Downturn to Climax in Oct-Dec Quarter
October 27, 2008
By Takehiro Sato | Tokyo
Drop in Economic Indicators to Accelerate
The current Oct-Dec period marks the fourth quarter since the peak of the economy (which we pinpoint as Oct-Dec 2007), but the average pattern of past recessions suggests that momentum is worst in the fourth quarter after the peak. For example, if the headline number in the BoJ’s Tankan (business conditions DI for large manufacturers) traces the average pattern for the four quarters following the economy’s peak, it would drop 17pt from the last reading; if it mirrors the average pattern for decline between the third and fourth quarters post-peak, the drop would be 11pt. Since the September headline number was -3pt, a December Tankan figure (due out on December 15) in the -14 to -20pt range – negative by double digits – is likely. Output cuts in manufacturing industry are also set to accelerate. Assuming the average pattern, as for the Tankan earlier, industrial production in Oct-Dec would decline by 1.8-2.6%Q, suggesting that cuts will deepen in comparison to the previous three quarter. We therefore expect downward momentum to be strongest in Oct-Dec, and while the direction will remain unchanged in the Jan-Mar quarter, the rate of decline should ease. Note though that as the recovery pattern for the Tankan headline indicates, even if data bottom out in the fifth quarter after the peak (Jan-Mar 2009), there is often virtually no sense of recovery for another two quarters (which would take us to Jul-Sep 2009). Is There a Convincing Case for Upside? It is not easy to come up with convincing evidence for upside at a time when the vector of the economy is downward. But it would be unwise to entirely dismiss brighter signs, as the adages about ‘darkness before dawn’ and ‘bull markets originating in despair’ imply. Here we outline areas that may offer some encouragement. (1) Improvement in terms of trade: Likely, but not yet The chief potential positive is the pullback in energy/raw materials prices and lowering of input costs as a result of yen strength, driving improvement in companies’ terms of trade. We do not expect any immediate uplift to the economy from this source, of course. Trade terms normally deteriorate when the economy is booming and improve when it is ailing. It therefore takes 12-18 months for improved terms of trade to boost an economic recovery, which is longer than is generally recognized. Even so, energy prices have been in rapid retreat; we can expect some effect on lowering input cost from F3/10 at a comparatively early stage. A 10% drop in the landed crude oil price would boost corporate earnings by about 3ppt, and simply assuming current prices, it would be reasonable to look for roughly a 10ppt lift from lower input costs in F3/10. We are forecasting a second consecutive year of double-digit earnings declines in F3/10, mainly because our top-line growth outlook is almost flat since demand (sales volume) is likely to stagnate globally next year, but this scenario of lower costs does provide a potential escape route. We anticipate that as company guidance is lowered in the F3/09 interim results season, the gap between our downbeat top-down view and company forecasts will gradually close. Conversely, guidance for F3/10 is likely to be extremely cautious initially, but awareness of the benefits of those input cost reductions should gradually seep through. (2) Expanded provision of liquidity: Likely in the near term following other major central banks The BoJ may be poised to switch course and pursue monetary easing. As we have already noted (see “QE or Rate Cut?”, October Outlook Report Preview, October 21, 2008), the BoJ is reviewing its reserve deposits system and may announce alongside the release of its Outlook Report at the end of October that it will start paying interest on such deposits, as the Fed is now doing. (Actual interest payments could begin when reserve deposits for November are topped up.) This move would keep the unsecured overnight call rate between the reserve deposit rate and the Lombard rate (currently 0.75%). And by setting the interest rate on excess reserve deposits below the target policy rate, as the Fed does, the central bank could expect to effectively lower overnight rates by increasing the supply of funds (a ‘stealth rate cut’). In other words, by paying interest on reserves deposited by banks, the central bank can massively expand liquidity provision without lowering the overnight rate to zero (quantitative easing without ZIRP). In the US, the effective fed funds (FF) rate has been lowered as a result of the 50bp emergency cut on October 8 and the start of interest payments on deposits from October 9, and has now dropped well below the guidance target for the policy rate (1.5%) to a level barely higher than the rate on surplus deposits (FF target minus 75bp). (The interest rate on excess reserves was changed to the FF target rate minus 35bp (1.15%) on October 23. The rate on required reserves stayed at the FF target minus 10bp (1.4%).) By adopting the same framework, the Bank of Japan could effectively step up monetary easing. By the logic of a central bank, however, a change in framework as above, without alteration of the guidance target for the policy rate, may not count as monetary easing. Payment of interest on reserve deposits has been adopted simply as a means of diversifying the monetary operation tools at the central bank’s disposal. The BoJ’s balance sheet is likely to swell with a return to quantitative easing in the future, but reserve deposits that earn interest represent just one route of fund absorption, and