Currencies
Sovereign Pension Funds
August 24, 2007

By Stephen Jen & Charles St-Arnaud | London

Summary and conclusions

SWFs will be one of the most important structural factors for the financial markets in the coming years.  However, in this note, we propose that a closely related ‘cousin’ to the SWFs — sovereign pension funds (SPFs) — also has great potential to be an important force augmenting the impact of the SWFs.  We believe that the SPFs in many countries will become much more outward-oriented than before, just like the SWFs, i.e., the ‘home bias’ is likely to decline sharply for many of these massive funds, with important implications for the international capital markets.  We urge investors to pay attention to this category of funds. 

The idea we have in mind …

We have written on the subject of SWFs, and urged investors to pay more attention to what we believe will be one of the key themes in the coming years. (See Sovereign Wealth Funds and Official FX Reserves, September 14, 2006, Tracking the Tectonic Shift in Foreign Reserves and SWFs, March 15, 2007, Russia: The Newest Member of the SWF Club, April 26, 2007, How Big Could Sovereign Wealth Funds Be by 2015? May 3, 2007, Sovereign Wealth Funds and Bond and Equity Prices, May 31, 2007, Why Japan Should Have Its Own Sovereign Wealth Fund, July 5, 2007, Excess Official Reserves, July 12, 2007.)   However, we don’t believe that the story ends there.  Increasingly, SPFs, most of which are denominated in local currency terms and have been invested primarily in local currency assets, are being invested more aggressively, with higher equity and foreign content in the portfolios.  In fact, many of these funds could eventually be managed by the SWF of the country in question, and could be deployed to purchase real investments overseas, i.e., FDI.  Here are some examples of the SPFs we have in mind:

Example 1.  Singapore’s GIC.  Sometimes the lines between SWFs and SPFs are blurred.  In fact, two SPFs have already been included in my table on the SWFs.   (This is the table I’ve been showing in my write-ups on SWFs.)  Singapore’s GIC, for example, invests not only part of Singapore’s official foreign reserves, but also a part of the CPF, which is the compulsory state social security fund. (The scope of the CPF is wide, covering benefits for retirement, healthcare, home ownership, family protection and asset enhancement.)  This makes the GIC both a SWF and a SPF.(Norway’s GPF is also both a SWF and a SPF.  France and Ireland have similar funds, but they are relatively small in size and their foreign currency content is likely to be modest.) 

Example 2.  Australia’s Future Fund.  Though this fund does not satisfy my strict definition of a SWF, it is likely to have a high exposure to non-Australian assets and will engage in foreign direct investment and, therefore, should be treated like a SWF.  (The Future Fund was established on September 10, 2004, to fund the Commonwealth’s unfunded superannuation liabilities by 2020.  Part of, or all, future federal budget surpluses will be transferred to this fund.  On February 28, 2007, the balance in the Future Fund reached A$50 billion, after the transfer of the proceeds from the government’s remaining stake in Telstra.)  Specifically, while the full capital is not yet fully deployed, my guess is that the bulk (80%) of the A$50 billion under management will be invested outside Australia.   

Example 3.  New Zealand’s Superannuation Fund.  Similar to Australia’s Future Fund, NZ’s SF is an investment fund that accumulates and invests government contributions to partially provide for the future cost of NZ Superannuation.   (This fund was established under the NZ Superannuation and Retirement income Act 2001.  The government plans to allocate NZ$2 billion a year to the Fund over the next 20 years.)  This fund began investing in September 2003 with NZ$2.4 billion.  As of May 31, 2007, the fund’s assets totaled NZ$13.3 billion, and are expected to grow to around NZ$109 billion by 2025.  Its portfolio contains exposure to equities, bonds, private equity and real estate.  Roughly about 80% of the investments are foreign and 20% in NZ. 

Example 4.  South Korea’s NPS.  The NPS has around US$220 billion under management.  While foreign investments currently account for only 10% of its portfolio, the plans are to double this to 20% by 2012 and to 50% by 2040.  It has begun to out-source to external fund managers, and intends to raise its exposure to assets with higher expected returns, such as equities.  Korea’s SWF KIC (Korea Investment Corporation), once it is fully operational, should have the capacity to help manage part, if not all, of the NPS’s assets, in my view. 

