Banco de Mexico's Next Move
November 02, 2010
By Luis Arcentales
| New York
When Banco de Mexico released its quarterly Inflation Report on October 27, most of the attention seemed to focus on a series of changes to enhance the transparency in the central bank's communication strategy, in addition to a move lower in the near-term inflation forecast.
Starting next year, the central bank will begin publishing the minutes of its monetary policy meetings and, given the "convergence of inflation over the last years to low and stable levels", the authorities decided to reduce the number of scheduled policy meetings to eight next year from 11 in 2010. Importantly, the reduced number of meetings doesn't mean that the frequency of information will suffer: combining the policy statements, minutes and inflation reports, the central bank will provide its latest thinking about the monetary policy outlook in every month of the year. And based on last week's rally in short rates, Mexico watchers seemed to also welcome the cut in the central bank's near-term inflation forecast range by 0.50% in 4Q10 to 4.25-4.75% and by 0.75% in 1Q11 to 3.75-4.25%.
Enhanced transparency is a welcome development, but the more relevant takeaway from the Inflation Report is that Banco de Mexico seemed to open the door for potentially cutting rates down the road, in our view. Indeed, on the eve of the Federal Reserve's announcement on quantitative easing, there seems to be an incipient debate about the direction of monetary policy in Mexico. After all, the central bank's move to scrap the uniform 0.50% range for forecasts starting in 2Q11 suggests that the authorities feel more confident about their ability to anchor inflation expectations by simply focusing on the 3% central target. Moreover, by presenting an improved risk balance for inflation (and downside growth risks), the central bank should have more room to focus on the fact that, even with overnight rates steady at 4.50%, the monetary policy stance has gradually become more restrictive due in great part to a strengthening in the real exchange rate. And tighter monetary conditions seem like the wrong prescription for a Mexican economy that remains in the midst of a two-tiered recovery, characterized by good manufacturing growth coupled with sluggish consumption and anemic investment (see "Mexico: The Two Tier Economy", This Week in Latin America, May 11, 2010). Despite all these considerations, however, we suspect that the central bank isn't ready to ease, though we believe that the next move is more likely to be a rate cut rather than a hike.
Room to Maneuver
The central bank's new guidance for inflation provides it with additional room to maneuver, which could eventually open the door for an easing in rates, in our view. Today's situation, in fact, is similar to the episode when the central bank first unveiled its assessment of the impact of the tax reform last December 2 and later reiterated its relatively cautious set of estimates on January 27. Back then, when markets were still pricing in significant interest rate hikes during 2010, we argued that Banxico would keep rates on hold as this conservative inflation assessment - which projected inflation averaging as high as 5.25% in 2H10 - meant that inflation had plenty of space to disappoint without forcing the central bank into the difficult position of having to revise its forecast path higher, with obvious consequences to its credibility and thus balance of risks (see "Mexico: Rate Hikes? Not This Year", This Week in Latin America, February 8, 2010). Today, the Inflation Report acknowledged the uncertainty associated with longer horizons by scrapping the narrow guidance for inflation to converge to 2.75-3.25% by 4Q11, in favor of its 3% central target with a 1% tolerance. In practice, this means that expectations for inflation in 2011 - currently running at 3.8% - now fall within the central bank's guidance, thus giving the central bank room to justify a potential rate cut, which would have been more difficult with expectations well above the previous 2.75-3.25% range.
Banco de Mexico's broader move to adopt some common best practices like the use of fan charts and publishing minutes may also signal a larger degree of confidence among policymakers about its credibility. Indeed, the central bank acknowledged that it no longer found the need to rely on quarterly forecasts with a uniform 0.5% band (in use since 3Q07) which had been a useful tool for anchoring inflation expectations over the past three years, which were characterized by a series of supply shocks, according to the Inflation Report. Importantly, after coming under fire late last year and at the start of 2010 for being seemingly too dovish - a criticism we did not endorse - the central bank's assessment has been validated by the market: after pricing in rate hikes due to fears about the inflationary impact of the tax reform, by May surveys indicated that the consensus was already calling for no change to policy rates until 2011 (see "Mexico: Hike Another Day", This Week in Latin America, December 8, 2009). And it is also worth pointing out that until last week's downward revision, the central bank's quarterly guidance for inflation had remained unchanged since December 2009, a stretch of time without precedent in the short history since the central bank adopted the quarterly forecast path.
Though we suspect that Banco de Mexico feels more confident today about its inflation-fighting credentials than a year ago, we don't want to stretch this point. After all, the transmission mechanism for monetary policy in Mexico remains limited, in part reflecting the low degree of financial penetration. In addition, there are well-known rigidities that have prevented inflation from converging towards the 3.0% target, including the policy of public price adjustments (mainly energy) as well as lack of competition in the non-tradeable sector. Still, it doesn't seem like a coincidence that the central bank is pushing for more transparency at a point in which, for most of the year, it has found itself on the correct side of the inflation debate.
Tighter Monetary Conditions
Looking past its move to boost transparency, the central bank faces the challenge that its policy stance has been gradually becoming more restrictive. When Banco de Mexico paused in July 2009 after slashing its target interest rate by 375bp to 4.50%, it pushed the real rate to negative territory. And real rates seemed to be what the economy required: after all, inflation had already peaked, the currency was regaining ground and economic activity was deeply depressed (see "Mexico: Reassessing the Balance of Risks", This Week in Latin America, April 20, 2009). By the time Banco de Mexico paused in July, the outlook for inflation - whether Banxico's own forecast path or market expectations - indicated that policy would remain in stimulative territory, as measured by real interest rates near or below zero in the near term and, with the approval of the tax reform later the year, the projected real rate would have also been negative over the course of 2010 (absent any rate hikes by the central bank). Instead, after a brief dip in early 2010 due to the uptick in inflation caused by the tax reform, real rates have moved again into positive territory. And the relative tightening in the monetary stance has taken place in a context of still sluggish domestic demand growth, including anemic trends in construction, equipment outlays and credit (see "Mexico: Running on a Single, Slowing Engine", This Week in Latin America, October 11, 2010).
Our monetary conditions index confirms the ongoing tightening in the policy stance. In addition to the increase in real rates, the appreciation in the real exchange rate has also contributed to a tightening in monetary conditions, even as the central bank has maintained its policy rate objective unchanged at 4.50%. Indeed, our work suggests that since July 2009, the stronger real exchange rate has essentially offset the entire easing cycle that Banco de Mexico conducted between January and July 2009. In other words, had the peso remained stable on a real effective basis at the level of July 2009, at current levels our Monetary Conditions Index implies that Banco de Mexico would have had to increase interest rates from 4.50% to slightly above the 8.25% prevalent before the easing cycle started.
Is the recent tightening in monetary conditions about to force the central bank's hand? At this juncture, the authorities do not appear to be in any hurry to modify their stance, though we see the risks to policy rates increasingly skewed to the downside. After all, whether we look at levels of real rates or our index of monetary conditions, both remain below historical norms, suggesting that there is still some space for currency appreciation before monetary conditions become clearly out of synch with the fundamental backdrop of sluggish domestic demand. With just one meeting left in 2010, moreover, the authorities are likely to be reluctant to move in a context of rising inflation, which is set to move higher through year-end in great part due to base effects. And even as the Inflation Report confirmed that Mexico is likely to remain on the sidelines of the ongoing ‘currency war', the start of quantitative easing in the US adds a significant degree of uncertainty to the near-term outlook, in our view.
As the Federal Reserve's announcement on quantitative easing draws near, there seems to be an incipient debate about the direction of monetary policy in Mexico. After all, the latest Inflation Report suggested that Banco de Mexico feels more confident about its ability to anchor inflation expectations, in a context of downside growth risks and an improved outlook for inflation. But even as the monetary policy stance has gradually become more restrictive, Banco de Mexico doesn't seem in any hurry to ease. But as the policy debate gains momentum, we suspect that more Mexico watchers are going to find that the risks to policy rates are increasingly skewed to the downside.
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Rate Call Change - We Expect a 50bp Cut
November 02, 2010
By Michael Kafe, CFA & Andrea Masia
| Johannesburg & Chuan Lim | London
We have revised our year-end target on USDZAR from 7.50 to 6.80, and now expect USDZAR to end 2011 at 7.50 (8.00 previously) before depreciating to 8.00 in 2012. With this new profile comes a significant improvement in our inflation profile, where we now expect CPI to average 4.3% in 2011 (4.8% previously), before rising to 5.5% in 2012 (5.7% previously). The improved inflation profile - together with weak economic data and declining inflation expectations - raises the chances of one more 50bp rate cut in the cycle, we think, and this could happen as early as the November 18 MPC meeting. A much tighter fiscal position than generally anticipated also gives the monetary authorities the room to ease further. From a quantitative point of view, our SARB EazyMeter estimates the probability of a rate cut at the November MPC meeting at a touch below 90%.
