Japan
Darkest Before the Dawn? (Part 1)
November 16, 2007

By Takehiro Sato | Tokyo, Takeshi Yamaguchi | Tokyo

Playing it safe, in recognition of some downside risks

Japan’s economy has pulled out of a summer slump and is recovering moderately, thanks mainly to exports driven by strong Asian demand.  Indeed, the economy looks to be increasingly driven by overseas demand, and as the independent demand in Asia grows, we expect the Japanese economy to decouple further from the US economy.  With domestic demand weak, however, we believe the pattern of sustained economic growth heavily dependent on the US and Asian economies looks increasingly fragile. 

Certainly, most Japanese financial institutions have not been directly affected by sub-prime mortgage-related problems, but the liquidity crunch in overseas markets since the summer could turn into a true credit crunch if policymakers do not respond appropriately.  In this case, Japan would not escape unscathed.  Our US economics team lowered its 2008 growth forecast and raised the probability of a recession to 40%.  With global financial markets still volatile and various policy missteps being made on the domestic front resulting, for example, in delays in construction permits, we think new, albeit temporary, downside risks to growth have emerged. 

In light of the risks, we lower our growth forecast for Japan’s economy.  It is not that we have completely given up, though.  We do not see the recent market turmoil as a lead-in to global recession, and for Japan’s economy in F3/09, we expect residential investment to normalise and consumer spending to recover moderately.  Overseas, sub-prime mortgage-related headline risk is likely to continue for several years and weigh on economic growth, but we think another crisis could be averted with appropriate policy action. 

The impact of a US slowdown on Japan

This past summer, when the sub-prime mortgage-related shocks hit, the US economy managed to grow by an annualised rate of almost 4% thanks to strong consumer spending and business investment and inventory build-up in anticipation of the year-end holiday sales season.  Meanwhile, our US economics team expects GDP growth from Oct-Dec 2007 to Apr-Jun 2008 of only around 1% annualised, as financial conditions tighten overall, owing to diminished liquidity and widening credit spreads, and both consumer spending and business investment pull back sharply.  Accordingly, it trimmed its US growth outlook for 2008 to 1.8%. 

If the US economy weakens, however, Japan’s economy is likely to hold up fairly well, considering that the growing presence of emerging economies has contributed to a decline in the US’s contribution to global growth from an average of 20% in the late 1980s to 2000 to an average of 10% since 2001, and the US’s proportion of Japan’s real exports has declined from about 30% in the tech bubble years (1999-2000) to an average of less than 10% since 2002.  Our colleagues covering emerging markets expect all regions to do well in 2008, and consequently we expect Japan to decouple further from the US, and Asia to continue to do well. 

One concern we have is that it is unclear what proportion of Japan’s notably strong exports to Asia of auto-related products and basic materials is driven by independent demand.  Since the tech bubble years, the proportion of Japan’s exports accounted for by capital-goods-related products and IT-related goods has declined, while the proportion- of capital goods and auto-related products has risen.  This trend suggests that Asia is increasingly becoming a source of new, final demand and not just an intermediary destination for processing and assembly.  The BoJ’s recent Outlook Report notes that the performances of different industries are not as strongly correlated as before, and changes in Japan’s output are smoother because of differences in the cyclical phase for IT-related industries and basic material industries.

Outlook for Japan’s economy

The economy slowed in the summer, as we expected, but by a greater magnitude because of the financial market turmoil stemming from sub-prime mortgage-related problems.  The economy started to grow again in Jul-Sep, as strong overseas demand, mainly in Asia, offset the negative impact of a decline in housing investment.  Consumer spending looks likely to rebound somewhat in Oct-Dec because of a diminished negative impact from local tax hikes, increased output of digital consumer electronics, and increased seasonal spending with the help of typical temperature and weather patterns.  In light of surveys like the BoJ Tankan, the continuing moderate growth in capex also makes the overall outlook not that bad, in our view.  Nevertheless, headline growth in the second half of F3/08 will probably not be that strong because of a lingering negative impact in Oct-Dec to Jan-Mar from a sharp decline in housing starts. 

Housing investment on a GDP basis is unlikely to recover until Apr-Jun 2008, because housing starts will probably level off for the rest of 2007.  We expect housing investment to have a 0.3pp negative impact on growth in F3/08 but a positive impact of the same extent in F3/09.  The swing in housing investment is of a larger magnitude than we expected, but even with all the uncertainties for the global economic outlook, we do not think Japan’s headline GDP growth in 2008 will be all that weak, thanks to a rebound in housing investment. 

