Hong Kong
Sustained Robust Growth in 2Q10; Forecasts Upgraded
August 17, 2010

By Denise Yam, CFA & Ernest Ho | Hong Kong

2Q10 GDP - Sustained Robust Growth

The Hong Kong economy sustained robust growth in 2Q10.  Real GDP expanded 6.5%Y, or 1.4%Q (+5.7% annualized), albeit slowing from the 8%Y (revised) jump (+2.1%Q) in 1Q10 attributable to the base effect.  In nominal terms, nevertheless, the economy demonstrated a more noticeable slowdown, from 10.1%Y in 1Q to 5.9% in 2Q, implying a dip in the GDP deflator to -0.6%Y (+2% in 1Q) and reflecting the worsening loss in terms of trade.  For 1H10 as a whole, the economy grew 7.2%Y in real terms and 8% in nominal terms, reversing the 2.8% and 2.6% respective declines in 2009.

Continued Revival in Service Exports amid Global Recovery

Similar to the story in 1Q10, the sharp surge in service exports was again a key driver of growth in 2Q10.  Service exports jumped 28.8%Y to HK$186.4 billion, or 45.1% of GDP, accelerating further from the 27.2% (revised) gain in 1Q, more than reversing the contraction in the year-ago period.  The biggest contributor to this strong growth was inbound travel (+10.7pp), followed by transportation (+8.6pp) and trade-related services (+6.4pp).  The contribution from other (i.e., financial and business) services (+3.1pp versus +5.3pp in 1Q) dipped somewhat in 2Q10, attributable to the lull in equity fundraising activities in the quarter (US$2 billion versus US$4.4 billion in 1Q) in the midst of European sovereign credit woes, although this is set to recover noticeably in 3Q.

Despite considerable growth in service imports (+17.8%Y), the service trade surplus expanded significantly to 22.3% of GDP from 16.6% a year ago.  In real terms, this added 4.3pp to overall GDP growth.  Meanwhile, as global demand gradually recovers, the negative contribution from the goods deficit narrowed to 8.8pp from 12.2pp in 1Q.

Domestic Demand Supported by Asset Market Resilience

Domestic demand growth also remained robust in 2Q10, underpinned by asset market resilience, in our view.  Private consumption grew 4.6%Y in real terms (albeit slowing from +7.1% in 1Q on base effect), while private fixed investment surged 12.1% (+6.4% in 1Q).  The pick-up in public sector construction activity (commencement of construction of the Express Rail Link) was worth highlighting.  Public investment surged 41%Y, contributing 0.9pp to overall real GDP growth, unseen since the airport construction program in the mid-1990s.  Stock accumulation, traditionally a volatile component in the national income accounts and at 8.4pp (even more than the overall growth rate) in 1Q10, normalized somewhat in 2Q, although it still contributed 4.7pp.

Marking Forecasts to Market

The Hong Kong economy has performed better than our earlier forecast in 1H10.  We attribute this mainly to the resilience in asset markets, as the positive support to monetary conditions from delayed policy exits in developed markets more than offset the challenges presented by the lackluster recovery in the US and deterioration in sovereign financial health in Europe.  We had maintained more conservative forecasts for 2010 than consensus as we refrained from extrapolating the recovery dynamics from 2009 - which were powered primarily by asset market gains - but factored in downside risks from government policy and asset market correction (see A Fragile Recovery in 3Q09, November 15, 2009), to which Hong Kong's economic cycle is more vulnerable than other economies in the region.

Nevertheless, having realized such robust growth in 1H10, we are lifting our forecasts.  We revise our 2010 GDP growth forecast to 6%, up from 4.5% previously.  We expect a slowdown to follow in 2011, to around 4%, up from 3.5% in our last round of forecasts.  The latest revisions, however, merely mark to market rather than representing a fundamental change in our view.  Although our team has repeatedly pushed back the expected timing of US monetary tightening (the Fed is now forecast not to hike rates until 2H11), thereby extending the support from easy liquidity conditions, we continue to see asset market fragility as a key risk factor to growth in the months ahead, especially following additional measures announced today to cool the property market through increasing land supply and tightening mortgage lending.

On the inflation front, recent trends in the headline CPI have been in line with our forecasts.  Indeed, asset price recovery significantly shortened the deflationary episode in the aftermath of the global financial crisis.  We are maintaining our 2010 CPI inflation forecast at 2.8%.  Yet, cost pressures stemming from the property sector are feeding through the economy, meeting with increasingly vocal demands for higher wages, and planned hikes in public transport fees.  So we forecast a pick-up in inflation to 3% in 2011, revised up from 2.5% previously.

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India
India to Outpace China's Growth by 2013-15
August 17, 2010

By Chetan Ahya | Singapore & Tanvee Gupta | Mumbai

In our second report comparing India and China in 2006 (India and China: New Tigers of Asia, Part II, May 29, 2006), we made a call that India had the potential to catch up with China in terms of GDP growth rates. That time has come, in our view. We believe that, over the next two years, India should start matching China's GDP growth of around 8.5-9.5%, barring another global financial crisis. More importantly, we think that, by 2013-15, India will start outpacing China's GDP growth notably. Morgan Stanley's Chief Economist for China, Qing Wang, believes that China's growth will move towards a more sustainable rate of 8% by 2015, following the remarkable 10% average over the past 30 years. We believe that India's growth will accelerate to a sustainable 9-10% by 2013-15, after an average of 7.3% over the past 10 years. In other words, over the next 10 years, we expect India's growth to outpace China's. Indeed, we expect India's per-capita income to reach China's 2009 levels of US$3,750 over the next 10-11 years. We believe that India will see a further rise in investments to GDP, particularly infrastructure, and China will see a gradual rise in consumption GDP.

India Is Transitioning to Higher Sustainable Growth Rates

India's GDP growth has moved from a range of 6% in the early 2000s to 8-8.5% currently. We believe that this shift has been premised on three key factors.

First, the improvement in demographics as measured by declining age-dependency (the ratio of the dependent population size to the working-age population size) has been the most important factor supporting this acceleration in growth. The ratio of the number of elderly people and children to the working-age (aged 15-64 years) population has declined from 68.6% in 1995 to 55.6% in 2010, according to United Nations (UN) estimates. In other words, the working-age population has been growing faster than the dependent population. This has helped support a structural rise in domestic savings.

Second, structural reforms have improved the utilization of the working-age population, a key resource. A positive demographic trend may be a necessary condition for strong growth, but it is not sufficient alone. Favorable demographics need to be converted into a virtuous cycle of acceleration in growth. A critical step in this process is the opening up of productive job opportunities through reforms. Over the years, India's government has been initiating reforms to encourage private sector investment, which helps to create the platform of employment for the working-age population. In this context, one of the long-standing challenges for India was acceleration in infrastructure spending. The government has finally been able to address this.

We expect infrastructure spending to rise to 8% of GDP in 2010 from 7.5% in 2009 and 5.4% in 2005. Similarly, business capex has been accelerating, except for during the recent period following the global credit crisis. The corporate sector has evolved from infancy to be ready to grow in an open global competitive environment. This rise in investment has indeed created the employment platform for the growing working age population. These reforms have played a critical role in boosting productivity growth. For an exhaustive list of reforms, please see Appendix 1 in the full report.

Third, globalization, as reflected in the steady rise in exports to GDP and capital inflows to GDP, has also helped accelerate the pace of growth. India has relied on both goods and service exports. India's performance in services has been a key differentiating factor. We believe that services exports have higher value-added components and more potential in terms of the impact on the rise in savings rate. India's share in global services exports increased to 2.6% in 2009 from 1.1% in 2000. Also, we believe that India has benefited significantly from a rise in capital inflows.

A combination of structural reforms (including reduction in import tariffs and other protection), an increase in private corporate and infrastructure investments and financial deepening, and changing corporate sector efficiency has resulted in a steady increase in total factor productivity (TFP) growth. Our estimates indicate that India's TFP growth accelerated from an average of 2.4% in the 1990s to 4% in 2005-09.

This interplay of demographics, reforms and globalization is crucial for the virtuous cycle of faster growth in productive job creation - income growth - savings - investments - higher growth. Over the past 10 years, India's savings to GDP has risen from 24-25% to 33-36%. Similarly, investment to GDP has risen from 24-25% to 35-38% and GDP growth has accelerated to a trailing five-year average of 8.5% in 2009 from 5.9% in 2000.

Factors Behind the Lag in India's Performance versus China

China has managed to convert its advantage of a growing working population into a virtuous loop of creating productive jobs for its expanding workforce and translate this to higher savings, investment and growth since the early 1980s. China's age dependency peaked in 1965 at 80.4%. Since then, the country's working population has been rising sharply. Its age dependency fell to 67.4% in 1980, 48.2% in 2000 and 39.1% in 2010. Concurrently, China's government has been able to increase productive employment opportunities and, in turn, generate higher savings. China's savings rate increased from about 25% in the mid-1960s to 35% in 1980, 37.5% in 1990 and 51.4% in 2009, supporting a major rise in investments to GDP. Real GDP growth in China has averaged 10% annually over the past 30 years, compared with 6.2% in India. During this period, China's GDP grew 16 times to US$5 trillion whereas India's rose seven times to US$1.2 trillion. China's exports (including services) surged 65 times over this period to US$1,330 billion while India's exports increased 22 times to US$250 billion.

