A Decoupling of Sorts
October 24, 2007
By Luis Arcentales | New York
While the debate on whether emerging markets can decouple from the US cycle rages on, one would be hard pressed to find ‘Mexico’ and ‘decoupling’ together in the same sentence. Given how mild the slowdown in US economic activity has been so far, the decoupling debate is unlikely to be resolved anytime soon (see “Emerging Markets: Emerging Questions”, Global Economic Forum, August 28, 2007). But while buoyant asset prices in emerging markets seem to be betting on decoupling, sentiment towards Mexico has been markedly different, given its strong link to the US economy – from the traditional manufacturing channel to worker remittances – which remains very much alive and cuts both ways.
Mexican exports to other trading partners are soaring at a time when US import demand is drying up. Indeed, US real merchandise imports have been essentially flat in the year ended in August according to our US economists. While non-US-bound shipments have been growing faster than exports to the US since 2004, it is remarkable how well they have held up so far this year, thus helping ease the blow to Mexican activity from weaker US demand. After jumping 15% in 2006, exports to the US are up just 3% so far this year (January-August); meanwhile, growth in exports to the rest of the world has averaged 23% in 2007, essentially unchanged from last year’s 24% clip. The contribution to Mexican export growth from the rest of the world has been remarkable. In the first eight months of the year, we estimate that the US contributed just 41% of the total 5.9% of total Mexican export growth – less than half its 83% market share. By contrast, Europe and Latin America – which combined represented just 12% of total exports – have contributed jointly more to exports growth (43%) than the US so far in 2007. The contrast with 2000 – the year before both Mexico and the US dipped into recession for the last time – couldn’t be starker: back then Mexican exports were fully US-centric, with the US representing over 90% of growth. But will strong global growth continue to provide support to Mexican exports? With perhaps the most significant risk to our benign global outlook coming from a US hard landing, our chief US economist Richard Berner points out that the US consumer alone no longer calls the tune of the global economy. Moreover, he adds that the spillovers from weak US growth could dent but won’t seriously undermine growth abroad (see “How Long Will Global Demand Support the US Economy?” Global Economic Forum, October 22, 2007). Mexico has already felt the pinch from the US and will suffer disproportionately if the US slows more than expected; however, if global growth holds steady, then Mexico might prove more resilient as well. Making inroads into the US market
The second set of good news is that Mexico has been making modest yet steady inroads into the US imports market, a trend that runs counter to the claims that Mexico’s competitiveness is eroding. Mexico’s total share of US imports is at its highest level in nearly three years. Importantly, however, this is more than just a story of soaring oil prices: once we strip out oil, the picture looks even better, with Mexican manufacturing exports commanding the highest market share since late 2003. Part of the improvement can be traced back to the success of the Mexican automobile industry, which has gained meaningful ground and now represents over 20% of the US market – a historical level. Still, strip auto shipments from total manufacturing exports and the picture is still a positive one. While there is little Mexican exporters can do about the trajectory of US demand going forward, they have certainly been doing something right since increases in market share are currently playing a more important role in driving export growth than in the past. The experience of 2000 is quite telling in this regard: with US merchandise import growth soaring 19%, it made little difference that the growth in Mexican exports explained by share gains was barely about 20%, with half of that coming from the auto sector. Today, by contrast, market share gains have accounted for nearly 40% of total growth of Mexican US-bound exports. Importantly, the auto sector has been a small drag this year, suggesting that diversification has played a positive role. Bottom line
The ability for the Mexican economy to insulate itself from the US business cycle is limited, but Mexico’s exporters have been in the midst of a decoupling of sorts. In the face of anemic import demand from the US, Mexico’s exports to the rest of the world have soared. And even within Mexico’s most important market, namely the US, Mexican exporters have managed to post modest yet steady gains in market share. The upshot: the magnitude of Mexico’s trade link to the US remains overwhelming, but the dynamism of Mexican non-US bound exports is helping to soften the hit on Mexican economic activity from sharply lower US import demand. The more important ‘decoupling’ Mexico has been experiencing of late, however, does not come from the trade front but from its own past of gridlock. The passage of the public pensions and, more recently, the fiscal reforms are a sign of an administration capable of breaking through the political gridlock that characterized Mexico’s past decade and raise the possibility of further reform progress. In particular, we suspect that moves on the energy front – an important step to reverse Mexico’s deteriorating oil trade balance – labor and telecom could come as early as next year, with positive implications for competitiveness and long-term growth.
