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Spain
Double-Dip or Single-Blip?
November 12, 2010

By Daniele Antonucci, Tomasz Pietrzak | London

Economic growth has likely decelerated in 3Q (numbers to be released on November 11) from the fractional pace of expansion of the previous three quarters, in our view - courtesy of further fiscal austerity. While we think there is a good chance that growth stalled or entered negative territory once again, this is unlikely to be followed by further contractions. We are not in the camp of a double-dip, though a single-blip seems quite likely.

 In This Issue
Spain
Double-Dip or Single-Blip?
UK
BoE Inflation Report: Risks Still Skewed Towards Low for Longer
Global
Concerning Capital Inflows
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 The Global Economics Team
 Melanie Baker
Melanie Baker is senior UK economist. She has been on the UK economics team since 2003. Before this, she worked on the currency economics team. She joined Morgan Stanley in 1999. She graduated in 1998 from the University of Edinburgh with an MA in Economics and Politics and has an MSc from University College London in Economics. She is also a CFA charterholder. Melanie is a member of TheCityUK's Independent Economists Group.
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Our core views have not changed, i.e., Spain is still dealing with the aftermath of a balance sheet recession and looking for a new growth engine - unlike most of its European neighbours. This structural rebalancing away from domestic demand and towards foreign demand is necessary and welcome. But, as long as it continues, economic growth is unlikely to accelerate meaningfully.

Some of the ‘known unknowns' are still out there, ranging from possible downside risks stemming from poor housing and labour market prospects (see The Housing Market and the Savings Banks' Restructuring, April 12, 2010) to the funding difficulties of local governments (see The Local Finances: Do We Need to Worry? October 18, 2010).

The consensus view is now too pessimistic on the economic outlook, in our opinion. The latest published economists' surveys point to growth of 0.5% in 2011. We expect twice as much for next year - and a pace of expansion of 1.5% in 2012. But that's not even half the rate of growth seen during the decade prior to the financial crisis, and it's below government expectations.

Markets still seem concerned about Spain - perhaps increasingly so over the past few days. However, it looks like there has been some ‘decoupling' from the smaller EMU peripherals. To us, this makes sense, as the risks for many real money managers being involved in the small peripheral countries are rather asymmetric. Spain benefits from its relatively larger size, a wider domestic investor base and a policy landscape that has shifted for the better.

The standard value added tax (VAT) rate was raised by two percentage points to 18% in July; and the reduced rate applied to new house purchases, transport services, and hotel and catering services was raised from 7% to 8% (the super-reduced rate applied to basic food, books and medicines remained unchanged at 4%). Along with some spending cuts starting to kick in, this will negatively affect growth.

In order to avoid the tax increase, the chances are that households brought forward their purchases of durable goods - such as cars - in 2Q. That may have boosted growth - but just temporarily. Consumer spending will likely contract outright in 3Q, in our view, as was the case with the double VAT rate hike back in 1992. Evidence from other countries, e.g., Germany, points to similar dynamics.

Even when there are such downward pressures on private consumption, however, economic activity might slow to a much more limited degree - or even pick up occasionally - if imports drop to such an extent that the contribution of net trade to GDP growth becomes substantially positive. Yet, this simply reflects the underlying weakness of domestic demand.

Preliminary data for 4Q are mixed. While the manufacturing sector appears to have recovered somewhat, the services sector appears to have weakened further. For example, the manufacturing PMI - which decreased from 52.0 in 2Q to 50.8 in 3Q - rebounded from 49.6 in September to 51.2 in October. Conversely, the services PMI has weakened further during the past few months and now stands at 46.5 - far lower than the ‘no growth' threshold of 50.

So, it looks like economic activity slowed in 3Q, with some of our models pointing to slightly negative GDP growth. Yet there are some early signs that - to some degree - the outlook has improved on the manufacturing front more recently. Does it matter for investors? We think so. While the Spanish stock market has historically been fairly insensitive to domestic economic news, the correlation with GDP growth, for example, has increased recently. Put differently, economic surprises - in either direction - might affect market sentiment to a greater extent than in the past.

Well-known structural factors (see our in-depth reports) continue to suggest that, with no clear substitute for the construction sector as Spain's economic engine, there is still a lot of work to do in terms of rebalancing the economy away from domestic demand and towards external demand. But this process is continuing apace, in part thanks to better-than-expected export numbers. Clearly, the labour market has not yet stabilized, if seasonally adjusted figures published by Eurostat on a comparable basis for all European countries are used. However, house prices appear to have fallen at a slower pace recently and, while we still think that further drops are likely, we expect an overall decline of around 5% or so next year (rather than a drop of 10% foreseen previously).