The lag in India's performance, in our view, was due to the lower level of support from demographic, reform and globalization factors. India's demographic cycle is trailing China's. Although the two had similar age-dependency ratios in the late 1970s, China has far outpaced India in the past 20 years. China was also well ahead of India in initiating structural reforms, introducing them in the late 1970s versus in the 1990s in India. One could argue that the pressure on policymakers to create jobs emerged earlier in China because of the way the change in the working-age population progressed there. India was also late in deciding to participate in globalization, as reflected in the import tariff trend.

India's integration with the global economy started to accelerate in the early 1990s while China's integration began in the early 1980s. For example, India had import tariffs above 30% until the early 1990s. Indeed, we believe that India is following the same path as China when we compare their export-to-GDP ratios, keeping the starting points for both as the years in which the countries initiated the liberalization that allowed their resources to interact with those of the rest of the world.

However, India's GDP growth is now inching closer to China's. Over the past three years, India has been narrowing the gap with China in terms of GDP growth. In 2010, we estimate India's GDP growth at 8.5% and China's at 10%.

India to Start Outpacing China from 2013-15

We believe that, by 2012, India and China will likely achieve similar growth rates of closer to 9% and from 2013-15 India will start outpacing China's GDP growth notably. The demographic trend is likely to diverge in the two countries. China is expected to reach an inflexion point in its age-dependency ratio around 2015. The UN estimates that China's age-dependency ratio will rise from 39.1% in 2010 to 40% in 2015 and 45.8% in 2025 whereas India's will continue to improve from 55.6% in 2010 to 51.7% in 2015 and 47.2% in 2025. This would be reflected in the median age in China, which by 2020 would reach 37.1 compared with 28.1 for India. The economic impact of India's demographic trends should improve further as age dependency declines.

India to Emerge as the Largest Supplier of Labor

India will account for almost 26% of the increase in global working-age population over the next 10 years, according to UN estimates. The large surplus in India's working population is forcing recognition in the world economy of the country's role in global competition and output dynamics. As mentioned, UN data show that, by 2020, India will contribute an additional 136 million people to the global labor pool.

In comparison, China and the US will contribute 23 million and 11 million, respectively, while Japan's and Europe's working populations are estimated to decline by 8 million and 21 million, respectively.

Demographics alone are not sufficient for acceleration in GDP growth and it is important that the working population is educated. Over the past few years, the trend in education in India has improved significantly. We believe that the quality mix of the fresh additions to the workforce over the next 10 years is likely to change dramatically. We estimate that only 7-9% of India's population moving into the 15-plus age bracket is illiterate and that this could dip well below 5% over the next 2-3 years.

Primary school enrollment rates have risen significantly in India over the past few years - on a net and gross basis to 90% and 113%, respectively. Key reasons for this have been the success of the government's Sarva Shiksha Abhiyan (providing universal primary education) program and Midday Meal Scheme (under which a free lunch is provided to students to encourage them to attend school). The number of out-of-school children in the primary age group dropped to around 5.6 million in 2007 from 18 million in 2000, according to World Bank estimates. Also, the drop-out ratio has improved significantly in recent years. According to District Information System for Education (DISE) data, the retention rate (the percentage of students who complete their education) at the primary level improved to 73.7% in F2008 (12 months to March 2008) from 58% in F2005 and 53% in F2004.

We estimate that, if current trends continue, the number of students graduating from primary school each year (out-turn) could increase from 18 million in 2009 to 20.3 million in 2015 and 21.4 million in 2020. The impact of higher enrollment would be felt on out-turn at the secondary level as well. Indeed, secondary enrollment rates have already started to pick up. According to World Bank data, the secondary school gross enrollment rate in India rose to 57% in 2007 from 46.2% in 2000. In India, there are two key secondary education levels - lower secondary (education up to Grade 10) and higher secondary (education up to Grade 12). We estimate that lower secondary out-turn could increase from 8.5 million in 2009 to 11.8 million by 2015 and 14.5 million by 2020, and that upper secondary out-turn could increase from 5.8 million in 2009 to 9.2 million by 2015 and 11.2 million by 2020.

This would also filter through to the tertiary level. Out-turn at the tertiary level could increase from 3.7 million in 2009 to 5.7 million by 2015 and 7.2 million by 2020, we estimate. This would imply an increase in India's tertiary-educated workforce size from 50-52 million in 2009 to 114 million by 2020. The out-turn of tertiary graduates in China has been much larger than in India because of a significantly larger delta in population in the 20-24 age bracket. However, this trend is likely to change over the next few years, with the delta in population in this age bracket becoming larger in India. By 2020, we believe that India will have the largest annual out-turn of tertiary graduates globally.

The availability of infrastructure and teachers will be key to ensure the quality of education and supply of an educated workforce does not become constrained with the rapid growth. For our estimates of growth in the primary-, secondary- and tertiary-educated population to materialize, there would need to be adequate measures to increase the number of teachers and professors. India's pupil-teacher ratio at all three levels is higher than those in other key countries. Indeed, at the tertiary level, we estimate that an additional 40,000 teachers/professors would be needed annually to maintain the current pupil-teacher ratio. This compares with the outstanding stock of teachers at the tertiary level of 540,000.

Steady implementation of structural reforms is important to create the employment platform for rising supply of educated/skilled labor. Further reforms that help create the platform of productive employment for the rising working-age population in India will be needed, in our view. India's voting population demographics are changing rapidly, with a rising bias towards younger people, who are literate and hungry for development. Indeed, the positive outcome of a larger share of the seats in parliament for the single-largest party in general elections held in May 2009 is allowing the Congress Party-led coalition government to initiate some difficult reforms. For example, over the past 12 months, the government has systematically focused on reducing the subsidy burden on oil and gas. Also, infrastructure execution is picking up gradually.

Over the next 12-24 months, we expect the pace of reforms to pick up with the government initiating the following reforms:

a) Further steady reduction in subsidies: For instance, the government announced a 10% hike in urea (fertilizers) prices and a new nutrient-based subsidy in February 2010. For gas, the government approved a revision of administered gas prices effective June 2010. Also, the government has increased domestic fuel prices twice so far in 2010 and has announced that gasoline prices will be market-linked from now on. We estimate that these measures will effectively reduce subsidy expenditure for an annualized rate of c.0.6% of GDP. We expect the government to maintain its path to reduce subsidy burden.

b) Introduction of Goods and Services Tax (GST) system: A transition to GST would be an important milestone from a macro perspective, moving from the current system of different types of indirect taxes and multiple rates of indirect taxes. The new system would cover a wider base, including all goods and services. The current system taxes production, whereas the GST will aim to tax consumption. Indeed, current law levies taxes on the movement of goods from one state to other, effectively creating borders within borders. It distorts the allocation of resources and inhibits productivity growth. India's budget confirmed government plans to implement the consolidated nationwide GST system from April 1, 2011.

c) Direct tax reforms: These reforms aim to broaden the tax base and will minimize exemptions. The budget for F2011 has confirmed a plan to implement direct tax reforms as recommended in the direct reforms code (DTC) in F2012.

The Ministry of Finance has issued a draft new code for direct taxation. The thrust of the new code, as its foreword says, "is to improve efficiency and equity in direct tax system by eliminating distortions in tax structure, introducing moderate levels of taxation and expanding the tax base". For broadening the tax base, the code will minimize exemptions. The removal of these exemptions will improve the tax-to-GDP ratio and efficiency in allocation of resources. The new code will also simplify the language and law to reduce litigation and check tax evasion. Moreover, the new code aims to encourage long-term savings. The tax incentives for savings will be rationalized. The code aims to follow the Exempt Exempt Tax (EET) rule, under which initial savings contributions and accrual of interest are exempt but withdrawals would be subject to normal taxes.

d) Consolidation of the public sector deficit: The government has accepted in principle the recommendation by the 13th Finance Commission for a fiscal roadmap for fiscal deficit and revenue deficit for F2010-15. The commission includes the following medium-term fiscal consolidation plan: i) to cut the consolidated (centre plus state government) fiscal deficit to 7.3% of GDP by F2012 and 5.4% in F2015. ii) This will enable the government to reduce consolidated public debt to GDP to 76.6% by March 2012 and 67.8% by March 2015.

e) Meaningful steps towards divestment of the government's stakes in SOEs: The government plans to initiate a meaningful divestment program, targeting collection proceeds. The budget target calls for raising Rs400 billion (US$8.7 billion, 0.6% of GDP) from divestments in F2011 compared with an estimated Rs250 billion (US$5.5 billion, 0.4%) in F2010. We estimate the value of the government's stakes in listed SOEs at US$300 billion. If we include unlisted companies, the value would be c.US$450 billion.

f) Acceleration in infrastructure spending, particularly for roads and power: The government plans to increase infrastructure spending to 8.4% of GDP in F2012 from 7.5% in F2009. The Planning Commission has estimated that infrastructure investment in F2013-17 will rise to a cumulative US$1 trillion compared with US$542 billion in F2007-12. Key areas where infrastructure spending is rising include power, roads and telecoms. We believe that this plan is realistic and achievable.

g) FDI in retail marketing and distribution: We believe that by mid-2011 the government is likely to allow foreign direct investment in multi-brand retail distribution with conditions attached for compulsory contribution to back-end infrastructure investments and absorption of the rural workforce. India, at present, allows FDI in single-brand retailing to the extent of 51%, and 100% for cash-and-carry wholesale trading. If the government were to allow FDI in the retailing sector for multi-brands, it would result in a dramatic increase in retail sector growth, in our view, involving an increase in input of capital, technology and new management practices, which could reform the whole retail business chain. In our view, this move of allowing FDI for multi-brand retailing would restructure: a) retail distribution via higher asset turnover and better inventory management; b) intermediary and logistics management; and c) production management for agriculture and manufacturing. Inefficiencies in the agriculture sector could be reduced significantly through improvement in the supply chain triggered by retail sector growth. Similarly, SME manufacturing would get a major demand boost and face pressure to increase efficiency.

