Global/Japan
The Tao of Reform - Lessons from Japan's RoE Surge
Jan 24, 2006

Robert Alan Feldman (Hong Kong)

Conclusion
A combination of the CRIC cycle and the equation for RoE suggests that Japan remains an attractive equity market, relative to other major equity markets around the world.

What’s New
Global investors at the Morgan Stanley annual MacroVision conference this year were focused on the tie between economic reform and RoE improvements. Structural reform presages RoE increases.

Investment Implications
All three components of the RoE equation have room to rise in Japan. In other major markets, only one or at most two components do.

Risks
A drop of global growth, complacency by Japanese firms, or political surprises could derail the reform agenda and stall any further rise of Japanese RoE.

Japanese companies have raised their return on equity (RoE) quite significantly over the last few years. This increase was not just the luck, derived from regional growth. Nor was it the result of corporations acting alone. Rather, the increase of RoE in Japan derived from the interaction of exogenous shocks, intelligent reforms, changed incentives, and the consequent restructurings. These factors combined to change the margins, turnover ratios, and leverage ratios that determine RoE. Thus, the CRIC Cycle — the sequence of crisis, response, improvement, and complacency that describes the interaction of policy and the economy — drove the various components of the basic equation for RoE, which determines the latter from the profit margin, the turnover ratio (sales/asset), and the leverage ratio (debt to equity).

The CRIC Cycles

The process that drove Japan’s RoE success starts with exogenous shocks, the crises of the CRIC cycle. The most obvious crisis was the banking crisis of the 1990s, but there were other major disruptions as well, such as globalization of trade, the IT revolution, and political upheaval. For illustration, I will use the financial crisis.

The first indication that Japan might not be miraculous after all came from the financial sector, where “incredible” estimates for bad loans of Y10 trl or even Y20 trl began to circulate in the early 1990s. There followed a number of scandals and embarrassments, with the result that the public lost confidence in the financial system.

After many fits and starts — including much misplaced fiscal stimulus — Japan finally tackled the financial system crisis seriously in 1998, when laws were passed to allow public capital injection into private banks and regulatory rules were strengthened. The Financial Services Agency (FSA) was split off from the Ministry of Finance, and thus an independent regulator was formed.

As a result of reforms, incentives for business and banks changed sharply. The new inspection manual from the FSA specified stricter and more uniform standards for loan classification. The gap between the banks’ self-classifications and the FSA’s classifications of loans were disclosed (at least in the aggregate). Prompt corrective action standards were introduced, with severe consequences for management of undercapitalized banks. For corporations, the benefit of being tied to a bank decreased, since bank financing might not be available after all, in bad times. Thus, lenders became less willing to lend, borrowers less willing to borrow, and excess debts of the bubble period declined. Write-offs rose as well. The decline of leverage ratios accelerated after the banking crisis of 1997-98.

Once the incentives changed, restructuring began in earnest. Both banks and their borrowers embarked on stringent restructuring. Although the restructuring took several CRIC cycles to blossom, the upturn in profit margins began in earnest from the mid-1990s, and accelerated after the banking crisis. Thus, the restructuring was two-fold, of both operations and balance sheets. Around 2003, even the turnover ratio began to expand slightly — although it remains below 1.0 for large non-financial firms.

RoE and the CRIC Cycle

The evolution of RoE is closely related to the trend of the CRIC cycle. As a result of crisis, response, improvement, and complacency stages, there are changes in the margins, turnover, and leverage that determine RoE. The peaks and troughs of RoE during the decade of 1993-2002 were largely the same, despite margin improvements, because leverage was continuously declining. After 2003, however, the declines of leverage eased while the rise of margins accelerated. Hence, RoEs rose sharply, and broke out of their decade long tunnel.

The next stage for Japanese RoE depends on what happens to each component. The news appears to be good. Margins still have room to rise. The recurring profit margin now stands at about 5%. Although this is the highest ever, it appears to remain well below comparable levels in other countries. Hence, there does appear to be room for margin improvement.

Turnover is also low, relative to historical norms. Moreover, turnover for large Japanese firms remains well below that for small ones, and below the norms of large overseas firms. In addition, turnover could be decreased relatively easily, by reducing liquid assets. The latter still constitute a bit more than 1/3 of the assets of large firms, and in some cases more. Share-buybacks or further balance sheet shrinkage could raise turnover ratios.

