In This Issue

Turkey Taking Stock and Revising Forecasts Japan June Tankan Preview: Set to Reconfirm Recovery, Yet Sees Business Plans Lowered Global Global Forecast Update: After the Deepest Recession, the Weakest Recovery View GEF Archive

		The Global Economics Team

		Read about other GEF team members

The economy has gone through a sharp weakening in 1Q, with the simultaneous collapse of external and domestic demand.  While the official data are yet to be released, we expect the 1Q09 contraction to be 12.5%Y - one of the worst on record.  Starting with 2Q, we project the deceleration in real GDP growth to gradually moderate and, in fact, we expect positive growth on a quarter-on-quarter basis. 3Q might witness a marginal negative growth, but the risk might be on the upside and hence it would not be surprising to see a flat reading. Finally, we expect positive growth in 4Q09 such that the overall GDP growth rate would be -4.7% in 2009. This is a downward revision to our previous base case forecast of -3%.  

As part of the revision of GDP forecasts, we raised our base case 2010 growth rate to 3.3% from 3% previously, which is still below the trend growth rate. Hence, we expect the output gap to remain, with the adverse consequences on employment while keeping inflationary pressures broadly absent. In terms of risks to our base case forecasts, namely the bull and bear case scenarios (which not only depend on country-specific macro dynamics but also the course of global growth, commodity prices as well as interest rates), we have adjusted those forecasts as well. Compared to our previous set of forecasts, we now envisage an overall worsening in 2009 but a moderately faster improvement in 2010.

Considering the massive size of credit squeeze in global markets, lack of domestic and external investment appetite as well as a noticeable decline in exports, the overall impact on growth could have been more severe. In our view, a set of factors played a role in this:

•           The economy started to slow much sooner than the global economy and especially Turkey's peers. After posting an average annual growth rate of 7.3% during 2002-05, 2006 GDP growth eased to 6.9%, followed by a further slowdown to 4.7% in 2007 - almost purely on the back of domestic macro-political dynamics. Last year, the economy grew by merely 1.1%, which was akin to none for Turkey's standards. Hence, the weak base year effects are likely to provide some statistical cushion in 2009.

•           The Central Bank of Turkey (CBT) acted in a very timely and appropriate fashion by easing the policy rate to unprecedented levels. Today, the CBT cannot be considered to be behind the curve, as the deterioration in demand had been significant and inflation pressures are absent. 

•           The government introduced various countercyclical fiscal measures that led to a noticeable deterioration in the overall fiscal picture. Part of these had been outright spending, while the rest were tax relief. Essentially, the tax relief consisted of lower or zero taxes for vehicles, white goods, furniture and IT equipment for a period of six months (ending June).  In our view, the impact of the fiscal policy on growth is likely to be short-lived and - in the absence of corrective action (with or without the presence of a Stand-By Arrangement with the IMF) - it could hinder medium-term growth. Recall that Turkey witnessed a period of high and consistent growth during 2002-07 when the fiscal discipline was at its peak (at annual primary surplus targets at 6.5% of GDP). This was solid proof that tight fiscal policy could in fact be expansionary.

Industrial Production: Getting Some Pulse Now

Following a series of dismal readings since the commencement of the global credit crunch, industrial production (IP) seemed to have bottomed out. Recent data point to the fact that February 2009 will mark the end of the slump in production and, with the help of the base year effects as well as the gradual improvement in demand conditions, IP growth should improve in 3Q09 and especially in 4Q09. That said, the improvement has been very marginal so far, and we expect the pace of pick-up in domestic as well as external demand to be very moderate. In fact, looking at the components of IP, we notice that the pace of improvement in production geared towards exports (such as machinery and equipment, automotive and electrical machinery) is still very weak. However, the deterioration in these areas had been so massive in 1Q that the only way seems to be up in the coming months. As discussed above, on the domestic front the initial signs of growth are likely to be seen in 2Q with the introduction of a series of temporary tax cuts offered in the automotive and white goods sectors, which seemed to have resulted in a sharp reduction in inventories. The preliminary data on automotive production, for instance, point to a noticeable rise in comparison to early 2009.

