Euroland
Deregulating Services Is Key for Jobs and Productivity
Feb 20, 2006

Eric Chaney (Paris and London) and Elga Bartsch (Paris and London)

Can Europe raise both productivity and employment?

The conventional answer is that there is a trade off: higher productivity is associated with restructuring and is supposed to rhyme with job cuts.  We believe that this view is mistaken and that, by deregulating domestic services, Europe could generate both jobs and productivity.  That is why the vote on the Services directive by the European Parliament (EP) on Thursday 16 February is important.  In a nutshell, we consider that the compromise brokered by German socialist MEP Evelyne Gebhardt and British conservative MEP Malcolm Harbour a step into the right direction, albeit a small one.  We also believe that national authorities, rather than Brussels, are accountable for delivering job freeing reforms.  If ruling politicians, which all swear their goal is to create jobs, really want to put their money where their mouths are, they should first endorse the Gebhardt-Harbour compromise without further restrictions.

The country of origin principle …

Ahead of the French referendum on the EU Constitution, French President Chirac, supported by the then German Chancellor Schroeder, used the original Directive designed to open up services to cross border competition, known as the Bolkestein Directive, as a scapegoat to stem rising euroskepticism amongst the population.   Unions also aimed their fire at the Directive, supposed to be a Trojan horse for wage-dumping and the erosion of workers’ protection.  In reality, the issue had almost nothing to do neither with wage competition between Polish and French workers, nor with social protection.  The Directive is only about a very small part of the services sector, namely services provided temporarily across borders. 

… good in principle, but with some flaws

Moreover, companies operating cross-border would have had to follow local labour as well as consumer protection laws, which are regulated by local law.  In fact,  consumers’ purchasing power in the host country would have been the main beneficiary of the original Services Directive, thanks to lower services prices.  The losers — there is no free lunch — would have been the providers of services in sectors artificially protected by ad hoc national regulations, such as the obligation to register to the local chamber of commerce to do business even for a couple of days.  The flaw of the country of origin principle was elsewhere:  business to business contracts should have followed the law of the country of origin.  In case of disagreement, the courts of the host country would have had to check and enforce laws of the other 24 countries of the Union.  While this is business as usual for large companies operating across borders in Europe, it would have probably turned into a business nightmare for the small businesses the Directive was suppose to help.  In this regard, the controversy about the Bolkestein Directive was probably a blessing in disguise.

A real but very limited deregulation

In contrast, the Gebhardt-Harbour compromise has dropped the country-of-origin principle and, instead, is banning local authorities from imposing unfair barriers, in accordance with the Rome Treaty (Articles 49 and 50).  In essence, the bill passed by the European Parliament aims at achieving the same goals as the country of origin principle without carrying its political and legal hurdles.  Although the deregulation of the bill is real, its scope is so limited that we would not expect a significant macro impact, on prices for instance.

What’s in, what’s out

Practically, should be open to cross-border competition services of general economic interest such as postal services, water supply, electricity, waste treatment; business and consumer services such as management consultancy, certification and testing, facilities management, advertising, recruitment, services of commercial agents, estate agencies, construction (including architects), distributive trades, the organisation of trade fairs, car rental, travel agencies, leisure services, sports centres, amusement parks etc…  On the other hand, are excluded healthcare services, industries covered by legislation specific to their sector, for example, financial services, broadcasting and transport, legal services, gambling and lotteries, and professions and activities linked to the exercise of public authority (for example, notaries) and tax services.  Services of economic interest are also excluded.  This long list of restrictions, the result of intense pressures by governments and professional lobbies comes as a disappointment.

