‘An Era of Inflation’ Dawns For China? Not So Early
September 11, 2007
By Qing Wang | Hong Kong
Headline CPI in August hit +6.5% YoY, driven by food price inflation of +18.2% YoY. This was an acceleration from 5.6% YoY in July and the highest headline CPI reading in a decade. I met a number of investors in the last week or so. China’s inflation outlook was always the No. 1 topic during the discussions. In particular, some investors are wondering whether inflation in China is not out of control and ‘an era of inflation’ has not dawned for China. Inflation in China is not out of control and to call ‘an era of inflation’ for China is premature, in my view. This current round of inflation is cyclical, rather than the onset of secular inflation. Although it has been driven primarily by a surge in food prices, I believe it has largely reflected demand-side pressures instead of supply-side factors (e.g., shortage of food supply or tight labor market). Under demand-side pressures, the prices of food, for which the supply response is relatively slow, tend to rise much faster than non-food prices. However, as long as inflationary expectations are anchored by stable non-food price inflation and policy measures, food price inflation is unlikely to translate into wage pressures, thus helping prevent widespread and persistent inflationary pressures, in my view. More generally, China’s surplus labor and rapid labor productivity advancement should continue to help contain inflationary pressures despite fast nominal wage growth over the next several years at least. On the policy front, I expect the PBoC to hike base rates twice more — with the next rate hike likely to be made this month — in the remainder of the year and to continue with its withdrawal of liquidity with a view to bringing money supply (M2) growth below 17% toward the year-end. These measures should be viewed as the authorities’ effort to manage inflationary expectations by ensuring positive interest rates instead of outright monetary tightening. There is a possibility that the authorities may be too slow to implement adequate tightening measures and thus miss the window of opportunity to bring inflationary expectations under control. If headline inflation were to remain above 5% through 1H08, I fear that inflationary expectations would become deeply entrenched, making tackling inflation much challenging. By the end of 1H08, and with the new government settling in, the authorities may be ready and have to take aggressive tightening measures to control inflation, which may risk causing a hard landing of the economy in 2H08 or early 2009. ‘An era of inflation’ dawns for China? Headline CPI in August beat our and market expectations (+6.0% and +5.9%), reaching +6.5% YoY, driven by food price inflation of +18.2% YoY. This is an acceleration from 5.6% YoY in July and the highest headline CPI reading in a decade. Some market observers have made the call that ‘an era of inflation’ has dawned on China. Indeed, China has seen double-digit GDP growth since 2003, with only moderate inflation, and this cannot last forever. The ‘universal law of gravity’ should apply to China, too — as the economy expands, the Chinese economy should eventually hit supply constraints, and inflation should emerge accordingly. Moreover, economic theory suggests that inflation is an unavoidable outcome, if an undervalued exchange rate is maintained for too long. Given that China is already experiencing broad-based asset price inflation — driven by excess liquidity stemming from persistent and sizable FX reserve accumulation that is symptomatic of an undervalued currency — it seems only a matter of time before widespread goods price inflation emerges. Indeed, the call that “inflation in China is not out of control and ‘an era of inflation’ has not dawned on China” is not easy to make, especially when both the theory and the latest developments appear to suggest the opposite. Understand China’s inflation: A conceptual framework Before elaborating on my call, let me first present a conceptual framework that I use to understand China’s inflation. Assume that Country A only consumes two kinds of goods — food and clothing, each accounting for a 50% weight in the consumption basket. Moreover, Country A has a large pool of surplus labor and tends to invest a lot in the clothing-producing industry, so that it always produces more clothing than it can consume and thus exports the rest. In this context, firms in the clothing-producing industry have little pricing power because of fierce competition among domestic producers. If Country A’s central bank runs a loose monetary policy and stimulates domestic demand, the resulting inflationary pressures will be manifested first and foremost in increased food prices rather than in increased clothing prices. In a demand-supply framework, because the supply curve for clothing shifts to the right — reflecting overinvestment and cheap labor — much more readily than that for food, the price increase in response to a positive demand shock (due to loose monetary policy) is much more pronounced in food than in clothing. Such an example, though rather crude, broadly fits China’s reality, in my view. Specifically, food items and manufactured goods currently account for about one-third and 40% of China’s CPI basket, respectively. Based on the above analysis, food items are the most sensitive to changes in underlying monetary conditions among the CPI basket components, in my view. In other words, inflationary pressure stemming from loose monetary conditions tends to be reflected in food price inflation first. In this context, although the current round of inflation — like that in 2004 — is being driven by a surge in food prices, it is not due to a supply shock, in my view. In this conceptual framework, inflation dynamics will work in the following sequence: positive demand shock à rapid rise in food price inflation à moderate headline CPI inflation due to stable non-food price inflation à food supply response + tightening policy measures à food price inflation eases à headline CPI inflation eases. I believe that this explains the development of inflation in 2004 and helps form the inflation outlook for this round of inflation as well. Tight food supply in China is not necessarily a source of secular inflation In the framework above, since the slow response of food supply under demand-side pressures is responsible for a rapid rise in food prices and thus headline CPI inflation, one may ask whether tight food supply in China will not become a source of secular inflation in China. After all, the level of arable land per capita in China is only about 40% of the world average. With income increasing fast, demand for food and related products in China may well outpace supply, generating sustained upward pressures on food prices. This is a legitimate question. However, the tight food supply in China helps explain China’s food price-driven inflation only to the extent that strong demand for food from China has driven up food prices globally, in my view. Agricultural goods in general and food items in particular are almost perfectly tradable goods in the world market. Tight food supply in one country can be alleviated by increased imports from other countries. Therefore, I do not believe that