With manufacturers planning to increase output of digital consumer electronics in anticipation of a peak in demand before the Beijing Olympic Games, industrial production is likely to remain solid in the first half of 2008.  The resulting strength of income formation in the corporate sector, particularly large manufacturers, should spill over to the household sector, albeit partially.  We think consumer spending will pull out of a summer slump and recover moderately from Oct-Dec, in light of growth in employment and a moderate increase in employees’ compensation.  A pullback in IT-related manufacturing is still very much a concern, but looking at micro trends also, we do not think there is as much of an inventory glut as the macro data show. 

So Japan’s economy is expected to grow at close to its potential output growth rate, led by capex and with help from moderate growth in consumer spending.  Capex is unlikely to accelerate because the economic cycle is maturing, but we think it will have to increase to offset a decline in per capita GDP stemming from a decline in productivity and an increasingly serious labour shortage, owing to an ageing population.  Contrary to the recent weakness in machinery orders, indeed, companies indicated in the September Tankan survey that they plan to maintain capex roughly on a par with that in F3/07.

Risks

One potential downside risk for the above scenario is the recent growing pullback of liquidity in overseas markets developing into a genuine credit contraction and hurting momentum in overseas economies.  While companies are drawing on commitment lines from banks to deal with liquidity pullback, this situation implies potentially higher credit costs at banks.  Increased credit costs from liquidity-related bankruptcies undermine the financial intermediation function and could turn into an all-out credit crunch.  We think too much emphasis on moral-hazard risk by overseas authorities as they address the credit contraction might delay crisis action, as happened in the late 1990s in Japan.  The subsequent increase in credit costs significantly erodes capital levels at companies and financial institutions and causes a negative leverage effect.  There is even a possibility of asset price deflation similar to Japan’s experience.  The growth potential of the Japanese economy could suffer a considerable blow given recent reliance on external demand.

Another downside risk is the residential investment problem.  This is a policy issue affecting supply and not a demand concern, as mentioned previously.  However, it could affect related segments, including funding difficulties for construction firms, delayed mortgage loan initiatives, and weaker housing-related consumption, if the current sudden brake on housing starts is prolonged.  We also expect an impact on capex from the recent sharp decline in factory, warehouse, office, and other non-residential starts in addition to housing starts.  In fact, the downturn in construction goods shipments has accelerated since September.  Yet we predict upside for the F3/09 growth rate on a rebound from this setback in domestic demand if starts stage a relatively upbeat recovery from the beginning of 2008, in line with our outlook.  Hence, the F3/09 growth rate may not drop much, even with slower momentum from overseas economies. 

The upside risk comes from a new phase of euphoria in asset markets if bold monetary easing and liquidity supply by monetary authorities in response to the liquidity pullback successfully halt the crisis.  Liquidity assistance from authorities has created asset bubbles after previous events, which tend to occur once a decade such as Black Monday in 1987 and the Asian and Russian crises in 1997-98.  Although some observers may think it is too early to talk about the possibility of a renewed bubble right after the collapse of a credit bubble, we think it deserves consideration, given the past track record.  Emerging countries are sustaining robust performance despite downside risk for major economies, and hefty increases in energy and primary commodity prices are generating bubble-like conditions.  Although we question the economic rationale of US$100/barrel oil prices, capital from emerging economies with a high risk tolerance is naturally flowing into markets with attractive anticipated returns to generate income, given sluggish performance by the asset markets of major countries. 

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United States
Scant Evidence of Import-Price Pass-through -- So Far
November 16, 2007

By Richard Berner | New York

Is a weaker dollar inflationary?  The answer, obviously, is yes.  It’s clear that a weaker dollar will, other things equal, boost import prices and possibly inflation expectations, and thus inflation.  But other things aren’t equal: I think that the economy is weakening, pricing power is fading, and thus, in today’s circumstances, the dollar’s influence on inflation likely will be small.  That logic also applies to the influence of rising commodity prices on inflation.  Thus, notwithstanding the Fed’s legitimate concerns about inflation risks, officials will have some latitude to respond to the incipient and palpable weakening in economic activity.

