nevertheless, I continue to see no need for aggressive tightening and therefore there could be more growth but a more stable interest rate environment at the same time next year. A common market misperception is that rate hikes will cause the KRW to appreciate further; in my view, this is not true. Korea’s interest rate policy has a very limited impact on the exchange rate since foreigners’ participation in Korea’s bond market is minimal compared to their high ownership in the stock market. Therefore, I believe that any reaction from the FX market due to today’s rate hike will be short-lived. In fact, by turning more aggressive on monetary policy, I believe that the central bank will try to defend the exchange rate more in order not to let the economy falter. Its latest act in reducing foreign banks’ incentives on short-term borrowings by using overseas funding is one example of trying to reduce volatility in the FX market. Nevertheless, I expect further appreciation in the KRW this year due to strong shipbuilders’ orders and their subsequent forward selling in USD for hedging purposes. However, given my expectation that the central bank will take a more active stance in smoothing out the FX fluctuations this year, I believe that the KRW will appreciate only in a gradual and manageable manner. Given the latest pick-up in the OECD leading indicator, I remain positive on the export outlook into 2008. While I believe that early rate hikes are unnecessary, there are two main positives: 1) it gives Korea more room for stimulus than other countries in the region when there is any unexpected shock; and 2) pushing rate hikes forward may reduce the chance/magnitude of rate hikes next year, and therefore the growth outlook in 2008 could see more upside under a pro-growth government. In my view, Korea’s overall financial conditions are still healthy and delinquency ratios remain very low. The pick-up in loan growth represents a structural shift into the service sector and mortgage market development, and most of the loans are used for production purposes. This is not 2001-02 when loan growth was driven by too much consumption. I believe that Korea is not facing any credit issues and the rate hikes further strengthen stability on this front. There is no need for aggressive tightening under the current credit situation, in my view, and again leads us to believe that the magnitude for tightening in 2008 could be small (i.e., stable interest rate environment) if overnight rates reach our 5% forecast by the end of this year. Meanwhile, deposit rates have been rising faster than lending rates during this rate hike cycle (although it could be a zero-sum game for the economy), and therefore helps provide some cushion to consumers. Bottom line I think that this early rate hike is not the most desirable for near-term growth, but it does provide stability over the long term, which is a base for more upside going forward. Meanwhile, rate hikes could reduce overall liquidity growth, but this does not stop the asset reallocation story, which in my view is an aging population issue that will continue to prompt households and pension funds to shift assets into higher-return investments to secure longer life expectancy.
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Politics: Moving in the Right Direction?
July 12, 2007
By Chetan Ahya, Shweta Singh and Deyi Tan | Mumbai, Singapore
First signs of stability Over the past two days, we have met with senior government officials, opposition parties, independent political analysts and corporate management teams in Thailand to assess the latest political and macroeconomic developments. After an 18-month political stalemate, it appears that the political environment in Thailand may be improving. Over the last six weeks, in the wake of the constitutional court’s ruling to dissolve the Thai Rakh Thai party, we have seen a big reduction in political demonstrations opposing the verdict. This has increased the probability of a non-violent transition towards the formation of a new government, in our view. Quelling rumours of another military coup, the government has reiterated its intention to hand over power to a democratically elected government. Domestic demand is bottoming out Thailand’s domestic demand had been weakening since the political instability following the 2005 general elections. The government’s efforts to increase public spending have been ineffective, and private consumption as well as investment have been weakening. Domestic demand growth declined 0.4% YoY during the quarter ended March 2007, compared with growth of 6.7% in 2005 and 0.2% in 2006. However, we believe that the lagged impact of a sharp reduction in policy interest rates and the recent government effort to accelerate spending will cause domestic demand to bottom out. Indeed, we expect a further 25bp cut in policy rates by the Bank of Thailand in the upcoming monetary policy meeting (July 18). However, a stable political environment is critical to ensuring a sustained meaningful recovery in domestic demand. In this context, the recent political developments raise hopes of a potential revival in domestic demand over the next six months. Long road to a stable government There are still many hurdles to be cleared before macroeconomic normalcy can return: (a) Outcome of national referendum: The revised draft of the new Constitution will be put to national referendum on August 19 (and