Investors looking to exploit this view should consider holding 5-10y SAGBs, keeping 2s5s flatteners and receiving 1x4 FRAs.
Rand to Remain Stronger for Longer
Defying most expectations, USDZAR rallied significantly to a low of 6.75 in mid-October. Although it has sold off a bit since then, it is important to note that it was unable to sustainably break through the psychological 7.00 level, despite market concerns about exchange control relaxation in the October 27 Medium-Term Budget Policy Statement (MTBPS). Full details of the proposed exchange control liberalisation will only be unveiled later this week. However, the conspicuous lack of commitment to exchange control relaxation expressed in the MTBPS document suggests that the authorities are unwilling to take advantage of the present deluge of capital to make any decisive policy changes on this front. We had expected the authorities to raise the offshore limits on pension funds and insurance companies from 20% to 25% of assets under management, at the very least.
The budget document did indicate that "private and public pension funds, including the Government Employees Pension Fund (GEPF), will be reviewed to support portfolio realignment and offshore diversification, especially within Africa and into other emerging markets". However, given that there was no mention of insurance companies (which account for some 1.5 trillion of the country's R3-3.5 trillion asset pool, it is clear that even if the limits on pension funds were raised to 25%, the potential outflow would be in the region of R30-80 billion only - i.e., much less than our initial expectation of R100-150 billion. At the margin, this potentially modest relaxation of exchange controls is likely to have a much smaller impact on the ZAR than we had initially anticipated.
Capital Inflows to Cap Potential ZAR Weakness
While the momentum has no doubt slowed recently, the size of portfolio capital inflows into the country since the beginning of 2010 has now reached R88.2 billion, and is likely to hit the R100 billion mark by year-end, on our estimates. FDI inflows have also been rather significant this year, while an unsolicited bid was recently made for one of the country's largest retailers. At the same time, the National Treasury has offered to guarantee a further R174 billion of Eskom paper, which should allow Eskom to issue significant amounts for foreign loans to help fund its infrastructure development programme.
With all these inflows of foreign exchange, we believe that the currency is likely to remain range-bound until mid-2011, before depreciating somewhat in 2H11 as the current account deficit widens, and as the USD strengthens (our currency team now expects the EURUSD to rally from 1.43 in 2Q11 to 1.32 by the end of that year - see FX Pulse: Weaker USD Forecasts, Plenty to FEER, October 29, 2010).
Significant Improvement in Inflation Trajectory
Thanks in large measure to what appears to be a significant underestimation of the inflation pass-through from currency strength and the impact of the output gap on our part, recent CPI outcomes have turned out to be much lower than we had anticipated. On a pure mark-to-market basis, the recent undershoot in inflation outcomes has taken our average CPI forecast for 2011 from 4.8% to 4.6%. The downward revisions to USDZAR are likely to shave a further 0.2-0.3pp off our 2011/12 CPI forecasts. On the whole, therefore, we now expect CPI to come in at 4.3% in 2011 and 5.5% in 2012.
Fear of Target Breach to Prompt Policy Action
At the September MPC meeting, the SARB expected CPI to bottom out at 3.7%Y in 3Q10, before rising to post an average reading of 4.8% in 2011 and an annual rate of 5.1%Y in 4Q12. Given a July CPI print of 3.7%Y at the time, simple arithmetic would suggest that the SARB's forecast for August and September CPI must have been in the region of 3.6-3.7%Y. Since then, August posted a 3.5%Y out-turn, while September came in at 3.2%Y, taking the quarterly average (and, as a corollary, the 2011 forecast) down by 0.2pp, to 3.5%Y. We believe that the improvement in the inflation trajectory will be seen in a positive light by the SARB.
It is also important to note that, with goods inflation now at just 1.5%Y and CPI ex administered prices moderating further to 2.6%Y, the SARB may begin to view a possible breach of the lower bound of the inflation target band as a high probability event. This may ring particularly true after the latest PPI data suggested that upside risks from food and energy prices could in fact be a lot more muted than hitherto anticipated.
Weak Real Economy Data Point to Soft Pricing Pressures
Since the last MPC meeting, high-frequency macroeconomic data have come in below most expectations: for example, August manufacturing production came in at 5.3%Y (8.6%Y expected), while August retail sales came in at only 4.6%Y (8.5%Y expected). Manufacturing production data for September (to be released a week ahead of the November 18 MPC meeting) are likely to print below 2%Y - i.e., much weaker than the August outcome.
Finally, the 3Q10 employment data showed that a further 86,000 jobs were lost over the quarter, while the SARB leading indicator, after recovering from 129.3 in June to 131 in July, dipped slightly to 130.9 in August. The SARB will no doubt bear these soft data in mind when it deliberates on the most appropriate policy.
SARB EazyMeter Points to 90% Probability of Rate Cut
When we launched the SARB EazyMeter in August (see South Africa: Calculating the Probability of SARB Repo Rate Cuts, August 23, 2010, and South African Chartbook: Consumer Spending Blues, August 26, 2010), the estimated probability of a rate cut at the September 10 MPC was less than 50%. After updating the model to reflect a subsequent downgrade to the SARB's 2010/11 GDP forecast as per its September MPC statement, the ex post decline in 3Q10 inflation expectations, a stronger-than-expected currency and much weaker-than-anticipated industrial production data for August, the probability estimate for a policy rate cut in 3Q10 rose to 88%.
Looking forward to the upcoming MPC meeting on November 18, we assume:
• A further decline in manufacturing production in September - thanks largely to protracted strike action - followed by a modest technical recovery in 4Q10 as throughput normalises post the strike, and as the sector embarks on some inventory accumulation.
• A further 1.5%Q appreciation in the nominal effective exchange rate, informed by our revised USDZAR forecast; and
• An improvement in year-ahead inflation expectations from 6.1% to 5.9%. Break-even spreads have continued to fall since the last MPC meeting, and although results of the 4Q10 BER inflation expectations survey will only be published on December 7, 2010, the latest Reuters Econometer survey shows that analysts' expectations of 2011 CPI have improved from 5.2% to 4.9%. In our opinion, it is entirely reasonable to expect the MPC to take the view that unions and businesses must have adjusted their expectations downwards too. Importantly, the decline in analysts' expectations alone takes the headline reading from 6.1% to 6%. Add to this a very conservative decline in labour and business expectations, and it is not difficult to see a final reading of less than 6%. Expectations of a sub-6% print here should give the SARB comfort that one-year-ahead inflation expectations have finally fallen within the 3-6% target band for the first time since 4Q07.
With these inputs, the SARB EazyMeter, which has successfully identified 11 out of the 13 quarters since the introduction of inflation targeting where policy rates were cut (i.e., a hit rate of 85%), estimates the probability of further policy easing in 4Q10 at 89%. This is well above the ‘low conviction' zone (grey area), where the success rate of the model is only 25%.
Tight Fiscus Leaves Room for Monetary Easing
Finally, in its MTBPS presentation to cabinet last week, the Treasury upgraded its GDP growth expectations, made downward revisions to inflation, and committed the country to responsible fiscal thrift. The pursuit of tighter policy by the fiscal authorities also gives the MPC space to relax policy further (see South Africa: Fiscal Frugality Positions South Africa for Sovereign Rating Upgrade, October 28, 2010).
On the basis of the above developments, we now expect the SARB to cut its policy repo rate by 50bp in November.
Hold 5-10y SAGBs, keep 2s5s flatteners and receive 1x4 FRAs: Given that we expect the SARB to be one of the few central banks that will cut rates this year, we recommend staying received ZAR rates and holding SAGBs. For real money investors, we think that holding SAGBs is still attractive, as we expect positive returns in both rates and FX (we target 6.50% for the R157, and our end-2010 forecast for USD/ZAR is 6.80). We think that the best place to receive is in the 5-10y sector, given that the ZAR curve is the second-steepest in the CEEMEA region. Continued inflows into the bond market should help to flatten the curve as well, and we therefore recommend keeping our 2s5s flatteners, which is our core medium-term trade.
Indeed, a SARB policy rate cut could cause the curve to bull-steepen immediately after the announcement, putting our curve-flattening call at risk temporarily. However, we would view this as an opportunity to add to the flatteners, as we do not expect more cuts from the SARB, and duration buying from real money investors on the back of continued inflows should prevent any excessive curve-steepening. Further, the front end has almost fully priced in a 50bp cut by January 2011 (but not yet by November 2010), so a rate cut may have a limited impact in pushing 2y lower. Given the steepness of the ZAR curve, and rates staying low for long in the core markets, we think that ZAR curve-flattening has further to go. For investors who are concerned about this risk, we suggest either reducing the pay 2y leg of the 2s5s flatteners ahead of the November meeting (to make the overall position net overlent 5y), or to receive the 1x4 FRAs, which is pricing in just 20bp of cuts at the November meeting.