Finally, leverage is extremely low, indeed the lowest in the history of the data series for large firms — which reaches back to 1960. Leverage is particularly low for manufacturing firms, but even the leverage of non-manufacturers is back to the level of the 1960s. Indeed, one might argue that Japanese firms are now underleveraged, and should raise levels of debt capital (but not short-term borrowing) to replace equity capital.

In short, as a result of reforms, incentives for banks and for companies changed, restructuring took root, and the three components of RoE moved. At times the components moved in contrary directions. The need for leverage reduction countered the improvements of margins. Now, however, all three are moving in the same direction, and appear likely to continue doing so

The Rest of the World

What does the Japanese experience imply for asset markets around the world? The answer lies in assessing the pace and sustainability of reform in each region. Although I am far from an expert on the US, Europe, or China, my sense is that none these regions is as attractive as Japan. Indeed, despite various crisis level imbalances (e.g. fiscal/savings/current account imbalances in the US, labor market imbalances in Europe, financial market imbalances in China), governments seem stuck in the reform agenda stage. For example, the US has accomplished very little in social security reform, despite a political offensive last year. Energy policy remains stalled. Continental Europe’s changes in labor laws are baby-steps compared to the changes in the US and the UK. And fragmentation among European fiscal and structural authorities makes progress in these areas unlikely. China’s financial system remains under great pressure from nonperforming loans, despite large capital injections from the foreign exchange fund. And the increase in social unrest inside China is making leaders cautious about further economic reforms.

So long as the US, Europe, and China drag their feet on structural reform, the incentives faced by their companies will not change. With no change of incentives, there will be no acceleration of restructuring. With no acceleration of restructuring, there will be no structural increase of RoE.

As Poor Richard once said, Felix quem faciunt aliena pericula cautum (Happy is he who learns from the perils of others.

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Japan
Rosy Scenario in Shocking Pink
Jan 24, 2006

Takehiro Sato (Tokyo)

What's changed:
Participants in Morgan Stanley’s annual MacroVision conference last week painted a rosier picture of the global economy than in most years, and were more positive on the prospects of Japan becoming a second driver of the world economy than before.

Conclusion:
First, global investors are remaining constructive towards Japan, and have not been swayed negatively by recent financial scandals and valuation issues. Investors regard Japanese equities as a promising market alongside the US and emerging markets, and are still looking to increase exposure. Second, the majority of participants expect mild yen appreciation. Third, the view that JGBs can be sold short, which tends to be popular among overseas investors, appears not to be in the majority now.

Investment implications:
Modesty aside, conclusions from the MacroVision conference have a pretty good forecasting track record, as Stephen Roach has highlighted, and accuracy is improving.

Risks:
Inflation and long-term interest rates are the risks for the global economy. Inflation could be sparked if risks impeding globalization emerge. For long-term interest rates the consensus opinion is that current levels will be sustained (4.5% at the end of 2006), but the number of investors looking to sell bonds is a source of some concern.

Global investors are more receptive to Japan than ever

During our trip to New York to attend the annual MacroVision conference, the Tokyo market was jolted by an accounting scandal at an Internet company. The sharp decline in Japanese stock prices had a global impact along with the weaker-than-expected earnings of high-tech firms. However, the scandal does not reverse our basic scenario for a “golden combination” of rising stock prices, a weak yen, and a stable bond market, and we maintain our constructive stance toward Japan’s asset markets. We have already outlined the reasons for this, and use this report to discuss the opinions of investors at MacroVision and their implications for Japan. As our chief global economist Stephen Roach has already highlighted, the conference participants had a rosier view of the global economy than in most years, and our impression is that they are more receptive to the idea of Japan as a second driver of the world’s economy than before.

Global investors are still constructive towards Japan

The first point to underline is that investors are still viewing Japan constructively, despite the recent series of unsettling incidents. Our equity strategist has repeatedly highlighted that it is hard to make a valuation case for buying Japanese equities, and most of the New York-based Japan equity investors concurred with this view. Investors with a mainly global focus, meanwhile, are looking at the potential for further structural reform on the corporate side, seeing ROE in Japan as still too low in the context of the expected global level of around 16%. They have a constructive approach, and see a large role for government in the reform process. Investors in equities still see Japan as a promising market in which to increase exposure, alongside the US and emerging markets.

