Venezuela
Is Akerlof Wrong?
January 16, 2008

By Boris Segura | New York

Venezuela is in the midst of a consumption boom, with a corresponding sharp rise in imports.  High oil prices, which are transmitted to the economy via greater government expenditure, are stoking demand pressures.  Exchange controls trap the enormous growth in domestic liquidity; in turn, the banking system recycles this excess liquidity in the system into ‘easy’ credit.

Domestic credit has been growing at explosive rates in Venezuela. Total credit in real terms has grown at a compound annual rate of 108% during 2004-07; consumer credit has grown at a rate of 132%, and credit to finance car purchases at 186%. Car loans now make up 44% of total consumer credit, up from 19% in December 2003.

Interest rate and exchange controls, plus directed lending by the central bank, are additional factors behind this explosion of car credit.  Exchange controls allow the monetary authorities to keep negative real interest rates without the fear of a balance of payments crisis. This discourages savings and promotes consumption, further fueling the ongoing consumption boom. Interest rate caps and directed lending encourage banks to focus their lending where they can charge the highest nominal interest rate, such as the purchase of vehicles, thereby boosting their bottom line. The Venezuelan banking system has been one of the most profitable sectors during the current boom.

The Venezuelan car market defies economic rules

In his seminal paper, Nobel-Prize winning economist George Akerlof employed the market for used cars as an example of the problem caused by quality uncertainty. One conclusion from his analysis was that, given information asymmetries, once you drive a car off the lot, its price immediately goes down.

However, in Venezuela, the opposite holds – once you take a new car out of the dealership, its price goes up.  For example, a used 2007 Ford Explorer XLT commands a 28% premium over a brand new one; in the case of a second-hand 2007 Ford Explorer Eddie Bauer Edition, that figure is 23%.  Is Akerlof wrong? We don’t think so.  There are long waiting lists to get a new car in Venezuela; in the case of a popular model, they can stretch up to a year.  So, consumers are willing to pay a premium in order to avoid delay.  This is clearly a case of excess demand for cars in Venezuela, which is explained by a series of distortions that engulf the Venezuelan economy.  Our concern is that these distortions may take a more meaningful toll on the Venezuelan economy in the medium term, although in the short term it will dance to the tune of oil prices.

The car market is red hot in Venezuela. Car sales rose to 500,000 units at the end of last year, up from 230,000 units in 2005. You can certainly appreciate this growth in the vehicle fleet in the middle of heavy traffic in Caracas.

Increasingly, imports have been filling this demand, and more export units are being diverted to the local market.  However, this is close to ‘as good as it gets’ for the car dealership community: The government is now licensing imports in order to protect the local industry, and has also set a total limit of 500,000 units to be sold in the domestic market for 2008, the same number as last year.

Venezuelais the world’s leader in subsidizing gasoline at the pump. As a result, if you own a car in Venezuela, you don’t feel the pinch at the pump.  This undoubtedly fuels demand for cars, but also promotes an inefficient use of energy.  Our equity research colleagues from the Energy team have prepared an interesting chart that compares gasoline costs on a global basis.

A cheap dollar subsidizes your car purchase.  The (real) bolivar has been on a tear since the last nominal devaluation in March 2005, appreciating by 66%. However, not all of this move can be construed as mere overvaluation; oil prices have risen steadily throughout the same period.

In a typical ‘Dutch Disease’ fashion, the strong real bolivar is hindering tradables production and promoting their consumption; in fact, it is subsidizing imports and also widening the non-oil current account.  Venezuelans have access to cheap dollars at the official exchange rate to buy imported cars, which are displacing local production.

Purchase of a car as a store of value and not as a consumption decision.  Another reason for the pent-up demand for cars is that they are increasingly being perceived as a store of value in an economy where there are few investment alternatives available for a large section of the population. This observation takes added significance given the large gap between the official and the permuta exchange rates.  If there are expectations for currency devaluation, a somewhat liquid asset such as a car could become a decent store of value, particularly when the much weaker permuta exchange rate is viewed as a replacement value.  Cars are cheap if you can sell dollars in the permuta market; the problem is that in Venezuela the main supplier of dollars is the government itself, via Pdvsa.

