Middle East/North Africa
The Challenging Trail of a Weaker Dollar
September 20, 2007

By Serhan Cevik | Dubai

The dollar’s weakness will challenge pegged exchange rate regimes in the Middle East.As the turmoil in financial markets has shifted the balance of risks from inflation to growth, the US Federal Reserve ended its four-year-long tightening cycle and cut short-term interest rates by 50bp to 4.75% in an attempt to limit the fallout on the real economy. The extent of monetary easing is more significant than what markets and our US economic team were expecting and will likely lead to a weaker dollar, especially as the rest of the world continues to outperform the US economy. In our view, the downward pressure on the dollar comes through two channels. First, with an aggressive decision, the Federal Reserve has opened the door to further rate cuts, while interest rates are unlikely to change or could even possibly increase in other countries. As our chief currency economist Stephen Jen argues, such a “stark divergence in the monetary paths” will weaken the dollar against other currencies. Second, the growth outlook for the US economy is now significantly worse than what we expect to see in the rest of the global economy. As a result, our currency economics team is projecting the dollar to depreciate against the euro to 1.42 by the end of this year and 1.43 in 1Q08. Although lower interest rates and a weaker dollar are good news for emerging economies like Turkey, countries with pegged exchange rate regimes now face new challenges, in our view.

Weaker dollar will worsen inflation dynamics in Gulf countries, in our view.Oil-exporting economies in the Middle East have already been struggling with an increase in inflation from an average of 0.1% between 1998 and 2002 to 4.5% last year and about 6.5% so far this year. We should point out that official indices underestimate inflation because of measurement errors and administered prices and hence may present a misleading outlook. Further, there are significant cross-country divergences, even among Gulf countries with similar economic endowments and structures. In our opinion, there are two main sources of inflation pressures. First, the abundance of petrodollar liquidity and accommodative macroeconomic policies have led to strong and accelerating growth in domestic demand and put upward pressure on all prices. This is most apparent in non-tradable sectors like housing and is likely to get worse before it gets better as new supplies come to market.  However, the problem is not just a supply bottleneck in the housing sector; it reflects widespread inflation pressures across the region.  The second factor is imported inflation through pegged exchange rate regimes (see Pegged Imbalances, July 16, 2007). With the dollar’s weakness, pegged currencies in the region have become an important source of inflation, and now lower interest rates will weaken currencies even more and intensify inflation pressures throughout the Gulf region.

The resistance to modify the exchange rate regime will worsen economic imbalances.With pegged exchange rate regimes, Gulf countries need to have interest rates in sync with the US monetary cycle. However, as argued above, the state of domestic economic conditions in oil-producing countries is significantly different from what is happening in the US and therefore requires different policy responses. That is, even though pegged exchange rate regimes demand to mimic the Federal Reserve’s decision to cut interest rates, Gulf countries actually need a tighter policy stance to bring inflation down. Unfortunately, the initial signals are discouraging. Central banks of Kuwait and the United Arab Emirates cut interest rates by 50bp and 15bp, respectively, to 4.75% and 4.7%, following the path of interest rates in America. While other countries (like Saudi Arabia) may not follow the US Federal Reserve, the current mix of interest rates and currency valuations and the oil windfall will keep expanding liquidity and pushing inflation higher. In other words, what may be the correct policy response in America is not what gulf countries need in order to stabilize inflation dynamics and achieve sustainable economic growth.

Recent developments confirm the need for currency revaluation.Imported inflation is becoming a bigger threat, as currencies pegged to the dollar keep weakening. Moreover, the abundance of petrodollar liquidity is becoming even more abundant with higher oil prices. Indeed, although the US economy is slowing down (by 0.6% to an annual rate of 2% over the next year-and-a-half, according to our projections), we expect the rest of the world to perform better and keep global growth at around 4.5% next year. That would be just a half point lower than the rate of growth this year and prevent a significant correction in the price of crude oil. Indeed, oil prices may even surprise us on the upside because of supply constraints. That means oil-exporting countries will likely enjoy an increase in export earnings, from an average of US$228 billion a year between 1998 and 2002 and US$786 billion in 2006 to close to US$1 trillion in the coming years. As a result, domestic liquidity will remain abundant and fuel economic activity. This is why we do not see a correction in inflation rates unless the authorities decide to revalue exchange rates. Of course, our call for currency revaluation is not just about curbing imported inflation, but would also support greater integration in the Gulf region (see Currency Union — Disunited They Stand, June 14, 2007).

 

Japan
Lower Headline Not Primed to Recession: September Tankan Preview
September 20, 2007

By Takehiro Sato | Tokyo

Tankan may seem poor, but slowdown is not recession

The key points to look for in the September Tankan are the business conditions DIs. The status of revisions to management plans unfortunately is not likely to reveal much useful information because this is the survey prior to interim results. For that reason, the headline is likely to decline, leaving the impression of not being a very good Tankan. We expect the summer economic slowdown will be more intense than we initially projected. However, since we believe that corporate fundamentals are good at this point, even with a weak headline, we do not see the current slowdown as an opening to recession.

