Currencies
Delay in GCC’s Monetary Union Raises Reval Risk
February 08, 2008

By Stephen Jen | Aspen, Luca Bindelli & Charles St-Arnaud | London

Summary and conclusions
The planned monetary union of the GCC (Gulf Cooperation Council) in 2010 looks to be an increasingly ambitious goal.  There is a rising risk that it will either be delayed or that a few, but not all, of the six GCC member countries will start this union on time, and others will join when they are ready.  In this note, we take a first look at this important plan, and highlight some key peculiarities about this prospective monetary union.  A postponement of the launch of the monetary union could complicate the exchange rate policies of the GCC countries.  Specifically, the longer the delay, the more tempting/likely it will be for some small open economies in the GCC to contemplate one-off revaluations, while still maintaining the dollar pegs. 

Historical background of the single-currency idea
The GCC itself was established in May 1981 and consists of Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the UAE.  As was the case with the EMU, this proposed monetary union is part of a comprehensive project to enhance economic and political integration of the member countries.  In November 1981, the leaders of the GCC signed the ‘Unified Economic Agreement’, which came into force in January 1982 and outlined the key objectives and measures of economic integration, replacing a web of bilateral arrangements.  A Free Trade Zone was established in 1983.  At the GCC Summit in Muscat in December 2001, the leaders of the GCC countries explicitly agreed on the planed formation of a monetary union by 2010 and, as an intermediate stage toward the monetary union, agreed to peg to the dollar by end-2002.  A Customs Union was finalised in January 2008.  The success of the EMU has certainly galvanised the GCC’s determination to form their own common currency area.  However, there are several issues that may delay the launch of this ambitious project.

Broad economic trends of the GCC
The GCC economies are rather unique.  We highlight some of their key traits here:

·  Modest economic size.  The total GDP of the six GCC countries is rather modest.  At US$790 billion in 2007, the GCC is a little more than half the size of Canada.  The total population of the GCC is 36 million, with Saudi Arabia accounting for 24 million of this total. 

·  Immense, but varied, oil and gas endowments.  The GCC countries collectively account for 40% of the world’s oil reserves and 23% of global natural gas reserves.  However, some countries are better endowed than others (more on this later). 

·  Exports to Asia; imports from the EU.  Roughly 37% of the GCC’s exports (mainly oil) go to Asia, while about 18% of imports come from the EU.  The US accounts for only 8.8% of the GCC’s exports and 11.4% of their imports. 

·  Low intra-regional trade.  While intra-GCC trade accounts for only 9% of total trade, excluding energy exports intra-regional trade is about one-third of the total. 

·  Developing financial markets.  In general, capital markets are becoming more developed.  Equity market capitalisation is around 128% of GDP, and bank loans are around 55% of GDP. 

·  Expatriate workers.  Though the population growth rate is high (3.2% per year in the past decade), the GCC is highly reliant on expatriate workers.  The share of nationals in total population is around 44% in the GCC, and 55% in the total labour force.  The public sector is dominated by nationals. 

Progress on convergence
While the GCC members have more natural (economic, social, language, historical and cultural) commonalities than the countries in the Euroland, there is relatively less convergence on economic measures.  We highlight several concerns: 

·         Concern 1.  Different endowments of natural resources.  Though it is well-known that, collectively, the GCC are well-endowed with natural resources, the amounts of these reserves are vastly different between countries.  Saudi Arabia accounts for more than half of the collective GCC oil reserves.  The UAE and Kuwait also have large oil reserves.  Qatar has the third-largest natural gas reserve in the world.  Bahrain and Oman, however, are less well-endowed.  In fact, at the current production level, and assuming no new discoveries, Bahrain’s oil and gas will be depleted in five years’ time.  Oman’s oil reserves could last ‘only’ until 2027.  Saudi Arabia’s oil may last another 70 years, while Kuwait and the UAE may last more than 100 years.   What this means is that a GCC monetary union may one day contain both oil exporters and non-energy exporters.  The desire to diversify out of energy, understandably, differs across the GCC, depending on the richness of the natural resource endowment.   