A number of clients listen politely to my rendition of that story, but quite reasonably disagree.  Their logic: The dollar’s decline is contributing to the surge in dollar-based commodity prices like oil and food, which boosted headline inflation to 3.5% in the year ended in October — and will push it past 4% in November.  That rise might yet hike inflation expectations, and import prices are accelerating.  Sellers may pass a portion of such price hikes through to consumers.  And even if that pass-through process is muted and slow, the Fed’s concern about future inflation risks and their apparent new focus on headline as well as core inflation means that there are high hurdles to further monetary ease. 

Who is right?  By any metric, US “core” inflation remained subdued in October.  Measured by the CPI, inflation excluding food and energy rose to 2.2%, compared with 2.1% in the year ended in September.  Likewise, we estimate that measured by the core personal consumption price index (PCEPI), core inflation remained 1.8% in the year ended in September.  In contrast, overall or headline inflation heated up significantly in October, courtesy of rising food and energy quotes.  While tamer than the 3.5% advance in the CPI, the overall PCEPI likely rose by 2.9% from a year ago.  For both gauges, November and December likely will show a further acceleration.

What’s more, there is no doubt that a weaker dollar has boosted import and some domestic prices.  The dollar on a broad, trade-weighted basis has depreciated by 8.3% over the past year.  And I believe that a weaker dollar has been a factor contributing to higher oil prices.  That’s because the decline in the dollar is reducing the non-dollar value of oil producers’ receipts, and thus of their purchasing power.  Eric Chaney and I think oil producers are trying to offset that purchasing power lost to a weaker dollar by restraining crude supply, thus keeping prices high (see “The Oil-Dollar Link,” Global Economic Forum, July 23, 2007).  We believe that sellers typically pass some of these price hikes through to core prices with roughly a 2-4 month lag, via transport fares, some rents, and other goods and services.  In addition, prices of imported foods jumped by 9.8% and those for consumer goods excluding autos rose by 1.4% in the year ended in October.  Those quotes don’t yet reflect the full extent of the recent dollar weakness, so there is more on the way.  Finally, my colleague Qing Wang is concerned that China — long viewed as a source of global disinflation — is now facing the risk of runaway inflation (see “Risk of Out-of-Control Inflation on the Rise,” China Economics, November 14, 2007).  Some argue that the fact that US inflation apart from food and energy has so far been tame may simply reflect lags, and that today’s hikes in import quotes will show up in tomorrow’s domestic price hikes.

Unlike in the spring, however, when inflation expectations were higher, the economy was stronger, and there was less slack in the economy, I think that these import price hikes are less likely to translate into higher inflation today.  The key reason is that the slipping dollar isn’t the whole story.  That’s because the boost to inflation from a weaker dollar has dwindled over the past two decades, reflecting weakening links between exchange rate changes and import prices and ultimately consumer prices.  Several Fed economists in a paper last year found that the decline is a global phenomenon.  Across G7 currencies, their work suggests that exchange rate pass-though to import prices has declined to 40% over the past 15 years from 70% in the 1970s and 1980s, and in the US, it has declined to only 30% (see Jane Ihrig et al., “Exchange-Rate Pass-through in the G7 Countries,” International Finance Discussion Paper 851, January 2006).  That is, a 10% sustained depreciation in the dollar might, other things equal, boost the import price level by 3% over a 2-3 year time period. 

The empirical fact that such exchange-rate “pass-through” has apparently weakened over the past several years, like the flattening in the Phillips curve, may reflect good monetary policies.  As well, it probably results from the globalization of markets and production that has promoted “pricing to market.”  That is, exporters not wanting to surrender market share have more closely matched their prices to those in their destination market and set their prices in the local currency; they tend to hedge their currency risk either ‘naturally’ by sourcing abroad or financially.  That probably muted the pass-through and lengthened the lags from currency moves to changes in relative prices long before the dollar began its descent. 

This pass-through link also varies with the cyclical state of the global economy and inflation expectations.  Over the past year, the weaker dollar may explain half the increase in the recent increase in import prices.  And the booming global economy may have accounted for the other half, by increasing the pricing power of exporters to the US.  But the cyclical state of the domestic economy also matters for assessing the impact of all these global factors on US consumer price inflation.  Looking ahead, therefore, the weakness in the US economy and prospective declines in utilization rates mean that sellers may thus find it more difficult to pass such price hikes through to consumer inflation (for more discussion, see “The Dollar and Inflation,” Global Economic Forum, May 5, 2006).  Morgan Stanley retail analyst Greg Melich confirms that food retailers are passing costs along, but that apparel retailers currently are unable to pass through higher prices for imported goods, and their margins reflect that cost pressure.  In fact, the accompanying table illustrates the point that rising import prices have not translated into higher domestic prices for many goods. 

