China
Increased Overheating Risk; Policy-led Downturn Unlikely
July 19, 2007

By Qing Wang & Denise Yam, CFA | Hong Kong

Increased risk of overheating

The National Bureau of Statistics released a key set of data for the 2Q07 on July 19.  It revealed yet another robust quarter, with GDP growth of 11.9% YoY in 2Q and 11.5% YoY in 1H.  Headline CPI inflation hit 4.4% YoY in June and 3.2% YoY in 1H on a sharp rise in food prices (i.e., 11.2% YoY in June and 7.6% in 1H by our estimate), reflecting in part the lagged effect of a rapid increase of broad money.

Investment and exports remain the two main growth drivers. We estimate that real fixed-asset investment (FAI) growth was 23% YoY in June and 21.8% YoY in 2Q, a visible rebound from the lows in late 2006 and early 2007.  Consumption continues to demonstrate steady and strong momentum, with real retail sales up by 12.9% YoY in 2Q, moderately faster than 12.6% YoY in 1Q and 2006.  Exports (27% YoY in June and 28% YoY in 1H) continue to outpace imports (14% YoY in June and 18% YoY in 1H) by a large margin, perpetuating the large trade surpluses.  While the growth of exports to the US appears to have moderated in recent months, that to other regions — especially the EU — has accelerated, in part reflecting the appreciation of the euro against the US dollar.

China’s FX reserves level reached US$1.33 trillion by end-June, or US$131 billion new accumulation since end-March. Persistent trade surpluses contributed to 42% of the FX reserve accumulation in 1H07, substantially smaller than the 71% in 2006, reflecting resurgence in ‘other inflows’ and giving rise to the question of whether there has not been a return of massive foreign speculative ‘hot money’ to China.  We think not.  We believe that the bulk of the so-called ‘hot money’ flows are not driven by foreign speculation — rather, they are cross-border fund movements carried out by China’s own financial institutions and are thus on the policy authorities’ radar screen and even under their effective control (see China Economics: All the Hype about Return of Massive ‘Hot Money’, July 16, 2007).

The liquidity impact of FX reserve accumulation was offset by the PBoC’s aggressive sterilization operations through raising the ratio for required reserves (RRR) and open market operations (OMOs).  We estimate that the PBoC may have offset the liquidity impact of almost 100% of FX reserve accumulation in the first five months of the year.

Money supply (M2) growth was 17% YoY in June, a visible rebound from 16.7% YoY in May and still higher than the PBoC’s target of16%, while bank loan growth was 16.5% YoY, slightly higher than the 16.3% in 1Q.  The re-acceleration of M2 growth was due largely to reflows of money into the banking system in the aftermath of the stock market correction.  This swing in money growth underscores the issue we raised about the unstable money demand function amid a rebalancing of household financial assets portfolios away from bank deposits to stock holdings (see China Economics: Tighter Policy on Structural Shift in Money Demand, July 3, 2007).

The renminbi appreciation against the US dollar accelerated markedly to an annualized pace of about 6% in 2Q from about 4% in 1Q and only 3.4% in 2006.  We estimate that the Rrenminbi nominal effective exchange rate (NEER) appreciated by nearly 7% at an annualized pace in 2Q, also much faster than both the 3% in 1Q and the less than 1% in 2006.

Serving the de facto primary objective of maintaining a gradual appreciation, domestic interest rates have been kept stable at relatively low levels.  This suggests that the liquidity situation in the inter-bank market — measured by interest rates — has remained largely unchanged, despite the PBoC’s aggressive withdrawal of liquidity.  The yield on one-year PBoC bills has been maintained in a narrow range of 3.0-3.1% such that the USD-Rmb interest rate spread has been kept broadly stable.  The authorities hope that the wide interest rate spread will help discourage speculative FX inflows and thus ease the pressure for renminbi appreciation.  Moreover, the base lending and deposit rates were raised by 18bp and 27bp in 2Q, respectively.

Excess liquidity and low interest rates support asset prices.  By end-2Q, the Shanghai composite index was up by 20% from its end-1Q level, although it was down by about 14% from its peak reached at end-May.  Moreover, there has been a broad-based acceleration of property prices across the country.  The magnitude of property price increases in the first five months of 2007 is larger than was seen in 2006 in a large majority of major cities in China.  In fact, property prices have been on the rise at an accelerated pace in a number of cities since 2004.

The near-term outlook

We remain bullish on the economy and believe that the expansionary phase of the current cycle has yet to run its course.  In light of this new data release, we upgrade our 2007 GDP growth forecast to 11.3% from the previous 10.5%.  This macroeconomic backdrop should prove positive for both the equity and property markets, in our view.

