Robust GDP, Fragile Income
April 18, 2008
By Takehiro Sato | Tokyo
How to Interpret Currently Robust GDP and Low-Key Consumption and Capex?
While production is threatened by the risk of dual recessions in the US and Japan in 1H08, from the expenditure angle we expect January-March real GDP (due out on about May 16) to show resilience, primarily in net exports and personal consumption, with annual growth at least around the mid-2% level and thus stronger than the growth potential (see Jan-Mar GDP Likely Better Than Expected – Policy and Market Implications, April 7, 2008). How, then, to interpret these two conflicting pieces of incoming data? If we look at real gross national income (GNI), the source of purchasing power in the national economy, we expect a sharp deterioration in the terms of trade to result in real income growth well below growth in production and expenditures, imposing structural impediments to a virtuous cycle from income to expenditures despite the resilience in GDP. Thus, we see no need to alter our view on the tone of the economy even if GDP were to prove surprisingly robust. Income Becomes a More Important Indicator than Production When Terms of Trade Deteriorate Significantly GDP (or GDE) is the normal concept of production (or expenditures) used when looking at the scale and performance of the domestic economy, but GNI (gross national income, total income received by a country’s inhabitants, the equivalent of the old SNA (68SNA) GNP) is regarded as most appropriate for looking at the national economy from the income angle. This is because while GDP (GDE) does not include net income from the rest of the world – which has grown noticeably in recent years – GNI does include such receipts. Below we provide a definition of GNI. Nominal GNI = nominal GDP + net income from the rest of the world … (1) Formula (1) shows that when net income from the rest of the world is positive, nominal GNI will be greater than nominal GDP, and if the positive margin increases, nominal GNI’s growth will diverge more widely again from that of nominal GDP. In the recent example of F3/07, net receipts of income from abroad grew to about JPY15 trillion, and the GDP-GNI gap widened. Note also that net income from the rest of the world rose, more or less without interruption, from about 0.8% of nominal GDP in F3/95 to about 2.9% as of F3/07. The left side of the formula is the definition of GNI on a nominal basis, but that on a real basis is a little complicated. This is because while concepts of output such as GDP can be separated into volume and price components, it is not generally possible to break down the income flow into volume and price. Therefore, the new SNA (93SNA) defines real GNI by introducing the additional concept of trading gains (losses), as in (2) - (4). Real GDI = real GDP + trading gains (losses) … (2) Real GNI = real GDI + net (real) income from the rest of the world … (3) = Real GDP + trading gains (losses) + net (real) income from the rest of the world … (4) Formula (2) shows that real GDI (gross domestic income) does not conform to real GDP, and it is only when the concept of trading gains (losses) is introduced that the link between the two is established. In that sense, in 93SNA the principle of three-sided parity between production, expenditure and distribution is in fact ambiguous. Moreover, formula (3) shows how real GNI is made up of two components: real GDI secured by a country’s inhabitants through domestic production, and the real value of net income from the rest of the world. This probably speaks for itself. Then there is formula (4), which brings together (2) and (3). In other words, real GNI is the sum of real GDI accruing to a country’s inhabitants from domestic production, plus net (real) income from the rest of the world, and as such indicates the purchasing power of a national economy. However, this depends not just on domestic production but also on trading gains (losses). Trading gains (losses) are a concept which shows how much the purchasing power afforded by real GDI increases (or decreases) as a result of improvement (deterioration) in terms of trade. For example, the Cabinet Office explains that ‘if terms of trade improve, the volume of imports that can be purchased for a certain volume of exports rises, and the volume of goods and services that inhabitants can purchase with the income arising from domestic production may increase”. Conversely, if trading gains shrink or trading losses increase, the rate of growth in real GNI will not necessarily surpass that of real GDP even if net (real) income from the rest of the world increases. In fact, real GNI growth has generally been below real GDP growth since F3/03, because even though we are currently seeing a rise in net (real) income from the rest of the world, worsening terms of trade resulting from soaring prices for primary products and energy are augmenting trading losses. In terms of levels, while net (real) income from the rest of the world grew to JPY15.9 trillion in F3/07, trade losses amounted to JPY15.2 trillion, so that the two, more or less, cancelled each other out. The difference of JPY0.7 trillion was the smallest since F3/95, which is as far back as the current format goes. Similarly, as trading gains inexorably gave way to trading losses from F3/03, the gap between real GNI and real GNP in F3/07 also narrowed to the lowest level