October 2007, year-over-year percent change
	Import prices	CPI
Household furniture & bedding	2.0	-2.4
Dishes & flatware	0.0	-3.7
Footwear	-0.3	-0.8
Apparel	1.5	-1.2
Household appliances	2.9	1.0
Prescription drugs & medical supplies	3.7	1.1
Toys, shooting & sporting goods	2.2	-
Toys	-	-5.6
Sporting goods	-	-1.3

Source:  US Bureau of Labor Statistics

 

Global factors — higher energy, non-oil commodity and import quotes, and a weaker currency — might also contribute to US inflation by reviving inflation expectations.  So far, however, the signals are mixed: Inflation compensation measured by 10-year TIPs spreads has risen by about 20 bp from its August lows, to 235 bp.  But distant-forward breakevens declined to four-month lows in recent days, hinting that these developments haven’t much altered market participants’ underlying inflation expectations.  Survey-based inflation expectations, such as the measure of 5-10 year expectations compiled by the University of Michigan, ticked up by 10 bp to 2.9% in early November, but are still below recent peaks.  I’ll concede that it’s early days for assessing the impact of these developments on expectations. 

The most important factor affecting inflation expectations is back home: The Fed.  Clear objectives and a straightforward sense of how to get there are both critical to anchoring longer-term inflation expectations.  And by and large, the Fed has been successful in doing exactly that over the past several years.  The FOMC’s just-announced changes to the way they communicate with the public — updating forecasts four times a year instead of two, projecting headline and core inflation, and extending the forecast horizon from two years to three — should help market participants understand how the Fed views the inflation outlook.  Gone is the old pretense of a 1% to 2% “comfort zone” for core PCE inflation, and in its place will be specific, third-year forecasts for both headline and core inflation.  I’ve long argued that both matter and that they matter for the Fed (see “Which Matters More: Headline or “Core” Inflation?” Global Economic Forum, October 2, 2006).  Investors will quickly conclude that these ‘forecasts’ represent the Fed’s preferred outcomes.  My hunch is that they will both center on 2%, which builds in a cushion for measurement error and disinflationary shocks.  Such clarity should help the Fed convince investors of the logic behind its views.

However, the Fed does have a communication problem: Fed officials have clearly stated their concerns about inflation risks and seem to have a high hurdle for further ease.  But their concerns about inflation ring hollow to many market participants, because they think the Fed’s balanced statement after the October 31 FOMC meeting was out of step with reality.  Financial turmoil is promoting a flight to quality as well as a near-certain view that inflation is not a problem, and that the Fed will ease in December and beyond.  Having watched the Fed go along with the market’s program in October, investors believe that the Fed will validate market expectations again with another move in December and more to come after that. 

This disconnect won’t likely go away soon.  How to play that contrast in views?  The yield curve will continue to steepen in almost any scenario.  If inflation stays low, additional Fed ease will reduce short-term rates more than longer-term yields.  On the other hand, with a set of global factors potentially pushing up inflation expectations, lingering questions about the economic outlook may translate into market uncertainty that pushes up term premiums and steepens the yield curve.  In our view, investors should buy TIPS as attractive insurance.

Risks abound, because the inflation outlook is uncertain.  The inflation tug of war might tip in the opposite direction if the dollar’s slide gathers steam.  A rebound in inflation likely would further undermine today’s fragile financial-markets.  The threat of protectionism could add to inflation risks, because it would block competition from overseas goods and services.  Escalating protectionism, moreover, might extend and/or intensify the dollar’s recent decline.

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UK
Rate Cut Likely in the Near Term
November 16, 2007

By David Miles | London, Melanie Baker | London

The Bank of England’s latest Inflation Report was one of the gloomiest documents it has produced in the 10 years since it became independent.  We also think it is realistic in seeing the most likely outcome that growth next year slows sharply in the UK and that inflation, while moving a bit higher near term, will be comfortably close to the 2% target level beyond that small near-term hump.  This Bank forecast is conditional on an assumption that rates follow a path implied by the short end of the sterling yield curve, which means two (25-basis-point) rate cuts — one imminently and a second a bit later next year.

