Japan
Goldilocks Says 'Just Right' (Part I)
Feb 22, 2006

Takehiro Sato (Tokyo)

Higher F2005-06 real growth rates and lower deflator

We modestly revise our economic and price outlook in light of first preliminary GDP results for Oct-Dec 2005. The Japanese economy posted robust +5.5% (annualized) growth in Oct-Dec and has already locked in our estimate of 3% real growth in F2005.  We raise our 2006 real growth rate estimates to 3.2% based on a higher base effect. This implies two straight years of 3% real growth. We also maintain our outlook for a slowdown to the lower 2% range in 2007 in line with slower global economic momentum. Our nominal growth rate estimates are 2.7% in 2006 and 3.0% in 2007, exceeding the real growth rate trend.

We expect a delay in GDP deflator improvement to a positive reading until late 2006 given recent sluggish results. Normalization (switch in the nominal-real reversal) in GDP data might be delayed into 2007 too. Yet this reflects technical factors, such as the upward revision of the oil prices assumption and lower fresh food prices, and does not mean that deflation is worsening. We reiterate our outlook for core CPI to remain near 0% YoY during the forecast period, though as a positive result of improved productivity from reform efforts by the public and private sectors in recent years. The better trade-off between economic activity and prices is also good news for sustained increases in asset markets.

Basic scenario: Prolonged recovery in personal consumption and capital investment

We expect personal consumption to expand in the 2% range annualized on relaxed income constraints, increased confidence in the job environment, and a wealth effect from stock market gains and higher land prices in major urban areas since summer 2005. We look for an increase of discretionary spending due to the retirement of the baby boomers which will gain momentum after 2007. The 2% range actually might seem cautious considering healthy employment and income conditions, but this assumes disposal income growth in the 2%+ from phasing out the special income tax reduction and other measures. Consumption hence will receive support from a decline in the savings rate on improved confidence in employment and a wealth effect.

Capex, meanwhile, is likely to expand at nearly a +10% annual rate through mid-2006 as investment projects leftover from 1H F2005 move to implementation from Jan-Mar. We anticipate a moderate slowdown in capex from Jul-Sep 2006 from near-term exhaustion of investment demand in the automotive industry, a key driver of manufacturing capex. Yet non-manufacturing, which accounts for 70% of overall capital investment, should see stronger replacement demand in a wide range of areas, including information and communications, utilities, and real estate. The larger scale of non-manufacturing investments, despite being replacement demand, should result in substantial spillover to other industries. Accordingly, corporate earnings are likely to improve with unexpectedly higher margins.

Risks

The direct threat to the Japanese economy from a retreat in overseas economic activity similar to the IT bubble collapse has diminished with the shift of the growth driver to domestic private-sector demand. However, asset market adjustment from factors other than the economic cycle could weaken the growth rate. Potential causes are 1) speculation about the drying up of excess liquidity following a reversal of quantitative easing and 2) changes in political conditions. We believe excess liquidity linked to quantitative easing is highly uncertain. We hence do not expect heightened volatility in asset markets from Japan-sourced excess liquidity via hedge funds forming and dismantling carry-trade positions as happened in 1998 .

Yet there is some risk from the second cause since foreign investors might change their views on the direction of Japan’s structural reforms depending on the next cabinet formed in October. Investor sentiment could differ with a cabinet led by chief cabinet secretary Shinzo Abe, who is committed to continuing current reform policies, compared with a cabinet led by former chief cabinet secretary Yasuo Fukuda, who might be seen as leading an anti-Koizumi alliance. Another important point is whether Heizo Takenaka, the Minister of Internal Affairs and Communications, a key person in the Koizumi cabinets and popular with gaijin investors, remains in the next cabinet. We do not have a firm view on what might happen at this point, though consensus candidates are often derailed. 

External risks are 1) major slowdowns in the US and Chinese economies, 2) a further sharp rise in oil prices, and 3) an unexpected sharp fall of the dollar. We are not that concerned about deceleration of the Chinese economy. But a major setback in US consumption and investment, which are important sources of final demand, from a collapse of the housing bubble is likely to have some impact on the Japanese economy even with the stronger role of domestic demand. However, our scenario does not incorporate a collapse of the US housing market in the forecast period given the global stability of long-term interest rates with surplus demand for duration from aging societies.

We expect higher oil prices to push global demand to a higher equilibrium point via the oil-money recycling effect observed up to now as long as prices rise on a demand shock. Therefore, an oil price hike is likely to remain supportive of the global economy, so long as geopolitical risks, such as the Iranian situation, that cause a supply shock do not materialize.

