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Peru
A Policy Dilemma
September 14, 2010

By Daniel Volberg | New York

The central bank in Peru finds itself in a tight balancing act.  On the one hand, activity in Peru has been on a tear with no signs of moderation, raising the risk that inflation could become a significant challenge next year.  On the other hand, the authorities are concerned that raising interest rates too quickly while globally policy interest rates remain at the lows (or near zero) may fuel a rapid appreciation of the currency that, in turn, may challenge the heavily dollarized financial system.  How does the central bank resolve this balancing act?  We expect the hiking cycle to continue, but suspect that future moves will be more data-driven. 

 In This Issue
Peru
A Policy Dilemma
Latin America
A Turning Point?
Turkey
What Is Next After the Referendum?
Euroland
Mastering the Challenges Ahead
Japan
Trimming 2011 Outlook with Policy Effects Wearing Off
United States
Review and Preview
United States
The Coming Trade Tailwind
View GEF Archive

 The Global Economics Team
 Tevfik Aksoy
Tevfik Aksoy is a Managing Director and the Head of Central Eastern Europe, M. East and Africa Economics at Morgan Stanley. He is also responsible for the macroeconomic coverage of Turkey and Israel. Prior to joining Morgan Stanley in 2008, Tevfik held a similar position at Deutsche Bank, where he worked since 2004. In this role he also covered a number of Eastern European and African countries such as Turkey, Croatia, Lebanon and Nigeria. Prior to his role at Deutsche Bank, Tevfik held a number of positions in the financial services, public sector and academia in the UK, US and Turkey. He has 24 years of professional experience, of which 19 years have been in banking. His previous experience includes positions ranging from being a production planning engineer at Turkey's ASELSAN (a leading military electronics manufacturing firm), an analyst at The Public Participation Administration of Turkey, a government body, and a Visiting Assistant Professor at the University of Delaware, USA. Tevfik is a graduate of the University of Delaware, where he received his Ph.D. in Applied Econometrics and Labour Economics and an MA degree in economics. Tevfik also holds an MBA degree and a bachelor of science in Mechanical Engineering from the Middle East Technical University, in Ankara, Turkey.
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Strong Growth

Economic growth in Peru continues to power ahead.  The economy expanded 10.1%Y in 2Q, driven largely by domestic demand, which grew 11.2%Y.  Investment grew by a dramatic 28.4%Y.  And this strong growth is not simply a rebound from last year's downturn - in Peru, GDP surpassed its pre-crisis peak in 4Q09.  Indeed, while year-on-year comparisons are useful in highlighting how far Peru's economy has come from last year, they may be less useful in exposing the current pace of expansion - for that purpose we rely on seasonally adjusted, annualized sequential growth.  These data suggest that the pace of expansion remains robust - in the three months through June the economy expanded at an 8.2% annualized pace.  While that marks a slowdown from the three-month pace in May (14.8% annualized), the underlying data are bumpy and in June the monthly pace of growth rebounded to 14.7%.  Indeed, high-frequency indicators such as electricity generation suggest that the strong economic expansion continued in recent months.

The strength of GDP growth in recent months raises the risk that Peru's economy may be overheating.  Given our estimates of sustainable growth in Peru in the 5-6% range and given that GDP growth is now running at near twice that pace, risks in Peru may be rising, in our view.  Indeed, if left unchecked, the strong growth raises the risk that the economy may overheat, inflation may rise and that the eventual macro adjustment may be an abrupt one.

Low Inflation

While the risk of inflation may be rising, actual inflation remains benign.  At near 2%Y in the three months through August, inflation remains in line with the 2% inflation target.  Indeed, the low inflation backdrop is broad-based - core inflation has also stabilized at near 2%Y.

Risks Rising

Between the inflation and macro stability risks coming from growth that is too strong on the one hand, and the benign current inflation backdrop on the other, we suspect that the risks associated with strong growth should be the focus for policymakers.  Why is currently benign inflation not a good reason for comfort?  Given that Peru has rebounded from a significant downturn in activity last year, the economy had built up significant slack.  The above-trend growth has been reducing that slack, but has not yet been transmitted into direct price pressure.  In addition, strong growth is usually transmitted into price pressure only with a lag.  This suggests to us that taking comfort in the currently low inflation readings would have been short-sighted.

Policy Response

The good news is that the central bank has been proactive, tightening policy and trying to slow the economy.  The central bank has raised interest rates by 175bp since May in an attempt to raise the cost of capital and slow the expansion in economic activity to a more long-term sustainable pace.  With rates now at 3.00%, monetary policy is moving out of stimulative territory.  However, given the strength of activity and the need to slow the pace of economic expansion, we suspect that the authorities should aim for a restrictive monetary stance.  Indeed, the authorities seem to have recognized that need for more aggressive policy tightening when they shifted to hiking rates at a 50bp clip in August from a 25bp pace previously.

While the policymakers may wish to continue aggressively tightening monetary policy, we suspect that currency appreciation may prove an important constraint.  The Sol has strengthened significantly in recent months, prompting the central bank to intervene heavily by buying dollars in the market.  Indeed, the authorities have bought near US$4.2 billion, equivalent to near 3% of GDP, in the June-August period.  In addition, the authorities have imposed a 120% marginal reserve requirement on short-term (up to two years) foreign capital inflows.  It appears that the central bank has taken these interventionist measures because it may be concerned that raising interest rates in Peru while rates remain at the lows around the globe is in part fueling capital inflows and currency appreciation.  But the underlying concern about rapid currency strength may be that an uncontrolled appreciation may pose risks to financial stability (via balance sheet effects) since near half of all credit in Peru is denominated in dollars.

The central bank faces a tight balancing act.  On the one hand, activity in Peru has been strong, with no signs of moderation, raising the risk that inflation could become a significant challenge next year.  On the other hand, the authorities are concerned that raising interest rates too quickly while globally policy interest rates remain at the lows (or near zero) may fuel a rapid appreciation of the currency that, in turn, may challenge the heavily dollarized financial system.  What does this mean for Peru's growth, inflation and monetary policy dynamics?

The central bank may slow the pace of monetary tightening.  Given the challenges facing the central bank, we suspect that it will slow the pace of tightening back to a 25bp clip before the end of the year.  Indeed, the statement from the monetary policy committee that accompanied the latest interest rate hike last week announced that future decisions will be more data-dependent.  We suspect that this signals a willingness on the part of the central bank to slow the pace of tightening in order to lessen the impact on the currency.

Forecast Revisions

We are revising our 2010 and 2011 macro forecasts, including interest rate, inflation and GDP.  We are revising our interest rate forecast for 2010 to 4.00% (from 3.25%) and maintain our 2011 forecast at 5.00%.  We are also revising our GDP growth forecast for 2010 to 7.9% (from 7%) and for 2011 to 5.5% (from 6.4%).  The revision to our 2010 growth numbers comes from stronger-than-anticipated growth in 1H10 and less moderation that we now project for 2H.  For next year we expect a slightly more pronounced moderation in growth since we now expect a bigger impact from monetary tightening on the back of the central bank's shift to more aggressive rate hikes in recent months.  In addition to the policy rate and growth forecast revisions, we are also revising the inflation, currency, fiscal and external balance forecasts.

Bottom Line

The central bank appears to be ready to shift gears.  With double-digit GDP growth far ahead of potential, the central bank needs to keep hiking to slow growth and head off an inflation issue next year.  But concerns that the interest rate hikes may in part be fueling rapid currency strengthening may temper the central bank's hiking zeal.  We expect the central bank to continue tightening monetary policy beyond year-end, but at a slower pace as the authorities engage in a tight balancing act between growth and the currency.



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Latin America
A Turning Point?
September 14, 2010

By Gray Newman | New York

Even as political risk appears to be on the rise in Europe and our US economics team has revised downward its outlook for growth in 2H10, Latin America keeps boasting record or near-record growth reports.  Mexico posted 7.6% growth in real GDP during 2Q.  Brazil is on track to end the year with annual GDP growth above 7% - indeed, we think closer to 8% than to 7%.  Even Argentina, where the authorities have yet to return to international capital markets despite a second round of restructuring that now includes 92% of all defaulted debt, the economy is on the verge of producing double-digit GDP growth for the year.  We expect real GDP in Argentina to rise by 9.7% this year. 

Rebound and Then Some

It is easy to dismiss the robust readings as nothing more than a rebound from the Great Recession of late 2008 and early 2009.  After all, Mexico's 5.2% growth rebound this year doesn't quite make up for the 6.5% decline in 2009.  But Mexico is largely the exception in the region. 

Aside from Venezuela, where the economy downturn has intensified this year, Mexico is the only other country in the region where production has not yet surpassed pre-crisis levels.  There is no doubt that the rebound after the initial hit from the Great Recession has exaggerated the growth pace in the region in 2010. But unlike in the developed world, where production has yet to recover to pre-crisis levels, in Latin America (and for that matter, in many of the emerging economies) production often surpassed pre-crisis levels by 2H09.  By late last year, Latin America's production surpassed what had been often been record levels of early 2008 and the growth in activity was coming at an ever quickening pace.

