United States
"Hybrid" Retirement Saving Plans
Feb 17, 2006

Richard Berner (in Florida, helping my 90-year-old mom manage her longevity risks)

Inadequate retirement saving and saving systems are among America’s long-term challenges, and how we meet them will determine the kind of society and the economic prosperity we leave to our children (see “America’s Long-Term Challenges: I and II,” Global Economic Forum, May 21 and 24, 2004).   To do so, I’ve argued that we need an appropriate mix of macro and micro policy changes (see “Meeting America’s Long-Term Challenges: Macro and Micro,” Global Economic Forum, December 17, 2004). 

Triage dictates first addressing our crumbling defined-benefit (DB) pension system.  The pitfalls and risks in DB pension plans are now obvious to many plan sponsors and policymakers, and employees have learned painfully that pension promises can be broken.  Both lawmakers and accounting watchdogs are moving in the right direction.  For their part, CFOs are acting to mitigate those risks by freezing DB plans and shifting their employees to defined-contribution (DC) plans, accelerating a long-standing trend.

However, in the rush to catalogue the shortcomings and hitherto-unappreciated costs of DB plans, CFOs may overlook two critical facts.  First, while DB plans per se are unattractive to most sponsors, some characteristics of DB plans are advantageous for beneficiaries and cost-effective for sponsors.  Consequently, some sponsors are maintaining their existing DB plans, and those key features are worth incorporating into any scheme to defer compensation as a retirement saving benefit.  And second, DC plans are not a perfect vehicle for such benefits; while they have some desirable features, they also have limitations.

As a result, I believe that “hybrid” plans that combine the best features of DB and DC plans offer a better solution to the benefits conundrum than either one or the other.  Hybrids aren’t new, of course; so-called “cash balance” plans are a hybrid that clearly has not worked.  But it was not the concept that was flawed; it was the implementation.  Cash balance plan sponsors made unrealistic DB-like promises to employees that resulted in volatile and unpredictable cash flows, and courts ruled that, as constituted, some of the plan designs and conversions discriminated against older workers.

So how should we reconsider hybrids?  To answer that, I proceed in four steps.  I first go back to first principles to understand the goals of any system of retirement saving.  Next, I explain why companies want to offer deferred compensation as part of that system.  Third, I explore the common and different features of DB and DC plans — which are advantageous, which aren’t — and discuss their costs.  Finally, I offer a template for hybrid plans and briefly discuss implementation.  I should add that while these are my views, I’ve benefited from discussions with Dallas Salisbury and Marty Leibowitz.

Four — or perhaps five — legs to the retirement saving stool

Market economies need several channels for retirement saving, for three reasons.   The first is to enable today’s workers to provide efficiently and prudently for their own retirement needs without burdening their children.  The second is to provide efficiently the capital for productive investment that will ensure future growth.  Third, a safety net is essential to minimize the risk that the truly disadvantaged will spend the last years of their lives in poverty. 

No one channel can meet all of those needs.  Traditionally, economists think of three legs to the retirement saving stool: Corporate or public pensions, which defer compensation; personal saving, in which individuals defer consumption; and the government safety net, which makes promises based on future economic growth.

In reality, there have always been two more legs for many.  The fourth leg: Working additional years has been an essential ingredient in the retirement infrastructure for many and will be for more people in the future.  Access to health insurance benefits is the fifth leg: Those who can obtain post-retirement coverage prior to Medicare retire early, while those who only anticipate Medicare have kept on working.  Many more in the future will keep working to assure health insurance.  The design of retirement saving benefits must recognize those facts.

Companies want to offer deferred compensation to employees for two reasons: First, the sponsor can offer a tax-deferred future benefit to employees and charge the cost against today’s corporate earnings.  Second, such benefits, if vested over time, may help attract and retain talented employees.  If properly structured, therefore, they are valuable to both sides.

But the first three and the fifth legs of the retirement saving stool are shaky, in our view.  First, as discussed above, America’s defined benefit pension plans are at risk. Second, the principal vehicle for individual saving, the 401(k) plan, also comes up short.  Participation is too low (30% for all workers aged 21-64, according to EBRI), consumers’ asset allocation is either too risk averse or too unstable to yield adequate returns, and plan assets aren’t growing fast enough because consumers raid their own savings for lump-sum withdrawals to finance education or bridge their needs when they lose a job or divorce, and they fail to roll funds over when changing jobs.  The safety net — Social Security — is adequately funded for now; the Social Security system is projected to be solvent through 2042, but we will need higher taxes or reduced benefits to assure 75-year stability.  And in keeping with its safety net mandate, the program provides minimal retirement benefits that replace a small fraction of the income needed.  Finally, the reductions in employment-based retiree health insurance and the costs of obtaining health insurance through the individual marketplace are both front-page news.

Thus, America’s saving crisis isn’t just about insufficient thrift; it’s about inadequate saving infrastructure that needs a thorough overhaul.   And designing a saving infrastructure that will last requires a look at the goals each piece should provide in the context of the overall system. 

Before looking ahead, however, it’s important to clean up the mistakes of the past by separating legacy from future costs.   It’s unfair, in some cases illegal, and at a minimum politically unacceptable to break promises already made to retirees and the elderly.  A solution: Walling legacy costs off from those applying to the future.  By treating legacy promises as debt, we can quantify them, assess their cost, and match the liabilities with appropriate assets.  That’s analogous to the “good bank-bad bank” structure used successfully to fix otherwise-healthy banking systems saddled with portfolios of nonperforming or dud loans.  By creating “bad banks” to house and manage the bad loans — separate from the “good banks” that could operate profitably with a fresh start — managers and policy makers clarified and helped unlock the value in each for investors.  The same can be true for legacy promises (for one approach, see “Defeasing Legacy Costs,” Global Economic Forum, November 28, 2005). 

The next step is to change promises made for the future.   Employers and policymakers are asking Americans to assume more responsibility for their own retirement saving and to pay more for their own healthcare, both out-of-pocket expenses for routine care and ongoing payments to insure against catastrophe.  Initiatives to do so in isolation, however, are insufficient to build a lasting retirement saving or healthcare financing infrastructure. 

In the case of saving, any reform should be one part of a broader campaign to ensure that policies strengthen all legs of the retirement saving stool — personal saving, corporate pensions, the Social Security safety net, and, like it or not, working longer and getting access to healthcare.  Each leg involves certain risks for beneficiaries and for sponsors.  Among them: The risk of unexpected longevity, the risk of market fluctuations and prolonged periods of underperformance, and the risk of economic or industry underperformance.  The success or failure of the saving infrastructure will hinge critically on the way that such risks are shared among workers, employers, and taxpayers and across generations.