Deregulating services: a challenge for governments, not for Brussels

While services are taking roughly 60% of the value added generated in the EU-15, less than 8% is traded between member states, according to Daniel Gros, Director of the CEPS (Telos – 12 February, 2006).  While intra-EU exports of services are worth 1.2 times extra-EU exports of services, the same number for merchandises is 2.0.  There is little doubt that the EU market for services is much less integrated than the market for goods (see Not in Service, Elga Bartsch, April 22, 2005).  Prominent academic studies have shown both theoretically and empirically that dismantling trade barriers in the services sector would both increase productivity by eliminating less productive firms and raise employment by removing entry barriers to new companies, including in host countries (see for instance Marc Melitz, NBER Working Papers 8881 and 1193).  According to MEP Arlene McCarthy, chair of the European Parliament’s internal market committee, “by opening up the market in services there is potential for 600,000 jobs”.  The fact remains that, unless EU countries were willing to delegate most of their legal corpus to a federal institution, an event we would ascribe a probability close to zero in the foreseeable future, the job of deregulating services remains in the hands of national constituencies.  The European Parliament bill, if ratified by the Council of Ministers (Ecofin), will help opening the door.  But won’t do the homework job of local governments.

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US
Review and Preview
Feb 20, 2006

Ted Wieseman (New York) and David Greenlaw (New York)

Fed Chairman Bernanke’s debut testimony on the Federal Reserve’s semi-annual Monetary Policy Report – regularly among the biggest market-moving days of the year under Chairman Greenspan – proved a complete non-event the past week, most likely a pleasing outcome to a Chairman dedicated to transparency and continuity but certainly a letdown for bored market participants who had been hoping that the testimony might provide a spark to lift the Treasury market out of its recent funk. Instead, the net market reaction was about the smallest in the modern history of the testimony, and after it wrapped up on Thursday, broad measures of interest rate market volatility collapsed to their lowest levels in more than five years. Not only was the market unmoved by Chairman Bernanke’s testimony, it also almost completely ignored a continued run of strong data – big upside in retail sales and housing starts, robust factory output along with rising capacity utilization and solid results from the early regional manufacturing surveys that suggested this strength has continued, and a well above-trend rise in core PPI inflation.

With a hawkish near-term Fed path priced into the futures market – a move to a 5% funds target in May is now seen as roughly a two-thirds likelihood – we seem to have reached the limit for now to which investors are willing to sell the front end, and there is a continued unwillingness to give up the idea that rate cuts will soon follow the last expected hike in May or June, helping keep the intermediate and longer ends supported. Ultimately, about the only thing that really put any life into the market all week appeared to be a desire by investors to put some money to work Friday post-testimony and pre-long weekend and also in anticipation of month-end adjustments, when the return of the long bond should contribute to a significant duration extension in Treasury indices (though with 2-year, 3-year, and 5-year sizes also having been raised, the net impact of the bond’s return will be somewhat tempered). This resulted in a sizable long-end led rally in Friday’s shortened trading session that left the market with small net gains on the week after having been in slightly negative territory through Thursday.

On the week, benchmark Treasury yields dipped 1 to 4 bp, and the curve flattened a bit after a 3 to 6 bp long-end led rally Friday reversed small prior losses and slight curve steepening. 2’s-30’s and 2’s-10’s both wound up 3 bp flatter on the week thanks to Friday’s reversal, with the 2-year yield down 1 bp to 4.67% and the 10-year and 30-year yields down 4 bp each to 4.54% and 4.51%, respectively. The richness of the latter two in relation to the off-the-run bonds between them, which have peak yields near 4.71% in the 2021 to 2025 maturity range, apparently spurred some increased demand and outperformance of these higher yielding issues. The large November 2021 issue, for example, saw its yield fall 6 bp on the week to 4.71%. The 3-year and 5-year performed in line on the curve, with the yield on the former down 2 bp to 4.63% and the latter down 3 bp to 4.55%. Note that the slight outperformance of the 10-year versus the 5-year on the week has now fully inverted the benchmark curve from the 6-month bill through the 30-year bond.