on some views fall outside the definition of the monetary base. In that case, however much liquidity was to be increased, the monetary base would not be affected. Even so, the original policy aim in the quantitative easing conducted via ZIRP in 2001-06 was to pep up the real economy and asset markets by expanding the supply of funds. The actual effects of the higher reserve volume, in the form, for example, of funding assistance for financial institutions or sharply lower long-term interest rates, may have differed somewhat from the initial intention, but the indirect contribution to shoring up economic activity was the same as what is sought now. In making a commitment to quantitative easing without ZIRP, receptiveness to the potential of the volume effect would seem to be the way for the BoJ to enhance its policy objectives. (3) Steps to ease funding of SMEs: First supplementary budget already passed the Diet On the fiscal side, income tax cuts of over JPY2 trillion and “the largest residential tax cut ever” (Bloomberg, October 23) are currently the centerpieces of the second supplementary budget. However, most of this could end up as savings, since there will be no benefit to households below the minimum tax threshold who are not paying income tax. The impact of a residential tax cut would depend on its size, but it is questionable whether this could have an immediate effect since incentives for buying homes have been undermined by fears about job security. We are more hopeful for an impact from the funding assistance given to small- and medium-sized enterprises (SMEs) via the credit guarantee system at the core of the first supplementary budget. The real spending on these measures in the budget is only JPY400 billion, but assuming a gearing of 20x with a loan default ratio of 5%, some JPY8 trillion in credit guarantees could still be provided. In the actual budget, the bulk (JPY9.1 trillion) of the total package (JPY11.7 trillion) has been allocated to funding support. The eye-catching part of the SME financing support is that the new credit guarantee system above lies outside the shared-responsibility system (instituted in October 2007), and therefore guarantees 100% of loan value. Under the shared-responsibility system, the lending bank shoulders 20% of the credit risk, leaving open the possibility that banks’ approach to SME lending may actually have become more cautious. However, if banks with backing from the credit guarantee corporations are able to lend risk-free, we might expect the bottlenecks caused by the shared-responsibility system to be cleared. The newly proposed emergency guarantee system to respond to spiraling raw materials prices has also brought a wider range of industries under the safety net than the previous system of guarantees in this area. What distinguishes these safety net guarantees from the extraordinary guarantees provided in 1998-99 is the credit screening process by the Credit Guarantee Corporations. The earlier extraordinary guarantees basically involved no oversight whatsoever, providing something like the ‘helicopter money’ that Paul Krugman talks about. Bad debts then ballooned early in the 2000s, and the financial underpinnings of the credit guarantee system were dented. The new system aims to provide necessary funds for working capital and business investment stresses to SMEs with financing difficulties while avoiding moral hazard. It also appears likely that the funding for these SME relief measures will be increased in the second supplementary budget. Policy and Market Implications With the sagging stock market and now the rising yen, the monetary policy conditions for a rate cut are coming into place. There was no sign of the customary upbeat references to the economy gradually moving into recovery in the BoJ governor’s remarks at the BoJ branch managers meeting on October 20. There was also no mention of the risk of amplified swings in the real economy caused by maintaining super-low interest rates over the long haul. In the communiqué following the October 7 policy board meeting, the BoJ inserted a number of qualifiers in the formulation of its constructive view, hinting at an upcoming change in its economic assessment, and the governor’s remarks on October 20 have reinforced this possibility. We believe that the BoJ’s assessment of the economy is likely to be downgraded in the Outlook Report on October 31, on the heels of the government’s revised outlook already reported. The timing of the rate cut that we have been calling for in the Jan-Mar 2009 quarter may also be brought forward to Oct-Dec, depending on the pace of yen appreciation (stock prices don’t need to fall any further to justify this). Even if the BoJ decides to change the reserve system as early as October 31, we believe that it will refrain from characterizing payment of interest on reserve deposits as monetary easing, as discussed above. The coming rate cut could then be made as soon as November or December as a separate policy move. Liquidity problems in the money markets have at times sent bonds lower even during the equity sell-off, with long-term yields spiking to 1.6%. Restoration of calm in the money markets has reduced JGB profit-taking sales and allowed the normal pattern of bond strength when equities are struggling to resume. We are forecasting long-term (10-year benchmark JGB) yields of 1.40% at the end of March 2009, but see the possibility of a strong rally sending yields down to the 1.0-1.2% range for a time towards the Jan-Mar quarter. This out-of-consensus view has not been well priced in the equity market yet, which may cast concerns for certain industries.