Part of the reason of course for the region's successful rebound was Latin America's starting point going into the Great Recession.  As we argued in late 2007 before the downturn and again in early 2009, Latin America was in better shape going into the downturn than it had been in decades (see "Latin America: Will Abundance Slow?" This Week in Latin America, September 10, 2007 and Latin America: No Hurry in 2009", This Week in Latin America, January 5, 2009).  The era of abundance did not produce the ballooning trade and current account deficits fueled by consumer spending seen in Latin America's past.  Nor was Latin America home to widening fiscal deficits that plagued other emerging economies.  And by avoiding a housing bubble that hit many developed economies, Latin America was not saddled with significant fiscal costs to deal with a debilitated banking system and the knock-on effects of a housing bubble that burst. This in turn helped to amplify the rebound in the region.  Latin America's better shape going into the downturn was partly due to merit - fiscal and monetary reforms clearly paid off, but the region also benefitted by accident. There was a humorous refrain used at the time in the region that before you could have ‘sub-prime', you needed ‘prime'.  The region's financial sector was by and large too small or underdeveloped to help finance a massive housing boom (and bust). 

Of course, there is another aspect to the region's recovery: the role that external demand played.  Brazil, Peru, Argentina - indeed most of South America where the links to China are stronger - staged a much more robust recovery much earlier than did Mexico, where the link to the US dominates.  While we continue to hear pundits highlight Brazil's low export-to-GDP ratio near 12% (the lowest in the region) as evidence that Brazil's economy is largely closed, we find the track record of the past decade, which shows a strong link between Brazil and global growth and commodity prices, as much more compelling. 

An Ode to Rear-View Mirror Economics

Latin America's rebound - in part due to merit, in part due to accident and in part due to external demand - has rightfully been praised.  But I would retain a degree of caution as we look towards 2011 in light of our global outlook.  The globe still matters a great deal to the region.  While revisiting the 2008-09 episode runs the risk that we will be accused of engaging in ‘rear-view mirror' economics, I think the episode is still relevant today. Although we are not arguing that the world economy is about to slip into a double-dip (our global team still sees modest, but sustainable, growth in 2011), the risk is present.  And while we are not arguing that if there were to be another downturn in 2011 that it would mirror the abrupt or deep decline of the Great Recession, the 2008-09 episode should serve to remind us that if global demand were to slow sharply, Latin America remains extremely susceptible.  

There is a popular, but I would argue mistaken, view that Latin America's largest economy, Brazil, was somehow largely untouched by the global downturn in late 2008 and 2009.  The usual supporting evidence is the following: Brazil's economy hardly contracted in 2009, with real GDP down only 0.2%, while the region's second-largest economy, Mexico, contracted by 6.5%.  Real GDP in Latin America ex-Brazil was down by 3.2% in comparison in 2009, according to our calculations.

Of course, the reliance on annual GDP reports obscures the dramatic downturn that Brazil's economy saw in late 2008 and the first months of 2009.  Indeed, a simple comparison of industrial output between the two countries shows that Brazil's industrial plant saw an even more dramatic decline than Mexico did in this period.  Brazil's industrial output fell by nearly 21% in the last three months of 2008 compared with an 8% decline in Mexico in the three months ending in January 2009 (the worst three-month decline seen in Mexico during the downturn).  Of course, part of Mexico's more modest decline in output was due to the fact that it had been in a recession that began in early 2008 and continued longer than Brazil's.  Still, if we measure Brazil's decline from peak to trough and compare it to Mexico's much longer peak-to-trough performance, the drop in Brazil's industrial production was still much more severe (-21%) than Mexico's decline (-11%).

The magnitude of Brazil's decline - 4Q GDP fell at an annualized pace of 13.1% - was obscured by simply looking at GDP figures for the year as a whole. While the decline in Brazil's quarterly GDP path (the hardest-hit quarter was 4Q08) was less severe than what Mexico saw in 1Q09 when it was hardest hit (the authorities estimate that real GDP was falling at an annualized pace of more than 24%), an annualized decline of more than 13% in Brazil is hardly reason for much consolation. 

The reason for Brazil's better annual GDP performance was not because it suffered only a mild downturn, but because its recovery began almost immediately, while Mexico's economy stalled for much longer.  The superficial comparison between annual GDP performance in each country - an average of four quarterly reports - obscures the severity of Brazil's vulnerability.  Brazil's economy stands out not because it did not suffer dramatically from the downturn, but because the downturn was so brief thanks in part to the policy response - important fiscal stimulus and a significant growth in public-led bank credit - but also because of the rapid recovery we saw in China's business cycle and in commodity prices.  And because the downturn was so brief and the rebound so quick in coming, the trauma in terms of jobs, income and confidence lost had a much less lasting impact in Brazil than in countries (such as Mexico) where the downturn lasted much longer.

While our global team is not calling for a repeat of the turmoil we had seen in 2008 and 2009 - there is certainly less leverage today, reducing the risk of market turbulence in the real economy - the evidence of Brazil's vulnerability to the global cycle is hardly limited to the events of the past two years. The recent history of Brazil shows that its business cycle has tended to move with the global business cycle.

I can already anticipate the response of the emerging economy booster: if the downturn were to begin to play out as it did in 2008 so would the outcome - demand for Chinese exports could evaporate and in turn prompt Chinese import demand to dry up, sending commodity prices tumbling, but then the Chinese would respond with another bout of stimulus.  That indeed seems as if it would be the case.  But I have a hard time understanding the wisdom of focusing on the prospect of a recovery if you fear that you are on the eve of severe downturn - you might be rewarded eventually, but would suffer a great deal in the meantime.

In 2008 as is the case today, domestic demand was booming in the region. But that didn't prevent the global business cycle from interrupting the party.  It is hard to see why the region's reaction should be significantly different in late 2010 if the globe worsens.  Indeed, on the margin, the region is slightly more vulnerable.  Reserve levels are not much better now than in mid-2008, while fiscal deficits are larger across the board.

You needn't go back as far as 2008-09 to be warned, simply look at the events of the last few months of this year in Brazil.  While demand conditions in Brazil have been robust - healthy employment growth, robust real wages, plentiful supply of credit to consumers and high consumer confidence - we saw production in Brazil stagnate in 2Q.  It's true that Brazil's 2Q GDP report showed an 8.8% jump compared to a year ago and even the quarter-over-quarter sequential upturn looked reasonably strong at just over 1.2% or 5.1% annualized, as the quarter-over-quarter measure was a comparison of the average of 2Q with the average of 1Q.  But on a monthly and sequential basis, activity stalled out with near zero growth for more than three months.  Recall that if activity was on a strong upswing - as it was in 1Q - and came to a halt in 2Q - as it did - you would see a good 2Q sequential GDP print despite the fact that activity stagnated during 2Q (as was the case).  While I suspect that the end of some fiscal stimulus along with an adjustment in inventories explained part of the weakening, I find neither explanation fully convincing.  I suspect in part that the 2Q performance was tied to concerns about global demand. 

Forecast Update

Our global view remains constructive, although more cautious than a few months ago. As part of our global team's review of forecasts, we are updating our Latin America numbers.  Most of the changes are modest.  Growth for the region rises from 5.8% to 6.2% in 2010, but despite the better carryover into 2011 we are still expecting a much more moderate pace of growth (4.0% growth in 2011, unchanged from our previous forecast). In Brazil and in Mexico, the growth trajectory remains largely unchanged, although we do see a somewhat more muted inflation picture in Brazil.   The more important changes take place in Colombia, where strong domestic demand and a supportive external environment (as Colombia rapidly builds its China link) have supported continued economic strength - GDP has consistently grown near a 5% annualized pace since 4Q09 - has led us to increase real GDP forecast for 2010 to 5% from 4.1% previously and in Peru where we now see GDP this year at 7.9% (versus 7% previously).  We also see a less severe fall in Venezuela this year as better weather conditions have allowed the main hydroelectric generation station to come back online, limiting energy restrictions, and as the authorities appear to be moving to ease the access to foreign exchange for importers via both SITME - the new bond trading system - and CADIVI - the official currency agency of the government.

Our view is that global growth should be modest but is able to avoid a double-dip.  If that is the case, at some point we may have to revise up our numbers for the region. In the near term, however, I worry that concerns could increase and should serve as warning to optimism in the region.  It appears that the best growth is behind us and that in turn could lead to new concerns that the region is facing a turning point.  I am particularly concerned in the case of Brazil, where the economy has shifted from an accelerating mode late last year into the beginning of this year with the pace of activity moving from 9% to over 11% and then stalling out near zero in 2Q (based on the sequential monthly data).  We are seeing a modest recovery in the July and August on the production side (which should still allow us to have average growth for the year well above 7%), but at some point I expect Brazil watchers to focus on the much more modest pace of growth the economy now appears to be producing. 