Forecast of business conditions DIs

We expect the business conditions DIs for both large manufacturers and large non-manufacturers to be +21 ppt, down 2 ppt and 1 ppt respectively from June. We also expect the outlook DIs to decline 2 ppt for large manufacturing and remain flat for large non-manufacturing. We expect a sense of stagnation to appear among manufacturers because of uncertainty over the global economy and among non-manufacturers because of slowing domestic demand in summer. It will thus be easy to take the current Tankan negatively.

That said, the reason why we expect the headline DI to decline by such a small margin despite such a pronounced increase in caution in market sentiment is that corporate fundamentals are unexpectedly solid. Past efforts to reduce fixed expenses have lowered breakeven points, so corporations can generate profits more easily even if sales slow down; recurring profit on the basis of MoF Corporate Statistics (capitalization of ¥1.0 billion or more, excluding financials) rose over 20% YoY in Apr-Jun. Although the rising yen (from ¥114.40/$ in management plan assumptions at the last Tankan) has likely removed a buffer for most export companies at the moment, we have a rough impression that corporations have already hedged 50-60% of their currency exposure in 2H forex contracts, and so the rising yen will not hobble earnings results significantly, at least in this fiscal year. Sentiment about the future should also grow cautious, as it has in the past, but it is worth remembering that the outlook DIs tends to get weaker as current sentiment gets higher. This means that the implications are not particularly negative.

Forecast of F3/08 plan revisions

As noted, the official cut-off date for September Tankan responses is September 11. We feel that companies generally do not factor interim results revisions into their responses. This means that the upcoming Tankan is not likely to see much in the way of revisions to management plans. Listed company results were quite strong in Apr-Jun, however, so we expect that large company profit plans for 1H will see upward revisions, albeit perhaps modest ones. However, we forecast that capex will be broadly even with June, since large companies have hardly revised at all. Real capex turned negative in Apr-Jun GDP, and confidence about the future among market participants has been ruffled somewhat, but the Tankan is not likely enough to wipe out such concerns.

1) Sales and profit plans:In the June Tankan, F3/08 large company (all industry) sales plans were up +2.8% YoY and recurring profit plans rather cautiously down -0.7% YoY. Given that Apr-Jun results were strong at listed companies, however, one may expect upward revisions in recurring profit forecasts, even if only modest ones. Since companies aim to cover profit declines in 1H with profit increases in 2H, however, we expect forecasts to be largely flat, since upward revisions to 1H forecasts will be offset by downward revisions of 2H plans.

2) F3/08 capex plans:The rate of revision for large company plans becomes largest between the March and June Tankans; between the June and September Tankans we usually do not see significant changes. The reasons for this are 1) few corporations have institutionally decided on plans at the time of the March survey, which is before the end of the results period, 2) many corporations make institutional decisions on management plans for the current period at the time of the June survey with the release of previous period results, and 3) the September survey period coincides with management plan revisions based on interim period estimates, so most corporations only make minor adjustments to plans from the prior survey period in June. Incidentally, the average rate of revision for such plans in the September Tankan since F3/05 has been at most -0.1% for large companies (all industries). This means that the incoming Tankan is unlikely to have much useful information on capex prospects. We forecast +7.6% YoY for large company (all industries) F3/08 plans (+11.4% for manufacturing, +5.3% for non-manufacturing).

Since real capex shifted to a decline in Apr-Jun GDP, market concerns over the sustainability of capex are rising; however, we are not backing down from our positive stance on capex on the basis of other capex surveys (e.g., Development Bank of Japan and the like), which show plans around +10%.

In manufacturing, we expect domestic capex plans to remain high in autos, despite a slump in sales in Japan and abroad. Personnel expense has remained flat for many years, increasing the edge for domestic production, and auto manufacturers are having to expand into other regions because the jobs-to-applicants ratio has topped 2 in Aichi Prefecture where they have difficulties in hiring enough employees. The basic materials industry is another driver and should maintain high growth. In non-manufacturing, we foresee spending to upgrade industrial infrastructure in electricity and transportation, and booming capex by financial institutions.

Policy implications

With no way out of the policy muddle foreseen in Japan despite the launch of a new Cabinet and growing worries of an economic slowdown brought on by the liquidity crunch caused by subprime loan problems aboard, the current Tankan is unlikely to have strong implications for monetary policy in the immediate future. First and foremost, the BoJ will probably be forced to take a wait-and-see stance until the liquidity crunch in financial markets abroad lightens up and worries over liquidity problems at financial institutions and corporations have sufficiently receded.

Of course, not all news flow about the future is bad. According to our US economics team, CP balances have now started increasing and lending facilities from the Fed have started taking effect, so there are now signs that the liquidity crunch may be abating. And while the data flow in Japan may not be great, prospects for manufacturing performance are looking solid as makers of autos and digital appliances shift to increasing production, and a virtuous cycle deriving from the income formation process in manufacturing should be starting up again. Consumer prices could start rising because of higher oil prices as soon as October, rather than November.

Given this situation, the next Tankan in December (Dec 14) could pick up with good manufacturing performance, and corporate plan revisions could be regarded as strong in both profit estimates and capex plans after good interim results. We assume that a third interest rate hike is possible at the December MPM (Dec 19-20) at the earliest for those reasons. The market consensus is more cautious, but the decisions to forego interest rate hikes at the January and August meetings show that the consensus has virtually no value regarding predictions of BoJ policy. We believe it is a time not to be deceived by the flood of superficial information and to once again assess fundamentals calmly.