China
China's Under-Consumption Over-Stated
September 15, 2009

By Qing Wang & Steven Zhang | Hong Kong

China's ‘Under-Consumption'

A popular notion among many market observers is that China over-invests and under-consumes. However, there seem to be two related but distinct concepts of ‘under-consumption' as far as China is concerned: domestic versus international dimensions. The domestic dimension of ‘under-consumption' is about the underperformance of household consumption relative to the rest of the economy: over the past decade or so, the growth of China's household consumption has been outpaced by fixed investment growth and exports and consumption as a percentage of GDP is low and has been on the decline.

The international dimension of China's ‘under-consumption' is that the contribution of the Chinese economy to the global economy as a consumer is much smaller than as a producer. More specifically, ‘over-consumption' has made the US an economy of US$10 trillion in personal consumption, while China is an economy of only US$1.6 trillion in personal consumption due to its ‘under-consumption'. If US consumers were to stop spending, the negative impact on the rest of the world would be too large for the Chinese consumers to play a meaningful offsetting role.

Underestimation of China's Consumption of Services

China's ‘under-consumption' - especially along the international dimension (i.e., relative to personal consumption in other countries) - has in part to do with underestimation of China's consumption of services, in our view. According to official statistics, the service sector (i.e., tertiary sector) accounted for 40% of China's GDP in 2008, and we estimate that consumption of services represents 26% of total personal consumption.

The consumption of services in China is substantially lower than that in not only industrialized countries but also China's peers among emerging market (EM) economies. For instance, while consumption of services in industrialized countries like the US, EU and Japan accounts for about 66%, 40% and 57% of their respective overall personal consumption, the shares of service consumption in total personal consumption in China's EM peers in the region such as India (39%), Korea (57%) and Taiwan (56%) are also significantly higher than that in China.

Actually, the underestimation of the importance of the service sector was more serious before the substantial upward revision of GDP in 2005 after the first nationwide economic census was completed. In the 2005 GDP revision, China's 2004 GDP level was revised up by 16.8%, and 93% of the increase was due to a substantial upward revision in the service sector such that the share of the service sector was lifted from about 32% to 41%. In explaining the revision, the National Bureau of Statistics noted that China had long been using the Material Product System (MPS), which was developed under the centrally planned economic system in its national accounts statistics until the 1980s, resulting in ‘very weak' statistics for the service sector. The second nationwide economic census is now underway, and the results will probably start to be released later this year and next year. The potential revision of the historical national accounts data will likely result in another significant upward revision of the share of the service sector in GDP, in our view.

A key source of underestimation of service consumption in China is the consumption of housing, in our view. Based on official statistics, we estimate that the consumption of housing accounts for only about 3% of personal consumption in China. This seems to us too low to be even close to the reality. As a comparison, consumption of housing represents about 16% of personal consumption expenditure in the US and 6.6% in India. We think that an important reason for the seemingly low housing consumption in China is that the imputed rent of owner-occupied housing is not appropriately accounted for. In other words, the statistical methods used in the US and China to estimate the consumption of housing are quite different. The fact that the house-ownership ratio in China is over 80% suggests that the potential underestimation in this regard could be quite substantial.

Another important source of underestimation of service consumption in China is personal spending on healthcare, in our view. While the share of spending on healthcare in the US is 15-16% of total PCE, this share in China is only about 6%. However, there is no shortage of anecdotal evidence suggesting that there are substantial gray and black markets in health spending in China - which are not captured by official statistics.

A Like-for-Like Comparison: A Top-Down Approach

The potentially substantial underestimation of the scale of China's service sector makes a cross-country comparison of the overall personal consumption between China and other countries - where the size of service sectors is more reliably estimated - misleading and thus could overstate China's ‘under-consumption', in our view. We therefore choose to make a more like-for-like comparison by examining personal consumption of the non-services, tradable goods sector, where such underestimation is less of an issue.

A comparison of consumption of non-services, tradable goods between the US and China indicates that the gap between the US and China is much smaller than suggested by the headline overall consumption data. In 2008, the personal consumption of non-services, tradable goods in the US and China was US$3.2 trillion and US$1.2 trillion, respectively, or China's figure was about 38% of the US level. This is more than double the ratio of 16% as suggested by the two countries' data for overall personal consumption (i.e., US$10 trillion in US and US$1.6 trillion in China).

Whether excluding the service sector or not makes a big difference in estimating the importance of personal consumption in China relative to the US, which reflects underestimation of the service sector in China. It is also the case that the US spending basket is more tilted to services than goods as the economy is more affluent and mature, and consumers choose to purchase services that are still being performed by Chinese consumers themselves today (e.g., restaurants or take-out meals).

That said, tradable goods should be much more relevant when it comes to assessing the impact of an economy on the rest of the world because they are the primary vehicles through which real economic linkage between economies materializes. In this context, it is worth noting that the negative impact of the recession in US personal consumption has been felt by the rest of the world in the form of a sharp contraction in US consumption of tradable goods instead of services. Specifically, in the first seven months of 2009, while nominal personal consumption expenditure (PCE) on goods in the US declined by 2.6%Y, the PCE on services increased by 1.1%Y.

A Like-for-Like Comparison: A Bottom-Up Approach

A like-for-like comparison of specific categories of goods and services consumed by households in both countries can also shed light on the magnitude of China's personal consumption relative to that in the US.

First, with respect to goods, we identify three types of useful candidates for like-for-like comparison - autos, beer and milk-drink products - with the former representing big-ticket consumer durables and the latter two consumer staples. In 2008, motor vehicle sales in China reached 9.4 million units, or 69% of the level in the US. In view of the continued rapid increase in auto sales in China while those in the US declined so far this year, the annualized units of vehicles sold in the first seven months in China already reached 12.3 million, exceeding those in the US for the first time in history.

Beer and milk-drink products are popular drinks in both countries and their quality is relatively homogenous and generic compared with many other categories of consumer staples, making them suitable like-for-like comparisons. In 2008, the amount of beer and milk-drink products consumed by Chinese households amounted to 38.8 million litres and 13 million tonnes, respectively, which are 158% and 59% of those consumed by their US counterparts, respectively.

It should be noted that the comparison of auto sales, beer and milk-drink products is based on volume. The structural undervaluation of the renminbi means that the underlying US dollar value is lower for Chinese sales than US sales. However, a car requires the same amount of steel or copper and a bottle of beer requires the same amount of barley and wheat wherever they are made; hence, the impact of China's consumption growth is very visible in the international markets for these products.

Second, making like-for-like comparisons for services consumption is a challenge, and we have to make some ‘thinking-out-of-the box' yet reasonable assumptions. To scale Chinese household consumption of services to that of the US, we compare revenues in two key sectors - financials and telecoms. In both countries, these industries derive the majority of their revenues from their domestic operations, and in both cases the majority of participants are quoted in the stock market. In China's case, this happened through sequential IPOs with the telecom names coming to the market earlier than the banks and insurers; hence, similar financial information for both industries is gathered by the vendor, MSCI, for both the US and China on a like-for-like basis. Recent data indicate that the size of these two markets in China already in value terms is considerable relative to that in the US: in 2008 the revenues of the listed telecoms sector in China amounted to 38% of that in the US, while that of listed financials totaled 23% of that in the US.

Note that, while data exist for other domestically oriented sectors such as consumer staples and consumer discretionary, a like-for-like comparison is not appropriate, in our view, for the following reasons: a) many of the participants in China are not included in the MSCI data set; and b) several of the key players in the US-equivalent sectors are global entities (e.g., Procter and Gamble, Coca-Cola).

Third, we use residential electricity power usage as a proxy for consumption of a mix of goods and services by households. In 2008, the total residential electricity power usage in China amounted to 408 billion Kwh, which is about 30% of that in the US.

While this like-for-like comparison under both top-down and bottom-up approaches is by no means a rigorous analysis, it seems to us that the broad message from this exercise is quite clear: the official data for headline aggregate consumption substantially underestimate the scale of China's personal consumption relative to that of the US, which is highlighted by consumption of tradable goods.

China's Incremental Dominance

As we have demonstrated, the absolute level of personal consumption in China is not nearly as low - compared to that in the US - as perceived by many market participants. Moreover, while the domestic dimension of China's under-consumption - namely consumption growth having lagged investment and export growth in China - is a valid observation, the absolute level of growth of China's personal consumption is remarkably strong in a global context. The incremental contribution of Chinese consumers in USD terms to the global consumption of tradable goods started to exceed that of the US in 2007.

In the aftermath of the ‘Great Recession' in 2008-09, the Chinese economy is expected to continue to expand at a considerably faster clip than the US over the next decade. For Chinese authorities, promoting domestic consumption is a policy priority. To this end, a multi-pronged approach is being pursued, including boosting domestic consumption directly through improvement of consumption-facilitating infrastructure and promoting non-mortgage consumer financing in the near term, expanding and strengthening the social safety net and other public services over the medium term, and rebalancing the economy and raising the share of household income in national income over the long run.