There was nothing in Chairman Bernanke’s testimony that should have prompted it, but the futures markets priced in a slightly more hawkish near-term Fed path on the week. The April and May fed funds contracts each sold off 1 bp to 4.74% and 4.865%, respectively, the latter fully pricing in a 25 bp hike in the funds target to 4.75% at the March FOMC meeting and the latter putting the odds of a move to 5% at the May meeting at around 65%. Even with the July contract rallying a half bp on the week to 4.96%, the market is still just about fully priced for a move to 5% in June if it doesn’t happen in May. Slightly more in the way of rate cuts post-September were priced in from this expected 5% peak, however, as the September 06 to September 07 eurodollar futures spread flattened 2 bp to -19 bp, just off the all-time low of -20 bp hit a month ago, with the former contract rallying 1.5 bp to 5.095% and the latter gaining 3.5 bp to 4.905%.

Fed Chairman Bernanke’s debut monetary policy testimony contained little in the way of any revelations regarding the Fed’s assessment of the economic and policy environment. Bernanke was impressed by the resilience of the U.S. economy and concerned that “output could overshoot its sustainable path” leading to upward pressure on inflation.

Therefore, as the FOMC indicated in January, “some further firming of monetary policy may be necessary.” At the same time, there are some potential downside risks. In particular, the Fed is watching the housing market closely for signs of a more substantial cooling than is currently anticipated. In this environment – and consistent with all the recent signals from inside the Fed – Bernanke stressed that the policy path is now highly data-dependent.

Not much market moving came out of the Q&A sessions at either the House or Senate sessions. Asked about the long rate “conundrum,” Bernanke reiterated his previous arguments that a global savings glut, along with declining term and risk premia in reaction to contained inflation expectations and an elevated demand for duration, has been the key driver of the unusually low level of rates. The new Chairman also stuck to his guns in response to repeated questions about specific tax, spending, and other Congressional policies, saying, as he did in his confirmation hearings, that unlike his predecessor he would not comment on specific Congressional proposals not directly related to his mandate as Fed Chairman.

The Fed’s economic forecasts contained in the Monetary Policy Report on which Bernanke was testifying predicted a nearly perfect economy this year combining solid, probably about trend-like growth and only a marginal pickup in inflation. The Fed’s consensus was for +3 1/2% real GDP growth in 2006 on a Q4/Q4 basis and +2.0% core PCE inflation.

Unusually, the forecasts for 2006 were given as point estimates rather than the typical “central tendency” ranges. Perhaps this way of presenting the forecast was encouraged by the upward skew in the inflation estimates, where the range of forecasts was +1 3/4% to + 2 1/2%, and a desire by the Fed not to present an official inflation forecast that ranged above the 1% to 2% “comfort zone” (and possible future target range) of the Chairman and many other Fed officials. The Fed’s views for this year are more sanguine than ours. We forecast +4.0% GDP growth and +2.2% core PCE inflation. For 2007, the Fed predicts a moderation to +3 to +3 1/2% GDP growth and +1 3/4 to +2% core inflation; our forecasts are pretty much in line with these at +3.0% and +2.1%.

Economic data released the past week were quite strong, with blowout results from the retail sales and housing starts reports, very strong underlying industrial production and an accompanying move higher in factory capacity use, solid results from the early regional manufacturing surveys that suggest this January manufacturing strength extended into February, and upside in core inflation.

Retail sales surged 2.3% in January with broadly based strength across almost all major categories. In line with the previously reported upside in unit sales, motor vehicle sales rose 2.9%. Excluding autos, retail sales surged 2.2%, far stronger than expected even after the robust chain store sales results. Big gains were widespread across various categories, including clothing (+4.2%), general merchandise (+2.1%), building materials (+3.4%), furniture (+3.7%), electronics and appliances (+2.0%), and restaurants (+3.2%). Gas station sales (+5.5%) also surged more than implied by the month’s upside in gas prices. The only major category to post a decline in sales was nonstore (-2.6%), of which internet retailers make up the majority. Even building in a correction in February in both auto and ex auto goods sales, we raised our Q1 consumption estimate to +5.5% from +4.8%, a sharp rebound after the 1.1% gain posted in Q4.

