Global Currency
‘RMBisation’ and the HKD
November 02, 2007

By Stephen L. Jen | London

Summary and conclusions

The HKD is under a great deal of speculative pressure to appreciate.  Investors understand that Hong Kong’s demand is driven by China but its monetary policy is set by the Fed.  This fundamental inconsistency suggests that either HK will need to on the one hand permit higher goods price and/or asset price inflation, or, on the other hand, revalue or float the HKD. 

We believe that the HKD peg will survive, and that HK will choose higher inflation, so as to preserve the peg. 

The purpose of this note is not to argue why we believe that the HKD peg will be preserved, but rather to suggest that there is a ‘way out’ for the HKD, and that the authorities have already sown the seed for an eventual ‘resolution’ of the HKD peg.  There will not come a time when the HKMA will be forced to re-peg or float the HKD. 

The peg will stay for the foreseeable future

Our colleagues in Hong Kong, including our AXJ FX Strategist Stewart Newnham, have already made the case for the HKD peg (see HKD: Withstanding the Perfect Storm).  We concur with this call.  Without going into too much detail, we highlight the key arguments in favour of the peg.

1. The benefits to HK from a transparent and stable currency peg still outweigh the costs, even in light of the intensified economic and financial interactions with the Mainland;

2. Hong Kong sustained a protracted period of stagnation and deflation following the Asian Financial Crisis in 1997; it did so to preserve the HKD peg.  Now, the ‘pain’ of sustaining asset price inflation is simply not that painful.  It is not clear why HK should be compelled to revalue.

3. There is no obvious link between the parity of the HKD and the CNY, relative to the USD.  Some argue that somehow the two should trade at par.  The logic of this argument escapes us. 

4. Back in 1997, the HKD was under depreciating pressure because the Chinese RMB was also being pressured to weaken.  The competitiveness argument was valid, though both China and HK did not relent.  However, just because China is allowing the RMB to appreciate does not mean that HK should do the same just to ‘remain as uncompetitive relative to China’. 

(One other observation we should make here is that, in our experience, it seems that most of the non-Chinese like the idea of the HKD peg being dismantled, while most of the Chinese/Hong Kongese think otherwise.) 

The ‘way out’ for the HKD

Whether the HKD peg is preserved in the coming 2-5 years is a valid debate, and one on which we have a firm position.  What we would like to discuss here, however, is what will happen to the HKD in the long run?  China will most probably continue to grow and mature.  Its currency and the financial markets will also become increasingly developed.  It is logical to expect Hong Kong to become even more integrated and reliant on China.  Will the HKD one day be pegged to the Chinese RMB?  If so, at what parity, and when will this happen?  These are all valid questions. 

However, we suggest that none of the above needs to happen.

Specifically, the Chinese RMB is already a legal tender (on a limited basis) in Hong Kong.  Some retail transactions can now be settled in CNY cash, and bank deposits and loans can be denominated in CNY.  Going forward, the HK government has the option of gradually liberalising the use of the CNY in HK.  One day, the CNY could attain full legal tender status as the HKD has.  

This system of having two currencies circulating in parallel bears resemblance to the ‘Bi-Metallic system’ in the UK in the 17th century and Europe in the 17th-19th century, and to the concept of ‘dollarisation’, whereby developing countries (such as Latin America) use and hold the US dollar as an alternative to the local currencies.  Our point is that, as the CNY gradually gains a reserve currency status, which will not be easy, the use of the CNY in HK will broaden, crowding out the HKD.  If China hits setbacks in internationalising the CNY, the use of the HKD will automatically gain ‘market share’ in HK.  This will be a competitive market that will allow ‘the best currency to win’.  One day, if everything goes well for the Chinese RMB, the HKD could simply not be used.  The HKMA may therefore not have to face the day when it needs to make a difficult decision regarding the HKD peg. 

We have the following thoughts: 

Thought 1.  The Chinese RMB’s road to a dominant reserve currency will be a long journey.   It is not easy for a currency to become a reserve currency.  The central bank will need to have solid credibility and transparency.  The financial markets need to be liquid and market-driven.  The bond market should be deep enough for both open market operations and to satisfy the demand from foreign investors who would like to hold underlying assets denominated in the currency in question.  The yield curve should be liquid and meaningful.  Last but not least, the capital account should be convertible.  This last point is important, as with the exception of the Japanese yen, the HK dollar, Australian dollar and the NZ dollar, none of the Asian currencies are fully convertible on a capital account basis.  Our point here is that anticipating a HKD peg to a fully convertible CNY may be premature. 

Thought 2.  The ‘Bi-Metallic System’ and Gresham’s Law.  In the 17th century in England and the 19th century in Europe, both gold and silver were circulated in parallel as legal tenders.  The metallic content and the relative price of gold and silver had a major impact on whether silver or gold dominated as the medium of exchange.  Gresham’s Law, which stipulates that bad money drives out good money, was based on the notion that the intrinsic value of the coins varied between coins with the same denominations or face values.  Bad-quality coins (those with a lower metallic content) tended to drive out high-quality coins. 

For Hong Kong, what we have in mind is just the opposite:  good money driving out bad.  With the CNY and HKD being freely circulated in HK, the relative merits and de-merits will be competitively determined.  In theory, the appreciating currency should be hoarded (as a store of value), while the spot exchange rate per se should not have a major bearing on how broadly the CNY or the HKD is used as the medium of exchange, contrary to popular opinion.

For the Chinese RMB to fully displace the HKD, the former will need to be seen as the superior money in all three aspects: store of value, medium of exchange and unit of account.  Our point above is that, as the RMB has appreciated against a stable HKD, the RMB’s role as a store of value has been enhanced but its role as the medium of exchange has weakened.  Unless the Fed completely loses credibility and contaminates the HKD, it is not clear why the RMB should be a better unit of account than the HKD.  Presumably, residents in HK should still be more familiar with pricing in HKD terms.  However, in the long run, when HK becomes even more integrated with the Mainland, pricing transparency in HK will also be an important consideration for the Mainlanders.  In that situation, using the CNY as the unit of account in HK may become more advantageous. 