The government has recently extended the six-month tax relief incentive by an additional three months, albeit amending the tax rates a little higher. As a counterbalance, tax on cigarettes had been raised, hoping that part of the revenues losses associated with the tax incentives could be offset. According to preliminary estimates, the rise in tax on cigarettes might bring an additional TRY6 billion to the budget covering the period until end-2011 (0.6% of GDP).

Looking forward, it would not be surprising to see a similar extension in incentives and/or the introduction of new measures such as car scrappage to provide a further lifeline to the industry. For us, these types of incentives have a moderate, if any, impact on the budgetary costs and, on the contrary, might even increase indirect tax revenues that would have been absent otherwise. Essentially, these incentives served to draw down inventories as domestic demand had clearly been muted for quite a while. However, given the nature of the actions, we suspect that the impact on growth will be temporary in nature.

The main downside to a sharp drawdown in inventories is that the new phase of production might bring in a marginal rise in inflation, as the new factor costs are likely to be higher, given the recent rise in commodity prices as well as the relative depreciation of the currency. That said, the benefit of bringing in some stimulus to growth clearly outweighs a marginal rise in inflation, in our view, especially considering the fact that inflation is likely to remain below the official target in 2009.

Capacity Utilization Also Signals Further Improvement Ahead

The improvement in capacity utilization (CU) has been even more noticeable in recent months, especially with the release of the May data that saw private sector CU rising above 70% for the first time since November 2008. In light of the CU figure for May, our preliminary calculations suggest that industrial production might display a noticeable improvement, albeit still pointing to a year-on-year contraction in the low teens. In case CU continues to improve gradually and exceed 75% soon, obviously we would then expect IP data to improve even faster.

Essentially, the future uptrend and the pace of pick-up in industrial production will be a function of how fast European growth improves; however, given the fact that Turkey has managed to diversity its exports in recent years, the normalization in consumption and investment in the Middle East would be key drivers as well.

Unemployment Rate Might Ease Marginally, but Is Likely to Remain Elevated in the Foreseeable Future

Unemployment had long been a sour topic in Turkey, but the decisive deterioration in the labor market since mid-2008 gained pace in 2009 such that the country was ranked second (next to South Africa) in terms of the highest unemployment rate in the world.

At 16.1%, the unemployment rate seemed to have peaked in February and, with the help of the seasonal factors, a marginal improvement to 15.8% had materialized. Essentially, this was mostly on the back of the increase in the labor force, concentrating in certain sectors such as agriculture and construction.  The dismal picture in the manufacturing sector remained unchanged as the industry continued to bleed, losing some 50,000 employees. This came on top of the 220,000 people that were laid off since October 2008.

An interesting observation regarding Turkish employment is that, unlike most countries, the finance sector steadily increased the number of employed since the beginning of the global crisis. In our view, this was an affirmation that the Turkish banking system has remained efficient and refrained from over-expansion since the financial crisis of 2001 as well as maintaining a strong balance sheet. Looking forward, we expect the unemployment rate to remain around 15% for most of 2009 and 2010 as we expect the economy to grow at a sub-par rate until 2011. The late response of the labor market to the ongoing rebound in the economy will be one of the main reasons why the upturn might only be moderate, in our view.

Inflation in Uncharted Territory

Last month, CPI inflation came out at 0.64%M, pulling down the 12-month trailing inflation rate to a new record-low of 5.2%Y. Thanks to the strong base year effect, inflation eased by some 0.9pp in May. We expect relatively tame monthly prints and the strong base year effect to keep inflation stable in the coming months, and possibly see it move below 5% in mid-summer.

Last month, we revised down our already below-consensus CPI inflation forecast of 5.9% to 5.2% and, in light of the recent data, we maintain this view. The headline CPI inflation print in May was higher than both our 0.35%M and the consensus estimate of 0.45%M but the deviation does not signal any trend change, in our view. Essentially, the main reason behind the higher-than-expected CPI figure was due to the relatively small decline in housing prices (i.e., the natural gas component) at -1.9%M against our forecast of -4%M. Otherwise, all price changes in sub-components seem to be fairly in line with our expectations and signal no change in the overall trend.

Meanwhile, producer price inflation came out at -0.1%M and pulled the 12-month trailing inflation rate to -2.5%Y. Clearly, this had been a result of the major contraction in economic activity on the back of a simultaneous weakening in both external and domestic demand. Hence, the PPI inflation entered uncharted territory, which might become a familiar place if prices remain suppressed on the manufacturing side.