As progress is made in implementing these consumption- oriented polices, we expect that consumption growth will catch up with investment and export growth, and is likely to be initially in line with and subsequently outpace overall economic growth over the medium and long run. Going forward, the incremental contribution of Chinese consumers to global consumption demand will probably begin to consistently exceed that for US consumers even in terms of overall consumption.

Implications

The thesis laid out in the book, The Rise of the Chinese Consumer, by Jonathan Garner et al., John Wiley & Sons, 2005, remains valid in this post ‘Great Recession' era, in our view. The influence of Chinese consumers on the rest of the world is already considerable and expected to become even greater on both marginal and average bases.

This point can be further illustrated by a simple exercise of comparing the growth outlook for China and the US over the next decade. Assume that over the next decade (2011-20), average nominal GDP growth per annum is 5.0% (i.e., 3% real GDP growth and 2% GDP deflator) in the US and 11% in China (i.e., 7.5% real GDP growth and 3.5% GDP deflator) and the renminbi is to appreciate against the USD by 3.5% per year on average. And assume personal consumption in both countries expands in line with their respective overall GDP growth rates, as the biases for ‘over-consumption' in US - which seems already underway - and ‘under-consumption' in China are corrected. Under this scenario, China's nominal personal consumption - of both goods and services - will outpace that of the US by 9.5 percentage points per annum in USD terms. This implies that China's incremental contribution to global consumption of both tradable goods and services will exceed that of the US by 2018, and China's total personal consumption will have reached US$5.8 trillion (in 2008 USD) per annum by then, representing about 40% of US consumption spending compared with only 16% in 2008.

Since in this exercise, we intentionally make rather conservative assumptions concerning real growth rates, inflation, (modest) renminbi appreciation, and the (constant instead of rising) share of consumption in GDP for China, the dominance of Chinese consumers over those in the US in terms of contribution to global demand could be achieved well ahead of 2018, in our view.

The implications for global consumer product companies and China's home-grown franchise names are profound, in our view. Specifically, if a global consumer products company operating in China has business that is performing in line with that of the market as a whole, it should be able to deliver top-line sales growth of 14%Y compounded on a sustained basis. For China's local franchise companies, which have demonstrated a track record of substantially outperforming the market and consistently expanding their market shares, their potential growth could be much higher, emulating the early success of the current US-based global franchise names (e.g., Coca-Cola, Nike) in their original effort to establish their dominance in a huge home market.

Moreover, against the backdrop of rapid expansion in aggregate consumption, the potentially profound impact of China's demographic trends (e.g., one-child policy, population aging) on consumption spending as well as changes in a social (e.g., urbanization, income disparity) and cultural context suggest that companies that are well positioned to ride the trends shaped by these structural changes will be best placed to benefit from the rise of the Chinese consumer.

In a companion research note, Jerry Lou, Morgan Stanley's China Equity Strategist, reiterates his thesis that the franchise stocks are the best way to profit from China's consumer theme over the long term (see China Strategy: More Jewels in the Crown: Adding More Stocks to Our China Franchise Basket, September 14, 2009).

We acknowledge Jonathan Garner's contributions to this report.

Important Disclosure Information at the end of this Forum

Japan
Revising Outlook Under New Government: Lowering F3/10, Raising F3/11 on Policy Lag
September 15, 2009

By Takehiro Sato & Takeshi Yamaguchi | Tokyo

Our General View of Overseas Economies Is Intact, but the Change of Government Will Affect Japan's Economy

We have changed our GDP forecast following the release of revised data for Apr-Jun (annualized growth revised from +3.7% to +2.3%). What's changed is that the handover of political power in Japan switches the economic policy emphasis away from corporations and towards consumers, causing a change in expenditure patterns that lowers the growth rate in F3/10, but raises that in F3/11. Naturally, there is much uncertainty about expenditure at this point, as the new administration is not yet formally underway, so we have based our economic outlook on assumptions drawn from the Democratic Party of Japan's (DPJ) campaign manifesto and policy statements by senior party figures before and after the election. Our main assumptions are 1) JPY1.5 trillion of the public works and other spending in the F3/10 supplementary budget will be frozen; 2) the funds made available will be diverted to pay for JPY2.7 trillion in child allowances from F3/11; 3) income tax increases via ending or reducing spouse and dependent exemptions will be postponed until F3/12 or beyond; and 4) the provisional gasoline tax surcharge will be scrapped from F3/11.

We have also extended the range of our forecast to cover F3/12, in line with our global teams. We think F3/12 will see broader application of income support, but also effective tax hikes due to extension of the income and corporate tax bases, leaving a net stimulus effect for the economy comparable to F3/11. This means zero incremental stimulus that year, and the prospect of economic growth remaining listless at a similar level to F3/11. As a result, we expect Japan's economy to trail the overseas economies.

DPJ's Basic Fiscal Policy and Impact on Japan's Economy

1) Public works freeze (F3/10): One likely near-term consequence of the change in administration is a freeze on spending supplementary budget funds. Senior DPJ figures have said that they intend to cut off funding totaling JPY4.3 trillion for 46 programs and some public works projects. In this event, the amount of unspent supplementary budget funds is critical, but since there are no real-time data for budget spending that include local governments, we have to make some important assumptions. Funding of the various government programs does little to boost near-term GDP, so would have a negligible impact on F3/10 growth even if frozen, but a public works freeze would directly reduce GDP, and so we lower our F3/10 forecast to reflect changes in public capital expenditure. The reduction is JPY1.5 trillion (0.3% of nominal GDP), and corresponds to about 60% of public works spending in the first supplementary budget. The impact would come mainly in the Oct-Dec 2009 and Jan-Mar 2010 quarters, which is when the effects of the supplementary spending would be most prominent. Therefore, the drop-back in the Apr-Jun and Jul-Sep quarters of 2010 becomes smaller than in our original forecast. The resultant impact on real GDP comes to -0.1pp in F3/10.

2) Provision of child allowances (F3/11) and income tax hikes (from F3/12): The DPJ's manifesto calls for child allowances of JPY2.7 trillion in F3/11 and JPY5.5 trillion every year from F3/12. This is a massive undertaking, as JPY5.5 trillion is more than 1% of nominal GDP and larger than the entire defense budget, but we have assumed that the funding in F3/11 would come mainly from the funds saved by freezing the supplementary budget from F3/10 (JPY1.5 trillion from public works and JPY1.2 trillion from other programs). This is because the DPJ's leadership has ruled out income tax increases in F3/11, implying that the hike from scrapping or reduction of tax exemptions for spouses and dependents will be delayed at least until after the upper house elections into F3/12. In this circumstance, the economic effects would be to push up GDP by 0.3% in F3/11, but by only 0.1% in F3/12, because the DPJ has said that it will raise JPY2.7 trillion in extra taxes in F3/12 by reviewing the special tax measures as well as income taxes. In other words, the net income transfer to the household sector excluding tax hikes will be virtually flat from F3/12 onwards, such that even if the full program for child allowances is implemented, the incremental lift to GDP in F3/12 will be limited. In the longer term, child allowances alongside the dropping of all charges for public school education could also do something to turn around Japan's total fertility rate (TFR). Something like this happened in France, where child allowance reforms in the early 1990s helped to push up the TFR for 2008 to 2.0-ish. However, achieving this goal would require detailed consideration of policy implications when providing incentives to increase the birth rate, such as eliminating waiting lists for nursery schools, in which social policy would play a key role.

3) Abolition of provisional gasoline tax surcharge (from F3/11): The DPJ's manifesto states clearly that the surcharge will be abolished. The basic structure of the pro tem tax rate is simply JPY25.1 per liter of gas. We have already seen the surcharge suspended for a time, amid wrangling between the upper and lower houses in April 2008, so it is easy to estimate the price impact. Doing away with this would depress the rate of core CPI (Japan-style core) year-on-year inflation by 0.5pp and depress the corporate goods price index by 0.4pp. However, the year-on-year impact would only come in F3/11. This would not affect the FY-based CPI outlook for F3/10, while lowering F3/11 by 0.5pp. The F3/12 CPI outlook would be unchanged.

Path of the Economy Based on Re-Oriented Fiscal Policy Under the New Government

Japan and Asia entered recovery in Apr-Jun 2009, earlier than the US, and restocking seems to be driving a relatively powerful rebound in Japanese manufacturing in Jul-Sep too (industrial production set for quarter-on-quarter growth of about 8% in Jul-Sep, after 8.3% growth in Apr-Jun). The US economy has been one quarter behind, but appears to have bottomed in Apr-Jun and to be tracing a V-shaped recovery in Jul-Sep, thanks to restocking, backed by the effect of the expanded stimulus program on auto purchasing.  Domestically, restocking pressure will subside in Oct-Dec, but we expect auto production to remain solid in the US even after policy-linked demand has played out (auto output rising about 3.0%Q in Oct-Dec, as estimated by our US economics team), leaving residual benefit for Japan's export sector from policy demand in the US. China's economy should also likely do well, thanks to policy traction, and our China economist, Qing Wang, in July raised his forecast by a full 2pp to 9% growth in 2009 and 10% in 2010.