In any case, the key point here is that the two currencies will eventually be in a competitive race, determined by market forces and their relative merits and de-merits.  It will be a rather ‘automatic’ process, obviating the need for the HKMA to adopt an interventionist stance or face the ‘day of reckoning’ with an abrupt policy shift on the currency regime. 

Thought 3.  ‘RMBisation’.  This concept is analogous to ‘dollarisation’.  It is also related to the ideas discussed above.  Rather than focusing on the HKD parity, 7.80 or a lower level, we believe that the Government of Hong Kong’s long-term strategy is centred on another degree of freedom, through the breadth of use of the Chinese RMB in HK.  In contrast to the experiences of developing countries with dollarisation, ‘RMBisation’ would be encouraged and legalised by the HK government. 

Bottom line

The Chinese RMB is already a (limited) legal tender in Hong Kong, circulating in parallel with the HKD.  Over time, it could be allowed to compete with the HKD, as a store of value, medium of exchange and unit of account.  This competitive process will automatically reflect the ascent or descent of the RMB as a reserve and internationalised currency, obviating the need for the HKMA to face a ‘day of reckoning’ with the HKD regime.  Taken to the extreme, it is conceivable that the CNY one day simply crowds out the HKD, as the preferred money in Hong Kong, without the HKMA being forced to make a discrete decision regarding the exchange rate regime. 

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Japan
Downside Risks from Policy
November 02, 2007

By Robert Alan Feldman | Tokyo

My colleague Takehiro Sato points out downside risks to the economy from the housing sector (see “Another ‘Subprime’ Shock” in today’s GEF). There are other downside risks lurking, which stem from paralysis, poor coordination and backsliding,

Policy paralysis risk

Policy paralysis risk has already emerged in some areas, such as defense policy. In seeking to force a general election, the opposition party, the Democratic Party of Japan (DPJ), is using all possible methods to pressure the government. A key part of this strategy is to use the power of the Upper House, where the DPJ recently won a majority, to stall appointments of candidates for government posts. Many such appointments require the approval of both houses of the Diet, and so the capture of the Upper House by the DPJ gives that party veto power over appointments.

In some respects, the DPJ is making valid arguments. It is necessary to have more open debate about the quality of appointments. For example, as I pointed out two weeks ago (Political Competition Will Make BoJ Better, October 15, 2007), a set of criteria on which to judge appointments to the top jobs should improve public acceptance of appointments. The downside is that a slowdown of appointments will also slow policy implementation.

For investors, the prospect of paralysis is troubling. For example, failure to act on the March expiration of the temporary cut of dividend taxes could harm the equity markets. Failure to act on the March expiration of temporary gasoline taxes could lead the fiscal deficit to balloon. The slowdown of appointments might give middle-level bureaucrats even more power over decisions.

Coordination risk

The supply-side measures that induced the sharp housing slowdown were one example of poor policy coordination harming the economy. In theory, major changes of regulations should be debated by the Council on Economic and Fiscal Policy (CEFP), and implementation coordinated among ministries. In this case, however, the rule changes were not considered in a cross-ministry context, and the result was adverse. Another example of policy coordination risk has arisen in financial markets. The impact might come in the foreign exchange market.

In order to improve investor protection, the new Financial Instruments and Exchange Law (FIEL) requires investors to attest to their ability to understand new products. According to people in the front lines of selling financial products, the specifics of the new requirements were only finalized with a month’s notice before implementation. This did not give the sellers of these products enough time to prepare for new procedures, or to discuss the implications of the new methods with the authorities. The result has been a nosedive in sales of many financial products. One retail fund of a major broker reportedly placed only JPY 50 billion out of a planned offering of JPY 400 billion. Others have reported as much as an 80% decline in the sales of some financial products.

Investor protection is clearly important, and some recent losses by unsophisticated investors in forex markets might have been avoided if such suitability rules been in place in the past. That said, the short period for understanding the new rules will likely exacerbate the collapse of bond outflows by residents. This collapse was already visible in data from the summer. Such outflows averaged about JPY 18 trillion at an annual rate from early 2004 to early 2006, but dropped sharply in mid-2006. After a recovery in spring this year that coincided with the weakening of the yen, bond outflows over the summer collapsed again, and coincided with a strengthening of the yen. Should the disruptions from the troubled introduction of the new investor protection procedures persist, then a key element in the argument for a renewed weak yen – outflow from retail investors – will be less convincing. Those positioning for a weaker yen could close their positions.

Backsliding risk

The biggest policy risk is backsliding. Already, the Fukuda government has reversed course on several important reforms. The new government wants to freeze the legislated increase of medical user charges, continue road tax earmarking, and focus on tax hikes (rather than spending cuts) as the main source of deficit reduction. Moreover, there is persistent talk of a major supplementary budget, in order to pay for policy changes. Once the momentum for a supplementary budget grows, it is very likely that many politicians – who face a general election soon – will opt for more spending.

So far, financial markets have not paid much attention to policy backsliding. However, once the difficult issue of the anti-terrorism law is settled, political attention is likely to return to the economy. In light of the focus on tax-and-spend policies by the ruling party, the reaction of taxpayers and markets might be adverse.

 

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Argentina
The Challenges Remain
November 02, 2007

By Daniel Volberg | New York

Argentina has elected a new president, but the challenges for the new administration of Cristina Fernandez de Kirchner are much the same as those facing her husband, the outgoing president. While we view the challenges on the fiscal and energy front as the most immediate tasks facing the new administration, we believe that the most difficult task centers on inflation and the Indec scandal. We expect the authorities to make progress on the fiscal and energy fronts, but are cautious about how successful policymakers will be in tackling inflation and rebuilding the credibility damaged early this year with the handling of the statistical institute’s measurement of inflation.

The fiscal challenge

In the run-up to the election, fiscal spending began to outstrip revenue growth, producing a significant risk to what has long been one of the most important anchors to investor confidence in Argentina. When we exclude asset transfers from the AFJP pension system – a source of funds that will not be available next year – we find that in the nine months of this year, total federal revenue has grown at an annual rate of 32%, compared with nearly 42% growth in spending. If the mismatch is not addressed in short order, Argentina’s overall fiscal surplus could turn into a deficit as early as 1Q08. 

