Global
The 2007 Financial Crisis: Inflationary or deflationary?
August 27, 2007

By Eric Chaney (London)

Once volatility in the money and credit markets comes down and the dust settles in the financial markets at large, investors and policy makers will have to ask themselves: Was the 2007 financial crisis inflationary or deflationary?  It is probably too early to answer with certainty, yet it is possible to build a simple macro framework to address the question (see ‘After the shock: Risks for the global economy and markets’, August 20, 2007).  My personal hunch is that the leveraged credit crisis will eventually help cool some of the cyclical inflationary pressures that were emerging before its outbreak.  However, the final answer will depend largely on the behaviour of the largest central banks in the world, Fed, ECB, BoJ, PBoC.

As I see it, there are two main deflationary factors and one possible inflationary channel.

Deflationary factor #1:   A wider global output gap

Even if the financial market crisis settles quickly, some companies may have experienced difficulties to fund their short-term liabilities in the US and Europe as well, since commercial paper markets have reacted similarly.  If the normalisation takes more time (several weeks), which is likely to be the case after the series of bad surprises on credit quality that have hit lenders who trusted rating agencies, we think retail and wholesale banks could face both funding difficulties and balance sheet losses.  Since banks on both side of the Atlantic are well capitalised, a full blown 1991-1992 type credit crunch is unlikely.  However, a milder form of credit crunch, i.e. banks tightening credit standards without intrinsic changes in their customers’ credit quality, would probably prove negative for non-financial companies.  In the euro area, this matters all the more, since corporate investment has been the main driver of the domestic recovery so far.  In a second stage, companies are likely to revise down demand expectations and cut spending (inventories, capex and flexible labour), thus amplifying the expected slowdown in aggregate demand.  This is the well known (inverted) accelerator effect.  In the end, with production scaled back, unemployed capacity would rise on a global basis.

Since most of the adjustment is likely to take place in the manufacturing sector, by far the most sensitive to demand gyrations, we have simulated the impact of a 1.5 percentage point decline of the manufacturing operating rate on core inflation in the G7, spread over the next six quarters (see ‘How much inflation is in the pipeline?’, June 20, 2006, for details on the model).  This would just bring back the operating rate to its long term average, and thus would be associated with a slowdown, not a recession.  On our estimates, it would cut inflation by 30 bp by mid 2009.

Deflationary factor #2: Lower commodity prices

The price of crude oil has already reacted significantly to the financial turmoil, even though the supply/demand balance has barely changed since early July.  Markets may have already anticipated that overall demand will slow more sharply than expected, but there are some competing explanations, such as the sudden rise of risk aversion and its impact on future and derivatives markets, or the unwinding of long positions by funds needing cash to cover losses in structured credit assets.  Hence, a ‘real’ slowdown in demand for crude oil in the coming quarters, due to slower global growth, would probably intensify downward pressures on crude quotes.  On the other hand, OPEC producers could try to halt the price drop by cutting production in order to keep the cartel’s basket price ($67.0 on August 23rd, down from $73.7 on July 20th) above, say $60.  This strategy could prove dangerous if implemented in times of uncertainties about the global economy, since it could make companies even more risk averse in their spending decisions and thus initiate a vicious circle which would ultimately cut demand for oil further and depress oil exporters’ income.  Yet, it cannot be excluded.

Our rule of thumb is that a 10% decline in the price of crude oil (from $66/bbl this year to $60 next year, for instance) would trim another 20bp from headline inflation.

Inflationary channel: De facto monetary policy easing

Since the quasi shutdown of the commercial and asset backed commercial paper markets and the overshooting of overnight rates in interbank markets, both the ECB and the Fed have injected liquidity in the markets almost ad libitum, without managing to fully quiet down the financial markets.  They are likely to pursue the same varieties of quantitative policies in the short term.   This is a de facto monetary easing, even if neither of the two institutions has changed its main instrument, the fed funds target and the refinancing rate.  Injecting liquidity in order to re-liquefy the markets that have dried up is imperative.  However, going too far may prove inflationary in the end, by fuelling excessive credit growth once the economy is recovering.  In this regard, changing the interest rate path more than expectations of slower growth should warrant, as was done in the aftermath of 9/11/2001, could re-ignite inflationary pressures over the next two to three years.