Domestically, on the other hand, a spate of factors holds back the recovery momentum in the near term. On the fiscal side, changes in spending patterns discussed earlier are expected to cause public investment to slow sharply from Oct-Dec, crimping overall economic performance.

Headwinds for employment and incomes are also set to continue. In manufacturing, the downshift in the global economic outlook since the Lehman shock has left surplus capacity, making cuts here, and industry realignment already central themes. With capacity utilization at historically low levels, reducing surplus capacity and regular employee headcount may go even further. In the household sector too, a negative impact on consumption sentiment from wage pressure is inevitable, despite income transfers via fiscal stimulus such as cash handouts, subsidies for trading in cars for greener vehicles, and the eco-point system.

Signs of downward pressure from Oct-Dec are already showing up in economic indicators. The current conditions DI in the August Economy Watchers Survey turned negative month on month. Since this leads the direction of the economy by about three months, it suggests a leveling-off from Oct-Dec. In the same vein, we expect Oct-Dec and Jan-Mar to see domestic demand stall, as public-sector demand especially for public works fades, and overseas demand will also reach a temporary plateau with production plans not yet in a position to kick on powerfully. It will probably not be until 2H of F3/11 before renewed growth in overseas demand rubs off on the domestic economy, in our view. Asian economies will likely be moving fully into an upcycle from 2H F3/11, heading towards the peak of the political cycle in 2012. Note that there are numerous key political events coming up in that year, headed by the Chinese communist party conference in July and the US presidential and mid-term elections in November, giving countries an incentive to reflate their own economies.

Risks

We stress relatively more downside risk in our revised outlook above compared with our previous outlook on August 17.

The upside risk in our updated outlook is that overseas economies perform solidly as a result of fiscal stimulus in various nations, preventing Japan from an economic soft-patch, and meaning that any dip in F3/11 be scarcely noticeable. The economic impact of the US fiscal stimulus is, in fact, weighted overwhelmingly towards 2010 rather than 2009, with an eye on the mid-term elections next year. China's economy too is expected to come close to overheating as a result of the stimulus measures. Feedback from the accommodative monetary conditions in Japan and overseas and more buoyant asset markets could give further support in this direction.  Like Japan in 1999, asset markets globally are finding support from 1) stabilization in the financial system via infusions of public capital; 2) massive fiscal stimulus; and 3) provision of an accommodative monetary environment via significant monetary easing and expansion of the credit guarantee program.  On the monetary policy front, we expect accommodative conditions to persist, with leading central banks not searching an exit strategy until mid-2010. 

Meanwhile, the downside risk is that tougher restrictions on equity capital currently under consideration for financial institutions and other measures restrict assets, thereby curbing overall demand. These stiffer restrictions on equity capital could well be the de facto standard prior to becoming official rule, though we have yet to see the complete views of leaders at the G-20 Summit. It has already been pointed out from various quarters that such a case could have far-reaching implications for Japanese megabanks, which have on average around 4% Tier 1 ordinary share/retained earnings levels.

Reflecting our outlook for prolonged deflation, we continue to expect the interest rate policy to be eased slightly in Oct-Dec 2009, as the policy rate level is revised to a band of 0-0.10% (0.05% midpoint). At such time, we expect the system of paying interest on reserves deposits to be maintained, with the rate set at 0.05% after the transition to a policy rate band. Although the above is not discounted by the consensus whatsoever, a reintroduction of policy duration commitment is the most likely option in the midst of deflation. In effect, we think that the BoJ may recommit to sustaining the present accommodative measures until the core CPI turns stably positive in year-on-year terms.

Though it is a fact that the stock market rally since March and improvement in the actual economy have hurt the chances of further monetary easing, the dollar is weakening of late in the FX markets. Our global currency research team forecasts the yen appreciating to JPY85/USD by end-2009, as FX trends could well provide a catalyst for further action. 

Unconventional policy measures could include the scope of JGB purchases being extended, as some DPJ members have stated. In such a case, the ‘banknote rule' setting a ceiling on the BoJ's long-term JGB holdings would likely be revised concurrently.  Practically speaking, it would be effective to revise the definition of medium/long-term JGB holdings and deduct those with less than one year left to maturity from the bank's balance. Even so, such a policy response is probably limited to instances in which event risks emerge, such as a sudden surge in long-term interest rates. 

Long-term yields have been stable at around 1.3% even after the massive bond issuance for the F3/10 supplementary budget; and with bank lending growth ahead expected to stall and supply/demand remaining favorable due to a downsized F3/11 budget, we expect the 10-year yield to fall to 1.15% at the end of F3/10. In looking for another surge above 1.4% in Apr-Jun 2010, we are factoring in seasonal anomalies rather than anything of profound significance. Even after domestic and overseas economies recover from 2H F3/11, we expect the 10-year yield to be stable at around the mid-1% level, as cash flow dynamics will make it difficult for risk premiums to materialize, given Japan's persistent deflationary environment.

Our anticipated timing for a policy exit is the Jan-Mar 2011 quarter. Absent any retreat in deflationary conditions during this time, our timing above remains sooner than the market consensus (F3/12 onward). However, once functionality of the financial markets is normalizing, we believe that the central bank will instinctively normalize the policy rate earlier than what the market anticipates. The timing of the policy exit by overseas central banks will be an important factor, too. Our US economics team is pegging a policy exit from Jul-Sep 2010. Once the overseas central banks have moved to raise rates, we do not imagine that the BoJ will stick to its course alone for very long. Yet, with deflationary conditions expected to linger into F3/12 or beyond, we do not anticipate further tightening, with the BoJ bent on raising the policy rate up to 0.25% during the forecast period.

Note that the BoJ's price outlook (F3/11: -1.0%) has been conspicuously more conservative than the market's view to this point, and in the upcoming end-October Outlook Report, the BoJ may issue an exceptionally cautious outlook on prices (i.e., negative growth), expecting continued negative feedback to prices with the output gap at around -7% currently.

Robust Macro Balance Is Japan's Strength

When it becomes tough to fund government debt internally, long-term interest rates tend to include a fiscal premium because overseas investors demand a risk premium. In Japan's case, however, there is still a buffer of more than JPY200 trillion when comparing net government debt with the private sector investment/savings gap (stock basis). Government debt can thus be entirely funded domestically.

In response to the ballooning fiscal deficit, the government has postponed its target for equilibrium in the primary balance in 2011 by up to ten years. Depending on nominal growth rates and government funding costs, the government debt ratio may continue to rise during this period. However, thanks to the buffer above, the increase in government debt can basically be financed domestically via changes in the asset structure of the public and private sectors. This robust macro balance means that we do not need to worry about a surge of government debt due to soaring long-term interest rates (a debt spiral). Maintaining an accommodative monetary environment should be supportive for the economy and asset markets in general.

Important Disclosure Information at the end of this Forum

Israel
Economy Turns the Corner
September 15, 2009

By Tevfik Aksoy | London

A trip to Israel: On September 7-8, we visited Jerusalem and Tel Aviv to hold meetings with senior officials at the Bank of Israel and Ministry of Finance and private sector banking representatives as well as economists. In general, we witnessed a rather upbeat picture with a broad-based consensus that the recession had been shallow and short. Indeed, compared to the only recession in the country witnessed in the past decade, when real GDP shrank for four consecutive quarters with an average rate of 4% in 2001, the recent episode has been visibly mild.

Timely and decisive policy response: The consensus view that emerged out of the meetings, with which we strongly concur, is that the lack of toxic assets on Israeli banks' balance sheets, the absence of a residential/commercial real estate bubble and the mortgage loans being backed up by large equity/collateral basis kept the global contagion at minimal levels. Moreover, as we had mentioned in the past, the rather short recession had been a combined result of the timely policy response from the BoI and the fiscal policy response by the government. The BoI had cut the policy rate to a historical low of 0.5% and the easing commenced earlier than most developed and emerging economies. This had been supplemented with the non-conventional measures (i.e., quantitative easing) such as daily purchases of government bonds and foreign currency. Starting March 2008, the BoI purchased a total of roughly US$30 billion such that FX reserves reached unprecedented levels. Similarly, a sizeable amount of bond purchases of some NIS 18 billion provided ample liquidity into the market. In terms of whether the bond purchases have had any direct impact on the market, the assessments in Jerusalem and in Tel Aviv played different chords. While some thought that the overall positive impact on the yield curve might have been as much as 30-40bp, some thought it had been neutral. An interesting view was that the BoI's bond purchases might even have caused a weakening in the bond market because of the belief that the presence of a major buyer might have drawn sellers who would have stayed sidelined otherwise.