In addition to these positive trends in demographics/talent supply and structural reforms, India should continue to benefit from globalization, which should help to increase productive job opportunities for the country's skilled labor force. We expect India's exports to GDP to continue rising. The combined effect of more favorable demographics and increased productive job opportunities should boost India's private savings level and push aggregate savings to 37-40% of GDP over the next 10 years, allowing the country to maintain an investment/GDP ratio of 39-42%, we estimate. This increase in savings and, correspondingly, the investment/GDP ratio should ensure a shift in India's growth to a sustained rate of 9-10% in this period.

Net capital inflows as a percentage of GDP in India have increased sustainably to 4-5%, except for during the credit turmoil. Gross FDI in India increased to 2.8% in 2009 from 0.9% in 2005. Indeed, FDI as a percentage of GDP in India is now higher than in China and Brazil. Capital inflows help India fund its current account deficit and allow the country to accelerate investments more than savings. Moreover, capital inflows into India tend to be in the nature of high-risk capital. Indirectly, this large source of risk capital acts as a catalyst to private corporate capex. The combined impact of the continued structural reforms, financial deepening and rising investments should help to boost productivity growth further over the next 10 years.

Qing Wang expects China's sustainable GDP growth to moderate to 8% towards 2015. With a changing demographic trend, China is unlikely to have a rise in the supply of cheap labor at the same pace as has been the case in the past 20 years. Over the next 10 years, China will add only 23 million people to its working-age population compared with 118 million people added over the past 10 years, according to UN data, while India will add 136 million over the next 10 years. The UN estimates that China's age-dependency ratio will start rising from 39% in 2010 to 40% in 2015 and 43.7% in 2020.

In this context, we expect China to initiate structural change in its growth model, reducing the dependence on external demand, increasing consumption to GDP, and narrowing the current account surplus. This rebalancing would primarily be premised on lifting wages as a percentage of GDP and the re-pricing of economic resources such as materials to reduce environmental costs. A corollary to this trend, we believe, will be the transition of the country's exports model from low-value-added manufacturing to higher-value-added manufacturing. Similarly, we think that China's share of consumption to GDP and services to GDP will rise over the next 10 years.

India to Offer Best Growth Opportunity over Next 25 Years

Over the next 20-25 years, we expect India to remain the highest growth economy among large countries. India could have the advantage of maintaining its high-growth phase for a longer period than East Asia did as UN data show that India's age dependency will continue to decline until 2040.

Indeed, UN projections show that India will be the only large country which will still have favorable demographics after 2010. Japan, Europe and the US (in that order) will have a significant rise in their aging populations. So, while in the past 20 years, China has benefited ahead of India from a faster fall (improvement) in age-dependency ratio, over the next 20-25 years India will have this advantage.

Internal Challenges to Sustain Strong Growth Story

We believe that there are several challenges to India's high growth story. First, the government needs to ensure that it delivers on execution of infrastructure development. The trend in China over the past 25 years indicates that, for 10% sustainable GDP growth, India would need to increase infrastructure spending to 10% of GDP from the current 7.5%. We believe that the government would need to focus on laying down the policy framework and support to ensure a sustained increase in investment in key sectors such as electricity, highways and railways.

Second, one of the key pillars of our strong outlook for India is a structural rise in domestic savings and investments. In that context, reduction of the government's revenue deficit would be critical. The government made a move in that direction in February 2010 by targeting a lower fiscal and revenue deficit, but such efforts would need to continue over the next few years.

Third, labor law reform would need to be prioritized. We believe that sustained strong growth in SMEs will be an important driver of India's growth. There are more than 40 labor-related laws from the central government on such issues as compensation, retrenchment, industrial disputes and trade unions. State governments also have several pieces of labor legislation. Most of these laws are not in sync with the practical realities of a highly competitive globalized world. We believe that labor law reforms would be needed to support growth in labor-intensive industries.

Fourth, development of less-developed states. Rising income inequality and high poverty levels in some states have increased the probability of social instability. Already, a few states have faced insurgency from naxalites and the internal security threat from this movement is a concern.

Fifth, as discussed, significant progress has been made in improving primary and tertiary education. The success of primary education has meant that the demand for secondary education infrastructure is beginning to rise rapidly. We believe that measures to further improve secondary and tertiary education infrastructure would be required to help sustain the strong growth story.

For details, see India and China: New Tigers of Asia, Part III, August 13, 2010.

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China
Social Housing: Lackluster Growth or Quantum Jump?
August 17, 2010

By Qing Wang & Ernest Ho | Hong Kong

A Roller-Coaster Ride

It had been quite a rough ride for the Chinese property market so far this year. Discussions of an overheating property market seemed never-ending, while on the contrary the almost unanimous expectations of ever-rising property prices in the local market baffled many investors. The tide finally turned against the exuberance after the State Council announced a series of austerity measures in early April, aimed at reining in speculation in the property markets in cities where housing prices were deemed to be too high and rising too fast. Transaction volume has since plummeted, with prices expected to follow suit. Fear of an economic hard landing was brewing, and bearish sentiment was widespread.

Going Against the Crowd

We disagreed with this popular notion, and argued that the anti-speculation measures would not lead to an economic hard landing (see China Economics: Can Recent Policy Campaign Against Property Speculation Cause a Hard Landing? May 24, 2010). Soon after, the optimism towards the ambitious social housing program faced the same fate, as many market observers dismissed the feasibility of a project of such unprecedented scale. At the height of the uncertainty, we again argued otherwise, noting that "this time is different", i.e., the social housing program would help secure a soft landing based on our assessments of still-supportive bank lending conditions, extraordinarily strong political will from both the central and local governments and the serious financial commitment from the government (see China Economics: Can Social Housing Program Help Secure a Soft Landing? June 17, 2010). Our view, which seemed based solely on faith just two months ago, is quickly gaining tractions in the market of late.

Revisiting Our ‘No Hard Landing' Thesis

Recall that in our first report on this subject (see China Economics: Can Recent Policy Campaign against Property Speculation Cause a Hard Landing? May 24, 2010), we proposed a framework to analyze the real estate market, in which we contended that the residential floor space construction could be categorized into ‘commodity housing', which had received almost all the attention of market observers, and the ‘non-commodity housing' space, which includes all the subsidized housing provided by government agencies, state-owned companies and large private companies to their employees, as well as social housing. The role of the latter in overall construction activities has been largely ignored until recently as social housing was again back in the spotlight.

In our early study, we found that, in terms of floor space completed, the residential commodity housing market accounted for 37% of total floor space construction nationwide, within which 15% was in the 35 largest cities, where the anti-speculation policy measures are particular relevant. Similar results can be deduced for floor space under construction, which is arguably more pertinent to gauging the current state of economic activities.

Specifically, the 35 largest cities accounted for 18% of the grand total, with about 6% concentrated in the top 10 cities, where property prices are deemed to be too high or have risen too rapidly. The four tier-1 cities, Beijing, Shanghai, Guangzhou and Shenzhen, where both the primary and secondary residential property markets are believed to be liquid and most prone to speculation, only added up to about 3% of total floor space under construction nationwide. Therefore, the tail risk of a potential economic hard landing as a result of the Chinese government's austerity measures is in fact not as significant as many expected, even in the extreme scenario where residential commodity building construction were to experience a deep downturn.

Revisiting Our ‘Soft Landing' Thesis

We then went further in our second report with the objective of shedding some light on the ‘non-commodity' part of the residential property market, arguing that an expected substantial expansion in the social housing program would not only help offset a potential slowdown in market-based residential property construction, but also contribute to a soft landing in overall fixed asset investment (FAI) growth (see again China Economics: Can Social Housing Program Help Secure a Soft Landing? June 17, 2010).

