Japan
Recovery Steady, Policy Response Gains Depth: March Tankan Preview
March 19, 2010

By Takehiro Sato l Tokyo|

Economy Generally Beats BoJ Scenario, but Deflation Worsens

We expect the March Tankan to confirm that brisk exports to Asia supported a generally better performance by the domestic economy than the BoJ scenario. However, we expect worsening deflation to be visible in key DIs, including those relating to prices and production capacity.

Despite upgrades to the economic assessments in the Cabinet Office's Monthly Economic Report and the BoJ's Monthly Report on Recent Economic and Financial Developments, we do not expect the government to let up the pressure on the BoJ to ease, given the rise in the effective yen rate. From the April-June quarter through July-September, we expect to see policies for introducing an inflation target and increasing the amount of JGB purchases, even while the cyclical recovery continues.

Business Conditions DIs: Pace of Headline Improvement to Gather Further Momentum

Thanks to brisk exports to Asia which are approaching the past peak in volume terms, we expect the pace of improvement in the headline to have accelerated markedly, from -24 in December to -9. Overall, export momentum is brisk even though the effective yen rate is rising, and at this point the recall by a major automaker is having no effect either, at least on domestic production plans. The outlook DI too, despite improving more slowly, is likely to point to a further rise in the headline in the following June Tankan. We expect large non-manufacturers to underperform manufacturers, at -16 versus -22 in December, but likely show steadier improvement thanks to various policy supports. We expect a similarly stark contrast at manufacturers and non-manufacturers in the SME DI. Elsewhere, the Economy Watchers Survey (leading indicator) is picking up again sharply after stumbling badly after the government's November deflation statement.

Input and output price DIs will likely point to margin erosion in general, for although commodity spot prices and energy prices remain elevated, wage deflation is intensifying downward pressure on final prices.

In terms of direction, DIs relating to the output gap - production capacity, employment, etc. - are likely to show that the sense of surplus is peaking out, but in terms of level we expect strong signs of capacity surpluses to persist. Though capex has stopped falling and begun picking up as of October-December, absolute levels of utilization rates remain historically low at around 70%, and neither has there been much visible progress with decommissioning or scrapping production plants. On the whole, we expect these DIs to point to prolonged deflation.

Our Forecast for F3/10 Management Plan Revisions and F3/11 Initial Plans

1) F3/10 sales and profit targets generally unchanged: Management recurring profit plans for large enterprises/all industries rose slightly, to -19.3%Y, in the December Tankan (revision rate versus September survey: +3.5%), but we expect it will remain largely unchanged in the March Tankan. Aside from F3/09, when production contracted sharply in the wake of the Lehman shock, the pattern has been for firms to make few major changes to sales or profit targets when forecasting results in the March Tankan. Note also that although large enterprises' profit targets are likely to be more upbeat than our cautious top-down forecasts (parent RP -20%Y), straightforward comparison is difficult because of disparities between consolidated and parent forecasts.

2) Expect optimistic sales/profit plans for F3/11: Firms tend not to have made institutional decisions on management plans for the next business year at the March Tankan survey, and in recent years have also disclosed more cautiously. This makes it hard to grasp the full/accurate content of plans via the Tankan, and we would recommend taking F3/11 plans in the March Tankan as merely a guide. Accepting these limitations, we anticipate an optimistic tone, with company plans for growth in both sales/profit. We expect especially upbeat targets of double-digit growth for profit, despite projections of only small sales growth, as efforts to cut fixed costs in F3/10 bear fruit.

Exporters seem more able to cope with a strong yen. We gauge the breakeven rate for exports (all-industry basis) to be about JPY91/USD for January-March, near the spot rate. We credit this mainly to capacity utilization recovery and lower input costs.

3) Expect large enterprises to continue nudging down F3/10 capex plans: Large enterprises/all industries again lowered their capex plans in the December Tankan, to -13.8%Y (revision rate: -3.4%), and in many instances the past pattern is for further downward revisions to forecast outcomes in the March Tankan. Although October-December GDP confirmed an end to capex cuts, which had reached their limits, we expect further small downward revisions to annual plans, and we forecast -15.1%Y for large enterprises/all industries (downward revision of -1.5%), including -29.2% for manufacturers (-1.4%) and -7.0% for non-manufacturers (-1.6%).