Unconventional measures stopped but interventions still continue: As the signs of recovery had begun to emerge and the inflation rate exceeded the target band of 1-3% (currently at 3.5%Y), the BoI stopped the alternative monetary easing efforts of daily bond purchases on July 27 and the FX purchases on August 10. That said, the BoI also announced a new strategy of FX intervention that would be implemented in the case of "substantial fluctuations" in the exchange rate. While there had been no major volatility in the currency during August, the appreciation pressures led the BoI to intervene heavily such that FX reserves rose by US$4 billion in August alone. In comparison to the monthly rise of US$2 billion on average, the figure seemed quite noteworthy, in our view. The initial signs so far in September suggest no reversal in the trend.

Surprise hike by the BoI: On August 24, the BoI decided to raise the policy rate by 25bp to 0.75% and became the first central bank both in the EM and non-EM universe to tighten. Following the move, the central bank's real GDP growth forecasts had been revised higher from -1.5%Y for 2009 to 0%Y and to 2.5%Y from 1%Y for 2010. According to BoI officials, the reasons behind the improvement in the forecasts stemmed from recent data showing improvement on the domestic side, but also the noticeable upward revisions in the growth of world trade volumes and country-specific forecasts.

Recent signs point to continued improvement: The state-of-the-economy index (S-index), which had been quite useful in predicting the coincident quarterly GDP growth, continued its ascent in July. In fact, the seasonally adjusted monthly rise in the S-index reached 1.2%, which looked quite a strong change. Fiscal data, especially tax revenues (even when accounting for the one-off measures) have been showing signs of revival as well. Also, our discussion with the authorities and market participants suggested that the real estate sector had also been enjoying a noticeable rise in property prices - another reflection that the economy has turned the corner, in our view.

Revising our real GDP growth forecasts: In light of the recent data and our discussions in Israel as well as the general impression we received during our trip, we are upgrading our forecasts. At the start of the year, we expected real GDP growth to be 0%Y in 2009, which we kept unchanged for a substantial period, but over the summer months we lowered it to -0.8%Y. Following the 2Q GDP data, the coincident indicators and the overall improvement in the global outlook, we now expect GDP growth to post a marginal increase of 0.2%Y. We also raise our forecast for 2010 from 2.1%Y to 2.7%Y.

Unemployment is likely to remain high until 2011: There is no question that employment had received a significant hit during the recession, even though it had been short and shallow. With the 1.7% annual population growth rate, the output gap at hand and the expected sub-trend growth in 2010, the unemployment issue is likely to see no improvement. In fact, there is a considerable chance that it might rise slightly to 8.2% in 2010 from our expectation of 8% this year before dropping gradually in 2011.

Fiscal ceilings likely to be undershot: The government managed to adopt a biennial budget in July 2009 and up to that date the previous year's budget had been taken as a reference for the spending limits. The fact that 1H09 had been without a proper budget might have been a blessing in disguise: The deterioration in the fiscal picture that had been lingering since late 2008 seemed to have slowed down and in fact improved; it could have worsened if the spending limits remained unclear.

In 2009, expenditure is projected to rise by 3% in real terms, followed by 1.7% in 2010. The expected gap associated with the additional spending limit for this year will be partially closed by the recent measures, involving a 1pp increase in the VAT, rises in other indirect taxes such as on alcohol and cigarettes as well as the green tax imposed on car purchases. Essentially, these measures are expected to fill the extra gap of NIS 6 billion estimated to have associated with the additional spending adopted by the government.

During 1H09, the average monthly budget deficit was around NIS 3 billion. In July, the monthly surplus of NIS 0.5 billion came as a positive surprise and the August deficit of NIS 2 billion added to the optimism that the government might actually be determined to avoid excessive fiscal expansion. After all, monthly expenditures in August declined noticeably and, if the trend is kept intact, we would not be surprised at all to see a better-than-expected deficit at year-end. In fact, we project the year-end fiscal deficit for 2009 at 5.2% of GDP as opposed to the 6% ceiling. While the officials in Jerusalem refrained from making numerical guesses, our impression was that they expected the fiscal outcome to be noticeably better. Among the market players, deficit forecasts seemed to have ranged between 4.8% and 5.5% of GDP.

We see a comfortable picture in terms of debt issuance: Our meetings with the Ministry of Finance officials gave a clear indication that we were facing a comfortable picture in terms of issuance:

First, nearly 75% of the full-year financing requirement had been completed, which leaves fairly light pressure in terms of borrowing for the rest of the year. Second, the bond switch auctions that reached some NIS 12 billion did help to smooth out the redemption pattern and lowered the cash exchange requirement in the market to a significant degree. The high redemption amount due January 2010, which stands at around NIS 12 billion, had already been reduced to NIS 11 billion, and our understanding was that the Ministry of Finance officials were open to the idea to continue this as long as the appetite in the market remained intact. Third, the external issuance went smoothly in March when Israel issued US$1.5 billion of bonds, facing a total demand of US$12 billion. Our impression was that the officials would be open to the idea of more issuance as long as they saw value (in costs) in pursuing it. Fourth, the officials stressed that the US-guaranteed funds of some US$3.8 billion had not been tapped even during the peak of the global financial distress.

Expect business as usual in terms of issuance patterns: Our take from Jerusalem was that the issuance picture will look smooth in the months ahead and, especially if government spending in December remains somewhat limited, the debt management process will be quite straightforward, removing any pressure from the market. We do not expect the Ministry of Finance to make any changes either in the style or in the composition of borrowing (i.e., nominal bonds versus CPI-linked) in the near future.

Debt to GDP to remain high and plans to lower it to 60% are likely to be delayed for another five years: Our impression from the trip was that the target to lower the debt to GDP ratio to 60% by 2015 will face a delay. We project the end-2009 figure at around 84%. At this juncture, 2020 might be a more realistic target to achieve the 60% target as debt to GDP is expected to rise further in 2010 and only decline gradually starting in 2011. As country examples demonstrate, the most sustainable way to achieve a stable growth rate hinges on a strong fiscal policy and lower debt to GDP, which improves the perception of future risks. That is, a tight fiscal policy can be expansionary. In that sense, any improvement on the fiscal front is likely to be rewarded noticeably by the market, in our view.

Fight with inflation in progress: During the peak of the recession, the perception had been that the path towards the 1-3% target band seemed straightforward, with the lack of domestic and external demand pressures, rising output gap and lower pass-through from the currency. Indeed, 12-month forward-looking inflation expectations declined sharply for most of 2008 and early 2009 before reversing course in 2Q09. This was mostly due to the fact that the housing component of the index, which takes a 21% weight in the index, has remained high since 3Q08.

As of July, CPI inflation stood at 3.5% and outside the target band. Our projections point to some improvement in numbers in the next three months, but again a rise starting in November owing mostly to the strong base-year effects.

Shortage of housing supply? The annual inflation in the housing sector reached a peak of 17%Y in June before easing partially to 15% in July. Taking base year effects into consideration and the possibility of some further appreciation in the shekel, we expect the annual rate to drop gradually; however, the low level of housing starts and the decline in inventories from 12 months' supply to 6-7 months suggest that prices might remain sticky for some time.

An interesting point made during our meetings in Tel Aviv was that the foreign buyers of apartments and houses in the country are believed not to be renting the places out. This, according to some, is fuelling further hikes in rental rates as the supply of housing is de facto being lowered. We are not sure if the impact might be as significant, but clearly it is a good candidate to be one of the inflationary factors.

Rise in indirect taxes and the water price surcharge: Transitory or permanent? As part of the measures to contain the fiscal deficit, the government introduced a 1pp hike in VAT to 16.5%, a rise in cigarette and alcohol tax and a surcharge in water usage costs at the end of 2Q. The overall contribution of these measures on the CPI is estimated to bring a 1.5pp rise in inflation.

According to the BoI, the rate of inflation stripped from the recent tax-related hikes is still close to the outer limit of the target band, which suggests that as of July only 0.5pp of the expected cumulative impact had materialized. We believe that once the temporary effects of the tax hikes fade out, inflation will return inside the target band, especially as the BoI had already commenced the tightening cycle.

Where had the FX pass-through gone? Another interesting point regarding inflation in Israel is that the FX pass-through had been on the decline as part of the ongoing change in the share of rental contracts that are FX-linked. Compared to the high share around 80% in the past, currently some 15% of the apartment rentals are based on FX-linked contracts, and this clearly helps to lower the FX pass-through. While this came in handy during the depreciation phase of the currency, it might bring little support to inflation in the future when the currency starts to appreciate.

Revising inflation forecasts: In light of the recent data on inflation as well as the impact of fiscal/monetary policy mix, we revise our inflation forecasts slightly higher for 2009 and lower them for 2010. We now expect year-end CPI inflation at 3.7%Y in 2009 and 2.2% in 2010.