no later than September 3). In the run-up to the referendum day, Thaksin’s supporters will likely try to galvanize people to vote against it. Further, several human rights organizations have raised issues regarding the security bill (which grants the Army Chief absolute powers during “national crises”). In spite of this, we see a strong likelihood that the people will give the new constitution the go-ahead in the hope of holding elections on time and returning to democracy. If the national referendum votes against the new constitution, market sentiment could be affected. The government would then be required to adopt any of the old constitutions within a month. (b) Timing of elections: We believe that elections will be held by the end of the year (most likely in December). The tentative dates for the elections (as announced by the Prime Minister Surayud Chulanont) are December 16 or 23. Although some political commentators have indicated that the enactment of the related organic laws could take time, and the elections could be delayed beyond December, it seems that the elections will be held on one of the scheduled dates. If the national referendum vote goes against the constitution, elections could be delayed by a month, as the current government would have another month to adopt any of the past constitutions. Although this new constitution could technically ask for further delays to elections by over a month, we believe that the current government would resist such a delay to avoid public uproar. (c) Role of military in conduct and outcome of elections: There is a risk that the military may play a more active role in influencing the conduct and outcome of elections. In this context, recent newspaper reports about the possibility of the Council for National Security (CNS) Chairman, General Sonthi Boonyaratglin (also Commander-in-Chief of the Royal Thai Army) leading a political party and contesting for the elections have raised concerns that the military may yet be involved in the formation of the new government. Recalling the events following the military coup in 1991, some political commentators are concerned about this development. Post the 1991 coup, the top military leaders formed a political party (Samakheedham) to contest in general elections (held in March 1992). This party won a large number of seats, and a military leader (Suchinda Kraprayoon) was appointed prime minister. However, mass protests and violence later led to the resignation of the ex-military leader in May 1992. In the current situation, there is a similar risk of military interference. (d) Stability of the new government: If elections are held by end-December, then the new government will be formed by end-January 2008. Assuming that the general election is fair and the military has no indirect representation in the new government, the outcome of the elections will be accepted by the public, in our view. However, it is patently clear that no single party will gain a full majority. Political commentators expect the TRT party (already weakened by the constitutional court’s verdict to dissolve the party, as well as ban its 111 top members from political life for five years) to be split into two factions. These two factions are likely to win a much smaller share of seats in the general elections. The Democrat Party may emerge as the single largest party, but it may not have the full majority due to its relatively weak presence in the North East, which has traditionally been the stronghold of Thaksin’s TRT party and accounts for one-third of the total voting population. We believe that there is a high likelihood of the Democrat Party leading the new coalition government, with support from 2-3 smaller parties. However, unless the new government is formed with a high concentration of seats within the top two parties, stability of the coalition will be a concern. We believe that, in such a scenario, private consumption and investments would remain relatively weak, albeit an improvement on the last 18 months. (e) What will the new government’s economic policies be? We believe that if the Democrat Party leads the new coalition government, there may be little change in Thailand’s economic policies from those of the previous government. During our discussion, the Democrat Party leaders emphasized that the party will work on three key broad objectives: (a) restoring full democracy in Thailand; (b) ensuring a strong economic growth recovery; and (c) ensuring peace in the South. Specifically, on the macroeconomic front, the party leaders are clear that they will: (i) spearhead economic policies that continue to improve the openness of the economy (free trade agreements, etc.); (ii) implement measures that increase foreign business investment; and (iii) increase public investment in infrastructure and education. They are also cognizant of the party’s need to reach the rural parts of the country and implement measures that address the social issues of the rural economy. Bottom line There are clear signs of improvement in Thailand’s political environment. We believe that macro sentiment is likely to improve from now until the general election. Further improvement and sustainability of the economic recovery will depend on the stability of the new coalition government. We believe that the wild card continues to be potential interference by the military in the conduct of the elections and formation of the new government.