Behind the capex cuts lies weak recovery in capacity utilization rates. Exports are brisk, but with capacity utilization at best reaching about 70% in January-March, the impression is of rather weak progress in relation to production recovery. One possible reason for this is that firms have been slow to reduce production capacity.

4) Expect large enterprises' F3/11 capex plans to remain low-key: For similar reasons to the profit plans, we do not expect the actual numbers cited in F3/11 capex plans to be all that reliable. At current forex levels, manufacturers lack incentives to increase domestic capex. Therefore, although capex has dropped below depreciation levels and firms are not investing enough in updating plant, it is hard to envisage a scenario of full-fledged capex recovery. Aside from large-scale spending by non-manufacturers on updating plant (electric power, transportation, telecom, etc.), we do not anticipate significant capex demand for the time being. As a result, we expect large enterprises/all industries to guide for a slight increase of +0.7%Y.

Policy Implications: Despite Ongoing Cyclical Recovery, We Expect Further Monetary Accommodation to Continue

From our analysis of the output gap, even on a fairly optimistic view of the growth outlook, it will be about 2013 at the earliest before underlying prices excluding food/energy and various systemic factors turn positive. This may well disappoint investors, but we see a need for even more caution at present with the chance medium-term inflation expectations of households and corporations are shifting down, reflecting demographic and other factors. After some 15 years of steady deflation from the mid-1990s, the behaviour patterns of households/corporations may be assuming deflation as a given. There is also a view that deflation in some sense fits with an aging society where pensioners total much of the population.

If households and corporations assume that prices will not rise in the mid/longer term and put off consumption and investment activity until well into the future, resulting in a further demand slump, improvement in the output gap is likely to be slow, and ultimately deflation is likely to worsen further. This is something the BoJ has already been alluding to in its Outlook Reports, in the context of risk of prices undershooting expectations. Yet, up to now the BoJ has maintained that expectations of mid/longer-term inflation are stable, and has been reluctant to undertake further monetary easing. But, it is possible that its rationale for taking this stance is collapsing.

Let us look at the specifics. One reason why the BoJ has shied away from further easing has been that despite lower expectations of inflation in the short run, expectations of inflation in the medium term are stable. Certainly, households' short-term expectations of inflation have subsided according to the Cabinet Office's Consumer Confidence Survey. Whereas the proportion of households forecasting price growth ahead is at a historical low, the proportion of those forecasting a fall in prices is at a historical high. At the same time, mid/longer-term inflation expectations gauged by the BoJ from its Opinion Survey on the General Public's Views and Behaviour (‘the BoJ Opinion Survey') are not much lower than before.

In a working paper drafted in 2008, staff of the BoJ's Monetary Affairs Department made some adjustments to the Carlson and Parkin method (1975) and applied these to estimating expected inflation rates from the BoJ's Opinion Survey. This method has the advantage of allowing separate estimates for short-term inflation forecasts (one year ahead) and longer-term inflation forecasts (five years ahead). Our replication of the BoJ's analysis using this method indeed puts the longer-term inflation forecast close to 0.5%, and seemingly also stable in positive territory even at the current time.

However, although a technical issue, we note that there is a wide margin of error in estimations of the expected inflation rate. If we take the estimating period as from F3/07 to allow for continuity with the original data, it is possible to get results that show mid/longer-term inflation expectations as negative. When changing the sampling method, the BoJ's estimations do not appear to have given that much consideration to continuity of the original data, and we cannot rule out the possibility that the longer-term expected growth rate for prices rate has already dropped into negative territory.

If the BoJ's argument that mid-term inflation expectations are stable no longer holds water, this weakens the rationale for the BoJ maintaining the current status quo in decisions on the direction of monetary controls. This is also one reason why, contrary to the market consensus, we have continually stressed the possibility of additional rate cuts. The BoJ decided at its March MPM to expand its fixed-rate lending facilities, but we think it is reasonable to anticipate the bank responding to government pressure and adopting of inflation targeting and increasing JGB purchases. A potential occasion for the former is the three-year deflation outlook in the April Outlook Report. After all, when clarifying its definition of ‘the understanding of price stability' at the December 2009 MPM, the BoJ has only recently stated that it will not tolerate a negative inflation rate in the medium term. The probable catalyst for the latter, meanwhile, is ‘The Medium-Term Fiscal Framework' due to be unveiled by the government in June, though raising JGB purchase amounts is likely to be contingent on the government presenting a credible blueprint towards future fiscal reconstruction.