Monetary policy tightening ahead: The BoI had been the first central bank both in the EM and non-EM universe to start the tightening cycle on August 24. By hiking the policy rate by 25bp, the central bank stressed two key issues, in our view. First, the inflation-targeting regime was intact and second, the economy has started to recover. At 75bp, the policy rate is clearly expansionary as the ex ante real interest rate stands at around -1.5%. Amid rising pressure on the currency to appreciate and the ongoing FX interventions, the BoI is clearly facing a challenging task of lowering inflation by raising the policy rate. However, our meetings with the officials confirmed our view that the BoI will be ready to hike as it sees fit in order to bring inflation back into the price stability range. While the timing of the next move remains difficult to predict, we believe that as long as the growth indicators continue to improve and inflation does not surprise on the downside, there will be at least one more hike in the coming months. The BoI might also opt to raise a further 25bp at year-end (effective January), which would bring the policy rate to 1.25%.

Looking into 2010, our scenario is built on the premise that the central bank might bring the real policy rate to around 0% by mid-2010 and slightly higher towards end-2010. Meanwhile, as we expect the tightening by the US Fed to arrive in 3Q10, this strategy might in fact limit the widening of the rate spread differential and hence the pressure on the shekel.

Shekel is facing appreciation pressures: With a current account surplus expected to reach 3.6% of GDP in 2009, the economy being out of recession and a higher-than-desired inflation rate as well as an ample level of FX reserves, the currency has been facing appreciation pressures. This had been partially avoided by the daily FX purchases by the BoI until early August and since then through direct interventions. Since the halting of the daily purchases on August 10, we estimate that the total size of the interventions might have exceeded US$5-6 billion.

Monetary tightening and FX interventions - a losing battle: The cost of defending the currency from appreciating amid monetary tightening is clearly associated with substantial costs and economically impossible to maintain for a long time.  This is especially true when the appreciation in the currency is based on fundamentals and not due to market speculation. Currently, the BoI seems to be ready to continue with the interventions, but the sterilization costs, which reflect on the fiscal budget through the issuance of short-term bills (Makam), might start becoming more pronounced. Moreover, if EURUSD continues along the current trend, the BoI's holdings will erode further, leading to a larger deficit than the BoI already is bearing. That said, we believe that the BoI must be actively managing reserves and rebalancing them so that the accumulated FX via interventions are not 100% USD.

We expect, at some point, for the BoI to ease on the defense of the shekel and let the currency appreciate in line with fundamentals and market flows. As one market participant suggested during our visit to Tel Aviv, the defense of the exporters should not solely be the BoI's responsibility, but perhaps the government might take certain actions to extend support. These actions might include, and not be limited to, some loan guarantees extended to exporters for them to provide vendor financing to importers abroad and tax incentives, etc. In fact, Finance Minister Yuval Steinitz recently mentioned that the government needed to do more for exporters rather than having the BoI facing the whole burden.

Important Disclosure Information at the end of this Forum

Poland
Budget Blues
September 15, 2009

By Pasquale M Diana & Alina Slyusarchuk | London

Fiscal concerns took center stage again this week: Last weekend, Finance Minister Rostowski said that the central government budget deficit would widen next year to an estimated PLN 52.2 billion (3.8% of GDP), sharply higher than this year's PLN 27.2 billion target (revised this week to PLN 22.5 billion). The numbers were confirmed in the draft budget presented this week. The Polish authorities no longer take issue with the European Commission general government deficit forecasts (6.6% of GDP in 2009 and 7.3% in 2010), but they do plan to keep overall public debt below 55% in 2010, given that the Polish fiscal rules stipulate that crossing this level would require draconian budget cuts. To that end, the authorities have set a very ambitious privatization target of PLN 28.5 billion (2% of GDP), up sharply from this year's PLN 12 billion target, of which not even one-third has been completed (PLN 3.9 billion). The budget has to be sent to the lower house by end-September.

Less deterioration than meets the eye, but where does it stop? We think there is far less to this deterioration than the headline numbers suggest. The significant jump in the assumption on the central government deficit (from 1.7% to 3.8% of GDP) is primarily due to a reclassification of some items from off-budget to on-budget. Indeed, the overall government deficit should deteriorate by around just 1% of GDP. And of course, fiscal deterioration is not confined to Poland: most EU countries are experiencing severe worsening of their fiscal position, mostly as a result of the cycle. While it is encouraging that the government faces up to reality (as recently as July the Fin Min was expecting the ESA-95 deficit to be around 5% this year), we note that there is no real adjustment path ahead: essentially the authorities are simply letting the cycle drive the fiscal position.

Conservative growth assumptions may hide a positive surprise ahead, but... The official growth assumptions both for this and next year look too low to us, as does next year's CPI assumption of just 1%. Also, the budget does not take into account any profit for the NBP, which would be paid in June 2010 to the Treasury. In short, at first blush there seems to be quite a lot of room for positive surprise next year. That said, when we go through the assumptions, especially on the revenue side, the numbers no longer look that conservative: for instance, indirect tax receipts are seen up 6% next year, and corporate and personal income tax revenues are forecast up 10% and 3%, respectively. Given the meagre rise in nominal GDP the MoF expects (just 2%), these look rather high. In addition, while of course achievable in theory, the privatization projections look rather ambitious: slippage relative to those plans would make a breach of the 55% debt threshold highly likely. We note that the assumption of flat market rates until the end of 2010 also looks overoptimistic. And finally, the assumption of a broadly stable unemployment rate looks clearly at odds with 1.2% growth in 2009. We estimate that growth of at least 2-2.5% is needed to stabilize the unemployment rate.

Cyclical versus structural deterioration: how much of each? In 2007, when growth was strong and deficit concerns seemed very distant on the horizon, we warned against complacency on the fiscal front. Our thesis was that the structural fiscal numbers were nowhere near as good as the headline numbers suggested (see Complacency Breeds Trouble, September 27, 2007), and a fiscal deterioration in 2008-09 was on the cards, due to fiscal easing and possibly a growth slowdown. Right now, there is a danger of getting overly negative, just as growth has bottomed and the cyclical headwinds are at their strongest. Poland's underlying deficit was never as low as 1.9% of GDP (2007), but it's likely less than the 7% it may reach in 2010.

While the cycle has surely taken its toll, both the EC and OECD numbers suggest that much of this deterioration in public finances has been structural, rather than cyclical. There is a huge degree of uncertainty around these cyclically adjusted numbers, and they must be treated with caution, we think. That said, they do suggest that, unlike elsewhere in the region (most notably Hungary), fiscal policy has been supporting growth via tax cuts, which likely explains at least some of Poland's remarkable growth performance this year. Indeed, in our global forecasts, Poland is one of just seven countries around the globe that will record positive growth in 2009 (also see Global Forecast Snapshots, September 10, 2009).

Debt Rules and the Electoral Cycle

The Polish authorities' desire to avoid breaching the debt thresholds, which would trigger automatic fiscal tightening, is clear. Breaching 50% this year would have limited consequences, though of course the 2011 budget planning would be affected (note that restrictions are implemented the year after the thresholds are breached. So, an overshoot happens at time t, is acknowledged at t+1, and corrective action is taken at t+2). Breaching 55% in 2010 would imply meaningful fiscal tightening (and, in the extreme, a balanced budget) for 2012. Having to worry about fiscal straightjackets going into an important electoral cycle (presidential elections in October 2010, parliamentary elections in 2011) is clearly not anyone's favourite choice. This is why privatization, which reduces the debt ratio without structural changes to tax rates or spending, looks like an attractive prospect.

Issuance: 2010 Another Boom Year; MPC Concerns Will Likely Intensify

The Min Fin said that it expects net borrowing needs to rise from PLN 43.8 billion this year to PLN 81.7 billion in 2010 (PLN 60.9 domestic, PLN 20.8 FX). In terms of gross borrowing needs, the increment is from PLN 163 billion this year to a planned PLN 203.8 billion next year (15% of GDP). The authorities continue to sound confident that the market will be able to absorb all this paper. And, we add, the no-strings- attached IMF flexible credit line worth US$20.6 billion represents a valuable alternative in case markets were to seize up (though this is clearly a last resort). The line, originally granted in May 2009, will expire in mid-2010, but we assume that it can be extended. That said, the sheer volume of government borrowing and the competition from many other, more highly rated countries suggests that the market may get saturated. The rise in long-term yields since the start of 2009 rings alarm bells; more broadly, fiscal concerns may weigh on the zloty, which on growth and structural grounds has long been our preferred currency in Central Europe. The MPC is clearly not indifferent to the steady fiscal deterioration, and we think it is just another reason for the bank to adopt a more cautious stance and move to a neutral bias this or next month.

