UK
Pessimism Becomes Excessive
September 04, 2008

By David Miles and Melanie Baker, CFA | London

It is easy to find ammunition to defend the view that the UK economy is about to descend into a protracted period of weakness that will see aggregate output fall for several quarters and unemployment rise by several hundreds of thousands. Surveys of consumer confidence have slumped to multi-year lows. Housing market transactions and new mortgage lending have declined dramatically. House prices – on some measures – have fallen by over 10% in the past year. The Chancellor of the Exchequer talks of an economic outlook as bad as has been seen in the past 60 years – though whether he was talking specifically about the UK is somewhat unclear. In the light of all that, one might conclude that if the next few years in the UK were to resemble the early 1990s – when output fell sharply and unemployment rose by a million – this would be at the optimistic end of what is likely.

But we think that the outlook – despite recent news on the economy and despite revising down our GDP forecasts – is much better than that. In this note, we explain why the most likely outcome is for a period of negligible growth, rather than protracted falls in output. (On our central forecast – our assessment of the single most likely outcome – a small fall in GDP between now and the end of 2008 is plausible but growth remains positive thereafter, albeit at rather anaemic levels until late 2009.) We explore the implications of this on asset values – arguing that gilt yields which reflect an expectation of 75-100bp lower Bank of England base rates look stretched if growth plays out as we think most likely. The implications for equity valuations of companies most exposed to the UK are more positive – especially as parts of the UK stock market (retail stores and some of the banks most involved in lending to the household sector) may have come to reflect an expectation that conditions will be as bad as the early 1990s.

Worst Outlook for 15 Years, but Not as Bad as Many Think

To be clear at the outset, it is likely that over the next year we get economic outcomes – for growth, employment and indeed for inflation – that are markedly worse than we have seen for most of the past 15 years. Our best guess now on the evolution of the economy is close to what we judged to be a pessimistic scenario at the start of the year in our annual assessment of the UK outlook undertaken in collaboration with the Institute for Fiscal Studies (see The Green Budget, Chapter 4, January 2008). This is for GDP growth for 2008 as a whole fractionally above 1% and marginally lower than that in 2009.

There are three main reasons why a worse set of outcomes – involving a protracted period of stagnant or falling output – is not our central forecast.

1. Sharp rate rises unlikely: Each of the three periods of falling output and sharply rising unemployment in the past 50 years (mid-1970s, early 1980s and early 1990s) have followed a very sharp rise in the level of interest rates that reflected a lagged response to alarmingly rising inflation. But it is not likely that the overall level of interest rates in the UK will rise significantly from here; indeed, rate cuts from the Bank of England are more likely than rates increases – our best guess is for no significant change in rates.   

2.  Link between housing market and consumer spending is often overstated: Lower transactions in the housing market and lower house prices are likely a negative drag on consumer spending; but our assessment of the scale of the impact on demand does not mean that consumer spending is likely to fall sharply. For the great majority of households, their month-to-month budgets are not much affected by conditions in the housing market. And for those households that do plan far ahead and consider the long-term implications of a fall in the value of their home, there is a natural and obvious offset to a lower value of their current house – namely a lower value of future housing costs.

3. Surveys do not tell the full story: It is important to draw a sharp distinction between what people say about how confident they are and what they do in terms of spending. While there has been a dramatic decline in reported consumer (and producer) sentiment, the link between that and behaviour is not so clear. There is a difference between what drives what people say (which is swayed by the way news is being reported and the attention housing gets in the UK – both of which are very negative) and what drives economic behaviour.

Not as Bad as the Early 1990s

The likely path of house prices may look comparable with the early 1990s, but our view remains that the economy as a whole will do better than during that period.

The key factor here is that the increase in the average interest rate on mortgages is likely to be very much less now than it was at the end of the 1980s and in the early 1990s. Even though the stock of mortgages, relative to the size of the economy, is much greater now, the scale of the rise in the average mortgage rate in the two years up to mid-1990 (the period when arrears and re-possessions began to accelerate very sharply) was far greater than seems likely now. We make some rough calculations on the scale of the hit to the available incomes of people with mortgages back in the early 1990s and the hit that could be coming now.

In the two years from mid-1988 to mid-1990, the average interest rate on the stock of mortgages increased by around 550bp. With a stock of mortgage debt to GDP of a bit above 0.5, this generated a decline in available income to those with mortgages that was worth about 2.9% of GDP. Now the stock of mortgages is worth around 0.85 of annual GDP so that a given change in the average interest rate of mortgages reduces the available income of those with mortgages by more (relative to the size of the economy).

Over the period from mid-2006 to date the average cost of existing mortgages has risen by a relatively small amount – Bank of England figures show that the effective mortgage rate of the outstanding stock of mortgages is up only around 50bp between mid-2006 and mid-2008. But a substantial number of mortgages will reset this year. It is likely that those mortgages that do reset will now have interest rates 100-175bp higher. There will also be a not insignificant tail that will reset with rates a lot higher than that.

Overall, it seems likely that by the middle of next year the average interest rate on the stock of outstanding mortgages might be 100bp or so higher than three years ago. The resulting hit to disposable income would be only around 30% as large as the impact in the early 1990s (-0.85% of GDP versus -2.87%). Even if the average interest rate on mortgages were to rise twice as much as that (by 200bp), the hit to disposable incomes, as a fraction of GDP, would still only be around 60% of the scale of the impact in the early 1990s.