Global
Risks in the Policy Mix
March 19, 2010

By Manoj Pradham & Joachim Fels l London|

Debt is rising, the global economy is recovering and inflation risks will play a crucial role in determining when major central banks start their exit from their ultra-expansionary stance. On these points, there is broad agreement all round. However, the timing of fiscal and monetary policy tightening to deal with these developments is a bit more contentious, and it is here that our view differs from that of markets and many of our clients. First, while most clients seem to be gearing up for a significant fiscal tightening in 2010-11, we see little sign of such restraint going by the forecasts from our global economics team (see "What Fiscal Tightening?" Global Forecast Snapshots, March 10, 2010). Second, we expect central banks to start tightening policy sooner than markets expect, acting as a counterbalance for weaker fiscal restraint. Finally, we do not see the recovery or the policy tightening process as a linear one. Specifically, we see more downside risks to growth in 2011 than in 2010, and believe that these downside risks will keep central banks from tightening policy aggressively, keeping the door open for inflationary risks to build up.

What fiscal tightening? The expansive fiscal packages deployed to stave off a second Great Depression, in particular in the major economies, have produced large deficits and rising debt. However, now that the worst of the Great Recession is behind us, governments have been talking tough on deficits and debt. If such rhetoric is taken at face value, then it seems logical to assume that fiscal tightening will be upon us in the not-too-distant future. Indeed, this appears to be a widely held view if our conversations with clients are used as a sample. However, debt and deficit forecasts for 2010 and 2011 from our global economics team (see again Global Forecast Snapshots) suggest that fiscal tightening is not likely to be significant. Deficits in the G4 economies will show some moderation, but they will stay quite large, contributing to an increase in debt in 2010 and 2011.

Monetary policy will have to carry a larger burden: If fiscal policy is likely to be less disciplined, then monetary policy will be looked upon to balance out the overall policy stance. Indeed, our forecasts suggest that central banks are gearing up for an earlier exit than markets expect. In addition, growth may surprise to the upside over the next few quarters, particularly in the major economies. Much of the weakness in 1Q10 is likely to be reversed quite quickly, though at differing speeds, with the US leading the charge and the euro area bumping along at the bottom of the G4.

An early exit: Our US team expects the Fed to ramp up its liquidity-draining operations during the summer and to follow these up with an official rate hike in 3Q10. In the euro area, downside risks to growth have pushed our ECB call for a first hike to 4Q10, but the ECB's recent move to a variable-rate tender and the continued reduction of maturity of liquidity operations will likely pressure euribor rates upwards before the refi rate is officially hiked. In China too, our China team is looking for an early rate hike, probably as early as April, along with appreciation of the currency against the US dollar by the summer.

Our India team expects the RBI to either deliver an inter-meeting cut of 25bp quite soon or, more likely, to raise policy rates by 50bp in April. Asia ex-Japan as a whole is heading for an early exit, given the strong growth in the region and the rising risk of inflation in some economies there. Finally, Brazilian monetary policy now seems likely to join the party. Our team there expects a stronger growth rebound in 2010, and consequently a more front-loaded path for policy rates with a total of 225bp of hikes expected this year. While his central case is for a first hike in April, Marcelo Carvalho thinks that the Copom could move as early as today.

But downside risks to growth in 2011 mean that rates should stay below neutral: Even though the rate hikes we expect in 2010 are only going to make policy less expansionary rather than outright contractionary, the reduction of the monetary stimulus could have an effect with its traditional lags to take away some tailwinds to growth in 2011. In addition, the risk to the fiscal outlook is that governments, concerned by sovereign crises and contagion, could act aggressively to reduce deficits. This generates another source of downside risk to growth in 2011. If such risks either materialise or simply remain in place, central banks will probably find it difficult to lift rates aggressively in 2011. Even on our current forecasts, where fiscal tightening is not very strong, a majority of the large central banks around the world are expected to tighten policy rates by less in 2011 than in 2010. We expect policy rates to remain below neutral throughout 2010, and for most if not all of 2011 as well.

The policy mix...and remix: In summary, we urge clients to reconsider the timing and dynamics of the fiscal-monetary policy mix, particularly in the G10 economies. To start with, the policy mix is likely to be one of less fiscal restraint and more monetary tightening than most expect. Later in the recovery process, however, the risks are that governments could try to address their fiscal positions to a greater degree, while downside risks to growth could keep central banks from being too aggressive - a turnaround of the balance in the policy mix.