Fiscal Worries Push EMU Further Away

Slovakia (EMU member since January 1, 2009) was the last country in CEE to exploit a very favorable window of opportunity in which strong growth curbed the budget deficit, and steadily appreciating FX tamed inflation pressures. That sort of combination is unlikely to be repeated soon, for a number of reasons (see EMU: Far Away, So Close, August 3, 2009). As confirmed by a senior EC official this week, Poland will have to spend at least two years in ERM II so, for instance, ERM II entry in the middle of 2010 would mean EMU in 2013 at the earliest, assuming a January 1 entry. Hypothetical euro adoption in 2014 would mean a deficit stably below 3% of GDP already by 2012. Given a deficit in the region of 6-7% in 2010, this looks achievable, but a rather tall order. The government has officially abandoned the unrealistic 2012 euro adoption target, and has not set a new one yet. There is a risk that fiscal concerns, which not long ago looked pretty minor, could derail EMU beyond 2014-15, our new forecast.

Important Disclosure Information at the end of this Forum

Mexico
Loosening the Fiscal Straightjacket
September 15, 2009

By Luis Arcentales & Daniel Volberg | New York

The announcement on September 8 of the long-awaited 2010 budget and tax reform proposals set off what is likely to be a critical period for Mexico's fiscal outlook and the sustainability of the public sector finances. While most of the market focus has centered on the immediate challenge of addressing next year's fiscal gap, the outcome of the budget and reform negotiations will also have considerable medium-term implications. As we have repeatedly warned in the past, Mexico's greatest near-term challenge relates to its fiscal accounts and the pressure on government receipts derived from the steady decline in oil output and exports (see "Mexico: The Fiscal Straightjacket", EM Economist, July 17, 2009). Indeed, given Mexico's political dynamics and electoral calendar, the congressional discussions that will take place in the coming weeks may represent one of the last real opportunities for policymakers to comprehensively address Mexico's fiscal vulnerabilities before the next administration takes office in December 2012.

The 2010 budget and tax reform drafts represent an ambitious step to address Mexico's fiscal challenge, in our view, particularly considering that the economy is only now slowly emerging from a severe recession, as well as the difficult political backdrop following the July mid-term elections. The proposal calls for a combination of some belt tightening mainly at the federal level, a modest expansion in debt financing to the tune of 0.5% of GDP and alternative sources of revenue. On the latter point, the economic program contains a tax reform that seeks to lift non-oil revenues by 1.4% of GDP in 2010 by relying primarily on a 2% consumption tax. Importantly, the macro assumptions in the 2010 budget seem for the most part conservative, particularly the US$53.9 per barrel target for the Mexican crude basket.   

But will the proposed tax measures be sufficient to limit the expected medium-term deterioration in Mexico's fiscal accounts? To address this pressing question and better understand the magnitude of the fiscal challenge, we ran a medium-term projection of Mexico's public sector accounts, incorporating the impact of the proposed tax reform. Our verdict is a cautiously optimistic one: the tax reform represents an important source of revenue that puts the fiscal accounts on the right path; however, avoiding meaningful medium-term fiscal deterioration would still require firm efforts to contain spending growth down the road. In other words, even if the tax reform is approved in congress without major modifications, we believe that Mexico will continue to face a fine fiscal balancing act in the coming years.

Fiscal Ambition

The 2010 budget and tax reforms reflect the authorities' commitment to fiscal discipline, in our view. While a lot can change between now and the end of October when legislators are required by law to approve the ‘revenue law', we believe that the budget and tax reform proposals, in their current form, contain several positive aspects.

The budget calls for only a modest 0.5% of GDP debt financing expansion (2.5% of GDP including Pemex capex), which is in accordance with what is allowed under exceptional circumstances by the Fiscal Responsibility Law, allaying concerns among Mexico watchers that the authorities would rely more heavily on borrowing rather than pushing for the tougher alternatives of belt tightening and taxation. On the latter point, the program calls for two primary sources of funds: a tax reform and non-recurrent receipts. At the heart of the tax reform - which seeks to lift 2010 revenues by 1.4% of GDP - is a new 2% ‘anti-poverty' tax on all consumption, which could generate as much as 0.6% of GDP and achieves the goal of broadening the tax base; in addition, the plan includes a series of small measures - including higher excise duties on alcoholic beverages and cigarettes, a 4% tax on telecom services and a temporary 2% hike in income taxes, among other changes - aimed at generating extra resources while spreading the burden without hitting any specific economic sector too hard. In great part the proposed measures increase taxes currently in place, thus providing credibility to the program by limiting execution risk. Last, the use of stabilization funds and non-recurrent items is expected to generate almost 0.8% of GDP next year.

For the most part, the macro assumptions in the 2010 budget seem conservative, in our view. The projected GDP growth of 3.0% (2.5% for the US economy) and, in particular, the cushion provided by the assumption for the Mexican crude basket of US$53.9 per barrel are cautious assumptions, given current conditions of economic recovery.  Indeed, if current futures prices were to materialize, the government could find itself with a windfall of around 0.6% of GDP in 2010, based on our calculations. Moreover, the proposal incorporates only modest fuel price hikes - an important source of revenue which can be adjusted in a discretionary fashion by the finance ministry.

Last, the announcement of the 2010 economic program showed that the Executive remains committed to advancing the structural reform agenda aimed at boosting the country's competitiveness. Though the timing is yet to be determined, the authorities unveiled guidelines for a new ‘competitiveness agenda' that includes, among other actions, measures to add flexibility to labor markets, strengthen the anti-trust agency, strengthen financial regulation and rethink the law for private-public partnerships with the aim of facilitating investment in infrastructure projects.  

Loosening the Fiscal Straightjacket

For all its positive aspects, the ultimate goal of the 2010 economic program should be to ensure medium-term fiscal sustainability. Indeed, to plug in the 2010 fiscal gap, the authorities seem to have plenty of options at their disposal, ranging from more aggressive fuel price hikes to more borrowing (see "Mexico: Fueling Inflation?" EM Economist, August 21, 2009). However, over the medium term we have warned that absent tax reform and/or meaningful efforts to curb expenditures, the fiscal accounts may be heading towards unsustainable deficits, as oil output continues to decline (see again Mexico: The Fiscal Straightjacket). 

To determine whether the tax reform adequately addresses Mexico's challenge, we ran projections of Mexico's fiscal accounts. We focus on projections for both fiscal revenues and fiscal expenditures. We proceed by breaking down fiscal revenues into two components: oil receipts and non-oil revenues. We then project both components of fiscal revenues out to 2015 to coincide with the mid-point of the next presidential term, since it gives a convenient estimate, in our view, of the potential fiscal pressures that the next administration is likely to face. Our revenue projections are made under two different scenarios: a low-growth scenario with real GDP growth of 1.5% - near the average growth of the Mexican economy during the ‘lost decade' of 1980-89 (1.6%) - or a trend-growth scenario with GDP growth of 3.0% - close to the average annual growth of the past decade (2.9%). Under these two scenarios, we also differentiate between low and trend growth in private consumption - 2.1% in the 1980s and 3.8% in the past decade - to better quantify the revenue potential of the excise and 2% ‘anti-poverty' taxes. We further assume that oil prices remain constant near US$70 per barrel - in line with current spot prices and recent averages - throughout the forecast horizon and that Mexico's oil output continues to decline by 5% per year. 

With the tax reform in place, the projected increase in non-oil revenues fully offsets the pressure from lower oil-related receipts under both scenarios, translating into total revenue growth of slightly more than 0.1pp of GDP on average per year. And this is by no means a small feat: after representing 8.0pp of GDP in the past five years, we find that oil-related revenues could dip by around two full percentage points by 2015 on average, depending on the GDP growth scenario. Over the forecast horizon, the tax reform yields slightly more than one full percentage point of GDP in additional revenues per year, even after the temporary income tax increases are rolled back by 2012.  

To estimate the potential fiscal pressures in the coming years, and complement our revenue projections, we created three scenarios for expenditures. In the first, we use the average real growth in realized expenditures in the past five years (+7.2%). For the second, we assume half of the aforementioned growth pace - an expansion rate we feel is consistent with inertial expenditure pressures derived from areas like pension liabilities, selected social programs and financing costs. In the third, we assume zero real growth.

While the new taxes go a long way towards offsetting the decline in oil-related receipts, they do not provide much margin for maneuvering on the spending front. For example, by cutting the rapid rise in expenditures seen in recent years to match inflation - a scenario that seems politically challenging, given mounting social and infrastructure spending needs - the fiscal accounts would revert to an improving, comfortable path, based on our calculations. This result is true even in our bearish growth scenario (1.5%), and it is clearly the case if the economy grows at twice that pace.

With outlays growing at a real rate of just 3.6% - half the actual pace of expenditure growth in the past five years - the fiscal shortfall would stabilize at a very manageable 2.6% of GDP - similar to the proposed 2010 shortfall - if the economy grows by 3% on average. However, the fiscal shortfall would approach 4.5% of GDP by 2015 in our low-GDP growth scenario. By contrast, if expenditure growth were to revert starting 2011 to the pace observed during 2004-08, even in the 3.0% growth scenario the fiscal deficit would widen to unsustainable levels. In what we suspect is the most likely outcome - one of moderate GDP growth and expenditure growth above inflation - the results from our scenario analysis suggest that avoiding fiscal deterioration would require a firm effort to keep a lid on expenditures, even if the tax reform were to be approved without major modifications.