tight food supply in China will necessarily constitute a source of secular inflation in China, unless global food supply cannot keep up with strong demand from such rapidly growing populous countries as China and India. In this context, to make the call that ‘an era of inflation’ has dawned for China due to tight food supply in China is tantamount to a call that global food price inflation is on a secular upward trend, in my view. Obviously, these are two separate questions. And I do not believe that the current world market food supply situation has had a direct impact on the sudden acceleration in China’s food price inflation. Along this line of thinking, I suggest that increasing food imports should be an effective approach to addressing the slow response of food supply and thus mitigating inflationary pressures in China at the current juncture, especially if it is combined with faster renminbi appreciation, which should help prevent imported inflation, if any. Strong wage increases are not necessarily signs of inflationary pressures Statistics show that the average growth rate of nominal wages in the manufacturing sector in China was in the low teens during 2004-06, making one wonder whether this is not a sign of a tight labor market and thus inflationary pressures. Indeed, high inflation is not sustainable unless it is underpinned by sustained upward pressure on wages. However, fast nominal wage growth does not necessary lead to inflation, if it is outpaced by labor productivity growth. I believe that this has been the case in China. I estimate that, despite fast nominal wage growth in the last few years (i.e., averaging 12.7% per annum in 2003-05), China’s labor productivity growth has still outpaced nominal wage growth significantly, resulting in a continued decline in unit labor costs (ULC) in the manufacturing sector. Recognizing that ULC estimates tend not to be very reliable and up-to-date due to a paucity of data in China, we also examine other indicators to help form a judgment. It is worth noting that during 2004-06, the average growth rates of both nominal GDP (i.e., +15.8%) and industrial profits (i.e., +28.7%) outpaced nominal wage significantly. These trends suggest that underlying labor productivity growth has been faster than nominal wage growth, such that profitability has not been eroded by strong nominal wage growth. Nothing wrong with the theories, but the reality is … The theories that help predict that China should experience inflation rest on a key assumption — that the Chinese economy is a normal economy that is close to full employment. The reality is that China is not yet a normal economy in that the price for capital, the key production factor, is still way below the market-clearing level. And China is still far from achieving full employment. A recent study by the Chinese Academy of Social Sciences (CASS), one of China’s top think tanks, concludes that the surplus labor situation could last at least through 2010. This surplus labor in the rural area should continue to help prevent nominal wage growth — especially for unskilled labor — from rising too fast, giving China a comparative advantage in labor-intensive production activity. Although it is difficult to estimate where a neutral level of interest rates is for a rapidly growing emerging market economy such as China, it is not difficult to conclude that current interest rates (e.g., 3.6% for deposits and 7% for lending) are being kept well below market-clearing levels in China, especially in view of the country’s rapid economic growth. This reflects in part the ‘financial repression’ that allows the government to channel a large amount of savings to government-preferred sectors (e.g., state-owned enterprises, the manufacturing sector) at a low cost. Low-cost capital encourages overinvestment and thus boosts production capacity. Persistently strong supply give firms limited pricing power, contributing to a secular dis-inflationary/deflationary tendency in the manufacturing sector. China is unlikely to enter ‘an era of inflation’ unless one of the two factors — cheap capital and low-cost labor — disappears, neither of which will happen in the near term, in my view. Policies: All boils down to managing expectations With no base for sustained secular inflation, whether the current round of inflation can be brought under control all boils down to whether or not the authorities are able to successfully manage inflationary expectations, in my view. If headline CPI inflation remains at elevated levels (e.g., above 5%) for a protracted period (e.g., 12 months), inflationary expectations may become entrenched. Then wage pressures would develop despite the existence of surplus labor, translating into broad-based inflation, from which point inflation may start to take on its own life. The fact that non-food price inflation has been remarkably stable despite a surge in food price inflation should make the authorities’ task of managing inflationary expectations less daunting than otherwise, in my view. Representatives from several government agencies have recently made public statements that headline CPI inflation for 2007 will be controlled below 4.0%. Meanwhile, the NDRC, China’s top economic planning agency, has instructed local authorities to postpone liberalization of administered prices and crack down on “illegitimate price hikes”. On the monetary policy front, I expect the PBoC to maintain its current pace of liquidity withdrawal through a combination of open market operations and further hikes in the ratio for required reserves (RRR). The PBoC will likely aim to bring M2 growth down to below 17% toward the year-end. With headline CPI in August now reaching +6.5% YoY, I change my call from “at least one more rate hike” to “two more rate hikes” in the remainder of the year (see China Economics: Inflated Fear of Inflation? August 8). The next rate hike could be made as early as this month, in my view. The authorities’ objective in hiking rates is twofold: a) signaling its determination to contain inflation; and b) making real bank deposit rates less negative, to help contain asset price inflation. Inflation forecasts I forecast that headline CPI inflation will remain above 5% YoY in September-October and start to decline below 5% YoY in November-December, as food supply catches up and inflationary expectations are largely anchored by still stable non-food price inflation and policy measures. The year average headline CPI will likely be around 4.3% in 2007 and 3.5% in 2008. These forecasts hinge on the authorities taking timely actions to manage inflation expectations, including through rate hikes and bringing money supply (M2) down to below 17%. Risks There is a possibility that the authorities may be too slow to implement adequate tightening measures and thus miss the window of opportunity to bring inflationary expectations under control. If headline inflation were to remain above 5% through 1H08, I fear that inflationary expectations would become deeply entrenched, making tackling inflation much challenging. By the end of 1H08 and with the new government settling in, the authorities may be ready and have to take aggressive tightening measures to control inflation, which may risk causing a hard landing of the economy in 2H08 or early 2009.