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No Differentiation in the Sell-Off
October 27, 2008
By Stephen Jen & Spyros Andreopoulos | London
Summary and Conclusions Virtually all EM currencies will weaken against the dollar in the months ahead, in our view. Global fundamentals are much more important than country fundamentals, and contagion is a more useful theme than differentiation in this phase of the cycle, we believe. Economic heterogeneity will not matter that much in determining how far or fast various EM currencies depreciate against the dollar as the world enters a synchronous recession, but will likely determine how early and strong the currency recovery will be several months from now. Looking at the experience with the Asian Currency Crisis, we find confirmations of our view that country-specific economic fundamentals matter little in the sell-off stage, but matter a lot in the recovery stage. Many EM currencies will overshoot first but eventually recover, at least partially. We believe that BRL, MXN and KRW are relatively strong in this context. But some currencies with weak economic and policy fundamentals may never recover the nominal levels prior to the shock. All of these currencies should be sold against the dollar now, as the global economy slows, but they will likely exhibit different recovery paths. But the latter is an issue which will have more relevance three or so months from now. The Debate About EM Currencies There are several debates ongoing regarding EM currencies. First, there is the view that EM currencies don’t deserve to weaken against the dollar – arguably the currency of the country most guilty in triggering the current state. Further, the US will not generate much growth in the coming year or so, while EM will continue to show positive growth. USD/EM should fall, not rise (i.e., the dollar should weaken against EM currencies), so it is argued. Second, there is the view that economic fundamentals matter. In many cases (e.g., Brazil, Mexico, Turkey, Korea and India), many have argued that their country-specific economic fundamentals are good and so the size of the currency depreciation should be limited. We dispute both points. We believe that, with the recent participation of EE currencies in this EM currency sell-off, we are only in the third inning of a very significant cyclical and structural shock that will eventually push many EM currencies 50% or more below the peaks in their values seen recently. We will not use the ‘c-word’, but believe this will be a global EM currency ‘moment’ more severe than all of the regional currency incidents we’ve witnessed in modern history. 1. Market positioning is ultra long-EM currencies. While some ‘fast money’ accounts may have trimmed their exposure to EM, we believe that legacy carry positions remain very significant: it will take a while before these funds completely unwind. Long-only real money accounts as well as sovereign wealth funds (SWFs) are likely to be highly exposed to EM. The view may be that it is too late to get out of these positions (i.e., realise the huge paper losses) and that the underlying investments in EM look very cheap. Without going into whether EM currencies will weaken or strengthen, our point is that the EM markets are more vulnerable to a further sell-off in EM currencies than a recovery. A further sell-off in EM currencies could trigger rounds of liquidation from EM accompanied by extraordinary currency weakness. Some investors have begun to ask when they can buy back the EM currencies. Our view is that it is still too early to answer that question. As long as the ‘second derivative’ of the global economy is negative, one should not buy back EM currencies. 2. The EM story is likely to be over-rated. As we have proposed recently, the structural story for EM needs to be fundamentally, comprehensively and critically reconsidered, if the US credit bubble was indeed a monumental mistake that should never have happened. While it is difficult to precisely describe the counterfactual of what the world would have looked like in the absence of the US credit bubble, it is likely to be the case that the C/A surpluses of Asian economies would have been much lower in the past years, and the global commodity cycle would have been much less pronounced. But exports and commodities are precisely the two engines of growth for EM. If we question the core basis for EM’s potential growth, it raises the question of whether the popular ‘EM-will-be-the-future’ view is indeed correct. At a minimum, there are likely to be many EM economies that have prospered with little effort of their own, just because the global economy was robust, while some EM economies may have restructured and genuinely improved their fundamentals over the years. The market is, in a way, trying to sort out who’s who, even though investors may not be making an effort to do this ‘filtering’. 