But no crisis is imminent.  As we have been arguing for a while, Venezuela does have the ability and willingness to pay its debt, based on current high oil prices and a healthy stock of liquid assets. But its policy framework is far from ideal, as it creates a challenging business environment and myriad distortions in the economy, such as those discussed above for the car market.  However, although we suspect that the economy will follow a slow process of deterioration, with increasing macroeconomic imbalances, we do not expect a crisis in Venezuela over 2008-09, unless there is a material and sustained drop in oil prices.

 

France
A More Flexible Work Contract in the Offing
January 16, 2008

By Eric Chaney | London

Maybe a watershed, but not enough to restore France’s competitiveness

French company managers (Medef) and three trade unions have reached an agreement on more flexible hiring/firing rules. I take this as a step in the right direction, i.e., towards a more flexible labour market, but insufficient to make the French labour market competitive vis-à-vis the best European practices. Yet, some sectors such as consultants or engineering might welcome the deal.

The news: Medef and several unions (FO-CFTC-CGC and CFDT will probably join the crowd later, CGT won’t) have reached an agreement on the ‘modernisation of the labour market’. Here are the main features of the deal, with my own appreciation:

• The open-ended generic contract (CDI) remains the rule (negative but largely rhetorical);
• Trial period extended, from one month to four months maximum for blue and white collar employees (small positive);
• Possibility to terminate a job contract if both sides agree, without losing unemployment benefits for the employee (small positive);
• Possibility to terminate a job contract when the position was opened for a specific project. This would allow companies to hire qualified workers/engineers on three-year (maximum) contracts for specific projects (positive, especially for consultants and engineering companies);
• Employees would keep their vocational training claims even after being fired (positive).

The next step: The government will probably draft a bill and pass it to the National Assembly before June. This bill is likely to be very close to the deal reached by employers and unions. Once elected, President Sarkozy had given six months to employers and unions to make a deal on a more flexible generic working contract, making layoffs less hazardous for companies and offering more cash compensation to fired employees. He promised to translate the agreement into a bill – if agreement there was. Otherwise, the government would have drafted its own bill.

The positive sides:

1. It will make the French labour market more flexible and more competitive;
2. For the first time in the history of French unions, a majority of representative unions (provided that CFDT underwrites the agreement) has agreed on making the labour market more flexible, albeit at a homeopathic dose. In the past, any negotiation had either failed (when unions were weak), or led to ever-higher protection. In this regard, the deal is a watershed in the French economic and social history: with considerable lags, the French social model is moving toward flexibility.

The negative sides:

1. If this is all we get, the deal will stop short of restoring the competitiveness of the French labour market. It goes in the right direction, but not fast enough to catch up with a fast-moving world (what I called years ago the ‘White Queen Syndrome’);
2. Since President Sarkozy promised that his government would underwrite the agreement, there is not much he can do at this stage to push the reform further.

Bottom line
I take this agreement as mixed news. It definitely moves the labour market in the right direction after decades of regression toward higher protection, causing what I have dubbed the ‘insiders’ disease, i.e., a two-tier labour market where insiders (protected workers) fiercely defend their rights, while outsiders (young workers with flexible contracts) lose hope of ever getting a ‘good job’ and companies pack up and promising start-ups quickly die.  If it’s only a first step, then France will progressively regain its lost competitiveness as the labour market reform process continues. If that is all, those who have elected Mr. Sarkozy to reform France would be deeply disappointed.

Canada
Canadian Economy: Slower Growth in 2008
January 16, 2008

By Charles St-Arnaud | London

Summary and conclusions

After four years of strong growth, I expect the Canadian economy to decelerate in 2008. The anticipated recession in the US is likely to be the main drag to growth, while domestic demand should moderate somewhat. Growth should rebound in the second half of the year. Overall, I forecast growth to average 1.7% in 2008 while core inflation  should decline as a result of past currency appreciations and the slowing economy. In response to moderating growth and inflation, I expect the Bank of Canada to cut interest rates by 100bp by mid-year, bringing the interest rate to 3.25%, and remain on hold thereafter.

