Passing Ships in the Night
Feb 03, 2006
Stephen Roach (New York)
Much is made of the so-called symbiotic relationship between the US and China. It has been an especially good story over the past five years. With the US consumer driving the demand side of the global economy and the Chinese producer increasingly driving the supply side, the two economies appear to fit together like a glove. China’s apparent willingness to play a disproportionate role in funding America’s gaping current-account deficit only adds to this conviction. My advice: Don’t get used to it. Like two ships passing in the night, both China and the US are headed in very different directions.
At the macro level, disparities between consumption and saving underscore one of the most important differences in the structure of the US and Chinese economies. US consumption has been holding at a record of around 71% of GDP since early 2002, while the gross national saving rate fell to only about 13.5% in 2005. By contrast, based on China’s newly revised national income statistics, the consumption share of GDP appears to have slipped to a record low of slightly less than 50% in 2005, whereas the overall Chinese saving rate rose above 45% last year. In both cases, these are unsustainable extremes. America needs to consume less and save more, whereas China needs to do precisely the opposite -- save less and consume more. Easier said than done, of course. But a shift in the consumption-saving tradeoff is an increasingly urgent priority for both economies. In the case of the US, a record shortfall of domestic saving leaves America in the difficult position of having to import surplus saving from abroad -- and thereby having to run massive current account and trade deficits in order to attract the capital. Moreover, America’s consumption binge has drawn its sustenance from the excesses of asset-driven wealth effects -- supported most recently by the precarious combination of a housing bubble and record levels of household sector indebtedness and debt service burdens. At the same time, China’s consumption shortfall is the mirror image of its all-powerful investment- and export-led growth dynamic -- two sectors that collectively account for about 80% of Chinese GDP and that are still growing at close to a 30% annual rate. This, too, is an unsustainable outcome for China. Further sharp increases in investment are a recipe for capacity overhangs and deflation. Continued sharp gains in exports are a recipe for trade frictions and possibly even protectionism, as the developed world responds to the politics of a mounting worker backlash. How to achieve these outcomes -- higher US saving and higher Chinese consumption -- is a different matter altogether. In the US, it will take nothing short of a groundswell of support for a national saving policy. And that won’t work unless the goal is attacked on two fronts -- a reduction of public sector dissaving (i.e., outsize federal budget deficits) and the enactment of some form of a consumption tax. In that latter regard, I continue to favor a national sales tax, with appropriate exemptions for low and lower-middle income families. Only by such an action, can America’s fiscal authorities alter the relative price between current and future consumption and thereby boost domestic saving. Sadly, there is little reason to be optimistic that Washington is about to embrace a pro-saving policy agenda. The budget deficit is going the other way, and the lack of support for tax reform effectively quashes any immediate hopes for major saving incentives. In China, it will take unprecedented policy initiatives to spark a shift in the mix of its powerful growth dynamic -- away from exports and investment and increasingly toward support from internal private consumption. The consumption piece of this equation could well prove to be one of modern China’s most vexing challenges. Its central planning heritage affords a natural advantage in the realm of resource mobilization by recycling a massive reservoir of saving into fixed investment and an export production platform. By contrast, a vibrant consumer culture -- long the DNA of market-based capitalism -- is not something well understood inside of China. In my view, China needs pro-consumption policy initiatives on two broad fronts -- the first being the establishment of a safety net (i.e., pensions, social security, worker retraining, and unemployment insurance) to deal with the job and income insecurity arising from ongoing reforms of state-owned enterprises. Secondly, China needs to focus on new sources of job creation in order to expand the purchasing power of its enormous population. In that regard, I still believe that China’s relatively undeveloped services sector affords the nation its greatest opportunities for an organic expansion of employment and labor income. Andy Xie offers yet another proposal to stimulate consumption -- a securitization of state-owned assets, which could inject added purchasing power into the Chinese household sector (see his dispatch in today’s Forum, ”China -- What Next?”). Whatever the option, rest assured that the Chinese leadership is very focused on shifting its growth mix toward private consumption. This point was stressed a year ago by Premier Wen Jiabao in his Work Report to the National People’s Congress and is likely to get further emphasis at the upcoming NPC, which commences on March 5. Governor Zhou Xiaochuan of the People’s Bank of China previewed this very point at the recent World Economic Forum in Davos, stressing the need for China to tilt its growth dynamic increasingly toward private consumption and services. China is well ahead of the US in tackling its saving-consumption imbalance. Pilot projects already have been established in setting up a safety net, especially in the social security area; moreover, under the terms of China’s WTO accession, the opening of domestic services is likely to accelerate over the next 3-5 years. My experience tells me never to underestimate the determination of the Chinese leadership to push ahead on a major policy initiative. For that reason, alone, China’s pro-consumption efforts can hardly be taken lightly. At the same time, there is little reason to be optimistic that Washington is about to embrace a pro-saving policy agenda. Yesterday’s passage of yet another $70 billion in tax cuts by the US Senate only underscores the seeming intractable character of America’s structural budget deficit problem. On balance, it appears that China is making better progress than the US in altering the balance of its consumption-saving tradeoff. In Davos, Governor Zhou also touched on another important aspect of this shift in the mix of China’s growth -- its consequences for the financing of America’s gaping current account deficit. In his view, an increased share of Chinese consumption could well have the important impact of dampening China’s rapid accumulation of official foreign exchange reserves. As he put it, China’s reserves growth of around USD$200 billion per year draws support form three sources -- its surplus in tradable goods, capital inflows (including foreign direct investment), and the surplus in “invisibles.” The goods surplus is likely to be the swing factor in this equation. Any successes on the Chinese consumption front undoubtedly spell more imports and a smaller trade surplus -- thereby leaving less saving to recycle back into dollar-denominated assets. Needless to say, that would only complicate America’s current-account financing burden -- putting the dollar and even long-term real interest rates under greater pressure than might have otherwise been the case. Policy activism has long been central to China’s extraordinary progress on the road to reform. China is now proposing to tackle its excess saving and subpar consumption story with the same fervor evident when it went after other aspects of its growth and reform story during the past 28 years. While success can hardly be taken for granted in a nation that knows little of the magic of the consumer culture, experience cautions in taking the other side of this bet. Failure has not been an option for determined Chinese reformers. And I don’t think it will be this time, either. This determination stands in sharp contrast with Washington’s inattentiveness to saving initiatives. That could spell trouble for the US. As these two ships pass in the night, America may feel China’s wake most acutely in the form of a painful and long overdue current account adjustment. So much for the pipe dream of a newly symbiotic world.