Given the lingering uncertainty and the significant implications on various sectors and the macro-economy in general, we think it is imperative that we derive an analytical framework that is, on the one hand, rigorous enough to have reasonable assurance of its relevance, while on the other flexible enough to incorporate possible scenarios, given the current conditions.

First of all, based on client feedback, we understand that many market observers would simply associate social housing with ‘residential commodity economic housing'. While this is definitely one of the pillars of the social housing program, there is certainly more to it. Its apparently insignificant share in the total floor space under construction also leads many to downplay its relevance to overall construction activities. If we agree that ‘residential commodity economic housing' is only part of the social housing program, the rest of it must fit somewhere in our ‘flowchart'. Considering the fact that the majority of social housing is in the form of low-rent housing and public rentals that are not sold in the commodity housing market and are not entirely market-based, the only rational place it could go would be under ‘residential non-commodity housing'.

The next question is: how much of social housing is classified as ‘commodity housing' and how much as ‘non-commodity housing'? Making reference to the social housing construction plan for 2010 announced by Premier Wen in his Government Work Report for 2010, it is reasonable to assume that a majority of it should be in the ‘non-commodity' category.

If indeed a majority of social housing construction happened/will happen in the ‘non-commodity' part of the residential market, it is again reasonable to expect that some of the residential ‘non-commodity' floor space under construction originally not for the purpose of social housing will now be ‘reclassified' under it, an easy route to fulfilling the 2010 target. In this case, at least some of the residential ‘non-commodity' floor space under construction for previous years will become social housing floor space completed under the ‘non-commodity' category.

It follows that an outright bearish scenario would point to a ‘total reclassification', making the relevant floor space completed in the residential ‘non-commodity' space for 2010 solely comprised of social housing construction ‘reclassified' from ‘non-commodity' housing construction in 2009 and 2010 intended for entirely different purposes.

This quite conservative scenario is actually what we had implicitly assumed in our stress tests done in our previous report (see China Economics: Can Social Housing Program Help Secure a Soft Landing? June 17, 2010), in which we concluded that the substantial ‘expansion' of social housing program this year, along with the supportive bank lending conditions, will help secure a soft landing in FAI growth.

A Potential Quantum Jump

Based on our analysis on the average historical run-rate of floor space under construction and understanding of the social housing program, we came up with a proposition that would potentially result in a ‘quantum jump' in construction activities.

By looking into the latest data available, as of end-June 2010, the total floor space under construction is 5,003 million sqm compared to 4,036 million sqm for the same period a year ago, representing 24%Y growth. The total residential floor space under construction demonstrated a similar trend, coming in at 2,789 million sqm versus 2,266 million sqm in 1H09, or 23%Y growth. The residential commodity floor space under construction also recorded strong growth, gaining 28%Y from 1,874 million sqm to 2,390 million sqm by end of 1H10.

Historically, the run-rate of total floor space under construction by mid-year was about 70% on average. Residential commodity floor space under construction showed a similar trend. If we assume the same run-rate for this year, the total floor space under construction will add up to 7,147 million sqm, a 24.5%Y growth rate compared to 2009, not quite a slowdown at all compared to last year.

Further, if one is still not entirely convinced that construction activities in terms of floor space under construction may have indeed registered some healthy growth instead of experiencing a sharp slowdown during 1H10, consider the following proposition: what if subsidized housing (i.e., housing provided by government agencies, state-owned companies and large private companies to their employees, which is in itself ‘social' in nature) was not included in any of the social housing plan? To put it differently, what if subsidized housing represents an additional section of the residential housing market that is not counted as part of the social housing construction target of 5.8 million units in 2010? It is possible, in our view, given that social housing, as defined by the MLR, includes low-rent housing, economic housing, and part of slum area reconstruction - i.e., no mention whatsoever of subsidized housing, which had long been a solid contributor to the total floor space construction nationwide as it is arguably more immune to market sentiment swing and less policy-driven than social housing or residential commodity housing - accommodations would be provided by companies, public or private, as the need arises, regardless of then-market sentiment or policy stance.

In the most bullish scenario, assuming that all the 370 million sqm of floor space were all completed by year-end as planned, the social housing floor space completed would surge from about 34 million sqm in 2009 to 370 million sqm, effectively a ‘quantum jump' of more than 10x. At the same time, it is almost certain that, by definition, the construction of subsidized housing would still go on as planned, while the latest data are telling us that an outright slump in residential commodity housing construction did not happen. All in all, real estate construction activities are ‘unimpaired', to say the least.

The Likely Outcome: No Lackluster Growth; Quantum Jump Not Impossible

Based on the above analyses, we feel quite comfortable in predicting that the growth of social housing construction will be anything but lackluster. At the same time, we are not able to rule out an alternative scenario where social housing construction would enjoy a quantum jump. The bottom line is that there will be absolutely no shortage of underlying demand for real estate construction this year, in our view.

In this context, we reiterate our prediction that the most important factor affecting FAI in general, and real estate construction in particular, in China is the availability of funding for investment, or bank credit in particular. The new loan target of Rmb7.5 trillion for this year implies an expansion of about 19%Y in the outstanding amount of bank credit. As long as this credit target is fulfilled, the probability of a hard landing of real estate investment growth is very low, in our view.

As a matter of fact, we have already detected a visible softening in policy tone in 3Q in view of the recent comments made by top leaders. Specifically, President Hu, while attending a high-level meeting on the economy and policy in late July, called, for the first time ever, for "strengthening economic monitoring and forecasts", leading us to believe that the authorities have come to realize that the ‘overheating' call after the 1Q10 data release was perhaps premature, and the policy measures initiated in April were probably overly aggressive. Separately, Premier Wen gave a new characterization of the current state of the Chinese economy and warned that "China's economy is facing increasing dilemmas given higher-than-expected severity of global financial crisis".

The overall macroeconomic condition will become even more conducive to a meaningful policy shift by early 4Q, when the 3Q macro data are released, which will likely indicate a further slowdown in year-on-year growth rates on all fronts including FAI, exports, IP, as well as CPI and PPI inflation, making it easy to reach a consensus for a policy shift in the form of easing credit controls and investment project approval controls.

Moreover, in light of moderating economic growth, controls on local government financing appear to have started to ease, as signaled by the modest rebound in the budgeted investments of newly started projects in July (see China Economics: Moderation Continues with Intensified Supply-Side Adjustment, August 11, 2010). In addition, ample ammunition has been saved for 2H10 as the issuance scale of local government bonds would quadruple to Rmb165.9 billion. Meanwhile, the issuance of city development bonds has resumed after a brief suspension. Given all these, a further substantial slowdown in FAI in 2H10 is unlikely, in our view.

Bridging the Information Gap

We recognize and understand that the lack of conviction for the social housing program among many China observers, given its poor track record in recent years and the apparent inadequate incentives for local government to actively participate in the program. The dearth of timely and reliable data was also doing a disservice to informed analyses, making it very difficult to track and evaluate the progress along the way. It is, however, extremely important information for the forecast of expected growth in fixed asset investments, not to mention its significant implications to related industries such as the demand for basic materials and construction activities.

This is what we are attempting to achieve through the analysis below - to fill in the information gap as much as possible, and to assist investors in making informed decisions with regard to the social housing program.

Land Supply - The Mother of All Debate

According to the latest data released by the Ministry of Land and Resources (MLR), the land supply for social housing actually realized by the end of 1H10 amounted to 95 million sqm, 133%Y growth compared to 1H09, with Ningxia, Hainan, Qinghai, Guizhou and Heilongjiang recording the strongest growth among all provinces/regions. However, the land supply realized so far represents about 39% of planned land supply for 2010 as a whole, making one wonder whether the whole year target can actually be delivered.

If History Is Any Guide (Which We Believe it Is)

While there is very little historical data specifically for the land supply of social housing, we can use the data for residential land supply as a rough reference to the mid-year progress normally reached historically.

We observe that, in 2008 and 2009, the pace of residential land supply accelerated considerably in 3Q and 4Q compared to 1H. While historical data for land supply are not available before 2008, a similar trend can be seen for land area purchased and developed. On average, 38% of land supply, and 38% and 36% of land area purchased and developed, respectively, was realized in the first six months of the year, followed by significant pick-up in activities in the second half of the year.

While the current run-rates suggest that the land supply for social housing is largely on track, it is also worth noting that the social housing program did not begin in earnest until after Premier Wen delivered his Government Work Report for the Year 2010 in March 2010, if not even later as the anti-speculation measures in the real estate market were announced in early April. We can, in fact, no longer describe the run-rate as ‘lackluster' if we consider it a result of mostly one-quarter's worth of efforts. Given all these factors, the probability of achieving the land supply target does not look remote at all, allowing for an expected significant pick-up in activity for the rest of the year.

Financing - Show Me the Money...One More Time!

Financing has always topped the list of most frequently asked questions. Investors are concerned about the lack of financing incentive from local governments, and the poor track record of social housing programs allegedly largely stemming from this very reason. A number of favorable developments on the financing front have emerged since our last report was published, making us become even more comfortable that it should not be a problem to, at the very least, make ends meet for a social housing program.