Slow, but Not Receding: Caving in and Cutting Our Global Outlook
September 11, 2007
By Takehiro Sato / Takeshi Yamaguchi | Tokyo
Financial markets have swiftly factored in the sub-prime problem, but headline risk will continue in real economy terms Turmoil in global financial markets in response to the US sub-prime problem has prompted us to cut our global forecasts. That said, we do not believe that the current market turmoil marks the beginning of a slide of the global economy into recession. In terms of the real economy, headline risks related to the sub-prime problem should continue to weigh, but with the financial markets having already discounted the problem to such an extent so quickly, we suspect that the recovery from this shock may also be fairly smooth. Cutting our outlook for the global economy, and for the Japanese economy due to the knock-on effect Our revised forecasts for global economic growth are +5.0% (+4.9% in our previous forecast) in 2007 and +4.5% (+4.8%) in 2008. For the US economy, we assume growth of +1.9% (same) in 2007 and +2.0% (+2.6%) in 2008. We cut our forecast for the Japanese economy to +1.9% (from +2.4% previously) in 2007 and +2.1% (+2.5%) in 2008 (+1.6% and +2.4% on a fiscal year basis), about 0.5ppt down, respectively. The downward revision for 2007 stands out in comparison with other countries, but this mainly reflects negative growth in April-June 2007. The 2008 revision reflects the cut in our global economic forecast. Growth in the economy turned negative in the April-June quarter this year, due mainly to a decline in capital investment, and this has prompted us to lower our forecasts. However, this reflects in large part the strong growth in the preceding two quarters and a technical shortfall in capital spending owing to statistical sample changes. It does not mean that the overall economic recovery has been derailed. Still, considering the impact of the local inhabitants’ tax hike and inclement weather, as well as the impact of many businesses moving up the timing of their bargain sales to June ahead of the tax hike, there is no shortage of negatives for the July-September quarter, which could well see some cooling in personal consumption. Risks are tilted to the downside. Within this context, one bright spot is the outlook for a strong performance by manufacturing beginning in the July-September quarter. With the Beijing Olympics coming next year, production of digital consumer electronics and the like are set to rise ahead of the expected April-June 2008 peak demand season. As output expands, so too should the income generation capacity of companies, thus preventing any sharp deceleration in the economy. High IT-related product inventories are a concern, but in the case of IT inventories the gap between micro and macro is wide, and surplus inventory at companies that is evident in macro statistics is unlikely to reach a level that would significantly weigh on production. From the October-December quarter, the effects of the tax hike should wear off marginally, while growth in employment should pave the way for gradual growth in incomes, providing a boost to personal consumption. But after this bump, the outlook for consumption is for a continued lack of momentum through 2008. That said, the rate of growth in the Japanese economy should continue to climb at around the potential growth rate, driven by sustained growth in capital investment. The capital investment cycle is maturing, so spectacular growth is unlikely; however, from a top-down perspective, natural growth in capital investment seems inevitable as the labor shortage deepens in the face of an aging society and per capita GDP falls on declining productivity. At the same time, overseas demand is likely to level off in early 2008 as overseas economies cool, leading to an unavoidable slowing of growth. Our forecast is for overseas economies to rebound in the second half of 2008, in turn providing a lift to the Japanese economy that should push up growth to 2.1% in 2008, exceeding the potential growth rate. However, a key assumption behind this outlook is that overseas monetary authorities will act successfully to counter the decline in liquidity, thus averting a crisis, and that improved liquidity will trigger a new round of euphoria in the resource markets. Crude prices will likely stay high for a while on concerns about hurricane damage, but we expect them to gradually peak out from the second half of 2007 through 1H08 as the global economy slows. Still, growth in the BRICs economies will probably not slow much and supply agreements should remain in effect, so we think that a sharp decline in crude prices is unlikely. On the forex side, we look for further appreciation of the yen, but do not expect to see an impact on exports in the short run due to continued gains from a weak yen as a result of the time-lag effect. In our view, volume effects associated with fluctuations in overseas demand will be more relevant. Risks The main downside risks to the above scenario are a wave of corporate failures overseas due to tightening of the credit environment. As Japan’s experience shows, the effectiveness of rate cuts in stemming a credit crunch is limited, but if overseas monetary authorities fail to deal promptly and competently with the liquidity crisis when it moves into full swing, the impact on the real economy could be protracted. On the other hand, the main upside risk is that measures to inject liquidity successfully avert a crisis, triggering a new round of euphoria in the asset markets. The current market crisis is another once-every-10-years event, following Black Monday in 1987 and the Asian/Russian currency crisis in 1997-98, but in times of past liquidity crisis, measures by monetary authorities to boost liquidity have created asset bubbles. In the current situation, with the credit bubble already having burst, it is arguably a bit premature to talk about the possible formation of another bubble, but history suggests that this is a possible risk. Realistically, the situation in short-term financial markets and corporate finances will probably need to deteriorate another step before authorities take action to inject liquidity. Price outlook still ultra-conservative Based on the above crude oil price outlook, we expect the core consumer price index (CPI), which has run in negative territory since February this year, to begin to turn around in November and move into modest positive territory in the January-March 2008 quarter. Our working assumption is that year-over-year factors will prompt a decline in 2H08, with the core CPI holding near zero as a result. Basically, we expect prices to peak in 1Q08, then gradually begin to ease in the second half. We assume growth of -0.1% in F3/08 (0.0% in 2007) and +0.1% in F3/09 (+0.1% in 2008). And this is not a risk scenario, but a highly probable one, in our view. The assumption is that while the core-of-core should recover, the pace will be remarkably slow at about 0.2ppt in the January-March 2009 quarter. This is because housing expense and food