Example 5.  Japan’s GPIF.  The GPIF has around ¥157 trillion (equivalent to around US$1.37 trillion) under management: it is a sizeable fund.  Currently, foreign securities (both bonds and equities) account for some 13.1% of the total assets under management (or around US$185 billion).  This is an increase from US$35 billion at the time of the Zaito Reform in 2001 (2.5% of the total FUM back then), but is programmed to be raised to US$243 billion by 2009 (17% of the total FUM).  We first highlighted this structural source of JPY selling in GPIF Outflows as a Medium-Term Support for USD/JPY (August 5, 2004), when I argued that this steady outflow would be a structural headwind for the JPY, and I updated my calculations in GPIF Outflows Still a Headwind for JPY (October 12, 2006). 

Going forward, the risk here is that, after 2009, when the fund is to be managed by a ‘private entity’, it is likely, in my view, that the foreign content will be raised significantly above the target of 17% of the total FUM.  For a portfolio that is US$1.37 trillion, every 1% is worth US$13.7 billion.  An international pension fund with a foreign exposure of 30% is not unreasonable, but that would imply foreign asset holdings of more than US$400 billion — suggesting additional outflows of US$150-200 billion relative to the target level in 2009.  Though this is not quite a sovereign wealth fund (i.e., it is not USD-denominated), a sovereign fund that has US$1.37 trillion under management, with more than US$400 billion invested in non-JPY assets, deserves our attention. 

Why we believe that the SPFs are important

We put together a list of the SPFs for the G10 economies.  (We will try to put together a more comprehensive list that also includes the major emerging countries’ SPFs.)  We make the following observations. 

Observation 1.  These funds are big.  The funds under management in the G10 economies in our sample total US$4.4 trillion, and US$2.5 trillion excluding the US.  This is massive, relative to the US$1.7 trillion in funds managed by hedge funds and US$2.6 trillion managed by SWFs(even netting out the double counting as some funds are both SWFs and SPFs).  Once we have a more comprehensive list of these SPFs, the overall value of their assets will be even more impressive. 

Observation 2.  These funds have a very low exposure to foreign assets.    The sample’s average exposure to foreign assets is only about 19%, compared to 100% exposure of SWFs.  This is the defining difference between SPFs and SWFs.  30% foreign exposure would not be unreasonable for a large country, and this figure should be even higher for smaller countries. 

Observation 3.  This will change, however.  We believe that we will witness a general rise in these funds’ exposure to both foreign assets and equities.  In a way, the same demographic pressures impinging on central banks to separate out their official foreign reserve holdings into a liquidity tranche and an investment tranche also apply to the SPFs.  With declining fertility and mortality rates, all of the G10 countries and much of the emerging world will experience immense budgetary burdens arising from the ageing process.  Far from turning more risk-averse (i.e., buying more bonds than equities, extending duration exposure and minimising currency risks), as predicted by most academic studies, we believe that most pension funds in the world, including especially sovereign funds, will actually move out on the risk-return curve.

In addition to having a greater risk-taking appetite, I believe that globalisation will lead to a greater willingness on the part of these SPFs to hold foreign assets.  Improved information flows on foreign markets, fewer capital controls and a genuine need to diversify assets away from the local markets will all contribute to a general decline in the ‘home bias’ of these funds, in my view.  This is a structural trend, quite independent from my previous point about rising risk-taking appetite. 

Bottom line

The emergence of SWFs is one of the key trends for the financial markets in the coming years.  Investors should also pay attention to some prospective changes in the way some of the SPFs may be invested.  Specifically, we believe we will witness a general rise in SPFs’ exposure to foreign assets and riskier assets (i.e., equities), with logical implications for the global financial markets.   

 

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UK
Fallout from Market Turbulence: A Tale of Two Sectors
August 24, 2007

By David Miles | London

Liquidity and credit quality concerns rumble on. They fuel expectations that central banks will cut rates. But it is very far from clear that cuts in central bank rates are the right response to such market turbulence; someone concerned that lending to an institution whose asset values are unknown, and potentially exposed to crystallised credit risks, is unlikely to change their view because the central bank cut its safe nominal interest rate on short-term borrowing by 25 or 50bp.