·         Concern 2.  Fiscal convergence will be difficult.  With  exports of energy being so dominant (energy exports account for an average of 80% of the total budget and a little more than 40% of overall GDP), swings in oil prices have had, and will continue to have, a major impact on the fiscal positions of these countries.  It will be difficult for the fiscal accounts to converge. 

·         Concern 3.  No more monetary convergence.  Until 2002, inflation across the GCC had been very stable, thanks to the currency pegs to the US dollar: from 1985 to 2005, inflation in the region averaged only 1.6%, with low variability.  However, in the past five years, inflation has accelerated and diverged across the region.  The average rate of inflation of the GCC has accelerated to 4.7% and Saudi Arabia has a reported inflation rate of 6.5%, while Qatar’s latest inflation print was 13.7%.  The fact that the world is less dominated by the US economy has rendered the dollar pegs a less perfect nominal anchor; the combination of high oil prices and a low fed funds rate has made it difficult for the GCC central banks to contain inflationary pressures.  In turn, inflation divergence has led to a divergence in the real exchange rates, and price competitiveness in the region.  This puts the monetary authorities in a difficult bind, as they confront the choice of letting their exchange rates appreciate in real terms through either nominal appreciation or inflation.  Either way, the monetary and exchange rate ‘glide paths’ toward the monetary union have gone off track, and the GCC members now need to think hard about their price competitiveness as they enter the monetary union.  The longer it takes to form a monetary union, the wider the window for policy interventions to adjust these glide paths.

·         Concern 4.  Low quality of macro data and a lack of transparency.  Originally, at the Muscat Summit in 2001, it was planned that the convergence criteria be defined by 2005.  However, not only has this not been done, but macro data in this region is also of relatively low quality – not conducive to facilitating close monitoring of the glide paths toward the monetary  For example, CPI inflation is available with a six-month lag in Kuwait, while Bahrain and UEA only have annual numbers.  In addition, the measures themselves are likely to be understatements of the reality.   

·         Concern 5.  Low degree of labour mobility within the region for the expatriate workers.  Though there is effective free movement of the nationals within the GCC, mobility is much lower for the expatriate workers.  One of the key requirements of an optimal currency area is free mobility of capital and labour, and the GCC has not satisfied this requirement yet. 

Currency implications
As we have argued in the past, the macroeconomic pressures impinging on the GCC are in some ways similar to those pressing on China.  In theory, the GCC should have their independent monetary policy, with a managed float exchange rate regime.  While it would, in theory, be better for the GCC to introduce major changes to their exchange rate and monetary regime after they have introduced a monetary union, based on our observations listed above, 2010 looks to be a rather ambitious target.  At the GCC Heads of State Summit in December 2007, the issue of whether to postpone the establishment of the monetary union was tabled for discussion, but no verdict was rendered.  Our best guess at this point is that the project will either have to be postponed to 2015 or that only a small subset of the six GCC members will form the initial common currency area, with the others joining in the future, when they are ready.  What this means is that the individual countries may have more leeway in devising their own policy paths in the meantime, i.e., it will no longer be essential that the GCC members move in sync and in a coordinated manner.  Modest step revaluations, while retaining dollar pegs, are indeed a possibility, particularly if the Fed continues to ease while oil prices don’t correct significantly.  The probability rises the longer the monetary union is postponed. 

Bottom line
Plans to establish a monetary union by 2010 seem ambitious to us, given the lack of economic convergence and other concerns.  While it would, in principle, be ideal to reform their exchange rate and monetary structures as a monetary union, the longer this union is delayed, the more tempted and likely some GCC members will be to contemplate making adjustments to their policy regimes.  Step revaluations, while still retaining the dollar pegs, will remain a risk, particularly for the small economies within the GCC.