To sum up, it's too early to sound the ‘all clear' on all fronts. Yet, we think that Spain is a somewhat different game relative to the smaller EMU peripherals (e.g., domestic investors offer a stronger support to the bond market than in Ireland, Portugal and Greece, and the policy landscape - from the 2011 budget approval to some structural reforms underway - has turned for the better). See our latest strategy recommendations in Sovereign Model Update & BTP-Bono Box, November 8, 2010.



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UK
BoE Inflation Report: Risks Still Skewed Towards Low for Longer
November 12, 2010

By Melanie Baker, CFA, Cath Sleeman | Europe, Johannesburg, London

What stopped the BoE voting for more QE? Upside risks to inflation: The bank's central forecast for inflation is still below its 2% target at the two-year horizon. It again raises the question as to why the MPC isn't voting for more QE (aside from Adam Posen, who did vote for a QE extension in October). The major barrier again appears to be that the risks to its central forecast are skewed to the upside. As a result, "the chances of inflation being either above or below the target by the end of the forecast period are roughly equal" (our italics). 

BoE GDP growth outlook: a little higher in the near term, similar further out: The MPC's central forecast for growth is slightly higher in the near term, presumably reflecting the stronger-than-expected print on 3Q GDP. However, its forecast appears broadly unchanged over the medium term. The balance of risks remains skewed to the downside (the Inflation Report highlights, for example, "significant downside risks to the path of private demand").

We still think that its outlook is too optimistic, appearing to sit well above our own and consensus forecasts.

BoE inflation outlook: stronger in near term, but similar further out... The MPC's central forecast for inflation is higher in the near term compared to its projection in August. The rise was attributed, in part, to higher import price inflation stemming from the recent depreciation of sterling and increases in a range of commodity prices. It also reflected the likelihood of somewhat larger increases in domestic gas prices (the MPC expects around a 10% rise "in the coming months").

On the bank's new central projection, inflation appears to remain above 2% until the end of 2011. Its near-term forecast looks a bit stronger than our own, although we will get a clearer idea of this when the bank's numerical projections are published next week.

In the medium term, its forecasts look similar to August's (focusing on the fan charts assuming unchanged monetary policy, i.e., comparing like with like). The MPC appears to have kept its central inflation outlook broadly unchanged over the medium term. But, we had anticipated a small rise in the forecast at the two-year horizon, given the second consecutive quarter of strong GDP growth (which we thought may have led the MPC to reduce its estimate of spare capacity). 

...and if anything a little weaker: Interestingly, its central forecast for inflation now appears to be falling at the very end of the horizon. Previously, it was rising. It is unclear what this might be the result of, but it may reflect different ‘base effects' from the changes it made to its 2011 forecasts.

Further, as we have already pointed out, BoE's assessed probability inflation suggests a slightly weaker average profile for inflation at the end of the forecast horizon. 

Key risks are external according to Governor King: The key uncertainty for the MPC (or at least for Governor King) is the external picture. Although less apparent in the Inflation Report itself, in the press conference, Governor King said: "There is no doubt that in my view the biggest risk that we face is in the external environment because we want and need a rebalancing. I think the private sector in our economy is going to insist that there is a rebalancing because they are not going to want to go on increasing indebtedness".

More disagreement than usual: There appears to be more disagreement than usual among the MPC members. The phrase "there is a wider than usual range of views among the Committee members over..." appeared six times, in various forms, throughout the report. It may suggest that other MPC members have joined either Andrew Sentance (voting for a rate rise) or Adam Posen (who voted last month for an extension to QE). However, it may also just reflect that, in contrast to August, there is now a ‘three-way split' in the vote on the MPC. We'll find out more with the release of the MPC minutes on November 17.

The BoE's forecasts versus ours: As before, the BoE's forecasts for GDP growth look optimistic versus ours (and consensus). Its forecasts for inflation look similar to ours and consensus (if a bit higher) until late 2011. But beyond that point, our forecasts for inflation are considerably higher. The MPC appears to more heavily weight spare capacity as a significant drag on inflation at that point of the forecast.