These recent developments, especially on the inflation front, will likely trigger some policy actions — including interest rate hikes and additional administrative measures to curb loan and investment growth, especially in “energy-intensive, high-pollution, and overcapacity” sectors — to address the potential risk of general economic overheating.  In fact, the authorities have modified their assessment on the current economic situation from “guarding against the risk of rapid growth turning into economic overheating” to “the risk of rapid growth turning into economic overheating has become more pronounced”.

We called for imminent rate hikes around mid-June (see China Economics: The Authorities Appear Poised to Initiate a New Round of Macro-tightening, June 14, 2007, and China Data Releases: Rebound in Fixed Asset Investment Growth Continues in May, June 15, 2007).  We made the calls around that particular time, because we believed that both the necessary condition (i.e., an above 3% headline CPI reading) and sufficient condition (i.e., a stock market rebound) for a rate hike were met (see China Economics: Pork Crisis and Timing of the Next Rate Hike, June 4, 2007).  While the authorities did not hike rates as we expected, the market reacted as if it did: expectations of rate hikes helped push the Shanghai A-share composite index down by 15% between June 18 and July 5 (We use the phrase “the authorities” instead of the PBoC, because the ultimate decision power on interest rate hikes is with the State Council.)  We believe that a main consideration in the authorities’ decision not to hike rates then was to avoid adding to the downward pressure on the stock market.  In a sense, market expectations helped achieve the effect of a rate hike without an actual delivery by the PBoC.

Now that June CPI inflation has exceeded the 4% YoY mark and the stock market has rebounded, albeit not yet fully recovered, we think that the case for a rate hike has become only stronger.  Moreover, if the authorities again choose not to act on the high CPI reading this time, they risk their credibility being compromised, in our view.  The market may interpret the authorities’ inaction as indicating that stock market performance rather than inflation features more importantly in the authorities’ interest rate decision-making, while senior officials from the PBoC have repeatedly communicated to the market that this is not the case.

We think that one of the following two policy moves will likely take place any time from now: a) a cut of the tax rate on interest income by half (i.e., from 20% down to 10%) to effect a deposit rate hike of about 30bp; or b) a hike of both lending and deposit rates by 27bp.  Of these two potential policy moves, we attach a slightly higher probability to the former, because it seems to us that an immediate policy objective is to make real deposit rates (i.e., nominal interest rates adjusted by ex post actual CPI inflation) less negative in view of the spike in headline CPI inflation, with the objective of maintaining positive year-average real deposit rates.  At the same time, we continue to call for two more 27bp hikes in both the lending and deposit rates in the remainder of the year, one in each quarter.

In addition to monetary policy measures, we expect that the authorities will have to resort to administrative measures (e.g., tighter investment project approval, “window guidance”) more frequently to help curb investment and loan growth.  However, we do not expect administrative tightening to be as tough as was experienced in 2004 and 2H06, due to: a) the political cycle; and b) absence of evident sectoral bottlenecks that featured prominently in previous rounds of economic overheating.  Regarding the former, trends since the early 1990s suggest that China’s fixed-asset investment cycle tends to coincide with the cycle of change of governments — at both the central and local levels — which takes place very five years.  If this pattern persists, fixed-asset investment growth in China appears poised to enter an upturn in the next 18 months through 2008, when the next change of government is due to take place (see China Economics: Upgrade Our GDP Growth Forecasts, June 18, 2007).

Another of the authorities’ near-term policy priorities is energy conservation through sector-specific policies.  The government’s 11th Five-Year (2006-10) Plan set an objective of reducing energy consumption per unit of GDP by 20%, or averaging a 4% reduction per year.  The government failed to achieve this target in 2006.  We expect the authorities to redouble their efforts in the remainder of the year.  This may involve consolidating the “high-energy, high-pollution, and over-capacity” sectors, including oil refinery, coke, chemical, cement, steel, metals and electricity generation.  Past experience suggests that small-scale, non-state-owned enterprises are likely to be most affected, as many may be closed down for failing to meet relevant industrial standards.

The rollout of a comprehensive reform of the pricing mechanism for a wide range of natural resources-based products — including water, fuel, electricity, natural gas and coal — appears to have been pushed back.  Such reform would involve normalizing the prices of these products, which have been kept too low, and we think that the authorities may not want to add to inflationary pressures at the current juncture.