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Revising Our ZAR, Oil and CPIX Outlook
October 24, 2007
By Michael Kafe and Andrea Masia | Johannesburg
Revisions to currency and oil price trajectory: After the June interest rate hike, we warned that the resumption in policy tightening was likely to dim growth prospects, stifle equity portfolio inflows and hurt the currency. Well, we did see a sharp move in $ZAR to 7.5 in the middle of August, but this had nothing to do with South Africa’s growth outlook. Nor did portfolio equity inflows dry up as we had expected. In fact, portfolio inflows soared to record levels in August. Since August, the currency has appreciated significantly, reaching a low of $ZAR6.73 this month. Although we still favor a weaker rand from here, the low base, together with a number of softer issues, calls for a revision to our year-end target. We now expect $ZAR to close the year at 7.20, before depreciating to 7.60 and 8.10 at the end of 2008 and 2009, respectively. This is 30c stronger than our earlier forecasts of 7.50, 7.90 and 8.40. Our rand forecast revision is driven by three main reasons: First is the recent appreciation in the currency: After the Monetary Policy Committee of the South African Reserve Bank opted to raise interest rates by 50bp in June, we highlighted the growth risk associated with the decision, and warned that our year-end $ZAR target of 7.50 (a 5.6% depreciation over two quarters, given an average $ZAR reading of 7.1 in 2Q07) could be brought forward if portfolio equity inflows dried up while the balance of payments on the current account remained in deficit. Well, we have been wrong on the currency since then, as the rand actually appreciated to 6.80 the very next month. Although we did see some brief weakness in August, that bout of weakness was driven more by general emerging market risk aversion than the idiosyncratic growth prospects that we had anticipated. In fact, the rand subsequently rallied to 6.75 earlier this month, and is now trading at 6.85. We still believe that weaker fundamentals (higher inflation, weaker growth prospects, political uncertainty, etc.) call for a weaker currency from here; hence, we leave the expected rate of depreciation unchanged for 4Q07, 2008 and 2009. However, the present low base implies that the year-end target should come in just above R7.00/$, ceteris paribus. But it is worth bearing in mind that South Africa’s political risk has no doubt risen lately, as the possibility of a Zuma presidency has gained traction, while opinion polls show that Mbeki’s popularity has waned. At some point, investors are likely to demand a higher risk premium to compensate for Zuma’s perceived affiliation with the left, in our view. This makes us believe that $ZAR could easily close the year above 7.00 – say, 7.20 or higher. Second is the country’s growth prospects: We have no doubt that policy tightening of 350bp since June 2006 is combining with currency strength to hurt the country’s 16%-of-GDP manufacturing sector, with negative implications for overall GDP growth (see South African Manufacturing More Sensitive to Interest Rates than Previously Thought, September 20, 2007, and Tight Squeeze in Monetary Conditions for Manufacturers, October 5, 2007). In fact, the SARB’s own leading indicator is now pointing towards weaker growth prospects, and we believe that the October 11 rate hike has worsened the outlook even further. However, as mentioned a fortnight or so ago (see South Africa: Prioritizing Inflation Over Growth, October 11, 2007), we are concerned that, in an attempt to close the preposterous R16 billion gap (0.8% of GDP) between the 2Q07 supply-side GDP (%Q, saar) estimate published by Statistics South Africa and current estimates of the residual-adjusted demand-side GDP published by the SARB, Statistics South Africa may feel compelled to revise this year’s GDP readings significantly higher, thereby making the official GDP statistics appear better. If this does happen when the 3Q07 supply-side GDP estimates are published next month, growth-driven portfolio equity inflows are likely to remain stronger for longer, lending further short-term support to the currency. Third is portfolio flows: As mentioned earlier, our view in June was that the resumption in policy tightening was likely to dim growth prospects, stifle equity portfolio inflows and hurt the currency. Well, in July, there was a very large unwind of portfolio bond investments, but this was fully offset by strong equity inflows. In August, we had record portfolio flows, driven mainly by bond scrip transfers of some R15 billion. Since then, both bond and equity inflows ebbed dramatically, although bond flows appear to be making a comeback this month, as a number of investors have taken the view that the