It is more likely that central banks, in setting their policy rates — as opposed to the wider set of terms at which they provide liquidity — will focus on the medium-term impacts on the wider economy of any market turbulence and re-pricing of risks. And in considering those potential knock-on impacts on the wider economy, the position is different both between and within countries.

In some ways, the UK economy is quite heavily exposed to wider knock-on impacts of credit re-pricing and availability of debt, though in others it is unusually well-cushioned. It depends very much on which sector one is looking at: households or non-financial companies. Non-financial companies are actually pretty well insulated from the direct impact of the sort of turbulence we have seen in financial markets. Consider the following:

First, the real problems we have seen over the past 10 days in the commercial paper market hardly impact the great majority of non-financial companies. The aggregate stock of commercial paper outstanding for UK non-financial companies fluctuates between about £10 billion and £20 billion. The total liabilities of the UK non-financial corporate sector are about £3.6 trillion. Commercial paper makes up less than 0.5% of liabilities. Outstanding commercial paper is barely above 1.5% of bank loans.

Second, UK non-financial companies are sitting on a load of cash. Currency and deposits held by UK non-financial companies are now close to 50% of annual GDP and over double annual aggregate gross operating surplus.

Third, corporate profitability is unusually high while overall debt gearing is not. The real rate of return on corporate capital in the UK is at a 20-year high.

Finally, as my colleague Lawrence Mutkin recently noted, the cost of credit for most companies has not increased. For investment grade corporate credits, debt costs have not risen over the past few weeks: investment grade corporate credit yields are lower than at the beginning of the month.

The household sector in the UK is less well insulated from a re-pricing of debt and possible tightening of lending conditions. Debt has increased enormously in the past few years and the household saving rate has fallen to roughly zero. (The official data puts the saving rate at a small positive level. But this includes saving made by companies in the form of corporate contributions to company pension schemes. This is a form of highly illiquid and not very transparent wealth to the household sector. Stripping that out, the household saving rate has recently been marginally negative.) Households have relied on a continuing flow of debt to keep consumer spending growing in an environment where disposable income has stagnated.

Increasingly, debt has been made available to people who would until recently not have been able to access credit. UK subprime mortgage lending is a different creature from its US cousin, but it is substantial and has over the past decade grown from small levels. No-one is entirely clear how substantial subprime mortgage lending is in the UK, largely because there is no tight definition of what subprime lending is. On a narrow definition — including only people who have adverse credit histories (that is people who have a history of defaulting) — subprime mortgage lending in the UK in recent years might have been only between 5% and 10% of all mortgage lending. This is a small — though clearly not trivial — part of overall lending to households. But if we widen out the definition of non-prime lending to include those who have no independent evidence on their incomes (so-called self-cert lending), the figures look very much bigger. On that much wider definition of non-prime lending, perhaps between 30% and 40% of lending has been non-prime. If we added in lending where the loan to value is above 95%, we would be at an even higher proportion of new lending.

What is much clearer than the absolute size of the UK subprime sector is that credit conditions there have tightened markedly in the last month. Some lenders have withdrawn from the subprime mortgage market — perhaps temporarily but quite possibly for a sustained period. Nearly all lenders operating in the subprime market have increased their interest rates — generally by around 1%, but in some case by a good deal more.

The knock-on impact of this tightening in credit conditions to households on spending and on house prices is hard to gauge; but it has the potential to be large.

So, it looks as though the fallout from financial market events of the past few weeks could be much more serious for households in the UK than for companies. Of course, companies that rely — directly or indirectly — on sales to UK consumers will get hurt by a marked slowing in consumer spending. To some extent, this is priced in, and worries about the new business volumes for UK mortgage lenders and for high street retailers have been around for some months.

All in all, we see the asset price implications of recent market events as being more negative for house prices than for the values placed on companies.