Risks

Despite these stronger-than-expected key indicators, we attach a very low probability to another round of macro-controls of the same intensity as we saw in 2004 and 2H06, especially in view of China’s political cycle.  We believe that a policy-led major economic downturn over the remainder of this year is highly unlikely. 

Against this policy backdrop, the risk of general economic overheating and asset price overshooting in the remainder of the year is not trivial, in our view.  Meanwhile, market volatility will also likely run high, as the authorities’ bottom line is being tested (see China Economics: Novice, Naïve or Super-speculative, June 4, 2007).  We think that the biggest downside risk is a substantial weakening in China’s external demand.  However, this risk appears to have diminished significantly of late, given the remarkable strength in the G3 economies.

 

Important Disclosure Information at the end of this Forum

Turkey
Trillion Dollar Economy
July 19, 2007

By Serhan Cevik | from Istanbul

Turkey has the potential to become a trillion dollar economy in the next ten years. With the approaching parliamentary elections, we all talk about politics, nothing but politics these days.  Political developments can of course have a decisive effect on economic and financial trends. Turkey’s own history, for example, is full of periods of political fragility or stability that have led to economic stagnation or faster, welfare-enhancing growth.  The last five years is a case in point. The 2002 elections — consolidating the political landscape — set the stage for the coherent implementation of prudent policies and structural reforms.  As a result, Turkey has started accession negotiations with the EU and achieved a significant degree of economic normalization that altogether set in motion the longest stretch of uninterrupted growth and disinflation.  But this is just the tip of the iceberg, and our calculations show that Turkey has the potential to become a trillion dollar economy in the next ten years. Therefore, the risk Turkey is facing today is not an economic collapse, but the opportunity cost of not realizing its true potential.  This is why we want to look beyond politics and identify what Turkey needs after the elections to accelerate real convergence.

Macroeconomic normalization is just a building block for a brighter future.  Turkey had one of the most distorted economies around the world, with the volatility of real GDP growth increasing from 2.5 in the 1980s to 5.2 in the 1990s and 8.4 during the 2001 crisis.  In our opinion, political fragmentation and structural weaknesses were responsible for boom-bust cycles and financial fragilities.  No wonder, political consolidation in 2002 — bringing prudent policies and structural reforms — led to economic rationalization and the moderation of business-cycle volatility. The volatility of real GDP growth (or any other macro variable, for that matter) declined to the lowest level in the past four decades and total factor productivity growth that used to stagnate throughout the 1990s surged to about 5% a year. This is why we have long argued that economic normalization functions like a technological innovation — accelerating productivity growth and improving the quality and sustainability of output growth (see Stabilisation as Innovation, May 9, 2005). The progress so far is very impressive, raising Turkey’s gross domestic product from US$154 billion in 2001 to US$403 billion last year. Nevertheless, although Turkey has the potential to become a trillion dollar economy, its per capita GDP is still 30% of the EU-25 average, just as it was in the 1990s. In other words, what we have witnessed in recent years is just a recovery out of the 2001 crisis. Therefore, Turkey needs to keep enhancing productivity and employment growth in order to achieve real economic convergence.

Having great potential is not a guarantee for faster economic convergence. According to our estimates, Turkey’s potential growth rate is around 7.5% — more than twice as much as the EU-25’s growth potential. Hence, under our ‘reform-driven growth’ scenario, per capita income would increase from 30% of the EU-25 average to about 60% by 2020. On the other hand, in our ‘sub-optimal’ scenario, with an average growth rate of 4.5%, the Turkish economy would lag behind and show just a marginal degree of real convergence. Consequently, the risk stems from the opportunity cost of not realizing the economy’s potential. However, having great potential does not guarantee faster, welfare-enhancing growth. Indeed, as we move towards the end of the normalization phase, maintaining growth momentum close to the potential will become more and more challenging. In other words, macroeconomic stability is not enough to expand the production frontier and raise per capita income growth. For that reason, while maintaining fiscal discipline, the next generation of policies and reforms must focus on removing structural bottlenecks and improving the economy’s capacity for labor absorption and innovation.

Turkey’s growing young population is a demographic gift that could accelerate convergence. If Turkey improves the state of the labor market and brings its employment rate to the European level, the number of employed could increase by almost 50%, or by 12 million workers. Given the significant difference between per capita GDP and per worker GDP, that would imply a level of per capita income that is already more than 50% of the EU-25 average. This is why we see Turkey’s growing young population as a demographic gift that could accelerate the pace of income convergence. The problem is the inadequate level of employment. While the share of the working-age population is 71.4% of the total population (compared to 64% in Europe), employment in Turkey is just 43.3% of the working-age population (compared to 63.8% in Europe). Put differently, the Turkish economy is utilizing less than half of the workforce, due partly to an unusually low labor force participation rate (47.9% versus 72% in Europe).

