Japan: US$1.5 Trillion GPIF Reform and Outflows from Japan
June 02, 2008
By Stephen Jen | London
Summary and Conclusions
While USD/JPY can spike lower in times of extreme risk aversion – as it did in March during the height of the financial crisis – it cannot stay below 100 for long, in my view. The main reasons are that (i) there are relative few JPY assets that foreigners might be willing to warehouse for a sustained period; and (ii) Japanese investors themselves, led by some institutional funds, will likely continue to diversify out of the JPY market. This note is about one particular aspect of the latter, that Japan’s Government Pension Investment Fund (GPIF) – Japan’s sovereign pension fund, with AUM of US$1.5 trillion – will almost certainly be restructured after the eight-year divestment programme is complete by end-FY2008/09. Thereafter, more divestment from JGBs and diversification into foreign assets will be likely, in my opinion. The recent proposal by the Council on Economics and Fiscal Policy (CEFP) to reform the GPIF is important, and investors should pay attention to developments in this space. This matter may also be related to the SWF (sovereign wealth fund) discussion in Japan, whereby the prospective SWF may become the main investment vehicle for the GPIF. Background on the GPIF I have written on this topic on several occasions. But here is a quick refresher on the background on the GPIF. In March 2001, as a part of the FILP (Financial Investment and Loan Program) Reform, or the ‘Zaito Reform’, the way government-managed pensions (or the pension reserves) were invested was significantly altered. The key aim was to sever the hard financing link between the pension reserves and the public works projects under the FILP. From 2001 onward, public pension funds would enjoy a great deal more flexibility in the assets to hold, while the public works projects (the FILP Projects) would compete for financing in the open capital markets, like any other project or business, though with a government guarantee in some cases. To minimise the ‘shock’ impact of this change – keep in mind that the FILP Projects were worth a huge ¥147 trillion (or about US$1.2 trillion) – this transition in the financing scheme was to be spread out over eight years (from 2001 to 2009). The aim was that, by end-March 2009, the publicly managed pensions would have no direct financing links with the FILP Projects. The 2009 targets for domestic bonds and stocks are 67% and 11%, respectively, while foreign bonds and stocks total 17% of overall assets. The current corresponding shares are 67.6%, 11.7% and 15.5%, respectively. What this means is that between now and 2009, there will be US$12 billion worth of JGB sales and some unwinding of Nikkei exposure to fund new foreign asset holdings. In other words, there will be US$21 billion in capital outflows in this fiscal year associated with this GPIF rebalancing programme. We are entering the ‘countdown’ period. I have been tracking the evolution of the GPIF over the years, mainly because I believe that its outward investments have provided partial support for USD/JPY, and kept the JPY below its ‘fair value’ for most of the past seven years. This is not a form of surreptitious currency intervention, as Japan’s MoF (Ministry of Finance) has been most transparent on this matter and has not intervened in the currency markets since March 16, 2004. It is, rather, a key part of a secular trend I believe has begun in Japan whereby its financial ‘home bias’ will be gradually reduced, due to both ‘pull’ (positive prospects in other parts of the world, such as Asia) and ‘push’ (relatively dim prospects in the low-yield Japan) factors. The eight-year portfolio adjustment period will come to an end by March 31, 2009, and discussions on how the GPIF should be comprehensively restructured will likely take place in the coming months. I have these thoughts on the GPIF and the JPY. • Thought 1. This is a JPY-negative event. There are no announced plans beyond 2009, but I believe that 17% foreign exposure and the 20% equity exposure are too low for Japan. (For comparison, Norway’s GPF is 100% in foreign assets and 60% in equities.) A restructuring of the GPIF will likely lead to more risk-taking and a further decline in the ‘home bias’. With US$1.50 trillion under management, every 10% is US$150 billion. A multi-polar globalised world offers a wide menu of investment possibilities for the GPIF. Like a SWF or other SPFs, a reformed GPIF will likely elevate the importance of risk-adjusted investment returns, and will not be as defensive as in the past. The GPIF can do better than mere ‘capital preservation’, and an important part of yield enhancement is to increase its exposure to non-JPY assets. There are large pension funds in other countries with foreign exposure higher than 30%. Such a target is not inconceivable for the GPIF. • Thought 2. A prospective SWF could be the new investment vehicle for the GPIF. SWFs don’t need to derive all of their assets from excess official foreign reserves. There are many examples with SWFs operating like a SPF (sovereign pension fund). The GPIF is a SPF. A possibility is that a restructured GPIF could have some of the funds managed by an entity that also invests assets derived from other sources. • Thought 3. ‘Push’ factors in Japan. The potential lack of policy direction, due in part to the political stalemate in Japan, will remain one of the ‘push’ factors for Japanese assets to be diversified. It is not a surprise that, throughout the financial crisis, even though Japan was not seriously hurt by the crisis itself, the Nikkei persistently underperformed other large markets. Questionable economic fundamentals and an uncertain political situation played a role, in my view. • Thought 4. No large latent JPY carry trades. Six months ago, many had speculated that there were large latent JPY carry positions as a legacy from the past two years when carry trades were a fad. Though this suspicion was legitimate, the move in USD/JPY from 120 in June 2007 to 96 in March 2008, before recovering to 105 now in such an orderly manner, suggests to me that there were likely to be no dangerous USD/JPY carry positions that could have imploded as the spot rate fell. I have long argued against the JPY carry trade hypothesis, and tried to promote, instead, the notion that genuine capital outflows from Japan, not carry trades, were the key theme in Japan. • Thought 5. The rest of the world moving to benchmark on JPY assets? We have suggested in the past that full deployment of SWF investments will likely be JPY-positive in the long run (i.e., several years), mainly because central banks are significantly underweight the JGBs, and the Nikkei’s market share should, in theory, lead to an increase in the official entities’ exposure to JPY assets. First, this is a long-term call, and is not something that will be a factor for the JPY in the coming year or so. Second, whether Japan can refrain from becoming more protectionist is something that we will only find out when SWFs start to buy up JPY assets. Bottom Line While USD/JPY could indeed spike lower in times of extreme risk aversion, I believe that there will be powerful factors preventing USD/JPY from staying below 100 for a sustained period. 110 for USD/JPY makes more sense than 90. The impending reform of the GPIF is one important example of how Japan’s financial home bias could continue to decline, keeping the JPY undervalued. Given the size of the AUM, I urge investors to pay close attention to the GPIF reform that will likely take place in the coming months.