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Rebound - Is It Real or Just the Weather?
Feb 03, 2006
Richard Berner (New York, Partly Cloudy, 49?F)
Judging by incoming data, US economic growth appears to be reaccelerating strongly in the first quarter of 2006. Indeed, following the sharp slowing to just a 1.1% annual rate in the last quarter of 2005, we expect a jump to a 5½% annual clip. Real final demand actually declined last quarter, but consumer, construction and capital spending all ended the quarter on a strong note. That “ramp” already provides a solid base for first-quarter growth. For example, even if consumer outlays are flat between December and March, the annualized advance in first-quarter consumer outlays would be a sturdy 3.7%. Moreover, that momentum appears to have extended into January; indicators of demand and production are so far moving higher from December’s base. These strong results seem to support our view that the economy will accelerate in 2006. Lately, however, unseasonably warm weather has unmistakably provided a lift to spending in particular and economic activity in general, and any such weather effects will clearly be temporary. As a result, first quarter growth will exaggerate the economy’s underlying strength, borrowing from Q2. Nonetheless, the fundamentals for stronger growth are highly favorable in my view, and I think this pickup is for real. Here’s why. First, there’s no mistaking the sharp, broad-based upswing in incoming data, even before the winter heat wave began. Beyond consumer spending, other demand components also appeared strong at year end. Relative to their fourth-quarter averages, December capital goods shipments and orders excluding defense and aircraft stood 9½-10% (annualized) higher, and construction outlays stood 3.3% (at an annual rate) higher, despite inclement weather in that month. Industrial production in December was 3% annualized over the Q4 mean in December. And weather or not, advance indicators suggest that consumer and capital spending and production gained in January. Chain store and vehicle sales rose, suggesting gains in consumer and capital spending (recall that business vehicle outlays were weak in Q4). Orders at purchasing managers remained high and export orders rose sharply. To be sure, the strength isn’t ubiquitous. Housing is sliding under its own weight, as rising prices have undermined affordability. New and existing home sales are well off their recent peaks, homebuilder traffic is down sharply, and housing starts fell sharply in December. But just as poor weather probably exaggerated the fundamental slippage in home sales and housing activity in December, warm weather probably gave them a lift in January. Nationwide, it appears that mean temperatures in January were close to a record 6 degrees above seasonal norms. Similar extreme weather episodes have often significantly boosted housing activity and payrolls. Based on past relationships, such a weather anomaly might boost housing starts and new home sales by 100,000 or more. What’s more, such warm weather might boost nonfarm payrolls, notably in construction, by 50-100,000 in a single month, and the workweek by up to several tenths of an hour. The only weather-related downside is in utility output, which will suffer as heating degree days hover at decidedly subpar levels. This weather-induced volatility in recent and forthcoming data will make discerning the economy’s underlying strength more difficult. As in the past, construction and retailing will be the main beneficiaries, but these examples suggest that the potential for distortion is more broadly-based, possibly adding a percentage point to overall growth. And the spring “payback” from these distortions will potentially also be significant; the return to “normal” weather in the second quarter could easily pare a percentage point from overall growth in that period. Distortions aside, the warm weather will promote a fundamental improvement in demand, courtesy of its restraining effect on energy quotes and heating needs. Three months ago, many worried that record heating bills would finally crack consumer budgets. Noting the forecasts for a warmer-than-expected start to the winter, I reckoned that those concerns were overblown (see “Winter Weather Worries,” Global Economic Forum, October 24, 2005). The outcome was even better than expected; the feared $50 billion heating-bill hit to consumer budgets fizzled after December’s cold snap, and could net to a plus for discretionary spending power. To be sure, the jury is still out on the rest of the heating season. On Groundhog Day, Punxsutawney Phil saw his shadow, thus auguring six more weeks of winter according to folklore. More scientifically, NOAA’s short-term outlook suggests a return to more seasonable temperatures over the next 8-14 days. It’s fortunate that natural gas and heating oil inventories are high, given the geopolitical tensions flaring in energy markets. Market participants have already discounted much of the strength in incoming data, as well as the likelihood that a less-certain tone in the Fed’s rhetoric implies two more tightening steps. Indeed, the recent change in market sentiment and the backup in interest rates have brought market pricing in line with our view that the Fed has more work to do. Equally, however, market participants seem to think that additional tightening will quickly be unwound, given the ongoing flattening of the yield curve and the persistent inversion of the Eurodollar curve from June 2006 to June 2007. In contrast, in our view, several fundamentals argue for hearty US growth: Pent-up demand for capital spending and hiring, a modest plus from increased government outlays, still-favorable financial conditions, and improving overseas economic activity. And as we see it, upside inflation risks and higher term premiums will re-steepen the yield curve later this year (see for example, “The Term-Premium Case for Higher Yields,” Global Economic Forum, January 20, 2005). Risks in forecasting the weather abound. With the groundhog having seen his shadow, and the possibility of a return to more seasonable weather, this lift to growth could be fleeting, and data will turn more volatile. But be wary of those who write off the economy’s strength as merely weather-induced; the fundamentals will still be supportive of hearty growth even when “normal” weather returns.