Even with that modest pace of growth in Brazil, we still expect that real rates will need to be closer to 7% (nominal above 12%) than at current levels closer to 5%.  Currently, many Brazil forecasts seem to assume good growth for 2011 (assuming a fairly benign global backdrop), but assume interest rates in Brazil should continue to reflect the developed world's concerns that we are on the verge of quantitative easing.  Unless global growth suffers substantially, Brazil and Latin America should continue to produce better growth than the developed world and consequently need a different set of policy rates than developed economies.

Bottom Line

The region is facing a turning point.  After the robust rebound of much of 2009 which quickened its pace at the beginning of the year, we are starting - particularly in Brazil - to see signs of softening.  Some slowdown was welcomed (to avoid overheating) and expected.  But it is easy for investors and policy makers to get lulled into extrapolating from the go-go rebound of the past year-and-a-half.  Despite signs of a resurgence of domestic demand in the region, the experience of 2008 and 2009 and more recently the experience of 2Q10 should serve as a warning that the region's fortunes still remain closely linked to the global economy.  In a period of a rapid rebound in Latin America, it was easy to distance the region from the debate and the uncertainty over the pace and direction of the global economy.  As the region settles back to a much more moderate pace of growth, that distance is likely to be reduced.



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Turkey
What Is Next After the Referendum?
September 14, 2010

By Tevfik Aksoy | Europe

Referendum results were better than anticipated but show no guaranteed victory at general elections: At 58% support for the change, the result of the referendum on the constitutional amendment package came out better than most polls predicted. While the headline result raises the comfort threshold of AKP ahead of elections, we do not see the outcome as a guaranteed win, with a considerable amount of support for the package coming from various segments of the population with varying reasons and motivations to support a change. These included those who are against the involvement of the military in daily politics, those seeking improved personal freedom or a more EU-compliant constitution, the Kurdish population and supporters of the ultra-religious and the ultra-right-wing parties.

No guarantees just yet: In our view, the results of the referendum and especially the ‘Yes' decision should not be perceived as increased support for the ruling party. It is true that AKP seems to be holding its position well, but the outcome still calls for continued efforts by AKP and/or PM Erdogan to secure a single-party majority government at the elections scheduled for mid-2011.  

Market reaction: As we had been predicting, the market reaction to even the better-than-expected outcome has been limited since Turkish assets are priced to perfection, in our view. The stock market rallied somewhat (~2%) but there was a catch-up factor in this (as the Turkish markets were closed for half of last week) and almost all EM equities (as well as DM) were up noticeably at the time of writing. Bond yields initially declined as a knee-jerk reaction, but are trading down just 3-4bp compared to the close of last week. The currency saw two-way flows, with non-resident fast money getting in while local retail investors were getting out of TRY.

What to look for next? Here is a short-list on the macro front:

1) Fiscal policy: The decision by the government to shelve the Fiscal Rule despite its high importance had been telling. As PM Erdogan stated last week, there seems to be a dispute on the issue among the cabinet members. For instance, PM Erdogan openly admitted that there was a disagreement on the Fiscal Rule with Deputy PM Ali Babacan, who had been the architect of the draft law. After months of debate and deliberations on the matter, the rule, which had been perceived as a strong fiscal anchor, has been put aside. This received criticism from the IMF and had a short-lived negative response from the market, but it seems like PM Erdogan is determined to go ahead as he believes that the rule would limit the government's efforts to spend on investments. In conventional terms, this is associated with an increased likelihood of election spending. In comparison to the case of a narrow victory, where an accelerated fiscal spending in the next 6-9 months would be a given, the rather comfortable margin provides breathing space. Hence, we are not overly concerned about fiscal policy for the time being. However, we will be scrutinising the fiscal data for any sign of deterioration.

2) Central bank independence: There had been a series of comments regarding the level of interest rates being too high and/or the currency being too over-valued by various cabinet members lately. Even the mandate of the CBT, which is solely based on maintaining price stability, came under debate. In our view, the independence of the central bank served very well in recent years to lower inflation and maintain market stability, and any back-step on that front could seriously raise risks. At this juncture we believe that there is no solid reason to be concerned, but as we get closer to April 18, when the current governor, Mr. Durmus Yilmaz's term ends, the appointment of the new CBT head and even changes in the MPC could become a topic of interest.



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Euroland
Mastering the Challenges Ahead
September 14, 2010

By Elga Bartsch, Arnaud Mares, Daniele Antonucci | London

There Can Be No Mistaking How Hard Ireland Was Hit... 

Nominal GDP (gross domestic product) has collapsed by 22% from its pre-crisis peak in autumn 2006. GNP (gross national product), which in the case of Ireland is a more appropriate metric, has declined even more steeply, losing a total of 27% over the same period.  House prices have fallen by ~40%, wider consumer prices by ~5% and wages by ~6%. Public sector debt is on the steepest rise anywhere in the euro area and the budget deficit is deep in the red and, at best, hovering sideways for now.

...but the Irish Economy Is Returning to Positive Growth

Overall activity has started to recover, with 1Q GDP bouncing back by a non-annualised 2.7%Q (or 11% in SAAR terms) on the back of a stellar foreign trade contribution. While we would not read too much into a single quarter, as quarterly GDP data for small, open countries like Ireland are volatile and often subject to sizeable revisions, we believe that the economy has turned the corner and we expect it to deliver positive sequential growth in the coming quarters.  Following such a strong performance in the first three months, we would not rule out a technical correction in 2Q, but such a renewed decline in GDP would not change our fundamental view on the recovery.  Because the Irish economy entered this year on a large negative ramp (caused by the marked contraction in GDP in the course of last year), the carried-over contraction will probably push the full-year growth rate for 2010 into negative territory.  Looking at the more meaningful 4Q/4Q growth rate, which we estimate to be in the region of 1.75%Y, underscores that 2011 will likely see the first positive full-year number since 2007.  Looking further ahead, we see potential output expanding at a 2.0-2.5% rate and actual GDP at a higher 3.25% over 2012-17.  This path is still substantially below historical growth norms.

But in our view, a number of potential risks remain in the aftermath of a credit-fuelled consumer and housing boom.

#1 Negative International Spillovers

For a very open, trade-dependent economy like Ireland, a renewed global downturn would likely bring a fresh bout of problems. Note that the Morgan Stanley global economics team expects a mild moderation in the remainder of this year and into next year, but not a double-dip (see Global Forecast Snapshots: Just Say No to the Double-Dip, June 10, 2010).  In addition, we probably have already built in some cushion into our external trade assumptions as we maintain below- consensus forecasts for the key trading partners of Irish companies, the UK and the euro area.  In terms of the currency, our EUR/GBP call seems to be on track at around 0.83, but our currency team now looks for an appreciation of EUR/USD to 1.36 in the remainder of this year. However, estimates compiled by the ECB show that Ireland does not suffer disproportionately from exchange rate changes (see also page 17 of European Economics: A Practitioner's Guide to European Macro Indicators, June 4, 2010). By contrast, Ireland tends to be twice as sensitive as the euro area to changes in foreign demand.

#2 Further Correction in House Prices and Construction 

In a recent cross-country study, the European Commission concluded that the bubble in the Irish housing market was already more or less deflated at the end of 2008.  Since then, the Irish property market has seen a further decline in house prices, which could even make the market undervalued relative to fundamentals. The result of the European Commission study is in line with an earlier Morgan Stanley report by David Miles, our former colleague and now MPC member at the Bank of England, who argued that the misalignment of the Irish housing market was relatively modest (see European Economics: Financial Innovation and European Housing and Mortgage Markets, July 18, 2007). While a further marked fall in residential property prices thus seems unlikely to us, metrics such as the house price to income ratio suggest caution.

#3 Worse-than-Expected Impact of Fiscal Tightening

As ever with large-scale austerity programmes, the impact could be non-linear. That said, the initial hit should be largely digested by now. After all, it is the change in the austerity programme that affects GDP growth.  As the government is addressing the issues, this should support private sector confidence in long-term growth, crowding in private demand.

#4 Further Funding Troubles for Banks and the Sovereign

We expect there to be a lot of focus in financial markets on what is perceived by some observers to be the debt threat to the Irish economy.  In the light of a series of key risk events around the Irish financial sector this autumn, we discuss the interdependence between the banking system and the sovereign sector in the following sections. In particular, we will separate the fundamental facts from the accounting treatment in order to provide investors with a framework. Where necessary, we will provide some numerical examples for the recapitalisation needs of the banking sector rather than point estimates.  For such point estimates, which are much more fluid than the analysis we present here, we would encourage investors to seek expertise of our equity bank analysts and our distressed trading desk.  

The Ireland Debate - Our Bottom Line

Clearly, Ireland is facing major challenges in the quarters and years ahead.  But, if there is one economy in the euro area that could meet such challenges, it is probably the Irish economy, in our view.  Mind you, these strong preconditions are not a guarantee that Ireland will be able to overcome the challenges that lie ahead easily.  But we believe that Ireland is fundamentally different from the other peripheral countries in that it is a fully deregulated, fully liberalised market economy.  Hence, it should be able to adjust to the new environment and work its way out of the current situation more quickly.  Alas, the challenges are also somewhat bigger than elsewhere - notably in the banking sector.  But Ireland is among the few euro area countries that have historically managed a major turnaround in fiscal policy (and the wider economy). On balance, we expect Ireland to master the challenges, and we would advise investors to take advantage of any renewed weakness in Irish government bonds to establish or add to fundamental long positions.