Retail sales were probably helped by the weather; housing starts almost certainly were. Starts surged 14.5% in January – the warmest in the 110 years the government has collected data – to 2.276 million units annualized, the highest level since 1973. Although weather clearly played a role here, unadjusted starts were up 11.3%, and gains were strong in the less weather sensitive South (+9%) and West (+17%), though the Midwest (+24%) and Northeast (+29%) posted significantly bigger advances. There were sharp gains in both the single-family (+12.8% to 1.819 million) and multi-family (+21.9% to 457,000) components in January, with the former hitting an all-time record high and the latter reaching the second highest level since 1998.

Though not quite as off the charts as the retail and housing numbers, data released on the factory sector the past week were also quite robust. Industrial production fell 0.2% in January, but all of the downside was accounted for by a record 10.1% plunge in utility output resulting from the unusually warm temperatures in January. The key manufacturing gauge rose 0.7% on top of significant upward revisions to prior months, bringing the annualized gain over the past four months to +12%, the largest rise over such a period since 1997. Upside in manufacturing was broadly based, with strong gains in motor vehicles, high tech, electrical equipment, petroleum refining, and chemicals. The overall capacity utilization rate fell three-tenths to 80.9% on utility weakness, but the manufacturing rate rose four-tenths to 80.5%, the high since July 2000 and a full percentage point above the average over the past 30 years. Together with the recent declines in the unemployment rate, the continued move higher in the manufacturing capacity utilization rate clearly highlights the rising inflation risks from “possible increases in resource utilization” of which the FOMC has recently been warning. Early regional surveys suggest that the manufacturing strength seen in January extended into February – at least on an underlying basis that is, as we expect there may be some negative weather impacts from the recent blizzard and return to more seasonal temperatures. The Empire and Philly regional surveys of manufacturing conditions during February showed little change on an ISM-weighted basis and held at strong levels (58.4 for the former and 56.9 for the latter).

Our preliminary forecast for the February national ISM is for a fractional dip to 54.5.

Along with these strong growth numbers, the past week’s inflation news was also negative, though we suspect seasonal adjustment issues probably played an important role in the upside. The producer price index rose 0.3% in January as flat energy prices (with a decline in gasoline offsetting a sharp rise in electricity) tempered a 0.4% jump in the core. This was the largest rise in the core since last January, highlighting some apparent seasonal adjustment problems this series often seems to have in January. Rebounds in car (+1.1%) and light truck prices (+0.7%), upside in a number of capital goods categories, and significant gains in some consumer items, notably drugs, accounted for the upside. News at earlier stages of production was mixed. The core intermediate gauge surged 1.0% on upside in chemicals and containerboard, but the core crude index dipped 0.1% as a sharp decline in steel scrap offset widespread upside in other categories.

In viewing the strong run of January data released so far, we certainly advise investors to pay heed to Steve Roach’s warning that the January data are almost certainly being boosted by the unusually warm weather in the month (see his article “Seasonally Mal-Adjusted” from February 17).

Putting together all the key data released since the advance GDP report – in particular manufacturing, wholesale, and retail inventories, retail sales, capital goods shipments, foreign trade, and construction spending – we now expect Q4 growth to be revised up to +1.6% from +1.1%. Despite expecting most of this revision to come from inventories – pointing to an offsetting subtraction from Q1 all other things being equal – we now see Q1 GDP tracking at +5.6%, up from our prior estimate of +5.5%, as the surge in retail sales points to significantly stronger underlying final domestic demand growth than we initially estimated. However, we caution that some of this expected surge reflects both a catch-up after the weak Q4 that was depressed by the hurricanes and resulting energy price shock and also the positive impact of the unprecedented warm temperatures across the country in January.

So some payback is likely in Q2, where we look for a slowdown to +3.2% GDP growth, before a reacceleration to near +3 3/4% in the second half of the year, about where we see the underlying trend at this point. One key point to keep in mind with regard to the weather, however, is that the much lower heating demand resulting from the January weather anomaly will have more than just temporary, borrowed effects on growth. The sharply lower heating needs (as seen in the record plunge in the utility measure in the IP report) have had a major impact on natural gas and petroleum product inventories and thus on prices – especially natural gas, where the price of the rolling front-month futures contract has now plunged 36% since the end of December – and this will have a lasting impact on consumers’ real purchasing power.