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Getting Away with it, for Now
November 02, 2010
By Pasquale Diana & Chuan Lim
Morgan Stanley visited Budapest on October 27-28 and held meetings with a senior advisor to the government, two MPC members, NBH research staff, two senior representatives of the asset management community and representatives from the Fiscal Council. This note goes through our main conclusions from the trip. Feel free to call for more colour.
Modus Operandi Still the Same, Communication Issues Remain
Economic policy unfortunately still looks erratic, communication could be improved: The government follows its instinct, at times good, but its actions are often perceived by market players and investors to lack sufficient strategic planning, we think. The relationship with international lenders has not improved, and the notion that the government will continue to deal with the EU, and avoid the IMF whenever possible, still reigns supreme. We think that there is a fundamental flaw with this policy: the EU will not be more lenient than the IMF on economic policy issues. Also, as the bulk of IMF money matures in 2012-13, we question the wisdom of a policy that alienates the Fund, given that, should market conditions deteriorate between now and 2012, the authorities may well have an interest in rescheduling loan repayments to the IMF. In addition, markets still pay a lot of attention to what the IMF says, so whether it likes it or not, the government has a clear incentive to be in the IMF's good books.
Most economic agents have taken a very dim view of the changes to the pension system (more on this below). Similarly, the ‘crisis taxes' were seen as negative for both growth and inflation, and carrying a negative message for future FDI into the country. As an example, there remains significant uncertainty about how the bank tax will be levied based on 2009 assets both this year and next, but there is no guidance on 2012 yet. Potentially, parent banks in Western Europe may be tempted to shrink their asset base in Hungary if they thought that future taxes will be levied on future asset bases.
All in all, our takeaways from the meetings were that decision-making seems very centralised, the communication between ministries could be improved, and there remains scope on the part of the government for improving communication with the investors.
Monetary Policy: Closer to a Rate Hike than the Market Thinks
The NBH reaction function, as we have spelled out many times, rests on two main pillars: The risk environment and the CPI outlook. The MPC will cut rates if the CPI outlook is benign, only if doing so does not jeopardise financial stability and weaken the HUF. And conversely, it may choose to hike rates even if the CPI outlook is benign, should financial stability concerns suggest that a higher return on HUF assets is needed. The reason for such an emphasis on HUF and financial stability is, of course, the well-documented stock of FX loans: cutting rates to stimulate the economy at the risk of weakening the forint is simply not an option in a country where household loans in foreign currency (mostly CHF) as a share of GDP now stand at 23% (versus 12% in Poland, 13% in Romania and 0% in the Czech Republic).
Revisiting the last three NBH meetings: While the background is clear, the recent history is quite instructive in gauging how the NBH's thinking has evolved. In August, the staff revised the official CPI forecast to above 3%, mostly on the back of stronger external price pressures (weaker HUF). In a very unusual move, the majority on the Council openly chose to distance themselves from the inflation forecast, on the grounds that it was "too high". In particular, the dissenting members argued that the FX pass-through had fallen, and that a weaker HUF carries fewer CPI risks, given how wide the output gap is. Also, the same members thought that a ‘wait-and-see' attitude was called for, given that the government may well announce some meaningful fiscal tightening in the following weeks. Therefore, the August meeting produced a split vote, with P. Bihari and Simor voting to hike (+25bp), lonesome dove Banfi voting to cut (-25bp) and the rest of the Council deciding to hold. In September, due to a combination of better risk appetite and the government's stated intention to bring the deficit below 3% of GDP in 2011 (a "milestone", according to P. Bihari's comment at that time), no one supported a rate hike. In October, however, there was once again a rate hike motion (the minutes are out on November 17).
What's changed? In essence, the government's ‘fiscal mix' for 2011 is seen as clearly pro-inflationary: This is because of two factors: first, the ‘crisis taxes' carry risks of spillover to final prices, as companies seek to make up for lost profits: the NBH (and the Fiscal Council) think that this effect may add around 0.3pp to inflation next year. Also, the tax reform has unambiguous pro-growth elements: while at first it looked as though only the rich would benefit (with a lower marginal propensity to consume), the introduction of family allowances ensures that everyone, except the poorest with no children, will be paying lower taxes next year. The boost to consumption that is likely to follow (assuming that the tax cut is not saved) may also raise price pressures. In addition, some members note that the last two retail sales releases have shown improvement on the spending side already.
The November inflation report will be key: Some of those who decided to give the government the benefit of the doubt, hoping for structural spending cuts and a very different fiscal policy mix, will likely be disappointed. These members may once again choose to put their trust in the inflation forecast and revert to strict inflation targeting: so, if the November CPI projection show inflation once again below 3% over the medium term (certainly possible), a rate hike would be a very serious prospect indeed. We will preview the November Inflation Report in more detail over the next weeks, but overall we feel that a rate hike is significantly closer than most commentators expect. Note also that locally the MPC does not seem at all influenced by the prospects of QE elsewhere, as they are viewed as less relevant to Hungary. And even if global QE should result in some upside pressure on the currency, we do not feel that at these levels there would be much opposition to it, both on inflation grounds as well as income effects (FX mortgage repayments would fall from their current elevated levels). Therefore, Hungary would probably not feel constrained by the trilemma that our global economics research team have laid out in their recent pieces (see "No ‘Currency War'...Yet", The Global Monetary Analyst, October 6, 2010).
If we were to see a rate hike by year-end, what sort of hiking cycle do we expect? Not an aggressive one, we think. The 3% target may be ambitious, but it is not miles away. Some on the NBH already note the fall in services price inflation, the moderation in wage growth and the rise in labour supply as constructive from a medium-term inflation standpoint. A near-term hike would therefore serve to anchor expectations, more than anything else. It would also mark a return to a more standard approach to monetary policy (inflation targeting). The clearest objection to a rate hike is that the economy is still weak, of course. Also, core inflation measures are soft and potentially a rate hike may fuel HUF gains. These are all valid points. Yet, we note that: i) the NBH targets headline, not core; ii) at these levels some currency gains are not detrimental to the export outlook; and iii) 25bp would hardly have a material impact on the economy, given continued impaired credit creation. Once again, a rate increase would be about the NBH sticking to its inflation-targeting mandate, more than anything else. So, while we still pencil in some rate adjustment in 2011 (100bp in total), the probability of a hike before year-end seems higher to us than most commentators perceive.
Fiscal Policy: Near-Term Fixes Hide Long-Term Problems
In our meetings, we found broad-based conviction on the government's ability to meet both this year and next year's fiscal targets (3.8% and 2.9% of GDP, respectively). Recall that, in order to stick to its targets, the government plans to collect HUF 61 billion from telecom companies, HUF 70 billion from energy companies, HUF 30 billion from retail chains and HUF 200 billion from banks, starting this year, for a total of HUF 361 billion of one-off tax increases (1.4% of GDP). In addition, the government suspended the payment to private pension funds starting in November, and until at least the end of 2011 - these are worth HUF 30 billion per month, or HUF 360 billion in 2011 alone (1.4% of GDP). Our current understanding is that these pension contributions are on top of the amount raised by crisis taxes in order to cap the deficit to 2.9% of GDP. So, unless these funds are spent (or the underlying trend is much worse than the government thinks), there is a serious risk of an undershoot next year, i.e., a lower deficit than planned.
Long-term issues remain, however: Once all the ‘crisis taxes' are out, there is a serious shortfall of around HUF 700 billion per year (c.2.5% of GDP). We found no clarity at all on measures to fill this structural hole, which will emerge fully in 2013, and we do not think it is likely that any will be announced any time soon.
Another, very serious long-term issue is what will happen to the pension system after December 2011, when in principle the government should once again start making payments into the privately funded second pillar. Recall that up until now, employers pay a 24% contribution to the social security system. Employees pay a 9.5% contribution, of which 8% the state collects and then passes onto the private pension fund managers (the compulsory ‘second pillar'). These are collected and invested in Hungarian government bonds (roughly 50% of the total funds), domestic and foreign equities, and corporate bonds. The total assets under management are around HUF 2.7 trillion (€10 billion).
The ‘state' portion, where contributions are three times as high, works as a standard PAYG system (defined benefit, or DB): current taxpayers pay for current retirees' pensions. The private portion is made up of individual accounts and will pay on the basis of a defined contribution (DC) system (you take out what you put in, plus the returns earned), so the state cannot use it to pay for current pensions. In countries (as in most of Western Europe) where there is no compulsory second pillar, the state collects more money under the first pillar and uses that money in the PAYG system. However, given the demographics, that system is clearly unsustainable in the long term. Even so, by collecting more money today from taxpayers to pay for current retirees, Western European countries have to borrow less than, say, Hungary or Poland. These extra costs to the deficit are often referred to as ‘pension reform costs', and were the reason behind the recent disagreement with Eurostat. Indeed, it looks as if it was Eurostat's refusal to allow CEE countries to explicitly exclude pension reform costs from official deficit/debt calculations that persuaded the Hungarian authorities to go ahead with this plan, without any warning to local pension funds (or indeed the IMF, we think).