Our second takeaway is that the majority of participants expect a trend of moderate yen appreciation as the US current account deficit widens, expecting a mild, sustainable consumption-led recovery in the US economy. This was the consensus view among our economists and strategists as well as among investors. Last year stock prices did unexpectedly well while the yen was weaker than expected, but this year conference attendees expect a more normal combination of strong stock prices and a strong yen. If this plays out, this would be the ideal combination for overseas investors in Japan, who could book capital gains from a stock market rally and benefit from forex profits.

The third point is that the tendency among foreign investors to see JGBs as an opportunity for short selling, though apparent in places, did not appear to represent the majority view. We think that investors have learned from experience that it is surprisingly tough to short JGBs even under zero interest rates, given the solid cash flow dynamics in Japan.

US long-term interest rates to hold steady, but some bearishness on US treasuries

Although the majority of participants expect long-term interest rates in the US to stay at the current level (4.5% at the end of 2006), there did seem to be widespread selling interest in the bond market. One of the key conference discussion topics was where the savings glut in emerging nations will end up, which generated conflicting opinions, namely: (1) if US exports grow as the world economy expands, the increase in investment opportunities in the US will shrink the savings surplus in emerging nations in Asia; (2) the savings surplus in emerging Asian nations will shrink even if the world economy slows. Putting to one side the question of consistency, the tendency to see the prospect of narrowing savings surpluses in emerging nations as impetus to sell US treasuries was revealing. Similarly, investors seemed to have a higher-than-consensus view of the FF rate at the end of this year.

Latent systemic risks were also highlighted, alongside recognition of global stabilization of interest rates and risk premium stemming from greater confidence in central banks, the inflation-risk suppressing effects of globalization, and advances in financial technology. If systemic risks were to be realized, however, our instinct is that investors would be more likely to buy US treasuries than to sell.

On the prospect of inflation targeting, which is looking more likely with the arrival of the new Fed chairman at the beginning of next month, the view of investors was that since the Fed has already set out the personal consumption deflator as a de facto policy target, a change in basic policy is unlikely, though investors are hoping for greater transparency. Some were concerned that policy would lose flexibility under inflation targeting, however.

For Japan, the consensus view is already that quantitative easing will be lifted soon and the zero-interest rate policy (ZIRP) will stay until mid-2007. Overall, and in a positive sense, there was remarkably little to argue about over Japan.

Downplaying inflation risk, bullish on capex

Inflation risk was another conference theme. However, investors seemed guarded this time, as previous consensus views have proved to be instances of crying wolf. They agree that globalism raises productivity, and suppresses inflation. On the other hand, they also see risks that could threaten productivity improvements resulting from globalization, such as (1) war, terrorism and natural disasters, (2) protectionism, and (3) a slowdown in job outsourcing (through worker backlash, particularly in service industries). There were also some interesting opinions about the remarkable impact on consumption demand of the wider availability of consumer finance such as credit cards and home mortgage loans in China and India, with the implication of inflationary pressure on a global scale.

The outlook for capital investment was another theme. Conference investors seemed surprisingly bullish, and may have been swayed by the tone of the introductory presentation by our chief European economist Eric Chaney. According to Eric, the momentum of manufacturing industry capacity increase in the G10 has been below the trend line for the last 25 years, and this trend becomes even more pronounced when China is factored in. This implies considerable room for capital investment to expand in order to ramp up capacity. Some investors, while continuing to a see a strong capex outlook, wondered whether the bulk of this might not be for replacing rather than adding new facilities. There were also some interesting views on whether the recent reactionary spike in energy prices might spark more investment in industrial infrastructure, such as power generation, gas, transportation, water resources, and especially oil refining. In fact the fields in Japan where near-term growth in capital investment is likely to be rapid are those traditionally regarded as non-manufacturing industries, such as energy (electricity and gas) and real estate and construction.

Some participants suggested that if energy-related investment is too low, IT investment may be somewhat excessive. It was noticeable at the break-out sessions as well as the larger meetings how participants were looking more to smokestack industries than to IT for potential capital investment. We noted also the view that higher energy prices will promote a shift from natural gas to coal and nuclear energy, and that demand for farm land will flourish due to increased demand for agricultural produce. 