Rebalancing the Irish Economy

Regaining Competitiveness within a Monetary Union...

We believe that it is key for Ireland to regain competitiveness, as for any other economy in the euro area periphery that has been overheating in the first ten years of the euro, fuelled by negative real interest rates, the piling up of private sector debt and asset price appreciation. 

...Requires More Flexible Prices and Wages...

Within a common currency union, where the nominal exchange rate can no longer adjust in response to imbalances, consumer prices, asset prices and nominal wages have to bear the brunt of the nominal adjustment.  In this context, the high degree of flexibility of the Irish economy should help, we think.  In the near term, though, this flexibility will likely reinforce deflationary pressures.  But irrespective of which metric you look at (relative unit labour costs or relative consumer prices), Ireland is currently gaining competitiveness against the rest of the euro area at an impressive speed.

...and an Attractive, High-Quality Product Mix

Competitiveness is not just about price and cost competiveness.  It is also about the product mix and the quality of the products offered.  Here Ireland is benefitting from being a location for inward FDI, notably chemicals, pharmaceuticals, electronics and financial services, which typically also involves a transfer of technology.  At the height of the FDI boom in the late 1990s, Ireland sported rather impressive productivity gains.  Since its export mix is tilted towards defensive sectors such as pharma and chemicals, Irish exports only contracted by 4.2% during the crisis, compared to 14.5% for the highly cyclical German exports. 

The Irish Trade Balance Is Improving...

Until recently, the main reason for the marked improvement in the trade balance was a plunge in imports on the back of falling domestic demand.  More recently, however, exports have rebounded too.  Going forward, we expect exports to continue to expand, albeit at a moderate pace, due to the defensive mix, slower global growth and a stronger euro.  But with a trade surplus at a whopping 25% of GDP in 1Q10, Ireland clearly offers something that the rest of the world wants.  As much of its export industry is foreign-owned, Ireland pays out a lot of income to overseas parent companies. The resulting negative foreign factor income balance (which also accounts for the discrepancy between GDP and GNP) pushes the current account into the red.  Nonetheless, the current account deficit never had the same size as that in other peripheral countries, and it has started to improve notably.  On our projections, the current account could move into positive territory as soon as the middle of next year and Ireland would start to have a small savings overhang for the first time since the 2000 boom. 

...and So Is the Current Account

The improvement in the current account is of interest with respect to the rebalancing discussion because, among other things, the current account also reflects the overall imbalance between domestic savings and investments.  Comparing it to changes in the public savings-investment imbalance, the budget deficit tells an interesting tale of how the private sector is adjusting.  Getting back into a national savings surplus - mirrored by a current account swinging into surplus - is key to the progress in the deleveraging process.  Hence, to see the country sporting a current account surplus, which could happen as early as next year, would mark an important milestone.

Deleveraging Still Has a Long Way to Go...

Deleveraging will need to undo the damage of rampant credit growth and asset price exuberance in the past. As such, it will likely be a drag on growth for years to come. However, without a stabilisation in house prices, it is difficult to see a sustainable recovery.  Irish house prices are down almost 40% from their peak. But the Commission estimates that the correction in the housing bubble in Ireland is quite advanced. By contrast, further adjustments in house prices seem likely in Spain and the UK (see Spain Economics: The Housing Market and the Savings Banks' Restructuring, April 12, 2010, and UK Economics and Banks: UK Property: Concern for the Future, August 12, 2010).  While distressed homeowners are the biggest legacy of the downturn, according to the Irish Financial Regulator, banks are now required to wait one year from when borrowers fall behind schedule before they can initiate a repossession.

...and There Is a (Temporary) Drag from Deflation

Falling consumer prices and wages will need to undo the loss of competitiveness.  Falling house prices will need to restore housing affordability.  In our view, this painful fall in prices is not going to lead to a deflationary spiral because capacity is taken out at an impressive speed in Ireland. But it is clear that Ireland is in deflation.  Consumer prices are falling, house prices are falling, even wages are down.  The declines in consumer prices are widespread. According to the IMF, more than two-thirds of the components in the CPI are falling.  As a result of the negative inflation prints, real interest rates (deflated ex post by actual inflation) have increased. The increase in ex ante real interest rates based on expected inflation - the relevant metric for making forward-looking investment decisions - will likely have been less pronounced though. We expect inflation to continue to fall this year and possibly also next year.

A Labour Market Turnaround Is Still a Long Way Off

Unemployment has increased from 4.5% of the labour force before the global financial downturn to around 13.5% recently, based on the EU harmonised definition.  The rise in long-term unemployment is a concern - also because of the resulting deterioration in human capital.  Redirecting resources from construction and financial services to more productive sectors would require retraining in order to prevent long-term unemployment from rising. There is a risk that unemployment will stay elevated for a long while, while numbers are flattered by outward migration.

Turning Around the Country's Fiscal Fate

At face value, Ireland started from a strong position. A string of budget surpluses since the late 1990s pushed the debt level to hit a historical low of 25% of GDP in 2007.  Below the surface, however, vulnerabilities had started building as there was excessive reliance of taxation on VAT, stamp duty, etc. At the same time, the strong revenue intake facilitated an expansion of structural spending.  With GDP/GNI so much lower after the steep falls, some loss in revenue will be permanent.  Hence, spending needed and still needs to be lowered, in our view.  Since 2007, the budget balance and the debt dynamics experienced a dramatic deterioration. While the underlying deficit will likely stabilise if not slightly improve this year, the debate now centres on whether the government debt can be stabilised below 100% of GDP in the years ahead. 

Government acted early and boldly to rein in the deficit. Now the negative impact of these past budget cuts on the economy is filtering through.  Clearly fiscal tightening dampens domestic income growth.  In our view, a slow turnaround in the budget balance is to be expected. In addition, time lags could likely limit any future improvements.  Like the European Commission and the IMF, we believe that the government is making rather optimistic growth assumptions in its multi-year Stability Programme.  Hence, we estimate that it will likely take longer than 2014 to bring the deficit back below 3% - at least if no additional consolidation measures are taken.

This year, there won't be a meaningful improvement in the underlying deficit, thanks to economic weakness.  Note that many deficit-relevant revenue and spending items also tend to lag the cycle.  This year's consolidation programme aims to offset lower tax revenue with higher social security contributions and other revenue (e.g., a carbon tax).  A larger surplus from the central bank (0.2% of GDP), a higher amount of pension assets transferred to the government (0.2%) and increased receipts from bank guarantees (0.2%) are largely offset by higher spending, notably on interest payments.  Meanwhile, higher primary spending in the social budget is offset by lower wages in the public sector and cuts in investment and inputs. Most of the adjustment is on the spending side, which has so far accounted for two-thirds of the austerity measures.

The EU has given Ireland until 2014 to reduce its budget deficit back to 3% of GDP - granting it a one-year extension.  This would require an average annual fiscal reduction of at least 2% of GDP between 2010-14. But the Commission believes, and we agree, that the Irish Stability Programme makes too rosy assumptions about growth and hence sees a need for additional measures to be taken (~2% of GDP until 2014). The Commission also wants to see the measures for 2011 spelled out in detail - ideally before the budget presentation in December. Presenting these details could also help to restore market confidence. Like us, markets will be watching out for when Ireland will return to a primary surplus (2014 on the government's projection and on our forecasts).  Reaching the 3% deficit matters because of the EU context. Finally, debt projections are likely to become a focus as underlying government debt is pushing towards 100% of GDP.

Risks to the government's deficit projections are tilted to the downside. They stem from rather optimistic growth assumptions, near-term expenditure overruns, medium-term consolidation fatigue (especially around the 2012 general election) and financial transactions to stabilise the banking sector.

Future debt dynamics depend on the size of the deficit, the snowball effect and the stock-flow adjustments (mainly relating to capital injections into banks).  While the deficit is likely to remain negative for several more years, the snowball effect and the stock-flow adjustment could limit or enhance the increase in the debt. For the snowball effect to limit the rise in debt, nominal GDP growth needs to exceed the average net interest paid on the general government debt (at ~4.5%, this is below market rates).

But bank recapitalisation could still add to debt and deficit. Next to the underlying deficit dynamics, recapitalisation of banks by the state will push both the reported government debt higher and, in some cases, also the deficit.  As financial markets are fretting over the size of the further recapitalisation needs in the Irish banking sector and the shape of any restructuring action taken, it is key to distinguish the news from the noise. In what follows, we focus on separating the fiscal fundamentals from the accounting announcements. We leave it to our bank analysts to estimate the recapitalisation needs, and instead focus on what investors should bear in mind when gauging the impact of these measures on the future debt trajectory of the Irish sovereign.