As a quick recap on the sources of financing, the central government has pledged to arrange Rmb63.2 billion specifically for social housing construction. An estimated Rmb136.6 billion will come from local government, which is 10% of Rmb1,366 billion, the land sale revenue for 2010 estimated by the Ministry of Finance (MoF).

Moreover, the fact that the MOHURD takes a leading role in encouraging local governments to borrow from the Housing Provident Funds (HPF) for social housing constructions represents a potential breakthrough in the financing bottleneck, in our view. Specifically, the construction of 133 social housing projects in 28 pilot cities was approved, to be financed by loans borrowed from the respective HPF now separately managed by the local governments. The eligible loan amount for these 28 pilot cities comes in at around Rmb49.3 billion.

According to a directive jointly issued last year by the MOHURD, MoF, NDRC, PBoC, National Audit Office and CBRC regarding "the use of loans from the HPF to support social housing constructions in certain pilot cities", up to 50% of the net outstanding balance in the fund (after setting aside enough funds for priority employee withdrawals, personal housing loans and provisions) can be used to support social housing construction. According to the MOHURD, as of end-2008, the net outstanding balance of all Housing Provident Fund nationwide add up to Rmb319.3 billion, 50% of it (i.e., Rmb159.7 billion), is thus potentially available for the specific purpose of social housing constructions. Further, the same six agencies will also join forces to inspect the operation, management and decision-making processes of the funds, in order to ensure that the fund assets are being utilized properly.

Moreover, a notable language change in PBoC's description of its credit policy in its 2Q Monetary Policy Report just recently published also leads us to believe that additional support is on the way (see China Economics: Our Quick Reading of PBoC 2Q Monetary Policy Report, August 5, 2010). Specifically, the 2Q report refers to a principle of "support and control". This is a change from a long-standing principle of "assurance and control" that was usually mentioned in previous reports. While ‘assurance and control' means that credit demand by some priority sectors would be guaranteed, those by some other low-priority sectors would be tightly controlled. We believe that under the new principle of ‘support and control', some priority demand for credit such as social housing programs will not only be satisfied, but will also receive additional support (e.g., in the form of lower interest rates made possible by fiscal subsidy).

Financial Innovation Comes into Play

It was reported in local media that a REIT based on Tianjin's low-rent housing projects recently received the PBoC's approval, and is likely to become China's first REIT once the State Council gives the final green light (see China Strategy: Another Step Forward in Social Housing: REIT Financing Model Unveiling, August 10, 2010). Our China Equity Strategy team estimated that REIT financing can potentially cover 20% of the financing need for low-rent housing in China, on top of the 60% pledged by central government. The remaining 20%, or less than Rmb20 billion, represents less than 1% of local governments' fiscal income in 2010.

All these favorable developments on the financing front not only reinforce the government's determination to ensure that ‘this time is different', but also point to increasing involvement from the private sector. The diversification of the sources of financing will be immensely helpful in the sustainable development of the social housing program going forward, in our view.

The Whole Nation Seems Playing Catch-Up

Based on the flows of news coverage for social housing, we detect that social housing activity has picked up significantly, not only in major cities, but also across the nation. This anecdotal evidence suggests that the social housing program is quickly gaining traction, and will likely run in full gear soon, in our view.

Stage Is Set for Social Housing Delivery Beyond 2010

While all eyes are on the one single, allegedly, most important figure of 5.8 million units of social housing completion target by end-2010, investors should not lose sight of the fact that the ‘visible hand' managed not only to kick-start, but also to create strong momentum toward a considerable acceleration in the social housing program for the rest of the year and beyond - from Premier Wen's address in March, the announcement of the anti-speculation measures in April, to the pledges repeatedly made by different officials to completing the social housing target this year, local governments are faced with increasing pressure to come up with detailed roadmaps contributing to the successful delivery of the target.

Reflecting strong political commitments, there are notable advances in the sources of financing this time round that effectively hit the nail on the head, and will help promote sustainable development of the social housing program in the long run. The potentially strong performance of the social housing program in 2010 bodes well for MOHURD to deliver its pledge to "solve the housing problem for 15.4 million of low-income households by end of 2012".

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Brazil
What Slowdown?
August 17, 2010

By Gray Newman | New York

It's difficult to know what to make of Brazil's economy today: on the one hand, we have been highlighting a series of data releases suggesting that the pace of economic activity stalled during 2Q, yet listed companies have so far produced strong earnings during the same quarter.  And perhaps more importantly, guidance from many companies has suggested that 2H should be strong again.  How can we resolve this apparent contradiction?  I'd propose three thoughts:

Sequential Thinking: On the Margin

First, beware of different measurement methodologies: strong 2Q results do not contradict our view that the economy virtually stalled in 2Q. Most company results compare the current quarter to the same quarter a year ago.  With that metric, even the macro data that we have been citing look strong.  Industrial production, which was off sequentially -1% in June, was still up over 11% compared with a year ago.  The month-on-month declines in industrial output in May (-0.2%) as well as April (-0.8%) all but vanished when those months' output is compared with the same month from a year ago: May industrial output was up 14.8% while April posted a 17.3% uptick when compared with the previous year.  Year-over-year comparisons tell you a great deal about where you have come from, but not necessarily much about the pace at which or the direction in which you are moving now.

The same distinction applies for the central bank's GDP proxy. When May's GDP was first released, the authorities calculated it was flat to the previous month, but even that weak result still represented a 9.8% upturn compared with a year ago.  The latest GDP proxy - for June - was released this past week and it showed the slump continued in June: real GDP in June posted a modest 0.2% uptick relatively to May, but June was still up 8.6% over the previous year.  (With June's release, May GDP was revised downward to show a 0.1% decline sequentially, but still a robust 9.3% uptick over the previous year).  Faced with such strong year-over-year results - both from the macro front and from company earnings - it is easy to argue with anyone suggesting a slowdown may be underway.  And yet, on a sequential basis, two of the most important measurements of activity - industrial output and GDP - suggest that the economy stalled in 2Q.

Indeed, even the 2Q GDP report runs the risk of glossing over the recent weakness.  It's not just corporate results that mask the recent stalling in the economy: if we map out monthly GDP levels as presented by the central bank in its relatively new monthly proxy, the IBC-Br, the level of output at the end of 2Q was virtually unchanged from that at the end of 1Q.  But that doesn't mean that when the national statistical authorities at IBGE announce 2Q GDP, they will post a result close to zero.  On a year-over-year basis, GDP should still be over 9%.   Even on a quarter-over-quarter basis (annualized), GDP should be near 5%.  But that is because quarterly GDP compares the average of output during 2Q to the average either of 2Q of the previous year or to 1Q.  If activity was on a strong upswing (as it was in 1Q) and came to a halt in 2Q (as it apparently did), you will still see 2Q sequential GDP up (as we likely will). 

For all the dueling metrics, we believe that a meaningful change took place in Brazil's economy during 2Q: production stalled. I still hear the view that in 2Q, the economy slowed the pace of growth, but that it was still growing.  The monthly GDP data suggest to the contrary: activity between June and March was largely flat: zero real growth.  I also hear talk that any ‘slowing' in the months ahead would simply represent a more difficult comparative from a year ago when activity began to accelerate. Our analysis is not about an easier or more difficult base of comparison: we are comparing each month to the immediately prior month.

Give Me Guidance

Second, what matters to most is not the quarter now passed, but what happens next: most companies have provided good guidance for 2H. That actually is our view as well: we expect Brazil's economy to grow near a 4% pace in 2H and into 2011.  That pace may fall short of what the growth in Brazil's labor force demands, but it is a pace at which Brazil should be able to grow without undue pressures on inflation or its balance of payments.

While we are in the 4% camp - in part because we expect a subdued pace of growth in developed economies to translate into softer growth in the emerging world than we had seen between 2003 and 2008 - we admit we could be wrong.  Brazil's economy could once again return to the 5-6% pace seen in recent years.  The surprise could either be temporary and akin to what took place at the end of 2007 and 1H08 when developed economies began to slow but Brazil posted strong growth, or it could be longer-lasting (the promise of the ‘de-couplers').  However, our concern is that if growth returns to the 5-6% pace or faster, we are likely to see it challenged by more inflationary pressures and by significant imbalances in Brazil's external accounts.  With all the focus on Brazil's strong growth earlier this year, little attention has been paid to the looming consequences of that on Brazil's broader external accounts.

What Just Happened?

Third, we still think it is important to revisit what caused the economy to stall during 2Q.  The most popular view is that the economy's ‘pause' was either a consequence of tightening fiscal (and/or monetary) policy or a mid-cycle reduction in the pace of inventory build-up.  As we discussed last month, we don't find the policy-induced explanation fully satisfying (see "Brazil: Slowdown - Comfort or Caution?", This Week in Latin America, July 26, 2010).  While fiscal measures (the end of tax breaks for white goods at the beginning of the year and for automobiles in March) clearly played a role in bringing forward some consumption from the second to the first quarter, it is hard to argue that those measures fully accounted for the dramatic shift in growth from 11% annualized to close to zero.  Especially since the fiscal impulse from both spending as well as revenues (and off-balance sheet activities of Brazil's development bank) at mid-year were at least as expansionary or more expansionary than at the beginning of the year.  And yes, the central bank began hiking, but the first move was on April 29, while the weakening in production dates to February and March. 