3. Too much fixation on the need to differentiate. We continue to be reminded by economists and investors that EM countries are different and that there is a need for differentiation. We agree and disagree, probably more the latter. It is obvious that countries are different. But in a global sell-off of risk assets and a global recession, global fundamentals matter much more than country fundamentals. (For example, we have recently argued that capital flows to EM depend on global growth more than EM growth: see Risks of a Sharp Reduction in Capital Flows to EM, September 25, 2008). Fixating on the need to differentiate in the sell-off stage may be the most counter-productive stance investors could take, in our opinion. Instead, heterogeneity will only matter in the recovery phase. Experience of the Asian Currency Crisis Not all crises are alike. But looking back at some of the features of the Asian Currency Crisis of 1997, we find lessons that may be useful for thinking about the current situation. We illustrate the relative magnitudes of nominal bilateral exchange rate movements in the period following the THB devaluation of July 1997. IDR was hardest hit, with the currency at one point losing more than 80% of its value against the dollar, while TWD was the biggest outperformer (losing 20% of its value at the lowest point), if we exclude the USD pegs of CNY and HKD. Back then, IDR actually had some of the best macroeconomic fundamentals in Asia. But this did not prevent the IDR from collapsing. The currency weakness, in turn, complicated policy-making and exposed structural weaknesses – both economic and social – that were not quantifiable in terms of the traditional macro variables analysts track. This is one reason why we have strongly argued against fixating on the country-specific fundamentals in assessing the sell-off. We highlight that, contrary to popular presumption, some currencies never really recovered from the Asian Crisis, at least measured by the nominal bilateral exchange rate vis-à-vis the dollar. It took PHP 82 months to bottom, and PHP has never really recovered from the shock. On the other hand, despite being sold harder and earlier than other Asian currencies, KRW recovered earlier (seven months after the crisis began) than others and most strongly in 1998/99 as imports collapsed and exports surged with the global economy. The US$33 billion turnaround in Korea’s C/A balance from 1997 to 1999 was the main reason for the recovery in the KRW. Inflation is important in determining whether we see a sharp recovery in the nominal exchange rate. High inflation erodes the real value of the currency in question, and the same real exchange rate corresponds to a weaker nominal rate. Thus, though neither the Reserve Bank of India’s decision to cut interest rates nor the National Bank of Hungary’s decision to raise rates will prevent INR or HUF from depreciating, higher inflation in India in the coming period could prevent INR from recovering several months from now. As observed above, it took KRW – the first currency to recover during the Asian Crisis – seven months to bottom. Since a global recession will prevent export-oriented countries from enjoying quick help from strong exports, we suspect that we will not see any EM currency start to recover before year-end. Bottom Line We believe that we are only in the third inning of the global EM currency ‘moment’, and expect to see substantial further pressure on virtually all EM currencies, regardless of the country fundamentals. Global fundamentals matter much more in the sell-off stage of the cycle, so investors do not need to differentiate among them in this phase. In contrast, country fundamentals will again matter in the recovery phase, which we believe is at least three more months away. Many EM currencies will overshoot first but eventually recover, at least partially. But some currencies may never recover the nominal levels prior to the shock.