That is a profile almost exactly in line with what has been our long-held view: that rates will soon move nearer to what we judge to be a neutral level of 5.25% — two 25bp rate cuts below where we stand today.  A rate cut as soon as the next meeting (December 6) is a strong possibility, and the Governor said clearly in the press conference accompanying the report that rate decisions at the next few meetings will be heavily dependent on the data releases.  We expect activity indicators to weaken over the next couple of months — a view consistent with the first piece of significant data coming after the Bank Inflation Report, which today showed that retail sales fell slightly in October.

Bank forecast lower GDP growth; higher near-term inflation: The Bank has significantly lowered its central GDP growth projection for next year.  Its GDP fan chart — which illustrates a central forecast but also shows bands within which outcomes may fall with assessed probabilities — shows a central forecast of GDP growth slowing to around 2.0% by about mid 2008.  Our best guess is that growth will be a bit lower than this.  While the Bank forecast suggests that a period when GDP growth actually falls (relative to four quarters earlier) is a fairly remote probability event — with a weight of less than 10%; the chances that we get two successive quarters of falling GDP are significantly higher.  The risks to the central forecast for growth in 2008 are disproportionately weighed to the downside.  In contrast the risks around the central (fairly benign) inflation forecast are judged to be balanced.

What the forecasts really mean: These Bank forecasts are unambiguously the collective view of the rate-setting Monetary Policy Committee (MPC) and not just a projection by staff economists.  They are forecasts conditional on a market-implied profile for the policy rate, which is 25bp lower in 1Q08, with another rate cut coming later in 2008 and rates at 5.1% by end-2009.  Very clearly this does not mean that the Bank is pre-announcing a timetable for rate cuts.  Equally clearly, however, it means that if events pan out in a way that does not lead the Monetary Policy Committee significantly to change its views, we shall see a strong case to cut rates — and soon. 

The MPC now judges that uncertainty on the outlook is higher than in the recent past.  This is inevitable given the scale of the potential knock-on effects of the credit crunch — which came in a situation where there already existed great uncertainty about how consumer spending would evolve after earlier rate increases, and where the savings rate had fallen to near an all-time low.  In fact, we suspect that the Bank forecast underestimates the uncertainty about the growth profile as well as being still somewhat optimistic. 

One reason why our central GDP forecast is a bit more pessimistic than that of the MPC is that the Bank’s central forecast seems to incorporate a more optimistic assessment of the likely medium-term effects of recent turbulence in financial markets.  The Inflation Report has a chart that shows three-month interbank rates derived from forward rate agreements relative to future expected policy rates.  This chart implicitly suggests a rapid return to ‘normal’ conditions.  By about May next year, the spread is back to pre-turbulence levels.  It is unclear to what extent this expectation is incorporated into the Bank’s central forecast, but it could certainly be regarded as erring on the optimistic side.

The Bank’s assumptions on the medium term re-pricing of risk in bank lending rates also look relatively optimistic.  The assumption is that over the medium term, the average premium over the policy rate for lending to households and businesses will rise by only about one-quarter of a percentage point relative to ‘pre-turbulence levels’.  Again, we would judge this as erring on the optimistic side — particularly for household lending.

Bottom line for the near-term interest rate outlook: No-one now is likely to be surprised by rate cuts from the Bank — a big change from the position just a few months back.  We still think a rate cut as soon as the next meeting is a strong possibility, and the Governor said clearly that rate decisions at the next few meetings would be heavily dependent on the data releases.  To some extent the market may now be pricing in an implausibly aggressive path of rate cuts from the Bank of England.  Yields on two-year gilts sit at around 110bp under today’s policy rate — a level that would seem to imply at least four, and quite possibly five, rate cuts of 25bp each.  That is certainly possible — and it is an outcome to which we have explicitly given a significant probability in our own assessments of the scale of rate cuts.  (For example, we have judged that by as near as June of next year, there is about a one in nine chance that rates are at 4.75% or lower.)  But it is not our central forecast and — self-evidently — it is not what the Bank of England expects its own future rate decisions to be.