Why do we forecast a rate rise in mid-2011? At that point, we expect inflation to be well above target, for recovery in the economy to have continued and inflation expectations to have risen. For us, 2011 rate rises would be taking monetary policy off an emergency footing, not ‘putting on the brakes'. Our view, however, now rests more than it did before on the expectation that, in 1Q11, persistently high inflation will push up inflation expectations and wage growth (prompting the MPC to raise rates earlier than its current forecasts effectively imply).



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Global
Concerning Capital Inflows
November 12, 2010

By Manoj Pradhan | London

China's hike in banks' reserve requirements today served notice to the G20 leaders' meeting later this week that capital inflows remain a major problem for EM policymakers.  Brazil Finance Minister Mantega's ‘currency war' tag has continued to stay prominent in the lead-up to the G20 summit and certainly in discussions in the media. If currency tensions are indeed frustrating EM policymakers, then perhaps the blunt tools of interest rate cuts could be called upon in the future. This would represent an important turning point in EM dynamics for growth, inflation and currency movements. However, if a currency ‘war' is not a huge concern for EM policymakers, then the use of only FX interventions and possibly mild capital controls could be enough to alleviate EM concerns. And this is indeed the story that seems to coalesce from the views of our EM economics teams. Rather than aggressively fighting a currency war with every tool available, EM central banks seem to be keeping the blunt tool of policy rate cuts away from the skirmish so far. Rather, they seem to prefer the well-directed tool of FX intervention to soak up capital inflows and consequently increase FX reserves.

But which exchange rate to consider? With QE2 emanating from the US, EM and DM currencies have appreciated vis-à-vis the US dollar. However, the effective appreciation of EM currencies against a broader basket of currencies has been much smaller (see EM Macro Strategy Update: Considerations on Currencies, October 15, 2010).

With AXJ economies tied closely to China through their trade links, and the Chinese currency virtually pegged to the dollar (modest appreciation aside), AXJ economies are effectively tied to the USD/CNY peg. Latin America also has close trade links with the US and growing ties to China. However, the situation is different for some countries in the CEEMEA region. For the CEE economies, the US dollar is secondary in importance to the euro. In fact, since the dollar affects imports (specifically commodity imports) more than exports, some appreciation against the dollar is not unwelcome.

QE blocs: Enhanced capital flows to emerging markets courtesy of QE2 have produced varying degrees of discomfort in the EM world. In a past note, we suggested that QE2 would create two ‘blocs' among EM economies (see "QE20", The Global Monetary Analyst, October 13, 2010). The first bloc, with economies at risk of overheating, would allow currencies to appreciate and dampen domestic growth and inflation. The other, with fewer concerns of overheating, would find currency appreciation unwelcome. This second bloc would likely act to stem the appreciation, and end up stimulating domestic growth. Getting a hands-on perspective from our EM economics teams, we find that this split is indeed borne out. The collective wisdom of our teams suggests that the economies that find currency appreciation unwelcome are also economies where overheating risks are small. On the other hand, economies at risk of overheating do not find the currency appreciation as offensive (with the notable exception of China, as discussed below), as policymakers there welcome the dampening effect that the appreciation has on domestic growth and inflation. 

In economies at risk of overheating where domestic demand is strong and the central bank allows currency appreciation, US imports will likely become cheaper. In economies where currency appreciation is resisted, domestic demand is likely to get a boost, and this should increase the demand for all imports, including imports from the US. This is what we called a win-win situation for the US in our QE20 piece.

As always, China is different: China finds the enhanced pressure on its currency highly unwelcome and it will likely allow only a slow and steady appreciation. However, China's highly effective capital and credit controls imply two things: i) there really has been no impact of QE2 on the currency, but FX reserves have probably soaked up a large quantity of capital inflows; and ii) the domestic economy has not received an additional stimulus from QE2. With Chinese growth at 10% for 2010 and 9.5% in 2011, one can hardly say that China should grow faster to generate import demand. In short, China does not fit our dichotomy as it resists currency appreciation on the one hand but maintains firm control over domestic financial conditions and the economy on the other.

The policy response: The policy response from EM economies to the signals about QE2 in the US sent since August is quite varied, but a majority of central banks in the EM world have kept policy unchanged since then. A handful have responded by postponing hikes (the central banks of Peru and Poland have pushed rate hikes further out to keep the currency from strengthening further), while the SARB has actually eased policy outright (and further easing appears to be on the cards - our economists are forecasting a 50bp cut, see South Africa: Rate Call Change - We Expect a 50bp Cut, November 1, 2010). Some central banks that face strong domestic growth have even tightened policy despite the risk that such measures will invite even more capital inflows and put additional pressure on currency values.