Features of DB and DC Plans

Both DB and DC plans offer tax-deferred compensation — a benefit for employers who get a tax deduction for compensation and for employees, who push into the future taxes on both the principal and on the returns from investing it. 

DB plans offer two valuable features that should be options in any benefit plan.   First, they offer a certain annuity income stream that mutualizes market and longevity risk across generations.  In addition, they offer professional money management.  For those who need discipline, DB plans that pay annuities also “force” employees to save. 

But even for employees, DB plans have some shortcomings: As noted above, DB benefits are less a sure thing than advertised.  In addition, they are not portable today unless they offer lump sums.  And, if they offer lump sums, they suddenly take on many of the weaknesses of a DC plan.  This is not a theoretical limitation: According to EBRI, over half of DB plans will now pay lump-sum distributions, and when they are offered, nearly 97% take the lump sum instead of the annuity — even at retirement.  Employees who leave a company before retirement lose benefits if they are not vested.  Given our flexible and dynamic labor markets, the traditional pension probably long ago outlived its usefulness as an employee retention device.  Other “risk-based” compensation has taken its place, based on employees’ contribution to the bottom line and not just on years of service.

In contrast, DC plans are portable and blend employer and employee contributions on a voluntary basis.   But beyond the drawbacks noted above, DC plans have their shortcomings: First, employees assume all the investment risks.  By law, DC plans are tax-deferred only up to a certain income level.  And they typically don’t offer annuitization.  According to data from Hewitt Associates, in 2003 only 17% of surveyed employers who offered a 401(k) plan offered an annuity option, and only 2% who received an annuity offer chose it. 

An Ideal Hybrid?

An ideal hybrid plan would feature at least six desirable characteristics of DB and DC plans while avoiding the pitfalls of each.  First, employers should make enrollment automatic.  Employees would have to opt out if they did not want to participate.  That would reduce the number of employees without coverage.

Second, hybrid sponsors should offer deferred compensation and tax-deferred income.   Sponsors and policymakers must decide on appropriate limits to contributions and how long the deferral should last.  Presumably the limits should rise with income growth and the deferral should extend with longevity and/or the retirement age. 

Third, hybrid sponsors should offer options for professional management, including asset allocation.  The Dalbar study of mutual funds demonstrates conclusively that chasing fund performance led the typical mutual fund investor to dramatically underperform benchmark indexes.  Risk-averse beneficiaries might select a guaranteed investment contract (GIC) as part of their asset allocation, but not up to 100%.  By limiting the allocation, employees share in investment risks and move closer to their efficient frontier.

Fourth, sponsors should offer options for lump sum distributions or annuitization, with clear tradeoffs and disclosure of the price of the annuity — and what might be the prospects of running out of money if you are long lived and do not choose the annuity option.

Fifth, an ideal hybrid plan should be portable.  Vesting should be conditional on years worked but not in a way that hampers labor mobility.

Finally, no plan, DB, DC or hybrid, should include allocations to company stock beyond a benchmark weighting. 

The conclusion?  Implementing the ideal hybrid retirement saving plan won’t be easy.  Blending the best characteristics of DB and DC plans up to retirement is difficult enough: Participation is the sine qua non for success; funding must be adequate; and sponsors and employees must share investment and economic risks over an increasingly long and mobile working life.  Changing sponsor and employee attitudes and legislation will take work.  Post-retirement management is even trickier.  How long to work?  Access to healthcare benefits may be the deciding factor.  How to manage and hedge longevity risks?  Appropriately-priced annuities are the clear choice, but few select them.  The bottom line from this brief discussion is that it’s tough enough to describe all the issues facing the crafting of the ideal suite of saving vehicles, but it’s much tougher to implement solutions.

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Turkey
Urban Recovery, Rural Poverty
Feb 17, 2006

Serhan Cevik (London)





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Czech Republic
Coping with a stronger CZK
Feb 17, 2006

Oliver Weeks (London)

The recent rapid appreciation of the CZK, around 2.5% against the EUR in the past six weeks, has attracted growing verbal intervention from the National Bank governor and board members.   We disagree that the appreciation amounts to a bubble, though recent balance of payments data suggest the pace of appreciation may now slow.  We do not expect direct FX intervention in the market, and do expect a rate cut from the CNB, though we think the Bank’s concerns over the impact of appreciation on overall growth may be exaggerated.  Domestic and external fundamentals look very different to us from those in 2002, when FX appreciation slowed the economy sharply.  PM Paroubek’s forecast of a 25.0 EUR conversion level, while probably infuriating for the CNB, also hints at the lack of political concern this time round.  Given the likely weakness of political support for rapid euro entry after the elections, we think his estimate may prove quite accurate, perpetuating the challenge for the CNB and the prospect of sustained low rates. 

Impact of investment and restructuring still emerging.   The outlook for labour productivity growth, particularly in the tradeable sector, remains extremely bright, we think.  Net inward foreign direct investment (FDI) since 1998 has amounted to 59% of GDP (against 35% in Hungary, 28% in Poland, and 47% in Slovakia) reflecting the combination of delayed reforms in the early 1990s with an attractive labour force and western location.  In the industrial sector foreign controlled enterprises now account for 52% of sales, and export 71% of their output.  Overall labour productivity in manufacturing was already up 7.7% in 2005, with unit labour costs in industry down 4.2%, aided by immigration.  Output of transport equipment was up 26.1% in real terms, more than compensating for declines in mining and textiles.  The investment cycle in the car sector suggests that these gains can accelerate.  Skoda Auto plans to raise its output from 480,000 cars in 2005 to 600,000 in 2006.  The new TPCA plant plans an acceleration from 100,000 units in 2005 to 300,000 in 2006, with further rises in capacity likely.  Hyundai’s expected EUR 1 billion investment is due to add a further 300,000 units by mid-2008.  In gross terms, we expect car exports alone to rise 50% in 2006, worth nearly 5% of GDP.  The import content of this output is also likely to continue to shrink as the growing critical mass of producers draws suppliers to relocate.  Terms of trade continue to deteriorate, and new FDI may boost imports later this year.  Nevertheless, with overall unit labour costs likely to continue to fall, we still expect the goods trade surplus to more than double in 2006.  