House Price-Consumption Link Not Strong Enough to Make Recession Likely

Having re-run our housing model with more up-to-date data, we now think that we are about halfway through a correction in house prices (for full details of our model, see The Mortgage Markets, the Wider Economy and the Banks in the Credit Crunch, M Helsby, D Miles et al, April 14, 2008). Our new central case is that nominal house prices decline a further 10% or so from here, with most of that decline likely over the next four quarters (previously we anticipated around another 5% or so decline from here).

Even with 10% or so more off house prices (which we think is a plausible central forecast), the hit to spending is not big enough to make a serious recession likely. We assume a marginal propensity to consume from housing wealth of about 2.5% (i.e., for every £100 increase in the value of a person’s home, he/she spends an additional £2.50). That is about the mid-point of academic estimates. That would imply a hit to GDP of only around 0.7%, likely spread over several quarters.

Not All Recent News Has Been Bad for the Growth Outlook

Since the start of the credit crunch, the trade-weighted sterling index has fallen by around 16%. All else equal, this should be positive for the GDP outlook by improving the contribution of net trade to GDP growth. The inflationary impact of sterling weakness makes rate cuts somewhat more unlikely, however (again, all else equal).

Our New Central Forecast: Anaemic Growth

We have slightly revised down our central forecast for GDP growth and employment and now expect one quarter of negative GDP growth. We expect real GDP growth of around 1.1% in 2008 and 0.9% in 2009 (from 1.3% growth in each year previously). A mild technical recession some time over the next year – that is two consecutive quarters of negative GDP growth – has close to a 50% probability, we think. An early 1990s recession remains a significant probability (around 25%, in our view). But our central case outlook for GDP growth is still markedly more optimistic than that (see page 7 of UK Economics: Pessimism Becomes Excessive, September 3, 2008, for our full forecast table).

Our latest forecasts largely reflect a sharper-than-previously-anticipated slowdown in residential investment and larger-than-previously-anticipated de-stocking. However, we have increased somewhat our forecast of government consumption spending and the contribution of net exports to GDP (partly reflecting the renewed fall in the sterling). 

We assume that 2009 sees a gradual pick-up in GDP growth, reflecting somewhat stronger domestic demand (an improved outlook for global growth leads to an increase in business investment, levels of house-building bottom out, lower inflation boosts household real incomes and spending somewhat). We also assume that some of the positive effect on exports from a weaker sterling acts with a lag over 2009 (combined with somewhat better demand growth in the UK’s main trading partners as the year progresses).

No Rate Moves from the Bank of England

We continue to think that the most likely outcome is that the Bank of England keeps rates on hold this year and next. Although we have lowered our GDP forecast slightly, we do not think that these changes are significant enough to warrant changing our central Bank of England rate profile, particularly when considered alongside sharper-than-expected sterling depreciation. Of course, there is a significant chance of rate cuts − we think there is about a 50% probability that interest rates are 4.75% or lower by the end of the year (compared to 5.00% currently) − but we do not believe that a rate cut is the single most likely outcome. For more detail on our current outlook for interest rates, see “Interest Rate Outlook: Rate Cuts More Likely, but Not the Most Likely Outcome”, UK Investment Perspectives, M Baker and D Miles, August 21, 2008.

Main Assumptions for Our Central Forecasts

Our central outlook for UK GDP growth remains on the optimistic side of many investors’ expectations. Our expectation for the level of interest rates from the Bank of England remains above consensus and market expectations. However, this central outlook for GDP growth and inflation depends on a number of key assumptions:

1. Households don’t look to aggressively save more; we assume that households increase their savings rate somewhat in 2009, but only to 2.4% for the year as a whole (compared to 1.6% in 2008 and 3.1% in 2007). Effectively, we assume that households respond to rising prices and the general squeeze on their disposable incomes in 2008 by saving slightly less, and then raise their savings rate somewhat in 2009, as real incomes improve a bit.

2. In terms of the GDP growth outlook, the BoE does not raise rates. This is plausible, given the inflation outlook and likelihood of a slacker labour market. (We expect additional unemployment of around 220K over the three quarters starting 3Q08.)

3. The cost of the stock of mortgages goes up only marginally from here (by 50bp or less).

4. Net exports improve in response to the 16% fall in (the trade-weighted value of) sterling since the start of the credit crunch. We assume that exporters become slightly more competitive, rather than absorbing all of any increase in profits resulting from the fall in the sterling. We assume that increases in sterling import prices are largely passed on.

5. We assume some extra government spending (partly in the form of spending directed at the housing market, the previously announced 10p income tax offset and help with fuel bills). In addition, we assume that usual cyclical stabilizers (e.g., unemployment benefits) will not be short-circuited because government will let them work to the full rather than try to stick to the old fiscal rules. 

What Are the Risks

It may turn out that our assessment of the outlook is too optimistic, and in retrospect comes to look complacent. But there are different sorts of risk that might play out, and they have different implications. We briefly consider what we think are the two most significant:

1. Consumer sentiment, which has declined sharply, is indeed a good guide to spending as consumer demand falls sharply. This would be plausible if the link between housing market conditions and spending is stronger than we think likely (we spelled this out in some detail in The Mortgage Markets, the Wider Economy and the Banks in the Credit Crunch, M Helsby, D Miles, S Hayne and M Baker, April 2008).