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Currencies
China’s Private Sector Is US$1.2 Trillion Short of Foreign Assets
November 16, 2007

By Stephen Jen | London, Charles St-Arnaud | London

Summary and conclusions

Residents of emerging market (EM) economies will likely be the next wave of countries divesting their home assets.  These structural flows will impart a powerful bias in the currency markets, partly offsetting the large capital inflows that have begun to enter EMs from developed markets.  In the case of China, while the official sector holds the world’s largest foreign reserves, the private sector has a higher ‘home bias’ than Japan; this is neither sensible nor sustainable, in our view.  The government fully understands this.  We calculate that, to bring China’s home bias into line with that of its neighbours, China’s private sector would need to expatriate US$1.2 trillion dollars, which is roughly comparable to the PBoC’s official reserve holdings.  In any case, secular divestment flows from EM economies are set ti be a major trend in the coming years, with implications for currencies and other asset prices. 

Financial diversification by the US and Japan

In our view, financial globalisation has been a major driver of exchange rates in recent years.  Economic decoupling and regionalisation have bolstered the case for financial globalisation, as financial diversification makes more sense if the world is out of sync.  We have witnessed, in recent years, huge diversification outflows from both the US and Japan by their own residents, and such structural outflows have weighed on both the dollar and the yen, almost regardless of the cyclical considerations of these two economies. 

In The Biggest Dollar Diversifiers Are American (July 19, 2007), we pointed out that US real money institutional investors have about US$20.7 trillion under management — roughly 3.5 times the size of the world’s total official foreign reserves — and that they have been steadily diversifying out of USD assets since 2003.  The motivation for such a tectonic shift in asset holdings is in dispute.  Part of the reason reflects the desire to diversify, to raise US investors’ exposure to other parts of the world.  On the other hand, this move may also reflect some investors’ bearish outlook on the US.  In any case, while investors’ focus has been on what official reserve managers in Asia and the Middle East may or may not be doing, the irony is that American real money managers have been the biggest dollar diversifiers since 2003, and therefore a major source of downward pressure on the dollar. 

Similarly, for Japan, the JPY being so undervalued for so long is also due in part to the desire of Japanese retail investors to reduce their extraordinarily high ‘home bias’.  We have pointed out on several occasions that Japanese households have 97% of their US$13.5 trillion worth of liquid financial wealth (excluding real estate holdings) invested in JPY assets.  In an economy with a shrinking population and labour force, and with the investment opportunities outside Japan having become more attractive, it would only make sense for Japanese retail investors to raise their exposure to non-JPY assets.  At the same time, large Japanese public institutions, such as the GPIF (Government Pension Investment Fund), Yucho Bank (Japanese Postal Savings Bank) and Kampo (Japan’s Postal Life Insurance Company), all need to attain a higher foreign asset exposure over time. 

Large diversification flows — other than the currency-rebalancing exercise undergone in some foreign central banks — have been powerful undercurrents in the currency world, forcing the dollar and the JPY below their values that are consistent with the economic fundamentals.  We believe that, in the coming years, we will witness a similar trend in large EM economies that have accumulated enough wealth and attained adequate confidence and knowledge about the international capital markets.  In other words, while many of these EM economies have been acquiring foreign assets through their central banks and SWFs, we believe that the private sectors of these economies will be major exporters of capital to both the developed markets and to other EM economies. 

The case of China

A key policy objective of Beijing is further to liberalise capital outflows from China.  One of the reasons why Beijing has resisted letting the market decide on USD/CNY is because China’s capital account is heavily skewed ‘inward’, reflecting regulatory distortions and history.  The ‘culture’ of investing overseas is not yet established in China.  Fully liberalising the foreign exchange market and refraining from currency interventions would lead to an exchange rate that reflects these distortions.  ‘Two-wrongs-don’t-make-a-right’ is the essence of the thinking on the part of the Chinese government regarding the CNY.  But China’s private sector, like that of Japan and Korea, has immense capacity to export capital in the coming years, even if the appetite to leave the buoyant Chinese and HK markets may not be large right now. 

We make the following points:

Point 1.  China’s private sector has a higher ‘home bias’ than that of Japan.  According to our estimate, China has US$8.5 trillion (271% of GDP) in total financial asset holdings, US$3.9 trillion of which is held by households, and most of the rest by Chinese corporations.  Excluding official reserve holdings, foreign assets account for only 2% of China’s total financial wealth.  Comparable figures are 18% in Japan and 12% in Korea.  Exposures to foreign assets were even higher in Japan two decades ago (5% in 1985) and in Korea a decade ago (6% in 1995).  In short, the ‘home bias’ of China’s private sector is extraordinarily and unsustainably high, compared with that of its neighbours. 