Throughout the downturn, the Irish government has deployed its balance sheet extensively to shelter the economy and Irish banks from successive shocks. The result is not just a very large increase in public debt, but also an unusually complex array of on- and off-balance sheet exposure, both on the asset and liability side. In the coming weeks, as further costs associated with the recapitalisation of the banking system crystallise on the government's balance sheet, investors will likely be confronted with the challenge of making sense of different and rapidly evolving estimates of the Irish debt and deficit.

To assess the true state of Irish public finances, we think it is worth examining three dimensions in turn:

•           The level of the debt and the deficit, taking account not just of gross liabilities but also of the assets acquired;

•           How this translates into actual funding requirements (or not) for the government; and

•           The nature of the mismatch between assets and liabilities, and how this may affect fiscal performance going forward.

What is the debt that really matters? Standard measures of debt, including that retained by the EU for assessment of a country's performance against the Maastricht criteria, refer to gross debt, i.e., the sum of financial liabilities of the government. With a few small exceptions, these liabilities are measured at face rather than market value. From the point of view of assessing debt sustainability, however, gross debt overstates the magnitude of the fiscal challenge, because it ignores the existence of income-generating assets. Contrary to government spending, the acquisition of assets can yield a return over time, either in the form of dividend/interest or resale value, and hence have key implications for the long-term debt trajectory (see Scenarios on Ireland's Fiscal Sustainability, July 21, 2009).  A more relevant measure of debt consists of netting identifiable financial assets off the gross debt.

What assets should be included in net debt estimates? A standard definition of net debt consists of netting only liquid financial assets off the gross debt - this is for instance the definition retained by the UK government. We think this is too conservative a definition. Assets that are illiquid in the short term, but can be easily funded for a long period of time, notably by the ECB, and can eventually be disposed of are relevant in the assessment of debt sustainability, in our view. This is the case with the equity stake acquired by the Irish government in banks and the property loans it has acquired through the operation of NAMA.

NAMA-related debt is not included in our net debt estimate. NAMA is a special purpose vehicle (SPV) set up specifically to purchase property loans from Irish financial institutions. NAMA acquires assets from banks at a discount, and pays for these assets in the form of so-called NAMA bonds (95% are government-guaranteed bonds, the remaining 5% being subordinated debt only redeemable if NAMA makes a profit). From our perspective, NAMA bonds are effectively a government liability, while the assets acquired by NAMA are effectively government assets. Debt-funded property-related assets expose the government to a risk, but the net effect on the government balance sheet is neutral initially. Hence, we would not include NAMA debt in our measure of net debt.

Eurostat does not account for NAMA debt either, but for a different reason. Because 51% of the capital of the SPV is in private hands, Eurostat does not include its debt in its standard measure of gross public debt. The same ruling had applied for the debt issued by SFEF, the vehicle set up by the French government at the height of the downturn to issue government- guaranteed debt and on-lend the proceeds to banks.

The difference between gross and net debt is unusually large in Ireland. In addition to the NAMA assets, the government holds very large cash reserves as a funding buffer (€20 billion, i.e., 12.5% of GDP).

In contrast to NAMA debt, promissory notes issued to Anglo Irish are a net liability. The Irish government is in the process of issuing promissory notes to Anglo Irish (or more exactly to the two new banks into which it is being divided) as part of the recapitalisation of the bank. These promissory notes, in our view, ought to be considered as ‘true' debt. The reason is that they are not compensated by the acquisition of any meaningful asset. They merely reflect the recognition of a fiscal loss by the government, which absorbs on its own balance sheet the losses of the bank - thereby protecting the interests of depositors and other debt holders. The amount of promissory notes being issued therefore represents an effective increase in public debt, both gross and net. This is also the interpretation retained by Eurostat, which is treating the issuance of these promissory notes as a capital transfer. The amount issued scores against both the level of the deficit and the level of public debt. The exact cost of this recapitalisation exercise is not yet known - the Central Bank of Ireland is to announce in October the amount of capital required. Assuming a realistic overall cost of €30 billion (of which €26 billion is in the form of promissory notes, the residual having already been provided in cash), the deficit for 2010 would rise from around 12% of GDP to around 28%. It may be a bit more or a bit less than that.

What if Anglo Irish were to be consolidated in the public sector? In the event that the whole balance sheet of Anglo Irish were consolidated in the public sector, this would push gross debt ratios higher, by the difference between the total liabilities of Anglo Irish and the government liabilities already held by Anglo Irish. This would likely imply an increase in gross public debt by around 35-40% of GDP. As has been evidenced in Germany, it is possible to set up the legacy banks so as to keep them off-balance sheet. On this matter, the European Commission and Eurostat have the last say but, in any case, we believe that investors should see through accounting treatments to the underlying economic reality. Whether the whole or part of the bank is included in public sector aggregates should not have any effect on our assessment of net debt - the relevant metric - nor on the degree of exposure of the government to the bank's assets.

Further pressure on the gross deficit could arise from bank refinancing concerns, but with no net debt consequence. Should the government need to assist the banks in refinancing maturing debt in the coming months (and years for Anglo Irish), this may lead to further expansion of the government balance sheet, but in our view with no meaningful net debt implications. As Anglo Irish's debt matures, it will have to be refinanced somehow (unless the assets mature faster). As the bank is now in wind-down mode, we see the two most likely routes as the following: first, the legacy banks can obtain refinancing from the Eurosystem, either through standard operations or through an Emergency Liquidity Assistance Scheme (in our view the preferable option). This probably implies that the central bank accepts as collateral the promissory notes received from the Irish government. A second option is that the Irish government raises finance in the market and on-lends the proceeds to the legacy banks. In that case, the deficit and gross debt would increase by the amount of the borrowing, which would push official debt figures yet even higher. Here again we think that investors should see through the accounting effects of such a scheme: the effect on net debt would be initially zero, because the government would build up both a liability and a matching asset.

Looking for a circuit-breaker. The government continues to be supporting other banks as well. It announced on September 7, as widely expected, an extension of its guarantee scheme for short-term bank liabilities from September 29 to December 31, 2010. Not much has changed since we described the vicious circle (not just in Ireland) of sovereign and banking crises mutually reinforcing each other because governments need to backstop banks, while banks hold large amounts of exposure to the government (starting with the NAMA bonds).

As we have argued before, only restructuring and recapitalisation of the banking system can act as a circuit-breaker for this potential spiral (see Eurotower Insights: The Lure of Liquidity, June 17, 2010, and The Global Monetary Analyst: Crisis, Credit and Capital, September 8, 2010). We see the announcement of a resolution proposal for Anglo Irish as one first small but significant step towards this goal.

Very large deficit, but no funding implications or liquidity risk. While the idea of a deficit of 25-30% of GDP can sound unnerving, it is worth underlining that the Irish government does not initially have to raise any cash to fund this deficit in the case of the Anglo Irish recapitalisation. The debt is increased by the means of off-market issuance of IOUs (the promissory notes) to the bank, with no initial exchange of cash. The intention is that the promissory notes be redeemed over a ten-year period, thereby raising the cash requirement of the government by a manageable €2.5-3 billion annually from 2011 onwards. This therefore exerts no immediate pressure on the government's cash position. The same observation applies to the acquisition of assets by NAMA, since this transfer takes place against the issuance to banks of NAMA bonds, which do not require any immediate cash transfer either. In fact, on the basis of its current cash position, we understand that the National Treasury Management Agency would be able to fund the ‘normal' operations of government until June 2011 without having to raise any more finance.

A contingency cash reserve in the NPRF. The Irish government also has a contingency reserve of cash in the form of the National Pensions Reserve Fund, an asset portfolio intended to help meet the cost of Ireland's social welfare and public services pensions from 2025 onwards (effectively a financial asset matched against a social liability - see Sovereign Subjects: Ask Not Whether Governments Will Default, but How, August 25, 2010, for a broader discussion of these concepts). The government cannot directly draw money from the NPRF for its own use, nor can the NPRF purchase government bonds. But the government can direct the NPRF to invest in banks or acquire other assets on the government's behalf. It did so already by directing the NPRF to acquire €6.8 billion of capital in Irish banks as part of a recapitalisation exercise in 2009 and early 2010. The NPRF holds an additional €4 billion of cash and around €15 billion of liquid assets that effectively constitute a contingency source of liquidity equivalent to 12% of GDP. Finally, there remains the option of using the EFSF as a source of liquidity.

Government-at-risk. The consequence of the various interventions of the Irish government in support of the banking sector is that its balance sheet incorporates a large leveraged position on the performance of bank assets. The mismatch between the government's liabilities (debt) and its assets (bank equity and NAMA's property loan book) exposes the government to a direct risk, not initially to a direct loss. It is ex ante as likely to make a profit as a loss. The dispersion of plausible fiscal outcomes (‘government-at-risk') is a reflection of the value-at-risk of its leveraged position. Given the magnitude of this leveraged position, this dispersion is very wide. In other words, Ireland, from an initial position that is not nearly as bad as gross debt figures suggest, still remains vulnerable to very large swings in its fiscal performance. Much depends on the performance of its bank assets.