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A Yield Curve for the De Facto Dollar Zone
Feb 03, 2006
Stephen L. Jen (London)
A Hypothesis for Bonds Based on a Hypothesis for USD In a note I issued on April 25, 2002, I argued that the USD had a zero-percent risk of crashing, even though the dollar was entering into a three-year-long structural correction that would end by mid-2004. My main argument was that Asia was a part of the ‘de facto dollar zone’. My belief is that the US yield curve is becoming the yield curve for the de facto dollar zone, not just for the US. Thus, while the FFR is set by the Federal Reserve for the US economy, the US long bond rate could be increasingly behaving as if it is the long bond rate for the de facto dollar zone. The interpretation that the short- and long-end of the US yield curve represent tensions in different markets may help explain why bonds look like a conundrum from the US perspective. The aim of this piece is to provoke thought, rather than to rigorously prove my hypothesis. Some Thoughts on My Idea for the Bond Yield • Thought 1. The dollar zone’s savings deficit is insignificant; this is the ‘income’ effect. While the US has a massive and growing C/A deficit, the C/A deficit of the de facto dollar zone is only around 2.5% of GDP, according to my calculations. Asia will likely continue to export excess savings to the US for a long time. If we also consider the net capital inflows into the de facto dollar zone, the balance of payments of this zone is likely to have been in surplus, explaining the dollar rally in 2005. Therefore, the US yield curve is, in a way, the representative cost of capital that corresponds to the rather benign savings and investment balance within this de facto dollar zone, even though the S-I balances within the US or Asia look worrisome. • Thought 2. A ‘Dornbusch overshoot’ model applied to the bond markets. In addition to the excess savings argument, which I call the ‘income effect’, there is also a ‘substitution effect’ involving a switching of preference among Asian investors to US fixed income products. A strong trend in the past few years is the globalization of the capital markets. Cross-border capital flows have risen sharply. As shown by a declining Feldstein-Horioka coefficient, the propensity for investors in emerging markets to invest in liquid, large markets has risen — in other words, the home bias has weakened. This means that there may have been a structural shift in the preference of emerging market investors in favour of US bonds. The US is now a ‘bank’ for the world as it receives short-term deposits, and invests back in emerging markets in the form of equities or FDI. This global debt-equity swap is both efficient and stable. My description above of the key driving force behind the de facto dollar zone suggests that, as there are differences in the speeds of developments in the real sector and the financial sector in Asia in response to globalization, bond prices in the US have overshot the levels that are consistent with US economic fundamentals. This concept is similar to Professor Rudiger Dornbusch’s overshooting model for exchange rates, except applied to bond prices, and with a ‘temporary’ effect on bond prices more permanent than in his model. Capital within the de facto dollar zone should continue to flow into the US bond markets, until either the S-I trajectory in Asia changes and/or Asia fixes its financial system. The resultant net flows into the US bond market have helped to hold down the US long-bond yield. A recent paper by the Fed estimates that foreign flows (both official and private) into the US bond markets may have depressed the long bond yield by 150 basis points. Foreign capital inflows matter a lot for the US yield curve. However, my point is that part of these inflows has been motivated by both the ‘income’ and the ‘substitution’ effects mentioned above. Incidentally, the role that the official foreign flows play in supporting the US bond market is exaggerated. Since 2002, official flows into the US accounted for less than a third of all capital flows. The fact is that private flows into the US have been immense. Bottom Line The US yield curve may represent the financial conditions in the US on the short-end and those in the de facto dollar zone on the long-end. There are ‘income’ (excess savings) and ‘substitution’ (Dornbusch-like bond overshoot) effects. We are likely to continue seeing a yield curve that makes sense from the perspective of the de facto dollar zone, but also one that looks like a conundrum from the perspective of the US economy or the de facto economic union.
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What Next?
Feb 03, 2006
Andy Xie (Hong Kong)
*****Overcapacity is causing investment slowdown: I estimate that fixed investment in industries that are experiencing overcapacity contributed 40-50% of GDP growth in 2005. Without other components of the GDP accelerating, China’s economy should slow in 2006. *****Spending more on infrastructure won’t reverse the trend: The infrastructure areas that can justify more investment account for 4% of total investment, I believe. Spending more there won’t reverse the trend. *****Stimulating property again could lead to another wave of bad debts: Giving property a second wind is a popular proposal for stimulating the economy. Cutting mortgage rates could boost sentiment. However, it would mostly encourage more speculation. The industry is already swollen and highly speculative. *****Lifting consumption is hard to do: The main problem for consumption is the low income and wealth of the household sector. To solve the problem, the government could securitize its assets for distribution to the population, which could create a consumption boom for several years. However, vested interests may prevent such a policy change. Summary & Conclusions China is running into serious overcapacity. On the demand side, I estimate fixed investment accounted for 58% of China’s GDP growth over 2000-05 and the current account 9%, using revised-up GDP as a benchmark. Of course, on the income side, export growth has accounted for most of the increase that has funded the fixed investment expansion. Overcapacity is likely to force China to slow down fixed investment. In addition, I expect export growth to slow down to 15% in 2006 from 28% last year due to deceleration in factory relocation. What could sustain China’s high growth rate in 2006? Property is widely discussed as the best option. China has vast overcapacity in steel and cement. Property is the primary user of both. This is why pushing property has become an attractive option. This sort of planning mentality could create another wave of bad debts, I believe, and cripple China’s economy for years to come. The signal for a property push would be a cut in mortgage rates. If this were to occur, the market could become euphoric again. I doubt that it would push up physical demand significantly. The disconnect between price and supply is too big to overcome simply via a reduction in mortgage rates. Prices need to come down substantially to clear current supply and support more supply to boost GDP. I think another wave of bad debts would be inevitable from such a bubble push for GDP growth. Infrastructure is considered an alternative. In terms of its fiscal situation, the government has ample room to stimulate. Infrastructure is overbuilt in most areas already, though. I believe a big push in selected areas (e.g. water and environment) would be worthwhile, but the potential boost from such areas would be insufficient to offset the overcapacity-induced investment slowdown or export deceleration. Consumption is the alternative that receives the most coverage, but rarely receives serious attention when it comes