We think yen appreciation risk is already built into the consensus view. But this factor should not significantly curtail economic activity absent a sharp, short-term move as proven by Japan’s economic record up to now. Rather, the current effective real yen rate is extremely weak. Therefore, risks of a downward revision of corporate earnings are limited, even with the yen appreciation. Investors are likely to benefit if yen appreciation does not have a harsh impact on the corporate earnings and the economy.

Thus, we conclude that the Japanese economy has strengthened its resilience to external shocks and the above-mentioned risks lack the clout to fundamentally alter our bullish scenario.

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China
Tales from the Middle Kingdom
Feb 22, 2006

Andy Xie (Hong Kong)

Summary & Conclusions

The vast gap between the nominal GDP growth rate and interest rate has created another wave of speculation.  The speculation ends when either liquidity dries up due to a downturn in US consumption or oversupply triggers a price downturn that narrows the gap between the nominal GDP growth rate and interest rate.

The following are three cases of speculation I have recently encountered.  They illustrate the excesses and tension within China’s economy.

Tom

   “You must invest in this company.  It’s China and energy!” a deal sourcing specialist exclaimed in Tom’s office.

Tom’s eyes lit up like neon lights on the bund.

“But, you must compete with a dozen other private equity funds to be chosen,” the specialist furrowed his eyebrows.

Tom is with a US private equity fund.  Five years ago, at the peak of the dotcom bubble, he was suddenly summoned to a partners meeting. 

“Everyone is talking about China.  We should do something about it.  You are Chinese, Tom.  What can you tell us about China,” a senior partner asked Tom.

“China has 1.3 billion people and has been growing at 8 or 9% per year for twenty years,” Tom said.

That was the right answer, and Tom was sent to Hong Kong to set up an Asian operation. But, Tom didn’t speak Chinese.  He had to take a crash Mandarin course to get by. 

Tom burnt midnight oil to burnish his standard presentation, highlighting the successes of his firm’s portfolio companies around the world.  His firm could marshal expertise from all over the world to his portfolio companies in China to succeed.

Tom and the specialist took a flight from Hong Kong to the prospect’s provincial capital – one with connections to Hong Kong.  The airport was big and new.  The international terminal had only a few flights to Hong Kong.

A car from the company was waiting for them at the airport.  They drove for three hours, pulled into a small town, and stopped before a new glass and steel building.

   “China Alternative Energy Warmly Welcome Famous International Investors,” a huge banner on the building read.

A couple of youth in company uniform showed Tom and the specialist into a conference room with a big oval table in the middle.  Some of Tom’s competitors were already sitting there.  Some were westerners in expensive suits.  Some looked like “sea turtles” – what Chinese call those who had studied and worked abroad and are seeking their fortunes in China.  Tom walked over and sat next to them.

Suddenly, everyone stood up.  “This is Chairman You,” someone shouted.  A serious looking guy in a shiny suite walked in.  He kept nodding at everyone and sat down in the middle, assuming a Chairman-Mao posture with legs crossed and a cigarette in hand.

   “Now we begin the International Investor Conference,” the same man shouted again.

Tom watched other guys walking up and making PowerPoint presentations one by one.  Tom didn’t catch much of their presentation but was really worried when they talked about what they could do to the company’s stock price at IPO.

The first guy mentioned 20 times earnings.   The second guy promised 30 times.  The third guy said that it could be 30 times 2008 earnings. 

The fourth guy, a Caucasian, instead of mentioning a specific number, went straight for the jugular. “When the company is IPO’ed, you will become the richest man in China, Mr. You.”

Mr. You’s face lit up.

Tom quietly deleted 15 times earnings for the IPO in his presentation and changed it to “a high multiple of earnings”.  But, he still stuttered throughout his brief when his turn finally came up.  He could see that he was losing the deal: Mr. You kept talking to his assistants during his presentation.

Jerry

   “I don’t bother with stocks anymore,” Jerry told me last time we met.

Jerry is an accomplished tech entrepreneur from Taiwan.  He has achieved financial success from speculating in tech stocks.  Jerry knows all the movers and shakers in the industry and somehow always knows the turning point.

He catches up with me from time to time to talk about the market.  He mainly wants to know what international investors are thinking.  He plugs it into his decision-making process along with his industry knowledge.

But, he is not in the stock market now, and Taiwan’s tech sector is up 30% since last October.

   “Look at this.  It tripled in value last year.”  He pointed at a white-and-blue plate.

It is indeed fine China, probably early Qing Dynasty.