Point 2.  China’s official foreign reserve accumulation is a form of ‘pre-funding’ of future private outflows.  As we have discussed previously, one way to look at China’s huge official reserve holdings is that these reserves are a way to ‘pre-fund’ future private outflows.  Indeed, if, hypothetically, China’s private sector were to raise its foreign asset exposure to the average of those of Japan and Korea in 2006 (i.e., 15% of the total financial wealth), this would imply a net outflow of US$1.2 trillion — coincidentally roughly the same as the current stock of the PBoC’s official foreign reserves. 

Point 3.  Future profile of USD/CNY will be significantly influenced by these private outflows.  The potential for the Chinese private sector (both corporations and households) to export capital beyond Greater China (including Hong Kong) is significant, and is not something investors should ignore.  While there is a lot of attention on China’s SWF (CIC), investors should also keep in mind that many of the acquisitions of companies in the West are likely to be by private corporations and institutional investors in China.  Not only can they easily divest overseas, but their savings are growing in leaps and bounds.  Using Japan’s experience as a benchmark, China’s total financial wealth could rise from US$8.5 trillion today to US$60 trillion in two decades (Japan’s financial wealth grew more than seven-fold in the last two decades).  15% of US$60 trillion is US$9 trillion; this is how large China’s private sector’s holdings of foreign financial wealth could become within our generation.  In any case, pent-up demand in China for non-CNY assets is likely to be large and, when it is vented, USD/CNY’s trajectory will be disturbed, just as the USD and the JPY have been affected by outflows, with USD/JPY consistently outperforming the forward curves. 

Point 4.  Diversification by other EM economies could be substantial.  As EMs accumulate wealth through trade globalisation, where and how they allocate their financial investments will be increasingly important, not just for the EM exchange rates, but also for the majors.  Where the next marginal billion dollars go — to the US, Euroland or other EMs — matters a lot for the currency markets.  While investors have focused on how EM could benefit from trade globalisation and, more recently, on how SWFs could influence the world’s financial markets, the next major theme, in our view, is financial globalisation, particularly EM’s divestment from their local financial markets.  China, India, Brazil, Russia and other EMs will experience a similar pattern, in our view, partly offsetting the secular appreciating trends of the EM currencies. 

Bottom line

The ‘home bias’ of China’s private sector is extraordinarily high.  This helps to justify Beijing’s reserve accumulation policy in the past few years.  But going forward, large capital outflows from the private sector of China and other fast-growing EM countries will be a major theme in the financial markets in the coming years, acting as a counter-weight to the structural capital inflows to EM as well as an augmenting factor for the outflows under the SWFs.

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Currencies
GCC: Transforming Oil into Financial Wealth
November 16, 2007

By Stephen Jen | London, Luca Bindelli | London

Summary and conclusions

The GCC members should aggressively accumulate wealth through their SWFs, in our view.  Not only is this strategy sensible from a financial perspective, but aggressively converting wealth ‘underground’ (in the form of oil) to wealth ‘above ground’ (in the forms of financial or physical assets) would have important non-financial benefits to these economies. 

GCC has US$44 trillion worth of proven oil reserves

The six members of the GCC (Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and UAE) have close to 500 billion barrels of proven oil reserves.  At today’s market price, this is worth some US$44 trillion.  At the same time, the financial assets of the SWFs of the GCC countries total some US$1.5 trillion, we estimate, which may have been invested 30:40:30 in bonds, equities and alternative investments.  In addition, there are about US$80 billion worth of official foreign reserves held by the GCC central banks. 

For the GCC countries, the ratio of the wealth ‘underground’ and that ‘above ground’ is around 28 — significantly above the ratio of 6 for Norway, which has been aggressively transforming oil and natural gas wealth into financial wealth for the past decade.[1]  Thus, even though the SWFs of the GCC countries are already among the biggest in the world, in light of the size of their proven oil reserves, they are still relatively ‘young’ in this transformation from oil to financial assets, and should grow substantially larger in size over time. 

It make sense for GCC members to sell oil and buy equities

Essentially, the GCC countries face the choice of, on the one hand, leaving the oil underground and waiting for it to appreciate in value and, on the other, extracting it, selling it and converting it into financial wealth.  Extracting and selling their crude reserves is not the same as ‘spending’ their wealth, but rather a transformation of one form of asset holdings to another.  The objective question, therefore, rests on the financial merits and demerits of doing so. 