The upcoming holiday shortened week has several key data releases and events in addition to more supply. In Fed news, the minutes from the January 31 FOMC meeting will be released Tuesday. Since it was in large part the job of Chairman Bernanke to summarize the consensus outlook arrived at by Fed officials at this meeting (despite not having actually attended it!), it seems unlikely that anything too surprising will come out of these. We think the market has probably gotten a bit ahead of itself, however, in its pricing of near-term Fed rate hikes (though we certainly don’t agree with the pricing of rate cuts starting as soon as September), and it would not be a major surprise if there were some indication in the minutes that the Fed may be contemplating a near-term pause in the rate hiking cycle – though likely a pause with a tightening bias given fears of upside inflation risks repeatedly expressed by numerous Fed officials. Chairman Bernanke will also give his first speech as Chairman on Friday evening on the topic “Evolution of Central Banking.”

On the supply front, Treasury will auction a $22 billion 2-year Wednesday (unchanged in size after the $2 billion increase last month) and $14 billion 5-year Thursday (up $1 billion). Treasury Secretary Snow waited until almost the last possible minute to fulfill the legal formalities required to begin disinvestment of the “G-Fund” that cleared enough room under the debt limit to allow the announcement of these auctions to go forward normally. Disinvestment of the G-Fund and the Exchange Stabilization Fund (over which the Treasury Secretary has complete discretion) would free up about $80 billion in marketable borrowing capacity, which by our forecasts (and Treasury’s, it seems, given their latest statements on the matter) will only last until around mid-March. At that point if no debt ceiling increase has been passed, Treasury will likely be forced to begin disinvestment of the Civil Service Retirement Fund. This is merely a technical accounting move that has zero actual negative impact on government retirees, but one that is easy to portray otherwise for political purposes, making the Treasury reluctant to use it until forced to. So there could be some temporary disruptions to auctions in mid- to late-March (weekly bills and the next round of 2’s and 5’s) if this issue hasn’t been resolved by then.

Key data releases due out in the coming week include leading indicators Tuesday, CPI Wednesday, and durable goods Friday:

* Based on the components available at this point, the index of leading economic indicators appears likely to post a sharp 0.9% gain in January, with the largest positive contributions from jobless claims, the money supply, and supplier delivery times. If our forecast is on the mark, the total gain in the index over the past four months would the biggest in almost two years.

* We look for a 0.5% increase in the CPI in January and a 0.2% gain excluding food and energy. A rebound in quotes for energy-related items should help push up the headline CPI this month. Meanwhile, the core gauge is expected to be in line with the recent trend as swings in a number of items prove to be roughly offsetting. For example, a hike in the price of postage stamps should lead to some elevation in the communication category. And, motor vehicle prices are expected to post a modest rebound following some softness of late. However, due to a seasonal quirk, hotel rates are likely to flatten out in January before resuming their march higher in coming months. On a year/year basis, the core CPI is expected to hold at +2.2%.

* We forecast a 4.0% decline in January durable goods orders. A pullback in the volatile aircraft category, following on the heels of the feverish pace of activity seen in November and December, should lead to a sharp decline in overall orders. Outside of the aircraft sector, bookings should be little changed. Indeed, the key core component – nondefense capital goods excluding aircraft – is expected to be +0.2%.

This would be consistent with the moderation in the pace of increase in order volumes seen in recent ISM surveys.

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Asia/Pacific
The Hot and Cold End
Feb 20, 2006

Andy Xie (Hong Kong)

Summary & Conclusions

Inflation and deflation may coexist in the global economy, but going forward may no longer offset each other as in the past.   The hot or high-inflation economies (mainly, Anglo-Saxon consumer economies and some low-investment emerging economies like India) may tighten more than expected. 

The cold or low inflation economies are China, Northeast Asia, and Europe that have excess savings, demographic challenges or excessive investment.  Their interest rates could surprise on the downside.

As most industries that could move to China have already done so, globalization is no longer as deflationary as before.  Overcapacity in China would thus not have the same deflationary impact on the global economy as before, in my view.