The administration will need to tackle ballooning public works – public investment and subsidies – and social security spending, which have contributed to the weakening in the fiscal accounts in 2007. Indeed, rising social security and public works spending each accounted for roughly a third of the total increase in outlays in the first nine months of the year. The deterioration in social security outlays is driven largely by a change in regulations that extends social security benefits to low-income individuals who never paid social security taxes. The good news is that much of the deterioration is one-off: after the current one-time 60% increase in the number of retirees this year, we do not expect to see a dramatic change going forward.

More worrisome is the increase in public works, evenly divided between investment and subsidies. The administration has widely used subsidies and increases in public investment in an attempt to alleviate the many bottlenecks resulting from the distortions caused by price controls, energy shortages and strong growth.

If the authorities fail to cut fiscal spending to shore up the fiscal position, Argentina could even begin to face financing difficulties next year. We estimate that Argentina has financing needs of roughly US$6 billion in 2008 that it will need to finance through new debt issuance.  If roughly half of that sum is raised through joint issuance with Venezuela and another US$1 billion is raised from the local financial sector, this could still leave roughly US$2 billion to be raised elsewhere, likely from foreign investors. While the authorities have been careful not to rule out the use of international reserves if financing conditions were dire, we suspect that they will institute spending cuts and indeed work on restructuring or repaying the defaulted Paris Club debt as their first act of business. This should help ease fiscal and financing concerns.

The energy challenge

The authorities are also facing an energy challenge,as strong growth in demand – rising by nearly 55% among regulated customers since 2001 – has outstripped relatively stagnant supply. Trying to determine exactly how close Argentina is to a supply-demand imbalance in electricity is always a difficult task, given the complexity of accurately determining peak factors and distinguishing between nominal and actual generation capacity. But the recent and reoccurring blackouts would suggest that the margin of maneuvering room has largely evaporated. 

We expect the new administration to avoid a major energy problem by partially liberalizing frozen energy tariffs in order to slow demand while also creating incentives for a medium-term increase in energy supply. A significant tariff adjustment implemented in the final months of this year or in the first few months of 2008 could slow demand and buy time for both public- and private-sector investment to come onstream. We doubt that the move will address all the challenges facing energy policy in Argentina, but we suspect that some tariff adjustment will be made that should alleviate pressures in 2008. There is talk in Argentina that the tariff hikes could be concentrated on residential consumers above a certain usage threshold in an attempt to maintain subsidized tariffs for the lowest income group.

The inflation and Indec challenges

While fiscal and energy challenges are the most immediate, we think that the inflation and Indec challenges are likely to prove harder to resolve and concern us the most.  Although we believe that the inflation and Indec challenges are two separate issues, they are intertwined. Indeed, we suspect that a full restoration of confidence in Argentina’s inflation statistics is unlikely until the conditions to bring inflation back under control are present.

We estimate that inflation in Argentina has accelerated from around 10-11% in late 2006 to roughly 15-17% today. It is hardly surprising that inflation has emerged as a problem. After all, with GDP growth near 9% for five consecutive years, an exchange rate policy that has allowed for little, if any, nominal appreciation despite the dramatic terms of trade shock and a wage policy aimed at boosting domestic consumption, the uptick in inflation is understandable. With real productivity growth likely to slow to near 2% next year, current nominal wage growth near 20% would imply an inflation rate of 18% to equilibrate real productivity and real wage growth. In such a scenario, there is a meaningful risk that unions would push for additional wage hikes, leading to further deterioration on the inflation front.

We expect that a combination of energy tariff liberalization, fiscal and monetary tightening and some temporary wage and price controls can be implemented in order to slow the economy and control inflation. Shoring up fiscal accounts and tightening monetary policy would likely go a long way towards reducing inflation expectations – currently median 12-month ahead expectations are at 20% – a necessary step in order to contain the fallout from wage negotiations in March. At the same time, liberalizing energy tariffs would translate into higher prices and, if wages are contained, could generate a downshift in demand while boosting investment. Bringing inflation under control would in turn make it possible to restore credibility to Indec, in our view.

Bottom line

While we expect steps to be taken to deal with the fiscal and energy issues in the near term, we are concerned that a successful resolution of Argentina’s inflation challenge requires a major rethinking of the current policy mix. The current mix, which has been very effective at stimulating demand growth, may have been appropriate to deal with the fallout of the crisis in 2001. But we suspect that today it is increasingly a drag on the economic outlook. The combination of controls and active intervention in the currency markets to keep the peso weak, along with accommodative fiscal and monetary policy despite the rapid growth in demand, needs to be rethought. The challenge for the new administration is to take advantage of the change in the presidency on December 10 to build the transition from what has been a remarkable five years of strong growth to an even longer period of sustainable growth.  On that front, the verdict is still out.

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Currencies
Waiting for Coordinated Intervention?
November 02, 2007

By Stephen L. Jen & Charles St-Arnaud | London

Summary and conclusions

The depreciation of the dollar is gaining speed, and what has so far been an orderly correction in the dollar is at risk of degenerating into a more violent correction.  The potential costs – collective costs to the G7 – of further dollar depreciation are quickly catching up to the benefits.  It is not too early to begin contemplating the risk of coordinated interventions by the G7. 

In this note, we make two points.  First, history shows that, as a rule rather than an exception, multilateral coordinated interventions have been key in establishing turning points in multi-year trends in the major currencies in the past three decades.  This does not suggest that multilateral interventions are all-powerful.  Rather that, done in the right circumstances, these ‘definitive policy gestures’ may have been effective in encouraging investors to react in a way that has helped the currency markets re-equilibrate themselves.  The sole exception was in 2002, when the dollar’s ascent began to abate, unprovoked by official action. 