SARB is at or close to the peak of the tightening cycle and could in fact be cutting rates by the second half of next year. We believe that interest rate risk is still skewed to the upside, and that weaker growth prospects are likely to lead to a dry-up of equity portfolio investments in the coming months. The big question is whether bond inflows are able to compensate for the anticipated pull-back in equity inflows. We remain agnostic that they will, although we must admit that, so far, bond inflows have been stronger than we thought. Revision to oil price outlook Last Friday, our European colleagues again revised their oil price outlook (see Global Economics: Oil Overshoot, Eric Chaney and Richard Berner, October 19, 2007 for details): They now believe that, although crude oil prices have overshot fundamentals, further increases toward $100/bl are still possible, thanks to the combination of lower-than-expected inventories, OPEC discipline, renewed geopolitical tensions and robust Asian demand. Our team now expect oil prices to close the year at $82/bl ($65/bl previously), fall back to $65/bl at the end of 2008 ($58/bl previously), before coming back to close 2009 at $70/bl ($66/bl previously). Implications for inflation in 2008 and 2009 Plugging the new oil price trajectory into our CPIX grid and incorporating our revised currency forecast leads to a modest deterioration in our inflation profile. We now expect CPIX to peak at 7.4%Y in February 2008 (7.2%Y previously), fall back within the 3-6% inflation target band by May 2008, and close 2008 at 5.5%Y (5.3%Y previously). For 2009, we expect CPIX to average 5.2%, with a year-end target of 5%Y. Interestingly, our 1Q08 forecast now comes in at 7.1%Y, which is higher than the SARB’s 6.8%Y estimate (presumably because of the upward revision to our oil price assumptions), but our end-2009 reading of 5%Y is marginally lower than the SARB’s 5.2%Y forecast. We also notice that revisions to our currency outlook appear to have taken some of the heat off our 2008 core CPIX trajectory. We now expect CPIX ex food and energy to dip to 4.7%Y in the next two months, rise to 5% by year-end, and average 5.3% in 2008. This is slightly lower than our previous estimate of some 5.5%Y, and makes less of a case for further tightening. Of course, things could change pretty fast if, on December 20, 2007, the National Electricity Regulator grants Eskom more than a 10% increase in annual tariff rates.
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Impact of Stock Bubble Burst: An Update
October 24, 2007
By Qing Wang | Hong Kong
Renewed fears of stock bubble bursting
We published a note on May 28 asking the question, “What is the risk to China’s economy if the A-share market bubble bursts?” The Shanghai A-share composite index has surged by 60% from the lows reached in the aftermath of the stamp duty hike on May 30 and now hovers around the 6,000 level. The average trailing P/E reached a historical high of 64 times in September. Against this backdrop, fears of serious consequences from a potential bursting of the stock market bubble appear to have re-intensified in recent weeks. In this context and with acceleration of property prices, similar concerns have been expressed by clients about the impact of a major correction in property prices. Investors are especially concerned about the potentially serious real economic impact of a negative ‘wealth effect’ on household consumption, the financing channel for corporate investments and banks’ balance sheets.I examine two scenarios under which the stock market plunges by 30% and 60%, respectively, in a relatively short period. Based on investor feedback, there are orders of correction that could trigger different degrees of concern about the implications for the wider Chinese and even global economies. Since the paucity of data prevents us from conducting a thorough or precise simulation of such a scenario, we rely on officially published data and make several rather strong assumptions with a view to gauging how bad things could get.
Emerging ‘wealth effect’ on personal consumption
We estimate that Chinese households had about Rmb64 trillion in assets (i.e., about 264% of GDP) by end-September 2007, of which about 13% (i.e., Rmb8.6 trillion, or 35% of GDP) are in the form of stock holdings and 55% (i.e., Rmb35 trillion, or 144% of GDP) are in the form of property. China’s headline stock market capitalization stood at about Rmb26 trillion at end-September, but only about one-third of this is actually ‘marketable’, i.e., available for investment by retail investors. The rest remains held by a small number of large shareholders (mostly the state). In other words, household exposure to the stock market is much smaller than that suggested by headline stock market capitalization.