An inter-related set of factors limits employment and productivity growth. In our view, sectoral productivity differentials — reflecting structural problems — explain Turkey’s low level of per capita income relative to the EU average. For example, gross value added per worker in the agriculture sector is less than one-third of those figures for the services and manufacturing sectors. This is a result of inter-related factors limiting productivity growth and the economy’s labor absorption capacity. The tax wedge, for instance, accounts for about 54% of gross wages (up from 23% in 1990) and consequently discourages job creation. Likewise, rigid labor market regulations reduce employment growth and create inertia in traditional sectors of the economy. Therefore, the first step of microeconomic reforms should aim to ease the burden of taxation and regulatory distortions. However, bureaucratic adjustments would not be enough to bring the other half of the working-age population into the workforce, since the problem is beyond regulatory limitations. Even though educational attainments have improved over the past decades, Turkey’s human capital is still very low compared to other (developing) countries. For example, the average level of schooling is less than six years in Turkey, whereas it is almost 12 years in Korea. Similarly, the share of the adult population with upper secondary education is 25%, as opposed to the average of 56% among other OECD countries. In our view, this is mainly because of the ‘gender gap’ in educational attainments, which also explains the lowest female labor force participation rate (23%) in Europe (see Gender Gap, May 5, 2005). This is why enhancing the economy’s growth potential requires a comprehensive strategy to improve human capital endowment, not just macroeconomic stability and microeconomic reforms.

Turkey needs complementary policies to foster innovation and value-added in production. Innovation is the leading engine of growth, but underlying characteristics of the Turkish economy unfortunately limit technological innovation and thereby productivity growth. With less than 30% of manufacturing firms making technology-intensive capital investment, there are significant sectoral divergences in technological capabilities and productivity growth. While technology-intensive sectors have maintained a competitive edge, traditional sectors dominated by small firms suffering from technological backwardness lagged behind in the new business environment (see Technological Sclerosis and Productivity Divergence, April 19, 2005). Unfortunately, these ‘bottlenecks’ limit value-added in production and therefore contribute to the current account deficit as well as inflationary pressures. Although macroeconomic normalization has forced firms and individuals to develop new skills and capabilities and has already delivered encouraging results, Turkey still needs complementary policies and structural reforms to spur productivity growth and increase value-added in production.

Institutional modernization holds the key to accelerating convergence on a sustainable basis. Market participants usually focus on short-term developments, but institutional factors that keep or break the confines of anachronistic institutions have an overwhelming influence over the economy’s long-term trend (see A Big Bang Theory of Convergence, June 8, 2007). In our opinion, accession negotiations with the EU provide the impetus and a clear strategy for institutional modernization that has already led to a reasonable degree of economic rejuvenation. Of course, institutional (and economic) development is never a linear process and takes place through occasional setbacks and struggles for change, as we have seen in many other countries and several times in Turkey. However, beyond political difficulties in the election year, the Turkish economy stands to gain from dynamism facilitated by institutional reforms that would bring the country closer to European standards, improve the business climate, and accelerate real convergence. Therefore, Turkey now has a historic opportunity to consolidate painful gains of the past and start creating the next trillion-dollar economy in the world.

 

Important Disclosure Information at the end of this Forum

Disclosure Statement

The information and opinions in Morgan Stanley research were prepared or are disseminated by Morgan Stanley & Co. Incorporated and/or Morgan Stanley C.T.V.M. S.A. and/or Morgan Stanley & Co. International plc and/or Morgan Stanley Japan Securities Co., Ltd. and/or Morgan Stanley Asia Limited and/or Morgan Stanley Asia (Singapore) Pte. (Registration number 199206298Z) and/or Morgan Stanley Asia (Singapore) Securities Pte Ltd (Registration number 200008434H) and/or Morgan Stanley Taiwan Limited and/or Morgan Stanley & Co International plc, Seoul Branch, and/or Morgan Stanley Australia Limited (A.B.N. 67 003 734 576, holder of Australian financial services licence No. 233742, which accepts responsibility for its contents), and/or Morgan Stanley India Company Private Limited and their affiliates (collectively, "Morgan Stanley"). As used in this disclosure section, Morgan Stanley includes RMB Morgan Stanley (Proprietary) Limited, Morgan Stanley & Co International plc and its affiliates.

Global Research Conflict Management Policy

Morgan Stanley Research observes our conflict management policy, available at www.morganstanley.com/institutional/research/conflictpolicies.