costs (excluding fresh foods), the main components of the core index, will probably show slower growth than the market anticipates. In the latter case, there have been many reports of higher materials costs having already triggered price hikes on processed foods and in restaurants, but despite the newsflow at the micro level, the impact on macro data is likely to be limited. With regard to prices, in addition to the above, we also expect to see a ‘CGPI shock’ as a result of rebasing of the benchmark year for the corporate goods price index (CGPI). The shift in benchmark year from 2000 to 2005 should result in the same contraction in growth rates seen in 2005, producing a similar ‘CPI shock’. Contraction of close to one percentage point is possible, while market price level sentiment could also be a factor. However, as indicated by our forecast for close to zero growth in prices, we do not assume a return to deflation. We are optimistic that there is plenty of room to boost productivity in the Japanese economy, which of course could create downward price pressure. We expect the GDP deflator to turn positive in year-over-year terms in January-March 2008 at the earliest, in which case statistical confirmation would appear around May 2008. Meanwhile, the domestic demand deflator is likely to stay close to the zero mark. Significant recovery in wages unlikely before 2009 Regular employment is expanding at an annualized rate of 1-2%, and a slowing in this rate seems unlikely anytime soon. But with employment growth concentrated in low-wage industries and ‘limited’ part-time employment on the rise, the problem of overall wages growing at a slower rate than hiring looks set to continue. Still, the gap between the job openings (labor demand) rate of 3.6% and the unemployment (labor supply) rate of 4.2% has shrunk to just 0.6ppt as a result of a demand shortage in the employment market. The market is just one more step away from achieving employment equilibrium, which in turn should help drive an increase in wages in the private sector. At the same time, however, it appears that genuine wage restructuring in the public and quasi-public (education and healthcare) sectors is finally set to get underway, as the government tries to hit its target of reducing overall labor expense by 5% over the next five years. This of course is a negative, and we expect wage recovery to be delayed until 2009 as a result. Since low wages tend to keep growth in service prices in check, improvement will not be easy and prices are likely to continue flying at low altitude for some time. Also cutting our corporate earnings outlook Under the slump in nominal wages, there is also little sign of change in the global shift toward a distribution weighted heavily toward companies and lightly toward households. Also, the downward revision in our growth rate outlook is negative for both corporate earnings and employee incomes, but households are likely to continue to take a disproportionately stronger hit while corporate earnings remain largely firm. In fact, April-June quarter corporate earnings, particularly in manufacturing industries (IT, autos), rose despite forex fallout. This is due in large part to strong overseas economies that allowed for gains on expanded volume. However, we look for a smaller volume effect due to a slowdown of overseas economies from the latter half of 2007 to the first half of 2008. In addition, there will be newly depressing factors such as higher materials costs and SG&A costs going ahead, especially in 2007. In light of the above, our F3/08 top-down corporate earnings forecasts at the recurring profit level (MoF Corporate Statistics basis, excluding financials, capital over JPY1 billion) are +5.6% YoY in F3/08 and a rebound to +10.7% in F3/09, with a smaller margin of improvement, especially for F3/08, compared with our previous forecast. Policy and market implications The major defeat suffered by the ruling party in the recent Upper House elections — turning it into the minority party — put an end politically to the debate on raising the consumption tax. The increased political gridlock that has resulted makes it very likely that a general election will be called much sooner than summer 2009, meaning that the consumption tax debate will probably be postponed until after then. The government’s goal of raising the consumption tax in April 2009 looks virtually impossible now, and April 2011 at the earliest seems far more realistic. The government’s fiscal deficit has not been as glaring a problem recently thanks to steady growth in corporate tax revenues. But this does not mean that high growth will continue. Much of the bump at the moment is due to a decline in losses brought forward by firms, resulting in higher tax payments, as companies who previously did not pay are beginning to pay corporate tax again. The Upper House election results could also derail the heretofore path of fiscal tightening. The implications for the market are mixed. A delay in the consumption tax hike will be viewed by the market as positive news in terms of providing support for a recovery in consumption, but it comes as bad news in terms of delaying economic reforms and improvement of the government expenditure structure. Implications are not positive for the bond market either, as it raises doubts about the outlook for the government program to cut debt. With respect to fiscal policy, the focus has been shifting to an emphasis on the ‘second pillar’ of monetary policy (risk of rise in asset prices), and the BoJ’s efforts to justify its normalization strategy has naturally collapsed. Due to the fallout from the sub-prime problem, the BoJ has no choice but to adjust the trajectory of its rate hike strategy, and a third rate hike will have to be put off until December at the earliest, and possibly the January-March quarter of next year. Compared to overseas credit markets, which have bubble aspects to them in many cases, most non-financial corporations and households in Japan maintain solid finances, and this situation should not change going forward. As long as this remains the case, it may become easy to lose sight of the significance of the second pillar strategy. As a result, we expect the goal of one rate hike every six months or so to be revised to one hike every nine months or so, beginning around December. This would put the policy rate at 0.75% by the end of F3/08 and only 1.00% by the end of F3/09. In any case, even if the US were to cut rates, we do not expect to see a return to Japan’s zero interest rate policy (ZIRP). As to who will be the next BoJ governor, we think it is unlikely that it will be someone with strong views, and our overall outlook is for a continuation of current policy for the most part. Since the basic goal of monetary policy is to reapportion income among debtors and creditors in any case, the DPJ, the largest opposition party, is unlikely to bet either way on a rate hike or cut, as betting on the specific side of the policy would not give rise to a new vote for the party.
Will Abundance Slow?