 

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Currencies
A US$100 Billion Supra-Sovereign Wealth Fund?
February 08, 2008

By Stephen Jen | London

Summary and conclusions
The IMF has been asked by the G7 to come up with a set of best-practice guidelines for the sovereign wealth funds (SWFs).  The irony here is that we believe the IMF itself should invest its capital more like a SWF (and more like a central bank).  The IMF has one of the largest gold holdings in the world.  At today’s gold prices, the 103.4 million ounces of gold that the IMF holds is worth close to US$92 billion.  Arguably, this is a good time to convert its gold holdings into paper assets, for not only are gold prices high, but the IMF now also has a genuine need to generate investment income. 

Our argument
At the G7 meeting in September 2007, the IMF (International Monetary Fund) and the OECD (Organisation for Economic Cooperation and Development) were asked to come up with a set of best practices for the SWFs and the recipient countries, respectively.  These two institutions were chosen because of expertise in dealing with balance of payments (BoP) and exchange rate-related issues (in the case of the IMF) and institutional knowledge on foreign direct investment (FDI) (in the case of the OECD).   Being multilateral institutions, these two entities are thought to also have the credibility and (relative) political neutrality needed to render a set of guidelines on a controversial issue that a wide range of countries would accept.  The irony, however, is that the IMF itself has ample reasons to consider forming a SWF of its own.  It now has both the ability and possibly greater willingness to do so.  Such a fund could easily reach US$100 billion in size in the not-too-distant future.  Even if invested in the most traditional ‘safe’ assets held by the most conservative central banks, the annual investment returns could be substantial and could go a long way towards helping the IMF to be better equipped to face the new global environment. 

The case for the IMF having its own SWF
The IMF now has both the ability and possibly greater willingness to contemplate forming a SWF of its own. 

The IMF is more able to do so mainly because gold prices have more than tripled since 2002.  The IMF’s gold holding – at 103.4 million ounces – is only surpassed by the US (261.5m) and Germany (109.9m).   The sharp rise in gold prices in recent months has pushed up the value of one of the IMF’s assets from US$23 billion in 2002 to US$92 billion now.  This is arguably a good time for the IMF to consider selling its gold holdings. 

At the same time, the IMF is more willing to consider a different investment style.  The new Managing Director of the IMF, Mr Dominique Strauss-Kahn, announced on December 6 the need to rationalise the 64-year-old institution, including a drastic 15% cut in staff.  The main reason for this is that, with the balance of payments (BoP) outlook of the developing world being much better than at any time since WWII, the demand for IMF resources has dwindled.  For example, outstanding IMF credit to the world declined from an average of  US$30.6 billion during 1996-2000 to US$4.3 billion at end-2007 .  This decline in lending has translated into a sharp fall in the IMF’s operating income, compromising the ability of this institution to pay for its staff and to run the institution in general: the IMF’s annual operating costs were around US$715 million in 2007.  Further, the more modest revenue path has also restrained its ability to finance the HIPC (Highly Indebted Poor Countries) Initiative.  

In our view, the IMF possesses one of the most talented pools of economists in the world, produces top research on both developed and developing economies and still enjoys great credibility in the world.  While sensible rationalisation from time to time is always welcome and justified, the ability of the IMF to operate at its full potential should never be compromised, in our view.  Retrenching now is tantamount to downsizing a fire department when there is a low incidence of fire.  Further, downsizing now when the global economy is down-shifting and with new and daunting policy challenges (lingering inflation, financial regulation, cross-border investment, etc.) confronting both developed and developing countries means that the timing may not be ideal.  

Convert the IMF’s gold holdings into paper assets
We ran some simple back-of-the-envelope simulations to calculate the possible earnings streams if the IMF were to sell some or all of its gold holdings and invest the proceeds in bonds and equities.  

Scenario 1 shows how the 103.4 million ounces of gold, if completely sold now, would grow over time, assuming a conservative annual nominal investment return of 3.5%.  Scenario 2 assumes a 5.5% nominal return.  

Scenario 3 shows how this latter profile would be altered if the annual operating expenses of US$1 billion were taken out from the investment returns in 2008.  With the operating expenses assumed to rise at an inflation rate of 2.5% beyond 2008, this ‘supra-SWF’ could reach US$130 billion in 10 years’ time.  Spending out of this fund would strictly be limited to the investment returns, and the principal would be protected in nominal and/or real terms. 