Eye-popping bullishness on the global economy

Japan is no longer subjected to the barrage of criticisms at MacroVision heard a few years back, and as the Japan economics team we no longer feel so vulnerable. We were taken aback by how favorable the global economic scenario outlined this year was, and it seemed as if investors in attendance were buying into this story. Stephen Roach’s cautious scenario prompted a certain amount of merriment, which he milked to good effect, and sessions running counter to our house views took place in good spirit. In our experience, if we may blow the firm’s trumpet, the forecasting record of MacroVision conferences is relatively good, as Stephen Roach highlights, and accuracy is improving. Japan’s markets were thrown into turmoil by news of scandals and executive arrests, but we are hopeful that the favorable scenario emerging from this year’s sessions will be on the money this year too.

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Latin America
In Central Banks We Trust
Jan 24, 2006

Gray Newman (New York)

In all of the years that I have been watching Latin America, I have never seen so much attention placed on the actions of central banks in the region as we are seeing today.  In some ways, this is a good thing: it represents a graduation of sorts.  After all, for years the region was plagued with fiscal irresponsibility which saddled governments with unsustainable debt burdens and left little room for central banks to do much more than bankroll bankrupt policies.  But I am a bit concerned that many Latin watchers have exaggerated the importance of central banks in the region and I see three risks.

Forest fires and tail events

First, in a world of slowing inflation, it is easy to overestimate the role that central banks in the region have played.   I will be the first to applaud the efforts of Latin American central banks to regain control over inflation and help reduce the uncertainty that has long hampered much needed investment in the region.  Brazil’s central bank, for example, has done a remarkable job in strengthening the credibility of the institution despite the limitations placed on it by its lack of formal independence.  There is much to be said for predictable and responsible monetary policy helping to reduce uncertainty, reduce inflation and with it usher in an era of lower real yields.  Indeed, I subscribe to the view that this is precisely what will take place in Brazil and is taking place in Mexico.  But, with the powerful disinflation forces of both China and India reflected in global inflation numbers, the central banks of the region have been receiving substantial imported support.  And that should not be ignored. 

The link between the success in the region and the global disinflation process is particularly important given the risk that our definition of inflation may need to be rethought.   Goods and services inflation may remain under control for years to come, but as we are seeing in much of the developed world there appears to be a new inflationary force — that of asset prices — which could prove to be even more troublesome.

This complacency, of course, is not limited to Latin watchers.   This past week I heard much the same while sitting with a large group of Morgan Stanley’s global clients at our annual MacroVision event — a gathering of Morgan Stanley’s global team of economists and strategists which is opened on the final day to a group of the firm’s largest clients.  While risk love has been building in recent years at the MacroVision events, there were many questions in recent years over whether the global imbalances might revert in a sudden or violent fashion.  Last year, many investors seemed uncomfortable with the handiwork of a prolonged period of liquidity. 

In contrast this year, there were few voices questioning the paradigm of low volatility, low inflation and low real yields.   Indeed, when warned by our chief global economist Steve Roach that global liquidity had peaked and that in an asset-based economy that meant problems ahead, one client responded with his own story of Noah and the ark.  When Noah saw sunshine after forty days, the client quipped, he did not begin to worry immediately about forest fires.  Nor, I would add, are most clients ready to worry about forest fires.  Indeed those warning of forest fires and tail events were hard to find.

Volatility falling, complacency rising

Second, I would warn that while predictable monetary policy may lead to low volatility and low inflation in the first round, its second round effect can be one of fiscal complacency.   While prudent fiscal policy was the precondition to central banks being able to successfully reign in inflation in the region, I am always on guard when the region begins to experience a bout of “abundance.”

Too many times success has lead to complacency.   Nowhere can this be seen more clearly than in Mexico, where the powerful inflows from oil to remittances and tourism have sapped the policymaking class of any urgency to tackle the challenges facing Mexico.  I remain concerned that with oil prices likely to remain high in Mexico during 2006, the new administration will likely squander its political capital when it takes office at the end of the year.

Third, those who focus excessively on monetary policy run the risk of being caught off guard by the serious upheaval taking place in the region’s policymaking class.   The election turmoil in recent months should serve as a reminder that viewing Latin America through the narrow lens of monetary policy is dangerous.  Even in Mexico, where its track record on the fiscal and monetary front have allowed it to enjoy investment grade status in recent years, the shortcomings of those policies can be seen in the widespread poverty throughout the countryside and the lack of opportunity in formal urban employment.