Towards full-scale nationalisation? Is this the first step towards full-scale nationalisation of the pension funds? And if so, what would happen? These are all legitimate questions, to which we found neither answers nor clarity in any of our meetings. If we assume that the end-game is the reversal of the 1997 pension reform, there are of course several options. One is that the government could simply continue to divert all contributions to the state social security system even after 2011, and offer attractive terms to induce people to move their stock of savings currently invested in the private pension funds back into the state system. Presumably, those holdings could be liquidated, although probably in very gradual fashion, to avoid adverse consequences for equity and bond markets. The government would still be liable for those accumulated pension liabilities, but were the investments to be liquidated, the money may be used for other purposes, we think.
Nationalisation may temporarily improve the fiscal ratios significantly: In the extreme, if the government used all the funds for debt redemptions, its current debt/GDP ratio would fall by around 10% of GDP. Of course, continuing to bring the contributions into the state pillar would also reduce the deficit ratio by around 1.5% of GDP per annum relative to what the deficit would have been otherwise (assuming of course that the extra cash is not used to fund more spending or a tax cut). Over the weekend, some comments by Economy Minister Matolcsy lent weight to the hypothesis that the government plans to use those funds to redeem debt. Matolcsy said that he expects a large part of those who are currently invested in the ‘second pillar' to choose to return to the state system, which could bring around HUF 2 trillion into the state coffers (7.5% of GDP), to be used to reduce debt. No more details were given. If that happened, essentially the second pillar savings would be used to lower debt/GDP in return for a promise for higher pensions in the longer term, delivered under the old PAYG system.
So, nationalisation (whatever form it takes) would bring short-term improvements in both deficit and debt/GDP ratios. Unfortunately, however, nationalisation would imply a reversal of the 1997 pension reform and a de facto shift from a (partly) defined contribution to a defined benefit system which is probably not viable in the long run. The European authorities have often praised the CEE countries for reforming their pension systems, so any steps taken towards undoing this reform are not ideal. Our meetings in Budapest confirmed that the universal reaction to these proposed changes was extremely negative.
Strategy Implications: Sell EUR/HUF Tactically
With a higher chance of a more hawkish MPC, coupled with our more constructive outlook on the external risk environment and CEE FX (see the latest CEEMEA Investor), we think that the best way to be tactically bullish on Hungary in the near term is by selling EUR/HUF. A 25bp hike would help to improve the positive carry on the position as well, but we do not believe that it would be damaging to growth. In fact, as detailed in the economics section of this note, a stronger forint (particularly versus CHF) could lift household consumption as their mortgage obligations fall. Further, looking at the past performance of the HUF relative to the rest of the CEE region following surprise rate hikes from the NBH, we can see that the last three surprise hikes (one of them was the 300bp emergency hike in October 2008) were accompanied by forint outperformance versus other CEE currencies.
The evidence is less conclusive when looking at the whole spectrum of hawkish surprises from the NBH, but we think that the currency performance is driven by the backdrop against which a hike occurs. Given the positive news on the budget, and the benign external environment, we think that any near-term hike will be followed by currency strength. Even if a hike is not forthcoming as early as in November, we think that the NBH will be more hawkish, potentially signalling a hike further down the road. This should be supportive of the currency as well.
Given the various emergency taxes, it looks likely that the budget deficit will print at 2.9% of GDP or lower in 2011. With the uncertainty regarding the pension fund changes (more below), we think that the FX market is a better place to implement our tactically bullish trade. Our first target is 265 on EUR/HUF. In terms of timing, given that the major event risk is the uncertainty regarding the Fed's QE2 this week, we suggest waiting until after the announcement on Wednesday before pulling the trigger.
The impact on the bond market is not clear-cut: More anchored inflation expectations on the back of a potential rate hike could support the long end of the curve, but we prefer to wait for more clarity on the private pension fund changes, as they could potentially present some negative risks on bond demand. On the proposed changes to freezing of social security contribution to the second pillar pension plans, our takeaways are:
• There will be no inflows into the private pension plans over the next 14 months (HUF 360 billion), thus reducing the demand for HGBs by around HUF 180 billion (around 50% of their portfolios are allocated to HGBs);
• The liquidity of the bond market could be negatively impacted as one of the main natural buyers of HGBs will be absent (local pension funds hold around 15% of total local government debt outstanding);
• Around HUF 360 billion of the ‘savings' due to the payment freeze will be counted as revenues by the government. If more than 50% of the ‘savings' are used to reduce the financing needs and subsequently government supply, this would be positive for the bond market, as the reduction in supply will be higher than the potential fall in demand;
• If Hungarians decide to move back to the state pension system, there will be no liquidation of assets to prevent a fire sale of bonds and equities. As these instruments will not be converted into cash in the near term, the government will not be able to spend them.
Overall, the net impact of the pension plan change is not obvious, we think. The fall in bond demand is a negative development, but this could be accompanied by a reduction in supply on the back of the proposed pension plan changes. The amount of supply reduction depends on how much the government decides to use the HUF 360 billion of ‘savings' to reduce financing needs. What is clear, however, is that the likely deterioration in market liquidity may deter investors from rushing into the market until a clearer picture emerges.
Hungary's Second Pillar Pension Plan - Some Background
Owing to the pension fund reform in early 2008, the local pension funds started to shift away from a 70:20:10 mix of bond:equity:other investments, towards a higher allocation to equities and lower allocation to bonds. Under the reforms, there are different types of portfolios:
• Growth portfolio (minimum 40% of AUM in equities): for contributors with more than 15 years to retirement;
• Balanced portfolio (10-40% of AUM in equities): for contributors with 5-15 years to retirement;
• Classic portfolio (maximum 10% of AUM in equities): for contributors with less than five years to retirement.
Given the relatively young workforce in Hungary, many would have moved into the growth portfolio. Since the reform became compulsory in 2009, we have seen a reallocation away from government debt into other assets, in particular mutual funds. The latest data show that the local pension funds currently allocate around 50-55% of their portfolios to local government bonds.
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Chinese Economy through 2020 (Part 3): A Golden Age for Consumption
November 02, 2010
By Qing Wang
| Hong Kong & Steven Zhang | Shanghai
Introduction and Overview
What are the megatrends that could define the Chinese economy through 2020, in terms of both growth trajectory and the structure of the economy? To what extent can we extrapolate China's economic success of the past three decades to the coming one? What are the potential pitfalls and risks down the road? How can investors best position themselves for the potentially profound transition and transformation of the economy?
We aim to address these issues in a series of reports under the umbrella Chinese Economy through 2020. In the first, we argued that China's economic growth rate potential is set to slow but should nevertheless average 8% per annum through 2020, with a profound structural evolution that leads to rising shares of consumption-GDP, service sector-GDP, and labor income-GDP (see Chinese Economy through 2020: Not Whether but How Growth Will Decelerate, September 20, 2010).
In the second installment (Chinese Economy through 2002 (Part 2): Labor Supply to Remain Abundant, October 10, 2010), we made the case that China will continue to benefit from a low demographic dependency ratio and abundant labor supply through 2020. The expected deceleration in the growth of the working-age population is unlikely to become a headwind to overall economic expansion in China.
This third report aims to assess how consumption will take off over the next decade as a driver of growth. We make the following key points:
1) The Chinese economy can prepare for a golden age for consumption over the next decade. While economic growth potential is set to decelerate, consumption will accelerate to take the baton from investment and exports as the power for headline growth, as both empirical evidence and theoretical analysis suggest that the Chinese economy is at an inflection point beyond which consumption is likely to outperform strongly over the next decade.
2) Our base case scenario is that China's total consumption will equal two-thirds that of the US level and account for about 12% of the world total by 2020. In terms of incremental consumption, China overtook the US in 2008 and will represent 20% of world consumption by 2020.
3) A Golden Age for consumption would feature two key aspects: a) the strong expansion of consumption; and b) a profound evolution in the structure of consumption. To realize the former would entail strong household income growth and/or a lower saving ratio. We identify eight drivers that would help usher in a golden age for consumption in China: 1) economic growth; 2) wage increase; 3) development of service industries; 4) public expenditure; 5) income redistribution; 6) aging population; 7) level of economic development and 8) urbanization. We group these eight drivers under three pillars that underpin a golden age for consumption in China: a) rising income; b) lower saving ratio; and c) consumption upgrade.
4) Large regional disparities make China special. To this end, we develop a framework to help understand the dynamic regional evolution of consumption.
5) We revisit the issue of ‘under-consumption' in China and reiterate our belief that China's private consumption is substantially underestimated.