The value of households’ stock holdings as of end-September reached Rmb8.6 trillion, an increase of 240% from end-2006, of which, I estimate, 60 percentage points were contributed by the rebalancing of households’ financial asset portfolios from bank deposits to stock holdings and 180 percentage points were contributed by market appreciation. Such a massive increase in household financial wealth, which amounts to about 12% of GDP by my estimate, should in theory generate a substantial wealth effect that helps boost consumption.
Although we do not have sufficient statistics to make a reliable quantitative estimate of the exact magnitude of the wealth effect, we do find some anecdotal evidence suggesting an emerging wealth effect. Specifically, in the past, household income growth has consistently and significantly lagged real wage growth; however, income growth started to outpace real wage growth by a large margin this year. Real consumption growth has followed a trend similar to that of real income growth. Moreover, sales of luxury and high-end consumer discretionary goods have been strong and have accelerated this year, suggesting that the wealth effect underpinned by the extraordinary stock market performance may have played a role. Potentially significant impact on consumption
A typical concern about the fallout from a major stock or property market correction is the impact of the negative ‘wealth effect’ on household consumption. Households that hold stocks directly or indirectly through mutual funds feel poorer when the stock market falls. This can result in a decline in current consumption.
We look at two scenarios under which the stock market plunges by 30% and 60%, respectively, in a relatively short period. I estimate, under the first scenario, that were the stock market to plunge by 30% from current levels, the value of households’ stocks would, ceteris paribus, shrink to Rmb6 trillion. With the value of other assets unchanged, total household financial wealth would decline by Rmb2.6 trillion, or about 11% of GDP. Under the second scenario, were the stock market to plunge by 60% from current levels to the level reached in the aftermath of the stamp duty hike in late May, the value of households’ stocks would, ceteris paribus, shrink to Rmb3.4 trillion. With the value of other assets unchanged, total household financial wealth would decline by Rmb5.1 trillion, or about 21% of GDP.
To determine how such a decline in household financial wealth might affect consumption, we need one important parameter – the ‘marginal propensity to consume out of wealth’ (MPCW). As we did in the previous study, we use estimated MPCW for the US – which is around 4% based on academic literature – as a proxy, given the extreme difficulty of estimating this figure for China, due to poor data quality and availability. In other words, we assume that every Rmb100 decline in stock wealth will lead to a Rmb4 reduction in consumption. I would caution that we view the MPCW of 0.4% as a high-end figure for China, given US households’ greater propensity to consume in general and the highly developed financial markets in the US – which make it much easier to translate financial gains into cash income.
Based on an MPCW of 4%, we estimate that the direct negative wealth effect could, ceteris paribus, cause personal consumption and GDP to decline by 1.2% and 0.4%, respectively, if the market were to drop by 30% from the current level, and by 2.4% and 0.8%, respectively, if the market were to drop by 60%. Furthermore, under the second scenario (i.e., a drop of 60%), if the bursting of the stock market bubble were to have a contagion effect on the property market, causing average property prices to fall by, say, 10%, it would add Rmb3.5 trillion to the loss of household wealth. In that event, we estimate that the overall direct negative wealth effect could, ceteris paribus, cause personal consumption and GDP to decline by 4% and 1.4%, respectively.
Clearly, the negative impact of a potential market correction at the current juncture has become substantially larger than five months ago, although it still appears broadly manageable by China’s double-digit growth standards, in my view. Moreover, I should point out that we estimate only the direct impact, and in practice there would be second-round multiplier effects that would amplify the ultimate impact. Nor do we assume any policy reaction in our estimate, while, in practice, policy makers may well react with various measures that would effectively mitigate the impact.
Moderate direct impact on investment
Investment would be negatively affected by a bursting of the stock market bubble through two channels: 1) If the underlying final demand (e.g., consumption) weakens due to a negative wealth effect, investment would be cut back due to a less favorable outlook; and 2) a bursting of the stock market bubble would halt the market’s function of capital raising. The first has to do with the impact on final consumption from a negative wealth effect, which we addressed in the previous section. Regarding the second, I do not believe that a correction of the stock market by 30% or even 60% from current levels would change the desire of Chinese companies to invest now for the purpose of a public listing in the future.