While Latin America may share a low inflation environment with much of the more developed world, beware of exaggerating the similarities.  The alarming inequality of wealth, income and land in the region leave it in a much more tenuous political state than its low inflation, low yield neighbors to the north.  The elections in Bolivia and those upcoming in Peru and even in Mexico may serve as just such a reminder.

Bottom line

Latin America is enjoying a benign, low inflation world.  That should be good for access to capital and also should allow the abundance of inflows to continue to the region.  In a region too often subject to extreme cycles of growth punctured by sudden downturns, an era of predictable, sustained growth can unleash a new round of investment and opportunities.  Still, despite the upbeat assessment, I would warn not to exaggerate the efforts of the region’s central banks.  The globe, after all, has been very supportive.  Indeed, there is a risk that the greatest global challenge facing central banks is one of asset-price inflation rather than goods and services inflation.

Inflation should never be viewed in a vacuum, least of all in Latin America where the preconditions to sustainable growth extend far beyond the purview of the central bank.  I do not think we can ask more from the central bank of Chile or of Mexico or of Brazil.  But sustainable growth will require much more than being able to trust in the central banks of the region.

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Israel
Between Neutrality and a Hard Place
Jan 24, 2006

Serhan Cevik (from Tel Aviv)

The Bank of Israel raised the policy rate by 25 basis points to 4.75%. As widely expected, the Bank of Israel raised short-term interest rates by 25 basis points to 4.75%, bringing the cumulative tightening to 125 basis points in the last four months. The current tightening cycle may not be over, but it is getting closer to the neutrality zone, in our view. Looking to the future, the central bank’s challenge is to discover the ‘sweet spot’ between inflationary pressures and economic growth. This is indeed an uncharted territory for the Israeli economy striving to internalise price stability. Moreover, traditional models of estimating the level of ‘neutral’ interest rates provide little guidance for today’s open economies. With the free flow of goods and financial capital, the concept of neutrality is not a solid benchmark for policymakers. Even with a credible inflation-targeting framework successfully anchoring expectations to the official target range, the Bank of Israel, as well market participants, may still struggle with policy ambivalence and directional uncertainty. In other words, the globalisation of supply chains and capital markets has made international factors almost as important as domestic developments in assessing the state of the economy and thus in determining the path and pace of monetary adjustments.

Could it really be possible to have no inflation to target in the Israeli economy? Inflation, measured by the consumer price index, increased from 1.2% at the end of 2004 to 2.4% last year. However, the latest inflation reading, down from an average of 11.3% in the 1990s, is well within the central bank’s multi-year target range of 1-3% and clearly signals the internalisation of price stability in Israel. Furthermore, just as in the past, the recent acceleration in inflation rates is mainly a result of the shekel’s weakness against the dollar, not a consequence of inflationary built-up in the domestic economy. As the shekel depreciated by 6.8% last year, we witnessed a comparable increase in exchange rate-indexed domestic prices. For example, the 6.5% increase in the housing component of the CPI basket contributed about 1.3 percentage points to the rise in the headline figure and, together with higher oil prices, accounted for slightly less than two-thirds of the overall increase in the CPI. To tell the truth, if we just exclude the exchange-rate factor, inflation declined by more than 1.5 percentage points from its level in 2004. But have globalisation and better coordination of fiscal and monetary policies truly eradicated the problem of inflation?

Global disinflationary pressures lower the cost of combating inflation. Core price indices validate the view that new sources of supply in the global economy hold prices down and thereby make the task of maintaining price stability easier. Nevertheless, as we have argued in our previous dispatches, the current state of the Israeli economy does not require an expansionary monetary stance. Currency movements and energy prices may have so far determined the trajectory of inflation rates, but the robust recovery in domestic demand will eventually have a more prominent role in the inflation process. The slowdown in productivity growth — even considering its pro-cyclical nature — from an annual rate of 5.6% in 2004 to 2.8% last year does not bode well, especially when we take account of above-trend output expansion in the private sector. In other words, macroeconomic trends, suggesting a rapid narrowing of the output gap, do not support long-term price stability.