to policy changes. China’s relatively weak consumption is due to demographics, skewed income and wealth distribution, arbitrary healthcare costs, and high property prices. The government could securitize and distribute government-owned assets to boost consumption quickly. Fixing the healthcare system and maintaining affordable property prices would boost consumption over the long term. Accounting for GDP Growth China’s national accounting data are very confusing. The latest revisions make it even more complicated. My suspicion is that the revised total value of GDP is closer to reality than the old value, but is on the high side of the potential range. Rmb18.2 trillion of 2005 GDP no longer underestimates China’s GDP, in my view. China compiles production data most diligently – a legacy of the planning economy. Demand side data are woefully inadequate. The income side data are missing. I have roughly estimated the various components of China’s national accounts on the demand and income side. In the text below, I provide a breakdown of my methodology in deriving these ‘guesstimates’. China keeps the most detailed information on production side data. Such data are the most difficult to verify. There are millions of business units in China. The market can check only the accuracy of trends by following selective corporate production data. For example, the decoupling of electricity and industrial production in 1998 was cited as the main evidence of overstatement of GDP growth at that time. On aggregate production data, we have to use whatever is available from the National Statistics Bureau. On the demand side, China keeps detailed data on fixed investment. Since central or local government has to approve virtually all significant investments, I assume that the data largely reflect reality. I suspect the main inaccuracies relate to the extent to which funds for investment are diverted for consumption. I would not be surprised if this sort of double counting represented as much as 10% of the investment amount. To allow for this, I assume Rmb8.1 trillion for fixed investment in 2005, compared with Rmb8.9 trillion in the monthly fixed investment data series. I derive a net export figure from my current account (CA) balance estimate. The differences between net exports and the CA balance have been erratic in recent years. The CA surplus was 40% higher than net exports in 2004. This is attributable to hot money inflows disguised as CA items. I estimate the CA surplus reached around Rmb 1.3 trillion in 2005. Considering that hot money inflow slowed substantially in 2005 compared with the year before, I consider a figure of Rmb1 trillion reasonable for net exports in 2005. The difference between GDP and fixed investment plus net exports is consumption. This number is also relatively simple for most people to estimate – we all have a reasonable feel for our own consumption, and how this compares with the average. Multiplying that by the population is consumption. Rmb9.1 trillion for China’s national consumption feels about right to me. I use the 2004 distribution shares of consumption among urban, rural, and government to divide Rmb9.1 trillion among the three sectors. The revised production data show that nominal GDP rose from Rmb9.9 trillion to 18.2 trillion between 2000 and 2005. I estimate that fixed investment rose from Rmb3.3 trillion in 2000 to 8.1 trillion in 2005 (accounting for 58% of the GDP growth), while net exports rose from Rmb 224 billion in 2000 to Rmb1 trillion (accounting for 9% of the GDP growth). On the income side, I identify Rmb3.1 trillion of household savings in household savings deposits, a rise in mortgage downpayments and principal paydown, life insurance and pension assets. Added to household consumption, this implies total household income of Rmb10.2 trillion in 2005. It suggests 30% of household savings deposits, which seems not unreasonable. Government income is the proceeds that the government uses to consume and invest, of which consumption is Rmb2 trillion and investment about Rmb0.5 trillion. This item is not big in other economies, but is very large in China due to the dominant role of the government in the economy. Monetization of natural resources is a big part of China’s GDP. Oil, coal, and land are the three big ticket items. The income from these sources usually goes into investment through local government or SoE accounts. I estimate that the profit component through the production chain in monetizing such resources was about Rmb1 trillion in 2005. Other sources of profits are primarily from state-owned monopolies (e.g., banks, telecom companies, utilities, etc.), export companies, property companies, and foreign owned businesses in the consumer sector. Based on profitability trends in companies’ reported data, I derive very rough profit estimates for these segments in 2005, as follows: the state-owned companies ex-the resource sector probably earned Rmb500 billion last year; exporters saw a net profit margin of about 3% on US$762 bn of exports (i.e. Rmb 185 bn in net profits); property developers probably earned Rmb200 bn, foreign companies in China’s domestic market probably earned Rmb 200 bn, and all other companies probably earned another Rmb200 bn. This produces a total of Rmb1.3 trillion. The residual of Rmb 3.2 trillion is assigned to depreciation. China invested Rmb27 trillion between 2001 and 2005. The total capital stock for productive purposes is probably over Rmb50 trillion now. On this basis, Rmb3.2 trillion of depreciation would represent about 6% of the productive capital stock. Considering how low the returns on capital are on most investments, 6% seems a reasonable level. The above estimates are really one man’s efforts. The true data could be off by 5% or even more. However, considering the opaque state of affairs, I think it is better than nothing. The Growth Gap from Overcapacity China may have over-invested in manufacturing, electricity generation, highways, ports, and property. These sectors accounted for about three-quarters of growth and 60% of total fixed investment in 2005. Under normal circumstances, overcapacity would lead to price and profit decline, which triggers investment decline. However, as local governments have strong influence over investment funding and are motivated by growing GDP at any cost, overcapacity may cause fixed investment stagnation but not decline. Stagnation of investment in sectors with overcapacity could still have a serious effect on GDP growth. I estimate that growth of investment in such industries accounted for 40-50% of demand growth in 2005. Without acceleration in other GDP components, China’s economy could experience a significant slowdown, deflationary pressure, and a surging trade surplus. Various ideas are being mooted as to how to sustain high GDP growth. I discuss three popular ideas below. Pump-Priming Again The government’s finances have improved tremendously; the fiscal balance bottomed at 2.6% of GDP in deficit in 2002 and was probably balanced in 2005. The actual improvement is much bigger. Many previously outstanding arrears, such as VAT rebates for imported components and equipment for export production, have been paid off. Fiscal incentives for purchase of domestic equipment have been increased. In short, China is in a good position to engage in fiscal stimulus. Because personal income tax is quite small in China’s tax revenue (direct taxes such as VAT, business tax, and tariffs account for 63% of tax revenue), cutting tax does not stimulate the economy effectively. ‘Borrow and spend’ could be effective, however. Increasing infrastructure spending is the policy suggestion that I have heard most. However, it won’t be easy technically. The transportation sector accounts for 40% of infrastructure investment and is already experiencing overcapacity. The container ports, for example, are headed for overcapacity on existing projects, despite rapid trade growth. China already adds more highways every two years than Japan has in total. The utilization rate of highways is low in most provinces. Even the railroads are not as underinvested as many believe. The coal-shipping bottleneck has eased and is likely to be solved for good once the three dedicated rail lines under construction are completed. The electricity sector has accounted for 90% of investment growth in the utilities sector. According to the National Statistics Bureau, installed capacity reached 500 GW by end 2005, with 300 GW under construction. The amount of capacity under construction is similar to the total capacity in the UK, France, and Germany combined. This sector is headed for a prolonged period of overcapacity, in my view. Gas and water distribution seem to deserve more investment. These sectors accounted for 1% of total fixed investment in 2005. 