Leveraged exposure to economic performance. What will drive the performance of bank assets is, ultimately, the performance of the Irish economy and its effect on household income, property value and corporate profits. It depends also, albeit more marginally, on the performance of the UK property market - in excess of one-third of loans already transferred to NAMA relate to projects in the UK. By leveraging its balance sheet, the Irish government has compounded the exposure it already has to economic performance through its tax revenues. As a consequence, small changes in the growth outlook can end up having great effects on debt dynamics. This leads to a conditionally constructive assessment: constructive, because of the conclusion reached in the first part of this note that Ireland is well placed to master its economic and fiscal challenges; but conditional, because the reliance of the Irish economy on external demand as an engine of recovery means that the government is not entirely the master of its own fate. So long as the global recovery continues a turnaround of the country's fiscal situation seems not just plausible to us, but likely. A global double-dip recession, however (which is not our expectation), by stalling the Irish recovery, could have a significant adverse effect on the government's balance sheet (through its impact on both tax revenues and financial asset performance).

Backstop in the Background: The EFSF

If all fails, there is still the EFSF that Ireland could turn to (see EuroTower Insights: Stress Testing Europe, June 30, 2010). Our understanding is that, in principle, the EFSF could help to fund the recapitalisation of the banking system if a sovereign in the euro area were to find itself unable to raise the necessary funds in the market.  However, it is unlikely, in our view, that the EFSF will take direct exposure to the banking sector. In fact, the Greek loan agreement explicitly stresses that it does not involve direct exposure to the Greek banking system.  Under the framework agreement signed on June 7 by all euro area finance ministers, the EFSF would lend to the government in question.  This means that the government would need to meet the strict conditionality attached to such loans, including a fiscal austerity programme and further structural reforms.  Based on the most recent assessments of the Irish economy, the European Commission and the IMF would probably demand some modest fiscal tightening measures from the Irish government over and above the 2% per annum the government committed to in its Stability Programme.  But the imposed adjustment is unlikely to be anywhere near the demands made on Greece. On the structural reforms, there is not that much to do in Ireland. A change in the tax treatment of housing could be part of the mix, but the Irish government is working on this anyway.

For details on our view on Irish banks and the Irish sovereign from our equity research and interest rate strategy colleagues, see Ireland: Mastering the Challenges Ahead, September 13, 2010.



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Japan
Trimming 2011 Outlook with Policy Effects Wearing Off
September 14, 2010

By Takehiro Sato, Takeshi Yamaguchi | Tokyo

Solid Growth Now, but Slower Growth Ahead

The first preliminary Apr-Jun GDP data were unexpectedly weak, but the revised figures exceeded the potential output growth rate, seen now as just below 1%. The trend for Jul-Sep appears generally favorable, especially for personal consumption, thanks to policy stimulus and the heat wave. Fears about a double-dip for the global economy are also receding slightly, with sentiment indicators for manufacturing in the US and China recently picking up. We had not been forecasting a double-dip for Japan anyway, but recent economic indicators have finally provided backing for this view.

Concerns have not been cleared, however. Eco-car subsidies that supported consumption in Jul-Sep have ended before the end-Sep deadline, and we expect domestic auto sales in Oct-Dec to plunge close to 40%Q. Downside for domestic production appears likely, primarily for automobiles. A reaction following the cigarette demand spurt ahead of the hike in tobacco tax from October cannot be ignored either. The Eco-point program for home electronic appliances has been extended to Jan-Mar 2011 in streamlined form, but when that expires from Apr-Jun 2011, durables consumption will suffer in the absence of front-loaded demand.

Thanks to the demand spurred by such policies, we expect bumpy moves in quarterly consumption between Oct-Dec 2010 and Apr-Jun 2011. Especially for the Oct-Dec quarter of 2010, we are likely to see near-zero growth. However, F3/12 should see the large increase in corporate earnings during F3/11 finally translate into higher numbers of employees, and summer bonus payments may show a relatively powerful recovery. We expect improvement in the wage and income environment to avert a consumption bottom, even when policy stimulus fades, and look for spending levels to build gradually from the Jul-Sep 2011 quarter.

Externally, exports to Asia which have underpinned the post-Lehman recovery have been generally flat since the start of 2010, and exports appear less able to drive the economy than before. The recovery in exports to the US has been subdued, and pre-Lehman shock levels have yet to be regained. However, the political cycle in both the US and China is moving towards a peak in 2012, and there is potential for support for the economy from fiscal policy at an early stage if needed - in Oct-Dec 2010, or during 2011 - which would be favorable for Japan's exports.

Given this, we think Japan's economy is likely to recover gradually during 2H F3/11 and F3/12 with support from wage/income conditions and the external environment, despite having to absorb the negative effects of waning policy demand. The actual growth rate may fall for technical reasons in F3/12 due to a lower base effect, but we do not envisage the economy sliding back.

There is some concern that the yen's recent strength threatens to cause a slowdown, but as long as the yen appreciates gradually, we think this is unlikely to be fatal for Japan's economy. This is because the real effective exchange rate adjusted for the gap between domestic and overseas inflation rates still indicates the yen is still considerably cheaper than in April 1995, when the yen was ultra-high. In the Apr-Jun corporate results season, guidance for manufacturing industry recurring profits to increase by about 70% in F3/11 was also maintained under conditions of a strong yen. In the last 15 years since 1995, Japanese manufactures have stepped up their offshore production, resulting in earnings being more resistant to currency swings. This ability of companies to adapt to a strong yen should not be underestimated.

As a result, though we expect Japan's economy to slow to 1.0% in 2011 from 3.0% in 2010, partly due to a technical factor (i.e., a lower base for the year), we forecast the economy to maintain growth slightly above its potential growth rate, seen as just below 1%, for two years in a row. Nominal growth should underperform real growth during this period, however, with the GDP deflator remaining negative year on year. Prices are becoming extremely unresponsive to changes in the output gap, so we expect the timing of the exit from deflation to be 2013 or beyond, as discussed later.

Upside and Downside Risks to Our Forecast

The risks to our outlook are political factors. Depending on the outcome of the DPJ's leadership election, the current policy of spending restraint could be temporarily replaced by an expansionary bias with emphasis on the expenditure commitments made in the manifesto. For example, former DPJ secretary general Ichiro Ozawa has pledged to increase child allowances in F3/12, to implement the full program for child allowances from F3/13, and to build a highway network across the country. This represents an upside risk to our forecast, as such steps would boost demand ahead, but only for the short term.

Whatever the outcome of the leadership election, the next administration may prove short-lived. The DPJ contest is drawing attention, but will do nothing to alter the division of party control between the upper and lower houses. And since the ruling parties do not have a two-thirds majority in the lower house, they are unable to overturn decisions made by the upper house. In this situation, there is a low probability that budget-related legislation would take effect in the upper house even if F3/12 budget proposals were passed by the lower house. The government may have to trade passing budget legislation for dissolving the Diet and calling a general election.

In this light, we believe that the government's fiscal policy is not likely to be expansionary over a sustained period, even if it turns in that direction for a time.

Downside risks relate to overseas. Our house global economic forecasts are quite bullish relative to the consensus. Risks to our outlook could be Japan-style deflation in the US and the flaring up again of sovereign debt problems in Europe, threatening lower growth rates. For the former, our US team does not expect the US to drop into deflation, one reason for this being employment and wage-setting mechanisms which are different from those in Japan. US employment practices which prioritize adjustments of jobs ahead of nominal wages do indeed make Japan-style wage deflation more unlikely.

For the sovereign debt problem, our European economics team believes that the recent stress-test announcements have ended the bad news for the time being. But far from resolving the problems, the stress tests have led to lingering uncertainty for the future by postponing the framework for comprehensive capitalization of financial institutions. We note the possibility that sovereign credit uncertainty could recur in 1H11.

Extremely Sluggish Pace of Price Recovery

Our price outlook has been cautious from the start, and we have highlighted the possibility that underlying prices - excluding fresh foods, energy, and the impact of systemic factors - will remain negative year on year until around the end of 2013. Although the underlying inflation in year-on-year terms bottomed in Jan-Mar 2010, the recovery thereafter has been listless.

In macro terms, there is a time lag of about three quarters between the output gap and underlying price trends. The output gap has been improving gradually from the region of -8.3% in Jan-Mar 2009 to -4.8% (Cabinet Office estimate, preliminary) in Apr-Jun 2010, and the bottoming of core prices in Jan-Mar 2010 is consistent with this.

However, concerns are unabated. We estimate that medium-term inflation expectations have improved marginally from negative levels in Oct-Dec 2009, but are still virtually zero. This depressed levels poses risk that investment and consumption by the household and corporate sectors will be consistently postponed, prolonging demand stagnation, delaying improvement in the output gap, and thereby causing deflation to drag on.