Important Disclosures

Morgan Stanley Research does not provide individually tailored investment advice. It has been prepared without regard to the circumstances and objectives of those who receive it. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages them to seek a financial adviser's advice. The appropriateness of an investment or strategy will depend on an investor's circumstances and objectives. Morgan Stanley Research is not an offer to buy or sell any security or to participate in any trading strategy. The value of and income from your investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized.

With the exception of information regarding Morgan Stanley, research prepared by Morgan Stanley Research personnel is based on public information. Morgan Stanley makes every effort to use reliable, comprehensive information, but we do not represent that it is accurate or complete. We have no obligation to tell you when opinions or information in Morgan Stanley Research change apart from when we intend to discontinue research coverage of a company. Facts and views in Morgan Stanley Research have not been reviewed by, and may not reflect information known to, professionals in other Morgan Stanley business areas, including investment banking personnel.

To our readers in Taiwan: Morgan Stanley Research is distributed by Morgan Stanley Taiwan Limited; it may not be distributed to or quoted or used by the public media without the express written consent of Morgan Stanley. To our readers in Hong Kong: Information is distributed in Hong Kong by and on behalf of, and is attributable to, Morgan Stanley Asia Limited as part of its regulated activities in Hong Kong; if you have any queries concerning it, contact our Hong Kong sales representatives.

Morgan Stanley Research is disseminated in Japan by Morgan Stanley Japan Securities Co., Ltd.; in Canada by Morgan Stanley Canada Limited, which has approved of and takes responsibility for its contents in Canada; in Germany by Morgan Stanley Bank AG, Frankfurt am Main, regulated by Bundesanstalt fuer Finanzdienstleistungsaufsicht (BaFin);in Spain by Morgan Stanley, S.V., S.A., a Morgan Stanley group company, supervised by the Spanish Securities Markets Commission(CNMV), which states that it is written and distributed in accordance with rules of conduct for financial research under Spanish regulations; in the US by Morgan Stanley & Co. Incorporated, which accepts responsibility for its contents. Morgan Stanley & Co. International plc, authorized and regulated by Financial Services Authority, disseminates in the UK research it has prepared, and approves solely for purposes of section 21 of the Financial Services and Markets Act 2000, research prepared by any affiliates. Private UK investors should obtain the advice of their Morgan Stanley & Co. International plc representative about the investments concerned. In Australia, Morgan Stanley Research and any access to it is intended only for "wholesale clients" within the meaning of the Australian Corporations Act. RMB Morgan Stanley (Proprietary) Limited is a member of the JSE Limited and regulated by the Financial Services Board in South Africa. RMB Morgan Stanley (Proprietary) Limited is a joint venture owned equally by Morgan Stanley International Holdings Inc. and RMB Investment Advisory (Proprietary) Limited, which is wholly owned by FirstRand Limited.

Trademarks and service marks in Morgan Stanley Research are their owners' property. Third-party data providers make no warranties or representations of the accuracy, completeness, or timeliness of their data and shall not have liability for any damages relating to such data. The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of MSCI and S&P. Morgan Stanley bases projections, opinions, forecasts and trading strategies regarding the MSCI Country Index Series solely on public information. MSCI has not reviewed, approved or endorsed these projections, opinions, forecasts and trading strategies. Morgan Stanley has no influence on or control over MSCI's index compilation decisions. Morgan Stanley Research or portions of it may not be reprinted, sold or redistributed without the written consent of Morgan Stanley. Morgan Stanley research is disseminated and available primarily electronically, and, in some cases, in printed form. Additional information on recommended securities/instruments is available on request.

The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (DIFC Branch), regulated by the Dubai Financial Services Authority (the DFSA), and is directed at wholesale customers only, as defined by the DFSA. This research will only be made available to a wholesale customer who we are satisfied meets the regulatory criteria to be a client.

The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (QFC Branch), regulated by the Qatar Financial Centre Regulatory Authority (the QFCRA), and is directed at business customers and market counterparties only and is not intended for Retail Customers as defined by the QFCRA.

As required by the Capital Markets Board of Turkey, investment information, comments and recommendations stated here, are not within the scope of investment advisory activity. Investment advisory service is provided in accordance with a contract of engagement on investment advisory concluded between brokerage houses, portfolio management companies, non-deposit banks and clients. Comments and recommendations stated here rely on the individual opinions of the ones providing these comments and recommendations. These opinions may not fit to your financial status, risk and return preferences. For this reason, to make an investment decision by relying solely to this information stated here may not bring about outcomes that fit your expectations.