September 11, 2007
By Gray Newman | New York
After five years of above trend global growth and one of the best growth records in Latin America in decades, the region could soon be tested with a growth scare — this time, one originating in the US. The slowdown in the US in turn is likely to raise a series of concerns about whether the rest of the world and Latin America in particular can decouple from the US economy. We expect the debate over Latin America and emerging markets to intensify in the coming months as the US economy shows signs of further weakness. Indeed, our US economists Richard Berner and David Greenlaw have just revised downward their US forecasts for the remainder of 2007 and 2008. The sharpest downward revisions take place in the fourth quarter of this year and early in 2008. While the reduction in 4Q07 to 1.5% real growth from 2.4% (previously forecast) does not meaningfully change the average growth for 2007 as a whole — near 1.9% — it reflects a path of much weaker growth that is seen most clearly in 2008. Our US economists expect growth to reach only 2.0% in 2008, down from 2.6%. The team also expects the Fed to begin cutting rates this month, with 100bp of cuts to take place by mid-2008. The US revisions have triggered a comprehensive forecast revision by our global team, with every major region in turn posting modest reductions in the growth path for 2008. Yet, despite the revisions, the collective consensus of our global economics team is that the globe is set for another year of above-trend growth in 2008. If our team is right, it would mark the sixth consecutive year of above-trend growth — a record not seen in over 30 years. And that in turn would be positive for Latin America. While Mexico’s economy can be expected to suffer from further weakness in the US, the rest of the Latin America should fare relatively well if our global team is right about the ability of the rest of the world to continue to ‘decouple’ from the US. Where are the excesses?
After all, although we are now five years into the current growth upturn, we have seen little of the excesses of past upturns in the region. The abundance of the past five years has not produced the ballooning trade and current account deficits fueled by consumer spending seen in the past in Latin America, nor widening fiscal deficits nor the spectacle of central banks burning through reserves to prop up woefully overvalued currencies. There are plenty of emerging economies with vulnerable financing needs either on the fiscal front or balance of payments, but they tend to be outside of Latin America. Moreover, Latin America appears to be in better shape than in the past to deal with a downturn in the global economy. If the globe slows by more than our global team expects, then so should Latin America. But we suspect that the risk that a downturn in growth leads to a major financial crisis in the region is lower today than in the past. With its fiscal and monetary houses in better order today than in decades, we suspect that most Latin American economies should fare better if 2008 disappoints than they would have in the past. The clearest example of the improvement in the region comes from Brazil. Here is an economy that epitomized all of the risks of emerging markets just a little over four years ago when investors were worried that it was on the brink of default and capital controls. Today Brazil has international reserves covering two times the entire gross public external debt stock. Indeed, we calculate that before the year is out, Brazil is likely to have enough reserves to cover all public and private external obligations. That’s right, reserves should soon cover not only syndicated loans to the sovereign and all outstanding sovereign bond issues, but every inter-company loan and other external obligation of the private sector. Forecast changes
Given the relatively benign view of the world economy from our global economics team, we are making only modest adjustments to our forecasts for the remainder of 2007 and for 2008. With the prospects of a slower US, Luis Arcentales has cut our Mexican GDP forecast to 2.9% for 2007 from our original 3.3% — a forecast that at the time it was made last year was viewed by many as overly pessimistic. In addition, we have lowered real GDP growth in 2008 to 3.2% from 3.6%. We expect a weaker external environment, a Fed in cutting mode and a weaker Mexican economy to do some of the work for Banco de Mexico, and no longer expect another rate hike this year. In Brazil, where the links to the US are much less direct and where the central bank is still engaged in a rate-cutting cycle, we are actually hiking GDP growth for 2007 to 4.9% from 4.5% — from a forecast that at the time was viewed as overly optimistic. But while growth gains ground and should continue near 4.3% in 2008, we expect some nervousness to feed through to the currency as Brazil’s current account surplus vanishes in 2008. Marcelo Carvalho expects Brazil to end 2008 with a small deficit of around -0.7% of GDP. We are not concerned with a small deficit, and indeed have long argued that it was to be expected. As Brazilian growth continues, we expect to see investment opportunities outstrip domestic savings, and see external savings tapped for financing. The other changes to our Brazil forecast are modest as well. Marcelo now expects the central bank to reduce interest rates on only one of the last two meetings to bring the Selic rate to 11% by year-end 2007, up slightly from our previous forecast of 10.75% However, the pause later this year should not be read as a signal that the central bank is through reducing rates. Marcelo expects the central bank to ease rates by another 100bp in 2008 to 10%. We are also making modest changes in the rest of the region. Daniel Volberg sees Colombian growth a bit more subdued in 2008 at 5.5% compared with 6.2% previously as a series of interest rates hikes last year and this work through to the real economy. While Argentina slows in 2008 to 6.2%, Daniel has actually raised Argentina’s real GDP growth rate in 2007 to 8% from 7.6% (the full details of our changes can be found on page 13 in This Week in Latin America, September 10, 2007). Beware of slowing