In the near term, there is concern that revision of the base year for CPI statistics could exacerbate deflation, albeit as a technical issue.

Monetary Policy Still in an Accommodative Cycle

The economy is trending ahead of its potential growth rate seen as just under 1%, but given the huge output gap, it is tough to envision an early end to deflation, and we expect the government to continue to press the BoJ for further easing. The BoJ for its part is likely to basically cooperate, to avoid losing its independence via revision of the BoJ Law. We see the timing of further easing as Oct-Dec 2010, with potential triggers being 1) additional easing by the Fed, and 2) the JPY/USD trend. Given the constraints of zero interest rates, the conventional options for further easing are not extensive, but as means for the BoJ to effectively conduct easing while preserving face (given its reluctance to adopt zero interest rate policy), we can envision: 1) transitioning to a guidance band for the unsecured overnight call rate (0-0.1%); and 2) raising the balance of current account deposit reserves.

We think Oct-Dec 2012 or beyond is the exit timing. The benchmark year for the CPI will be revised in August 2011 (using 2010 for the nationwide data from July 2011), and as the rates of decline in the revised index are expected to be amplified, we postponed our outlook for exit timing when revising our interest rate forecast recently.

Meanwhile, long-term yields have come down, consistent with the global trend of fiscal retrenchment and fears of a double-dip for the global economy, and the 10y JGB yield hit our year-end target level of 0.90% on August 25. There has recently been a period of correction, due to concerns over fiscal expansion and profit-taking by financial institutions brought about by falling stock prices. However, the deflationary domestic environment is unchanged, and systemic and accounting factors also argue for lower interest rates, so we believe that the trend remains downwards. We keep our year-end target of 0.90%.

For details, see Japan Economics: Trimming 2011 Outlook with Policy Effects Wearing Off, September 10, 2010.



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United States
Review and Preview
September 14, 2010

By Ted Wieseman | New York

After a modest bounce Tuesday, Treasuries moved steadily lower over the holiday-shortened past week, extending a major market correction that began September 1 when the much stronger-than-expected manufacturing ISM report started a run of better economic data after a dreadful run in August.  The past week's economic calendar was unusually quiet, but the improved tone continued in what was released, with a big narrowing in the trade deficit and upside in wholesale inventories leading us to boost our 3Q GDP forecast a half-point to 2.6% and jobless claims sharply extending a reversal of the upside seen in July and August that increasingly seems to be confirmed as a temporary census distortion.  On top of the ongoing reduction in investor pessimism about the growth and inflation outlook, supply was a problem for the market over the past week, with 3-year, 10-year and 30-year auctions that ended poorly with a soft 30-year reopening Thursday.  There was also supply pressure in the MBS market that led to significant underperformance on the week that weighed on the intermediate part of the Treasury curve after prepayments showed a sharper-than-expected acceleration in August, pointing to a ramping up of origination going forward.  Corporate issuance was also heavy, and while this provided some support to rates markets during the short Tuesday pause in the recent sell-off as rate locks were unwound and the new supply swapped, it ultimately probably added to pressure on the market later in the week. 

On the week, benchmark Treasury yields rose 6-10bp, with 5s and 7s lagging as mortgages underperformed.  The 2-year yield rose 6bp to 0.57%, old 3-year 7bp to 0.86%, 5-year 10bp to 1.58%, 7-year 10bp to 2.23%, 10-year 9bp to 2.80%, and 30-year 9bp to 3.87%.  So far this month, yields are up 9-34bp, with 2s-30s up 25bp, the first significant period of weakness since the five-month-long market surge began in early April.  Accompanying the back-up in nominal yields and steepening of the curve has been a big move higher in inflation expectations in the TIPS market, with almost all of what was looking to be a significant deflation scare after the August FOMC meeting now having been reversed.  On the week, the 5-year TIPS yield rose 1bp to 0.17%, 10-year fell 4bp to 0.99%, and 30-year rose 1bp to 1.71%.  This left the benchmark inflation breakeven up 13bp on the week at 1.81%, a high since the 1.85% close on August 10, the day of the FOMC meeting after a disturbingly abrupt move down to a low since spring 2009 of 1.52% on August 24.  Shorter-end TIPS have not seen as much outperformance, so forward measures of inflation expectations that the Fed has been known to focus on more have normalized even more, with 5-year/5-year forward inflation breakeven up about 40bp from the August 24 low to near 2.20% - which is pretty much exactly what our point estimate is for what CPI will average from between 5 and 10 years from now. 

Mortgages performed badly on the week, with parts of the market lagging the significant Treasury market sell-off meaningfully, after August MBS prepayment results showed a significantly faster-than-expected acceleration, raising fears of sharply rising origination supply if the refi wave that seems to be underway continues.  The worst-performing parts of the MBS market were the 4.5% to 5.5% coupons that saw the most upside in prepays, but lower coupons also lagged slightly, leaving current coupon MBS yields up about 10bp to near 3.55%, a high since the first week of August after a 35bp rise since the August 31 record low.  Primary/secondary mortgage spreads have narrowed somewhat as a result of this sell-off, but they started at very wide levels, so this shouldn't necessarily translate into significant upward pressure on 30-year mortgage rates for now.  Still, with the prospect of a refinancing wave leading to a big pick-up in mortgage origination activity and new supply of lower-coupon MBS, we think it would be sensible for the FOMC to shift its reinvestment policy at the upcoming FOMC meeting and start buying MBS along with its ongoing Treasury purchases with the proceeds from MBS and agency maturities.  These purchases should be significantly higher in the second month of revived buying from mid-September to mid-October.  The accelerated MBS prepay rates reported for August point to about a $25 billion rundown of the Fed's portfolio on top of about $5 billion in agency maturities, so the New York Fed will need to reinvest about $30 billion after the $18 billion bought from mid-August through this week. 

Risk markets traded conversely to rates markets through the week, giving back some ground Tuesday but then rallying through the rest of the week.  The upside from Wednesday to Friday was much more muted than the move in rates, however, as equity and credit markets only managed marginal gains for the week as a whole while Treasury yields ended up significantly extending the initial reversal in the first few days of September.  For the week, the S&P 500 ended up 0.5%, with similarly muted performances across major sectors.  Credit upside was also minor, with the IG CDX index tightening 1bp to 103bp and the HY index improving 5bp to 554bp. 

The past week's economic calendar was very light, but the key numbers that were released extended the improved run that began with the ISM release on September 1.  The most notable release was the foreign trade report.  The trade deficit narrowed $7 billion in July to $42.8 billion, almost fully reversing an $8 billion surge in June, as imports pulled back 2.1% after surging 3.1% and exports rebounding 1.8% after falling 1.3%.  This big reversal of the surge in the trade gap at the end of 2Q puts net exports on pace to add significantly to 3Q GDP after the huge 2Q drag.  We now see trade adding 0.7pp to 3Q GDP growth, up from our prior 0.3pp estimate, reversing a small portion of the near-record 3.4pp (exceeded only once, in 1947) subtraction in 2Q.  On top of the trade upside, inventories also appear on pace to provide a good boost in 3Q.  Wholesale inventories surged 1.3% in July after the 1.0% gain reported for the factory sector last week, as some of the shockingly strong import growth in 2Q that seemed way out of line with demand growth and inventory accumulation may be showing up with a lag early in 3Q.  Incorporating this result, we now see inventory accumulation adding 0.9pp to 3Q growth, up a couple of tenths from our prior estimate.  Combining the better outlook for trade and inventories and a continued expectation that final domestic demand growth will slow to 1% from 4.3%, we raised our 3Q GDP forecast to 2.6% from 2.1%. 

The calendar is a lot busier in the upcoming week, and the key activity measures, retail sales and IP, are likely to extend to more positive recent run of data.  Notable data releases include the Treasury budget Monday, retail sales and business inventories Tuesday, industrial production Wednesday, PPI Thursday and CPI Friday:

* We expect the federal government to report a $94 billion budget deficit in August, $10 billion narrower than in the same period a year ago, reflecting a modest pick-up in tax receipts, partially offset by slightly higher outlays.  With one month left in the fiscal year, we see the FY 2010 budget deficit at $1.315 trillion - or 9% of GDP.  The deficit should continue to shrink in coming years due to cyclical forces, but there is a considerable amount of policy uncertainty at this point clouding the outlook.

* We forecast a 0.3% rise in overall retail sales in August and a 0.6% gain ex autos.  The motor vehicle sales reports point to a dip in the auto dealer category.  But chain store results were strong - likely aided by expanded sales tax holidays in some key states.  So we look for a solid gain in sectors such as apparel and general merchandise, leading to an expected 0.5% rise in the key retail control gauge.  Finally, we should see another price-related gain at gas stations.

* Very sharp jumps at both the manufacturing and wholesale stages point to an outsized 0.9% rise in overall inventories in July.  Also, June should be revised a bit higher.  Still, the I/S ratio should hold at a low 1.26 in July, reflecting the lack of any inventory excess at present.