3G could increase telecom investment. This sector is less than 2% of total fixed investment. Similarly, rail, at about 1% of total fixed investment, may deserve more investment. These three sectors totalled 4% of total fixed investment. A push there could ease the decelerating trend, but would hardly reverse it. Second Wind for Property? Stimulating property is the hottest macro idea in the market at present. The cement and steel industries have massive overcapacity. Property construction needs both. Wouldn’t it be smart to stimulate property again? Property has become a vast industry that involves all local governments, tens of thousands of property developers, thousands of construction companies, banks, and tens of thousands of materials suppliers. The government reported 18.6% growth in property under construction in November 2005. If that growth rate continued into December, total property under construction would be 1,666 million sq m. At Rmb 2,759/sq m (the official average selling price in November 2005), the total market value of property under construction would thus be Rmb 4.6 trillion – or 25% of revised-up 2005 GDP. The property data are not reliable. Local governments have incentives to skew the data in their favor in relation to the central government and potential buyers. The overwhelming incentive is to underreport volume under construction to boost price expectations. It is obvious that property is not selling well in some key cities. But, local officials still report brisk sales. Hence, volume under construction is probably considerably understated. Understating average selling prices has also become widespread, as the central government has shown displeasure at skyrocketing prices that upset people. However, to entice potential buyers, local governments and property developers must project a picture of skyrocketing prices. This is why the media under the control of local governments or property developers report sensational stories about price rises while the government statistics show low and stable average selling prices. I would not be surprised if the properties under construction were worth 35% of GDP if all the data were properly adjusted. Even levels of around 25% are associated with economies that subsequently experienced big problems (e.g. Thailand in 1997). The average selling price of an 80 sq m flat is 8 times average urban household income, on my estimates. In some hot cities, the ratio is as high as 12 times. While such high prices are not unheard of (about 8 times in Hong Kong), the combination of such high prices and high volumes has never happened before. If we take the official data, China was building 1,290 mn sq m of residential properties or about 16 million flats at the end of 2005. That is about 10% of urban households. The government data still show strong sales of properties. Because this is such a fragmented industry, it is impossible to verify the data. However, it is easy to see the empty buildings in so many cities. In the western cities, the situation is even worse than in the coastal region, I believe. If China wants to give property a second wind, it could cut mortgage interest rates. China’s mortgages are all floating rate. The interest rate of 5.5% is 3.25% higher than the one-year deposit rate. This sort of spread for mortgage products is unheard of elsewhere. It would seem reasonable to cut mortgage interest rates by one percentage point. Such a policy decision would certainly lift the property industry, mainly through reviving speculation rather than genuine final demand, I believe. For final demand, the disconnect between price levels and income is the main issue. Further, it would lead to another wave of borrowing for land speculation. Land purchases have exceeded land under development massively in the last few years. I estimate that purchased land not developed could total 725 mn sq m, 3.6 times the land that went into development in 2005. Anecdotal evidence suggests that land flipping is widespread. Cutting mortgage rates could lead to another wave of bad debts, in my view. If 725 mn sq m land does go into development, and 80% of it is for residential property, this could result in 25 million more flats. Together with the 16 million already under construction, 41 million flats would be equal to 25% of urban households. We do not know how many sold flats are empty, but a figure of 5 million wouldn’t surprise me. In my view, giving property a second wind is just an excuse to turn bank loans into revenues for local governments and profits for speculators and leave a wave of bad debts behind for the Chinese population. I am not ruling it out, though. Vested interests may be powerful enough to bring about such a policy shift. Lifting Consumption Shifting to a consumption-led growth model has been China’s dream for ten years. The reality, I believe, is that consumption declined to around 50% of GDP in 2005 from 65% in 1995, after taking into account the GDP revisions. There are many technical reasons why China’s consumption is relatively weak. The main political factor is that the Chinese government is too powerful in the economy and too interested in mobilizing resources to invest to show progress. The household savings rate is about 30%, on my estimates. This is high by international standards, but cannot explain China’s low consumption level. The low share of household income in GDP (56%) could be a more important factor. To boost consumption, then, the government needs to increase household income. I think the most effective way is to securitize government-owned assets and distribute them among the population. Currently, monetizing natural resources such as coal, oil and land creates income that goes immediately into investment through government-controlled channels. Were these assets owned by the broader population, they could decide how much to consume and how much to save. Such a policy could lead to multi-year consumption boom, in my view. However, in the past few years, powerful vested interests have emerged to take advantage of government-controlled assets, making pro-consumption reforms difficult. This is why I am not optimistic that China can shift to consumption-led growth. Declining cyclical savings could naturally lead to a higher share of consumption in GDP. During an economic boom, the prices of natural resources (e.g., coal, oil, and land) surge, which is a tax on household income and shifts money to businesses and government, which are more interested in investment. When the cycle cools and the prices of natural resources decline, the process reverses and household income’s share in GDP rises. Consumption’s share in GDP also rises naturally. However, this sort of cyclical fluctuation does not signal any change in China’s development model.