Core Inflation Is Under Control

Given the strong base year effect and the continued weakness in general domestic demand, underlying inflation had been under control. In our view, the path of core inflation (by almost all measures) as well as the ongoing behavior of the currency suggest that the disinflation trend is intact. In fact, the simplest form of core inflation (CPI ex-food and energy) had been responding rapidly to the widening in the output gap and the FX pass-through had so far been minimal even though the currency depreciated considerably towards the end of 1Q.

Currently, the main risks to the inflation outlook are comprised of: (i) a steady and permanent rise in global oil prices; (ii) a faster-than-expected pick-up in domestic demand; (iii) a sharp depreciation in the currency, again permanent in nature; and/or (iv) corrective fiscal action by the government that might involve one-off hikes in certain taxes.

CBT Is Likely to Stay Put, but the Door Is Left Slightly Open for Another 25bp

The CBT eased the policy rate by 50bp to a new historical low of 8.75% on June 16, surprising the market slightly as the consensus and Morgan Stanley expectation was an easing of 25bp. While our base case assumption was that the terminal policy rate would be 9%, we kept the door open for a more aggressive rate of 8.75% and hence the move did not surprise us (or the market). If the CBT decides to continue with easing in the coming months, then we would consider that as a surprise and, in fact, we would rate that as unnecessary risk-taking. The ex-ante real policy interest rate now stands at around 2.8%. In the accompanying statement following the MPC meeting, the CBT indicated that another measured cut could be on the cards, but it all depended on data. Hence, one more cut is likely to be priced in by the market, in our view.

Given the fact that the central bank had acted in a very timely fashion in starting the monetary easing back in November 2008 - since when rates came down by 800bp - and we are likely to see some impact in the coming months, we believe that we have come to the end of the easing cycle. From now on, all data related to growth will be monitored, and in the absence of an external shock, we expect to see an improvement in almost every indicator, suggesting that the worst is over.

On the inflation front, we remain optimistic that the downward trend (on a yearly basis) will continue and we maintain our below-consensus year-end forecast of 5.2%. That said, the recent rise in oil prices and possibility of a faster-than-expected improvement in sentiment might pose risks to this. In addition, the absence of an IMF fiscal framework might add to medium-term risks as the ongoing deterioration on the fiscal front might necessitate revenue-raising measures (i.e., raising indirect taxes) at some point, which would be inflationary. At this juncture, these risks seem distant and we believe that the CBT officials are convinced that the output gap in the economy could absorb some pressure on prices. Hence, it is conceivable that the current policy rate could be maintained for some time well into 2010; currently we pencil in the first rate hike to materialize in 2Q10.

Balance of Payments: Still Supportive of TRY

The current account went through a major transformation with the combination of a sharp drop in energy prices and the lack of domestic demand. Once considered as the main risk to the economy, given the high financing requirement that it brought with it, the current account had rarely been of mention in recent months. We do not see a noticeable change to this in the near term, although the uptick in oil prices in recent months poses an upside risk for late 2009 and 2010.

As of April, the 12-month trailing current account deficit stood at US$26.8 billion, which shows an improvement of some US$22 billion from the trough of US$49 billion seen in August 2008. We expect the rapid adjustment to continue through most of 2009 such that the year-end deficit could be as low as US$9 billion, based on an average oil price forecast of US$60 per barrel for the year (using the futures curve).  We should note that oil prices constitute the main risk to our current account deficit forecasts but, in the absence of a significant rise globally, the impact is likely to be manageable. Our rule of thumb is that, ceteris paribus, for each US$10/bbl change in the price of oil, Turkey's current account change by approximately US$4.5 billion (assuming parallel moves in natural gas prices, although there is usually a lag of some six months between the two).

The External Financing Issue: We Are Still Comfortable

Even though there had been a consensus view that Turkey's current account deficit would shrink massively in 2009, most of the analysts had been overly concerned that the drying up of global capital would hinder private sector borrowing or even debt rollovers. Since the start of the credit slump, we had long argued that Turkey's external financing position was not as bad as it seemed (see External Financing in 2009 - How Much is Needed? November 26, 2008). We defended the idea that a significant portion of the private sector external debt, especially that of the non-financial sector, had been received on a collateral basis or that borrowed funds were simply companies' own resources that were parked at offshore accounts. Even so, we assumed a rather low rollover ratio and estimated the financing gap for the year at US$10-15 billion.