China's Consumption Has ‘Underperformed'
China's economic achievements since the launch of economic reform in 1978 have been extraordinary. By 2009, nominal GDP had reached US$3,679 in 2009, or 16 times 1978's level of US$226, representing a real GDP CAGR of 9.5% across the period, outperforming not only the developed economies but also developing peers by a wide margin.
Investment and exports have been the primary drivers of China's strong growth, while consumption growth has underperformed: its share of GDP declined by nearly 14pp from 2000 to 2009.
In consequence, by 2009, China's consumption-GDP ratio was significantly below not only those of high-income countries (e.g., the US) and middle-income peers (e.g., Malaysia) but also those of low-income ones (e.g., India).
These comparisons have helped form a consensus among most China observers that there is serious under-consumption in China and that a substantial boost to consumption is required to ensure more sustainable and balanced growth. On this subject, some China observers have become much more concerned as they fear that this is not only an issue of rebalancing China's economy over the long run but also of economic stability in the short run. Some China bears even predict that the Chinese economy is about to implode, as the consumption-GDP ratio in China is simply so unusually high and thus fragile that economic growth could easily collapse in the face of a major shock.
While we share the consensus view that China's consumption is relatively weak, we dismiss the rather alarmist view that the Chinese economy is so seriously imbalanced as to pose a threat to economic stability in the short run. This is because we believe that China's official statistics substantially understate the true magnitude of consumption (especially the consumption of services) in China. We address this in China's Under-Consumption Overstated in this report (see Special Topic Two).
China's Consumption at an Inflection Point: Empirical Evidence
China's economy is at an inflection point beyond which we believe consumption is likely to outperform strongly over the next decade.
As argued the first installment of the Chinese Economy through 2020 series, the Chinese economy is at an inflection point similar to that of Japan in 1969 and of Korea in 1988. (see Chinese Economy through 2020: Not Whether but How Growth Will Decelerate, September 20, 2010). History suggests that, beyond this inflection point, the economic structure tends to undergo profound transformation, with the three key ratios of the economy - consumption-GDP, service sector-GDP, and labor income-GDP - rising rapidly.
For instance, Japan's consumption-GDP ratio increased from 60% in 1969 to 69% in 1979, and Korea's from 60% in 1988 to 65% in 1998, as consumption growth began to significantly outpace overall economic growth.
China's Consumption at an Inflection Point: Theory
In our view, a country is justified in accumulating physical capital and wealth at the early stage of development to pave the way for the transition towards the more consumption-driven growth. For a developing economy, saving is an essential and integral part of industrialization process. History has shown that the only way to industrialize an economy is to increase the capital-labor ratio so that poor farmers can be equipped with industrial machines and equipment to produce goods that have higher value than farming. To install that piece of machinery, you need to save and invest.
There are a number of theories that shed light on the development stages of a country, with the most popular ones including the ‘U curve' theory, Rostow's Stages of Growth, and Chenery's Division of Industrialization Stages.
•· The ‘U curve' is the most straightforward theory explaining the trajectory of economic transition, in which the investment intensity of the economy (or investment-GDP ratio) keeps rising during the early state of industrialization until an inflection point is reached, beyond which the consumption intensity of the economy (consumption-GDP ratio) starts to bottom out.
•· The Rostow's Stages of Growth is one of the major analytical frameworks that explain the pattern of economic development. It postulates that economic modernization occurs in five basic stages of varying length, featuring ‘traditional society', ‘preconditions for take-off', ‘take-off', ‘drive to maturity', and ‘age of high mass consumption'. Rostow asserts that countries go through each of these stages fairly linearly and describes a number of conditions that would likely occur to investment, consumption and social trends at each stage.
We unify the two theories -‘U curve' and ‘Rostow's Stages of Growth' - into one framework to help illustrate the potential consumption trends in China. According to Rostow's Stages of Growth theory, an economy's development divides into five stages. China appears to be passing Stage III of ‘take-off' and is poised to transition into the Stage IV of ‘drive to maturity'. The ‘drive to maturity' features a "rebalancing among sectors, great poverty reduction, improving living standard as the society no longer needs to sacrifice its comfort in to order to strengthen certain sectors". Fitting the Rostow's Stages of Growth into the ‘U curve' framework, the consumption intensity declines in the stages of ‘pre-conditions for take-off' and ‘take-off' but is set to rebound in the stage of "drive to maturity".
Size Up China's Consumption through 2020: Three Illustrative Scenarios
We construct three scenarios to help illustrate how consumption in China will likely evolve through 2020 relative to that of US and the world economies. These scenario analyses are based on the forecasts we laid out in the first installment of the Chinese Economy through 2020 series, which benchmark the footprints of the transition experiences of developed economies such as Japan and Korea (see Chinese Economy through 2020: Not Whether but How Growth Will Decelerate, September 20, 2010).
The key parameters under different scenarios are summarized below:
•· Base case (70% probability): We expect annual real GDP growth and CPI inflation at 8.0% and 3.5% per year in our base case. Meanwhile, benchmarking with the experiences of Japan and Korea during the take-off period of consumption, the increment of consumption intensity per year is set at 0.7pp per annum, which would bring consumption intensity to 56% by 2020 from 49% in 2009. The USD/CNY exchange rate is expected to reach 5.5 by 2020.
•· Alternative scenario I - current trends continue (20% probability): The Chinese economy continues ‘business as usual' with no material change from the previous decade - featuring strong growth (GDP: 9.5%Y), modest inflation (CPI: 2.5%Y), and no meaningful transformation of the economic structure (consumption intensity slides 0.5pp per annum to 44% in 2020). RMB exchange rate mechanism reform is slower than expected such that the USD/CNY rate reaches 6.0 by 2020.
•· Alternative scenario II - a Japanese-style adjustment (10% probability): A Japan-style transition featuring a drastic deceleration of growth (GDP 6.5%Y) and structural adjustment (consumption intensity improve 1.4pp per annum to 63% in 2020). Such a scenario could be catalyzed either by very proactive (perhaps draconian) policy intervention to artificially correct the structure of the economy or external shocks such as a complete meltdown in external demand and sustained surge in international commodities prices due to supply shocks. The pace of RMB FX reform accelerates under Alt II (RMB/USD at 5 by 2020).
US/World growth: In the aftermath of the global financial crisis, we assume that US trend growth is low, averaging 2.7% of real GDP growth and 1.6% of CPI inflation during 2010-20. This assumption is based on the IMF's latest World Economic Outlook for 2010-15 with a moving average of previous three years for 2016-20. Meanwhile, reflecting the need for US households to repair balance sheets by saving more, we assume that the consumption intensity in the US would decline by 0.5pp per annum. Finally, we assume the trend growth of world GDP of 4.5% with 2.9% of average CPI inflation during 2011-20 (the IMF forecasts during 2010-15 and the rolling average of previous three years for 2016-20), while the consumption intensity would stay unchanged at its current level.
The Results from Our Scenario Analyses
•· China's incremental consumption in US dollar terms overtook that of the US for the first time in 2008. While incremental consumption for the US was negative in 2009 as the result of the financial crisis, China still managed to maintain expansion, suggesting that it had replaced the US as a primary driver of global consumption growth. Going forward, we expect China's incremental consumption to dwarf that of the US thanks to faster headline GDP growth and rising consumption intensity as the underlying economic structure evolves. By 2020, we estimate that China's annual incremental consumption should be roughly double that of the US under our base case scenario.
•· Total consumption: In our base case scenario, China's consumption would reach two-thirds of the US's level by 2020 from about 9% in 2000 and 20% in 2010. Meanwhile, the contribution of China to world total consumption will rise to 12% by 2020 from 3% in 2000 and 5.4% in 2010, while the US contribution will decline to 18.3% by 2020 from 27% in 2010.
•· Additional colors from alternative scenarios: In terms of incremental consumption, China will reach 1.2 times of US and 12% of world total under Alternative Scenario I but 2.5 times of US and 24% of world total under Alternative Scenario II. In terms of total consumption, China will reach 49% of US and 9% of world total under Alternative Scenario I but 74% of US and 14% of world total under Alternative Scenario II.
•· Of particular note, we envisage that Alternative Scenario II would feature a ‘Japanese-style adjustment', namely despite a relatively sharp slowdown in headline GDP growth, consumption growth remained very robust, as the consumption-GDP ratio rose rapidly after the inflection point was crossed.
A Golden Age for Consumption: Three Pillars
China's consumption is at an inflection and we believe that it is about to enter a Golden Age for consumption, in our view. We come to this conclusion by drawing on the development experiences of Japan and Korea, which, we believe, are most relevant to gauging the long-run outlook for China. While the analyses under different scenarios help to quantify the potential size of aggregate consumption in China through 2020, they are mostly for illustration purposes. The key remaining question is how this Golden Age for consumption will materialize. More specifically, what are the potential drivers for consumption in practice?