I believe that monetary authorities around the world may not truly appreciate the bifurcation of the world into hot and cold economies.  The risk of policy mistakes on monetary policy, especially among hot emerging economies, seems to be rising.  The excesses in some cases have reached proportions seen in prior emerging market crises.

The Three Pillars of the Deflation Boom

Anglo-Saxon consumerism, Japan’s zero interest rate policy, and China’s surplus labor are the pillars of the current global boom, in my view.  China’s surplus labor has kept inflation low; Japan’s zero interest rates have kept interest rates low; and Anglo-Saxon consumerism has kept demand strong.  Globalization has brought the three together through outsourcing and the carry trade, creating a world not too hot, not too cold but one that has allowed central banks to tolerate loose liquidity conditions.

How this world works is best illustrated in the diverging trends in tradable and non-tradable inflation, in my view.  In Australia, non-tradable prices have been rising at 3.9% p.a. versus 1.9% for tradable since mid-1998.  In the US, services prices have been rising at 3.2% p.a. versus 1.6% for goods since 1995, despite the sharp increase in energy prices.

Even India has benefited from this global deflationary force.  Its housing component in CPI has been rising at 11.1% p.a. since 1995 compared to 5.5% for overall CPI and 3.5% for the clothing component.  In the past ten years, India’s imports from China have risen twelve-fold.

Modern macroeconomics is about inflation.  The economists that run the world’s central banks have been trained to watch for inflation, and, in the absence of inflation, to maximize growth.  This is why they have tolerated loose liquidity conditions for so long.  But, in my view, they have ignored how liquidity has translated into demand, and run the risk of paying a high price for their failure to recognize this interplay.

The Asset-driven Deflation Boom

Rising asset prices have been the main channel for liquidity to turn into demand during this cycle.  While strong asset markets and strong economic tends to go together, the later usually causes the former.  The causality has been reversed in this cycle, I believe.

The most important asset in this cycle is property.  A few examples can illustrate the property overvaluation.  The US’ household property value is 50% of GDP, above the historical norm; Australia and Britain’s is 100%.  China’s property under construction and bought but undeveloped land are worth 50% of GDP.  The excess value in the global property bubble is probably over US$15 trillion, or roughly 40% of global GDP.

The global stock market is also overvalued, I believe.  While P/E multiples for developed markets are within the normal range, earnings may have been exaggerated by asset-driven demand.  The rising share of financial earnings is a case in point.  Emerging markets are already overvalued by historical norms, in my view.

The total capitalization of stock markets around the world is about US$36 trillion or 90% of global GDP, quite close to the high in 2000.  The exaggerated earnings linked to strong Anglo-Saxon consumption, the financial sector, and the commodity bubble may have exaggerated market capitalization by 15-20%.

Antiques, arts, gold, and other storage vehicles of value have also seen a strong rise in value.  Gold held by households globally may be close to 30,000 tons, which would be worth about US$550 billion at current prices.  The antiques and arts held privately are probably worth more.  While the financial mania in the antique and art world is small relative to property and stock markets, the amount of value inflation is still hundreds of billions of dollars.

The Bubble May Burst in 2006

The liquidity foundation is based on the cross-border mixing of deflationary and inflationary forces in the right amount.  Financial markets have played a decisive role in maintaining this world of ‘not too hot, not too cold’ by pushing up the currencies of the economies that have high inflation and down the currencies of the economies that have low inflation, and ignore current account balances.

The logical ending of this world is when: (1) the currency market shifts its attention from the carry trade to the current account, which would exacerbate inflation in the economies that have big current account deficits; and (2) excess demand from the economies with current account deficits overwhelms the deflationary force in China and Japan to trigger global inflation.  Neither is within sight yet, I believe.

But, a third scenario is emerging.   The deflationary force from China is no longer effective in keeping inflation down in high-inflation economies.  The transmission mechanism between China’s cheap labor and overcapacity and the consuming economies is trade. 