2. Inflation proves to be more deep-seated and does not look likely to return to close to the 2% target level by the end of next year. A combination of further declines in the sterling and some up-tick in wage settlements could mean that inflation remains stubbornly above target.

Right now, the first of these risks looks greater, but the second could easily come to look very real between now and Christmas. And self-evidently, these two risks have opposite implications for the likely path of interest rates and therefore for fixed income assets.

Market Implications

Our assessment is that the economic outlook is less bad than is implied by much media comment. More significantly, it is also likely to be less pessimistic than the assessment implied by some asset prices.

• Gilts and money market rates: Gilt prices and money market rates imply that the Bank of England might cut rates by close to 75bp by the middle of next year – an assessment we think overstates the likely response from the Bank of England. We think the 10-year gilt yields, at 4.5%, look expensive if the Bank of England does not cut rates.

• Equities: Our equity strategists expect corporate earnings to fall – and they are well on the pessimistic side of the consensus on this. However, they think that P/E ratios and dividend yields are such that, given our economic assessment, stocks of companies exposed to the UK in general do not look stretched. They now believe that the risk-reward profile for the domestic cyclicals is becoming relatively more favourable and, although news flow is likely to be poor, they advocate starting to buy selectively in retail, banks and leisure.

• FX: Despite the sharp fall in the sterling against the dollar, it likely remains overvalued on a fundamental basis – PPP-type calculations and the trajectory of the UK current account deficit give plenty of reasons to make further declines seem justified. And the re-balancing in demand away from domestic spending and towards net exports would be welcome and so would not prompt any attempt to offset it from the BoE, in our view.

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Turkey
Negative Inflation: Counter to Ramadan Effect
September 04, 2008

By Tevfik Aksoy | Istanbul

Headline CPI inflation turned out to be negative at -0.24%M, pulling the 12-month trailing figure down to 11.8%Y: The headline figure was well below our forecast of 0.4% and the consensus estimate of 0.3%. The surprise deviation was almost entirely due to a very tame reading in food prices: food price inflation was zero in August (-0.03% to be exact); this should be considered highly unusual, taking into account that August was the month preceding Ramadan, when food prices typically surge. We believe that retailers over-stocked foodstuff this year and demand fell a bit short of market expectations, leading to an opposite effect.

In light of the August inflation data, we are revising our year-end CPI inflation forecast to 10%Y (from 10.4%Y): Due to seasonal factors (such as schooling and the end of the holiday period), we still expect September inflation to be relatively high. This should also result in inflation remaining broadly unchanged on a 12-month trailing basis next month. However, with the help of the base-year effect, as well as the impact of the monetary tightening of the past six months, we expect inflation to gradually decline towards year-end and to maintain the trend throughout 2009. We keep our 2009 CPI inflation forecast unchanged at 7.2%Y.

Looking at the components of the CPI index, we notice that the main surprise was with food price inflation (0%M), which pulled the 12-month figure down to 13.3%Y from 15.3%Y. The most significant contribution to headline inflation was from housing (2.1%M), which was a reflection of the sizeable adjustment in natural gas prices introduced in early August. Clothing prices dropped a further 6%M on top of the 8% decline recorded in July, and rose merely 3.7%Y.

Transportation prices dropped by 1.6%, thanks to easing oil prices globally but also due to currency strength. In the absence of a further depreciation in TRY, we would expect transportation costs to decline further in the coming months. With the exception of health, all service sector items such as communication, entertainment & culture, restaurant-café and hotels posted fairly tame inflation prints. Looking forward, we expect education and schooling-related items to post noticeable price gains in September (a purely seasonal factor).

Core inflation measures also point to a tame picture, but still have some way to go: With the exception of the core inflation measures, namely CPI ex-seasonal goods (0.6%M), all of the other eight core measures posted negative inflation prints in August. The last time we saw such an encouraging picture was in July 2007. With a negative inflation outcome in most of the core inflation measures, the 12-month trailing rates eased in some while others mostly remained stable. However, the central bank’s recent favorite core inflation measure went up 7.1% in August, which should be taken with caution by the CBT, although in general the core measures did point to some marginal improvement. However, we believe that the CBT is unlikely to be content with the current picture, and think that it will continue to seek a decisive drop in core inflation.

Rates to be kept on hold: In light of the August inflation data, we maintain our view and expect the CBT to keep the policy rate unchanged at 16.75% at the next meeting. We also believe that the CBT will keep rates on hold this year (as opposed to some analysts who expect a tightening towards year-end). We believe that the CBT will maintain its tight and cautious stance until 2Q09, when it might start to ease gradually.

 

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Ukraine
Harder Times, but Not the Next Georgia
September 04, 2008

By Oliver Weeks | London

Strong balance of payments data for July seem likely to have marked the near-term peak of support for the UAH. With steel prices finally showing signs of weakness and a massive gas import price hike in January, inevitably Ukraine’s relative good fortune on trade prices may now be running out. Even with falling oil prices, we expect a current account deficit next year of around 10.5% of GDP, while recently strong FX inflows are likely to begin to slow. We expect the UAH to reach 5.0 to the USD by year-end, with risks of a spike weaker around year-end gas negotiations. We also continue to expect a significant slowdown in growth next year, but do not think that Ukraine is the next Latvia, or the next Georgia. The Georgia crisis and the start of a new parliamentary season will highlight internal political divisions, which may trigger early parliamentary elections. However, while sovereign CDS spreads seem to imply a sharply higher risk from a more aggressive Russia, we think that the external impact of events in Georgia may prove quite positive for Ukraine, triggering a better trade offer from the EU. 