 

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Euroland
What Now, Mr Trichet?
August 24, 2007

By Elga Bartsch | London

With the September Council meeting approaching fast, it’s going to be crunch time for the ECB. ECB President Trichet had virtually pre-announced another refi rate hike from 4.0% to 4.25% at an impromptu press briefing in early August. At the press briefing he had emphasised, as usual with certain code words, that the ECB does not pre-commit to any particular course of future action. Whether the ECB will be able to stick its initial plan to tighten monetary policy further at the upcoming meeting will very much depend on whether in its view money market conditions have sufficiently stabilised. If the turbulent markets continue to linger and new wobbles emerge, an ECB refi rate hike might seem to become less likely. In addition, the chances of a further firming of monetary policy in the remainder of this year are also falling, we think, because of the emerging downside risks to growth and inflation. That said, there is no mistaking the ECB’s resolve to contain the rising inflationary risks. This past week, it was quick to stress that by conducting an extraordinary longer-term refinancing operation, it does not intend to send a different message on its monetary policy outlook than the one Trichet gave in early August. In my view, this underlines that the ECB is willing to provide liquidity to the market whenever and wherever it’s needed, but not necessarily at bargain prices.

On balance, I still believe that a refi rate hike is marginally more likely than a holding operation, provided that market conditions stabilise in the course of the coming week.But as market liquidity remains fickle and pricing volatile, the subjective probabilities I would assign to both scenarios are close to a toss-up. I would still deem a rate hike marginally more likely because postponing the rate hike by one month would probably not do much to restore market confidence, especially as the ECB will likely want to maintain a tightening bias. To formally go on hold for the foreseeable future —which clearly would help to shore up confidence —would be a stretch for the bank. Remember that the ECB was perfectly happy with the markets pricing in two more rate hikes in the remainder of this year less than a month ago. Despite the August turbulence, the macroeconomic fundamentals in the euro area haven’t changed much in the course of the last four weeks. We would expect this to be echoed by the remaining August business survey due out this coming week, and also by the September ECB staff projections. Hence, hiking now, assuring markets that it would provide sufficient liquidity and refraining from further tightening in the future might seem more sensible.

Last week, we mapped out a worst-case scenario for the global economy in which we could see GDP growth being dented by up to three-quarters of a percentage point globallyand where we would expect G5 central banks to take action to contain the damage to the global economy and the financial system (see After the Shock: Risks for the Global Economy and Markets, August 20, 2007). In the euro area, we pointed to potential downside risks to growth of 0.5-1.0%, primarily for next year. With GDP growth falling below trend for several quarters in the alternative scenario, there would be no need for further tightening by the ECB, we think. The currently present inflationary pressures would likely abate even without further monetary policy tightening. If the slowdown in the economy coincides with a marked deceleration in money and credit aggregates on the back of a noticeable tightening of credit standards by European banks, this would likely affect the ECB’s medium-to-long-term inflation outlook meaningfully. As a result, we could see the ECB lowering interest rates later this year or, more likely, early next year to nip the risk of a credit crunch in the bud.

Apart from ticking off days in your desk calendar to mark the passage of time in the current financial market crisis,which in itself will likely be a factor in determining the impact on the real economy, there are a number of indicators that we would pay close attention to in gauging the potential fallout on the real economy. As the impact in the euro area will likely be mainly on investment spending, we would study the business survey with even greater interest than usual to gauge whether recent events are starting to take a toll on corporate morale over and above what you would expect at this stage of the business cycle. In addition, we would be looking at the monthly monetary statistics published by the ECB, which provide precious information on the dynamics in total bank loans outstanding, and at the MFI interest rate statistics, which summarise trends in new and renegotiated loans extended to euro area residents. Last but not least, the 3Q lending survey due out in October will give a comprehensive overview of how lending standards and loan demand have evolved.