In the past five years, industries that compete against China have been moving to China.  China’s FDI in manufacturing dropped by 14% in 1H05 from the year before.  All indications are that factory relocation to China has peaked.  When China’s exports are small, its deflationary impact is huge as it was a price setter for producers elsewhere.  As factories that compete against China have moved to China, when China cuts prices, it no longer has the same effect.

This would suggest that inflation would surprise on the upside among the consumption-led economies.  Australia is a case in point.  As its housing market has peaked, its GDP has also slowed considerably.  But, its inflation is picking up.  It may be headed towards stagflation, especially if its currency drops when the commodity bubble bursts.

The global economy in 2006 may be characterized by inflation in some economies and deflation in others (or part hot, part cold).  Because the interplay between the two is less effective than before, the high inflation economies may have to tighten despite slowing GDP.  Because the deflation economies remain sources of liquidity and sustain speculation in the high inflation economies, their central banks in the hot economies have to tighten more than otherwise to contain inflation.

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India
Disguised 100 bps Hike in Policy Rate
Feb 20, 2006

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

Short Policy Rate Is Up 200 bps from the Bottom

Over the last five months, the sharp slowdown in foreign exchange reserves accretion has resulted in a decline in excess liquidity.   This has meant that the Reserve Bank of India (RBI) is back to injecting liquidity into the system instead of absorbing excess liquidity.  In effect, the relevant short-term policy rate is now the repo rate (the rate at which the RBI infuses liquidity) instead of the reverse repo rate (the rate at which the RBI absorbs excess liquidity).  However, the repo rate is at 6.5%, compared with the reverse repo rate of 5.5%.  Hence, for the money market, the short-term policy rate has effectively risen by 200 basis points from the bottom of 4.5% (of the reverse repo rate), and not just 100 bps as represented in the rise in reverse repo rate from 4.5% to 5.5%.

Blame the High Level of Current Account Deficit

Although foreign capital inflows are still relatively high, they are being offset by the rising current account deficit, resulting in a sharp decline in net foreign liquidity injection (that is, forex reserves accretion) in the system.    The current account balance widened to a US$7.7 billion deficit during the quarter ended September 2005 (the quarter ended December will likely also have been US$6-7 billion), compared with US$3.5 billion during quarter ended September 2004.  This is one of key factors behind the decline in 12-month trailing net annual foreign liquidity (NFL) injection from US$40 billion in mid-2004 to US$ 7-8 billion as of February 2006.

Market Determined Short Rates Up Sharply Too

This decline in NFL has pushed the market-oriented short-term rates (91-day T-Bill) to 6.7% from 5.2% over the past four months (Exhibit 2).   Indeed, the short-term market rate has started moving gradually towards the repo rate, reducing the relevance of the reverse repo rate.   The 180-day AAA corporate commercial paper rate has also shot up by 275 basis points to 7.8% over the past five months.

Unwinding Excess Liquidity Could Add to the Pressure

As forex reserve accretion has slowed down, the RBI has been unwinding the stock of excess liquidity built during the times when flows were strong.    This stock of excess liquidity has already declined to about US$9 billion currently from US$28 billion at the start of September 2005.   If the current trend is maintained, unless capital flows rise sharply, the stock of excess liquidity balance will be completely wound up over the next four months, limiting the RBI’s capability to check the rise in interest rates.

Need a Minimum of US$20-25 Billion Net Injection of Foreign Liquidity

Observing the trend in forex reserves and market-oriented short-term interest rates, we believe that India needs 12-month trailing NFL (that is, forex reserves accrual) of least US$20-25 billion to ensure that there is no major rise in the cost of capital, which would threaten its consumption-driven growth.  Unless the current account deficit starts declining (which is possible only if growth slows), capital flows will need to rise from the current run rate of US$25 to 30 billion to about US$50 to 55 billion, which we believe is a tall order.  We believe that this decline in excess liquidity is likely to maintain the upward pressure on domestic interest rates.