Net net, the shock should prove disinflationary

On balance, I concur with my colleagues Richard Berner and Joachim Fels who write that ‘this shock is disinflationary’ in their global assessment.  As far as central banks are concerned, walking the fine line will prove challenging, given the uncertainties surrounding the exposure of real economies to a crisis hitting financial instruments that did not exist in previous financial disruptions.  At this stage, central bankers seem reluctant to lower their guards, worried as they are by moral hazard issues, i.e. by the risk of bailing out agents that may have bet on the unconditional help of authorities even when taking reckless financial decisions.  In my view, the risk could be that they underestimate the deflationary factors I have detailed.  In this regard, I see no urgency whatsoever for the ECB to raise its refinancing rate to 4.25% in September.  Building a robust assessment of economic and market conditions before acting should be ‘of the essence’ in the current circumstances, in my view.

 

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China
‘Non-linear’ Impact And China-US Decoupling
August 27, 2007

By Qing Wang (Hong Kong)

In one of our recent research notes, we argued that the potential impact of the subprime crisis on Chinese economy could be ‘non-linear’ (see “China Economics: Potential ‘Non-linear’ Impact of Subprime Crisis”, August 16).  Some clients have asked how the ‘non-linear’ impact under the two different scenarios – benign and adverse – is linked with the issue of China-US decoupling.  In particular, some wonder that, since the Chinese economy has decoupled from the US economy, whether the adverse scenario we described in our earlier note has not been overplayed.

Headline GDP growth data indicate that there appears to be a ‘China-US decoupling’.  However, this is in part due to an ‘investment-consumption decoupling’ in the US economy, in my view.  If US consumption were to weaken substantially in the aftermath of the subprime crisis – adding to already weak investment – and thus lead to a recession in the US, I doubt there would be a meaningful US-China decoupling, and the adverse scenario may well materialize.  This is not the baseline scenario I envisage for China, however.  My baseline scenario is broadly similar to the ‘benign scenario’ described in our earlier research note: China will continue to experience robust growth and excess domestic liquidity stemming from sustained FX inflows.  Judging from the policy moves made last week, I think Chinese policy-makers have envisaged a benign scenario as well.

On the downside, US consumption may turn out to be less resilient than currently envisaged, threatening China-US decoupling.   While there is considerable flexibility for aggressive policy action to offset substantially weaker external demand, such that China’s GDP growth may look rather benign ex post even under the adverse scenario, the financial indicators at the corporate level (e.g., earnings, profitability) and hence stock market performance may not, in my view.

‘Non-Linear’ Impact Of Subprime Crisis: A Recap

In a benign scenario, the crisis would remain a market event instead of an economic one (i.e., no recession in the US economy as a result), China’s economic growth would remain robust, and China would likely experience more capital inflows, reflecting a ‘flight to quality.’   Hence excess liquidity and the attendant issues (e.g., risk of overheating, asset price inflation) would persist.   In an adverse scenario, if the US economy were to be knocked into a serious recession as a result of a substantial weakening in US consumption, China’s economy would be negatively affected by the resultant slower exports.   Under this scenario, China’s growth would slow, disinflation/deflation would emerge, and the asset markets would tumble.

On the policy front, under the benign scenario, we would expect the PBOC to continue its efforts to mop up excess liquidity, in conjunction with rate hikes – the timing of which might be chosen more discreetly to minimize the psychological impact on the rest of the global markets – and faster Renminbi appreciation against the US dollar.   Under the adverse scenario, we would expect the PBOC to halt its rate hikes and stay on hold and the pace of Renminbi appreciation to slow, while the fiscal policy stance might be loosened substantially to boost domestic demand.

If Decoupled, Why ‘Non-Linear’?

Some clients have asked how the ‘non-linear’ impact under the two different scenarios – benign and adverse – is related to the issue of China-US decoupling.   In particular, some wonder whether, since the Chinese economy has decoupled from the US economy, the adverse scenario we described has not been overplayed.

Indeed, headline GDP growth data indicate that there appears to be a ‘China-US decoupling’.   While US GDP growth started to moderate from 3.3%YoY in 1Q06 to 1.8%YoY in 2Q07, China’s GDP growth has actually accelerated from 9.9%YoY in 4Q05 to nearly 12% YoY in 2Q07.   This seems to suggest that the negative impact of developments in the US economy – including the subprime crisis – on China should be rather limited.

However, the seeming China-US decoupling has in part reflected a ‘consumption-investment decoupling’ in the US economy, in my view.   Private domestic investment in the US started to decline in 2Q06 and has since registered negative year-on-year growth for three consecutive quarters. Meanwhile, personal consumption expenditure in the US has demonstrated remarkable resilience and its growth rate was broadly stable around 3.0%YoY in the most recent three quarters.