I am a bit more skeptical. It is not that I don’t believe in the progress that Latin America has made — I do. The economic starting point of Brazil today is much different from where it was in 2001 or where Chile is today compared with 1997 or Mexico today versus 1994: the massive financing gaps in each case contributed to a much more painful and high-risk adjustment than is likely today. My skepticism has four components: First, I suspect that a great number of believers in emerging markets and Latin America as a ‘safe haven’ will have a confidence crisis if the globe ends up with a year of sub-par growth. The emerging market boosters and the ‘safe haven’ arguments have emerged in a world that is now in its fifth year of above-trend global growth (see “Emerging Markets: Emerging Questions” Global Economic Forum, August 28, 2007). We simply haven’t seen a string of this many good years of global growth since the early 1970s. Yes, it is true that the trio of massive reserve accumulation, current account surpluses and fiscal surpluses means that these are not the emerging markets of yesteryear. And yes, starting points do matter: if the globe is heading for a soft patch and credit will be less plentiful, having large reserves makes a difference, as do surpluses on the fiscal and current account front. But that is unlikely to provide any immunity to business cycles. Second, I am skeptical of the ‘decoupling’ thesis. Our global team hasn’t really been forced to deal with the issue. After all, our US economists’ latest revisions avoid having the US economy fall into a recession. But I am wary of extrapolating from our new forecast in which the US economy is growing near 2% to a case in which the US economy suffered a sharper downturn. In that case, I suspect that the linkages from US to commodity prices and demand and the favorable terms of trade shock that most of the emerging markets have enjoyed would be called into question. It is not difficult to imagine a bout of weakness in commodity prices prompting a sell-off in the Brazilian Real. An exchange rate that remains above R$/US$ 2.3-2.4 could breach the central bank’s inflation target according to Marcelo Carvalho and call into question room to ease interest rates. And with over a third of Brazil’s debt stock linked to overnight interest rates, it is not difficult to see how a new bout of investor nervousness could emerge. Third, there are still plenty of vulnerable economies in Latin America. While the precise links between strong global demand, robust terms of trade and the fiscal performance of each economy in the region vary, there can be no denying the importance that commodities has played in Latin America. Fourth, while abundance has brought stability and good growth to Latin America, it has also brought widespread complacency among policy makers. The gridlock is particularly concerning since the failure of progress in Latin America is much more worrisome: the shortfalls in human capital, the often limited funding for infrastructure and public investment, the inadequacies in the regulatory environment to promote competition and the wide disparities in assets and income mean that in downturns the ‘safety net’ is often frayed at best. Prolonged downturns can easily set off political and social turmoil. On that front, we applaud the actions of Chile to run a strong countercyclical fiscal policy and the first steps from Mexican policymakers to boost access to non-oil revenues. Bottom line
After five years of above-trend global growth, our global team is willing to bet on a sixth year despite weakness in the US. If they are right, Latin America should post a sixth year of strong growth. But I suspect that even if our global team is right — and our forecasts are based largely on the inputs from around the world — the slowing in the US economy is likely to keep investors cautious about Latin America. And if the US slowdown morphs into a patch of below-trend global growth, I’d suspect that there will be fewer believers in the ‘safe haven’ thesis in Latin America or in emerging markets. Ultimately, Latin America’s response to a global slowdown could have a positive impact on investor perception. By weathering a global slowdown if it emerges, the region’s performance could prompt a rethinking of its risk. Latin America is hardly immune to a global slowdown, but I suspect that it is indeed less prone to producing a financial crisis today. But this kind of positive thinking is a bit premature; I suspect that the test has yet to come and, when it does, we are likely to find fewer believers in the emerging markets thesis than today.
Global Troubles and the Biggest Investor You Probably Don’t Know
September 11, 2007
By Serhan Cevik | from Istanbul
Higher uncertainty and tighter financial conditions will slow the pace of global growth. After five years of above-trend growth, the global economy is now facing significant downside risks. The extent of the fallout from deepening troubles in the credit markets remains unknown, despite the coordinated effort of central banks to bring an end to the turmoil and normalise credit conditions. Consequently, we now expect higher uncertainty and tighter financial conditions to slow the pace of global growth in the remainder of this year and especially in 2008. Our new baseline scenario envisions a more pronounced correction in the US economy but no outright recession, while the rest of the world exhibits a ‘soft decoupling’ and keeps global growth at a reasonably robust range. Of course, even though the global economy has come to stand on stronger structural pillars, the growth trajectory is still highly dependent on the US economy. Our calculations show that the correlation of business cycles between most of the countries and America has increased over the past decade, worsening the risk of contagion (see Day and Knight, August 20, 2007). Therefore, with our ‘soft decoupling’ projections, we may be underestimating challenges in the financial sphere and downside risks to growth. Turkey’s susceptibility to troubles in the US comes mainly through the financial channel. Turkey’s direct exposure to the US economy is limited, with exports to America accounting for a mere 5% of the total. Nevertheless, Turkey’s growth correlation with the US increased from -0.16 in the 1990s to 0.71 in the last six years. In our view, such a curious increase in correlation reflects indirect trade linkages and more importantly financial integration. As a result, we cannot dismiss the effects of what happens in the US on the Turkish economy and financial markets. Let’s start with the business cycle. The US slowdown will no doubt have knock-on effects on the rest of the world, and in Turkey’s case what matters most is the behaviour of the European business cycle. With exports to Europe accounting for 60% of the total, the Turkish economy is certainly vulnerable to a marked slowdown in Europe. The good news is that our colleagues covering Euroland expect a temporary slowdown, cutting real GDP growth forecasts from 2.4% and 2% in 2008 but projecting a rebound to 2.5% in 2009. In our view, that would have a minimal effect on Turkey’s growth outlook, especially considering the dollar’s weakness and structural changes allowing Turkish firms to gain greater market share. However, the trade channel is not the ultimate determinant of growth dynamics in the Turkish economy. What matters most is global risk appetite and the extent of the correction in international capital flows. Abrupt changes in global liquidity conditions increase volatility in Turkey. When global risk appetite deteriorates, developing countries like Turkey with an exposure to liquidity-driven flows get hit worse than others. In fact, even if Turkey had no current account deficit, the situation would not be much different, simply because foreign inflows have already been running about US$50 billion above the cumulative current account deficit. With economic normalisation and alluring interest rate differentials, Turkey has attracted strategic investments as well as carry trades. For example, foreign investors own more than 70% of the free float in the equity market, increasing their holdings (adjusted for changes in asset prices) from US$4.5 billion at the end of 2002 to over US$45 billion this year. In a more dramatic way, foreign investors channeled 22.5 billion lira into the