Bottom Line

The recently unveiled 2010 budget and tax reform proposals represent an ambitious effort to put the fiscal accounts on the right path, in our view. While a lot can happen between now and the eventual approval of the budget, even if congress passes the tax reform in its current form, avoiding meaningful medium-term fiscal deterioration would still require firm efforts to contain spending growth down the road. Looking beyond the immediate fiscal challenge, we believe that the best test of Mexico's success would be to continue advancing its structural reform agenda to boost competitiveness and potential growth. Insofar as Mexico's growth performance remains subpar, the country should continue to face a fine fiscal balancing act in the coming years.

Important Disclosure Information at the end of this Forum

United States
Review and Preview
September 15, 2009

By Ted Wieseman | New York

Treasuries posted solid long end-led gains over the past week, as investors sharply extended a major reversal in Fed pricing since the release of the July employment report a month ago, continuing to move back to pricing the Fed holding rates at very low levels for a long time, which points to a lower-volatility world for a while in which current long-end yields could still be quite attractive even after the substantial gains seen over the past month that has left them near four-month lows.  The latest week's rally gains came during a very quiet economic calendar that had little market impact, but as risk markets continued moving to new highs through most of the week before leveling off Friday, and substantial supply had to be taken down.  If we are indeed looking ahead to a lengthy period of very low short-end rates, solid growth, no inflation worries and lower volatility, then there wouldn't be much reason to expect the generally tight inverse correlation between interest rate markets and stocks and credit of recent years to continue.  Meanwhile, the auctions all went quite well, extending a run of positive results seen since the August quarterly refunding auctions a month ago and revealing a strong demand for Treasuries from final investors, who took down large shares of each auction.  Also supporting the market upside was a break to four-month lows in mortgage yields to near 4.25% for current coupon issues that started to add a mortgage duration hedging-related bid to the market.  The economic calendar was light and somewhat mixed.  A wider-than-expected trade deficit and bigger-than-expected decline in wholesale inventories led us to reduce our 3Q GDP forecast to +3.7% from +4.5%, but the sharp gains in both exports and imports that netted to the bigger-than-expected trade gap were still longer-term positive signs, and any shortfall in inventories in the current quarter will be made up in bigger production upside going forward, as long as underlying demand continues to improve.  And as we start to look ahead to the next employment report, with the initial round of economists' estimates expected this week after the claims report, the past week's jobless claims numbers showed notable renewed improvement after having been stable for a time following the big improvement in July. 

On the week, benchmark Treasury yields fell 4-10bp and the curve flattened.  In the five weeks since the recent highs were hit after the August 7 release of the much less bad July employment report, which briefly got investors way too worried about the prospect of imminent Fed rate hikes, yields have now fallen 41-55bp, with the intermediate part of the curve leading as the MBS market has kept pace with the gains and mortgage yields have moved to multi-month lows back not far from all-time lows.  In the latest week, the 2-year yield fell 4bp to 0.90%, old 3-year 6bp to 1.38%, 5-year 7bp to 2.29%, 7-year 11bp to 2.94%, 10-year 10bp to 3.34%, and 30-year 10bp to 4.17%.  TIPS performed quite well, as a series of new lows for the year by the dollar through the week helped to boost energy prices significantly through Thursday.  Even when oil prices pulled back significantly Friday, however, TIPS didn't give up much ground compared to nominals.  The short end of the TIPS curve way outperformed on the week, but the benchmarks also did well compared to the nominal gains, with the 5-year yield plummeting 18bp to 0.88%, the 10-year down 8bp to 1.59%, and the 20-year down 7bp to 2.10%. 

Driving the continued Treasury rally was a big further dovish repricing of the Fed, which extended a major reversal of market thinking since a rate hike as early as December was priced as a real risk after the July employment report was released.  With the January fed funds contract down to 0.195% from 0.345% on August 7, no meaningful risk of a rate hike before year-end is now seen.  The timing of the first hike to 0.50% is now priced for the April FOMC meeting, with the May fed funds contract gaining another 4.5bp on the week - and 52bp now since August 7 - to 0.475%.  With the January 2011 contract gaining 8.5bp to 1.355%, either a 1.25% or 1.50% fed funds target is priced for the end of next year, way down from the 2% or 2.25% priced in at the height of the premature rate-hiking scare on August 7.  Current pricing is now pretty much in line with our forecasts.  We see the first hike coming a few months later than April, but we think the fed funds target will end next year at 1.50%, about in line with futures pricing. 

The MBS market performed quite well in the past week, with current coupon yields falling to near 4.3% from around 4.45%, a low since late May and not too far from the record-low levels close to 4% seen from late March through late May.  This improvement has brought average 30-year mortgage rates back down towards 5% from 5.25% levels seen during most of July and August, correspondingly not far above the record lows close to 4.75% maintained from late March to late May.  As mortgage yields moved down to new recent lows and MBS duration declined, offsetting buying and receiving to extend duration back out started to help boost Treasuries and swaps.  The benchmark 5-year swap spread fell 3bp on the week to 36bp and 2-year 4bp to 32bp, the former now very close to the record low hit in 2003, while the benchmark 10-year spread fell 3bp to a two-month low of 17bp.  The normalization in interbank lending conditions that has been an underlying support to spread narrowing appears to have finally fully run its course, at least on a spot basis.  3-month Libor extended its long run of daily record lows to just below 0.30% Wednesday and then rose marginally Thursday and Friday.  This left the 3-month Libor/OIS spread, which closed as high as 364bp at the worst of the turmoil in October 2008, down at only 12bp, pretty much back to pre-crisis norms.  Forward Libor/fed funds spreads in 2010 and 2011 remain a bit higher at above 20bp, so it's possible that there could be a bit more improvement there going forward, but there will probably be some lingering risk premium priced into forward spreads after that astounding blowout in 2008. 

Risk markets had another good week, continuing to defy seemingly widespread fears coming into the month that they were vulnerable to a seasonally weak September.  The S&P 500 gained 2.6%, ending the week marginally below the high close of the year hit Thursday.  Credit also performed well, especially high yield.  The investment grade CDX index was 10bp tighter on the week at 111bp in late Friday trading, a bit higher than the best close of the year of 105bp hit August 7, while the high yield CDX was already 108bp tighter on the week at 747bp at Thursday's close and with another 7/8 of a point rally through Friday afternoon (after having ripped up another point-and-a-half at Friday's best midday levels) was breaking to new tights for the year below the prior best close of 734bp on August 3.  The commercial mortgage CMBX market also had a very good week and is moving back towards the year's best levels hit a month ago after a big pullback in mid-August.  The AAA index gained 3.58 points (+5%) to 79.52 and the junior AAA rose 3.13 (+7%) points to 47.38, versus the year's best closes of 83.41 and 49.11 hit August 7.  In contrast to the volatile recent behavior of the CMBX market, the subprime ABX market now appears to be frozen in place across all indices.  The BBB- and BBB indices stopped moving away from 3.00 in April and the A and AA started barely budging from 3.50 and 4.00 in June.  Now the AAA index has been pinned at 27.00 for almost a month, rising 0.02 points in the latest week to 27.05. 

It was a light week for economic data.  A couple of releases were arithmetically negative for current quarter growth, leading us to reduce our 3Q GDP forecast to +3.7% from +4.5%, but were more positive in their underlying details.  Big gains in imports and exports pointed to much improved domestic and global demand, though the larger rise in the former pointed to a bigger subtraction from net exports in 3Q than we previously expected, while another huge decline in wholesale inventories in July pointed to a somewhat smaller boost from slowed inventory liquidation in 3Q but correspondingly greater upside to production going forward. 

The trade deficit widened to US$32.0 billion in July from US$27.5 billion in June, with both exports (+2.2%) and imports (+4.7%) starting to strongly rebound from the collapse seen from last summer into the spring.  Exports are now up 6% in the past three months after a 27% decline over the prior nine, and imports are up 7% in the past two months after a 35% collapse over the prior ten.  The real trade deficit didn't widen quite as much as the nominal deficit, as falling export prices provided a boost to constant dollar numbers, but the result was still more negative than we assumed.  We now see net exports subtracting 0.7pp from 3Q growth instead of 0.2pp, with exports running at +17% and imports at +19% after the extreme weakness seen in the year through 2Q.  There was a bit of a positive offset from a surge in capital goods imports that led us to boost our forecast for business investment in equipment and software to +7% from +5%.  Sometimes imports are correlated with wholesale activity, but that was not the case in July, as wholesale inventories plunged another 1.4%.  We now see inventories adding 1.7pp to 3Q GDP growth instead of +2.1pp, but this just means a correspondingly bigger add in 4Q. 

