Lessons from 2005
Jan 04, 2006
Eric Chaney (London)
One year ago, we expected euro area GDP to grow by 1.4% in 2006 and the ECB to raise the refinancing rate to 2.5% by year-end. On our current estimate, based mostly on actual data, GDP growth was 1.4% and the refinancing rate rose to 2.25%, a relatively small deviation from our initial target. Surprisingly, our macro call was correct despite three large errors on some key macro assumptions: oil prices at US$55/bbl on average, versus US$37 expected (which explained why our inflation forecast was too low), the euro/dollar exchange rate at 1.24 on average versus 1.36 expected and 10-year bond yields ending the year at 3.4% versus 4.5% in our projections. So maybe we were just lucky. Although I would certainly concede that getting a point estimate correct in macro forecasting requires a chunk of good luck, with the benefit of hindsight, I see two lessons that could help investors willing to embed a macro dimension in their investment strategy. First, many macro forces have diametrically opposing effects on the business cycle; in other words, not all macro inputs may bend on the same side. Second, it is worth focusing on the fundamentals rather than the latest hot story heard in the market place.
Lesson #1: Not all macro parameters may bend in the same direction. Two pairs of macro variables played a critical role last year: oil prices and the US dollar exchange rate on the one hand, wage inflation and interest rates on the other. Very expensive oil: the other side of the coin Oil prices shot up much higher than we had expected, and this was clearly negative for consumer purchasing power. With inflation 0.7 percentage points higher than forecast, consumer spending should have been 0.7 p.p. lower, other things being equal. Yet consumer spending growth came out very close to our expectations, at 1.4% versus 1.3% in our forecasts of one year ago. True, we were probably too pessimistic about euro area consumers. The interesting thing is that soaring oil prices had two positive consequences. First, the rise in oil exporters’ income translated into stronger demand for European made goods. Trade structures show that the euro area is generating 1% of its GDP by exporting to big oil producers such as Russia and Gulf states, three times as high as corresponding US or Japanese numbers. Second, because oil exporters’ income has increased dramatically two years in a row — by US$125 billion in 2004 and US$270 billion in 2005 — the oil exporters have bought far more US assets than expected, thus helping the USD to hold well against the euro and other currencies. This has clearly alleviated the macro pain stemming from high oil prices, even though, on a net basis, the impact of the oil spike was negative on real GDP growth. Wages and interest rates are not independent Nominal wages and interest rates are another interesting pair of macro variables. One year ago, we forecast compensation per employee to accelerate to 2.5% in 2005, from 2.3% in 2004. We thought that wages would start catching up with prices, even partially. The opposite happened: on our current estimate, compensation per employee increased by 1.8% only, despite the acceleration of inflation. From a strict income angle, slower wage growth and higher inflation were a double blow for consumer spending. However, persistent wage moderation was a crucial factor that helped keep long-term interest rates much lower than we had expected. Often warned by policymakers that wage inflation might eventually pick up, the financial markets took note and concluded that core inflation was likely to stay low for a protracted period and that the ECB would not pursue an aggressive tightening policy in the future. Therefore, interest-rate-sensitive credit growth picked up — credit to the private sector was up 9% from one year ago last November — offsetting the negative effect of the deceleration in real wage income. Lesson #2: trust the fundamentals There is a myth about continental Europe, which says that economic growth comes exclusively from the external sector. We did not base our forecasts on this idea, for a very simple reason: since the inception of EMU, 90% of euro area GDP growth came from final domestic demand, net exports playing only a marginal role. Consequently, one needs to look carefully at domestic demand to build a macro forecast for the euro area. Because domestic demand is sensitive to interest rates, although with uncertain lags that were longer than we had assumed, we had anticipated that corporate investment and consumer spending would recover during the year, spurred by historically low real interest rates. This is indeed what happened: the recovery that is currently taking place is driven by domestic demand. Looking forward, our euro area team expects GDP growth to accelerate above 2% this year. Although still modest, this would make it the best year since 2000. The two lessons I took from last year make me relatively confident about our GDP growth call for 2006. As I see it, the two main exogenous downside risks to our call are, first, a belated but significant depreciation of the US dollar and, second, an unexpected slowdown in American and Chinese domestic demand. In each case, there are other macro variables that would mitigate the shock. If, for instance, the USD depreciated against the euro in the coming months, interest rates would not rise as much as we are currently discounting. In a first stage, manufacturing surveys would react negatively to currency developments but, in a second one, interest rates would have the upper hand. If the two engines of global growth since 2002, the US and China, failed to feed global trade growth, commodity prices would drop, offering the equivalent of a tax cut to both consumers and companies. Last but not least, the lagged impact of zero real short term rates would continue to support final domestic demand, the fundamental variable that really matters in the euro area.