The central bank will raise short-term interest rates to 5.5% this year. Judging from inflation expectations that remain within the official target range, the Bank of Israel does not need to increase the policy rate any more. However, the current policy stance is still accommodative and political developments (such as the forthcoming Palestinian and Israeli elections), which the central bank obviously cares about, may lead to unwarranted volatility in financial markets and have significant influence on expectations in the near term. This is why we believe that the central bank should — and will — continue raising short-term interest rates, as a part of policy normalisation, towards 5.5% in the remainder of this year.

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Turkey
Biofuelling the Economy
Jan 24, 2006

Serhan Cevik (from Tel Aviv)

Supply disruptions may well be changing the nature of today’s energy shock. According to the consensus view, the recent energy shock is fundamentally different from previous episodes in the 1970s when politically-induced supply disruptions pushed the price of crude oil to a peak and economies around the world into stagflation. However, even though the spike in energy quotes was originally a result of demand outpacing supply, as an increasing number of energy-inefficient developing countries has joined the foray of industrialisation, the dispute between Russia and Ukraine — and now between Iran and the west — shows that the risk of 1970-style supply constraints is no longer negligible. Together with above-trend rises in demand for fossil fuel, supply-driven shortages would no doubt push energy prices higher and have distressing effects on the global economy. Moreover, even if we assume an eventual ‘mean reversion’ in the petroleum market, the scarcity of fossil fuel in the longer term makes it necessary to improve conservation and to seek out alternative sources of energy.

Higher energy prices create a drag on growth in fossil-fuel dependent countries. Turkey has become dependent on a growing volume of energy imports that now account for 6.2% of its GDP and consequently make it vulnerable to external shocks. When energy prices increase to excruciating levels, the Turkish economy suffers on three major fronts: creating a drag on economic growth, slowing the pace of disinflation towards price stability, and resulting in a widening in the current account deficit. In our view, the problem with Turkey’s energy dependency is beyond price oscillations and more structural in nature. The elasticity of oil demand has already become steeper and, if unrestrained, fossil-fuel imports will double in the next five years. This is why we have argued in favour of developing innovative measures to reduce over-reliance on imported energy sources — especially, fossil fuel from Russia and the Middle East — in a new era of energy insecurity.

Turkey can hit ‘two birds’ by developing a rational energy policy. Having an infrastructure that could provide reliable, low-cost energy is sine quo non for sustainable economic development. Therefore, the goal of energy policies should be improving the diversification of supply and resources to minimise economic and environmental costs of energy. On the other hand, we also realise that policy-making should not be a single-dimensional process and a rational approach to energy security can potentially help in addressing other problems in an economy. For example, the Turkish authorities should consider, in addition to building a network of nuclear power reactors, promoting biofuel that can increase agriculture income and reduce oil dependency and carbon-dioxide emissions.

Improving the agriculture sector would help on the energy front as well as on the EU front. The share of agriculture declined from 40% of GDP in the 1960s to 11.2% last year, but the sector still employs 34% of the workforce. Because of institutional constraints and populist policies, Turkey has a fragmented farm structure that lowers productivity and thus income growth (see Agriculture — The Ultimate Test for Structural Reform, June 2, 2000). The size of the average farm in Turkey is just 6 hectares, compared to 16.5 hectares in Europe. Consequently, since small firms account for 70% of cultivable land, Turkey’s farm productivity is barely 50% of Europe’s output per hectare. In our opinion, the government should introduce reforms encouraging land consolidation and also make approximately 2 million hectares of unused farm land available for the development of ‘biofuel’ crops.

Biofuels can give a boost to Turkey’s unproductive agriculture sector. Biofuel — a mixture of alcohol or ethanol with gasoline — is fast becoming a cost-effective alternative to fossil fuel. For example, Brazil, once being completely reliant on fossil-fuel imports, has achieved energy independence by developing sugar-based ethanol industry that now accounts for about 30% of the country’s transport-fuel consumption. Turkey has a similar potential to develop biofuel plants using local products (such as maize, wheat and sugar beet) and to benefit tremendously from technological advancements that will soon make producing cellulose ethanol from agricultural waste like cereal straw far more competitive. On the whole, we believe that biofuel is a realistic alternative source of energy that could boost agricultural output growth and improve the diversity of energy supply in Turkey.

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