Since my view on this particular point has remained unchanged, the paragraphs below are based on the relevant section in our previous note with updated data (see China Economics: What Is the Risk to China’s Economy if the A-share Market Bubble Bursts, May 28).
The theoretical counterpart to the ‘wealth effect’ on consumption is the ‘Tobin’s q theory’. According to this theory, a firm will invest if the stock market’s valuation of new capital addition (or investment) to the firm is higher than the actual replacement cost of the capital. Tobin’s q is the ratio of market valuation of the capital to its actual replacement cost. When q is greater than one, investment is worthwhile and encouraged. For example, if a firm has an investment project that costs Rmb10 million and the completion of the project will increase the overall market value of the firm by Rmb12 million, it makes sense for the firm to carry out this investment, as it creates an additional Rmb2 million of market value. As such, a booming stock market encourages investment; conversely, a plunge in stock market prices tends to lead to a contraction in investment.
However, we believe that a 30% or even 60% correction in the stock market from current levels would be unlikely to have much of an impact on fixed-asset investment in China. First, we argue that the value of Tobin’s q in China is always substantially greater than one regardless of the performance of the stock market, mainly reflecting the low replacement cost of capital goods in China. The financing costs of investment projects (e.g., the interest rate on the bank loans) are kept substantially below the market-clearing level. The binding constraint on investment decisions is usually not the cost of capital but the availability of bank loans. Reflecting low interest rates, there is always strong demand for investment, generating the tendency for over-investment. While a booming stock market should drive Tobin’s q far above one, a 30% or even 60% decline in the stock market from current levels would by no means take it below one, in our view. Put another way, we do not believe that Tobin’s q is a binding consideration when investment decisions are made in China. This explains in part why approvals of IPOs in China are still tightly controlled and even rationed.
Second, as a source for investment financing, the amount of capital raised directly from the stock market remains very small. In 2006, only slightly over 2% of total financing for fixed-asset investment came from the A-share market. Although this ratio has increased substantially in the first eight months of this year, it is still very small. This suggests that even if stock market financing is shut off completely in the wake of a correction, corporate investment financing conditions would not deteriorate significantly, as long as other channels of financing remain open.
In fact, at the current juncture, there could be a rather perverse outcome: A bursting of the stock market bubble may make more funds available for investment in physical assets. With expected returns from investing in the stock market substantially and persistently higher than those from traditional investment activity, firms may have channeled the funds that would otherwise be used for fixed-asset investment into the stock market. A bursting of the stock market bubble should help firms to refocus on and make funds available for real and productive investment activity.
Other impact
My view on the other impact of a bursting of the stock market bubble (e.g., banking sector, social and global) remains broadly unchanged (see China Economics: What Is the Risk to China’s Economy if the A-share Market Bubble Bursts, May 28, and China Economics: An ‘Untimely’ Question: What Could Go Wrong with the Economy? July 23).
In particular, I continue to believe that the impact on bank balance sheets will likely remain manageable for the reasons I discussed in two previous notes. I would become more seriously worried if bank loan growth started to get out of line with the underlying real activity, as this would indicate that some funds from the banks are somehow being channeled to the stock market, even if there is no clear evidence that funds borrowed from banks are invested directly in the stock market. This is because money is fungible: Banks could still be indirectly exposed to the stock market if the corporate sector invests its own funds in the market and simultaneously increases borrowing from the banks for other ‘legitimate’ purposes. In this regard, I have not detected a disconnect between the growth rate of bank credit and that of real underlying activity. At the same time, I shall remain vigilant on this front, as cross-country experience suggests that the longer the bubbly stock market lasts, the more exposed the banking sector will likely become.
Risks
This type of exercise is rather crude, and our estimate is subject to considerable uncertainties due to paucity of data. Nonetheless, it illustrates that the potential impact of the bursting of the stock market bubble will increase substantially if the market continues rising rapidly. We shall keep a close eye on stock market developments and their impact on the real economy and convey to clients our regular updates on the potential impact of the stock bubble bursting.
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