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Excess Liquidity Stock Shrinking Rapidly
Jan 04, 2006
Chetan Ahya and Mihir Sheth, CFA (Mumbai)
Excess liquidity stock halved in past three months Since F2003, rising capital flows had caused a huge increase in forex reserves resulting in excess liquidity. Foreign capital inflows not absorbed (excess liquidity) by the domestic economy were sterilized by the central bank in the form of short-term paper issued in the money market. However, with the reversal in the foreign reserves trend after three years of continual rises, the excess liquidity has begun to unwind in the past three months. Our pro-forma estimates indicate that outstanding stock of excess liquidity has declined to a 20-month low of about US$13.5 billion as of the end of December 2005, compared with the peak of US$28.9 billion in August 2005. We believe that this decline in excess liquidity is likely to weigh on domestic interest rates going forward. Rising domestic absorption and slowing capital flows The decline in excess liquidity is due primarily to a slowdown in foreign reserve accretion (Exhibit 2). Indeed, forex reserves are likely to decline by US$1 billion during the current financial year compared with a rise of US$22 billion, US$37 billion and US$28.6 billion in F2003, F2004 and F2005, respectively. The reversal in forex reserves trend has been due mainly to the following factors. Rising current account deficit. India’s current account balance posted a deficit of US$7.7 billion (4.2% of GDP, annualized) during July-September 2005, compared with a deficit of US$3.5 billion (2.2% of GDP) during the same period the previous year. Apart from higher oil prices, increasing domestic absorption (rise in domestic consumption and, more recently, investments) has been the key factor behind the widening current account deficit. The deterioration in India’s current account balance (CAB) has been much sharper than trends in Non-Japan Asia ex-India and ex-China. Indeed, the CAB trend in India has been diametrically opposite to that in China. Moreover, unlike India, most of the deterioration in current accounts across the rest of NJA appears to have been largely a result of higher oil prices. The non-oil trade surplus in NJA ex-China ex-India has remained flat while the surplus in China has widened further. Narrowing rate arbitrage and lower net foreign debt inflows. Given that interest rate differentials in India and the US have narrowed and the rupee has begun to depreciate, interest arbitrage has become less attractive. As a result, while State Bank of India redeemed US$7.3 billion of non-resident deposits during the quarter ended December, a negligible amount was reinvested by non-residents. Foreign institutional investors are also selling their holdings of government bonds. As a result, net foreign debt inflows are estimated to have declined by US$3.1 billion between April and December 2005, compared with US$7.9 billion during the same period the previous year. Transitioning from excess liquidity to tight liquidity Although policymakers appear to be brushing aside liquidity concerns, indicating that this is a one-off issue due to a significant debt redemption by the State Bank of India, we believe the underlying trend of slower forex reserve accretion and the high liquidity absorption rate will continue to put pressure on interest rates. We believe that, unless capital flows rise sharply from current levels, there is a fair possibility of the excess liquidity balance being completely wound up and the central bank injecting liquidity over the next six months. As the excess liquidity balance unwinds, the floor short-term rate would be the repo rate (the rate at which RBI injects liquidity into the system), which is currently at 6.25%, instead of the reverse repo rate (the rate at which RBI sucks out excess liquidity), which is currently 5.25%. Declining excess liquidity weighing on domestic cost of capital The central bank has been slower to raise short-term rates in India compared with the US. This has been due largely to the high level of excess liquidity stock, which provided a buffer to the central bank. However, declining excess liquidity has started to push up market oriented short-term rates. Over the past six months, both the average interbank call rate and the average 91- day bill rate have shot up to a three-year high of 5.9% and 5.7%, respectively. The rise in the short-term rates has been sharper in India than in other NJA countries. Indian banks have increased their deposit rates by 50-75 basis points recently, pushing up their cost of funds. They are also suffering from treasury losses on their government bond portfolios (which account for about 30% of their assets) with rising bond yields. Banks’ have been increasing their lending rates for the first time in five years to protect against weak treasury income and a sharp rise in cost of funds, as reflected in the short-term benchmark rate (91-day T-bill), which has risen to 5.9% from 5.5% in October. We expect this cost pressure to be maintained with the 91-day T-bill rising further to 6.5-6.75% by the end of 2006. This rising cost of capital trend will also have implications on growth. India’s aggregate debt to GDP has increased by 28 percentage points over the last five years, largely to fund government and household consumption growth. We believe that this debt-funded consumption growth, which has been at the heart of the above-trend GDP growth over the past three years, will be hit by the rise in the cost of capital.