Growth currently strong but outlook weakening. For now, growth is firm, and the FX reserve build-up continues apace.  Preliminary real monthly GDP growth dipped to 5.4%Y in June but rebounded to 7.3%Y in July – the strongest level for the year. Agricultural output and exports are likely to surge in the next few months. The government’s grain harvest forecast is up 53% on last year – partly a reflection of growing investment in a neglected sector, but mainly of better weather.  While oil import prices are falling, steel export prices have so far been firm (steel accounting for 38% of exports in the year to date), and Russian demand for machinery exports has been strong. Meanwhile, FX inflows have so far remained very robust. FX reserves in July were up US$2.5 billion, an all-time record. Yet, the medium-term outlook is clearly becoming more difficult. Despite continuing terms-of-trade gains and unusually low gas imports in the first few months of the year, the current account deficit is widening rapidly, reaching 7.2% of GDP in January to July. Imports in 1Q were up 20.2%Y in real terms, against just 0.9%Y real export growth. Real household consumption was up 22.0%Y, leaving total consumption accounting for a record 86% of GDP in 1Q. Real fixed investment growth by contrast slowed to 14.7%Y.  Vehicle imports were up 81%Y in 1H. The government ascribes much of this import surge to better customs administration, but the consumer boom may prove hard to sustain. Nominal wage growth remains spectacular, up 36%Y in July, reflecting a shrinking and increasingly internationally mobile labor force. Real retail sales growth was up 27%Y in July. By contrast, domestic industrial production growth in July was at its slowest level in two years. Even the relatively fortunate steel producers are increasingly vociferous about the obstacles they face from a deteriorating transport infrastructure. 

Terms of trade finally to deteriorate. Seasonally and structurally, the external deficit looks set to widen further. Even if the oil price correction continues, terms of trade are likely to deteriorate following an extraordinary 28pp improvement over the last five years. Gas price negotiations for next year have begun early but may well drag out again. Gazprom has been reported in the press to be proposing a price after transit fees of 75-80% of Poland’s price, implying a rise to around US$400/tcm from the current US$179.5. With the threat of disruption and continuing oil price declines, we expect Ukraine to negotiate this down significantly, but given the growing competition for central Asian gas and Gazprom’s promise to central Asian producers of European prices minus transport costs, a sharp hike looks inevitable to us. In the likely absence of a deal to transfer gas transit control, our central case for Ukraine remains for a 95% increase to US$350. If import volumes remain stable, as we expect, this would add another US$11 billion, or 4.8% of 2009 GDP, to the import bill. Given growing awareness of the risk of a gas supply squeeze in the next few years and the construction of other transit routes, medium-term risks appear to us to be still on the upside. Meanwhile, export price risks are mainly to the downside. Russia, now further from its own WTO accession, is threatening restrictions on its bilateral free trade agreement. We expect government-led demand for steel in Russia and China to keep export prices relatively resistant to a global slowdown, particularly with Russian producers discouraged from exporting, but clearly any upside for steel export prices is now much less than for gas.

Fiscal and external deficits likely to rise. Fiscal loosening may also contribute to imbalances. Although policy has been conservative for several years, and recent revenue has been helped by the inflationary boom and more stringent revenue collection, risks of more stimulative policy in 2009 appear to be rising. Official 2008 budget execution looks likely to come in close to balance, well below the latest 2.1% of GDP target, assuming that parliament fails to agree on further budget revisions this year. The Finance Minister reports that the Treasury cash balance is currently at an impressive UAH 25 billion. The government will still have to borrow externally to refinance next year’s US$0.5 billion of maturing Eurobonds and cover the 2009 deficit, but official debt levels remain very comfortable at 10.3% of GDP, well below the average for the rating level. However, the official data exclude not only the four off-budget social funds but also a quasi-fiscal deficit in the state energy sector that the IMF estimates at 3.25% of GDP in 2008 and further explicit and implicit loan guarantees of around 2% of GDP. Naftogaz support requirements are likely to rise significantly with gas import prices. Meanwhile, political pressure to spend down revenue windfalls is likely to grow. The PM has already promised construction companies a huge reduction in local taxes (promising to reduce the tax take on housing from 49.5% to 4% of construction costs), and a significant minimum wage hike will be hard to avoid. The government has already spent UAH 5.9 billion on compensation for lost Oschadbank deposits, further skewing spending towards consumption, and broadening such payments is likely to feature in the PM’s presidential election campaign. Even with lower oil prices, we expect a C/A deficit of around 10.5% of GDP in 2009, up from 7.5% in 2008. 