domestic debt market over the past year alone, increasing their holdings in the fixed-income space from 8.6 billion lira at the end of 2003 to 45 billion lira this summer. Put differently, foreign investors now carry 16.5% of the domestic debt stock, up from 7% a few years ago. This is why changes in global liquidity conditions lead to occasional bursts of volatility in Turkey. However, we should not ignore economic fundamentals in assessing the vulnerability of growth and disinflation prospects (see Shockwaves and the King of Carry Trades, August 15, 2007). Structural improvements in the Turkish economy should limit the global fallout. The global liquidity crunch and a possible increase in home bias could weaken the lira, worsen the inflation outlook and even lead to slower output growth. However, we are cutting our real GDP growth estimate marginally from 6% to 5.6% in 2007 and from 8.5% to 7% next year. That is still a robust pace and should accelerate even further to 7.8% in 2009. On the other hand, we expect consumer price inflation to keep declining towards the 4% target, albeit in a more gradual manner. Wishful thinking? Not at all. The Turkish economy has faced numerous challenges in the last five years, but kept outperforming overly cautious consensus expectations that fail to incorporate structural improvements. Economic fundamentals are now far stronger and there are no more skeletons in the closet. Furthermore, the authorities will speed up the implementation of structural reforms, improving the economy’s competitive features. On the financial front, stronger balance sheets in the banking sector and residents’ dollar holdings shield against exogenous shocks. There is also the rise of the Unemployment Insurance Fund with assets growing from 362 million lira at the end of 2000 to 27 billion lira this year. The fund invests exclusively into the domestic debt market, providing an institutional cushion that was never available before.
Revising Growth Forecasts in Light of a US Slowdown
September 11, 2007
By Chetan Ahya (Singapore) and Tanvee Gupta | Mumbai
USGDP growth likely to be slower than estimated earlier
Recent macroeconomic developments in the US have raised concerns about the outlook for 2008. While earlier our US economics team had highlighted the rising risks from the US housing slowdown and sub-prime problem, now they believe that those risks have morphed into reality. In Downside Growth Risks Become Reality, September 10, 2007, our US economist, Richard Berner, highlighted that, paced by a deeper and longer housing recession, he now expects that US growth will average just 2% over the next six quarters, or 0.6% below that of a month ago. The tighter financial conditions in the US are likely to squeeze consumer and business capital spending, add to business caution, and limit gains in inventories and hiring. Reflecting these concerns, our global economics team has cut its 2008 forecast for the global economy to 4.5% from 4.8%. Limited downside to India’s growth from US soft landing India’s exposure to the global trade cycle is one of the lowest in the region and therefore the impact of slower foreign trade is likely to be one of the lowest. Indeed, exports to GDP are relatively low at 21.8% as of 2006 compared with the average of 60.1% for Asia ex-Japan (excluding India). Even as goods export growth may suffer, we believe that the services exports will see only a slight negative impact. We believe that, during the period of economic slowdown, outsourcing to cheaper destinations will likely continue. Moreover, the share of outsourcing in overall IT/IT-enabled services spending is still low. Hence, we are lowering India’s growth for 2008 by only 0.3 percentage points to 7%. Most of the cut in our growth estimates is due to lower external demand. However, we estimate external demand to recover in 2009, enabling overall GDP growth to rise to 7.8%. Past monetary policy tightening already weighing on domestic demand Our growth estimates have already built in a significant domestic slowdown due to the lagged impact of the aggressive monetary policy tightening. Monetary tightening between December 2006 and March 2007 has lifted banks’ lending rates significantly. Despite the recent 25-50bp cut, mortgage lending rates are still about 400bp higher from the bottom. Mortgage lending rates are still close to 2001 levels. Similarly, in our view, banks’ lending rates for cars, trucks and two-wheelers are 450-500bp higher from the bottom. We expect that the current high level of lending rates will ensure that domestic demand remains firmly on the path of deceleration. Indeed, corporate revenue growth has already decelerated to 13% during the quarter ended June 2007 from 22% during the quarter ended December 2006. Limited support from monetary policy loosening in the near term While the US slowdown will add to the pressure of the overall growth slowdown underway in India, given that early elections in 2008 are a real possibility, we believe that India’s policymakers will keep a close watch on the inflation risks. We believe that monetary policy support will be minimal in the initial phase of the slowdown. Moreover, if the government continues to comply with the fiscal deficit targets specified in the Fiscal Responsibility and Budget Management Act, there will be limited scope to pursue an expansionary fiscal policy. Re-acceleration in 2009 We believe that India’s growth trend will recover to 7.8% in 2009 from the trough of 7.0% in 2008, with positive support from external demand. We expect domestic demand to improve only marginally in 2009, supported by normalization of private consumption growth. Our overall growth forecasts do not indicate full recovery in growth to 2007 levels as we believe that the possibility of early general elections in 2008 would imply that investment spending would remain constrained by the slow pace of reforms through to 1H09. Potential sharp slowdown in capital inflows is the key risk Over the last 3-4 years, India’s growth acceleration has benefited more from the globalization of capital markets than from the globalization of trade. The inflexion point for the current growth cycle was April 2003, which signaled the beginning of the synchronous rise in emerging market equities. We believe that a favorable sustained global risk appetite trend has been at the heart of India’s current growth acceleration cycle: Average GDP growth accelerated to 9.2% during F2006 and F2007 from an average of 6.1% in F2003 and F2004. The risk-appetite growth linkage is as follows: rise in risk appetite — rise in non-FDI capital inflows — lower real rates — strong credit-driven growth. Indeed, India has increased its outstanding bank credit stock to US$475 billion from US$162 billion in April 2003, supported by liquidity generated from global capital inflows. In this context, we believe that the key concern for India’s growth outlook will be a potential turbulence in US financial markets and its impact on capital inflows into India. Bottom line
We believe that, if the US economy undergoes a soft landing, there is a high probability that India witnesses a soft decoupling. The key risk to this outlook is any potential significant turbulence in the US financial markets spilling over into Asian and Indian financial markets.