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Turkey
Curing Hysteresis
Feb 20, 2006

Serhan Cevik (London)

One-time disturbances may have long-lasting effects on portfolio allocations. When residents lose confidence in domestic currency and assets, the result is usually capital flight and a spontaneous process of currency substitution and financial dollarisation. We have seen this phenomenon in a range of countries where political instability and economic volatility eroded policy credibility and investors’ faith in domestic currency-denominated assets as a store of value. Turkey, with a long history of economic shocks that had resulted in fragile debt dynamics and extreme sensitivity to ‘noise’ in financial markets, presents a valuable case to study dollarisation and currency substitution — terms which we use interchangeably. The consequences may seem obvious in retrospect, but dollarisation reflects a complex, evolving interaction between history and the behaviour of investors and macroeconomic variables. In our previous reports, we argued that the accumulation of ‘one-time’ disturbances may have long-lasting effects on residents’ portfolio decisions and that the only way to break out of this vicious conundrum is a positive policy ‘shock’ that would redraw investors’ mental map (see Hysteresis in Currency Substitution, July 25, 2000).

Recurrent episodes of macroeconomic instability caused dollarisation in Turkey. Although de facto dollarisation in Turkey was underway even before the removal of foreign exchange controls in 1985, recurrent episodes of economic uncertainty altered portfolio choices and accelerated the flight from lira-denominated assets. For example, the share of foreign currency-denominated deposits in the banking system — a narrow measure of financial dollarisation — surged from 13.5% at the end of 1985 to 50.5% in 1994 and to 57.2% after the 2001 crisis. The endless wave of monetary disruptions increased currency and inflation volatility and thereby kept fuelling the hysteresis in dollarisation. In other words, the lack of trust led to a self-fulfilling process and path dependence in portfolio allocations, propagating the behavioural tendency to ‘hoard’ foreign currency-denominated assets and to use foreign currencies as a medium of exchange. Even though currency substitution was obviously a form of financial adaptation protecting savings and income stream against unexpected developments, the dollar addiction and the resulting vulnerability to shocks had become detrimental to economic performance at an aggregate level.

Turkey is a unique success story in reversing financial dollarisation. Macroeconomic stabilisation is necessary to deal with the problem of financial dollarisation, but not necessarily enough to reverse a process that may have become imprinted in investors’ psyche. Indeed, in many other countries — save Israel and Poland — with a high degree of dollarisation, even successful stabilisation attempts have failed to deliver a meaningful reversal in dollarisation. In our view, since currency substitution is generally a structural phenomenon and reflects the lack of policy credibility, disinflation alone is not enough to break path dependency. The cure for hysteresis is about reshaping long-term expectations and thus must incorporate structural reforms and significant fiscal consolidation. And this is exactly why Turkey is becoming a success story in de-dollarising the economy.

Financial dollarisation declined from the peak of 43.8% in 2001 to 26% of late. Measuring financial dollarisation and currency substitution in the economy is a challenging task, because of the difficulty in accounting for foreign currency notes circulating in Turkey and residents’ financial investments and bank deposits abroad. As a result, we used, in our previous reports, foreign currency-denominated bank deposits as a proxy for financial dollarisation. However, the Central Bank of Turkey has recently put together a comprehensive set of data on residents’ portfolio allocations (including all domestic financial instruments and external debt, but still excluding Turkish holdings abroad). Correcting for exchange rate movements, the share of foreign currency-denominated assets in residents’ financial portfolios declined from the post-crisis peak of 43.8% in 2001 to 28.8% in 2004 and then to 26.1% at the end of last year. Thanks to measures improving the sustainability of stabilisation, the Turkish lira has become, once again, a store of value and a medium of exchange.

De-dollarisation is good news, but also brings new challenges. A correction in residents’ portfolio allocations in favour of lira-denominated assets is, without doubt, an encouraging shift that reduces the risk of currency-fuelled inflationary pressures and improves the effectives of monetary policy. But there is no gain without pain. De-dollarisation of Turkey’s economy and financial markets, coupled with foreign capital inflows, has resulted in a revaluation of the lira’s equilibrium value — a pleasant development for the economy as a whole, but a challenge for inefficient sectors.

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