Second, the weak dollar has so far served some countries well, while not being troublesome enough, yet, to alarm the G7.  This means that we may be some distance away from seeing coordinated interventions, and therefore the dollar could fall further.  Having said this, though coordinated interventions may not be an immediate threat, they should now be on our radar screen.  Any coordinated interventions are most likely to occur when the Fed, the ECB and Japan believe that their monetary policy paths have stopped diverging, i.e., the Fed is done cutting rates, or the ECB is done hiking rates.  This may be at least several weeks away. 

Our conclusion, therefore, is that the dollar could weaken further before such countermeasures are deployed by the G7, but investors should start to anticipate this eventuality.

The toxic mix of cyclical and structural USD concerns

Despite our structurally constructive bias in favour of the dollar, against the EUR and GBP, at these spot levels, we believe that there are compelling reasons why the dollar has weakened in the last two months and why it is likely to stay on its back-foot for the coming two quarters.  The expected divergence between the US economy and much of the rest of the world (RoW), and the associated monetary divergence, have contributed to the decline in the dollar since this summer.  This dollar downtrend is likely to persist as the US slows, and as risk capital flows continue to build in order to capitalise on the growth opportunities outside the US. 

Even though we are strong proponents of global economic de-coupling, whether this thesis is absolutely correct has not yet been truly tested, as US consumption has not yet slowed materially.  All that has been propelling the dollar lower are investors’ expectations of economic slowdown in the US and the Fed’s front-loading of rate cuts.  From a cyclical perspective, this is the worst environment for the dollar.  In other words, we are at the (deep) trough of the ‘Dollar Smile’. 

We believe that investors are shorting the dollar not only because of the cyclical worries, but also because of some structural concerns.  To us, some of these concerns are more valid than others.  The process of trade globalisation – for which the US has been the biggest champion since WWII – entailed a form of ‘Economic Colonialism’ whereby a core-periphery relationship between the developed and the developing countries benefited primarily the capitalists in the developed world and the labourers in the developing world.  (While we do not feel totally comfortable with the negative connotations of the word ‘colonialism’, we believe that it describes this asymmetric core-periphery relationship reasonably well.)  However, what is fundamentally an asymmetric trade relationship, over time, has helped make the world more symmetric.  As a result, a uni-polar world centred on the US has evolved into a multi-polar structure that is intrinsically more stable.  Further, as developing countries’ financial systems mature and their policy-making capacity improves, no longer is there as much demand outside the US for the dollar as a store of value or a medium of exchange.  This is an incremental shift, not a discrete change, in the hegemonic status of the US dollar.  But the point is that the current cyclical vulnerabilities of the USD and dollar assets have kindled some investors’ longer-term worries about the role of the dollar in the world, triggering large capital flows that are unfavourable for the dollar.  This is, we believe, one reason why the dollar has weakened so much, so quickly. 

Not only is the world less US-centric, and growth opportunities outside the US are looking more attractive, but economic decoupling also implies that financial portfolios in general should be more diversified across countries.  The likely currency impact of the sovereign wealth funds (SWFs) is one derivative of this line of thinking, that financial wealth accumulated in these developing countries is likely to be deployed in a pattern that is more proportional to the relative size of the various economies and markets, rather than skewed in favour of the USD, EUR and GBP sovereign bonds. 

Other structural worries are perhaps less compelling to us, such as the US geopolitical stature, its moral leadership and the current account (C/A) deficit.  In any case, we recognise that some structural worries about the dollar are legitimate, and have turbo-charged angst regarding the dollar that should fundamentally be cyclical in nature. 

The dollar may not stop falling unless it is stopped

Given this backdrop, how much further will the dollar fall?  What will halt this slide in the dollar?  We make the following two points: 

• Point 1.  The key turning points of major trends in the G3 currencies since the 1970s have coincided with coordinated interventions.  Over the past three decades, multi-year adjustments in the USD, (synthetic) EUR and JPY have almost always coincided with or were led by coordinated interventions, with one exception in 2002.  Since the 1970s, the natural economic mechanisms that should, in theory, have helped halt the dollar sell-off (i.e., sharp turns in trade balances and large capital flows attracted by asset prices at ‘fire sale’ levels) were not in fact usually strong enough to reverse these currency trends.  This was why multilateral interventions were usually required to facilitate the re-alignments of exchange rates. 

In Econ 101, we all learned that large exchange rate moves should, in theory, have two main effects which should, in turn, temper the exchange rate movements and, up to a certain point, actually help to reverse the currency trends.  Specifically, as its currency weakens, the trade balance and net capital flows of the country in question should, in theory, improve; in turn, this should temper the currency depreciation, notwithstanding the J-curve effect.  However, in practice, the experience witnessed in the past three decades post-Bretton Woods has been quite different.  Specifically, with only one exception (the dollar’s topping out in early 2002), all of the multi-year adjustments in the G3 currencies coincided with or were led by multilateral currency interventions.  The Plaza Accord and the Louvre Accord are well-known.  In 1995, when USD/JPY crashed, joint G2 interventions helped stabilise the market.  In the subsequent two years, the sustained and powerful rise in USD/JPY contributed to the Asian Crisis, and prompted the US and Japan to conduct joint interventions in the summer of 1998, to support the JPY.  Similarly, EUR/USD declined to 0.83 by autumn 2000 before the G7 conducted coordinated intervention on September 22, 2000.  (Incidentally, there were ample predictions of the permanent demise of Europe and anything European, much like the terminal sentiment about the US and the US dollar right now.)

The curious observation is of course that such big moves in exchange rates failed to trigger a self-equilibrating process through either trade or cross-border investments. 

In the current episode, while the Fed’s broad dollar index has weakened by more than 22% since early 2002, and the US C/A deficit has finally begun to shrink, it has evidently not shrunk enough – in terms of both speed and magnitude – to halt the decline in the dollar.  Capital flows have played an important role.  The question is, at these levels of the USD and US asset prices (properties, company shares, etc.), why there aren’t greater capital inflows (M&A and portfolio flows) to stop the fall in the dollar.  If anything, we are witnessing a probable wholesale diversification from USD assets, by US real money investors, some central banks, and almost all the SWFs.  