The 3.5% nominal return is a most conservative assumption.  Depending on the IMF’s investment strategy, higher investment returns would, of course, be possible, even if investments were limited to AAA rated bonds.   Asking the Fund to hold equities may be unreasonable, given the associated market risk, liquidity concerns and reputational considerations.  But the point is that the IMF has a great deal of scope to enhance its investment returns without exposing itself to undue market risk.  Having most of the assets yielding no investment return does not seem to make a lot of sense.  Even if the IMF only sells off a portion of its gold holdings, it would be helpful, from a financial perspective.

Ultimately a political decision
The economic and financial argument in favour of the IMF altering its investment style seems compelling to us.  The key impediment to this proposal is mainly political.  The US government, in particular, will need to reconsider its thus far firm position on gold being a good, prudent asset for the IMF to hold.  But with the financial proposition being so different now than a decade ago, when the idea of gold sales to finance the HIPC Initiative was first proposed – and rejected, perhaps the IMF may be allowed to sell its gold holdings this time around.

Bottom line
‘SWFs’ are far from a four-letter word.  They are an inevitable and rational consequence of some of the most powerful structural trends in the global economy.  Demographics, excess savings and artificially depressed sovereign long-term interest rates are all factors that have altered the ability and the willingness of sovereign funds to modify their investment portfolios.  In this note, we argue that the IMF itself confronts similar pressures, and that, in our view, it should seriously contemplate setting up a supra-sovereign wealth fund, out of the gold holdings it has.  Fully financing the operating expenses of the IMF, this prospective fund could be launched at US$92 billion and grow to US$130 billion in 10 years’ time.

 

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Japan
Be Prepared for Dual Recession
February 08, 2008

By Takehiro Sato | Tokyo

GDP in the US and industrial production in Japan are decisive factors
The risk of dual recession is mounting. Our US economics team is already calling for capex-induced negative GDP growth in successive quarters (Jan-Mar, Apr-Jun), for a technical minor recession in the first half of the year by definition. We are forecasting that Japan will cling on to a modicum of growth in the Oct-Dec 2007 quarter, boosted by external demand, but there is a possibility that, like the US, that quarter will mark the peak and the economy will retreat in Jan-Mar. Future data for industrial production will tell us if this is the case.

If industrial production drops in Apr-Jun, Japan will also be in recession
The US economic cycle is defined by GDP data, but in Japan the cycle can be straightforwardly linked to the industrial production stats. We hone in on industrial production because the coincident index of business conditions (or more precisely its historical DI), which is used to officially assess the economic cycle, contains a large number of production-related components. As many as six of the ten items that make up the coincident index are production data, or closely linked to such: the index of industrial production, the index of producers’ shipments, large industrial power consumption, overtime hours in manufacturing industries, index of producers’ shipment of investment goods, and sales by small and medium-sized manufacturers. The direction of the coincident index therefore roughly matches the trend of industrial production.

Incidentally, in Japan’s case, quarterly GDP data are too volatile to be a suitable criterion for calling the economic cycle. This is clear from the GDP trend in past recessions. Yet while GDP has at times been positive when the economy is in retreat, industrial production has consistently mirrored the downward path of the economy. It seems reasonable to say that the critical factor for assessing the economic cycle is simply the direction of industrial production.

Japan industrial output to drop in Jan-Mar
METI forecasts indicate that industrial production is likely to drop in the Jan-Mar quarter. Cuts led by the steel, non-ferrous metals, electrical machinery and transport equipment sectors are poised to reduce output from the manufacturing sector overall in successive months, by 0.4% MoM in January and 2.2% MoM in February. Even a flat March would leave production for the quarter down 1.5% sequentially for the first drop in four quarters. IT-related industries such as electronic components and devices are planning to curtail output in January and February after increases in December. Over-extended production forecasts for general machinery (+4.4% MoM in January) and IT/telecom equipment (+12.8%) also suggests that plans may not be met.