* We forecast a 0.5% gain in August industrial production.  Even though the employment report showed a drop in manufacturing jobs during August, the average workweek ticked up.  In fact, the hours data point to a solid rise in output.  In particular, we look for sharp gains in sectors such as computers, electrical equipment and chemicals.  Meanwhile, motor vehicle assemblies retraced some of the sharp jump seen in July, when many plants skipped their usual summer shutdown.  So, we look for a solid 0.6% rise in the key manufacturing category and a 0.8% jump in manufacturing excluding motor vehicles.  Finally, the utilization rate is expected to hit a new 22-month high.

* We look for a 0.7% surge in the headline producer price index in August and a 0.1% uptick ex food and energy.  A rebound in the energy component, along with another jump in food prices, is likely to push up the headline PPI this month.  Meanwhile, the core should be better behaved than in July when higher quotes for motor vehicles and prescription drugs helped to trigger some upside.

* We forecast a 0.3% rise in the overall consumer price index in August and a 0.1% rise ex food and energy.  Gasoline prices are expected to post another sharp jump this month.  Also, food prices appear to have begun to head higher, led by significant upside in quotes for grains and beef.  Meanwhile on the core, as we have been highlighting in recent months, the key shelter component - which accounts for more than 40% of the core - appears to have bottomed.  Indeed, a turnaround in shelter is consistent with increasingly widespread evidence of lower rental vacancies and rising rents.  Finally, note that our August estimate implies an uptick in the year-on-year core CPI rate, to 1.0%.  This would be the first uptick since last December and, from our standpoint, reflects a meaningful trend reversal in core inflation.



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United States
The Coming Trade Tailwind
September 14, 2010

By Richard Berner | New York

From headwind to tailwind.  Our thesis that strong global growth would support US (net) exports and thus output (GDP) hasn't worked so far this year.  Indeed, in 2Q it proved spectacularly off the mark, as surging imports (and net exports) depressed GDP by 3.4pp - the second-largest quarterly overseas hit to US output on record.  To be sure, the key culprit was an unsustainable surge in imports rather than the moderate decline in export growth. 

But incoming data have also suggested that global growth is slowing, which would spell trouble for gains in US exports.  Echoing that worry, the diffusion index of export orders in the August ISM survey, while still a strong 55.5%, was the lowest in 2010.  Non-defense capital goods orders and shipments decelerated dramatically in the three months ending in July - to 2.8% and 6.2% annual rates, respectively - which could represent weakness in overseas deliveries of capital goods as well as domestic investment outlays.   

We think that weakness is either temporary or primarily domestic, and that trade tailwinds are coming.  Indeed, the $7 billion narrowing in July's trade gap hints that these tailwinds are just offshore.  Moreover, we think that surprises on both sides of the ledger will contribute to a narrower trade gap and thus to upside surprises in US growth.  In our view, still-hearty gains in global domestic demand will promote more-than-proportional gains in exports, while a sharp moderation in US demand and inventories will slow imports dramatically.  The combination should partly reverse the trade headwinds that hampered 1H and promote up to a full percentage point contribution from net exports to US growth in 2H. 

Exports: Global Reacceleration.  Surely, that improvement cannot come entirely through exports, as the 16-18% gains in real US merchandise exports over the past year are clearly unsustainable. After all, global growth has slowed, paced by slowing Chinese and other Asian economies as China's monetary restraint tempered its domestic demand.  But it does appear that Asia's economies are beginning to pick up steam again as policymakers have either deferred policy tightening - in India, Korea and Malaysia - or taken their foot off the brake in the case of China, which is reviving both domestic demand and production.

That pattern underscores our view that, even as global growth slows from 4.7% this year to 4.1% in 2011, gains in US exports likely will outpace it.  Three factors are important in that regard: 1) a shift in the mix of US exports toward faster-growing EM economies and Canada; 2) a global capex upswing; and 3) the Russian drought and export ban that will boost agricultural exports. 

1. A shift in the regional mix.  The share in US exports of goods and services delivered to Asia ex Japan, Latin America and Canada has risen significantly in the last decade, thanks in part to these countries' faster growth.  Despite the global recession, the share of US goods exports going to countries other than Europe or Japan rose from 69% of the total to 73% over the past five years, while the share of US services exports going to those economies also rose 4 percentage points, to 46% over that period.

In addition, the dollar's ongoing decline on a real effective basis has given US exporters a competitive edge in those markets.  Measured by the Fed's real effective trade-weighted exchange rate index relative to other important trading partners, the dollar has declined by nearly 19% from its peak in 2003.  At the same time, local currency appreciation in those fast-growing trading partners has improved their terms of trade, thus boosting real incomes and fueling their demand and import growth. 

2. Global capex revival?  It's worth noting that global rebalancing of the sort we envision involves the potential for a significant upswing in capital spending, including in infrastructure, not just in EM economies but also in the developed world.  As our colleague Joachim Fels likes to describe it, there is a lot of spare capacity, but it's in the wrong places and the wrong sectors.

That fits our script in three ways:  First, an export-driven US recovery may require new growth in US supplying industries, including small and new businesses.  Second, some of that investment will likely come in the form of foreign direct investment (FDI) in the US.  Global investors will likely begin looking to strategic corporate US assets rather than our sovereign debt.  Third, there is the time-honored ‘accelerator' mechanism: Global companies have reduced their older and less-productive capacity, and gross investment is rising simply to maintain the capital stock; in addition, they are replacing it with more productive capital.  Those factors should benefit US capital goods producers exposed to global markets.  As evidence, 2H capital spending in Korea and other Asian economies is rising by 20-30% over 1H; in response, Chinese and Korean imports accelerated in August, with US-sourced machinery and equipment a contributor.

3. Russian drought likely to fuel US agricultural exports.  US exporters of farm products will likely fill much of the void created by the drought in Russia and the EU.  In what appears to be a replay of the food price spikes in 2008, Russia's plight and its August 15 ban on exports of wheat and grains has thrown the global food grain supply balance into sharp relief.  Indeed, the USDA reported this week that the shortfall in global grain output is depressing the supply and stocks of wheat and other feedgrains.  Against the global backdrop of rising demand for meat and feedgrains to produce it, the bad news is that food prices may rise significantly further.  The good news for US farmers is that this supply shortfall will boost exports; for example, the USDA projects a 1.4 million ton increase in US wheat exports, a 1.3 million ton increase in corn exports, and a 10 million bushel increase in sorghum shipments abroad.   

Empirical evidence in two forms.  Statistical relationships illustrate these points.  We estimated the parameters of a simple relationship to explain growth in US exports as a function of growth in non-US GDP, plus changes in the real exchange rate and non-oil imports (the last variable represents the influence of ‘round-trip' trade on exports).  Importantly, the estimated elasticity of real exports with respect to non-US GDP alone is about 2 - implying that, other things equal, 5% growth abroad will yield 10% growth in US exports.  The elasticity of exports with respect to the real effective exchange rate implies that the 5% depreciation in the broad trade-weighted dollar over the past 30 months will add another 3.5% to exports.  Those estimates are consistent with our view that US real merchandise exports will grow by 10% over the four quarters ended in 2Q11.

Imports: Leveraged to the slowing in US domestic demand.  In contrast, we think that the significant slowing in US domestic demand will likely promote an even sharper deceleration in imports.  That's because imports have been far outstripping domestic demand, and the recent surge has largely caught up to previous levels of import penetration or share.  With final domestic demand slowing to an estimated 1.5% annual rate in 2H, imports henceforth should grow as slowly or more slowly than domestic demand, and additional monthly declines would not be surprising.  Moreover, a shift in the mix of demand away from durables and a much slower pace of equipment spending likely will depress big-ticket-heavy imports.

Empirical evidence on imports supports that outlook.  A simple relationship explaining the growth of real non-petroleum imports depends on the growth in consumer and equipment investment outlays, swings in inventories (which wash out over two quarters), the growth of exports (to capture and control for ‘round-trip' trade), and the real effective exchange rate.  The elasticity of imports with respect to the domestic final demand components is 1.1, suggesting that moderate gains in demand will be associated with similarly moderate growth in imports.  The model also suggests that the 2.2% decline in the real trade-weighted dollar over the past 12 months will trim about 2 percentage points from the growth in non-petroleum imports.

Trade and inventories.  Swings in inventories have promoted even sharper swings in imports and magnified the widening in the trade gap.  Just as sharp declines in imports cushioned the shock of production cuts in the recession - adding nearly 6 percentage points to output in 2Q09 - so has an import surge dampened recovery in domestic output this year.  Some of that surge likely resulted from Chinese exporters accelerating shipments to beat the removal in July of export tax rebates on hundreds of items, including steel, fertilizers, glass, rubber and medicine.  Those Chinese exports shipped here likely wound up in US inventories; as evidence, wholesale inventories jumped by 1.3% in July.  Before ordering more, distributors will probably work off those imported inventories.  And because the leverage (or magnification) between imports and inventories works both ways, we think that a temporary stalling in inventory accumulation will depress imports.  In our view, imports are still out of line with fundamentals, and more slowing is on the way.



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