So far, the overall picture has been even better than we envisaged, not only because the banking sector debt rollovers had been more than satisfactory, but also as the non-financial sector rollovers did not decline as much as once feared. While data for a month is clearly not sufficient to make a strong judgment, in April the rollover ratio seemed to have bounced somewhat.

That is not the end of the story: Net errors and omissions - the balancing item of the balance of payments that is used for unaccounted FX flows - posted a series of positive inflows that reached a cumulative US$18.1 billion over the past seven months. To put this figure in perspective, one needs to consider that the non-financial firms made total debt payments of US$16.3 billion and borrowed US$14.3 billion. In our view, the sudden rise in net errors is clearly not a coincidence and is related to the repatriation of funds by firms and individuals that are in need of fresh funding. By definition, it is not possible to assume an ‘error' when setting up the external financing framework for a given year. However, as had been the case in previous ‘crisis episodes' Turkish firms and individuals tend to bring part of their offshore funds to onshore and one needs to account for it when making strong judgment about their ‘capacity to pay'.  On the flip side, it would be too strong of an assumption to expect the net errors to continue at the current pace throughout year. However, the government submitted new legislation to the parliament to extend the tax amnesty on funds brought to onshore from offshore accounts and from ‘under the mattress'. The extension is expected to cover the period until September 30, 2009. In the first round of the tax amnesty, some TRY14.8 billion of funds had been declared and a portion of those failed to be brought onshore. We believe that the government might have received certain requests to extend the amnesty, and it must believe that a considerable sum might be brought onshore this time.

The IMF Stand-By Arrangement: With or Without You

One should give credit to the Turkish government that the expectations regarding a new IMF SBA in the market and among the analyst community had been managed quite impressively between October 2008 and March 2009. Essentially, the market had been waiting for a new deal that would entail significant funding, which kept Turkey fairly shielded from the sell-off witnessed in other emerging markets. This had been the very period when Turkey was considered to have a dire need of fresh funding. As discussed earlier, this did not turn out to be the case, and so far no shortage of FX funding has been felt. In fact, we still maintain our view that ‘solely for external funding purposes' an IMF SBA might not be needed this year, although 2010 could also remain challenging unless the credit market improves a bit further. After March 2009, the expectations regarding the SBA started to fade and, as of today, the baseline scenario is that a new deal might be in place "at the end of summer" as Prime Minister Tayyip Erdogan commented recently. Nowadays, the proponents of an IMF SBA defend the view that the IMF funding would be necessary to lower the borrowing or the debt rollover rate of the Turkish Treasury so that the increased liquidity could be channeled to the real sector as credit by the banking system. Another view is that an IMF SBA would put a lid on the ongoing deterioration in the fiscal budget. Here is what we think:

•           External financing: The IMF's role in external financing would not be as important as it could have been some 3-4 months ago. In the absence of another wave of global credit squeeze, we do not expect Turkey (and Turkish firms) to face any increased funding issues in 2009, and the exact financing gap in 2010 depends on the global credit conditions as well as the risk appetite for EM assets. In that sense, the presence of a funded program would clearly help but might not be crucial.

•           Fiscal transparency: An issue we feel quite strongly about is the extent of fiscal transparency, policy implementation and especially spending patterns that are in place. With the presence of an SBA, the monitoring of these have clearly been stronger in the past and, given the ongoing weakening in fiscal numbers these days, we believe that an IMF SBA would improve vision significantly.

•           Supporting bureaucrats and the cabinet members in charge of economic policy-making: While PM Erdogan might not be very keen on accepting IMF conditionality and dragging feet to sign a deal, we believe that the policy makers and those implementing it would prefer an SBA. This is so because by referring to the program constraints on the budget, they can reject investment and spending requests from other ministries, the members of the parliament and some pressure groups. While this might seem trivial at this point, we remember the experience of 2002-07 when it had been much easier for bureaucrats to say ‘no' for spending requests citing the IMF.