There were mixed indications on the lagging job market, with renewed improvement in claims suggesting that payroll declines will probably moderate further in September, but a weak Manpower survey showing continued cautiousness about hiring going into 4Q.  Initial jobless claims fell 26,000 in the week of September 4 to 550,000, a two-month low, causing the 4-week average to dip 2,750 to 570,000.  Continuing claims in the prior week fell 159,000 to 6.088 million, a low since early April.  After a major improvement in July from horrible spring numbers, claims improvement had recently stalled out, corresponding to the big moderation in the pace of payroll declines in July but lack of much further improvement in August.  So this latest result was an encouraging indication that improvement might be resuming as we move into the survey week for the September employment report.  On the other hand, the seasonally adjusted net hiring plans index in the Manpower employment outlook survey fell to a record low -3 for 4Q from -2 in 3Q.  In unadjusted terms, just 12% of respondents said they planned to increase hiring in 4Q, a record low, and 14% said they planned to cut jobs, a seven-year high.

The economic calendar is much busier in the coming week.  In addition to much of the rest of the key August releases, of which retail sales on Tuesday will probably be the main focus, the initial round of September manufacturing surveys (Empire State Tuesday and Philly Fed Thursday) will set early expectations for the September ISM after the strong August report, and initial claims in the Thursday's report will cover the survey week for the September employment report, helping to set initial forecasts for September payrolls.  Other data releases due out include PPI and business inventories Tuesday, CPI and industrial production Wednesday, and housing starts Thursday:

* We forecast a 2.8% surge in overall retail sales in August and a 0.8% rise excluding autos.  The ‘cash-for-clunkers'-related surge in car buying should provide a big boost to headline retail sales in August.  Also, we should see a sharp rebound in the gas station category tied to higher prices at the pump.  Most importantly, the chain store reports pointed to very sharp gains at clothing retailers and general merchandise outlets.  So we see retail control (the main input to the consumption measure in the GDP data) rising 0.5%, which would represent the best performance since February.  For 3Q as a whole, consumption is expected to be up a bit more than 2.5%.

* We expect the overall producer price index to gain 2.0% in August but the core to only be up 0.1%.  The impact of a sharp 16.5% expected surge in wholesale quotes for gasoline will be exacerbated by a seasonal adjustment factor add-on of nearly +10%, leading to a sizeable advance in the energy component of the PPI.  Otherwise, prices are expected to be little changed.  Note that the ‘cash-for-clunkers' program should not have any impact on the PPI.

* We look for a 1.0% plunge in July business inventories.  The results for the manufacturing and wholesale sectors point to another sharp drop in stockpiles.  However, the pace of inventory decline appears to be moderating, consistent with a topping out of the I/S ratio.

* We forecast a 0.2% rise in the overall consumer price index in August and a 0.1% decline in the core.  Rising gasoline prices should help to boost the headline CPI in August.  However, the core is likely to be held down by the impact of ‘cash-for-clunkers'.  The BLS has confirmed that it will treat the price reduction associated with C4C as a discount off the purchase price - rather than as an inflated value of the trade-in.  New motor vehicles have a weight of a little less than 6% in the core CPI.  About 40% of August sales were C4C-related, and the average discount appears to have been roughly 15%.  Applying a modest haircut because the BLS sampling never seems to pick up the full impact of these sorts of sharp changes, we arrive at an assumed 0.25pp subtraction from C4C.  On a year-on-year basis, core CPI is likely to slip all the way to +1.2%, but the temporary impact of C4C should be unwound in the September report. 

* We look for a 0.7% gain in August industrial production, led by a further jump in vehicle assemblies.  A weather-related advance in utility output is also likely to provide some support.  Meanwhile, manufacturing ex motor vehicles is expected to eke out a 0.1% advance - which would represent the first rise since last October.  Positive contributions are expected from the food, petroleum and chemicals industries.

* We expect August housing starts to rise to a 600,000 unit annual rate.  The employment report showed continued job losses in the residential construction sector, and sales of newly built residences continue to be sluggish.  But the number of unsold new homes stood at a 16-year low in July, and starts appear to have bottomed earlier this year.  So, we look for another modest rise in starts this month (+3.3%), with the key single-family category again leading the way.

Important Disclosure Information at the end of this Forum

Disclosure Statement

The information and opinions in Morgan Stanley Research were prepared by Morgan Stanley & Co. Incorporated, and/or Morgan Stanley C.T.V.M. S.A. and their affiliates (collectively, "Morgan Stanley").

Global Research Conflict Management Policy

Morgan Stanley Research observes our conflict management policy, available at www.morganstanley.com/institutional/research/conflictpolicies.

Important Disclosure for Morgan Stanley Smith Barney LLC Customers The subject matter in this Morgan Stanley report may also be covered in a similar report from Citigroup Global Markets Inc. Ask your Financial Advisor or use Research Center to view any reports in addition to this report.

Important Disclosures

Morgan Stanley Research does not provide individually tailored investment advice. It has been prepared without regard to the circumstances and objectives of those who receive it. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages them to seek a financial adviser's advice. The appropriateness of an investment or strategy will depend on an investor's circumstances and objectives. Morgan Stanley Research is not an offer to buy or sell any security or to participate in any trading strategy. The value of and income from your investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized.

With the exception of information regarding Morgan Stanley, research prepared by Morgan Stanley Research personnel is based on public information. Morgan Stanley makes every effort to use reliable, comprehensive information, but we do not represent that it is accurate or complete. We have no obligation to tell you when opinions or information in Morgan Stanley Research change apart from when we intend to discontinue research coverage of a company. Facts and views in Morgan Stanley Research have not been reviewed by, and may not reflect information known to, professionals in other Morgan Stanley business areas, including investment banking personnel.

To our readers in Taiwan: Morgan Stanley Research is distributed by Morgan Stanley Taiwan Limited; it may not be distributed to or quoted or used by the public media without the express written consent of Morgan Stanley. To our readers in Hong Kong: Information is distributed in Hong Kong by and on behalf of, and is attributable to, Morgan Stanley Asia Limited as part of its regulated activities in Hong Kong; if you have any queries concerning it, contact our Hong Kong sales representatives.

Morgan Stanley Research is disseminated in Japan by Morgan Stanley Japan Securities Co., Ltd.; in Canada by Morgan Stanley Canada Limited, which has approved of and takes responsibility for its contents in Canada; in Germany by Morgan Stanley Bank AG, Frankfurt am Main, regulated by Bundesanstalt fuer Finanzdienstleistungsaufsicht (BaFin);in Spain by Morgan Stanley, S.V., S.A., a Morgan Stanley group company, supervised by the Spanish Securities Markets Commission(CNMV), which states that it is written and distributed in accordance with rules of conduct for financial research under Spanish regulations; in the US by Morgan Stanley & Co. Incorporated, which accepts responsibility for its contents. Morgan Stanley & Co. International plc, authorized and regulated by Financial Services Authority, disseminates in the UK research it has prepared, and approves solely for purposes of section 21 of the Financial Services and Markets Act 2000, research prepared by any affiliates. Private UK investors should obtain the advice of their Morgan Stanley & Co. International plc representative about the investments concerned. RMB Morgan Stanley (Proprietary) Limited is a member of the JSE Limited and regulated by the Financial Services Board in South Africa. RMB Morgan Stanley (Proprietary) Limited is a joint venture owned equally by Morgan Stanley International Holdings Inc. and RMB Investment Advisory (Proprietary) Limited, which is wholly owned by FirstRand Limited.

Trademarks and service marks in Morgan Stanley Research are their owners' property. Third-party data providers make no warranties or representations of the accuracy, completeness, or timeliness of their data and shall not have liability for any damages relating to such data. The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of MSCI and S&P. Morgan Stanley bases projections, opinions, forecasts and trading strategies regarding the MSCI Country Index Series solely on public information. MSCI has not reviewed, approved or endorsed these projections, opinions, forecasts and trading strategies. Morgan Stanley has no influence on or control over MSCI's index compilation decisions. Morgan Stanley Research or portions of it may not be reprinted, sold or redistributed without the written consent of Morgan Stanley. Morgan Stanley research is disseminated and available primarily electronically, and, in some cases, in printed form. Additional information on recommended securities/instruments is available on request.

The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (DIFC Branch), regulated by the Dubai Financial Services Authority (the DFSA), and is directed at wholesale customers only, as defined by the DFSA. This research will only be made available to a wholesale customer who we are satisfied meets the regulatory criteria to be a client.

The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (QFC Branch), regulated by the Qatar Financial Centre Regulatory Authority (the QFCRA), and is directed at business customers and market counterparties only and is not intended for Retail Customers as defined by the QFCRA.

As required by the Capital Markets Board of Turkey, investment information, comments and recommendations stated here, are not within the scope of investment advisory activity. Investment advisory service is provided in accordance with a contract of engagement on investment advisory concluded between brokerage houses, portfolio management companies, non-deposit banks and clients. Comments and recommendations stated here rely on the individual opinions of the ones providing these comments and recommendations. These opinions may not fit to your financial status, risk and return preferences. For this reason, to make an investment decision by relying solely to this information stated here may not bring about outcomes that fit your expectations.