Inflows strong but may slow slightly. Ukraine’s overall external financing capacity is clearly still very high, but also risks deteriorating slightly. The financial account surplus in January-July amounts to an impressive US$12.6 billion, or 11.6% of GDP, 80% up on the same period before the credit crunch and 50% higher than the current account deficit so far this year. Medium-term loans to the banking sector account for 44% of this and are so far holding up better than we had expected. Net foreign liabilities of commercial banks are up an average UAH 7.6 billion in the past three months, still above the 2007 average. We still expect the combination of tighter European funding conditions, a closure of foreign markets to smaller banks and slower credit demand in Ukraine to slow these inflows. However, the relative weakness of local players still offers profitable margins to better-funded competitors. While some west European banks are becoming more cautious, Russian and some Greek parent banks appear ready to increase funding to local subsidiaries. Current parent funding plans suggest that the nine largest foreign-owned banks would reduce funding by around 5% in 2009 – though such plans look to us to be on the optimistic side. Equally, net inward FDI, US$6.9 billion so far this year, is likely to weaken without progress on privatization or further major bank sales. The president and PM appear reluctant to trust each other with privatization revenue, while the current administration of the State Property Agency is more interested in reversing recent sales than starting new ones. With the constitutional court unlikely to take a clear view on such issues and the relationship between the president and PM unlikely to improve, we assume no meaningful privatization revenue in the next two years. This does not imply a halt to FDI. The interest of companies like Evraz in Ukrainian steel, coal and transport assets underlines the still-huge scope for private sector non-bank inflows, as property rights in the industrial sector settle and investment needs grow. However, in the context of a widening current account deficit, such inflows may prove less supportive. 

Only limited relief on inflation. Although headline CPI has peaked as food supply improves, we expect inflation and interest rates to stay relatively high. The government’s main core index, excluding unprocessed food, fuel and controlled prices, was up 13.1% in the first seven months of the year, not far behind the food-dominated 14.9% of the headline index. Further supply-side rises will be increasingly hard to resist. Kiev’s subsidized bread prices have finally been hiked, and household gas prices will rise 13-14% in September. While the latter are largely supplied by domestic production, prices have been unchanged since January 2007, and at US$70-280/tcm depending on usage, appear well below sustainable levels. (Household prices in Russia average US$54/tcm but are being rapidly liberalized.) Municipal heating companies still buy imported gas at around 25% below the current border price, building losses for Naftogaz that the government acknowledges will require a combination of continuing subsidy and price hikes. Rail freight tariffs will be hiked 40% by end-2008. On the demand side, wage growth pressure looks unlikely to slow significantly, given the growing demographic squeeze and strong regional demand for Ukraine’s still-cheap labor force. Meanwhile, capacity constraints and under-investment are becoming increasingly evident. We expect CPI to be still just above 20% by year-end, and even with lower food and oil, it is hard to see a return to single-digit levels in the next few years, in our view. 

Rates likely to remain high. The National Bank’s freedom of action in this context will remain limited. While we think that the previously very conservative NBU has recently managed the exchange rate well, loosening the peg into what is likely to be the last period of appreciation pressure for some time while resisting an overshoot, monetary policy is likely to remain largely balance of payments-driven. July’s surge in inflows saw a collapse in money market rates as the NBU bought dollars. The local debt market offers little scope for significant sterilization − the MinFin has issued only UAH 437 million of domestic bonds in 1H, against a full-year plan of UAH 7.8 billion, reflecting a reluctance to pay double-digit rates in the context of a current budget surplus. As the balance of payments begins to tighten, money market rates look likely to stay high. The bank is unlikely to be comfortable with current rates of credit growth, and its most significant recent administrative restriction, a hike on reserve requirements to 20% on new short-term FX loans, has recently been suspended by a Donetsk court. At 61.1%Y in July, bank credit growth is slowing but remains relatively strong, and recent growth rates are biased downwards by UAH strength. Half of total credit outstanding, and 62% of household credit, is FX-denominated. Bank credit as a share of GDP, at 60%, is high by regional standards, and smaller domestic banks are facing severe funding constraints. Average apartment prices in Kiev at around US$3,400 per square metre look high against national average monthly wages of US$410. While we no longer expect policy rate hikes from the NBU, we see little scope for near-term cuts, particularly as the UAH weakens. 

Short-term political headwinds likely to worsen. While PM Tymoshenko has offered robust political support for a strong UAH (boosting voters’ purchasing power), any return to power of the Regions party (closer to the commodity exporters) would heighten downside risks. Encouragingly, constitutional reform negotiations between BYT and Regions appear to have restarted, but the failure of Tymoshenko’s attempts so far to agree on a move towards a stronger parliamentary system do not seem to bode well for prospects of coherent government in the near future. The rushed December 2004 constitutional reform left deep ambiguity as to the division of power between the president, PM and parliament. Until this is resolved, we think that politics is likely to remain a three-way struggle focused on changing the rules of the game rather than policy reform, with the two weaker players attempting to limit the strongest (currently Tymoshenko). A surprise constitutional reform agreement would be positive, but more probable near-term scenarios do not look market-friendly. The BYT-Our Ukraine coalition is clearly no longer functional, but an alternative deal between Our Ukraine and Regions so far lacks the necessary majority within Our Ukraine, and now would have to overcome the party leaders’ opposite views on Georgia. Yanukovych may also consider that prolonging the current dysfunctional coalition could boost his chances in 2010’s presidential election. It now seems increasingly likely that the constitutional court may shortly accept that the current governing coalition has collapsed, triggering new elections that are unlikely to be more conclusive. While political chaos has not yet obviously restrained growth, with imbalances building and funding less abundant, the UAH looks less likely to remain unscathed.  