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Europe More Exposed to EM Bank Debt than the US or Japan
October 27, 2008
By Stephen Jen & Spyros Andreopoulos | London
Summary and Conclusions As a percentage of GDP, European and UK banks are about five times more exposed to EM (emerging markets) than the US and Japanese banks. Pressures on EM economies, therefore, could have a particularly negative ‘boomerang’ effect on European banks. (Our European banks team is also very bearish on European banks with heavy EM/CEE exposure.) For currencies, if EM becomes the second epicentre of the global financial crisis, as we believe it might, EUR seems more at risk than USD or JPY. BIS Data on International Bank Lending We base our analysis on data from the Bank for International Settlements (BIS Quarterly Review, September 2008, Statistical Annex), and make the following observations: 1. Bank debt to EM accounts for only 13% of total international bank debt. The international banking system is huge. Total cross-border bank lending has reached US$36.9 trillion, with lending to EM totaling some US$4.7 trillion. 2. However, European and UK banks have been extraordinarily active in lending to EM. Cross-border bank lending by European and UK banks to EM accounts for 21% and 24% of the respective GDPs, compared to 4% for the US and 5% for Japanese banks. In absolute terms, European banks have US$3.5 trillion in loans to EM, compared to ‘only’ US$0.5 trillion for the US and US$0.2 trillion for Japan. (The absolute size of ‘foreign’ bank loans by European banks is also multiple times bigger than that of the US and Japan: US$25 trillion versus US$1.8 trillion and US$2.4 trillion. This is due primarily to intra-Europe lending that is considered ‘foreign’.) 3. Austria, Switzerland, Spain and Sweden have the largest exposure to EM. By country, total loans to EM by Austrian banks amount to 85% of GDP – with EE accounting for 80% of Austrian GDP. Switzerland ranks second on this measure, with bank lending to EM amounting to 50% of Swiss GDP. Number three is Sweden at 25%. 4. EE the largest destination of G10 bank loans. Despite its relatively modest size of GDP, Eastern European countries, together, account for US$1.6 trillion of bank lending from G10 banks, while Asia and Latam account for only US$1.5 trillion and US$1.0 trillion, respectively. 5. European and UK banks have the largest exposure to Emerging Asia. In absolute terms, European and UK banks have US$827 billion and US$329 billion lent to AXJ. As a percentage of GDP, these are equivalent to 5% and 12%, respectively. Take China, for example: of the total US$301 billion in foreign bank loans, European and UK banks account for US$222 billion (73% of total). Similarly, for India’s US$227 billion in foreign bank loans, European and UK banks account for US$174 billion (77% of total). Thus, if Asian banks falter, the UK seems to be more vulnerable than Japan – in contrast to the Asian Financial Crisis of 1997. 6. European and UK banks have the largest exposure to Latam. Contrary to presumptions, US banks do not have a large exposure to Latam, as US banks account for only US$172 billion of US$976 billion in total bank borrowing by Latam countries. Again, European – mostly Spanish (US$316 billion, or 32% of total lending to Latam) – and UK (US$102 billion or 10% of total) banks are most exposed to Latam, in absolute terms for the European banks, and as a percentage of GDP for the UK. 7. European banks are by far the most exposed to EE. Of the US$1.6 trillion in total foreign bank borrowing by EE economies, European banks account for US$1.5 trillion – equivalent to 9% of European GDP. Austrian lending to EE totals US$297 billion, even higher than Germany, Italy or France. In fact, Austrian banks are the biggest debt holders of Hungary and Ukraine – the two economies likely to seek assistance from the IMF. (We suspect that Greek banks’ exposure to EE should be substantial in relation to the country’s GDP. However, Greek data are not separately available from the BIS.) 8. Concentration of Baltic risk on Sweden. The three Baltic states – Estonia, Latvia and Lithuania – have a total of US$123 billion in foreign bank loans, US$83 billion of which come from Swedish banks, accounting for 18% of Sweden’s GDP. ECB Extends Liquidity Assistance to EE In light of the huge exposure of European banks to EE and other EM economies, it is not surprising to see the ECB extending its liquidity assistance to Hungary. Euroland and EE are in a symbiotic relationship, with Euroland being exposed to EE through bank debt, while EE is exposed to Euroland through export demand. This symbiotic relationship is arguably more fragile, at this particular juncture, than that between the US and Asia/China. Part of the reason why EUR/USD continues to drift lower, in our opinion, has to do with the rising risks that pressures in EE will have a negative boomerang effect on Euroland. IMF Programmes IMF programmes, if big enough, should help to ameliorate this problem, as EE economies are lent hard currencies to help them repay the debt. However, austerity policies – most probably centred on eradicating EE’s ‘Anglo’ housing cycle, should lead to lower capital flows into EE in the coming years. More subdued global demand should also help to temper FDI flows from multinational companies with headquarters in Euroland. In short, we believe that IMF programmes will help to moderate the pressures on the EE currencies, but not reverse their weakening trend. Bottom Line European and UK banks have five times as much exposure to EM than the US or Japan, with most lending going to East European (EE) economies. They have the biggest loan books in Asia, Latam and EE. Austria, Switzerland, Spain and Sweden are particularly exposed to further stress in EE. Potential problems in Asia or Latam should also undermine the EUR and GBP more than the USD or JPY, due to this bank lending channel.
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