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BoP Surplus, Inadequate Sterilization and ‘Steadily’ Fast Money Growth in 2Q07
July 12, 2007
By Denise Yam, CFA | Hong Kong
US$131 billion BoP surplus in 2Q07…China’s FX reserves reached US$1,332.6 billion at the end of June, implying a balance of payments surplus of US$131 billion in 2Q07 (+98% YoY), similar to that in 1Q07 (US$136 billion). The accumulation of reserves was US$64 billion in excess of the trade surplus (US$66 billion) in the quarter, suggestive of continued significant capital inflows. … against Rmb0.6 trillion intended liquidity withdrawal: We have been following the size of the BoP surplus versus the extent of the PBoC’s quantitative tightening as an assessment of the tightness of the monetary policy stance. Specifically, we attributed persistently strong loan growth and a reacceleration in economic growth to incomplete sterilization of the BoP surplus over 2H04-3Q06 (see Soft Patch in 4Q but Friendly Liquidity Cushions Landing, November 17, 2006). Tightening stepped up only in 4Q06, but monetary policy appears to have become loose again in 1H07. Bond issues net of maturing papers, together with the 1.5 percentage-point hike in the reserve requirement ratio in 2Q07, were intended to withdraw Rmb0.6 trillion (US$79 billion) of liquidity from the banking system, only 60% of the BoP surplus in the period. Nevertheless, we do not yet have updated data on the actual change in financial institutions’ reserve deposits with the PBoC in the same period, so we cannot yet quantify the actual achieved sterilization in 2Q07. Given that financial institutions still held excess reserve deposits with the PBoC, it is likely that the reserve requirement hikes did not result in a corresponding actual increase in the reserve deposits, hence the ‘achieved’ sterilization was likely even smaller than what was ‘intended’. Money growth picked up again in June: After cooling for three straight months, broad money M2 growth rebounded to 17.1% YoY, from 16.7% in May, still above the central bank’s target (16%) for the year. Narrower definitions of money, M1 and M0, also saw faster growth in June, at 20.9% and 14.5%, respectively, up from 19.3% and 13.9% in May. Deposit growth rebounded, decline in household savings deposits halted, but diversion to stock market continues: The growth in total deposits rebounded to 16% YoY (+14.6% in May) after slowing for four straight months. However, this was contributed mostly by faster growth in enterprise deposits (+19.5% in June versus +17.2% in May), while household savings deposits continued to suffer from slow growth of 9.4% YoY (+9.3% in May). A comforting sign was that household savings deposits took a breather from contracting month on month; deposits recovered by Rmb168 billion, though they have yet to reverse the Rmb446 billion decline in the preceding two months, as households diverted funds from deposits to speculate in the stock market. Indeed, ‘quasi-money’, defined as the difference between M2 and M1, has seen growth trending down consistently since early 2006 (above 22%) to 15% in June 2007. We believe that this continues to worry policymakers. Loan growth stable, but still too fast: New renminbi loans made in June totaled Rmb451.5 billion (Rmb247.3 billion in May), up 14.3% YoY. Loan creation in 1H07 in aggregate rose 16.9% YoY to a total of Rmb2.54 trillion, already reaching 80% of the 2006 total (Rmb3.18 trillion). YoY growth in outstanding loans remained unchanged for the third straight month at 16.5% in June. Still preparing for more monetary tightening…The latest set of figures does not alter our view that more monetary tightening is in the pipeline in the remainder of the year. Specifically, fast loan creation calls for further quantitative tightening, such as hikes in the reserve requirement ratio, while the continued diversion of deposits to more liquid forms and stock market investment serves as a reminder that the cost of capital remains too low in China relative to the pace of economic growth and stock market performance. With the law recently passed, we expect the tax on deposit interest income to be scrapped in the imminent future, which brings about an effective increase in the deposit interest rate (1-year) by 61bp. In addition, we still expect both lending and deposit rates to be hiked twice (27bp each) in 2H07. … but how about the timing? More economic data for June, together with the 2Q07 GDP report, are due to be released next Wednesday (July 18). Amid the sustained surge in meat, egg and edible oil prices, June CPI inflation is expected to accelerate from the 3.4% rate in May (we forecast 3.8%), and further above the central bank’s target of 3% for the year. Nevertheless, a higher CPI number for June, even if it exceeds 4% YoY, would not be a big surprise to the market. As we have argued before (see Pork Crisis and Timing of the Next Rate Hike, June 4, 2007), 3%+ inflation is a necessary yet not sufficient trigger for the next rate hike. We believe that the PBoC has a list of other considerations when deciding on the timing of the next tightening move, including the performance of the stock market. In addition, the PBoC is now anxiously monitoring and preparing market conditions for the upcoming large bond issue to set up the China Investment Company (CIC), the state’s new investment vehicle for its foreign reserves. A high June CPI figure could help justify accelerated tightening, but overall financial market conditions are playing an increasing role in the timing of policy actions, in our view.
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