In any case, the upshot is that, in the current episode, the dollar could potentially weaken meaningfully further, with EUR/USD, cable, AUD/USD and other crosses setting new highs in the coming two quarters or so, despite the fact that the dollar is already under-valued against these currencies. 

• Point 2.  The preconditions for G7 coordinated interventions have not yet been met.  A weak dollar is rather acceptable to most of the G7.  So far, the dollar correction has been orderly.  Despite the US Treasury’s ‘strong dollar policy’, the weak dollar has contributed to some of the recent improvement in US export competitiveness.  For the US, as long as the pace of the USD decline does not trigger inflationary pressures or a more violent capital flight that undermines the US Treasuries market, a weakening dollar should not be a concern.   

Across the Atlantic, the ECB is facing stagflationary conditions, with the HICP drifting towards 3.0% (2.6% in October and rising), and the economy starting to exhibit signs of a slowdown.  Buba President Weber’s espoused position that the ECB should remain vigilant on inflation is, in our view, a good reflection of the concerns in the Council at this juncture.  A strong EUR has obvious benefits, in terms of inflation control. At the same time, it is far from clear that the high level of EUR/USD is exerting serious pressures on European exporters, who remain reasonably competitive and are likely to be flexible enough to cope with the EUR’s appreciation.  Further, around 70% of Euroland’s exports are to EU members anyway.

For Japan, the weak dollar has only been felt through the EUR/JPY axis.  Given the recent deceleration in economic activities in Japan, Japan should not feel too uncomfortable with the dollar’s trajectory in the last two months. 

When will the G7 contemplate intervention?

It is difficult to pin-point specific levels of possible interventions.  However, we suspect that we may not see coordinated interventions below 1.50. We have the following considerations: 

1. Look for a peak in inflation and M3 growth, and a deceleration in output growth.  A collapse in the dollar would be a major concern for Euroland, despite what the German officials say.  Many multinational exporting firms are not competitive at the current level of the EUR, and have a limited period (6-12 months) in which to find ways to cope with the strong EUR before their currency hedges expire.  But as long as the HICP is drifting higher, and M3 growth remains in the 11-13% range, it might be difficult for the ECB to agree to coordinated interventions, because a pre-requisite to doing so would, in our view, be a termination of the tightening campaign and policy bias.  This scenario may be several bad data prints away.  In any case, the ECB could be, as we argued previously, tardy and less pre-emptive in voicing its concerns about the EUR, unless economic data deteriorate significantly. 

2. The strong EUR has kindled a considerable amount of pride for Europeans.   The ascent of the EUR may be a source of pride and confidence for some Europeans. It may also have helped soften memories of 2000 and 2001 when the EUR collapsed, and validates the notion that Euroland is a genuine economic rival to the US.  This sentiment is likely to offset much of the exporters’ complaints and delay the timing of coordinated interventions. 

3. The US may not act on the dollar in the near future.   Inflation pass-through in the US is extremely low, according to the Fed’s research.  We calculate that, using the Fed’s elasticities, the dollar index needs to fall by 50% to generate a 0.75% rise in inflation.  Thus, the depreciation in the dollar is not likely to be an inflation worry for the Fed.  The more likely risk is a wholesale withdrawal from USD assets.  This is a greater concern to us, and we suspect that if EUR/USD continues to drift higher at the recent pace, there could be a material risk to such a capital flight scenario.  It is not clear if the US Treasury is as worried as we are about this risk.  Further, the US Treasury has maintained the ‘market-is-always-right’ ideology regarding exchange rates.  It would take a lot for the Treasury to renounce this ideology and conduct interventions. 

4. Japan would intervene if USD/JPY collapses towards 100.   Continued dollar descent will lead to mounting pressures on USD/JPY.  Most investors agree that the JPY is undervalued, and don’t find the Japanese diversification argument convincing (while we do).  This means that, if and when USD/JPY sells off, it is likely that non-Japanese investors will quickly build short USD/JPY positions in anticipation of a repeat of 1998.  In real bilateral terms, the 24% collapse in USD/JPY in the summer of 1998 is analogous to a decline from the current level to 87.4.  We suspect that the MoF would want to avoid such a scenario. 

Bottom line

Since the 1970s, it has been a rule rather than an exception that major turning points in the G3 currencies coincided with coordinated interventions; somehow the market mechanisms that should in theory help re-equilibrate the currency markets tended to be ineffective.  This means that it may take coordinated interventions to halt the current slide in the dollar.

 

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Currencies
Cyclical Dollar Weakness: Still in Its Seventh Inning
November 02, 2007

By Stephen Jen & Luca Bindelli | London

Summary and conclusions

We like risky assets and believe that the dollar will remain on its back foot.  This is a view we’ve held since the financial crisis of July/August.  For the next three months or so, we share the market’s consensus opinion, which is also positive on risky assets and negative on the dollar.  However, on a 6-12-month perspective, we believe that the preferred trades will evolve: while EM currencies may continue to perform well, we are less convinced that GBP/USD and EUR/USD can keep overshooting and stay above 2.10 and 1.50 or so. 

In this note, we present our assessment on some of the popular trades.   

Our opinion

We believe that the Chinese RMB is a good trade, but a well-priced one.  Similarly, the AUD and CAD are popular trades that are fully justified by economic fundamentals and should rally further against the dollar.  The NZD, however, is under-appreciated by investors, in our opinion.  EUR/USD and cable are crowded trades, which will likely reverse if conditions change in the next six months.  We believe that the HKD and GCC pegs will hold, in contrast to the popular opinion in the market.  Moreover, in our view, inflation will likely become a major worry 6-9 months from now, when the US economy starts to reassert itself.  But it should not be an issue in the US, even though Fed cuts will intensify the policy ‘trilemma’ associated with the ‘Impossible Trinity’. 