•           Limiting the deterioration in the fiscal budget and improving the prospects of debt dynamics starting 2010: Looking at the government's past track record when the primary surplus target had been kept at a record 6.5% for many years, one could argue that the current deterioration in the fiscal picture would be temporary. Clearly, the government felt the need to introduce countercyclical fiscal measures as well as increased spending to ease the pain of the recession. However, the extent of the deterioration had been rather large and, so far, the authorities have not come up with a solid plan to convince the market that this would be temporary and that the expected rise in debt to GDP could be reversed. We expect the fiscal deficit to reach some 5.5% in 2009, which will be a sharp rise compared to the 1.8% posted in 2008. Considering that the general elections are scheduled to take place in 2011, naturally there is a certain level of concern that if the fiscal policy is not put in order soon, risks could elevate substantially. The issue is actually nothing new and the early signs had been there since the start of the year (see Deteriorating Fiscal Performance Calls for Action, February 12, 2009), but only after the deterioration gained speed did the concerns surrounding fiscal management escalate. In our view, for the sound implementation of fiscal policy and the introduction of a credible fiscal rule, an IMF SBA would be highly beneficial.

•           Lowering the debt rollover ratio of the Turkish Treasury and providing liquidity to local banks to be channeled to the economy as credit: The idea is that at least part of the IMF funding would be made available for the use of the Turkish Treasury such that it could lower the domestic debt rollover rate. The excess liquidity in the banking system would be extended to the corporates and/or consumers as credit in an effort to fuel growth and lower crowding out. A notion that seems viable in theory would not work in practice, especially in 2009, in our view. The rollover ratio has been in the neighborhood of 110% during 1H09 and a very significant amount of funding is needed to lower this. Besides, banks are not only limiting their lending because of liquidity constraints, but also due to their conservative approach to risk-taking. And of course, there are two sides to the story: Those firms that banks are willing to lend actually do not need funding and those that are willing to borrow are considered less qualified for lending. On the part of the consumer, the main demand for credit has been with credit cards rather than housing or vehicle financing simply because of the fact that the real wage erosion in the past year and the rise in unemployment led people to utilize short-term credit for day-to-day spending needs. The rising non-performing loan ratio on credit cards is a good indicator of this.

In summary, we believe that the signing of a new SBA with the IMF would be highly useful to allay funding concerns of the market, improve transparency in fiscal accounts, manage spending and add increased credibility to budgetary targets. However, the alternative path - i.e., moving on without the IMF - might not necessarily mean that the outlook would worsen dramatically. In that case, we would expect the government to announce plans to introduce a fiscal rule and, after revising the 2009-11 budget (once more), try to deliver some solid results to convince the market. Clearly, in the latter case, the market is likely to remain extra cautious where the phrase ‘seeing is believing' might prevail.

TRY Bonds: Not as Attractive

We have long been supporting the idea that TRY-based bonds offered good value (see Good News for TRY Bonds? December 1, 2008). On the back of the sizeable rate cuts and the appetite on the part of local banks, yields eased from 20% annual compounded levels in early December to 12.5% today. During this rally, the main participants in the bond market had been local financial institutions, while non-residents remained mostly on the sideways and in fact lowered exposure amid global risk-aversion. Since the start of the year, the bond stock held by non-residents decreased from US$20.2 billion to US$19 billion, but the currency and price-adjusted change (i.e., the actual size of bonds that had been sold) reached US$2.2 billion. On the equity side, the stock of shares held by non-residents increased from US$23 billion to US$29.4 billion but the price and currency-adjusted change was actually pointing an inflow of merely US$969 million.

Therefore, in the absence of non-resident inflows, almost all of the new issuance by the Turkish Treasury so far had been absorbed by local banks. While this served them quite well in posting strong net income so far this year, thanks to easing yields, it also suggests that - in the absence of a change in foreign investor behavior - one needs to consider the capacity of local banks to handle more issuance. Especially if the Turkish Treasury continues with a rollover ratio of 100% or more, then we should not expect any meaningful decline in interest rates. First, the banking system is still being funded by the central bank via the repo market, which is clearly a short-term solution to liquidity. Second, the average maturity of local deposits, which banks use as part of funding, is still averaging around four months. This clearly represents a maturity mismatch risk. Third, despite the declining policy rates and bond yields, the interest rates paid for local time deposits seemed to have stuck around 12%. Banks find it difficult to lower this rate due to the ongoing competition in the sector and because of the fear that lower rates might induce retail investors to switch out of TRY deposits to FX, i.e., currency substitution.