since F3/95. The inference from this is that when growth in imported materials and energy prices is as much stronger by comparison with other price indices as we are seeing at the moment, poorer terms of trade will readily result in a situation of mounting trading losses. Consequently, even if net (real) income from the rest of the world were to increase, i.e., as a result of growth in workers’ salaries, interest receipts, dividends or patent fees from abroad, and nominal GNI were to outperform nominal GDP in terms of both level and growth rate, real GNI might surpass real GDP in terms of the level, but it would still underperform in terms of the growth rate. The real purchasing power in a national economy would therefore not increase to the extent of the real GDP headline. As a real example, while real GDP on the basis of preliminary quarterly data grew at an annualized +3.5%Q in October-December 2007, real GNI for the same period was only +1.7%, and real GDI was even weaker (+0.9%). This lack of growth from the income angle became increasingly evident from July-September last year, when surging prices for imported primary products became more visible, through October-December. This is likely to be more apparent again for January-March. When real income growth is not as strong as production growth, it becomes harder to paint a rosy picture based on a virtuous cycle from production to income to expenditure that the BoJ has envisaged up to now for personal consumption and capex. Where We Differ from the Market View While we expect the market to remain focused on the headline GDP, we favor a balanced look at GDP and GNI. As discussed above, in the current GDP data, the principle of three-sided parity is ambiguous on a real basis, and growth in real GNI is likely to undershoot far from that of real GDP due to worsening terms of trade on the back of further advances in raw materials and energy prices in January-March. If we take a balanced look at the two, we are likely to find that the true shape of the economy in January-March emerges as considerably weaker than the real GDP headline. Moreover, even the rapid appreciation of the yen in January-March provided little succor in the face of growth in import costs, and this trend is also likely to have carried on into April-June. What’s Next As mentioned, January-March GDP data are due out on about May 16. At the same time, the March IIP (2005 benchmark; due April 30) and results of METI’s production forecast survey for the Apr-May are likely to provide some important indications of whether manufacturing production corrections will persist in April-June (see IIP Rebasement: More Moderate Current Pace of Decline, but…, April 10, 2008). The IIP under the old standards (2000 benchmark) peaked in October and production clearly trended downwards in January-March, providing evidence that the business cycle had already hit a peak in October-December last year. While the rebased index published recently also peaked in October, the decline in January 2008 was narrower (-0.5%M versus -2.2%M under the old benchmark). This is because transport equipment (excluding steel vessels and railroads) was revised from a production-down (-3.2%M) to a production-up (+1.8%M) industry. This means that, under the new benchmark, production of transport equipment (primarily autos) was still in an uptrend as of January this year. Another factor that contributed to the narrower fall in the production index was the rise in the weighting of transport equipment from 11% to 16% under the new benchmark. Still, it is clear from the March-April production outlook survey that autos are already in a production adjustment mode, and this trend should be confirmed in the upcoming February revised report on April 17 and the March preliminary report on April 30. Assuming that is the case, the slowdown should become more visible heading into April-June, and unlike the picture up to now, production could fall more steeply in April-June than January-March. Although the production decline conversely accelerated for electronic components and devices in January (from -3.6% under the old standards to -7.6% based on the new benchmark), the weighting of this sector was reduced from about 11% to 8%, thereby diluting the impact of the production cut. Risk Factors In its Monthly Report of Recent Economic and Financial Developments for April, the BoJ says that based on survey hearings from corporations, it expects industrial production to hold more or less flat in April-June. We, on the other hand, have held the view that output falls could accelerate in April-June, especially in the automotive and IT fields. It should be possible to get some idea of which view will transpire from the April-May production outlook survey findings on April 30. Moreover, even if the production outlook for April-May is generally firm, we have already noted the tendency for actual production to fall short of METI forecasts in IT-related fields, such as electronic components and devices, and general machinery. Moreover, the production figures this time will have been compiled just as the US enters into a recession. Production and exports have demonstrated resilience on the back of phenomenal demand in Asia. However, perfect decoupling is never possible, and even in Asia, a sense of slowdown in the overheated domestic demand is probably looming as exports to the US slow.