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The Search for Yield Still Dominates the G10 Space
Feb 03, 2006
Stephen L. Jen (London)
Yield-Seeking Environment Remains Strong in G10 Near-record-high EUR/JPY, stubbornly high NZD/USD, and high sensitivity of EUR/USD to micro changes in expectations of monetary trajectories are all circumstantial evidence supporting the notion that ‘nominal variables’ are more powerful drivers of the major exchange rates than ‘real variables’. For USD/AXJ, however, real variables are increasingly more important drivers, pushing USD/AXJ lower. I believe that USD/CNY will show an accelerated down-trend in 2006, guiding all USD/AXJ lower this year. Key to this view is a robust global growth. Nominal Dominates Real • Observation 1. While foreign investors cite the good growth prospects in Japan in support of their bearish-USD/JPY view, Japanese investors are still so keen on the nominal yield pick-up on foreign assets that capital outflows have overwhelmed capital inflows, supporting the USD/JPY. If the Fed is moving the FFR to 5.00% or above and the ECB does the same, capital flows out of Japan and the desire to hedge against JPY exposure by foreign investors is likely to be so powerful that USD/JPY could be pushed toward 125. On the other hand, real economic fundamentals suggest USD/JPY should be trading close to 100 (our valuation framework estimates). These two centres of gravity make USD/JPY an intrinsically unstable exchange rate, in our view. USD/JPY’s path will be dependent on the focus of the dominant players in the market. For the time being, the risk to USD/JPY appears biased to the upside. But I expect USD/JPY to end the year at a lower level than the actual one. • Observation 2. Both EUR/USD and USD/JPY have been higher than they should have been because nominal variables overwhelmed the real variables. Based on real fundamentals, EUR/USD should be trading at around 110. However, petrodollar and central bank distribution flows have artificially elevated EUR/USD, while the carry has kept USD/JPY high. • Observation 3. This year, the dominant macro trade in the currency space is short-NZD/USD. The problem is that we are still very much in the carry environment. My guess is that, until this mentality changes, NZD/USD will not trade lower. In fact, I would even argue that NZD/USD will trade lower at the same time as EUR/JPY trades lower, as they have been supported by the same yield-seeking mentality. • Observation 4. EUR/USD is highly sensitive to the perceived monetary paths of the Fed and the ECB. This also suggests that we are still in a yield-seeking environment. The only reason currency investors are scrambling now to buy dollars is that they had been dismissive of the ability and the willingness of the Fed to keep tightening, in our view. We see it as more of an adjustment from a dovish interpretation of the December 13 minutes than a genuine revision of views on the outlook of the US economy in the past two days. Real variables drive USD/AXJ Yield differentials in Asia matter only to the extent that they affect hedging costs and the cost of an outright position on the currency. Real economic and export growth in AXJ is a far more important driver for the AXJ currencies than in LatAm. Compared with Japan, AXJ’s interest rates are higher, and AXJ’s investors tend to be less focused on yield differentials than their Japanese counterparts. Monetary policies in Asia are influenced by exchange rate movements, rather than the other way around. The most remarkable development in the last two months is more evidence that global demand is extraordinarily robust. The global economy is on track to register three consecutive years of growth above 4.0%, for the first time in more than 30 years. In any case, this robust global backdrop should not only lead to persistent downward pressure on USD/AXJ, but also help the Asian central banks in deciding to permit USD/AXJ to trade lower. This latter prediction is what will make 2006 unique, in our view. Many have called for a USD/AXJ down-trend in the past three years. But the key, I believe, is in calling for a change in the Asian central banks’ intervention policy. USD/CNY Will Soon Take the Spotlight from the Majors China decided to float the CNY on July 21. The reason for this choice was that China wanted to time the float in an environment of a strong dollar, therefore avoiding the risk of triggering a massive USD sell-off. If Mr Bernanke is to underscore a hawkish bias on February 15, this would give Beijing the first opportunity to permit a wider de facto variability in USD/CNY, without changing the existing micro structure of how USD/CNY is traded. Bottom Line The circumstantial evidence presented above supports the notion that ‘nominal variables’ are more powerful drivers of the major exchange rates than ‘real variables’. For USD/AXJ, however, it seems that real variables are increasingly more important drivers, pushing USD/AXJ lower.