We suspect that inventory build-up contributed to part of the strength of the recovery in late 2009 and the first months of 2010. Indeed, national accounts data suggest that inventory accumulation played an important role in the 11.4% annualized jump in GDP during 1Q.  We are a bit more hesitant to ascribe too much weight to national statistical measures of inventories. Inventories or stockbuilding is often used to resolve discrepancies between various measures of GDP.  But there is both anecdotal evidence and word from Brazil's auto industry that suggest the rebuild in inventories has slowed and with it some of the robust production growth seen prior to 2Q.

What I still wonder is whether some of the slowdown in 2Q also came as companies looked abroad and saw a weakening global outlook and decided to slow the pace of production.  If that was the case, it might explain the sharp contrast between the weak production data and most demand indicators that have remained strong.  Employment growth is still strong in Brazil; real wages remain robust; credit to consumers remains healthy; and consumer confidence remains high. And it might explain the recent weakness seen not in ‘current conditions' readings by businesses as much as in ‘expected conditions' later in the year.

The link with the globe would also be consistent with Brazil's own track record: for all the talk that Brazil is largely a closed economy with a low export penetration, in recent decades Brazil's economy has moved with the global business cycle and with commodity prices.  And it should serve as a reminder: if the globe slows, don't count on the Brazil domestic demand drivers rescuing you.  A brief bout of production pause has little impact on employment or consumer confidence or credit, but if the hit to production were to return and last longer, the link to employment, consumer credit and confidence would not likely be far behind.

Bottom Line

After the overheating scare at the beginning of the year, I'd like to be the first one to welcome the pause in 2Q. A slower pace of growth should ease both inflation pressures and the scope of central bank tightening. Indeed, we suspect the central bank provides only a small hike on September 1 of 25bp or even goes on hold through the year's end.  A slower pace of growth also reduces the risk of a greater imbalance than what has already formed in Brazil's external accounts.

But there is only one problem: it is not clear precisely what drove the economy's stalling out. While the conventional wisdom in Brazil seems to be forming that it was a much-needed response to policy tightening or an adjustment to inventories, I find neither explanation fully convincing.  I suspect in part the 2Q performance was tied to concerns about global demand and that means Brazil watchers should not allow the attractive story of powerful domestic demand to leave them unprepared for the risks from a more pronounced global slowdown.

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United States
Review and Preview
August 17, 2010

By Ted Wieseman | New York

Big gains at the intermediate and longer ends and small front-end losses led to a substantial flattening of the Treasury yield curve over the past week as a continued run of sluggish economic data pointed to slower growth in 2Q and 3Q, and the FOMC's decision to prevent a passive scaling back of quantitative easing by directing the New York Fed to start reinvesting MBS and agency maturities into Treasuries ended up negatively impacting sentiment.  The Fed's shift itself was not a surprise, but the decision to buy Treasuries across the curve made the move somewhat more substantive than symbolic relative to our thinking that the buying would be concentrated in shorter-dated Treasuries.  After a mildly positive initial reaction, however, many market participants apparently decided that the Fed was to some extent validating rising (excessively so, in our view) pessimism about the economic outlook but without actually doing much about it aside from stabilizing the amount of excess reserves in the banking system at $1 trillion by keeping the size of its retained portfolio at $2 trillion while extending the duration its holdings a bit.  In addition to a much better relative performance by the long end of the Treasury curve after the FOMC decision following a poor run over the prior few months that had left 5s-30s and 10s-30s at all-time record highs at Tuesday's close, the more sour post-FOMC sentiment was also seen in a sizeable move lower in inflation expectations in the TIPS market after several weeks of modest upside, sizeable pullbacks in equity and credit markets, some softness in commodity prices and a safe-haven rally in the dollar.  Most of the week's net swings took place in just one rough trading session on Wednesday, however, so the unhappiness of some investors with the Fed's approach may have only a short-term impact for now.  After Wednesday, rates markets dealt with some temporarily disorderly losses in the MBS market that was partly related to the Fed's portfolio shift, but risk markets stabilized Thursday and Friday.  A continued soft run of economic data also fueled the market pessimism.  A much bigger-than-expected widening in the June trade gap and another disappointing retail sales report for July pointed to a bigger downward revision to 2Q GDP growth and a weaker initial trajectory for 3Q.  Coming into the week, we were expecting 2Q GDP growth to be revised down to +1.7% and saw 3Q tracking at +3.8%.  Incorporating the trade and retail figures, we now see 2Q being revised down to +1.3% and 3Q running at +3.4%, so the mid-year growth pace looks about a half-point slower.  It's important to note, however, that as miserable as a +1.3% 2Q GDP result would be, at this point all of the revision we expect relative to the initial +2.4% outcome is expected to come in trade and inventories.  Underlying final domestic demand grew over 4% in 2Q, and in the process sucked in a huge amount of imports instead of immediately flowing through into similar upside in domestic production.  We don't expect that pace to be sustained, but we do think that a pace of underlying demand growth near 2.75% can be sustained in the second half, which, along with a positive shift in net exports and continued inventory restocking, can support overall GDP growth near +3.25% in coming quarters. 

With the long and intermediate parts of the curve posting good gains, led by the 10-year over the past week and short end selling off slightly, there was a decent curve-flattening move.  The 2-year yield rose 3bp to 0.54% and old 3-year 2bp to 0.77%, while the 5-year yield fell 4bp to 1.46%, 7-year 14bp to 2.06%, old 10-year 16bp to 2.66%, and old 30-year 13bp to 2.87%.  After several weeks of steady outperformance since lows in inflation breakevens for the year were hit in July, TIPS badly underperformed after the FOMC meeting, sending inflation expectations back down to the July lows.  The 5-year TIPS yield rose 7bp to 0.06%, 10-year fell 4bp to 0.98% and 30-year fell 7bp to 2.07%.  As a result, the benchmark 10-year inflation breakeven, which had risen from a low of 1.69% on July 19 to 1.85% at Tuesday's close, was back down at 1.70% at Friday's close after an initial move higher Tuesday afternoon after the FOMC statement was released was sharply reversed in subsequent days.  This tracked a pullback in commodity prices, with September oil down 6% on the week and December wheat down 3% on the week and 10% since the August 5 high, and a rally in the dollar.  And for some reason TIPS initially responded negatively to the CPI report, which showed a bit of upside.  The consumer price index rose 0.3% in July, lifting the year-on-year pace slightly to +1.2%, boosted by a 2.6% jump in seasonally adjusted energy prices as gasoline held steady in a month when it normally declines.  The core CPI gained 0.1% (keeping the annual pace at +0.9%) on a gradual turn higher in shelter costs after this category accounted for all of the deceleration in core CPI over the past several years.  After an unprecedented run of declines in late 2009 and early 2010, the key owners' equivalent rent category rose marginally in May and 0.1% in June and July, tracking with a lag a tightening in rental conditions across the country.  Rents turned up earlier and have risen for five months now, and hotel prices have shown a run of good increases since February. 

After a big initial curve-flattening rally Wednesday as the market sharply reversed the initial reaction to the FOMC statement to price in a more negative outlook, the rates market focus mostly turned to some dislocations in the mortgage market.  Higher-coupon mortgages have been underperforming for two-and-a-half weeks now since investors first started to consider more closely what could happen to the sharply elevated prices on these issues if policy changes were implemented to allow more homeowners to refinance who are now stuck in high-rate mortgages because of tighter credit standards and lower home equity.  Lower-coupon MBS had continued to outperform the strong run in Treasuries, however, taking current coupon yields to fresh all-time lows below 3.4% at Wednesday's close.  This persistent strength finally seems to be starting to drive some downward pressure on 30-year mortgage rates after they held just above 4.5% on average through July as MBS yields were falling, resulting in the current unusually wide spreads between mortgage yields and mortgage rates.  Freddie Mac's national survey showed average 30-year rates at another record low of 4.44% this week, so there seems to be some movement.  Given where MBS yields are, without the current capacity constraints and reduced competition in the shrunken mortgage origination industry, rates would probably already be down near 4.25%, which would probably be leading to sharply elevated rates of prepayments on 4.5% MBS (based on underlying mortgage rates around 5.25%).  These issues broadly have strong credit quality and substantial positive equity since the underlying mortgages were extended after the financial crisis hit, so when rates become attractive enough, there shouldn't be any of the issues restraining refis in the higher coupons  The Fed's portfolio shift, at least in a symbolic sense selling MBS for Treasuries, and rising concerns about market positioning if the Fed's huge holdings of 4.5% MBS start to refi at an elevated pace into new lower-coupon issues that the market will have to absorb, coming on top of the ongoing pressure on higher-coupon issues as investors price in some risk of a policy shift for high-rate mortgages led to the worst day for the MBS market in a year-and-a-half on Thursday, with large and somewhat disorderly losses across low and high-coupon issues.  This had big knock-on impacts on volatility (which moved up significantly after hitting two-and-a-half-year lows Wednesday), swap spreads and Treasuries.  Thursday's MBS rout created a lot of investor nervousness, naturally, but things settled down quickly, at least for now, on Friday.  On the week, 4.5% MBS lagged Treasuries by about a third of a point, but after a good recovery Friday still posted a modest rally in absolute terms, leaving current-coupon MBS yields near 3.4%, just above the record lows hit Wednesday.  Our desk was noting a good pick-up in mortgage origination activity Friday and expects that the weekly mortgage applications survey could start to show a more substantial pick-up in refinancing activity in the coming weeks.  On top of this expected pick-up in refis, investors will be watching Tuesday's Treasury Department conference discussing the future of housing finance and the GSEs for any new policy initiatives that could impact refinancing speeds. 