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Slower Growth; More Cautious Pace on Reforms
April 18, 2008
By Eric Chaney | London
In contrast with the sharp deceleration of growth in close trade partners such as Italy and Spain, the French economy is likely to post a rebound in 1Q08. Several short-term indicators – such as temporary jobs (4.4%Y in January-February), consumption of manufactured products (up 1% on the quarter on our estimates) or the Insee manufacturing survey – are pointing to a rebound in GDP growth. Therefore, we have revised our GDP growth forecast for 1Q from 1.5% (quarterly annualised rate) to 2.0%. However, adverse macro factors are too powerful to leave the economy unscathed in the coming period. France Is Not Immune to the Credit Crisis Even if the French banking system was totally immune to the credit crisis, which is not the case, the French economy would be hit by the rise in the cost of funding, the real appreciation of the euro and the fallout from the credit crisis hitting key trade partners such as the UK, Spain and Germany. In the real world, the French financial system (mostly banks, mutual funds and, to a lesser extent and with less macro consequences, insurance companies) is exposed to the credit crisis. Both the Ministry of Finances and the Bank of France believe that this exposure is very limited. However, at this stage, neither authorities nor supervisors/regulators have published estimates of the potential losses linked to the credit crisis incurred by French financial institutions. While we see no reasons to question the confidence expressed by the French authorities, we nevertheless believe that the French banking system will have to write down more potential losses than has been done so far, often because of a strong reluctance to mark asset prices to markets when the latter are still dysfunctional. Potential Losses for French Financials: Limited but Not Negligible Based on estimates published by the IMF in its Financial Stability Report (April 2008), the total amount of losses incurred by the EU financial system might be as high as US$380 billion (€245 billion), or 1.6% of the EU-27 GDP. Assuming that France is less exposed than the average of the EU would imply that the total amount of losses should be less than 1.6% of GDP or, rounding the numbers, €20 billion. Note that SocGen trading losses (€4.9 billion) caused by a rogue trader are not included in this estimate, since they were not related to the credit turmoil. Note also that IMF estimates are potential losses for the global financial system originated solely from corrections in US underlying asset prices. Since European asset prices are also experiencing significant corrections, especially but not only in the housing sector, potential losses for European financial institutions reported in the IMF report might be underestimated. Credit Standards for French Companies Are Getting Tighter At the end of 2007, the total outstanding debt of the French non-financial corporate sector had reached €1,476 billion, or 79.2% of GDP. This is slightly less than the euro area average (85% of GDP, on our estimates) but nevertheless shows the weak link in the French economy if, as we believe, credit conditions tighten further in the coming months. First, the increase in corporate leverage since 2004 (the previous trough) is worth 10.7% of GDP, practically the same increase as in the previous debt cycle (1994-2001), although concentrated over a shorter period. Second, the quarterly bank lending survey of the Bank of France indicates very clearly that French credit institutions lending to companies have already significantly tightened credit standards. According to the January 2008 survey, banks started to tighten in the last months of 2007 and intend to go one step further in 1Q08. Interestingly, large and small companies are evenly treated, suggesting that the change is coming from the supply of credit, rather than from the creditworthiness of non-financial companies. Let’s Call a Spade a Spade – a Credit Crunch Is Looming This hypothesis − in plain English, that some sort of credit crunch is unfolding in the funding of French companies − is supported by the reasons banks give to their announced policy: for the first time since the survey started (2003), banks mention their own funding difficulties as well as their liquidity position as highly relevant factors. Since the interbank money market is far from healing − at the time of this writing, the 3M Euribor spread vis-à-vis the ECB’s refinancing rate was 75bp − we think that banks may have tightened lending policies further since January. As the survey shows, the usual way lenders operate is by widening bank margins, a point confirmed by corporate treasurers surveyed by AFTE, the French association of corporate treasurers. In this regard, the April AFTE survey is alarming: for the first time since the credit crisis started, corporate treasurers are expressing serious concerns about their treasury position. A credit crunch is not easy to detect − even less to quantify − since credit data are by definition collapsing supply and demand curves. It is thus difficult to predict the advent of such development. As we have already explained for the euro area as a whole (From ‘Soft Rebalancing’ to ‘Conflict of Interest’, March 19, 2008), we believe that the credit crunch is likely to hurt companies in 2H08, with consequences on corporate investment spreading well into 2009. Households Should Be Relatively Insulated from the Credit Crisis … So far, the only sign of slowdown in credit is coming from housing loans: the growth of outstanding loans has decelerated from 15.8% in October 2006, the peak in this cycle, to 12.6% in January. New loans are decelerating even more sharply, as indicated by the Bank of France lending survey, which has been signaling that demand was deflating already one year ago. The reasons for the slowdown are different from what we are expecting in the corporate world. They are mostly higher interest rates and thus a higher cost of borrowing, and a stabilisation of house prices that is auguring a possible outright decline. Since consumers, in France as in other European countries, have been highly sensitive to the acceleration of inflation since last summer, we would not exclude that households