As Deputy Governor Knut Kjaer of the Norges Bank pointed out, from a long-term perspective, real equity returns have far outstripped real returns on bonds, money markets or oil.  Though oil prices in the coming years may continue to be squeezed higher, there is considerably higher volatility associated with oil prices than with equity prices.  The composite value of equities has risen close to 400-fold, while bonds, money markets and oil have risen less than eightfold.  The justification for the GCC countries to convert wealth in the form of oil to ‘higher-octane’ assets such as equities makes a lot of financial sense, purely from an expected returns perspective. 

The oil and equity price volatility consideration

Not only have equities had a far superior track record in terms of expected returns, they also have a much better risk profile, as we mentioned above.  Looking back over the past century, oil has been a relatively low-return but high-volatility asset, while equities are a high-return and high-volatility asset.[2]  Bonds act as a counter-weight to equities to help achieve the risk-reward balance that is preferred by the owner of the portfolio.  Our guess is that the GCC countries may have a 30:40:30 split between bonds, equities and alternative investments.  If we are wrong with this guess, the chances are that their exposure to bonds may be less than 30%, and their exposure to alternative investments may be higher than 30%.  In any case, the optimal portfolio, from a financial perspective, is one that has a high exposure to equities.      

Thoughts on the GCC’s SWFs

We have the following thoughts on the GCC’s SWFs, to add to those we have expressed in the past:

Thought 1.  The GCC should continue to build on their SWFs.  The GCC countries are, in the aggregate, exporting US$610 billion worth of oil per year at today’s oil price (GCC total oil production was 18.4 million barrels per day in 2006).  In theory, as long as oil prices remain reasonably supported and oil production capacity is enhanced by the recent investments, the GCC’s SWFs should grow rapidly; this was our assumption when we issued the long-term projection for the world’s SWFs.[3]  A related question is whether Canada should also have a SWF that goes beyond the scope of the Alberta Heritage Fund.  This would help shield the Canadian economy from large swings in oil prices and could be a source of national wealth. 

Thought 2.  Risks of a global recession, and the correlation between oil and equity prices.  Intrinsically, the GCC’s wealth, both oil and financial, is not well diversified, as oil prices and global equity prices tend to be broadly positively correlated.  If the US economy goes into reverse, for example, it is quite likely that crude oil prices as well as global equity prices will fall sharply.  Our guess is that the GCC’s SWFs currently have a relatively high-risk, high-return profile, with a high exposure to equities and EM.  But from a ‘big-picture’ perspective, these SWFs may benefit from a higher exposure to bonds, as a hedge, particularly in times of downside risks to global growth. 

Thought 3.  Spend on infrastructure.  The total population of GCC member countries is a relatively modest 33 million, with Saudi Arabia accounting for 22 million of this.  Infrastructural spending (physical, educational and otherwise) to facilitate the development of the non-oil sector and to push the GCC up the value-added ladder is key.  Singapore and Switzerland are good models for emulation, as these economies with relatively small populations have managed to punch above their weight by being more competitive and productive.  The GCC members have a great opportunity to engineer such a great leap forward, with the help of oil and SWF earnings. 

Thought 4.  Currency diversification.  The exchange rate regime and the currency composition of the SWFs should be separate considerations.  The widely held presumption that the GCC will abandon the dollar peg and adopt a basket peg, as the Governor of the Central Bank of UAE al-Suweldi suggested earlier this week, should not be a new dollar-negative factor.  Having said this, the SWFs of the GCC, being public funds for the future generations, should have a currency composition consistent with the likely import basket.  This means that some dollar diversification is justified.  We will have a more detailed discussion on the issue in the future.

Bottom line

There are compelling reasons for the GCC countries to continue to accumulate wealth under their SWFs.  With US$44 trillion in oil wealth underground, to be converted into financial wealth, the current SWF holdings of US$1.5 trillion of financial wealth reflect a fraction of this multi-generational oil-to-equities transformation. 

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[1]In this note, we draw on a speech given by Deputy Governor Knut Kjaer of the Norges Bank, From Oil to Equities, November 2006, which justifies Norges Bank’s Government Pension Fund — Global. 

[2]In the coming years, oil prices are likely to remain on a structural uptrend.  However, we think it is likely that equities will continue to outperform. 

[3]See How Big Could Sovereign Wealth Funds Be by 2015? March 15, 2007.

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