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Revival in FDI Inflows
Feb 03, 2006
Charles St-Arnaud (London)
As a sign that the global economy is healthy, that globalisation continues and the business climate is favourable, we estimate that global FDI inflows increased by 29% in 2005 to US$896.7 billion from US$695 billion observed in 2004. This is the highest level since 2000 and ends four years of declining or virtually constant FDI inflows. UK becomes the biggest beneficiary of FDI In 2005, the UK was the biggest beneficiary of FDI for the first time since 1977, with inflows of US$218 billion. This amount accounts for half of the total FDI flows received by the EU15 countries and twice that received by the US. Despite the fact that about US$81 billion is accounted for by the huge merger that produced Royal Dutch Shell, FDI inflows to the UK are still close to the all-time-record of US$122.2 billion recorded in 2000. Strong M&A activity in the UK is the main driver for these higher FDI flows. In 2005, increased M&A activity compared with 2004 (about US$31 billion) represented almost 75% of the increase in FDI inflows, after excluding the exceptionally large merger. Our calculations suggest that the net FDI flow in the UK for 2005 was around US$110 billion. This is more than double the size of the UK’s current account deficit, which we estimate is about US$43 billion. This huge inflow was able to provide some support to the GBP, which has depreciated by 1.8% in effective terms over 2005. The US and EU ex-UK are lagging The US is still among the biggest receivers of FDI inflows. However, the level is still far from that seen in the late 1990s and one-third of the record high of 2000. An interesting observation, however, is that net FDI flows are positive for the first time since 2000. This development could be the result of HIA-related flows. There is a similar situation in the European Union. The FDI inflows to the EU, excluding the UK, are also one-third of the level of 2000. However, net FDI flows have been consistently negative for some years. An interesting case in Europe is Germany, where FDI inflows were negative and remained small in 2005. This situation was due to huge loan repayments by affiliated firms to their parent companies abroad. Recent data indicate that this should be coming to an end. FDI inflows and Asian economies The offshoring movement that we have witnessed in recent years seems to have slowed somewhat in 2005. FDI inflows to emerging Asian countries have remained mostly constant in 2005, increasing by only US$2 billion. Only India and Hong Kong saw a significant increase of 13% and 17%, respectively. India has enjoyed a gradual increase in FDI inflows over the past seven years, driven mainly by the offshoring of corporate services business. China remains the principal beneficiary of FDI flows in Asia and is third globally after the UK and the US, receiving around US$60 billion. The opportunities provided by low production costs and its growing domestic market are the main drivers of these flows and should persist going forward, in our view. The stabilisation of FDI inflows for most of the Asian countries explains in part the slower accumulation of reserves by the Asian central banks in 2005. However, with sustained global growth and continuing globalisation, these flows should increase, putting pressure on AXJ currencies to appreciate. Bottom line As global economic growth looks set to be sustained over 2006 and M&A activity should be stronger than in 2005, FDI inflows should continue to increase. In turn, this should provide some support for the currencies of the net beneficiaries of FDI flows, mainly Asian countries. This reinforces our call for stronger AXJ currencies in 2006.
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Faster growth, slower inflation, lower rates
Feb 03, 2006
Oliver Weeks (London)
While growth, and particularly investment, are accelerating in Poland, inflation remains well below target and our recent expectations. Some of the recent food and fuel price falls are unlikely to be sustained, but demand pressure on inflation remains hard to detect and zloty risks still appear on the strong side. With strong output growth and the relative weakness of the populist parties mitigating some of the fiscal risk from the agreement with Samoobrona and LPR we see a good chance of interest rates falling below 4.0% in the first half of this year. Inflation outlook cut, risks to downside The National Bank’s new inflation report, the first since August, offers some ammunition to both sides of a clearly very divided Monetary Policy Council. The central projection for CPI has been cut significantly, remaining below the target range (1.5-3.5%) for the whole of 2006 and below the central point of the target through 2007. Risks as represented by the fan chart are skewed slightly to the downside. On the hawkish side the Bank’s staff highlight risks not adequately captured by the model, particularly that the pick up in employment seen in the second half of 2005 is sustained, boosting consumption and inflation, and that oil prices remain above the assumed level (USD 61 for Brent in 2006). On the dovish side the report notes the risk of a downside surprise to CPI from the consumer basket revision in January, which will include mobile communications for the first time. After the latest deal with the EU we note concessionary VAT rates look unlikely to rise in 2008. Most important for the medium term, however, are the exchange rate forecasts, which seem conservative to us. PLN risks still to strong side in our view The latest MPC statement highlighted that the zloty in January was already stronger than assumed in the Inflation Report. The exchange rate assumption is not precisely specified but the report predicts a short term depreciation of the zloty to correct perceived excessive strength in H2 2005, and a further gradual weakening from Q3 2006 driven by a smaller yield gap with Euroland. The exchange rate remains the dominant driver of inflation in the Bank’s model. Research director Czyzewski’s estimate that this week’s 25 bp rate cut would add 0.1 pp to inflation in 12 months suggests less inflation impact than a sustained 1% zloty depreciation. We continue to see currency risks on the strong side, even with a shrinking yield gap and a more cautious Finance Ministry. While an investment recovery may now begin to widen the current account deficit, we think export weakness is likely to be a short-lived reflection of Russian import bans, particularly as the German recovery accelerates. On most real effective exchange rate measures the zloty continues to look highly competitive, particularly once slow recent wage growth is taken into account. Recent FDI weakness also looks unlikely to be sustained, while the recent resurgence in popularity of household FX mortgages is likely to drive further inflows. We expect gradually improving efficiency in the disbursement of current EU allocations, and anticipation of a hike in net transfers towards 3% of GDP from 2007, to provide further support for the PLN Growth risks to the upside In fact the other main area where recent data has slightly superseded the report assumptions is investment, where assumed greater delays in EU fund absorption drive a reduction in the medium term fixed investment growth forecast from around 11% to around 9%. The surge in fixed investment in Q4 implied by the 2005 GDP data suggests this may have been over-cautious. With interest rates easing, corporate cash balances growing, and consumer confidence at record highs we are optimistic that investment strength can be sustained. While the cold weather and certain gas supply restrictions suggest some near-term downside for output data, with external demand accelerating, we keep our forecast for GDP growth this year at 4.8%, above the Bank’s 4.4%. With investment likely to boost productivity growth, and consumption growth still restrained by unemployment, we suspect domestic demand is still some way from proving inflationary however. It remains hard to see the output gap closing in the next three years. Budget resilient to politics for now Among other exogenous risks identified by the Bank are the impact of politics on the zloty and weaker fiscal and structural reforms. Full details of the pact signed with Samoobrona and LPR are not yet available but given the slump in support for the populists we do not expect their agenda to be closely followed in practice, despite some alarming rhetoric. In particular National Bank independence looks reasonably well defended by the Constitution, which defines the term of MPC members and allows them to define policy goals. Clearly the populists are not reliable partners and early elections look likely to come back on the agenda by the autumn. At this point a (plausible) scenario of stronger support for Samoobrona and weaker PiS ratings could begin to damage policy and the 2007 budget. However until then we remain relatively relaxed about a budget that is likely to benefit from stronger than forecast revenue growth, competent management, and a healthy cushion of revenue from 2005. As yet we can also detect no firm commitment to raise the level of financing on the local market, rather to tone down the last Minister’s aggressive rhetoric on FX issuance. Doves winning out on the MPC With Governor Balcerowicz clearly opposed to further rate cuts communications from the Council are likely to remain cautious. Debate at the January meeting seems to have been intense. However the Governor has probably been outvoted at four of the last seven meetings and may have lost the recently reliable backing of Marian Noga. Professor Filar has been keen to emphasise the move of Polish rates below the Fed’s and even the dovish Miroslaw Pietrewicz has only called for another 25 bp cut so far. However we think that unless political surprises weaken the zloty significantly the Council may gradually reassess its view on where neutral rates stand in a context of real appreciation, much as the Czech National Bank has done. One more rate cut this quarter looks likely, and we now expect rates to fall to 3.75% by the middle of this year. With Mr Balcerowicz likely to be replaced early in 2007 our previous end-2007 target of 3.5% may be met by mid-2007, without we think serious risk to inflation.