Looking back to previous episodes of sharply rising credit risks(such as the LTCM crisis, the Enron scandal or the GM downgrade), there seems to be no systematic impact on lending trends on this side of Atlantic. If anything, bank lending seems to have gained momentum after some of these events in the past. Indeed, the impact of the current freeze of credit markets on bank lending is ambiguous. If individual borrowers find it more difficult to tap into the capital market directly, they are more likely to turn to the banks again. Hence, after an extended period of dis-intermediation, we might witness a period of re-intermediation by the banking system. At the same time, bank balance sheets could also be negatively affected by recent events. Some off-balance sheet items will likely become on-balance sheet items. Marking to market some of these investments could create a need for exceptional write-offs, which in turn could influence banks’ ability and willingness to lend. At this stage, the net effect is unclear. Therefore, it will be even more important to study the aggregate balance sheet of the euro-zone banking system, underlying the monthly M3 money supply report, carefully.

 

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Currencies
Beware of Structural Headwinds for the JPY
August 24, 2007

By Stephen Jen | London

Summary and conclusions

For as long as general risk-taking appetite is in retreat, the JPY could rally as Japanese investors repatriate and the so-called ‘JPY carry trades’ are unwound.  However, I believe that some investors may be under-estimating the structural headwind that the JPY faces, that the ‘home bias’ in the investment portfolios of the Japanese households is likely to continue to decline.  This is a generational shift, one that can only be offset by either large capital inflows or an outperformance in the Nikkei.  The JPY rally we’ve just witnessed in the past month will not last, I’m afraid.  As risk appetite is rebuilt, the JPY will resume its weak trend. 

Long JPY has been a great trade in this risk-unwind

The JPY crosses have unambiguously been the highest-octane trades in the past month.  Since July 23, NZD/JPY had declined, at one point, by 26.2%, AUD/JPY by 19.6% and EUR/JPY by 9.7%.  Prior to the sell-off, these three crosses were the three most over-valued currency crosses in the G10 space.  To a large extent, the corrections in AUD/USD, NZD/USD and the AXJ currencies were driven by unwinding of tactical JPY shorts (the so-called ‘JPY carry trades’).  But, importantly, there was a temporary spike in Japan’s ‘home bias’, as Japanese retail investors temporarily held back on their purchases of overseas assets, and may have repatriated some of their holdings overseas. 

JPY to resume its weakening trend when risk recovers

While much of the rally in the JPY crosses may have been due to short-covering, I think that they will rise further.  Specifically, I think that USD/JPY will reclaim 120 in the coming weeks, even though I think that the JPY is grossly under-valued.  The key driver will be capital outflows from Japan, which are not the same as ‘JPY carry trades’.  I make the following points: 

Thought 1.  Distinction between ‘JPY carry trades’ and ‘capital outflows’ from Japan.  In my view, the notion of ‘JPY carry trades’ has been grossly exaggerated.  Data don’t support the view that JPY carry trades — strictly defined as trades that capitalise on the cash yield differentials between Japan and elsewhere — were that large.  (In its latest Selected Issues report on Japan (IMF Country Report No. 07/281), the IMF reports that estimates on the size of the JPY carry trades vary from US$100 billion to US$2 trillion, but suspects that the actual figure is closer to the lower end of this wide range.  The IMF also reports, in the 2007 Article IV Staff Report, that the stock of foreign investment by Japanese residents (households and institutional funds) doubled from 60% of GDP in 2000 to 120% in 2006 (valuing at US$5.25 trillion).  Retail investments through mutual funds have been the key source of outflows.)  I’m not disputing that there were JPY carry trades; but I challenge the widely held belief that they were dominant in size. While on-line trading (mostly carry trades) has risen sharply, foreign currency deposits at banks have declined sharply, roughly matching the size of the volume of online trading. 

Rather, the more important story, in my view, is capital outflows from Japan, motivated by a generational shift in risk appetite that began last summer.  Associated with this idea is the notion that the ‘home bias’ of Japan’s investment portfolio is still too high.  My back-of-the-envelope calculation suggests that, for Japan’s households to have a similar portfolio (in terms of foreign content) to those of the other OECD countries, Japan would need to export US$10 billion of capital flowing into securities (equities and bonds) per month for the next 20 years.   (Japan’s households control about US$13 trillion in liquid financial assets.  At present, 50.5% of this capital is on deposit or in cash, and only 40% is in securities.  The analogous figures are 10% and 83%.  So, for Japan’s balance sheet to look like that of the US, Japan’s households would need to convert 1% of total investment worth of deposits into investments in securities each year for 20 years.  1% of US$13 trillion is US$130 billion, a year.  This translates into a little more than US$10 billion a month.)