Digging deeper: Overheating economies: A large majority of EM economies have shown strong growth. Unsurprisingly, AXJ economies feature prominently here along with Brazil, Chile and Peru from Latin America and Turkey, Israel and Poland from the CEEMEA regions. A smaller number of these strongly growing countries, however, have inflation concerns. This latter group includes India, Indonesia, China, Korea, Brazil, Peru and Poland. Clearly, this bloc would prefer some help in dampening domestic growth, and some currency appreciation might not be unwelcome. We illustrate that these overheating economies are also where central banks are not extremely concerned about currency appreciation (with the important exceptions of China discussed earlier and Brazil discussed below). However, as the cases of Poland and Peru show, even inflation concerns have sometimes been subordinated to keep in check excessive appreciation of the currency. In the case of Poland, inflation concerns are likely to win out fairly shortly, according to our Poland economist, Pasquale Diana.

Brazil clearly dislikes its stronger currency, has been intervening aggressively in FX markets and has quickly raised taxes on foreign investments in local fixed income products. The postponement of rate hikes in Brazil, however, can be traced back to its own slowdown earlier in the year rather than to a growing probability of QE2.

Digging deeper: No overheating: In economies where growth has either not led to inflation and even where growth has been weak with inflationary concerns, the EM emphasis on growth clearly shows because of the desire of these economies to keep their currency from appreciating. Most economies in this category have either intervened in FX markets or have stayed put on monetary policy. Thus, either through accumulating FX reserves leaking into the economy or through the postponement of monetary tightening, economic growth is likely to benefit from a tailwind.

The economies where growth is weak and inflation risks are present (Romania and Hungary) are worth noting. As noted before, these economies are more closely tied to the euro and might actually welcome an appreciation against the dollar, given the asymmetric effects on imports and exports. They do not therefore face the same dilemma as most other EM economies.

FX intervention: Central banks appear to be less reluctant to get involved in FX intervention. The bulk of EM central banks are involved in at least some FX intervention. Further, half of that pack have been intervening quite aggressively in currency markets, but even then with limited results. The difference in the way policymakers seem to have used broad monetary policy and FX intervention to deal with QE-related inflows could be explained in three ways: i) monetary policy is seen as a blunt instrument with broad effects, while FX intervention is seen as a targeted tool best equipped to deal with an FX problem; ii) FX interventions are a less public way of dealing with capital inflows, compared with the public attention that usually accompanies monetary policy changes and capital controls; and iii) EM central banks view FX policy and reserves policy as being distinct, and are accumulating reserves in excess of levels that could ostensibly be used for the defence of the currency.

Different strokes: Different emphases on each of these explanations apply to EM economies. For example, the objectives of FX intervention in Turkey appear to be oriented towards increasing the size of the reserves. Brazilian FX interventions, in line with its aggressive rhetoric and milder capital controls, have probably been aimed at keeping the currency from appreciating. And finally, in Israel, FX interventions have been used to stifle the impact of policy rate hikes on the currency. In all three cases, however, FX interventions have not been entirely successful in keeping the currency from appreciating.

Summary: The extent to which the ‘currency war' debate has been ramped up in the media does not gel with the feedback from our EM economics teams. In general, EM central banks appear to be unwilling to take strong, aggressive action in the form of postponing policy tightening or cutting rates outright (with the notable exceptions of the central banks of Peru and Poland for postponed rate hikes, and the SARB for outright easing). Rather than fighting any such ‘currency war', EM central banks appear to be dealing with the very familiar three-way trade off between capital inflows, exchange rate concerns and monetary policy independence - the trilemma (see "No ‘Currency War'...Yet", The Global Monetary Analyst, October 6, 2010). Central banks seem far less reluctant to use FX intervention. In fact, FX intervention is likely being used as a better directed tool to temper FX appreciation and build up FX reserves (in some cases) at the same time.

The feedback from our EM teams suggests that QE is indeed splitting the EM world into two broad blocs. Economies with strong growth and overheating concerns appear to be more willing to accept currency appreciation in order to dampen domestic growth and inflation. Countries where growth is weak, however, seem to be less tolerant of currency appreciation. The desire there to keep the currency from appreciating is likely to lead to higher domestic growth either through newly accumulated FX reserves leaking into the economy or via inaction (or less tightening, or even easing) on the policy front.



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