As the outlook for declining output in Jan-Mar becomes clearer, the key question becomes whether this will carry over into the Apr-Jun quarter. If it does, the economy may prove to have peaked last year in Oct-Dec, and more specifically in October, supporting the view that Japan and the US entered a period of recession at the same time.

Automobile production may correct
Our auto industry analyst, Noriaki Hirakata, has highlighted the risk that imbalances between inventories and shipments in North America may result in output cuts in Apr-Jun. This point has important implications for Japan’s industrial production outlook.

Automobile inventories in the US were up sharply YoY at the end of January, and Hirakata believes that if automakers were saddled with surplus inventories around the turn of the year, they could well start cutting production from March, and during the Apr-Jun quarter in earnest. According to the production forecasts in the METI survey cited earlier, the transport equipment industry is already facing consecutive output cuts in January and February. This is ominous, even though the lunar new year in Asia has some impact on February. The transport equipment sector, which contains automobiles, has an 11.3% weighting in the industrial production statistics even when steel ships and railway carriages are excluded, and a 15.0% share of shipments. Its tentacles extend to many related fields, such as electronic components, steel, plastics and glass & ceramics. Cutting back auto production would obviously depress industrial production as a whole, albeit with some time lag. This means that there is risk that things will turn nasty for Japan and the US at the same time, in the Jan-Mar and Apr-Jun quarters.

How long would a recession last?
The debate about decoupling/recoupling of the leading economies and emerging markets has ended with the recoupling view predominating in the markets. Even if economic performance has decoupled, the performance of the markets has been closely interlinked, whether in developed or emerging countries. And while Japan’s ratio of exports to the US has nominally sunk below 20%, it is still above 30% when exports routed via other Asian nations are factored in, and the argument that Japan’s economic performance is still decoupling from the US is unconvincing. As the risk of the onset of a simultaneous downturn in Japan and the US mounts, talk will move on from whether or not there will be a recession to how bad and how long the recession will be.

As the stimulus from the tax cuts and massive Fed easing filters through, the US economy should get a lift in the summer, and our US economics team is forecasting a healthy 4.5% annualized growth rate in the Jul-Sep quarter. That would make for a mild and short-lived recession in the US. What about Japan? Despite the imminence of a general election, Japan does not have to fiscal wherewithal to bring out a package of stimulus measures like that in the US, and with only 50bp to play with in cutting the policy rate, macro policy traction will be limited even if there is a rate cut during Apr-Jun as we are forecasting.

The signs of a recession in Japan are still incipient, so it is probably too early to start talking about the timing of the recovery. If the US stimulus package bails out Japan’s by allowing industrial output to pick up in Jul-Sep, the domestic recession like that in the US would fizzle out in just two quarters. In that event, it might not even earn the official designation of a ‘recession’, and instead be characterized as a ‘soft patch’ like the hiccups in early 2003 and the second half of 2004. Whether we do get a full-blown recession probably depends more on trends in the US economy than on domestic factors, and especially on whether US housing prices crash as commercial banks and the household sector are slammed with balance sheet adjustments on the scale seen in Japan. If there is balance sheet deflation in the US, there is no guarantee that the recession there would end with two mild quarters of negative growth. Besides which, what happens in China may have a lot more impact than is currently recognized.

Is China a risk?
Our China economics team has been harping on about an ‘imported soft landing’ due to a slowdown in exports. A deceleration in external demand could actually be a welcome coolant for China’s economy, where domestic demand is overheating chiefly in response to investment in fixed capital. But there does nevertheless seem to be growing downside risk for the Chinese economy now, with snow damage coming just as measures to rein in aggregate demand such as the cap on bank lending are starting to bite. Our China team believes that if signs of a pullback appear, the authorities could loosen their tight monetary policy and there is still ample scope for fiscal stimulus. The problem though is that taking macro measures once demand has already headed down is like pushing on a string, and frequently fails to achieve the intended effects. If China does fare worse than expected, the risk that a dual recession could escalate into a triple recession would come into play.

 

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