Current account gap to narrow further, but watch short-term funding.   The impact on the wider current account deficit will be partly counter-balanced by profit repatriation — net income outflows were 5.2% of GDP in 2005 on preliminary CNB data.  However investment is also beginning to feed gains in the surplus on services (1.9% of GDP), which may also be boosted by incipient EU service sector liberalization.  Free movement of labour is also boosting the surplus on transfers (2.4% of GDP).  We continue to expect a current account deficit around 0.5% of GDP this year.  On the funding side 52% of the income outflow is effectively repatriated in FDI, with total net FDI at 8.1% of GDP in 2005.  Without the Cesky Telecom flow (2.8% of GDP converted by the CNB) we expect the total to slow to around 4.4% of GDP this year.  The only potential concern on the funding side is in the portfolio and other investment sectors.  Portfolio investment saw a 2.4% of GDP outflow in 2005, led by equities.  We expect net bond inflows to pick up, and recent CZK strength to reduce the attractions of diversification for local investors.  However, equity valuations look vulnerable in the view of our strategists, suggesting outflows may continue.  The ‘other investment’ category of the financial account turned negative on an annual basis in the final quarter of 2005, driven by large outflows of short term assets from local banks.  Again, we expect the strength of trade flows to limit the appetite of foreigners to borrow CZK but this item and June’s elections may at least restrain the pace of appreciation.  We keep our end-2006 EUR/CZK forecast at 27.75. 

Fiscal and political risks mild for now.   Other constraints on monetary easing look limited, in interesting contrast to neighbouring Slovakia.  Real household consumption growth was only 2.6% year on year in the first three quarters of 2005.  Real retail sales growth was only 2.9%Y in Q4, with disposable income in 2006 likely to be further restrained by rising energy bills and indirect tax rises.  Household consumption lending is accelerating, with growth reaching 38%Y in December, but the bulk of borrowing growth remains in mortgages.  The CNB continues to highlight demand risks from looser fiscal policy — understandably given the generous social security spending proposals currently going through parliament.  However while the longer term risks from lack of spending reform and an aging population are real, in the short term it is hard to see the fiscal deficit causing problems for monetary policy, with the 2005 ESA deficit likely to have been below 2.5% of GDP, revenue growth strong, and limited capacity for rapid spending disbursement.  We expect the 2006 fiscal deficit to remain below 3.0% of GDP.  Politics may begin to impinge on the market slightly as the risk of more overt Communist involvement in the next government gains attention as June elections approach.  The new labour code, raising trade union power, already reflects a leftward drift.  However we expect the clearest implication of the new government to be more overt Euroscepticism, whether through the Communists or through ODS (see Central Europe: Further from the Euro, September 7, 2005) — ultimately implying more time for appreciation as EU capital transfers eventually begin to rise. 

Little risk from easing.   The Bank’s own forecasts already have ‘monetary policy inflation’ — excluding the first round impact of indirect taxes - below the 3.0% target on the 18 month working horizon for monetary policy.  Clearly risks are now further to the downside.  CPI excluding all administered prices was only 0.8%Y in January, far below headline CPI at 2.9%Y.  Although the CNB has raised its assumption of equilibrium real exchange rate appreciation this year, to 3.5%, after raising assumed risk premia the forecasts still assume nominal EURCZK stable around 29.1.  Even current exchange rates would suggest to us monetary policy inflation may be close to the bottom of the target range by mid-2007.  Interestingly, despite its currency forecast the Bank is relatively pessimistic on GDP growth, expecting only 3.9% this year.  Even with further appreciation we think 5.0% remains achievable this year.  Further rate cuts may not be necessary from an aggregate growth point of view, but the Bank’s forecasts imply a more cautious view, and pressure from less competitive sectors of the economy may be significant.  Although the Board is clearly divided we expect a rate cut this quarter.  With nominal rate ammunition limited, we think the Board would do well to save a further cut for a possibly less supportive external environment in 2007.

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Asia
Behind the Curve
Feb 17, 2006

Andy Xie (Hong Kong)

Much of Asia is behind the curve in fighting inflation.  The upward trend in inflation is apparent with the exception of China, which faces an overcapacity problem.  As the Fed keeps raising interest rates, Asian currencies could weaken, which would exacerbate the inflationary pressure.  The region’s central banks need to keep a tightening bias, I believe.

The region’s governments are too pro growth and are not vigilant enough against inflation or asset bubbles.  As the Fed continues its rate hiking campaign, the risk is rising that the region could face another macroeconomic crisis.

Asia may also be bifurcating into high and low inflation economies.  India, Indonesia, Philippines, and Thailand have high inflation and behave like traditional inflation-prone emerging economies.  They should be especially vigilant against the potential scenario of weak currency and acceleration inflation.

India faces the greatest macro risk in 2006.  It is exhibiting all the symptoms of an overheating emerging economy: widening current account deficit, overheating property market, and accelerating inflation.  It should tighten as soon as possible, I believe.

The low-inflation economies should watch for asset inflation in determining their monetary policy.  China and Korea stand out in that regard.  Korea faces an emerging price bubble in its asset markets.  The Bank of Korea is pursuing the right policy to normalize its monetary condition-policy rate at 4.5–5% vs. 4% now.

Reluctant to Tighten

Asian economies are behind the curve in their monetary policy, I believe.  The region’s monetary authorities have been reluctant to tighten despite rising inflation rate.  The reluctance stems from the growth starvation after the Asian financial crisis.  This psychological bias against tightening could get the region into macroeconomic trouble again.

Korea and Singapore stand out in their appropriate policy adjustments.  Others have increased interest rates reluctantly and sparingly, which has condoned overheating in quantity or goods and/or asset price.

More excesses today will exact more adjustment costs tomorrow.  As the Fed continues its tightening campaign, the day of reckoning is within sight.  I believe that Asian governments can no longer afford to ignore the overheating excesses in their economies and should increase tightening.

Divers Overheating Excesses

In this cycle, the overheating excesses are different across the region.  In the boom one decade ago, all the economies showed similar symptoms: high inflation, property speculation, and widening current account deficits.  The symptoms are different this time, which has caused some confusion among policymakers and contributed to the reluctance to tighten.

INDIA faces the greatest macro risk in 2006 and should tighten aggressively to contain the risk.  It is experiencing typical overheating symptoms of an emerging market boom: widening current account deficit, high and accelerating inflation rate, and rampant stock and property market speculation.  India’s macro environment is quite similar to Latin America in 1980s and Southeast Asia in 1990s.

India’s trade balance deteriorated to 5.3% of GDP in deficit in 2005 from 2.3% in deficit in 2004, while the current account deteriorated to -0.8% of GDP in deficit from 2.3% in surplus during the same period.   If India does not address overheating, its current account deficit could deteriorate to 3% and trade deficit to 8% of GDP in 2006.