Assessing the Impact of Slowdown in the US
September 11, 2007
By Chetan Ahya and Deyi Tan Singapore and Shweta Singh | , Mumbai
US growth forecasts for 2008 reduced significantly Recent macroeconomic developments in the US have raised concerns on the global growth outlook for 2008. While our US economics team has previously highlighted rising risks from the US housing slowdown and sub-prime problem, now they believe that those risks have become reality. In Downside Growth Risks Become Reality, September 10, 2007, our US economist, Richard Berner, highlights that paced by a deeper and longer housing recession, US growth will average just 2% over the next six quarters, or 0.6% below that of a month ago. The tighter financial conditions are likely to squeeze consumer and business capital spending, add to business caution, and limit gains in inventories and hiring. Reflecting these concerns in the US, our global economics team has cut the 2008 US forecast to 2.0% from 2.6%. We believe that this will weigh on external demand and business investment growth for ASEAN region. Soft decoupling in ASEAN underway Even though US growth is likely to average just 2% over the next six quarters, 0.6% below that of a month ago, we expect the ASEAN region’s growth to decelerate less than proportionately. While external demand for the region has already been slowing for the few months, domestic demand has been recovering gradually. While to some extent the business investment growth, which tends to lag export trends, will decelerate, affecting the domestic demand, we expect the other components such as private consumption and government spending to hold up well, ensuring that overall GDP growth decelerates less than proportionately in response to the US slowdown. We are cutting ASEAN GDP growth to 5.6% from 5.9% for 2008. So what supports a soft decoupling in the region’s growth trend from that in the US? First, the ASEAN macro balance sheet is now in very different shape compared with that in 1997-1998 as evident in the FX reserves and external debt trend. While external debt to GDP (excluding Singapore) has declined to 34% as of 1Q07 from 78% in 1999, foreign exchange reserves to GDP has increased to 39% as of June 2007 (US$413 billion) from 35% in 1999. Second, the rise in foreign exchange reserves over the past few years has been driven by current account surpluses instead of capital inflows. The ASEAN region’s current account is in surplus of 8.7% of GDP during four quarters ending 1Q07 compared with the deficit levels seen prior to 1998. Third, the financial leveraging in the real economy is also manageable in this cycle. Most of the countries in the region have seen a steady decline in their credit-deposit ratio to about 67% as of June 2007 compared with 113% in December 1997. The healthy macro-balance sheet is already supporting a gradual recovery in domestic demand acceleration. Domestic demand growth has accelerated to 5.3% during the quarter ended Jun-07 from the trough of 2.7% in Mar-06. While we expect the weaker export growth to weigh on fixed investments, overall domestic demand will still be relatively healthy in the outcome of a soft landing in the US. Also, in the current cycle, the direct impact of a slowdown in the US will be lower than that in the previous cycle as the share of US in ASEAN exports is lower. Asymmetric impact within the region In terms of trade linkages, the impact of a slowdown in the US will be most severe for Singapore then Malaysia and least severe for Indonesia then Philippines. Although the external dependence has reduced over the years, the US still remains as the key export destination for Singapore and Malaysia, accounting for about 10-20% of the export share. While the domestic demand momentum on the back of property-led capex recovery and government policies for Singapore and Malaysia, respectively, will serve as fundamental support, a slowdown in US growth will still shave considerable momentum off the headline growth we are expecting. We are therefore cutting our Singapore and Malaysia GDP growth forecasts to 6.1% and 5.5% in 2008 from 6.5% and 5.8%, respectively. Thailand is also more dependent on external demand, though less than Singapore and Malaysia. However, we believe that Thailand should see some benefit of a gradual recovery in the domestic demand with the improving political scenario. Hence, we have cut its 2008 GDP growth by only 0.2 percentage points to 4.8%. While Indonesia and Philippines are less exposed to global cycle through foreign trade linkages, they will be affected adversely to some extent on account of mild risk aversion in the financial markets and an increase in volatility. We are therefore reducing our forecast for Indonesia and Philippines to 5.9% and 5.6% from 6.3% and 5.8%, respectively. We think that Indonesia, with its low basic balance (current account surplus + FDI), is one of the most vulnerable to a potential risk aversion in global capital markets among the ASEAN markets. Looking for a full recovery in 2009 We expect GDP growth in the region to recover in 2009 from the trough in 2008 with positive support from external demand. We expect global GDP growth to rise to 4.9% in 2009 from 4.5% in 2008. We expect ASEAN GDP growth to re-accelerate to 6.0% in 2009 from 5.6% in 2008. All the countries in the region are likely to see growth above the 5% mark. Indeed, Indonesia and Singapore are likely to grow by above 6%. Bottom line We believe that hard decoupling of the real economies (implying ASEAN GDP remaining steady or accelerating) is a low-probability outcome. We believe that if the US economy goes through a soft landing, the ASEAN region will see a soft decoupling (i.e., GDP growth decelerates but in less than proportionate manner). The key risk to this outlook is the potential significant turbulence in the US financial markets transmitting to ASEAN financial markets.
|