Stocks took a big hit on the week and credit came under more modest pressure, supporting the Treasury market gains.  Almost all of the weakness in stocks was in a 3% plunge Wednesday, however.  For a week-and-a-half prior to that, the S&P 500 hardly moved on a day-to-day basis, and then Thursday and Friday it was back to barely moving again, just at a lower level.  For the week as a whole, the S&P 500 fell 3.8%.  The post-FOMC worsening in growth expectations among many investors was reflected in bigger losses in cyclical areas, with industrials, financials and tech underperforming.  Credit also took a significant hit Wednesday, but there was a bit of upside early in the week and small gains late in the week, so the net losses weren't too big.  The investment grade CDX index widened 4bp to 108bp and the high yield index about 30bp to 575bp.  While the effectively zero credit risk agency MBS market saw some substantial volatility and a particularly rough day on Wednesday as investors worried about the pace of future refinancings and the implications of the Fed's reinvestment policy shift, the weaker credit areas of the mortgage market put in a good showing on the week, with the AAA subprime ABX index up 1% and AA up 4%..  Gains were supported by the FHA's announcement on August 6 that its "FHA Short Refinance" program that was initially discussed in March would launch on September 7.  The program will "offer certain ‘underwater' non-FHA borrowers who are current on their existing mortgage and whose lenders agree to write off at least ten percent of the unpaid principal balance of the first mortgage, the opportunity to qualify for a new FHA-insured mortgage".  To qualify, the homeowners must be underwater on their mortgage, which cannot already be an FHA mortgage, current on their existing mortgage payments, and qualify for a new mortgage under standard FHA underwriting requirements.  Meanwhile, the lender has to agree to write the principal on the mortgage down by at least 10% and lower the loan-to-value ratio to no greater than 115%.  Our SPG research team was initially quite positive on the possibilities for this approach when it was announced in March, but it thinks that under the current structure the incentives for lenders and borrowers to participate may not be attractive enough for it to gain much traction. 

Economic data released over the past week continued the recent sluggish trend, with worse-than-expected results in the international trade, retail sales and retail inventories pointing to slower growth in 2Q and 3Q.  Retail sales gained 0.4% in July, but all of the upside was in autos (+1.6%) and gas stations (+2.3%).  The key retail control grouping (sales ex autos, gas and building materials) fell 0.1%, extending a soft run since March.  The most notable contributor to the recent weakness has been grocery store sales (-0.3%), which have fallen for five straight months even as food prices have shown small upside.  Worse results for mall type categories - clothing (-0.7%), general merchandise (-0.2%) and sports, books and music (-0.1%) - than seemed to be suggested by the monthly chain store results also weighed on July results.  And the most directly housing related categories - building materials (-0.3%), furniture (-0.3%) and electronics and appliances (-0.1%) - were soft again after some upside in the spring when ‘cash for appliances' incentives provided a boost.  We were assuming a 0.4% rise in retail control in July, so the 0.1% decline was significantly worse than expected, and there was only a minor offset from a small upward revision to June (+0.3% versus +0.2%).  Incorporating this result, we lowered our 3Q consumption estimate to +2.0% from +2.3% after the sluggish 1.6% rise in 2Q (which the June retail control revision wasn't large enough to alter). 

Also negative for the growth outlook was a much-bigger-than-expected $7 billion widening in the trade deficit in June to $50 billion, high since October 2008, on a 1.3% drop in exports and 3.0% surge in imports.  The somewhat good news in the worse-than-expected result for exports was that it was largely in a steep decline in capital goods (-3.8%), indicating that more of June's gain in domestic capital goods shipments went to domestic investment instead of overseas than previously thought.  Industrial materials exports (-3.1%) were also down sharply and mostly as a result of lower volumes instead of prices, with drops across a range of energy and metals items.  The jump in imports was led by a huge gain in consumer goods (+8%), and autos (+7%) also surged as automakers prepared for an unusually active July for the industry that should be reflected in a strong industrial production report on Tuesday.  Capital goods (+1.2%) posted a decent gain, adding to the positive outlook for investment.  BEA assumed a large widening in the June trade gap in preparing the advance GDP estimate, but this result still ended up being much more negative than expected.  As a result, we look for the already enormous 2.8pp net exports subtraction from 2Q GDP growth to be revised down a half-point more to a near record -3.2pp.  And the much-worse-than-expected June starting point pointed to less room for a quick reversal of this huge drag in 3Q.  Even assuming about half of the major June deterioration in the deficit is reduced in July, we cut our 3Q net exports contribution estimate to +0.5pp from +1.0pp.

Building in the June trade deficit miss and a smaller-than-expected gain in June ex auto retail inventories (0.0% versus BEA's +0.1%) on top of previously reported data that were worse than the assumptions in the advance GDP report, in particular non-durable goods manufacturing and wholesale inventories, we see 2Q GDP growth at this point being revised down to +1.3% from +2.4%.  Underlying demand still looks like it will show a very solid gain, however.  We don't expect any revision to the initially reported 4.1% jump in final domestic demand - GDP excluding trade and inventories, so growth in consumption, business investment, residential investment, and government spending - a high since 1Q06.  Instead, we see the full percentage point expected downward adjustment coming from a 0.4pp cut to the net export contribution to -3.2pp and a 0.6pp cut to the inventory contribution to +0.5pp.  It is also important to note that the big drag from trade reflected the strength in domestic demand, so as arithmetically negative as it was for GDP growth, it did suggest economic weakness.  We look for 2Q import growth to be revised up to +31% from +29%.  Looking to 3Q, the expected downward revision to 2Q inventories initially suggested a half-point or so potential upside to our initial GDP forecast of +3.3% (which assumed no contribution from inventories), but with the quarter-point reduction in our consumption forecast to +2.0% and the worse outlook for net exports, we see 3Q at this point tracking at +3.4%.  This builds in a 2.25% gain in final domestic demand after the 4% jump in 2Q, a half-point add from inventories, and a half-point add from net exports. 

The economic calendar is busy early in the coming week but very light after Tuesday.  Initial jobless claims this week will cover the survey period for the employment report and the initial regional manufacturing surveys will be released - Empire Monday and Philly Fed Thursday - so data focus will be partly on setting initial expectations for the August employment and ISM reports.  The Fed's Treasury buying will start Tuesday in the 4-year to 6-year sector and there will be a second round of buying on Thursday in the 6-year to 10-year range.  There are nine operations scheduled over the next month and total buying is projected by the Fed to be $18 billion.  On the other side of the supply ledger, another big week of new supply after the past week's refunding auctions will be announced on Thursday, when the amounts of the following week's 30-year TIPS, 2-year, 5-year and 7-year auctions will be released.  Supply has not been a problem at all for nominals recently, but the 30-year TIPS has been under some pressure recently on nervousness about the reopening on August 23.  Key data releases due out include PPI, housing starts and IP Tuesday and leading indicators Thursday:

* We look for the headline producer price index to fall 0.2% in July, which would be a fourth consecutive monthly decline, as energy prices continued to slide.  However, the dip is expected to be somewhat smaller than seen in June because food prices appear to have registered a modest rebound on higher quotes for dairy items (the recent spike in wheat prices is unlikely to show up until next month's report).  Meanwhile, the core should be well behaved, with a modest rebound in the motor vehicle sector offsetting some further slippage in metals prices.

* We forecast a small rebound in housing starts in July to a 560,000 unit annual rate.  Starts plummeted nearly 20% from April to June, reflecting the expiration of the homebuyer tax credit.  We look for a modest 2% uptick in July, with the gain expected to be concentrated in the volatile multi-family sector.  Rental market conditions have improved and vacancy rates are down, so we should start to see some improvement in apartment construction.

* We look for a 1.0% surge in July industrial production.  The employment report pointed to a sharp jump in factory output for the month, with the auto sector likely to lead the way, as vehicle assemblies soared nearly 18% in seasonally adjusted terms.  There should also be strong gains outside of motor vehicles.  In particular, the metals, machinery, computers and textiles industries are all expected to post gains of better than 2%.  One of the few negative contributions this month should come from a modest pullback in utility output, which had registered sharp gains in preceding months.