India’s large fiscal deficit is quite inflationary.   It crowds out the private sector investment that could contain inflation by increasing supply capacity.  Despite the massive economic boom, the fiscal deficit was 8.3% of GDP in 2005, barely down from 8.4% in 2004.

India’s interbank rate has risen by the same amount as inflation since the beginning of 2005.   It suggests that the central bank is not tightening at all; i.e., there is no restraint on inflation accelerating.  Global enthusiasm towards India’s stock market has helped keep Indian rupee stable.  However, as the Fed keeps tightening, sentiment could change and the currency could become an inflation accelerator.

CHINA faces a different situation from India’s.  Its high savings rate and export success have led to a capex bubble.  The resulting overcapacity is increasing deflationary pressure.  China is primarily experiencing a quantity bubble.  In property, it also experiences quantity-cum-price bubbles in some major cities.

It is too late for China to raise interest rates.  Instead, the overcapacity could cause prices to decline and real interest rate to rise, which would decrease investment.  Indeed, China may have to cut interest rates to cushion the downturn.

HONG KONG’s monetary condition is tightening involuntarily due to its currency peg to the dollar.   Its economy is not as strong as the US’s but is subject to the same conditions.  The speculation in Rmb revaluation has boosted Hong Kong’s liquidity, which has allowed Hong Kong to keep interest rates 93 bps lower for overnight and 69 bps lower for 3M interbank rate than the dollar interest rate.

This gift has considerably cushioned Hong Kong’s property market from the impact of the Fed’s tightening cycle.  It also leaves Hong Kong exceptionally vulnerable.  The Fed may tighten another 50 bps before June 06.  If the Rmb revaluation story loses steam, Hong Kong’s interest rate could rise by over 100 bps soon.

Taiwan’s growth potential has declined due to a lack of investment by its corporate sector.   The outflow of population to the Mainland contains inflationary pressure.  Taiwan can afford to keep interest rates low despite further rate hikes ahead.  NT dollar will remain one of the weakest currencies in the region.

INDONESIA’s inflation rate is too high for economic stability.   No economy can develop soundly with double-digit inflation.  High inflation decreases investor confidence that decreases capacity formation, which exacerbates inflation problem.  The currency strength, thanks to hedge fund demand, is keeping inflation spiraling up further.  Indonesia cannot rely on hedge funds to manage its monetary condition.  Raising interest rates could depress the economy severely, which may trigger further confidence crisis.  Indonesia requires comprehensive reforms to restore investor confidence.

While MALAYSIA’s inflation level is still low, the trend is worrying.  As Malaysia’s investment has been relatively weak, it does not have the spare capacity to contain inflationary pressure.  Its current account surplus is certainly sufficient to keep currency strong, which helps contain inflationary pressure.  But, vigilance is required to contain inflationary expectations.  Malaysia needs to raise interest rates also.

THAILAND should watch out for the scenario of weak currency and rising inflation.  The stability of the Thai Baht, due to investor enthusiasm towards emerging markets, has kept inflation from spiraling out of control.  But, as in the case of India, the Fed’s continuing tightening increases such risk.  Unlike its neighbors, Thailand does not have a big current account surplus to cushion the interest rate effect on its currency.  The Thai monetary authority should view management of such risk as central to its policy and should take the appropriate decision to increase interest rates.

THE PHILIPPINES has benefited from currency appreciation, as the currency market rewards it for current account surplus.  The weakness is that, despite the currency strength, it still has a high inflation rate.  If the Fed keeps raising interest rates, the peso could weaken and inflation could accelerate.  The Philippines should raise interest rates also, I believe.

SINGAPORE is another economy, in addition to Taiwan, that does not need to raise interest rates.  Because of its extraordinary current account surplus, it does not need to worry about currency weakness either.

Managing Macro Instability Risk

Asia has experienced another boom due to: (1) the low US interest rate; (2) surging US import demand; and (3) market share gain for China due to factory relocation.  The US monetary cycle is moving from super accommodative to mildly restrictive.  The transition is full of risks for Asia that has become used to the environment of loose dollar supply.  I believe that Asian monetary authorities should be cautious in tolerating excessive liquidity.

However, political incentive is to maximize growth.  After the Asian crisis, the region suffered a period of low growth and fiscal deficits.  The region’s governments really want to grow out of their problems.  This is why there is extreme reluctance to tighten.  But, the Fed tightening cycle is always dangerous for the region.  The risk from keeping liquidity loose is rising rapidly.  There is a strong case for tightening in Asia.

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India
Annual Budget Hopes
Feb 17, 2006

Chetan Ahya (Mumbai) and Mihir Sheth, CFA (Mumbai)

Is the importance of annual budget declining? Since India initiated the liberalization program in 1991, the central government’s annual budget has been the anchor policy instrument for shaping the reform process.  Over the last few years, however, the importance of the budget has been diminishing.  First, a large part of the major the tax rate changes (key function of the budgets in the 1990s) has been accomplished; second, the coalition dynamics make it difficult for the finance ministers to announce path-breaking reforms in the budget before arriving at a consensus with the coalition partners.

What are we looking for?    On mix, typical budget measures can be classified into two broad areas: fiscal management and policy reform.  For a structural correction in the fiscal deficit, the government needs to initiate major expenditure reforms.  On policy reform, three key areas that need direction in the budget are privatization, foreign direct investment and infrastructure.

What are the Likely Measures?   On mix, we have limited hopes for the introduction of public expenditure reform in the coalition environment.  On policy reform, we see little likelihood of any major push for privatization and foreign direct investment.  However, we believe that infrastructure and social development expenditure, such as on education and health, should get a further moderate push in the budget.

Union Budget: Declining Importance?

Since India initiated the liberalization program in 1991, the Central Government’s annual budget has been the anchor policy instrument for shaping the reform process.  Over the last few years, however, the importance of budget has been diminishing.  First, a large part of the major tax rate changes (key function of budgets in the early 1990s) have been accomplished; second, coalition dynamics make it difficult for the finance ministers to announce path-breaking reforms in the budget before arriving at a consensus with the coalition partners.  More and more, the credibility of the budget statement for anything other than tax rate changes is declining.  Often, major policy reforms announced in the budget are held back at the implementation stage.  For instance, the Finance Minister announced an increase in the foreign direct investment (FDI) limit to 74% from 49% for the telecom sector and to 49% from 26% for the insurance sector in the July 2004 budget statement.  The increase in telecom sector FDI became effective only in November 2005 (15 months after the announcement) and some uncertainties remain on the guidelines related to this move.  The increase in the FDI limit for insurance is not yet effective.