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Declining Inflation, Declining Uncertainty
Feb 03, 2006
Heloisa Marone (New York)
Brazil’s improving inflation story has come hand in hand with a decline in volatility and, in turn, a reduction in uncertainty. While we have warned against overemphasizing the importance of the role of central banks in the region (see “Latin America: In Central Banks We Trust” in GEF, January 24, 2006), it is hard to deny that a crucial component to Brazil’s success is due to the central bank’s adoption of an explicit inflation-target regime, coupled with improving fiscal performance. Yes, Brazil has benefited from a global backdrop of high liquidity, low inflation and low inflation volatility, but it has also moved forward on the fiscal and monetary fronts. No one can accuse Brazil’s central bank, with overnight rates among the highest in the world, of being overly accommodative or merely relying on global liquidity to set policy. The results to date have been dramatic. Although the inflation-target regime has been costly, with overnight interest rates varying between 15.25% and 26.5% in the past five years, inflation and inflation volatility have fallen dramatically in Brazil along with an improvement in economists’ inflation forecasts. This, in turn, has helped to reduce uncertainty and with it, the prospects for stronger economic growth have improved. The convergence of expectations and the increase in central bank credibility should help lower Brazil’s inflation risk even further. And this should allow interest rates to continue to fall, thereby lowering the overall cost of the adjustment process. Fewer mistakes and more agreement Inflation, as well as the precision of inflation forecasts, has improved in Brazil since early 2003. The twelve-month average monthly inflation rate declined by nearly a third: from a peak of 1.34% in May 2003 to 0.46% in December 2005. In addition, the average ratio of actual to expected inflation rate dropped from 1.10 in mid-2003 to close to 1.03 by the end of last year. This average ratio stayed very close to one (that is, with actual inflation equaling expected inflation) for the twelve-month periods ending during most of 2005. The increase in this ratio in the twelve-month period ending in September and October 2005 was mainly the result of the increase in fuel prices in early September, to which economists may have responded slowly in adjusting their forecasts. Not only have economists been making fewer mistakes but they have also been agreeing more frequently. This suggests a scenario with a lower level of uncertainty and, hence, a higher convergence in expectations. The standard deviation of individual inflation forecasts for the 12-month period ending in December 2005 declined by more than two-thirds when compared to the peak in the 12-month period ending in August 2003, while the average expected inflation dropped by half over the same period. Are economists getting smarter? While it is possible that economists are getting smarter, we suspect that less volatile prices have most likely helped economists to increase the precision of their forecasts, leading to a convergence in their opinions. Low variability of inflation over time makes expectations over the future price level more certain. Surely, the convergence of inflation forecasts also contributes to lower price volatility. The combination of these two effects has brought Brazil’s inflation to a benign path since late 2004. Unconditional twelve-month moving average inflation volatility has eased by nearly two-thirds between mid 2003 and late 2005 and stayed flat throughout the second half of 2004 and most of 2005. Relative price volatility, measured as the weighted sum of squared relative price changes using the IPCA basket weights, also declined dramatically in this period. Most important, however, is that the decrease in uncertainty due to less volatile prices has decreased the inflationary risk premium required to hold Brazilian assets. Yield curves inverted in 2004 and got flatter in 2005, suggesting that the market is pricing a more stable macroeconomic and political environment. The improvement in economists’ estimates and the decrease in uncertainty tend to lower the cost of decision-making for firms, fostering a positive environment for investment, production, and consumption. Indeed, average investment spending increased by around 5% between September 2003 and September 2004 when the volatility of relative prices fell by more than half. We suspect that maintaining very high real interest rates, which increase the opportunity costs of investing in Brazil’s real economy, has offset some or most of the positive effect from low inflation volatility. With time, however, we suspect that the lower inflationary risk should usher in much lower interest rates: a view reiterated in January by the Copom in the minutes explaining its rationale for a 75 basis point reduction in the overnight rate to 17.25%. Caveats Of course, we see risks to the process of low inflation and low volatility. An adverse shock in the global economy could throw Brazil off the current benign inflationary path by increasing inflation and inflation volatility. Furthermore, the second round effects of excess liquidity could lead to complacency, particularly on the fiscal front. While prudent fiscal policy has been a precondition for the success of Brazil’s central banks in gaining control over inflation, we are always on guard against the risks of complacency. This can hardly be overemphasized. Despite the positive gains that resulted from a committed central bank, we consider fiscal reforms essential for interest rates to fall to single digits. Bottom line We believe that Brazil is still in a disinflationary mode, despite the largely seasonal uptick seen in some of the inflation releases in recent weeks. Lower inflation should, in turn, help to strengthen the credibility of the central bank and further reduce the volatility and the uncertainty which have long plagued Brazil. But while markets are rightfully focused on the path of inflation in the months to come, we would argue not to overlook the achievements already made. The progress to date on the inflation front, with a reduction in uncertainty and volatility, should prepare the terrain for a lower inflation risk premium and set the stage for lower real yields, thus boosting growth. While we suspect there is more good news to come on the inflation front, the news to date has yet to be fully reflected in interest rates and hence in Brazil’s real economy.
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