* The index of leading economic indicators is likely to post a fractional 0.1% increase in July after a small decline in June.  This would leave it up 1% annualized in the past four months following a 12% surge in the year ended in March.  The main positive in July should be the yield curve, with smaller adds from the manufacturing workweek, claims and supplier deliveries.  Consumer confidence and the money supply are partially offsetting negatives.

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United States
FOMC Recap: Now That the Dust Has Settled...
August 17, 2010

By David Greenlaw | New York

The big news at Tuesday's FOMC meeting was a change in the reinvestment policy for the Fed's portfolio of mortgage-backed securities (MBS). The Fed will now begin to reinvest the cash flows associated with principal repayments of MBS and agency debt into Treasuries instead of letting the portfolio run off.  This move seems to have been spurred by the recent deceleration in economic growth, uncertainty about the fate of the expiring tax cuts, and risks of further declines in inflation.  We view it as a form of double-dip/deflation insurance. 

Although the Fed's MBS buying program ended in March, its portfolio of MBS has just started to contract because a significant portion of the purchases were for forward settlement.  Until now, the settlement of these transactions has just about offset the impact of prepayments, and the Fed's overall MBS holdings have thus remained fairly steady.  However, almost all of the forward trades had settled as of the end of July, so the underlying shrinkage in the principal balance would have started to become more apparent shortly, absent any new action. 

The decision to buy "longer-term" Treasuries represents a significant surprise.  We (and others) had thought that the Fed would focus any buying related to a change in its MBS reinvestment policy on short-dated Treasuries.  That's because the program was being advertised by the Fed as a "symbolic" change that did not have much economic significance.  Also, we thought that resistance to the reinvestment change by the hawks on the FOMC would, at best, lead to a compromise in which any buying would be focused in the front end in order to alleviate concerns about an eventual exit strategy.  Instead, the Fed appears to want the program to have somewhat greater economic significance by spreading out its buying across a broader maturity spectrum.  

In fact, it's important to recognize that by using terms like "longer-term" and by following up with an indication that the purchases will be concentrated in the 2- to 10-year sector, the Fed is using the very same language that was used to announce the $300 billion Treasury purchase program in March 2009.  In that case, the average maturity of the purchases wound up being about eight years.  Last Wednesday, the Fed's open market desk released its schedule of operations for the next month, confirming that the Fed will buy across the curve - including TIPS.  Keep in mind that there are large sectors of the Treasury market where the Fed is already bumping up against the 35% limit on its ownership share.  So, the open market manager will have to pick and choose carefully among outstanding issues.  The Fed's goal will be to hold its SOMA (System Open Market Account) portfolio near the current level of $2.054 trillion.

Market implications.  This change in the Fed's reinvestment policy is more than a symbolic shift because it both avoids a passive shrinkage of the Fed's balance sheet and tees up the markets for a more aggressive asset purchase program at some point down the road if - contrary to our expectations - economic conditions were to deteriorate in a meaningful way.  Also, the Fed's buying will take duration out of the market that the shrinking balance sheet would otherwise have added; this should bring down retail mortgage rates.  However, mortgage prepay speeds are slower than would be expected in the current rate environment, so our trading desk estimates that principal repayments will lead to about a 1.1% per month decline in the Fed's MBS portfolio over the next few months.  On a base of $1.12 trillion of holdings, this amounts to about $12 billion per month.  Add in another $2 billion for agency reinvestments and this totals $14 billion per month (note that this amount could increase in the not-too-distant future if prepay speeds were to rise, and also that the first round of buying will be somewhat larger - $18 billion - because it includes an extra payment date).

How do the Fed purchases stack up against new Treasury supply?  Our budget deficit forecast is $1.3 trillion for FY2010 - and a bit less than that for next year.  So, in rough terms, these Fed purchases can be scaled against about $100 billion per month of net new Treasury issuance.  Also, the new coupon issuance has an average maturity of about seven years, which is reasonably close to the expected average maturity of the Fed's purchases.

Is the Fed running out of ammunition?  Since the FOMC announcement yesterday afternoon, we've received a number of enquiries with a common theme.  They all go something like the following: "What is the Fed trying to accomplish?  Treasury yields are already so low that a modest amount of Fed buying is not going to do much.  In fact, they are running out of bullets.  The three examples of additional monetary stimulus that Bernanke offered in his Humphrey-Hawkins testimony are next to meaningless.  Changing the wording of the "extended period" reference isn't going to accomplish anything; eliminating interest-on-reserves (IOR) does more harm than good; and expanding the balance sheet will just create more excess reserves.  Nothing the Fed can do will create jobs, stop homeowners from defaulting, or cause banks to start lending." (And this is a relatively restrained synopsis of my incoming emails!)

As a starting point to understanding the Fed's approach to preventing deflation, one might want to go back and review the seminal speech that Bernanke delivered on this topic in November 2002.  The key excerpt from the speech is shown in italics below, but the approach can be simplified as follows:

1) Take the policy rate to zero (or as close as is practical).

2) Reduce short-term Treasury yields by either promising to keep the policy rate low or by setting a cap on the yield of these securities.

3) Reduce longer-term Treasury yields by setting a cap on the yield of these securities.

4) Reduce MBS yields by setting a cap on the yield of these securities.

5) Lend directly to the private sector - via the banking system - by accepting a much broader range of collateral at the discount window than at present.

6) If all else fails, rev up the helicopters.

To be sure, the Fed has studied this issue in greater detail since Bernanke delivered the speech in 2002, and it may have identified a better mouse trap.  But it's still useful to understand the model that the current Fed Chairman outlined almost a decade ago when he was a mere governor and could speak more freely about such topics.  Most importantly, it's clear that the monetary transmission mechanism in his model works through rates - not the size of the balance sheet or the quantity of excess reserves (this is one reason why the "QE2" terminology is a bit of a misnomer).  The creation of excess reserves is merely a by-product of asset purchases or direct lending.  In this model, it is lower rates that are supposed to help spur a pick-up in aggregate demand (of course, I can't resist pointing out that a streamlined refi initiative would provide powerful reinforcement for this objective).  In the end, I'm not sure that a review of Bernanke's 2002 model will alleviate concerns that the Fed is running out of ammunition, but at least one might now have a better sense of the bullets that are still in the clip.

Here is the key excerpt from Bernanke's 2002 speech:

So what then might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero? One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure - that is, rates on government bonds of longer maturities. There are at least two ways of bringing down longer-term rates, which are complementary and could be employed separately or in combination. One approach, similar to an action taken in the past couple of years by the Bank of Japan, would be for the Fed to commit to holding the overnight rate at zero for some specified period. Because long-term interest rates represent averages of current and expected future short-term rates, plus a term premium, a commitment to keep short-term rates at zero for some time - if it were credible - would induce a decline in longer-term rates. A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields. If this program were successful, not only would yields on medium-term Treasury securities fall, but (because of links operating through expectations of future interest rates) yields on longer-term public and private debt (such as mortgages) would likely fall as well.

Lower rates over the maturity spectrum of public and private securities should strengthen aggregate demand in the usual ways and thus help to end deflation. Of course, if operating in relatively short-dated Treasury debt proved insufficient, the Fed could also attempt to cap yields of Treasury securities at still longer maturities, say three to six years. Yet another option would be for the Fed to use its existing authority to operate in the markets for agency debt (for example, mortgage-backed securities issued by Ginnie Mae, the Government National Mortgage Association).

Historical experience tends to support the proposition that a sufficiently determined Fed can peg or cap Treasury bond prices and yields at other than the shortest maturities. The most striking episode of bond-price pegging occurred during the years before the Federal Reserve-Treasury Accord of 1951...

To repeat, I suspect that operating on rates on longer-term Treasuries would provide sufficient leverage for the Fed to achieve its goals in most plausible scenarios. If lowering yields on longer-dated Treasury securities proved insufficient to restart spending, however, the Fed might next consider attempting to influence directly the yields on privately issued securities. Unlike some central banks, and barring changes to current law, the Fed is relatively restricted in its ability to buy private securities directly. However, the Fed does have broad powers to lend to the private sector indirectly via banks, through the discount window. Therefore a second policy option, complementary to operating in the markets for Treasury and agency debt, would be for the Fed to offer fixed-term loans to banks at low or zero interest, with a wide range of private assets (including, among others, corporate bonds, commercial paper, bank loans, and mortgages) deemed eligible as collateral. For example, the Fed might make 90-day or 180-day zero-interest loans to banks, taking corporate commercial paper of the same maturity as collateral. Pursued aggressively, such a program could significantly reduce liquidity and term premiums on the assets used as collateral. Reductions in these premiums would lower the cost of capital both to banks and the nonbank private sector, over and above the beneficial effect already conferred by lower interest rates on government securities.

Finally, here is the link to the full Bernanke speech: http://www.federalreserve.gov/BOARDDOCS/SPEECHES/2002/20021121/default.htm

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