What Can the Budget Really Do?

From a macro perspective, typical budget measures can be classified into two broad areas – fiscal management and policy reform.

Fiscal Management

Tax Revenue Mobilization and Structure:   The central government has been accounting for about two-thirds of the total revenues raised by the central and state governments combined.   Hence, its annual budget has always been a major influence on overall public resource mobilization.   However, the government’s ability to increase tax collections by hiking tax rates is limited by its decision to open up the economy for global competition.   We expect some minor measures to improve compliance and the withdrawal of exemptions for improving the tax to GDP ratio.

On the tax structure, we believe the budget is unlikely to make any significant changes related to direct taxes.  Most of the changes are likely to be the introduction of a value-added tax (VAT) and the usual minor rate changes to streamline anomalies.  We expect the government to move a further step forward on the plan for a transition to a common goods and services VAT (GST) from the current multiple rate and multiple level taxes.  Last year, the government initiated the first step in this direction, whereby 25 out of 32 states/union territories moved to a state level taxes (SVAT) system.   This year, we expect the central government to get the balance states to join SVAT.   It may also announce a timeline for the transition to a common goods tax system, whereby taxes levied by the central government and state governments (SVAT) will be merged into a common countrywide goods tax regime (Exhibit 6).

In addition, the government could continue with minor tinkering to streamline tax rates.  Also, excise duty rates may be reduced in some individual sectors.  For instance, we believe that excise duty on cars, polyester and pharmaceuticals could be lowered (Exhibit 9).

Expenditure Control and Management:    This remains the most disappointing issue in fiscal management.  On the face of it, there appears to be an improvement in fiscal management by the central government.  The government has managed to cut its fiscal deficit to an estimated 4.3% in F2006 from the peak of 6.2% in F2002.  However, a large part of the reduction is due to a higher ratio of tax to GDP.  The rest of the decline is explained largely by a decrease in interest cost, largely due to a fall in interest rates (not a lower debt burden).  We believe the improvement in tax to GDP is largely cyclical, reflecting a leveraged, consumption-driven growth cycle (Exhibit 4).  For a structural reduction in the deficit, we believe that the government will have to initiate expenditure reforms.  A report on the implementation of the Fiscal Responsibility and Budget Management Act (FRBM) by a government-appointed task force led by Dr. V. Kelkar recommends a broad strategy for expenditure reforms (Exhibit 8).  The expenditure reforms strategy should focus on improving the mix towards development expenditure, which has been declining over the last few years (Exhibit 5).

Although, implementing major expenditure reforms will be politically difficult, the government should at least ensure that the expenditure trend does not deteriorate.   Our concern stems from the recent press statement by the Prime Minister that the government intends to appoint a sixth pay commission (an administrative mechanism that decides the salary levels for government employees).   The concern stems from the experience of the huge pay hike and rise in the government’s wage bill after implementation of the fifth pay commission’s recommendations.   We also remain concerned on the way in which the government is affecting public finances by deferring the domestic oil product prices even as the international prices remain high.

(2) Policy reform measures

We see three key areas that need a major policy reform push from the government:

Privatization: Since India first initiated the privatization of public sector units in 1991-92, the process has been very slow.  The total amount collected through privatization is just US$12.8 billion over 15 years – US$850 million per annum – and an annual average of just 0.2% of GDP.  Privatization remains a highly debated and politicized topic, although the previous government appeared to be moving in the right direction.  The key argument presented by politicians against privatization is that it results in job losses, adding to social pressure.   In our view, however, the right application of the funds raised from privatization could actually help create more jobs and alleviate the social pressure.  As per our approximate estimates, we believe that the government’s listed and unlisted companies are valued at about US$225 billion.  Our estimate excludes central government assets in the form of infrastructure facilities (such as Indian Railways) and other operations, which are not yet corporatized.  

Foreign Direct Investments: Although, India’s rank has improved significantly amongst global surveys on FDI destinations, its share in global FDI flows remains low at an estimated 0.7% in 2005.   India ranks 21st in the world in the size of FDI inflows.   There is clearly a need for a major policy push to increase direct investment limits but, more important, to improve the general business environment for attracting foreign investments.  The trail of progress for some of the large FDI proposals conveys the inability of the government to translate this opportunity into a quick rise in investments.  For instance, POSCO first announced its intention to invest in India in July 2004, and from the way the project is progressing, it appears that no significant amount is likely to be invested before the second half of 2007 (Exhibit 7).  It seems unlikely there will be any major FDI-related announcement in the budget this year.

Infrastructure and social development expenditure: Infrastructure and social development continued to be among the most important issues gaining the attention of policymakers over the past two years.  There seems to be a consensus among policymakers that the issue of infrastructure needs immediate attention.  After several years of hiatus, there is a pickup in this expenditure – albeit at a gradual pace.  We believe there is an urgent need to have a more concerted and coherent plan to accelerate infrastructure and other social welfare expenditures, which may have to be accompanied by a resource augmentation plan like aggressive privatization.  We expect the government to continue with its efforts to make a moderate push for infrastructure and social development investment, particularly for education and health.

Bottom-line

We believe the annual budget statement may bring small changes related to individual sectors but is unlikely to produce any major macro surprises.  Under the coalition environment, we have limited hopes for any government effort on a structural correction in the fiscal deficit by the introduction of expenditure reforms.   On policy reform, we have no major expectation on privatization and FDI.   However, we believe that infrastructure and social development expenditure, such as on education and health, should continue to get a moderate push.

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Japan
The Two Threats to Sustainable Growth
Feb 17, 2006

Robert Alan Feldman (Tokyo)

What’s New:   Scandals, guerilla tactics threaten reform

Investors are concerned about sustainability of economic reforms. Recent scandals in the corporate sector and bureaucratic guerilla tactics are threatening the reform agenda.

Conclusion: Reform will survive and thrive

The reform agenda will survive the current threats. The September 11 election showed that the public wants reform. Politicians will do what the people want. Strong political leadership will punish bureaucratic guerilla tactics.

Market Implications:   Equity market still solid

Equity market weakness due to policy uncertainty likely will wane. As the reform agenda regains thrust, corporate earnings growth will be more secure. The key test will be public reaction to the stances that contenders to replace PM Koizumi take on the reform agenda.

Risks:   New revelations, ticking clock

The major risk to my view is new scandal revelations, which could distract policymakers and derail legislation.