A Golden Age for consumption would feature two key aspects: a) strong expansion of consumption; and b) profound evolution of consumption structure, in our view. To realize the former would entail strong household income growth and/or a lower saving ratio. We identify eight drivers that would help to usher in a Golden Age for consumption in China: 1) economic growth; 2) wage increase; 3) development of service industries; 4) public expenditure; 5) income redistribution; 6) aging population; 7) urbanization; and 8) level of economic development. We group these eight drivers under three pillars that underpin a golden age for consumption in China: a) rising income; b) lower saving ratio; and c) consumption upgrading.
Pillar I: Rising Income
The primary source of consumption growth stems from household income growth. Since compensation of labor is the most important source of income for the vast majority of Chinese households, household income in China is primarily a function of overall economic growth, labor-intensify of the economy and wage rates. Looking ahead, we expect all three factors to provide robust support to rapid income growth in the next decade.
(1) Economic Growth
Under the base case scenario, we believe that the Chinese economy will still be able to maintain an average of 8% growth per annum over the next decade: That is a slowdown of slightly more than 2pp from the average growth achieved in the previous decade. We expect the deceleration in China's growth to be slower than that displayed by either Japan or Korea. Average CPI inflation over the next decade would be 3.5%, a significant acceleration from the average inflation rate of 1.9% over the previous decade. The higher inflation rate mainly reflects a labor market that is increasingly normalized. At this pace of development, China's nominal GDP would triple from its current size, reaching Rmb103 trillion. Assuming an average 3% appreciation of the renminbi against the US dollar per annum, Chinese nominal GDP in US dollar terms would quadruple its current size, reaching US$20 trillion by 2020 (see Chinese Economy through 2020: Not Whether but How Growth Will Decelerate, September 20, 2010).
(2) Development of Service Industries: Job-Rich Growth
China's service sector is underdeveloped. Since the sector tends to be labor-intensive, this has made China's growth largely ‘jobless'. Looking ahead, as the service sector develops, the labor intensity of the economy will likely increase, helping to boost household income growth, in our view.
•· Despite three decades of rapid development, the tertiary industry (service) represented just 42% of total GDP in 2009, not only far below the advanced economies (such as the US and Japan) but also developing peers (e.g., India). Even compared to the levels in Japan 40 years ago and Korea 20 years ago, China's service sector is lagging.
•· The service sector is labor-intensive, thus its lack of development helps to explain the ‘jobless' growth in China over the past two decades (see Chinese Economy through 2020 (Part 2): Labor Supply to Remain Abundant, October 10, 2010).
•· Looking ahead, we expect service sector growth to outpace overall economic growth such that service sector growth as a percentage of GDP will keep rising, by following the developmental experiences of Japan and Korea.
•· Development of the service sector should help to improve the labor intensity of the economy and boost the share of aggregate labor compensation in national income.
(3) Wage Increases
Labor market normalization has been underway for several years in China, which should underpin sustained wage growth over the long run. The unit labor cost in the industrial sector started to register largely positive growth since 2004, which represents the beginning of the end of surplus labor supply in China, in our view. Moreover, since then, a seasonal labor shortage, especially in coastal areas (i.e., around Chinese New Year), has become the norm instead of the exception (see China Economics Should We Be Worried about Large Minimum Wage Hikes? June 7, 2010).
Looking ahead through 2020, we believe that labor supply in China will remain abundant and unlikely become a binding constraint that would cause overall economic growth to slow down sharply (see Chinese Economy through 2020 (Part 2): Labor Supply to Remain Abundant, October 10, 2010). That said, as labor market normalization is underway, wage growth in China is more likely to be strong - in line with labor productivity growth - instead of being depressed by the large pool of surplus labor, which has been the case over the past 30 years, in our view.
On the policy front, a key policy priority under the 12th Five-year Plan is to make sure labor compensation increases in line with overall economic growth. To this end, a large majority of provinces in China raised local minimum wages this year, and the authorities are reportedly mulling over approving a Wage Bill, which features a collective wage negotiation mechanism.
Pillar II: Lower Saving Ratio - Household Saving Ratio to Peak Out
A declining saving ratio would boost consumption growth, given income growth. We expect Chinese households' saving ratio to peak out and even start to decline through 2020. The potential trends of three important factors over the coming decade will help bring about a lower household saving ratio, in our view. First, more government expenditure on public goods (e.g., express rail train, social housing) and services (e.g., education, healthcare) would help to lower the precautionary savings of households. Second, income redistribution would help to lower the overall saving ratio, as the saving ratio of high income households tends to be higher than that of low-income households. Third, as population aging kicks in, the average saving ratio tend to decline.
(1) Government Expenditure on Public Goods and Services Helps to Reduce Precautionary Savings
Government expenditure helps to reduce precautionary savings by households. The social welfare system has gone through profound changes during China's transition from planned to market economy. Under the planned economy, social welfare such as education, medical services, housing and pensions were largely free such that personal expenditures on those were almost negligible. The subsequent reform of the public welfare system has made education, medical services and housing much more expensive than before or even unaffordable for the poor. Consequently, households have to save more to pay for those used-to-be public goods and services. Precautionary savings have increased sharply as a result, crowding out consumption. For example, given the low penetration of commercial medical insurance in China, the portion of health expenditure financed by the government (45% in 2007) was very low in China, which requires household to set aside noticeable amount of additional saving for the health expenditures of family members.
In recent years, the government has realized the importance and urgency to mend its social welfare system to unlock consumption. Ambitious plans are being implemented in: (1) Healthcare reform aiming at full coverage of basic medical services; (2) Pension reform to address the problems stemming from aging society; and (3) Aggressive push-forward in social housing programs to provide affordable housing to low-income households. As these policy initiatives are being progressively carried out, it should reduce uncertainty and boost confidence of households and therefore lower the current precautionary savings ratio.
(2) Income Redistribution
Income inequality in China has widened over the past decade. Addressing this has become, and will likely remain, a key policy priority.
•· The Gini Coefficient, the measure of the income inequality, has been rising since the debut of economic reform in late 1970s. The indicator has passed the red line of ‘40%' in the 2000s, suggesting that income disparity in China is already quite serious. While China stopped publishing the Gini Coefficient in 2005, we estimate that this indicator may have reached over 50% by 2009, or close to the levels of Latin American countries such as Brazil, Peru and Argentina.
•· Since the propensity to consume is much higher in low-income households than high-income ones, the rising income inequality has a negative impact on consumption growth. There is empirical evidence that every increase of 1pp of Gini Coefficient would reduce the propensity to consumption by 0.5-0.7pp.
•· The Chinese authorities have realized the importance of income distribution for sustainable economic growth, especially the underpinning of consumption growth. Besides strengthening the social safety net that is targeted at the poor, we expect several tax measures to be implemented soon: a) the minimum threshold for personal income tax will be raised substantially to reduce the tax burden on middle- and low- income households; b) the marginal tax rate for high income bracket will be raised to quite a high level; and c) a real estate tax, or some special forms of property tax, could be implemented in 2011, as a means to tax the stock of wealth (as opposed to flow of income) owned by the rich.
•· Putting these policy measures in place would help China to achieve a more balanced income distribution featuring a large pool of middle-class households by 2020, according to MS Asia/EM equity strategy team, led by Jonathan Garner.
(3) Aging Population
The demographic profile is perhaps one of the most important factors in explaining the evolution of saving rates for an economy, especially a developing or emerging market economy. In particular, cross-country data show a clear pattern that as a country's dependence ratio rises, its saving ratio tends to decline.
China formally became an ‘aging society' in 2005, according to the UN definition of >10% of the total population being aged above 60. According to the UN, China's dependency ratio will bottom in 2010 and triple to 31.1% by 2050. The rising dependence ratio suggests that the overall saving ratio in China will peak out in the coming years and start to decline perhaps as early as the second half of the next decade.
Pillar III. Consumption Upgrade
A Golden Age for consumption in China would have two key aspects: a) the rapid expansion of aggregate consumption; and b) a profound and rapid change in the structure of consumption, or consumption upgrade. Consumers' preference and taste for different products and services typically reflects the level of economic development. In this regard, China is perhaps special in that as the economy develops, a massive structural shift is also taking place. That is rapid urbanization, which will have important impact on the structure of consumption beyond the implications of the level of development.
(1) Level of Economic Development
Reflecting sustained economic growth, the living standards of Chinese households have improved substantially since the early 1980s.
•· The Engel's coefficient, which is defined as the proportion of expense on food to the consumption expense and an index used to evaluate the living standards of households, has registered a significant decline for both urban and rural residents.
•· There has been a broad-based consumption upgrade. Compared with the consumption structures in1992 and 2009, while the share of necessities like food, clothes and home appliances declined, the shares of residence, healthcare and recreation, education and culture - representing a more advanced form of consumption - have risen markedly.