In conclusion, we expect the Turkish Treasury to borrow at pretty much the same pace in the absence of a funded program with the IMF, which would place continued pressure on local banks and hence the CBT. With lower carry and record low real interest rates, the risk/reward profile might not justify taking risk on the part of non-residents, and this would limit the potential for capital gains. In addition, despite our optimism that inflation will remain tame throughout the year, any pick-up in domestic demand, fiscal measures that raise indirect taxes and especially global energy prices pose upside risks.

Currency Is Supported by Short-Term Fundamentals and Positioning

The low current account deficit, unaccounted inflows (net errors and omissions) and the lack of non-resident positioning in the FX market had been supportive of the currency, especially since mid-March. As we do not anticipate any significant changes in the near term, we expect the low volatility to remain and the lira to stay relatively strong.

The sharp decline in local interest rates and the appreciation in the currency over the past three months led local retail investors to gradually build up FX deposits, which reached US$62 billion at end-May. This is associated with an US$8 billion rise while still being some US$10 billion short of the peak we had seen back in July 2008. At any rate, in case the volatility in the currency escalates and TRY goes through some depreciation, we would expect the local FX depositors to take advantage of the move and switch part of the positions that would support TRY once again. Compared to previous episodes, however, the attractiveness of TRY deposits are substantially lower and, as global interest rates gradually rise, this might result in a partial depreciation in TRY in 4Q09.

Japan
June Tankan Preview: Set to Reconfirm Recovery, Yet Sees Business Plans Lowered
June 19, 2009

By Takehiro Sato | Tokyo

Tankan Should Bring Hard Evidence That the Worst Is Over

We expect the headline to pick up fairly dramatically from the worst reading on record in the last survey. Meanwhile, for F3/10 capex we foresee sharp downward revisions by large enterprises for the first time since F3/03 for the June Tankan, resulting in a double-digit decline. Large companies are also set to lower their F3/10 recurring profit targets. Yet even then, corporate profit plans will likely remain more bullish than our guarded top-down forecast, leaving room for further downward revisions.

The market has already discounted a pick-up in the June Tankan headline, and we do not expect a fresh positive surprise. However, F3/10 management plans are bound to be revised down. We expect domestic demand to be hobbled by fixed-cost cutting and industry realignment by companies striving to survive, but this could provide a series of new equity stories for the Japanese market.

Our Forecasts for Business Conditions DIs

As the drop in production and exports leveled off along with normalization of trade financing and overseas inventory restocking, we expect the headline (business conditions DI for large manufacturers) to show a relatively sharp improvement from -58 in March (which fell below -57 in June 1975 during the first oil crisis) to -46. We look for the outlook DI to improve to -38 as well. Large non-manufacturing companies should also see improvement to -27 from -31 in March. In light of the pick-up in grass roots sentiment highlighted by the Economy Watchers Survey and Shoko Chukin Bank's Business Survey Index for Small and Medium-size Enterprises, we also expect the DIs for SMEs to improve in general. With the headline improvement, the June Tankan survey is set to reconfirm that the recession that started in November 2007 ended in February 2009.

However, given the recent move up in commodity and energy prices and intensifying downward pressure on prices for end products brought by the retreat in domestic demand, we expect the input and output prices DIs to show margin deterioration.

Measures related to the output gap such as the production capacity and employment DIs are also likely to highlight clearly an increase in idle production capacities. These would indicate that domestic demand will likely remain feeble, in contrast with the improvement in the business conditions DIs.

Our Forecasts for F3/10 Management Plan Revisions

1) Sales/profit targets: The rate of decline in recurring profits for F3/10 as projected by large companies in all industries in the March Tankan was a surprisingly limited 11.0%Y. We think, however, that few companies had settled solid business plans for F3/10 by the official deadline (March 10) and the data from the last survey are not very reliable, and the real corporate guidance following F3/09 earnings should be better reflected in the June Tankan. Yet, interim data for listed companies compiled in the Nikkei Shimbun (May 18) point to an outlook for recurring profits to fall only 8.1%Y, which still looks optimistic to us. Assumptions for the capacity utilization rate and sales behind profit plans could have been overestimated, and thus we could start to see downward revisions after 1H reporting as reality sinks in. There is still a wide gap between our top-down forecast for a 40% decline in profits and the bottom-up numbers, but we still think that ultimately the latter will converge with our top-down outlook.