Two sources of threat to economic reform agenda are emerging, scandals in the corporate sector and bureaucratic guerilla tactics against reform. Investors are naturally worried whether these to threats will gather strength, and derail the expectation that Japan will break into a world of historically higher return on equity.

Scandals, Equality, and Reform

Recent scandals in the corporate sector have become highly politicized. Rather than focusing on the reasons for the scandals (e.g. inadequate oversight, too-slow rule making, understaffed enforcement agencies), the debate has been politicized. The anti-reform elements in the Liberal Democratic Party (LDP) are using the scandals as a tool to bash reform. The opposition Democratic Party of Japan (DPJ) is using the scandals to attack the government.

The anti-reform elements in the LDP have many wounds to lick. Their ranks have been thinned sharply by retirements -- in part forced by PM Koizumi -- and in part by outright election losses. Their expenditure-based model of political pork-barrel remains under threat by on-going budget cuts. After the stinging losses in the September 11, 2005 election, they are naturally looking for some way to reassert their power. Since the protagonist in the corporate scandal ran (and lost) against Shizuka Kamei, the poster-boy of the anti-reform movement in the last election, the anti-reformers see an opportunity reassert power.

Similarly, the DPJ has been floundering since the last election. Its new leader, Seiji Maehara, has had difficulty uniting his party on issues. This problem runs very deep for the DPJ, because it is so ideologically diverse, running from a socialist/pacifist wing to a capitalist/rearmament wing. With little hope of strengthening and uniting his own party for the July 2007 Upper House race, Mr. Maehara has taken the corporate scandal as an opportunity to weaken his opponent, the LDP.

Both the LDP anti-reformers and the DPJ have made much of the assertion that income differentials are widening. There are two parts to the debate, economic and political. The economic part breaks the rise of income inequality into several components. According to government and think-tank calculations, the lion’s share of the rise of income inequality is due to aging. Since incomes fall sharply on retirement, inequality naturally rises. Moreover, a society moving toward wages based on effort rather than membership in a company would naturally see some increase of income differentials.

The political part of the debate concerns how the public reacts to differentials. Quite contrary to the impression taken from newspapers, a recent survey of Japanese public opinion showed about 60% of respondents favoring a society based on competition, and only about 15% favoring a society based on equality. The public cannot logically side with PM Koizumi favoring a society that rewards effort and then complain when income differentials rise.

In light of these results, in appears unlikely that the appeal to inequality by both the anti-reformers and the DPJ will succeed politically. Thus, while the corporate scandals are clearly a negative factor for PM Koizumi and the reform camp, the ability of others to capitalize on the scandals remains limited.

Bureaucratic Guerillas

A larger threat to the reform agenda is bureaucratic guerilla tactics. Indeed, based on recent discussions in government task forces suggest that the old-line bureaucrats see an opportunity to reassert control. The combination of the looming end to the Koizumi Government in September and the corporate scandals has meant that foot-dragging is now a more promising strategy for old-liners. For example, the tone of recent government working groups on fiscal policy has turned nasty. At one recent meeting, a professor blasted the bureaucratic presentation on social welfare spending, and demanded that the Cabinet Office take charge of integrating the contributions of different ministries. The Cabinet Office official replied that he could not do so, because the ministries would not release information needed for detailed forecasts. Refusal to disclose information is a typical foot-dragging technique. Pleading lack of information is another typical technique. (Fortunately, the committee chairman in this case directed the official to do as the professor said.)

Bureaucratic guerillas are only a problem when top-down discipline is loose. In there early part of the Koizumi government, there was a significant discipline problem, because the bureaucracy thought that the government would not last long. However, once PM Koizumi demonstrated leadership by making decisive personnel changes, discipline improved. Now, with the Koizumi government scheduled to end in September, the problem is beginning to return.

The weakening of discipline will not last long, in my view. The leadership of reform committees in both the government and in the ruling party is stronger than before, and is willing to tell bureaucrats what to do. Moreover, the current corporate scandal problems are likely to subside, and allow leadership to refocus on reforms. Most important, as word spreads that bureaucrats are foot-dragging, the public reaction is likely to be intensely negative.

Market Milestones

Although economic and political fundamentals suggest that the threat to reform will subside, it will nevertheless take a few weeks at least for the storms to pass. In the meantime, investors will be looking for clues on which way the battle is turning.

The key factor is likely to be the public reaction to stances on reform taken by the contenders to succeed PM Koizumi. If the public approves of pro-reform stances by the contenders, then the risk of reversal of reforms will fall. If not, then risks will rise. At the moment, with Chief Cabinet Secretary Shinzo Abe in the lead, his reactions will be particularly important. In addition, it will be important to watch the support rate for the DPJ. While some rise of DPJ support is likely in light of recent scandals, a sustained rise might spell trouble for reform sustainability. In addition, decisive personnel decisions -- such as dismissal of bureaucrats to resist orders from the Cabinet -- would also raise confidence in the sustainability of reform.

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Japan
GDP (Oct-Dec)
Feb 17, 2006

Takehiro Sato (Tokyo)

[Key Points]

What’s changed:

The headline was below our bullish estimate but beat the consensus view, with impressive positive contributions from all demand items save for public investment.

Conclusions:

The Japanese economy is on a sustainable growth trajectory near a 3% real expansion pace led by domestic private demand. Our existing forecast works out to a +3.5% real GDP growth rate for F05 (C05: +2.8%) with no changes in the projected Jan-Mar growth rate from our Dec 13 economic forecast. The F06 (C06) estimate is +3.1% (+3.4%). We will release a revised economic outlook early next week.

Policy/market implications:

We expect temporary soft spots for stock and bond markets in Apr-Jun due to unexpectedly strong rate volatility from the reversal of QE. However, we maintain our favorable bias over the medium term that views dips as excellent buying opportunities.

Risks:

The main risk is the weaker GDP deflator caused by a modest dip in the domestic demand deflator primarily from a wider decline rate for the personal consumption deflator and a sharp rise in the imports deflator. Deflator improvement has been moderate relative to upbeat economic performance.

[Detail]

Ideal pattern with all demand items positive except for public investment

The headline number was +1.4% QoQ (+5.5% annualized), missing our bullish estimate but beating the consensus. The substance of the report was also impressive with positive contributions from all demand items except for public investment. We conclude that the Japanese economy is on a sustainable growth trajectory near a 3% real expansion pace led by private-sector, domestic demand and reiterate our scenario for an end to the nominal-real reversal with 3% growth in F2006.