Economic growth

The Canadian economy has enjoyed strong growth of close to 3% on average over the past few years. This enviable performance is the result of sound macroeconomic policies, structural reforms and favourable external conditions.  As a result of the solid growth, the Canadian economy is operating beyond its capacity, according to the Bank of Canada. Over recent years, the strong labour market has boosted disposable income in Canada, and this has translated into strong household spending. In addition, the terms of trade improvement coming from higher commodity prices has led to higher real income and stronger domestic demand. However, vigorous domestic demand coupled with a stronger currency translated into solid imports, while the currency appreciation and sluggish demand from the US slowed export growth, resulting in a drag on the economy from net exports.

Going forward, I expect the drag coming from net exports to intensify. First, the sharp currency appreciation over 2007 should continue to have a negative impact on exports, while providing some support to imports. Second, our US economic team expects a recession in 1H07.  Growth in the US is now expected to be negative in the first two quarters of the year before rebounding in the second half, for a growth rate of 1.1% for 2008 as a whole.

In addition, I expect domestic demand to moderate in 2008 from its current high level. Tighter credit conditions are likely to put some pressure on the Canadian economy, but the impact should be less than in the US. Consumer spending should abate somewhat, as the labour and the housing markets soften, while the one percentage point cut in the GST could prove to be not so supportive. Investment in machinery and equipment should also moderate, as slowing demand from the US is likely to mitigate the impact from lower costs for imported equipment coming from a stronger Canadian dollar and high corporate profits. In addition, weaker commodity prices will likely offset some terms of trade gains made in 2007, reducing their impact on real incomes and domestic demand.

In 2H08, I assume that the rebound of the US economy will provide some support to Canadian exports. This should reduce the drag on the economy coming from net exports and lead to a reacceleration of the Canadian economy.

Overall, I expect growth in Canada to slow in 1H08 to a rate of around 1.0% before rebounding in 2H, with growth at around 2.0%. On average, growth in 2008 is forecasted at around 1.7%.

Inflation profile

Inflation has remained higher than the Bank of Canada’s 2% target and its expectations in 2007: inflation is likely to have averaged 2.3% for headline and 2.5% for core.

With the forecasted slowdown of the Canadian economy, I expect excess demand pressures to gradually dissipate and to reverse to a small excess supply. In addition, the past appreciation of the Canadian dollar should continue to push prices of imported goods lower, while the moderation in house price inflation should reduce the upward impact coming from the housing component. In addition, a slight base effect is likely to also contribute to bringing core inflation lower. As inflationary pressures abate, I expect core inflation to gradually drift lower throughout 2008, from 2.0% at the end of 2007 to reach 1.5% by mid-year and a low of 1.3% by the end of the year – well below the Bank of Canada’s target for inflation.

Headline inflation should be distorted for most of the year by the one percentage point cut in the GST. Past estimates from the Bank of Canada point to a 0.6 percentage point drop in headline inflation as a result of lower sales tax . Once this effect is removed, headline inflation should start the year high due to strong oil prices, before creeping lower as commodity prices abate. 

Monetary policy

The Bank of Canada pre-emptively cut interest rates by 25bp in early December, as the combined impact of the sharp CAD appreciation, tighter credit market conditions and weaker US growth outlook will likely slow the Canadian economy in 2008.

Since December, credit markets in Canada have improved somewhat. As the Bank of Canada pointed out on January 4 2007, “pressures in short-term money markets have eased from their earlier peaks, although spreads have not yet returned to historical levels”. The spread between the overnight rate and 3-month Libor, the 3-month corporate paper, and the 3-month banker acceptances have decreased, but are still higher than their 10-year averages. Some market participants are debating whether we have experienced a fundamental repricing of risk.