•· Compared with the consumption structure of more advanced economies, the consumption upgrade in China apparently has a long way to go. Passenger car penetration is a case in point. During the 10 years after they reached the same level of development as China today, the number of passenger cars per 1,000 persons increased by 3.5 times in Japan and 6.5 times in Korea.
•· We find that the consumption structure of China's urban households in 2007 was close to that of Japan in 1971. Specifically, food and clothing accounted for 37-38% of total private consumption; and housing was 15-16% for both urban China in 2007 and Japan in 1971. For healthcare, transportation & communication and recreation, education & culture, urban China in 2007 was only higher than Japan in 1971 by 1-2pp.
•· Assuming that the evolution of China's urban consumption upgrade would follow Japan's pattern, we may envisage what urban China's consumption structure would look like in 2020 by benchmarking that of Japan in 1984: the share of daily necessities should continue to fall, with food and clothing down 6.4pp and 1.2pp, respectively. The winner is healthcare, which would gain 2.6pp, followed by residence (2.1pp) and transportation & communications (2pp). In other words, healthcare, property and auto & telecom will likely benefit most from China's consumption upgrade over the coming decade.
China has been experiencing fast urbanization in the past two decades, with the urbanization ratio surging from 26.4% in 1990 to 46.6% in 2009, averaging 1% per year. Over 270 million rural residents moved into urban areas during 1990-2009. Nonetheless, China's urbanization remains low, not only relative to developed economies like the US, Japan and the UK, but also to Asian neighbors like Korea, Malaysia and the Philippines. China's urbanization is still roughly at the same level as that in the US 100 years ago.
If the current pace of urbanization is sustained in the next decade, with the urbanization ratio rising 1% per year, China's urbanization rate should reach 58% in 2020. If, however, the average pace were to accelerate to 1.5% per year, which is likely, especially given that urbanization is now given a high policy priority, we estimate that the urbanization rate would be able to reach 63% by 2020. This would imply that 12-20 million rural residents would be urbanized per year through 2020 (see China Economics: One Country, Three Economies: Urbanization as a Primary Driver of Growth, March 3, 2010).
There is a large gap in income and consumption levels between urban and rural households in China. In 2009, rural household income and consumption per capita was only 38% and 51% of that of urban households, respectively. Other than for housing, rural per capita consumption of major goods and service was barely that 50% of urban households. The penetration of major durable goods in rural areas lags far behind that in the urban sector.
We therefore expect that consumption upgrading in rural areas should mainly be reflected in the improvement in penetration of relatively low-end durable goods (air conditioners, washing machines, refrigerators) which have now largely reached a saturation point in urban sector.
The still sizeable difference in development stage between urban and rural areas suggests that the evolution of China's consumption upgrade will differ from those of other advanced economies like Japan and Korea, where the producers of consumer goods have to either look for external demand or retrench production once domestic demand is satisfied. In China, while urban residents are seeking more advanced consumption in the form of high-end durable goods and more services, the consumption upgrade in rural areas in the context of urbanization continues to generate strong demand for goods that have reached saturation level in urban area. In this context, China's consumption upgrading is expected to benefit the entire industrial chain from low-end to high-end and even from goods to services.
Special Topic One: A Golden Age for Consumption: A Regional Perspective
China is a big country in terms of both territory and population. Equally important is the massive regional disparity in terms of levels of development (see Strategy and Economics: One Country, Three Economies: Play the Regional Disparity in China, May 26, 2010). If we make a case for Golden Age for consumption in China, it is important to examine this issue from a regional perspective. We therefore dedicate a special section to discussing the potential dynamic trajectory of consumption across different regions in China.
Besides the historical reasons, the economy of the eastern region took off much earlier than the central and western regions, as the eastern region was the first to benefit from economic reform and the open-door policy. In terms of GDP per capita, the provinces of the eastern region averaged US$6,468 in 2009, double the average of the central (US$3,043) and western regions (US$2,818).
Since the eastern region is the most developed of the three, it is perhaps natural to expect that it would have the greatest consumption intensity (i.e., consumption-GDP ratio). In fact, the average consumption share of the eastern provinces is lower than for the central and western regions.
We explain the seemingly perverse relationship between consumption intensity and economic development through the framework of The Dynamic Trajectory of Regional Consumption Intensity as follows (see our full report for accompanying chart):
Construction of the Framework
•1) If we plot the ratio of consumption to GDP (Y axis) against the GDP per capita (X axis), it is interesting to observe that 36 provinces constitute a conspicuous ‘U' curve (slightly tilting to the right-hand side).
•2) Taking a step further, we may divide the space into four quadrants with two lines (Vertical: US$ 4000 GDP per capita; Horizontal: 48.6%, which is the national average consumption to GDP ratio).
•3) Then the space is divided into four quadrants: Quadrant A and D represent that consumption to GDP ratio is above national level while quadrant B and C are opposite; quadrant A and D represent that GDP per capita is below US$4,000 while quadrant B and C are opposite.
•1) The majority of western provinces (yellow spots) and some less-developed central provinces (dark blue spots) concentrate in the ‘quadrant A', which features high consumption intensity but low GDP per capita.
•2) Several central provinces appear in ‘quadrant B', which features low consumption intensity and low GDP per capita.
•3) The majority of eastern provinces are concentrated in ‘quadrant C', which features low consumption intensity but high GDP per capita.
•4) The three most developed provinces, Shanghai, Beijing and Guangdong (all from the eastern region), are grouped in ‘quadrant D', which represents high consumption intensity and high GDP per capita.
The Dynamic Relationship Between Four Quadrants
•1) ‘Quadrant A' is the ‘over-consumption' stage (high consumption intensity but low income) while ‘quadrant C' is the ‘under-consumption' stage (low consumption intensity but high income). ‘Quadrant B' is the ‘transition' stage between ‘quadrant A' and ‘quadrant C'. Finally, ‘quadrant D' should be the ‘mature' stage, with a relatively balanced economic structure.
•2) The ‘over-consumption' stage here does not suggest the over-growth of consumption but the leanness of the contributions from investments and net exports. This also explains why some less-developed countries are found to have a relatively high consumption intensity than advanced industrial economies.
•3) For the ‘over-consumption' provinces to take off would entail aggressive investment and possibly strong growth of net exports, as the result of which consumption intensity may drop significantly and the provinces may move from ‘quadrant A' to the ‘transition' stage in ‘quadrant B', featuring both low consumption intensity and GDP per capita.
•4) Aggressive investments and exports may bring strong economic growth, which would be reflected in rising GDP per capita. However, since the growth of investments and exports may still outpace consumption by a wide margin, the provinces may enter the ‘under-consumption' stage in ‘quadrant C', featuring low consumption intensity but high GDP per capita.
•5) When the marginal return on investment starts to peter out and export growth falters, the transition of economic growth shall take place by returning to consumption. Then the economy may upgrade from ‘quadrant C' into ‘quadrant D', where consumption intensity improves quickly.
•1) The consumption intensity of provinces in different regions should evolve along the ‘U' curve by following the trajectory of ‘A → B → C → D'.
•2) Not all provinces are likely to enter a golden age for consumption simultaneously over the next decade. Provinces in ‘quadrant C', or the ‘under-consumption' stage, will likely among the first to brace for a Golden Age for consumption with most rapid consumption upgrade. Provinces in ‘quadrant B', the ‘transition' stage, will likely also register strong consumption growth, but aggregate expansion is perhaps more profound than structural upgrade. Provinces in ‘quadrant A' are unlikely to enter a golden age for consumption until perhaps toward end of the next decade.
•3) It may take longer for China to achieve a take-off of consumption (relative to GDP) similar to Japan or Korea due to pronounced regional differences. This echoes the point we made in the first installment of our Chinese Economy through 2020 series (see Chinese Economy through 2020: Not Whether but How Growth Will Decelerate, September 20, 2010). This is because while the consumption intensity of eastern provinces in ‘quadrant C' will rise when moving into ‘quadrant D', the consumption intensity of western provinces in ‘quadrant A' will decline when moving into ‘quadrant B'. These two offsetting trends point to a more extended period of rebalancing in China compared to the case for Japan or Korea.
Special Topic Two: Under-Consumption Overstated
While we share the consensus view that China's consumption is relatively weak compared to other economies, we, however, dismiss the rather alarmist view that the Chinese economy is so seriously imbalanced as to pose a threat to economic stability in the short run. This is because we believe that China's official statistics substantially understate the true magnitude of consumption (especially consumption of services) in China.
We addressed this issue in a report published in 2009 (see China Economics: China's Under-Consumption Over-Stated, September 13, 2009). In that report, we reached the following conclusions:
•· First, Chinese official statistics for personal consumption expenditure substantially underestimate its true magnitude and impact, primarily due to the underestimation of consumption of services - especially housing and healthcare - in China.
•· Second, a comparison of consumption of non-services, tradable goods between the US and China - which is, in our view, more relevant to assessing the impact on the rest of world - indicates that the gap between the US and China is much smaller than suggested by headline overall consumption data.