Given that personal consumption expenditure still accounts for 70% of US GDP, if US consumption were to weaken substantially in the aftermath of the subprime crisis – adding to already weak investment – and thus leading to an economic recession in the US, I doubt there would be a meaningful US-China decoupling, and the adverse scenario may well materialize.   After all, China’s direct exposure to the US market through the traditional trade channels remains large, as the US is the destination for about 20% of China’s total exports.   Factoring in China’s indirect exposure to the US market through third countries, the impact of developments in the US on China would be even larger.

Globalization: A Double-edged Sword for China

China has been reaping the greatest economic benefits from globalization.   Exports have been the primary driver for growth in the current cycle.   In the five years subsequent to China becoming a member of the WTO in late 2001, the country’s exports have grown by an average of 30% p.a., more than double the average pace of 12% in the previous five years (1997-2001).   Exports expanded by another 28%YoY in 1H07.   We estimate that exports now account for over 40% of GDP.   With such large exposure to external demand, the Chinese economy is vulnerable to a substantial weakening in external demand.

In this context, it is logically inconsistent to make the following two statements simultaneously, in my view: a) “China’s strong economic performance in the past few years has been attributed to globalization”; and b) “China will be able to de-couple from the US regardless”.   Specifically, if the most powerful growth engine – the US economy – shifts to a low gear, there are still ‘N-1’ smaller engines running (as our colleague Stephen Jen often puts it in his research notes), keeping the global economy going.   However, if the most powerful growth engine – the US economy – shuts down completely, the rest of ‘N-1’ smaller engines – including the Chinese economy – would be unable to work properly, in my view.

A Benign Baseline Scenario

The baseline scenario I envisage for China is not the adverse scenario but rather similar to the benign one described earlier.   The current assessment made by our global economics team led by Dick Berner and Joachim Fels is that “a severe US and global downturn are still unlikely.”   (See “Global Economics: After the Shock — Risks for the Global Economy and Markets” August 20).  Against this global backdrop, China should be able to maintain robust growth despite increased downside risks to the US economy, in my view.

In particular, a continued broad-based upswing in the EU economy would underpin China’s exports.   China’s exports to the EU have outpaced those to US by a significant margin since 2003, likely resulting in the EU overtaking the US as the largest destination market for China’s exports in this year.   Therefore, even if China’s exports to the US were to soften further in the aftermath of the subprime crisis, China’s overall export growth will unlikely slow significantly provided there is no substantial weakening in US consumption.

The Scenario Envisaged by Policy Makers

Recent policy moves by the Chinese authorities suggest that policy makers have perhaps also envisaged a ‘benign scenario’ for China, and their policy focus is on addressing the risks of economic and asset price overheating in China.   As soon as the global markets showed signs of stabilizing upon the US Fed’s decision to lower the discount rate by 50 bp, the Chinese authorities made two policy announcements.   On Monday, August 20, China’s SAFE announced that retail investors will be allowed to invest in the Hong Kong market directly.   Retail investors who invest through this particular program are not subject to the US$50,000 annual cap that is currently imposed on individual Chinese residents.   This is a theoretically bold move to move toward ‘managed capital account liberalization’, in my view.   The main purpose is to facilitate FX outflows to ease domestic excess liquidity and the pressures on Renminbi appreciation.   In my view, the timing of the policy announcement suggests that the authorities may have considered the recent sell-off in the Hong Kong market as temporary and providing a good buying opportunity for Chinese retail investors.

On Tuesday, August 21, the PBOC hiked the base deposit and lending rates by 18 bp and 27 bp, respectively.   This rate hike is broadly in line with our expectations. However, its exact timing (i.e. on a Tuesday) was a bit of a surprise to us.   We suspect that the authorities may have been preparing to hike the rate on the previous Friday, but decided to hold off with a view to avoiding exacerbating the then heavy selling pressure on global markets.   The PBOC justified the rate hike by “the need to reasonably control money and credit expansion and stabilize inflationary expectations.”

In fact, from a policy perspective, the disinflationary effect of somewhat weaker external demand would be a welcome development for the Chinese economy, which runs the risk of overheating at the current juncture.

Risks

US consumption may turn out to be less resilient than currently envisaged, threatening the US-China decoupling.   While there is considerable flexibility for aggressive policy action to offset a substantially weaker external demand, such that China’s GDP growth may look rather benign ex post even under the adverse scenario, the financial indicators at the corporate level (e.g., earnings, profitability) and hence stock market performance may not, in my view.   This is because government-spending-driven growth will likely have quite different impacts on sectors and companies compared with externally-demand-driven growth, especially during the transition from one type to another.