Our opinions are as follows: 

·        Opinion 1.  The dollar to continue to weaken in the near term.  Despite the (justified) angst regarding the US housing market and the tighter credit conditions, the US economy is demonstrating remarkable resilience in sectors outside housing and in its labour markets.  We expect weakness in the housing sector to eventually infect these other sectors and push the overall US GDP growth rate down toward the 1.5% mark in 4Q07 and 1Q08, before recovering in the subsequent quarters.  The issue now for the dollar is that, while the economy has not yet begun to weaken in earnest, expectations are already very negative and the Fed has been front-loading the rate cuts while the rest of the world (RoW) has exhibited traits that are fully consistent with the global de-coupling hypothesis, which we have long endorsed. 

This means that the dollar will likely fall faster due to divergent monetary paths and expected de-coupling, with the dollar stuck at the Dollar Smile’s trough, as the impending US slowdown does not seem scary enough for investors to worry too much about the RoW.  If anything, economic de-coupling, combined with the de facto dollar pegs (or ‘sticky’ exchange rates), is further cornering the monetary authorities of some economies (e.g., China, Hong Kong and the GCC countries) into accepting either higher inflation or nominal revaluation.  In other words, pre-emptive monetary action by the Fed could be excessively stimulative for the RoW when its output gap is already slim in size. 

The Fed fully expects the housing market to go on being a detractor to overall growth, and may be a bit surprised that the labour market has not weakened further.  Okun’s Law, which draws a simple linear relationship between the overall GDP growth rate of the US and the unemployment rate, has, in recent quarters, deviated from its short-term relationship.  Specifically, there seems to be a trade-off ratio of around 2:1 between these two variables (2% growth = 1% decline in the unemployment rate). This relationship has been reasonably robust over the period (1973 to 2007).  If anything, the US labour market should start to weaken.  At this level of headline GDP growth, Okun’s Law implies a rise in the unemployment rate by 0.7 pp or so to 5.5%, from the current 4.7%.  If monthly NFPRs data do indeed start to deteriorate in the coming months, further rate cuts by the Fed may be justified.  Indeed, our US economists are looking for one more rate cut (another 25bp from the current 4.50%) by January.  A cumulative 100bp in rate cuts by the Fed, but with the RoW either remaining on hold (the ECB and BoJ) or tightening (the PBoC and RBA), should lead the dollar to depreciate. 

·        Opinion 2.  GBP/USD is not a great trade.  Though it has performed well, cable is unlikely to go on performing well, in our view.  This trade will make increasingly less sense if the UK’s housing sector slows and cable becomes more over-valued.  From a multi-year perspective, buying cable (or EUR/USD) at these levels seems risky, particularly if we all believe that the US is in a mid-cycle slowdown and that it is unlikely that the dollar has lost its hegemonic status.  We are not saying that this is the time to short cable or EUR/USD, but reiterating that, while long EM currencies may be a compelling trade justified by the changing structural fundamentals in the world, the USD versus the EUR and GBP is a different story, particularly given the size of the misalignment.  We believe that when the US housing sector stops contracting, which could be late 1Q08, investors should be watchful of a meaningful correction in EUR/USD and cable. 

·        Opinion 3.  The CNY is fully priced.  While we also believe that the pace of decline in USD/CNY will likely be accelerated (we’re looking for 7.30 by end-2007), we believe that it is fully priced in and USD/CNY will struggle to meet the market’s ambitious expectations (7.00 in one year’s time).  The AXJC (Asia ex-Japan and China) currencies are much more compelling trades that have ample scope for further appreciation, in our view.  The KRW, TWD, INR, MYR and SGD are all well positioned to appreciate further against the dollar.  The ‘merchantilist’ bias no longer dominates the thinking on the part of the policy makers in these economies, and if they all appreciate in sync, the effective exchange rates shouldn’t move too much anyway. 

·        Opinion 4.  The dollar pegs are likely to hold.  We believe that the HKD and the GCC pegs will survive, and believe that the best way to capitalise on the policy inconsistencies (the ‘Impossible Trinity’), high oil prices and the associated demand for infrastructure spending, and rising food price inflation is to long the local equities un-hedged, not to speculate against the currencies themselves.   (We have a separate piece on the HKD.)  It is not a surprise to us that the local equity markets of some of these strict and semi-dollar pegs have been extraordinarily buoyant (124% YTD in the Shanghai A-Shares, 52% in the Hang Seng Index, and 98% in the Dubai Investable Index).  If the slowdown in the US is indeed a mid-cycle event, or if the US slowdown turns into a vicious recession, we believe that much of the RoW will turn more in sync with the posture of the Fed.  Perversely, it is this ‘US soft-landing-the RoW decouples’ scenario that should exert the most pressure on the dollar pegs. 

·        Opinion 5.  The NZD is under-rated, even though it is over-valued.  We agree with investors’ bullish outlook on the AUD and NZD.  Despite the fact that they are over-valued, they remain good ‘China plays’, in our view.  Similarly, we are more constructive on the outlook for NZD/USD than many investors are.  In addition to a strongly positive terms of trade shock that offsets the incipient weakness in the housing sector, a serious threat to the inflation outlook is emerging: a possible fiscal stimulus associated with the upcoming election.  Given New Zealand’s fiscal position (a surplus of 4% of GDP), there is ample scope for such an election-motivated fiscal boost that will need to be countered by further hikes in interest rates. 

·        Opinion 6.  US inflation will likely be the topic investors will be talking about in 6-9 months’ time.  In our view, the Fed is correct in being concerned about lingering inflationary pressures, in light of the still relatively tight labour market, the rising energy and food prices, the closing of the output gap in the RoW and the depreciating dollar. (5Y5Y forward inflation expectations were relatively stable lately, but 5Y inflation derived from TIPS is drifting higher.)  While a mid-cycle slowdown should postpone the timing of rising inflationary pressures, we believe that it will be the key issue investors will talk about 6-9 months from now. 

Bottom line

Don’t go against the powerful trends we’re witnessing in the equity markets, currency markets and commodity markets.  There are legitimate reasons behind these trends, in our view.  Having said this, on a 6-12-month perspective, we believe that the preferred trades will evolve.  