UAH weakness likely to be tolerated. We continue to expect the UAH to weaken against a broadly stronger USD, as seasonal support fades. Official policy is to maintain a +/-4% band around a central parity, currently at 4.847 on USDUAH. In practice, UAH has been allowed to trade slightly outside this corridor on the strong level. The bank has also indicated that it plans gradually to take account of other exchange rates in setting the reference rate. If USDEUR strength continues, as Morgan Stanley expects, we would expect a slightly weaker central parity by year-end, though such moves are likely to be slow. As well as slowing inflows and rising import costs into year-end, we would expect pressure from the population selling UAH, reversing a sharp move into UAH cash holdings in 2Q. NBU management has also indicated that it plans to build more FX reserves in line with President Yuschenko’s target of six-month reserve coverage. For now, reserves remain modest at US$37.9 billion, and the NBU looks unlikely to stand in the way of depreciation. Our forecast is for USDUAH to reach 5.0 by end-2008, though a prolonged gas dispute could see a temporary spike higher. Risks of a more serious collapse still seem limited to us, if only because continuing restrictions on FX trading have greatly limited speculative inflows. 

Not the next Georgia, or Lebanon. We also do not think that the recent sharp deterioration in Ukraine sovereign risk prices, with 5-year CDS spreads currently in line with Lebanon’s, is justified. Russian citizens in Crimea are longer-standing than the recently acquired passport holders in South Ossetia and Abkhazia, but Ukraine’s messy politics look less of a threat to the Kremlin than those of Georgia, and most Ukrainian politicians have taken a much less confrontational course. President Yuschenko is personally close to President Saakashvili but is a waning force, while PM Tymoshenko has been tactfully quiet on the conflict. NATO membership for Ukraine has always looked a distant prospect, given domestic opposition. However, given the EU’s relative impotence in intervening directly in Georgia, we think that a more attractive economic offer to Ukraine is a plausible alternative response.  EU and Ukrainian leaders will meet in Evian on September 9 to set a political framework for future relations. A dramatic breakthrough so quickly may be unlikely, and EU membership looks decades away at best, given the current difficulties around Romania and Bulgaria, but we think that progress on a free trade deal may now be accelerated. The medium-term outlook for the Ukrainian economy continues to look strong to us, and not reflected in current CDS levels.

 

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China
Can the Property Sector Be Counted on as the Engine of Growth?
September 04, 2008

By Qing Wang | Hong Kong and Steven Zhang | Shanghai

Importance of the Property Sector to the Macro Economy

The double-digit growth in China since 2003 has been driven primarily by two engines: exports and investment. With exports as an engine of growth cooling along with the downturn in G3 economies, the outlook for robust growth in China hinges critically on the strength of domestic investment, as consumption has not been the primary factor contributing to the stellar performance of the economy in recent years.

The strength of investment growth in the property sector is key to gauging the sustainability of overall investment growth in the context of weak external demand.

First, investment in the manufacturing sector – which accounts for about 30% of total investment – is sensitive to external demand, as investments in this sector boost China’s manufacturing capacity, which directly or indirectly serves to support China’s exports. In this context, when exports weaken, investment appetite in the manufacturing sector tends to be dampened, albeit with a lag.

Investment in property and infrastructure combined account for close to 40% of total investment, with a roughly equal split between the two categories. Given its public goods nature, investment in infrastructure is usually carried out by the government and thus tends not to be influenced much by the cyclical conditions of the economy in the short run. 

However, in China’s reality, the infrastructure projects carried out by local governments are financed in a significant part by proceeds from land sales. The performance of land sales is, in turn, influenced by the property market: a buoyant property market boosts land sales and pushes up land prices. We estimate that proceeds from land sales may have financed at least 25-30% of investment in infrastructure in recent years.

The amount of direct investment in the property sector, together with the indirect impact on infrastructure investment through financing, underscores the importance of the property sector to the economy as a whole. We believe that the outlook for robust growth in China hinges critically on the sustainability of investment growth in the property sector. Indeed, it is hard to justify a positive outlook for the Chinese economy in the next 12-24 months, unless one remains constructive about the role of the property sector as an engine of growth, particularly in some areas (e.g., Chongqing).

Current Difficulties in the Property Sector

The latest developments suggest considerable difficulties facing the property sector. Specifically, the floor space of apartments sold has declined sharply since 3Q07, when the austere measures against the property sector were launched. On the other hand, the expansion of floor space for apartments completed and under construction has not slowed. This indicates rising risks of oversupply in the property market in the coming months.

Despite sluggish sales, the average property prices in major cities remain stubbornly stable, although there has been scattered anecdotal evidence that property prices in some communities of several cities have declined since the beginning of the year. If the slow property sales were to persist, it would sooner or later be shown in slow investment in property, which, as discussed above, will have broader negative implications for the rest of the economy.

A potential scenario is that the property developers will be forced to cut prices, and lower prices will improve affordability and revive buying interest and thus boost property sales. In fact, recent price cuts by some of China’s largest property developers have received quite positive responses from home buyers. Under this scenario, sales will pick up at the expense of a margin squeeze on the property developers’ part. Since developers are widely believed to have already enjoyed quite fat profit margins, some margin squeeze is unlikely to dampen their interest in investment significantly. If investment growth in the property sector were to be sustained, this sector could still be counted on as an engine of growth.

However, the actual outcome could turn out not to be as benign as described above: the property sales may well remain sluggish despite the price cut. This is possible if there has been a bubble in property prices driven by strong speculative demand. In this case, a cut in property prices will only serve to further depress buying interest. Moreover, a large number of property developers may be faced with serious liquidity problems as a consequence.

A House Price Bubble?