Component breakdown

(1) Personal consumption (+0.8% QoQ; annualized +3.2%): Personal consumption grew sharply over Jul-Sept.  With employee income turning up, and consumer sentiment getting better, personal consumption appears to have been strong, particularly for the high-ticket discretionary items. Strong sales of winter goods thanks to the cold spell from December have also helped.  Although heavy winter snowfall and a reactionary fallback from Oct-Dec leave some concerns for Jan-Mar, Tokyo metropolitan area department store sales registered a third straight month of year-over-year growth as low temperatures made for lively winter wear sales at their new year and clearance sales.  Therefore, we think a precipitous decline in Jan-Mar personal consumption is unlikely. 

(2) Residential investment (+1.9% QoQ; annualized: +7.6%): With greater confidence in employment and rising prospects for higher interest rates, supply-side factors such as the sales competition for mortgages by banks, and some months are now seeing new housing starts approaching 1.3 million units.  Despite a lull in housing starts growth after major snowstorms and a rash of cases involving fraudulent condominium quake-proofing data, since GDP-based residential investment is recorded on a progressive basis, we think housing investment is likely to remain firm in Jan-Mar. 

(3) Fixed capital investment (+1.7% QoQ; annualized: +7.2%): We had been looking for capex to gain momentum in Oct-Dec, in response to many capex plans in Jul-Sept being pushed out to the 2H.  The Cabinet Office’s Jan-Mar machinery orders outlook (+6.5% QoQ, for orders from all sectors) signals a possible rise in orders from the replacement/upgrading demand for electrical power firms.  In Jan-Mar, we look for pent-up demand to emerge, swinging capex momentum upward.  New forms of demand are also materializing, such as labor-saving investment to respond to the expected labor shortage, as well as in energy resources-related investment and improved production infrastructure.

(4) Inventory investment (+0.0ppt QoQ; annualized: +0.1ppt): Inventory investment made a flat QoQ contribution in Oct-Dec, following the mini inventory correction in Jul-Sept.  Going forward, with deflationary expectations changing, we look for companies to shift gears from holding down inventories to inventory growth, and think that GDP growth rates will likely be lifted by inventory accumulation.

(5) Public investment (-1.7% QoQ; annualized: -6.6%): Public investment was the only demand item that declined amid continued budget cutbacks. Media reports suggest that the government will be cutting back further, including a target for the reduction of public spending linked to a percentage of GDP.

(6) Net exports (+0.6ppt QoQ; annualized: +2.4ppt): Real exports were +3.1% (contribution: +0.4ppt) and real imports were -1.3% (+0.2ppt).  Demand is holding firm in the U.S. and China, the latter leading to record-setting performance for Japanese exports to China, and pushing overall exports skyward.  Given the retracement in imports from the buoyant Jul-Sept as well, both exports and imports in Oct-Dec posted positive contributions.  We expect stable global demand ahead to keep exports strong.  However, with the rebound in imports in Jan-Mar, as well as robust domestic demand, we expect imports to remain firm.  As a result, external demand is likely to make only a marginal contribution to overall growth ahead.

(7) GDP deflator (-0.5% QoQ; annualized: -1.9ppt; -1.6% YoY): The surge in oil prices and weak yen caused the import deflator to surge +5.7% QoQ (+24.6% annualized, +13.3% YoY).  Going forward, we think softening crude oil prices will likely hold down the import deflator, and boost the GDP deflator.  We still anticipate that the GDP deflator will return to a positive level in F2006 for the first time since F1997 with the improvement in the domestic demand deflator. Housing and public investment deflators turned positive have remained at positive rates QoQ for three straight quarters, and the capex deflator is stopped declining. However, the overall domestic demand deflator actually fell to -0.6% in Oct-Dec due to a wider decline rate for the personal consumption deflator.

3% growth not dream, but a reality

If we assume that the growth rate for Jan-Mar and on will be as it was when we prepared our previous forecast (December 13, 2005), the real GDP growth rate for F2005 would be +3.5% (C2005: +2.8%).   We now also look for another take-off point in F2006, with a second consecutive year of 3% growth, at +3.1% (C2006: +3.4%).  More specifically, we look for an unspectacular but steady 2% personal consumption growth for the three straight years since F2004, along with capex as a major driver of GDP growth. 

We note that capex plans in the December Tankan (including software, but excluding land) rose 11.3% YoY for all industries, including financials.   In the upcoming March Tankan, we look for capex plans to lowered to the +10% range, chiefly for large enterprises.  Nevertheless, assuming that the capex deflator falls to around an annualized -1%, we think real capex growth here will stand at near +11%. 

We intend to publish our revised economic outlook early next week.

Policy implications

With the economy performing as robustly as noted above, we look for the core CPI inflation rate to expand further into positive territory, leaving timing as the only problem for the ending of quantitative easing (QE).   We continue to expect this to come near the April 28 BoJ Outlook Report.  However, a little surprise move came on February 15 when a freeze was announced on personnel changes related to the BoJ’s next Director-General of the Monetary Affairs Department until early April, with an eye toward ending QE .  We thus think the target date for ending QE could be moved up to April 11. 

The main issue is the timing of a rate hike, however. We think the Bank will have trouble justifying this since improved productivity is likely to restrict the core CPI rate from the second half of 2006. In other words, the fixed-income market is currently over-discounting for a rate hike.

Another key point for policy outlook is whether the F2006 nominal growth rate meets the government’s +2% target. If the target is met, the government will no longer have a justification for criticizing the Bank and a rate hike might even highlight the economy’s success in pulling out of deflation. We hence maintain our outlook for a rate hike in Apr-Jun 2007 once the F2006 nominal growth rate is officially confirmed.

Market implications

We believe that the stock market is in the process of shoring up the bottom after already reaching our projected level of 1,700 points (TOPIX; ¥16,500 for the Nikkei 225 Average) based on investor euphoria in response to the “end of deflation” theme (namely, we take a neutral view from achievement of the target level). Although the market might temporarily soften in Apr-Jun on increased volatility for interest rates (explained below), we retain our favorable bias, and think that dips during Apr-Jun should offer excellent buying opportunities, given our bullish corporate earning outlook.

We expect the bond market to follow the BoJ's lead in the near term since the core CPI rate's positive margin is likely to widen in Jan-Mar. We also anticipate considerable volatility from the unsecured O/N call rate after the removal of the QE for a number of technical reasons, fueling speculation about an early rate hike. However, our prices outlook indicates that the core CPI rate might turn negative again in the worst case just a few months after ending the QE. This will inevitably ratchet up political pressure for further easing and might force the Bank to set an inflation target for its own defense. While the market is currently discounting for a 25bps rate hike by the end of 2006, these expectations might change significantly depending on prices, the basic economic fundamentals.