This will also depend on corporate fixed-cost reduction efforts going forward, however. We think that companies are indeed making more aggressive efforts than we expected. Meanwhile, fixed-cost cutting initiatives could potentially lead to large-scale elimination of existing capital stock, and eventually industry realignment. Many manufacturers may record losses for two straight fiscal years starting in F3/09. However, with regard to corporate capital policies, it only seems natural for companies to make every effort to avoid consecutive losses. In fact, we now see many firms unveiling major restructuring plans with, or close to the announcement of, the new earnings guidance.

The above could lead not only to the restructuring of facilities, but also a full-blown reorganization of manufacturing industries. We foresee the initiation of such moves in areas including electronics, diversified chemicals and paper/pulp from the second half of F3/10. The government will likely promote such moves with financing/capitalizing schemes through the Development Bank of Japan.

2) Forecast for F3/10 capex plan revisions: At the time of the March Tankan release, capex plans were not very reliable, as a complete list of corporate plans was unavailable. June Tankan capex plans are far more reliable in sales and profit plans, as the figures are based on F3/10 company guidance. This time, assuming that the capacity utilization rate recovery will be slow, and that firms will decommission/scrap facilities that are not in operation, we expect downward revisions for the first time since F3/03 for the June survey, centering moreover on manufacturing. We anticipate that capex at large firms in all industries will show a double-digit decline of -10.3% (revision rate from the March survey: -6.1pp). Of this, we estimate a 20.8% drop for manufacturing (-12.1pp), and a 4.2% fall for non-manufacturing (-2.9pp). 

For reference, the Nikkei capex survey (June 8) indicates that large firms in all industries expect capex to fall sharply by 15.9%Y (-24.3% for manufacturing, and -4.5% for non-manufacturing). Although simple comparisons are muddled by coverage differences (this survey encompasses both domestic and overseas capex on a consolidated basis, while the BoJ Tankan covers only domestic capex on a parent basis), they clearly suggest a severe outlook for capex.

Policy Implications

The economy ended its nosedive in the Jan-Mar quarter; yet we think that the dollar weakness, higher long-term interest rates overseas and the issuance from July of large amounts of JGBs will again tend to overload monetary policy. The imminent risk of inflation is low due to the weakened financial intermediation function. And, in the case of Japan especially, the central bank has significant room for discretion. In March, the BoJ decided to increase JGB buying (Rimban) operations. We think the BoJ has room to expand buying operations, exceeding the so-called banknote ceiling, while maintaining credibility in the yen. Going forward, we expect to see fiscal and monetary policies becoming increasingly integrated in the form of increased JGB buying by the BoJ and reexamination of the cap on JGB holding (banknote ceiling). 

As a preliminary step, we could well see a further rate cut, depending on currency and stock market trends. Meanwhile, we expect the timing of a rate hike to be Oct-Dec 2010, for a slightly earlier exit than the consensus view. However, if the BoJ's price forecast materializes (F3/11: -1.0%), we think it would, in practice, be difficult to exit within F3/11.

On the fiscal front, we do not foresee any new progress ahead of the general election. However, additional economic stimulus programs are likely to be implemented towards year-end, regardless of the post-election political landscape, considering the upcoming Upper House election in summer 2010 (or simultaneous elections for both Upper and Lower Houses). In this case, we think that the risk of a double-dip in 1H of F3/11 would recede substantially.

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Global
Global Forecast Update: After the Deepest Recession, the Weakest Recovery
June 19, 2009

By Joachim Fels | London

Bottom-fishing: In our previous Global Forecast Snapshots two months ago, we argued that a bottom for the global economy was in sight.  Our global team's read of the data released since then suggests that the bottom now seems to be in place and has thus arrived a bit earlier than expected. Following three quarters of outright contraction - during which global GDP dropped by about 3% from its peak in 2Q08 to the (likely) trough in 1Q09 - we estimate that the global economy returned to positive, though very subdued, growth in the current quarter.  While we had still expected global economic activity to contract slightly in 2Q09 two months ago, we currently see global GDP tracking at a positive 2% seasonally adjusted annualised pace this quarter. Thus, the massive global policy stimulus applied in response to the credit crisis has successfully short-circuited the vertiginous downward spiral of global demand, output and trade witnessed during late 2008 and early 2009.  As we see it, the stimulus helped to spark the recovery in risky asset markets and vaporised deflation fears, thus supporting economic activity.  