In the past few months, Japanese retail equity outflows have been 7-8 times the size of bond outflows.  (Monthly investment trust equity flows have been running at around US$16 billion or so, compared to US$2 billion in monthly uridashi outflows.)  Japanese retail investors are much more interested in foreign equity markets (especially those in Asia) than the pick-up in the cash yield.  The important implications are that (1) BoJ action should not be that important in driving the JPY (The window of opportunity for the BoJ to tighten has closed dramatically in recent weeks.  The main argument the BoJ has been using is that, despite the low inflation data, the ‘second perspective’ may suggest that it should keep normalising rates.  One of the considerations in the ‘second perspective’ is equity and other financial market conditions, which have deteriorated sharply in the past month, restraining the ability of the BoJ to tighten.) and (2) while JPY carry trades may be discouraged by higher volatility, JPY could still weaken due to structural capital outflows. 

Thought 2.  State-run funds are likely to continue to diversify as well.  The GPIF is in its sixth of eight years of its diversification programme.  It is large (US$1.37 trillion), and will continue to raise its foreign exposure until 2009 (please see my other note, Sovereign Pension Funds, August 23, 2007).  Between now and March 2009, the GPIF will export around US$30 billion a year.  Beyond 2009, my guess is that another US$150-200 billion will be exported by the GPIF.  Other public-run funds such as Japan Post also have a very high ‘home bias’ and bond bias.  This will likely change over time, as they seek more foreign and equity exposure. 

Thought 3.  The long-term fundamentals of the JPY are good, however.  Over time, however, I think that the JPY should do well.  First, it is cheap.  On our measure, the fair value of USD/JPY is 103 and that of EUR/JPY is 110.  Second, the economic fundamentals are good.  Total factor productivity continues to be the biggest contributor to overall growth, bigger than capital deepening or labour growth.  Third, headline output growth has been at or above trend for three years, and will likely remain so for another two years.  All these factors are implicitly captured by our valuation work.  However, structural capital flows could ‘temporarily’ distort the JPY’s market value from its fair value.  How long ‘temporary’ lasts depends on the strength/size of these cross-border flows. 

Thought 4.  In the near term, the risk to the JPY seems to be biased to the downside.  I think that as risk is rebuilt, the JPY will likely resume its weakening trend.  While some carry trades may be rebuilt, more importantly, Japanese households are likely to resume exporting their capital to foreign equity markets, in my view.  (I find the dichotomy between the performances of the equity and money markets this week most remarkable.  In my view, equity markets should better reflect the strong global economic fundamentals, while the money/credit/bond markets reflect more the liquidity problems that still plague them.  Equities and money markets don’t have to be in sync.  If the Fed cuts the FFR in the coming days, I think that global equities will rally sharply higher, even if the reaction in the money markets may be ambiguous.  The fundamental problem in the credit/interest rate markets is an information deficit, something that takes time to resolve.  But the stabilisation of the global equity markets this week suggests to me that we are not likely to be dealing with a wholesale deleveraging process, and that a process of resolution that is credit-specific may be possible in the weeks ahead. 

I think that currencies will follow equities, not the money markets.  In my framework, general ‘risk-taking’ will be measure by the buoyancy of the equity markets, not whether the interest rate markets function well at ‘normal’ prices.  If equities continue to rise, so will USD/JPY and NZD/JPY.  If the Fed cuts by 50bp in the coming days, I think that this scenario will play out, as I think that Fed action will have traction in the equity markets, regardless of whether the knot in the interest rate markets is untied.  )

Thought 5.  Keep looking for the trigger for the JPY to genuinely appreciate on a sustained basis.  I believe that the long JPY trade has been an opportunistic/tactical trade, one that would work when the world was in a risk-reduction mode.  But this trade will cease to work as soon as investor sentiment stabilises, in my view.  For the JPY to appreciate and retain its strength, I believe that Japanese equities will need to outperform to attract the attention of the Japanese investors, who are not necessarily in love with foreign assets; they are simply more tolerant of risky assets that perform well.  Thus, if the Nikkei outperforms, I think there is a good chance that much of the capital may stay at home, permitting the JPY’s good fundamentals to be revealed in the spot rate.  However, until that happens, or unless we get another bout of risk aversion, the JPY will likely drift lower.  In a way, there is a ‘JPY Smile’, much like the ‘Dollar Smile’. 