Whether the property sector can be counted on as an engine of growth seems to boil down to judging whether: 1) there has been a bubble in property prices that is about to pop; or 2) there has been a deterioration in sentiment and/or affordability such that an improvement in sentiment and/or a welcome correction of the property prices would boost underlying real demand, which is genuine and still robust.

Housing affordability has been widely used as one of the key indicators for assessing whether property prices have been so high as to become a bubble. Relative to household income, house prices have declined substantially since 1997. Although the relative affordability deteriorated moderately in 2004-05, it has since improved somewhat. Therefore, despite much talk about rapid rising property prices in recent years, property affordability has been broadly stable since 2003.  In other words, average property prices today have not become more expensive than they were five years ago because average nominal household income growth has been faster.

However, some market observers argue that the absence of material deterioration in housing affordability over time does not necessarily mean that there has been no house price bubble, and a more relevant indicator in this regard should be the housing price-income ratio (HPIR), which measures the absolute housing affordability. Indeed, the average HPIR in China was in the 8-9x range during 2003-08, which is much higher than the established HPIR norm of 3-6x. (The HPIR is estimated as the ratio of the average price for a 90 square metre apartment to the average urban household disposable income per year.)

However, it is important to note that this oft-cited ‘international norm’ for HPIR is based on the data of developed, middle/high-income countries. A World Bank survey of 96 countries and regions shows that the HPIR for developing, low-income countries tends to be much higher than that for developed, middle/high-income countries. 

China’s average urban annual household income during 2005-07 was about US$4,400, which is roughly equivalent to about US$3,500 in 1998 by our estimate. Benchmarking China’s income level with the World Bank’s survey results suggests that the current HPIR in China is not particularly out of line with the international norm adjusted for the difference in income levels between countries.

In summary, housing affordability today has not deteriorated much over the past 4-5 years. Although China’s HPIR is high, suggesting low absolute housing affordability, this seems to be in line with the norm for a majority of developing, low-income countries like China, which does not necessarily support the argument for a bubble in house prices.

Understanding the Seemingly High HPIR in China

The HPIR in China may have overstated the seriousness of low absolute affordability due to some China-specific factors, in our view. Adjusting for these factors would make housing more affordable than suggested by the current HIPR, lending further support to the argument for no bubble in house prices.

There are at least two such factors at play. First, Chinese household income growth has been very strong on average, and this secular trend is expected to remain largely intact for the foreseeable future. During 2002-07, the average annual nominal growth of household disposable income per capita was about 12%, which is much faster than that in many emerging market economies, let alone developed ones.  Factoring in the rapid income growth in the foreseeable future, the income growth-adjusted HPIR (IGA-HPIR) (i.e., continued strong income growth with fixed housing purchasing prices) in China will decline substantially in the years immediately after the house purchase. We argue that when gauging housing affordability in a fast-growing economy like China, the IGA-HPIR should be a more appropriate indicator than the HPIR.

Since the HPIR norm of 3-6x in developed economies should be a function of expected income growth in these economies, when estimating the IGA-HPIR for China, we use the difference in expected income growth between China and the developed economies. If we assume that China’s nominal annual household income growth is 5pp higher than that in developed economies, which is by no means a strong assumption in view of the track records in the past 5-10 years, the average HPIR for a house purchased in China today will drop from the current 8.3x in 2007 to 6.5x five years from now.

The second China-specific factor that helps to explain the seemingly high HPIR in China is the very high house- ownership ratio and the strong demand for housing upgrade. The house-ownership ratio in China is over 80%, one of the highest in the world. This is a legacy from the planned economy era. Under the planned economy, a vast majority of employees stayed in public housing that were later privatized and sold to these employees at a heavy discount – and even for free in many cases. In this context, the unusually high house-ownership ratio is a reflection of the distortion of the planned economy in the past instead of a natural work of a market economy. 

Most public housing – especially those inherited from the planned economy era – is of low quality, and China is no exception. Given the rapid household income growth in recent years, this is the key reason for the strong demand for housing upgrades despite the already high house-ownership ratio. We estimate that at least 30% of the underlying housing demand in recent years may have reflected the need for housing upgrade. And the down-payment for this type of house purchase is typically financed by the proceeds from the sale of the first house. In other words, about 30% of home buyers already have a sizable endowment – which reflects the wealth transfer from the state when the public housing was privatized – to allow them to make the down-payment without tapping into their current income. This is a quite different situation from that in the developed economies, where there is a well-functioning property market and no pent-up demand for housing upgrade.

We assume that out of the need for housing upgrade, home buyers make a 40% down-payment (which is a conservative assumption, given that the current average down-payment is about 35%), and the down-payment is fully financed from the proceeds of the sale of the first house. Adjusting for this special factor due to the demand for housing upgrade, we estimate that the HPIR can drop from the current 8.3x to 7.3x.

Factoring in these two China-specific factors, we estimate an adjusted HPIR ratio of around 5.7x, significantly lower than the current 8.3x.

If Not a Bubble, Why Austere Measures?

The Chinese authorities have taken a series of austere policy measures with the objective of arresting the rapid rise in property prices since 2006. However, if housing affordability is not an issue and there is no property bubble, why is controlling property prices such a high policy priority in the first place?

We believe that these austere policy measures are aimed at addressing income/wealth disparity, which is a social issue, instead of a genuine meaningful property bubble, which is an economic/financial concern. Here’s why:

When estimating the HPIR, we use average household income. However, when we take account of the underlying income disparity, the actual affordability for middle- and low-income households turns out to be rather low. While the adjusted HIPR for upper-middle income or above households is below 5x, that for households of middle income or below is substantially higher than 6x. If we draw a line at HIPR of 6x, it appears that, at the current level of property prices, only about 40% of urban households can really afford a house in China, while the other 60% cannot.