Against the backdrop of improving financial markets conditions, a slowing Canadian economy and decreasing inflationary pressures, I think that the Bank of Canada will remain pre-emptive and continue to cut interest rates sooner rather than later. We are now in a period where the cost in terms of inflation from cutting interest rates is outweighed by the cost in terms of growth coming from leaving interest rates on hold for too long. In addition, inflation expectations in Canada remain well anchored close to the BoC’s target. I therefore expect the Bank of Canada to cut rates by 50bp in 1Q – 25bp at the January meeting and a further cut at the March meeting – and then twice again in 2Q, bringing overnight rates to 3.25% by mid-year. I then expect interest rates to remain on hold for the rest of the year. However, there is always the risk that the Bank of Canada could move by 50bp if it judges it necessary to front-load some of the cuts.

Risks

There is some risk that growth could surprise on the upside. I have advocated in the past that, during the last five years, the links between the US and Canada have weakened somewhat and that growth in Canada is less dependent on exports than during the previous recession. Therefore, Canada could be less negatively affected by a US recession than in the past.   In addition, the solid gains in household income in 2007 could provide more momentum for consumer spending, while stronger demand from Asia and Europe could offset some of the negative impact from declining exports to the US.

The main risk is that the US recession could be deeper and longer than we currently forecast. This would drag the Canadian economy lower for longer. Nevertheless, the risks of a recession in Canada are low, in my view. Also, we could experience another round of credit market turmoil, as further big losses related to the US sub-prime crisis could be announced. This would lead to tighter credit conditions for both consumers and corporations.

Japan
Housing Investment: Not V-shaped but L-shaped
January 16, 2008

By Takehiro Sato & Takeshi Yamaguchi | New York

Summary

The market as well as the Ministry of Land, Infrastructure and Transport appear to think that the housing market slump, owing to the revised Building Standards Law, will be temporary, but it may unexpectedly last longer. We think that the trend in housing investment is more likely to resemble an L-shaped pattern than a V-shaped recovery. The housing market slump is likely to be a protracted one because of problems in clearing up bottlenecks in the proliferation of approved software and the diminished affordability of homes.

What’s new

On January 8, the ministry announced it would provisionally approve by January 21 some of the software for structural calculations based on the revised Building Standards Law. The ministry plans to ask review entities to review applications within 35 days because approved software streamlines the construction permit review process. As a result, some of the bottlenecks in the review process are widely expected to be cleared up. However, we doubt that housing starts will normalize soon because of supply bottlenecks in the construction permit process and the diminished affordability of homes, an unexpectedly major issue.

On the supply side, we believe that it is unclear whether provisional approvals using ministry-approved software will dramatically improve the construction permit review process because of several factors. First, there are still only a limited number of qualified people for peer checks of the structural calculations. Second, the ministry’s approved software can be used for offices, plants, warehouses and other buildings with simple structures, but may not be useful for condominium buildings with fairly complex structures and atypical designs. Third, reviews using newly approved software may not save much effort because the structural calculation software is not limited to software newly approved with anti-fraud features, and can be existing software. Accordingly, we doubt that construction permits and construction starts will rebound sharply in 2008.

On the demand side, households are unable to afford as much as they used to. Home prices in urban areas have risen quite substantially in the past two years because of increases in land prices. In addition, nominal wage growth at the macro level remains sluggish because of a decline in the average wage owing to the retirement of many seniors and margin deterioration at smaller companies. Finally, mortgage rates have risen by more than household incomes have, following two BoJ rate hikes since 2006. The number of Tokyo-area condos sold in November 2007 (based on Real Estate Economic Institute figures) declined 43.6%Y to less than 4,000, the weakest November figure in 16 years. The contract ratio was notably weak, at only 64%. The recent sharp decline in housing starts might thus be attributed to a combination of weak demand and shocks from policy problems rather than entirely to a poorly prepared ministry. Regardless of whether the supply bottlenecks are cleared up, the prospects for a sharp recovery in housing investment are likely to weaken further.