Asia leads, the US and Europe lag: Remarkably, global GDP growth has turned positive even though the US and euro area economies, which together account for more than 40% of global GDP, are still sinking. We only expect these two laggards to start growing gradually later this year.  The turnaround in global activity almost entirely reflects a bounce in Asia in recent months, led by China and now becoming visible too in Japan, India and elsewhere in the region. Consequently, our local teams in Asia have upgraded their 2009/10 GDP forecasts for most countries over the past two months.  With commodity prices having risen on the back the rebound in Asia and ample global liquidity, our Latin American economists have also just revised up their forecasts significantly, especially for Brazil (see This Week in Latin America, June 16, 2009).  By contrast, our 2009 euro area GDP forecast has been downgraded again, reflecting the even-worse-than-expected outcome for 1Q and a bad start to 2Q.  Likewise, most of our recent revisions for 2009 GDP in Central and Eastern Europe have still been on the downside.

After the deepest recession, the weakest recovery: While global bottoming is now happening, we continue to believe that hopes for a V-shaped global recovery will be disappointed.  Consumers are likely to be cautious in the face of rising unemployment (labour markets lag), companies will hold back on capex in the face of high excess capacities, and construction activity is unlikely to rebound sharply with house prices still falling in many countries.  Thus, final demand growth is likely to be sluggish in the foreseeable future, despite the strong support from fiscal and monetary policies. In our baseline forecast, we see global GDP expanding at quarterly annualised rates of only 2-3% between now and the end of 2010, unusually low for early recovery phases.  This would take full-year 2010 GDP growth to 2.9% (from -1.6% this year), still well below the 4.7% average annual growth rate in the five years preceding the crisis.  Given the downdraft in activity over the last few quarters, our forecasts imply that it would take until the middle of 2010 for global GDP to return to its previous peak level reached in 2Q08.  In the G-10 advanced economies, which were hit harder than most EM economies by the credit crisis and which we expect to show a very anaemic recovery, only about half of the total GDP peak-to-trough loss of some 4.5% during the recession will have been recouped by the end of 2010.

Could we be wrong? Yes, easily, because of the unprecedented combination of a hugely negative shock to the financial system, whose effects are still lingering, and a massive monetary and fiscal response.  All available models are estimated using data on ‘normal' business cycles and policy reactions, and are thus of little help in gauging what lies ahead.  That's why we continue to emphasise the risks on both sides of our base case and regularly construct a bull and a bear case that should each have a ‘reasonable' outside chance (of about 20% each) of occurring.  In our bear case, we assume that policy finds very little further traction in the advanced economies in the remainder of this year, risky assets tumble again and EM recoveries falter as global risk-aversion returns. Global GDP would shrink by 3% this year (against -1.6% in our base case) and grow by only 1.4% next year (base case: 2.9%).  Conversely, in the bull case, policy finds strong traction, asset markets rally further and the financial sector recovers quickly, translating into a V-shaped recovery that produces close to 5% GDP growth in 2010.  

No early monetary policy reversal: With the economic recovery likely to be tepid, the financial sector remaining fragile and inflation expected to remain subdued, we expect the major central banks to keep rates at the currently abnormally low levels for the remainder of this year and, in most cases, well into next year.  On our baseline forecasts, the Bank of England and the Bank of Canada will be first out of the blocks, probably in 1Q10, followed by the ECB and the Swedish Riksbank in 2Q.  Our US team has pencilled in the first Fed rate hike for around the middle of next year, and our Japan team sees the Bank of Japan starting to tighten only towards the end of 2010.  As we have argued elsewhere (see "QExit", The Global Monetary Analyst, May 20, 2009), most central banks are likely to unwind quantitative easing very gradually and with simultaneous increases in official rates.  With much of the announced quantitative easing still to come over the next several months, and policy rates likely to remain at their very low levels until 2010, we believe that global excess liquidity is likely to rise further and remain plentiful for the foreseeable future.

For our complete forecasts, please see Global Forecast Snapshots, June 18, 2009.

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