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Currencies
CHF: After the Carry
August 27, 2007

By Luca Bindelli (London)

Our Bias Is for Renewed Weakness
Short-term uncertainty remains substantial in financial markets. However, the recent liquidity injections by Central Banks likely helped keep volatilities upper bounded in the short run at least. In our opinion, this constitutes a potential short-run negative for the CHF. Moreover, implied volatilities are decreasing fast and risk taking is coming back fast as well, as reflected by the rebound in equity markets. While we suspect that volatility may not go back to pre-crisis levels for a while, carry trade attractiveness has risen again.
Carry Unwind Appears Limited
It is interesting that during the recent crisis, the CHF remained relatively less affected by carry trade unwinding, especially when compared to the JPY.  Carry trades in CHF are often related to loans (and other mortgages) in other European countries — in particular Eastern Europe. 
Accordingly, we looked at the non MFI loans extended in CHF (at constant exchange rates) in both the Euro Area and Hungary since 2003. Starting with Hungary, we observe that loans have indeed been growing continuously, albeit at a decreasing trend. Also, after the May-June 06 risk reduction episode, loans extended in Hungary only decreased 1.2%Q in 3Q06.  In 1Q07, these loans were equivalent to CHF25 billion, which we would deem relatively modest in size.  In the Euro Area, loans extended in CHF have been decreasing since end-2005 but remained stable in early 2007.  As of 1Q07, these loans represented CHF151 billion.
While Hungarian loans in CHF increased in early 2007 by 14%Q, we suspect that overall funding pressure on the CHF coming from these loans is fading. Moreover, this anecdotal evidence suggests that the risk of unwind of the carry trade is rather limited, and that it should not bear any strong impact on the CHF.
Fundamentals Should Gradually Take Over
Since the last rate hike in June, the CHF strengthened by 1.4% on a trade-weighted basis. While this may seem modest, this is equivalent to almost 50 bp of tightening according to the MCI trade-off used by the SNB.  We do not think that this will prevent the SNB from raising rates in September, however, as the economy is still performing very well and is unlikely to suffer significantly from the current financial turmoil.  We think that the most likely outcome is for the SNB to continue its gradual tightening despite the recent turbulence.
While the Swiss growth path may not be left untouched by the financial crisis, it is still likely that several factors will help the economy avoid or a least dampen any substantial impact.
First, while any “sneeze” in the EU growth engine should ultimately cause Switzerland to “catch the flu”, we think that past CHF depreciation will continue to influence the Swiss external competitiveness positively and delay the transmission of any EU weakening. In fact, since December 2004, the BIS Broad Real Trade Weighted Index has lost 11.6% and paralleled the continuous real export growth since 2004.  Also, the Swiss economy remains relatively more exposed to the current buoyant global growth, especially to the emerging economies.
Second, better export diversification is likely to help external growth remain solid, despite a US slowdown. In fact, between 1998 and the first quarters this year, the export share to the EU and the US both decreased in favor of faster-growing emerging economies.  Moreover, while Swiss exports share to the EU and US have decreased from 65% and 11%, respectively, to 60% and 8%, export shares to Asia and EMEA increased from 8% and 4% to 11% and 6%. Any direct contagion of a US slowdown through lower exports to the US should be modest, in our opinion.
While indirect exposure through economic partners’ external activity may be more substantial in nature, we still consider a US slowdown as our central case rather than a full fledged US recession. To us, this suggests not only a reduced impact on the global economy, but also a higher likelihood of economic decoupling from the US.
Third, as we highlighted in the past, the ongoing structural domestic changes in Switzerland are probably starting to feed through the economy. In particular, the 2Q employment figure (the first data point covering the full liberalization of the labor market) suggests that employment grew 2.4%. This is the highest rate since 2000. Importantly, the vacancy index grew by 32%. This bodes well for employment growth and domestic consumption going forward.
Finally, while investor sentiment is a bit gloomy, as apparent from the most recent ZEW survey, corporates are still very confident. The KOF survey showed that all sectors remained optimistic about the near future and are expecting further strengthening of demand.
In the longer term, we believe that from the currency-market standpoint, the transition to economic fundamentals will be forced through a gradual policy tightening. In addition, the current re-pricing of risk will likely take some time, and remaining uncertainties on US economic growth and the financial crisis spillover to the real side of other economies should help keep volatilities higher than pre-crisis levels.  If sustained, this may slightly facilitate this transition to fundamentals.

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