 

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South Africa
Money Pot Overflows
November 02, 2007

By Michael Kafe & Andrea Masia | Johannesburg

The National Treasury of South Africa released the government’s Medium-Term Budget Policy document earlier in the week. The details confirm some deterioration in economic fundamentals, although fiscal health is still improving. Spending plans for the general government’s capital infrastructure program have been cut for the current fiscal year, while medium-term estimates for selected departments have been bumped up slightly, confirming our long-held view that general government capex projects are likely to be back-loaded until spending capacity improves. Infrastructure expenditure plans by non-financial public enterprises have, however, been raised, as pressure mounts to urgently address structural bottlenecks in the power and transport sectors.

Fiscal revenues are expected to rise further, thanks to higher commodity prices, higher domestic inflation and bracket creep, contributing significantly to a swing in the medium-term estimates of the fiscal balance from deficits into meaningful surpluses. This is despite an anticipated slowdown in domestic growth, where estimates have been cut by more than half a percentage point in each of the next two years. Also, government borrowing remains in check, despite modest increases in the funding requirement for this year and next.

As expected, inflation has been revised higher, while the current account deficit is expected to widen to record levels.  There were no changes to exchange controls, the inflation target regime or taxes.

Swing from fiscal deficits to surpluses a huge positive

In our view, the highlight of the Budget was the anticipated improvement in the fiscal balance, at a time when growth estimates have been revised downwards. Although the current fiscal year’s surplus has been revised downward from 0.6% of GDP in February to 0.5% of GDP, the readings for the upcoming two fiscal years have swung from deficits of -0.1% and -0.4% of GDP, respectively, to surpluses of 0.7% and 0.6% of GDP. The improvements in the fiscal balance are expected to be driven by higher revenues, offset by measured increases in expenditure. The National Treasury also estimates that South Africa’s structural budget balance (i.e., the budget adjusted for temporary tax revenues) will average a deficit of some 0.6% of GDP in the medium term.

Income tax buoyancy to lift revenues…

On the revenue front, expectations are for sustained tax buoyancy as higher inflation compensates for weaker growth. Significant upward revisions were made to personal and corporate income taxes, while VAT was revised downward for fiscal 2007/8, 2008/9 and 2009/10. With regards to VAT, the Treasury believes that the recent outperformance of this tax handle was not only driven by improved efficiencies in tax administration, but also by robust cyclical growth in consumption expenditure, which is now expected to unwind somewhat in the coming years. 

Income taxes are now expected to come in R15 billion higher than previously forecast in this fiscal year, and the numbers have been revised by a further R25.6 billion (1.2% of GDP) for fiscal 2008/9 and R33.4 billion (1.4% of GDP) for 2009/10. Personal income tax increases are expected to originate from employment growth and the effects of bracket creep as higher wage settlements push labor into higher marginal tax brackets, perhaps with little compensation for fiscal drag. Corporate taxes will also likely be supported by higher commodity prices and domestic inflation, although there should be some offset from tax breaks on rising investment outlays by mining companies. Although real GDP growth estimates have been revised downwards for the next two years, nominal GDP estimates (on which tax revenues are based) were revised upwards, thanks to higher inflation prospects.

…while expenditure growth remains muted…

Contrary to the huge increases of R25 billion and R38 billion pencilled in for total revenues in the main budget, government expenditure is forecast to increase by only R5.8 billion and R15.3 billion in 2008/9 and 2009/10, respectively, allowing the general government (i.e., national departments, provincial departments, municipalities and extra budgetary public entities) to print fiscal surpluses of R16 billion and R14 billion in those two years. It is true that a total of R81 billion has been added to the expenditure budget for the next three years. We note with interest, however, that only a quarter of this will be spent in the upcoming two fiscal years, leaving as much as R60.6 billion to be spent only in the final year of the Medium-Term Budget framework.

…thanks in part to capacity constraints

Also note that, due to what we believe could be the clearest indication yet of public sector capacity constraints (although we must admit that there has been some anecdotal evidence of improvement in delivery capacity recently), the National Treasury eventually bit the bullet and revised the capital expenditure budget of the general government downwards, leaving non-financial public enterprises (Eskom, Sentech, Transnet, etc.) and public-private partnerships (PPP) to take up the slack and shoulder all the planned increases to the public sector capital infrastructure program. Our calculations show that, of the estimated R22 billion increase in the capital expenditure budget from R416 billion to R438 billion in the 2007/8 to 2009/10 period, more than 80% of that increase is to be rolled out by non-financial enterprises, while public-private partnerships take up the rest. General government infrastructure expenditure is, in fact, expected to decline by R8 billion over that period.

Finally, we also estimate that, of the R81 billion extra fiscal spending pencilled in for the next three years, only R33.5 billion goes into infrastructure, while the rest goes to enhance service delivery and toward funding the payment of social grants and a higher wage bill that seeks to compensate civil servants for the higher-than-expected inflation outcome.

Declining debt ratios could help secure ratings upgrade

Given this background of higher revenues and modest increases in spending intentions, it is not surprising that the public sector borrowing requirement remains well contained.  Domestic debt is expected to rise by R5.5 billion this year and a further R11 billion next year, before declining by R5.7 billion in 2009/10. Over the forecast period, cash balances in the National Revenue Fund are expected to rise by a cumulative R53 billion, which has already been ring-fenced for reserve accumulation and foreign debt management.

Assuming that the full amount goes into reserve accumulation, this would imply a further increase of some US$8 billion at current exchange rates. By not spending all the cash flow from taxes during the present cyclical upswing, the government hopes to help limit the current account deficit, take some pressure off domestic interest rates and contribute to the sustainability of longer-term economic growth.

The government expects total debt (net) as a percentage of GDP to fall from 23% this year to no more than 15.8% of GDP by 2010, putting South Africa in the league of non-OECD countries with debt-to-GDP ratios of less than 20%. At the margin, the sustained improvement in debt ratios here could be one of the indicators that helps secure South Africa a ratings upgrade in the near future.