Where we differ

In our revised economic forecast as of December 11, 2007, we estimated that GDP-based real housing investment would decline by 14.5% in F3/08, not much different from the Toyo Keizai consensus expectation of a 12.5% decline, but we expected it to shrink 3% in F3/09, versus the consensus expectations of a V-shaped recovery of 6% (likewise, the government looks for a similar drop of 12.7% for F3/08 and sharper rebound of 9.0% for F3/09). The difference stems mainly from our cautious assumption for construction starts. Based on our housing analyst Hiroko Kubota’s latest estimates, we assume that housing starts will slump to 1.04 million units in F3/08 from 1.28 million in F3/07, and then recover, but only to 1.14 million in F3/09 at most. Based on the above assumptions, we currently look for GDP-based housing investment to drop 12.1% in F3/08 and rise 1.5% in F3/09, which is a little better than our original forecast due to the stronger rebound of the October and November housing starts numbers. That said, there is not a significant difference for the upcoming L-shaped trajectory of housing investment.

Our expectation that housing starts will remain weak in F3/09 may seem inconsistent with the recent MoM rebound, but we are not needlessly pessimistic. To be sure, November starts of detached housing, for which structural calculations are fairly simple, again declined, by 14.9%Y, to 1.01 million (not annualized). However, November starts of condominiums, which require somewhat complex structural calculations, declined 63.9%Y to 8,300, with no indications of a rebound.

Under such circumstances, the proliferation of ministry-approved software is widely expected to ease some of the construction permit requirements and lead to a rebound in housing starts sometime soon, but we doubt that condo starts will recover quickly because of the existing supply and demand problems we noted earlier. A decline in the amount of property that households can afford is also likely to hold back any rebound in housing starts in F3/09. Housing starts peaked in F3/07 and are unlikely to recover that much because of a likely decline in the number of households and increases in construction costs. Demand may surge ahead of a consumption tax increase, but probably not until F3/12. The slump in housing starts may also reflect a reduction in the housing stock following an excess of supply through mid-2006, when the BoJ’s zero interest rate policy (ZIRP) was in place. Condo developers competed to develop new buildings in those years because the carrying costs for land were relatively inexpensive and land prices were expected to rise. We think that we are now seeing a reversal of the trend.

What’s next

GDP-based real housing investment, which slumped 7.8% (27.9% annualized) in July-September, probably weakened further in October-December (the figure comes out around February 14; we estimate a decline of 8.6%, or 20.4% annualized based on the housing starts figures up to November) because the figure is based on construction progress rather than starts. However, as construction starts by floor area recovered in October-December, real housing investment might achieve positive growth in January-March for the first time in five quarters. Even so, we expect a base effect to hurt real housing investment in F3/09, as explained later. We thus think that the January-March figure will be technically important for gauging real housing investment in F3/09. The January-March GDP data are scheduled to come out in mid-May.

We think that a more fundamental factor for whether our caution is warranted will be the trend in condominium starts in the first half of 2008. Given the reports of a bottoming out of construction permits among some developers, we intend to closely follow monthly housing starts and micro-level data.

Risks

Our cautious view could prove mistaken if conditions seriously worsen, the ministry implements measures to safeguard against radical change, or the revised Building Standards Law is watered down. However, we believe that the construction permit process will become irreversibly tougher because the ministry wants to expand the market for existing homes by ensuring that they are more durable. We also think that the process needs to become more stringent to improve Japan’s housing stock.

A second risk factor for our cautious view is the base effect. In our forecast dated as of December 11, 2007, we expected GDP-based real housing investment to grow in every quarter in F3/09 but still be down slightly on a year-on-year basis because of a low launch pad (i.e., negative base effect), stemming largely from the figures for October-December 2007 and January-March 2008. As stated above, however, these figures might be stronger than we expect, given that November housing starts, which were announced on December 28, grew by slightly more than we expected, and we cannot exclude the upside risk that housing investment in the October-December and January-March quarters prove to be stronger than our original outlook. Even in this case, however, we doubt that real housing investment will grow in F3/09 by as much as the government expects (+9.0%Y). Rather, we think that the trend in housing investment will resemble an L-shaped pattern after all.