Bottom line

I believe that the JPY crosses will drift higher, if we can trust in recent risk-rebuilding in equities.  In my view, the key propellant of this will be capital outflows from Japan, including JPY carry trades but also other types of investments.  Japan’s ‘home bias’ is still too high and great scope still exists for Japan’s households to have a higher foreign and equity exposure.

 

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Japan
Welcome Back, ZIRP?
August 24, 2007

By Takehiro Sato | Tokyo

Third rate hike likely to be put off until December

The turmoil sparked by the subprime issue has forced the BoJ to alter the course of its rate hike strategy. This is likely to mean that the next (third) rate hike does not take place until December at the earliest. Following the decision not to hike the rate at the August Monetary Policy Meeting, for a start, it seems only natural to expect that, in the interests of international cohesion, at the next MPM (September 18-19) Japan too will veer towards putting off a rate hike if the Fed has cut its rate and the ECB delays the hike it has already announced. If so, it should also be difficult to opt for a hike at the two meetings in October (October 10-11, 31) or the one in November (November 12-13). This is partly because the next Tankan in September (due for release October 1) is very likely to point to a fall in the headline figures (and in any case the September Tankan habitually tends to focus solely on the headline numbers). Plus it is also possible that in the Outlook Report at the end of October, the BoJ will downgrade its base scenario owing to a weakening outlook for overseas economies, which would undermine the rationale for a rate hike at the November meeting coming hot on the heels of such a downgrade. Ultimately, assuming that the December Tankan (due out December 14) brings confirmation of underlying firmness in corporate sentiment, and that corporate management does not revise down earnings forecasts by very much following the interim, we think that the soonest another rate hike might occur would be at the December MPM (December 19-20). A more orthodox progression of events would probably involve an interim appraisal of the scenario downgraded in the October Outlook Report at the January 2008 MPM (January 21-22), and a decision on whether on not to hike rates on that basis. As such, the possibility of next rate hike being put off until January-March next year is not that slight either.

A rate cut or return to ZIRP seem unlikely

Even so, we anticipate underlying firmness in domestic economic fundamentals, making it unlikely that the BoJ would go so far as to cut rates — or return to ZIRP (a zero interest rate policy) — even if the US does. For a man who as a member of the Fed’s Board of Governors argued during his BoJ visit that Japan might escape from deflation if the BoJ adopted a non-conventional approach to buying assets other than government bonds (even if it was only ketchup), it might be a relatively easily matter for Ben Bernanke, now Chairman of the Fed, to arrive at a decision to make the unconventional move of purchasing asset-backed commercial paper, say, in response to the credit crunch currently taking place on his own doorstep.

With regard to domestic fundamentals, although poor weather and the effects of higher residents’ taxes kept a lid on consumption up until July, the very hot weather in August and the likelihood that the effects of the tax increases will wear off marginally in October-December should gradually restore a sense of recovery from the early autumn, alongside a firm employment trend. Manufacturing, too, should come through the output curbs in the wake of the July earthquake, and momentum for production growth should increase from the July-September quarter, in particular for digital consumer appliances, in the build-up to the expected demand peak in April-June 2008 just ahead of the Beijing Olympics. Indeed, Governor Fukui himself looked fairly upbeat on the outlook for domestic manufacturing production in his regular press conference after the August MPM. At the same time, however, he gave no clear sign of an extremely forward-leaning stance on a near-term hike, saying that the BoJ will carefully monitor the ongoing turmoil in the overseas credit markets as to the negative effects on the overseas economy, and on corporate financing and confidence on the domestic side. 