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UK
Monetary policy outlook - no change in sight
Feb 17, 2006

David Miles (London) and Melanie Baker (London) and Vladimir Pilonca (London)

The Bank of England’s quarterly Inflation Report is the clearest statement of the collective judgment of the Monetary Policy Committee (MPC) on the outlook for the economy and for monetary policy. The message from the February report - published earlier this week - was very clear: at unchanged interest rates the Bank’s best guess is that inflation stays right on target. Risks of inflation being above or below the target - again at unchanged rates - are evenly balanced. It would seem to follow naturally that if the monetary policy committee behaved in a risk neutral way, so that it was content to adopt a stance that on average meant the target for inflation was hit, then our best guess should be for no change in rates. Yet the weight of market opinion is still that rates are more likely to be cut than held at 4.5%. To our mind this has led to yields on short dated gilts all being driven down to levels that are hard to reconcile with the message in the Inflation Report.

The Bank of England’s February Inflation Report and press conference was consistent with our view that further rate cuts in coming months are not the most likely path for monetary policy.  Our central expectation is that interest rates remain at 4.50% through most of 2006 (and we tentatively anticipate a rate rise in Q4 2006).

If the economy moves in line with the MPC (Monetary Policy Committee) central projection (of course the chances of this happening exactly are very small), then there would be no need to cut rates again: inflation would be very close to the target rate of 2% for the whole of the next three years.

In this latest report the MPC revised both their central inflation and growth forecasts.   The central inflation projection (based on ‘market expectations’ for broadly unchanged interest rates) shows inflation close to the 2% target for the whole of the forecast horizon.  The Bank’s central profile is now flatter than in November’s report which showed inflation dipping below the target and then rising two years out. 

They describe risks to their inflation profile as substantial, but balanced.  The Bank continue to ascribe a large degree of uncertainty to their central projection.  On GDP growth they now see the balance of risks to their central projection as a little to the downside.

Our central forecasts are not very different from the Bank’s.  With GDP growth likely close to potential growth this year and with unit wage inflation above the 2.0% CPI target rate, however, our central case remains that a rate rise will look likely by the end of the year.

The Bank’s new inflation forecast is much flatter than the one in the November Report.  This is not a profile which suggests that the Bank are feeling complacent on risks to inflation, rather that the path remains quite uncertain but that the risks are evenly balanced.  The Bank see the main risks as being the outlook for growth, the margin of spare capacity (energy prices may have shrunk potential supply) and the evolution and effect of energy prices.  On the latter, the Bank point out that while there is a direct impact on inflation from higher energy prices, the indirect impact can be positive or negative.  Pricing pressures can build along the supply chain as input prices rise or companies may squeeze other parts of their cost base, e.g. wages.

The Bank’s central projections for inflation assuming unchanged rates look somewhat similar to our own, though our central profile is a little more volatile.  On growth, the Bank remain, if anything, a little more optimistic than us, though our estimate of potential growth is likely to be a little lower.  Nevertheless, if the economy evolves in line with either set of central forecasts, a rate cut does not seem the most likely outcome.

Many commentators continue to stress that what might appear to be weak consumer spending figures suggest a rate cut in the UK is imminent. This view is at odds with our own interpretation of the latest data and also with what the Bank now says. The Inflation Report notes: “Retail sales indicators suggest that consumer spending growth was firm in Q4”, though this is based on partial information.  At the Press Conference for the publication of the Inflation report Governor King gave very measured responses to questions on the outlook for consumer spending, again stressing that retail sales only account for about a third or so of household consumption.  He described how consumer spending growth had remained below its average growth rate in the past year having previously grown at an unsustainably high pace.  He attributed the slowdown in spending to a rise in taxes relative to disposable income and a relative rise in the prices of “boring” items (such as utility bills and petrol) relative to more “fun” items (the items more related to much high street spending).  After accounting for the “boring” items, “discretionary” income growth was negative in the second half of last year.  This is similar to what we found using our own measure of discretionary income (see for example “UK Consumer: Bills, Bills, Bills…” 13 June 2005).  Our own analysis also suggests that this measure has since shown positive growth.  The Bank’s central profile has consumer spending growth edging up “towards its historical average” this is in line with our own projections of a marginal increase in consumer spending growth in 2006 and 2007.

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Singapore
Trade Momentum Eased in January
Feb 17, 2006

Deyi Tan (Singapore) and Denise Yam, CFA (Hong Kong)

Trade momentum eased in January: Trade momentum eased slightly in January.  Exports rose 18.2%YoY in January (vs +22.6%YoY in Dec).  Imports also eased to 10.0%YoY (vs +21.4%YoY) on the back of slow oil imports (+2.8%YoY). Meanwhile, trade balance stood at S$5.1mn (vs S$6.3mn in Dec).

Ignore monthly variations; trajectory should broadly be rising in 1H06: Non-oil domestic exports rose 17.5%YoY (vs +31.6%YoY in Dec).  This is a sequential decline of 8.1%MoM.  Momentum in non-electronics (+25.4%YoY) continued to outstrip that in electronics (+9.5%).  In particular, pharmaceutical exports rose 107.1%YoY (vs +386.9%YoY in Dec), although petrochemicals contracted (-6.7%YoY). Meanwhile, electronics NODX fell back to single-digit territory at 9.5%YoY.  Disk drives appear to be losing competitiveness (-29.5%YoY).  Three of the five major products – i.e. integrated circuits (+12.8%YoY), PC parts (+17.9%YoY) and telecoms (+48.9%YoY) – sustained double-digit strength nonetheless.

US demand contracted, China demand sustained: NODX demand from the US contracted 11.6%YoY (-1.9ppt).  Meanwhile, demand from China also sustained its pace at 9.4%YoY (+1.1ppt and vs +9.6%YoY in December).  Strong markets in January were EU (+53.2%YoY and +9.6ppt), Taiwan (+43.4% and +1.7ppt) and Malaysia (+15.4% and 1.4ppt).

January trade numbers put economy on strong footing going in 2006: Regardless of the monthly variations, we think the January trade numbers still put the economy on a strong footing going into 2006.  The semiconductor industry looks set for stability in 2006.  We think the rising trajectory will continue in 1H06 with electronic acceleration, although monthly movements will be underpinned by volatility in pharmaceuticals exports.  We expect a declining trade surplus for the full year as imports are ramped up on the back of expected stronger investment and consumption.

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