While average housing affordability is not an issue, to the extent that the middle- and low-income households – which are the majority – cannot afford a house, thus becoming a social issue, the authorities may be concerned and want to take policy actions to slow the increase of (or even bring down) house prices.

The relatively brief history of China’s property market development has exacerbated the social aspect of the housing affordability issue. Deterioration in income/wealth disparity in China was an issue long before the rapid development of the property market in the past 4-5 years. However, the income/wealth disparity does not become as obvious when a majority of households start to realize that they cannot afford a decent house. In a sense, the property market serves as a mirror that reflects the underlying income/wealth disparity that existed long before the rapid rise of the property market. To the extent that the underlying income/wealth disparity is revealed through the property market within a relatively brief period, it constitutes a shock to many low- and middle-income households in China, exacerbating the social aspect of housing affordability issue.

In this context, we believe that the austere policy measures imposed by the authorities on the property market are aimed at addressing a social issue: to improve the housing affordability of low- and middle-income households instead of deflating a meaningful bubble in property prices out of concern about broader implications for economic and financial stability.

Affordability Likely to Improve

Largely reflecting the austere policy measures targeted at the property sector, sales have slowed markedly recently. However, average property prices have been broadly stable.

This is not a sustainable situation, and a broad-based property price decline now appears inevitable to us. Assuming that nominal household income growth is only 10% in 2008, which is quite conservative compared to the 13% average annual growth during 2003-07, we estimate that if average property prices were to drop by 9%, the adjusted HPIR would decline to below 5x, a substantial improvement in housing affordability. 

However, the key question is whether improved affordability would lead to a rebound in sales. The large volatility in property sales suggests that a strong pick-up in sales is indeed possible. The decline in property prices is neither necessary nor a sufficient condition in this regard, in our view. The key is an improvement in potential buyers’ sentiment, which entails a policy shift away from the current policy stance, in our view. But will this policy shift be even possible?

Economic Hard Landing Is a Bigger Policy Concern

Failure to maintain the property sector as an engine of growth risks bringing about an economic hard landing (i.e., below 8% GDP growth), given the importance of the property sector to the economy, as discussed above. The question is whether the authorities will ease the austere policy measures when faced with the risk of an economic hard landing.

We believe that the authorities will ease policy controls over the property sector when they start to appreciate the potentially serious downside risk posed by the property sector to the overall economy. This is because a deeper economic slowdown and the attendant unemployment will have much more serious and broader social implications than those associated with housing affordability. To wit, the latter is the lesser of two evils.

We expect potential policy responses to be aimed at boosting housing demand, including, for instance, easing the stringent mortgage lending rules and lowering mortgage interest rates. These measures, together with a welcome correction in property prices, should be able to increase housing affordability, improve sentiment and revive property sales, in our opinion. The outcome could turn out to be as a benign scenario as described above: sales will pick up at the expense of a margin squeeze on the property developers’ part. Since developers still have decent profit margins, some margin squeeze is unlikely to dampen their interest in investment significantly.

Further boosting fiscal spending to increase supply of affordable housing will likely be another major policy initiative in the authorities’ efforts to strike a balance between supporting economic growth and the social objective of improving housing affordability for low- and middle-income households. However, we do not expect a government-financed affordable housing program to play a significant role. Moreover, we argue that a viable affordable housing program is predicated on a buoyant commercial housing program.

First, both cross-country experiences and China’s own recent history from the planned economy era suggest that an affordable housing program financed primarily by the government in a large country like China is not financially feasible. Second, in our view, a private sector-based affordable housing program can be commercially sustainable only when it is designed as a type of cross-subsidy arrangement under which the participating property developers make profits from their commercial housing programs to cross-subsidize the affordable housing programs. In this context, a buoyant commercial housing program constitutes a necessary condition for a sustainable affordable housing program.

Implications

Our positive view about the property sector underpins our overall constructive outlook for the Chinese economy, as reflected in our GDP growth forecasts of 10% in 2008 and 9% in 2009. Specifically, while we expect the contribution of growth from net exports to be close to nil in 2009, investment growth could still hold up relatively well, with only a moderation in real estate investment growth to be offset by some pick-up in infrastructure investment, reflecting easing in fiscal spending. Consumption growth will normalize around its secular growth trend after a mini-boom in 2007 boosted by buoyant consumer sentiment on the back of an extraordinary stock market performance.

The timing of the potential easing in property sector policy will hinge on the pace of an export-led slowdown, in our view. Based on our global economics team’s forecasts for G3 economies, China’s export growth will likely decline substantially to around the single-digit level in 1Q09, which may trigger a major policy shift, in our view.

Risks

Our baseline scenario remains an imported soft landing of the economy. Policy easing, especially in the property sector, that boosts growth is a key element of this scenario. An alternative risk scenario is a ‘self-made hard landing’ in 2009. This would be a possible outcome, if the authorities were to pursue a misplaced policy priority to deflate a non-existent property bubble, in our view. However, we attach a less-than-25% subjective probability to this risk scenario.

For more details, please see China Economics: Can the Property Sector Be Counted on as the Engine of Growth? September 2, 2008.

 

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