Growth outlook is weak

As far as the macroeconomic outlook is concerned, the Finance Ministry admits that “while analysts’ forecasts continue to suggest robust growth for the period ahead, there is probably greater uncertainty in the economic environment today than at any point in the past six years”. We couldn’t agree more with this assessment. GDP growth forecasts for 2008 and 2009 have been cut from 5.1% and 5.4% to 4.5% and 4.8%, respectively, in line with our estimates of 4.2% and 4.8% for that period. The lower growth numbers are expected to be driven by weaker consumption and capital formation growth, presumably as the 350bp of interest rate hikes and a weaker global growth outlook take their toll on private domestic demand. Government consumption is, however, forecast to come in slightly higher than expected, as higher wage settlements lift the public sector wage bill.

Revised inflation forecasts appear optimistic

Inflation readings have also been revised upwards from 5.1%, 4.7% and 4.5%Y for 2007, 2008 and 2009 to 6.2%, 5.4% and 4.6%, respectively. While the revised 2007 estimate appears reasonable (Morgan Stanley: 6.3%Y), the estimates for the subsequent years still appear optimistic, especially the 2008 estimate, which appears to be even lower than the SARB’s most recent estimates. At the October 11, 2007 MPC meeting, the SARB’s forecast showed that CPIX would likely average 6.8% in 1Q08. Assuming for a moment that this is correct (although we think it could be as high as 7.5%), then simple mathematics suggests that CPIX needs to average less than 5% in the other three quarters of 2008 in order to get an average reading of 5.4% for the year as a whole. We believe that this is unlikely. Instead, we share the SARB’s view that CPIX will likely remain above 5% throughout 2008 and 2009.

Current account deficit to reach record high

Finally, the National Treasury revised its estimate of the current account deficit upwards from 5.3%, 5.7% and 5.9% of GDP in 2007, 2008 and 2009 to 6.7%, 6.9% and 7.7%, respectively, and has now pencilled in a 7.8% of GDP estimate for 2010. Although our current estimates of the current account deficit fall below the Treasury’s, we believe that its forecasts are entirely reasonable, for three reasons. First, they are based on the new (and higher) public expenditure forecasts; second, the government may have pencilled in a higher delivery capacity than before; and third, they may have been based on a higher oil price profile than ours.

Conclusion

On the whole, we believe that this was a bond market-friendly budget, given the continued improvements in fiscal health. However, the deterioration in other economic fundamentals such as GDP growth, inflation and the current account deficit call for some weakness in the currency markets.

 

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Japan
Another ‘Subprime’ Shock
November 02, 2007

By Takehiro Sato | Tokyo

The housing shock is not only hurting the US but also Japan with a larger magnitude. The economic impact is worsening here in Japan. Actually, housing starts plummeted in YoY terms again in September, reflecting influence from the amended building standards legislation enacted in June.  Also, new residential starts held at an annualized 720,000 units, roughly 60% of the normal level, and the July-September average for housing starts floor space was down 33.8% QoQ, a 25-year low.

Obviously this is not coming from demand-side issues, but is a typical bottleneck brought about by the MLIT’s ‘subprime’ handling of the new regulation. Indeed, it’s another subprime issue, but with a totally different twist. The MLIT seems bothered by a sudden sharp drop in construction starts from July, and has expressed the intent to pursue working improvements by publishing some proposals for changes in how building standards legislation is implemented at the end of October. There are two main changes: simplifying application documentation and doing away with the requirement to apply for approval for minor design alterations. According to the Ministry, the rule changes will be covered by a ministerial order that will not require a Diet resolution, and should come into effect between mid and late November.

However, we doubt that the changes will trigger a sharp rebound in residential investment in the immediate future. This is because of 1) the increasingly complicated nature of the inspection process, 2) insufficient numbers of qualified assessors to conduct secondary inspections such as peer-checks, and 3) delays in development of software for double-checking structural calculations, all of which argue against a swift rebound in starts themselves.  As such, housing starts shouldn’t recover in earnest at least until early next year.

What concerns us is that if the current slump drags on extensively, the problems would probably spill over to the demand side as well.  A cash flow crunch from this could be incited at construction firms, and in related industries.  So it is too soon to say whether the plunge in starts will not go beyond a temporary shock on the supply side.

Such a housing shock is likely to stunt economic growth, albeit temporarily. A tentative calculation of residential investment in July-September GDP (due to be published on November 13) based on the starts data suggests that the contribution from this component may have dragged down GDP by 0.3ppt YoY (an annualized -1.4ppt). While the impact on October-December GDP will largely depend on the incoming starts data, in the base case we expect the contribution to be down by just 0.3ppt YoY as well (or an annualized -1.1ppt). Naturally, uncertain abounds at this point as to how the starts data will pan out for October-December, and if housing starts do continue falling, there is a risk that the effect in terms of depressing GDP could be greater still. In the July-September quarter, such a negative contribution of residential investment is likely to be easily offset by buoyant export growth.  But our concerns are on the October-December quarter, when we doubt a decent positive contribution from exports due to a retracement, and both residential investment and net exports are likely to dampen growth to virtually 0% QoQ, in the worst-case scenario.

Not all is hopeless, however. Indeed, it may be that the fall in housing starts floor space actually halted in marginal terms in September. Actually, the amount of floor space involved in housing starts, which is used in the GDP estimation, showed an improvement in owner-occupied starts, and rebounded by a slight +3.2% MoM. Much uncertainty remains still, but it is possible that housing starts floor space has hit the bottom in marginal terms, and we look for a sizable bounce back from next year. As such, we expect housing investment to suppress real GDP growth in F3/08 by 0.3ppt, but to provide upward support in F3/09 by roughly the same magnitude.

In all, Japan’s housing shock will likely distort the near-term growth pattern greatly.  Admittedly, our recent call for a modest upturn is now in danger of retreat. But we’ll hang tough since there are also some signs of improvement in wages, with buoyant performance in manufacturing industries supported by vibrant demand from Asia. In fact, recent wage statistics are showing smaller negative YoY margins, and a possible modest upturn in personal consumption should be regarded as largely positive together with a recovery in housing investment from next year.  Incoming dataflow will likely depress, but we note that it is simply the darkest before dawn.

 

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