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Targets of Inflation Targeting
Jan 04, 2006
Serhan Cevik (London)
The Turkish economy has entered the new year with a new set of rules and targets. Turkey has made remarkable progress in the past four years, with output growth reaching over 30% on a cumulative basis and inflation declining from an average of 77.5% in the 1990s to 7.7% at the end of last year. Supported by prudent fiscal policies and structural reforms, the Central Bank of Turkey successfully utilised an implicit inflation-targeting framework in the fight against inflation. And now, after outperforming its own ambitious targets, it is formally adopting inflation targeting to achieve and maintain price stability. The authorities will target year-end inflation rates of 5% this year and 4% next year and also in 2008. Given the inherent short-term volatility in price movements, the central bank has decided — prudently, in our view — to introduce an ‘uncertainty band’ ranging from 3.0% on the downside to 7.0% on the upside this year. Though the uncertainty range is marginally wider than what we would be comfortable with, we think the bank will keep adjusting its policy stance according to the central points. Inflation targeting should improve policy transparency and thus reduce the risk premium. From the very beginning, the central bank’s inflation-targeting framework will increase the transparency and accountability of the policymaking process. Since perceived policy credibility is one of the most important factors shaping the evolution of inflation expectations, the adoption of inflation targeting should gradually eliminate the problem of inertia in non-tradable sectors of the economy. Furthermore, the new regime, already delivering successful results in a diverse group of countries around the world, should help Turkey to consolidate macroeconomic gains attained in the past four years and move towards price stability on a sustainable basis. Therefore, we expect to see a further compression of real interest rates in the coming years. On our estimates, inflation will decline from 7.7% at the end of last year to 4.3% in 2006. The year-on-year inflation rate, measured by the consumer price index, declined to 7.7% at the end of 2005, from 9.4% in 2004 and an average of 77.5% in the 1990s. Considering the adverse effect of higher commodity prices on Turkey’s import-dependent economy, the speed of disinflation, albeit decelerating, remains in line with multi-year targets. Indeed, the ‘core’ CPI posted an annual increase of 6.6% last year, down from 9.9% at the end of 2004. Even though non-tradables are still lagging behind the pace of disinflation in sectors open to global competition, we believe that prudent fiscal policies and structural changes in the economy will facilitate the movement from disinflation to price stability. Productivity-driven economic growth supports, not obstructs, disinflation. We think the above-trend growth trajectory is not an obstacle for completing the disinflation process. The acceleration in productivity growth has been a key factor in revolutionising growth and inflation dynamics, and the latest figures show that the surge in capital expenditure is indeed helping to maintain productivity gains and expanding the country’s supply frontier. This is why the Turkish economy is still operating with an output gap, not, as some observers argue, suffering from an episode of overheating. Accompanied by the stabilisation of unit labour costs after declining by almost 40% in the last four years, the output gap will let the headline inflation rate to decelerate toward 4.3% by the end of this year. The focus should shift from short-term interest rates to the long end of the yield curve. Although the lagged pass-through from higher energy prices and base effects will result in a temporary increase in year-on-year inflation rates in the first quarter, the secular disinflation process will remain intact and thereby allow the central bank to lower short-term interest rates by 150 basis points to 12% by the end of this year. However, in our opinion, as the end of fiscal dominance and disinflation towards price stability improve Turkey’s credit quality, the compression of long-term interest rates should become the focal point, not what the central bank does with short-term interest rates.
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