have implicitly scaled down the assessment of their own purchasing power, and thus of their savings capacity. This might have also contributed to tame demand for housing loans. Yet, the slowdown is not caused by tighter lending conditions from banks, according to the bank lending survey. Moreover, the creditworthiness of French households looks robust. First, households’ debt has increased only moderately since 1995, the credit trough in the previous cycle, from 33.2% of GDP then to 48.2% in 2007, less than half the indebtedness of UK and Spanish households and significantly lower than German households’ debt. In addition, French consumers are the champion of savings within the euro area, with a personal savings rate taking 16.3% of disposable income in 2007 (versus 14% for the euro area), largely because typically one-third of house purchases are financed directly from personal savings. … but Not from the Macro Downturn and Higher Inflation In fact, the credit crisis is likely to hit French households and, to some extent, consumer spending through more traditional macro channels: a slowing economy will generate fewer jobs, and thus nominal disposable income is likely to slow this year. Since inflation should accelerate by more than one percentage point this year, peaking at around 3.25% on our forecasts, real disposable income will slow even more sharply. The trump card is of course the aforementioned very high French savings rate. In our annual forecast, we have discounted a half a point of disposable income decline in savings flows but would not exclude a larger fall, provided that consumers do not anticipate a permanent rise in inflation. If this happened, consumers would probably react by saving more, not less, in order to compensate for the erosion of their real savings in non-interest-bearing bank deposits. Postponing the Recovery to Mid-2009 In summary, we now think that the trough for the real business cycle in the euro area and in France will take place in late 2008 to early 2009, with consumer spending slowing once companies start to shed jobs in order to preserve their long-term profitability. In our main case scenario, which assumes that the financial markets will operate normally again (although with a higher liquidity premium in money markets) at the beginning of 2009, the recovery should occur as soon as companies anticipate a brighter macro outlook and start spending again. This should happen by the middle of next year, in our main case scenario. More important than the timing, which is highly uncertain, it is worth stressing that, since the euro area downturn is not caused by the same deep imbalances as those now hurting the US and UK economies, the recovery should propel GDP growth above its potential, i.e., significantly above 2% per annum. Yet, this is a story for 2010, we believe, not for 2009. In the meantime, the best thing the French government could do would be to take advantage of the slowdown to push forward its reform agenda. Structural Reforms Remain on the Agenda In this regard, the reaction from French policymakers is positive: taking stock of the economic slowdown, President Nicolas Sarkozy and Prime Minister Francois Fillon have clearly stated that there would be no pause in the reform process. We will have a better grasp of the agenda for economic reforms at the end of April, when Mrs. Christine Lagarde unveils her ‘modernisation of the economy bill’ (‘Loi de modernisation de l’economie’), which is likely to include some of the long list of reforms that came out from the Attali Commission. After the disappointment caused by the compromise between employers (Medef) and unions on labour regulation, which is very far from candidate Sarkozy’s platform, it seems that the government will focus its efforts on the deregulation of the retail sector, by removing most of the price regulation that prevents retailers and producers from negotiating freely, and removing the main entry barriers created by the Raffarin bill. In addition, a single competition watchdog, with enhanced powers, should contribute to making the French market more competitive and thus more consumer-friendly. Since, as often, the devil may be hidden in the detail, we will refrain from commenting on these reforms further until they are made public. A Pro-Cyclical Fiscal Policy in the Pipeline? With slower GDP growth in the pipeline, tax receipts are unlikely to meet the budget’s September targets this year. If the French public finances had enough leeway, this would not be a problem: fiscal stabilizers are welcome in periods of downturn. However, since the overall deficit (central and local governments as well as welfare funds) reached 2.7% of GDP last year and also because some of the tax breaks implemented last August will have a residual effect in 2008, the French public deficit is likely to rise to, if not above, 3.0% of GDP this year. Although the watered down version of the Growth and Stability Pact does not give great powers to the EU Commission to punish the French government, even the traditional scorning exercise from France peers would be unwelcome in government circles, we think. Since the French public is sensitive to the public debt issue − that was a common theme for all candidates for the presidency last year − we believe that the government is likely to use the risk of crossing the 3% line as an incentive to cut spending and, in particular, to reduce the civil service headcount more quickly. While we cannot but welcome spending cuts in France, where spending by all government bodies reached 53.4% of GDP in 2006, we do not exclude that fiscal policy becomes slightly pro-cyclical, i.e., contributes to the slowdown, instead of supporting aggregate demand. This is a classic case of temporal mismatch between policy incentives and economic rationality: in good times, the political pressure is for bigger spending, and vice versa. Provided that fiscal policy does not turn excessively pro-cyclical, we think that taking advantage of the bad times to take some tough decisions will be rewarding in the long term. For all these reasons, we expect the general government deficit to be capped at 3.0% of GDP this year, before ebbing somewhat next year, to 2.9%, as fiscal policy turns more conservative.
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