•· Third, under a bottom-up approach, a like-for-like comparison of specific types of goods and services consumed by households in both countries indicates that the magnitude of China's personal consumption relative to that in the US could be much greater than is commonly perceived by the market.
We estimate that China's private consumption-GDP ratio could be underestimated by at least 10 percentage points, or personal consumption is underestimated by as much as 30%). In the same vein, we believe that China's investment-GDP ratio may have been overstated by the official statistics by as much as 10 percentage points.
If we do a simple exercise - adding 10 percentage points to consumption-GDP ratio while subtracting 10 percentage points from investment-GDP ratio - the trends of the adjusted consumption-GDP and investment-GDP ratios are amazingly similar to those of Japan and Korea when the two at a stage of development similar to China today.
We believe that the bulk of the underestimation is due to underestimation of consumption of services, especially private consumption-related services (e.g., housing). If we do a similar adjustment to the production structure by adding 10pp to the service-GDP ratio while subtracting 10pp from the industrial sector-GDP ratio, the trends of adjusted service-GDP and industrial-GDP ratios are also amazingly similar to those of Japan and Korea when the two economies were a similar stage of development.
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QE2: Will the Fed's Actions Match its Rhetoric?
November 02, 2010
By Richard Berner, David Greenlaw, Ted Wieseman & David Cho
| New York
The Fed needs to send a clear message. The Fed faces a dilemma: As officials prepare to implement a new round of quantitative easing, they clearly want to adopt a flexible, open-ended approach to asset purchases, one that can be scaled to financial conditions and the economic outlook. Just as clearly, market participants, skeptical about QE's success, will likely gauge the Fed's resolve by the size and pace of the purchase program. We expect the Fed to announce an initial commitment to buy Treasuries at around a US$100 billion monthly clip for the next six months, close to what officials and market commentary have discussed, but less than markets seemed to price in over the past couple of weeks.
How to resolve the dilemma? We think that clear communication about goals and tools would help markets understand the Fed's commitment, which matters more than the size of initial purchases and should give officials the flexibility they need. By underscoring its resolve to achieve specified goals, the Fed could imply how long it will hold on to the assets it purchases. For example, downward revisions to the Fed's inflation forecasts for 2010 and 2011 would imply that policy will be more aggressive for longer to cut off any deflation tail risk. Equally, the maturity distribution of purchases should matter more than the initial size and pace of the program. Skewing purchases to the longer end of the yield curve could increase the bang for buck.
QE eases broad financial conditions. QE1 might provide guidance to estimate the impact of new large-scale asset purchases (LSAPs). Studies suggest that QE1 trimmed nominal Treasury yields by about 50bp, although the econometrics aren't robust enough to narrow a wide range of estimates. It's worth remembering that the decline in Treasury yields is far from the only channel through which QE1 worked; the easing in financial conditions more broadly was as important, and it may be more important today. Easing channels included boosting risky asset prices, depreciating the dollar, and promoting easier financial conditions abroad. It's no coincidence that equity and credit markets bottomed and the dollar peaked (on a broad, trade-weighted basis) just before the FOMC announced that it would buy Treasuries and scale up its purchases of mortgage-backed and agency securities at its meeting on March 18, 2009. Moreover, QE1 had a powerful impact on inflation expectations, judging by the 120bp increase in 5-year, 5-year forward inflation breakevens between March 2009 and April 2010. (Note that distant forward breakevens have risen by nearly 90bp from their August 2010 lows.)
QE removes duration. In addition, because LSAPs work by taking duration out of the market, the maturity distribution of purchases might be as important as the volume. We agree with Chairman Bernanke and Brian Sack, who heads the New York Fed's Markets Division, that LSAPs work through a "portfolio balance" effect. In Chairman Bernanke's words at his speech this summer in Jackson Hole, the "degree of accommodation delivered by the Federal Reserve's securities purchase program is determined primarily by the quantity and mix of the securities the central bank holds or is anticipated to hold at a point in time (the "stock view"), rather than by the current pace of new purchases (the "flow view")." In other words, "by purchasing long-term securities, the Federal Reserve removes duration risk from the market, which should help to reduce the term premium that investors demand for holding long-term securities".
It follows that by lengthening the maturity of the securities the Fed holds in its portfolio, it can get more duration bang for every buck it buys. A recent study by Laurence Meyer and Antulio Bomfim of Macroeconomic Advisers shows that "nearly 60% of the Treasuries bought in the first round of asset purchases had a remaining life of six years or less". The authors translate that into a mean duration of about four years and show that, even if the Fed respects its self-imposed restriction that prohibits it from owning more than 35% of the outstanding amount of any individual Treasury security, the Desk could construct a portfolio with as much as eight years of duration. Moreover, as we noted earlier this month, this rule can be waived at any time and thus does not represent a significant barrier to concentrated purchases. Indeed, there are only about US$550 billion of Treasuries outstanding with a remaining maturity of greater than 10 years. So, if the Fed was to concentrate its buying in this sector, it could have a powerful impact on long-term yields.
Channels of monetary policy blocked or dysfunctional. The decline in long-term yields and easing in financial conditions should have a positive impact on credit-sensitive demands of the economy. However, it is difficult to quantify the economic stimulus that this will provide, because some traditional channels of monetary policy are blocked or dysfunctional. For example, the plunge in mortgage yields is having a smaller impact on refinancing activity than in the past. Tougher mortgage origination criteria - including ensuring that the loan is no more than 80% of the appraised value of the property, plus verification of the borrower's FICO score and income - have limited the number of eligible borrowers. Originators faced with ‘putbacks' from the GSEs (Fannie and Freddie) on prior loans are understandably skittish to extend credit to less-than-pristine borrowers. And the uncertainty around mortgage foreclosures and putbacks may further tighten the availability of mortgage credit.
What do policy rules say about size of stimulus needed? Traditional policy rules may provide some guidance for how much additional stimulus is needed, but with a wide range of error. New York Fed President Dudley suggests that US$500 billion of purchases would provide as much stimulus as a reduction in the federal funds rate of between half a point and three-quarters of a point. An estimated, traditional Taylor Rule prescribes that under the present circumstances - if policy rates could be negative - they should be -6% or even lower today. Combining these two models suggests that several trillion in asset purchases might be required to achieve the Fed's dual mandate. Given the blockages in monetary policy transmission channels, such estimates may have some validity, especially if policies to fix housing imbalances are unavailable. Yet, those estimates are obviously subject to substantial error.
Yields likely to drop further. The recent sell-off in Treasuries suggests that the market has scaled back its expectations for the size and scope of QE2. However, we believe that the actual start of the program will trigger further significant yield declines, especially if the Fed is as resolute as its prior rhetoric. Our conclusion seems to conflict with the notion that the likely size and scope of the Fed's plan are already ‘in the price'. But results from some simple regressions suggest that the Fed's extensive discussion of QE2 over the past two months, apart from its influence on the expected path of policy out two years, has had little direct impact on the level of 10-year nominal or real yields.
Uncertain and muted impact, but potential help from abroad. The economic impact of the change in financial conditions is highly uncertain; the fractures in the monetary policy transmission mechanism probably mean that QE won't yield much bang for buck. For example, Meyer and Bomfim at Macroeconomic Advisers in September estimated that a US$2 trillion asset purchase program might: 1) lower Treasury yields by 50bp; 2) increase GDP growth by 0.3pp in 2011 and 0.4pp in 2012; and 3) lower the unemployment rate by 0.3pp by the end of 2011 and 0.5pp by the end of 2012. However, they admit that these may be "high-end estimates" because they don't take into account the unique nature of the current credit environment and the potential blockage of some of the normal transmission channels. Thus, one could argue that several trillion in asset purchases is needed, as suggested by our prior analysis. We would add that uncertainty about the fate of expiring tax cuts - if it persists - may negate some of the impact of QE2.
Beyond its direct impact on the domestic economy, however, QE2 may indirectly promote faster US growth through a less-recognized, international channel: The Fed's actions are strengthening currencies abroad and forcing policymakers to choose whether to accept currency strength, adopt easier policies, or implement capital controls. Many central banks in both EM and DM economies (e.g., Australia, Canada, Korea) are accepting currency strength and/or choosing easier policies to resolve this ‘trilemma', or impossible trinity. As our colleagues Alan Taylor, Manoj Pradhan and Joachim Fels noted recently, "while the policy responses have been diverse, the net effect is a further loosening of the domestic monetary policy stance in many emerging market economies (except China), which should amplify the effects of the US monetary easing, and a depreciation of the US dollar that should support US exports and global rebalancing". At the same time, such pressures do risk fanning currency tensions or even triggering protectionist measures, which would be extremely negative for global markets and the global economy. That's all the more reason for the Fed to be clear about its goals this week.
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