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Taiwan: Resilient Growth
June 02, 2008
By Sharon Lam & Katherine Tai | Hong Kong
1Q08 GDP growth beat expectations again: Taiwan reported 1Q real GDP growth at 6.1%, beating our and consensus forecasts (5.5%) by a wide margin and representing another quarter of strength above a five-year average trend growth rate of 5%. 1Q headline growth was lower than the 6.5% in 4Q07, but the increase was attributed to stronger import growth, as demand rose on the back of improving sentiment. However, the surge in import prices continued to erode national income in nominal terms, with 1Q08 nominal growth slipping to 4.4% from 6.6% in the previous quarter. Export kept surprising on the upside, while domestic demand is gradually picking up: As we had forecast, the deceleration in export growth was much milder than expected due to the strong demand from emerging markets, illustrating that the US economy is becoming less important for Taiwan’s tech exports. Resilient export growth in 1Q is also a comforting sign that Taiwan’s export competitiveness has improved despite TWD appreciation. As demand kept surprising on the upside, capacity growth in Taiwan expanded and has contributed strongly to the overall economy in 1Q. Domestic consumption is also gradually recovering, together with better sentiment. We do not see inflation dampening pent-up demand, and in fact we believe that households have been under-consuming for so long that their savings should be able to help cushion against rising prices and therefore limit the downside for consumption. Well-balanced policies: While the latest gasoline price increase came in smaller than expected, we think that this represents an effort by the government to balance between inflation risks and the fiscal burden. We expect CPI growth to average 3.5% this year, and oil subsidies by the government, likely at below 1.5% of GDP, are in a healthy range, in our view. On the monetary side, we also expect the central bank to use a combination of TWD appreciation and rate hikes to help fight this imported inflation and keep inflation expectations under control. So far, the new authorities’ policies have not disappointed on the economic front, in our view. 1Q08 growth has become more balanced between domestic demand and exports. Private consumption – in line with expectations (2.1%Y in 1Q08 versus 1.9% in 4Q07): We thought that 1Q spending should have seen a slight uptick, but not by much as sentiment was mixed among political and external uncertainties in 1Q. As the sentiment rebound has only become more visible after the March 26 presidential election, the stronger consumption momentum that we are anticipating is therefore to be shown in 2Q data and onwards. We do not expect rising inflation to dampen consumption in Taiwan, as inflation is actually relatively well contained with TWD appreciation and with the government also committed to take up part of the financial burden from the oil price increase. Meanwhile, despite interest rates continuing to rise, the real interest rate level is still negative and therefore asset prices should not be hurt yet. Fixed investment – upside surprise (5.8%Y in 1Q08 versus -1.7% in 4Q07): The main contribution to the upside came from private sector investment (6.7% in 1Q versus -2.6% in 4Q), as businesses have spent more on machinery and equipment (20% in 1Q versus -1% in 4Q) but much less on transportation equipment (-18% in 1Q versus +7% in 4Q), possibly due to concerns regarding high oil prices. The increase in machinery intake could be because corporates were simply too pessimistic in 4Q07, and yet demand has surprised on the upside and therefore capacity growth was needed to match demand. Construction investment also reaccelerated sharply (3% in 1Q versus -11% in 4Q), which we believe was due to contractors delaying projects from 4Q07 into 1Q08 to capture better pricing. The upside in capex came in contrast to worries about external uncertainties. Over the medium term, we believe that pro-growth incentives from the new government (such as corporate tax rate cuts) should be the main catalyst for stronger capex going forward. Exports – in line (11.4%Y in 1Q08 versus 12.9% in 4Q07): There was simply no apparent slowdown in exports as the market had feared. This supports our argument that the impact from a US downturn on Taiwan will be much milder than expected due to sales in emerging markets. In fact, this is what consensus is missing, and they marked their forecasts too low, in our view. Imports – stronger than expected (9%Y in 1Q versus 5.2% in 4Q): The increase in imports is not related to the surge in oil prices, since this is expressed in volume terms. Import growth in 1Q was mainly due to a stronger intake of machinery and consumption goods. This has led to a smaller net export contribution and was the reason why the overall headline growth in 1Q08 was lower than in 4Q07. Bottom Line We remain confident with our above-consensus 2008 GDP forecasts at 4.8% (versus consensus at 4.3%). Along with the GDP report, the government has revised up its official forecast from 4.3% to 4.8%. We expect the market to catch up with its forecasts. In fact, we even see upside to our already bullish number, as we believe it is rather unlikely that growth in the next three quarters will dip below the trend average. We expect the central bank to raise interest rates again in June by 12.5bp. We do not see the urge to raise interest rates aggressively – 25bp as some have suggested – since the TWD-USD interest rate spread is already at its highest level since 1994. We believe that this is only a method to anchor inflation expectations, as this round of inflation is imported rather than domestic demand-driven. Gradual rate hikes could continue into next year as we expect more asset price inflation ahead.
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