Pace of subsequent rate hikes should also be slower

The consensus has been that rate hikes were likely to continue at a rate of one every six months or so, but the important lesson now learned is that — particularly where Japan’s monetary policy is concerned — consensus has no value. We think it a foregone conclusion that the BoJ’s argument for shifting the emphasis towards a ‘second pillar’ (risk of asset prices overshooting) and justifying a normalization strategy has already collapsed. Indeed, we see glimpses of ‘inconvenient truths’ in several areas — not only the upheavals in the credit and stock markets triggered by the subprime debacle, but other indications of a change in tone in the asset markets and further languishing of fund demand. Specific examples are a waning appetite for land acquisition among non-manufacturers, and heightening activity in debt repayment by SMEs and households, as well as growth in small-scale bankruptcies. If these are no more than one-offs, then there should not be all that much deviation from a normalization policy which looks to the next two years or so. However, whereas overseas credit markets had become rather inflated, possibly by some bubble-type factors, these phenomena in Japan show that domestic ordinary companies and many households have been espousing sound financial management, and we think this could continue going forward. For example, when urban land prices soar, companies are now the first to rein in land investment rather than busting a gut. As long as companies maintain this sensible approach, the meaning of a strategy that emphasizes the second pillar could easily become obscure. Ultimately, we expect the strategy of raising rates roughly once every six months to go into retreat, and the pace to slow to about once every nine months, if that, from December.

Summary of our interest rate outlook

Our ultimate view is that policy rates will only reach 0.75% by the end of F3/08, and rise to 1.00% at the highest by the end of F3/09. Moreover, while we would expect the spread between the Lombard rate and the policy rate to widen to 0.50% once the policy rate hit 1% following careful scrutiny of the impact of Post Office privatization from October this year on the short-term markets, we do not think that the BoJ will go about trying to widen the spread in any particular hurry.

Growth in long-term rates is likely to be limited, even with a total hike of 50bp in the policy rate during the forecasting period, and resistance is likely to remain firm at 2%. We have already been forecasting that the core inflation rate will not go beyond +0.1% in F3/09 on average, and we anticipate protracted dis-inflation. In these circumstances, the markets are unlikely to sympathize with a rate hike, and the curve is likely to become still more bear-flattened. On the supply-demand side, although banks are not currently significant buyers of bonds, we expect them to resume more of a presence in the bond markets as lending decreases with depressed demand for funds. Buying on pragmatic grounds by real money investors such as life insurers and the like should also help lessen market volatility. 2% is an appealing level for 10-year rates in terms of the relationship between their lending rates and cost of debt, and hence, even if the policy rate were to reach, say, 1.0%, we would not expect the 10-year JGB yield to move significantly higher than 2%.

Risk factors: Change of BoJ leadership, though current policy should generally be maintained

The risk in the aforementioned conservative scenario is that policy could swing sharply towards either easing or tightening with the changes in BoJ leadership in March 2008. For example, the Democratic Party, which became the leading party at the Upper House election, previously called for rate hikes favoring depositors, and one concern is that the next governor could be someone who follows this course advocated earlier (for example, Eisuke Sakakibara, the Democrats’ shadow finance minister). That could raise the risk of interest rate normalization being pursued without regard to the outlook for the economy or prices. On the other hand, should a supporter of reflation (such as Takatoshi Ito, member of the Council on Economic and Fiscal Policy) be nominated, far from the pace of rate hikes slowing, the possibility of an about-turn to ZIRP could even arise. Our view in reality is that even if there was a move to nominate someone with such distinctive views as the next BoJ governor, consistency of policy would largely be maintained. This is because, first, the Policy Board operates a collegial system of its nine members and only has the right to execute one vote, even for the governor, and second, we would expect one of the two deputy governors to come from either within the BoJ or the old boys’ network (e.g., Masaaki Shirakawa, a past executive director), who would likely play a key role in forming consensus within the Board. Even so, it seems obvious to all who care to look that the logic of a normalization strategy based on ‘two pillars’ is falling apart, suggesting that some of the issues for the next leadership will be rebuilding the framework based on ‘two pillars’, reviewing the function of ‘understanding price stability’ along lines more akin to setting an inflation target, and like the Fed and ECB, shedding some light on the policy path prior to the event.

 

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