   “My contemporary Chinese paintings doubled on average last year.  Some increased five times.  Why would I want to bother with stocks?” Jerry looked at me.

   “Aren’t you worried that some of those painters may paint more of the same stuff,” I warned.

   “No worry.  I turn the stuff faster than they can paint,” Jerry smiled at me.

Artron.net, an online auction information site, claimed that the turnover at China’s art and antique auction houses reached Rmb15.3bn in 2005, up from Rmb7.2bn in 2004 and Rmb2.3bn in 2003.

I have no way to verify such data.  But, the chat among moneyed people suggests that art and antiques have become big.  Two years ago, people just wanted to talk about Shanghai property.  Everyone was bragging about the big appreciation in his or her Shanghai holdings, it seemed.

Lately, the same people are talking about obscure distinctions among the paintings from equally obscure contemporary painters.  These distinctions apparently make or break the appreciating potential of the paintings.

It seems like a mania to me.  The same liquidity that has caused the property bubble and overinvestment in steel is driving this market too.  China’s liquidity has surged, with exports more than doubling in three years and the massive inflow of hot money speculating in a renminbi revaluation.  The gap between the nominal GDP growth rate and deposit interest rate has exceeded 10 percentage points since 2003, similar to what occurred between 1992 and 1995.

There was massive land speculation 10 years ago.  The antique and art market was not significant then.  It is still small compared to the property market (I think that 1.7 bn sq m of properties under construction could be worth Rmb5.5 trillion at Rmb 3,200/sq m or 30% of GDP), but, it has become big enough to suck in a large number of people.

   “The market works like the semi sector. You just have to get out before the liquidity dries up,” Jerry said confidently.

The tech sector is probably the most cyclical industry.  Jerry has been through many cycles.  If anyone can get out before the crash, he can.

Sue

   “I missed Shanghai.  I just bought in Beijing,” Sue declared to me.

   “Don’t worry.  I will sell in 2008,” she said defensively, before I could comment on her decision.

Sue is an overseas Chinese in the financial industry.  Like all Chinese, Sue loves properties and is always talking about her properties in exotic places.

Shanghai’s star is clearly down among the moneyed people.   Even though they own multiple properties in Shanghai, it is not fashionable to talk about it anymore.  Beijing is still fashionable.  At least, one can talk about owning a place to stay during the 2008 Olympics.  It sounds so cool.

It seems that everyone has the same view about Beijing property: buy now and sell in 2008.  Beijing sold 25.7mn sq m of residential properties in the primary market last year, doubling sales of 11.3mn in 2001.  Buyers like Sue have been a main driver of the market’s growth.

Some have even been buying in Shenzhen.  But, it is not fashionable to talk about it.  Ten years ago, many Hong Kong people bought in Shenzhen, believing that Shenzhen property prices, less than 10% of Hong Kong then, would converge towards Hong Kong’s.  It dropped instead.  It is embarrassing to talk about trying again.

Property is the main show in this cycle.  Overseas Chinese like Sue have played a decisive role in hot markets like Beijing and Shanghai.  The two cities accounted for one third of the primary residential sales in value in 2004; Guangdong, Jiangsu and Zhejiang, the other three prosperous coastal provinces accounted for 27%.  These provinces are closely tied with China’s export sector, which overseas Chinese dominate.

China’s income distribution is highly skewed.   Some government agencies acknowledge that China’s Ginni coefficient is over 0.4.  Private estimates are much higher.  A recent study by Boston Consulting claims that 0.6% of households own 60% of the private wealth.  Such data suggest that the size of China’s population who can afford cars and properties is relatively small.

This is where overseas Chinese like Sue come in.   There are about 60 million overseas Chinese in Hong Kong, Taiwan, Southeast Asia and North America.  They have GDP equivalent to about US$1.1 trillion or half of China’s.  There are probably more overseas Chinese able to afford properties in Beijing and Shanghai than locals. 

This is why property advertisements usually show up in airline magazines on flights between Hong Kong and Chinese cities, or on billboards from airports to downtown hotels.  This is why, if local people are bullish, they talk about the potential demand from people like Sue.

   “We are an international financial center.  Lots of foreigners will have to come to buy,” one Shanghai speculator who could not unload his property mentioned to me over the Chinese New Year.

But, overseas Chinese believe that the case for the rising property price is that local people have a lot of money, and that they are being smart by front-running the locals.

China’s property market seems to thrive on two mindsets crossing over each other.   As long as there is enough liquidity to satisfy both beliefs, it doesn’t matter.

I hope Sue sells in 2007.  It would be a crowded trade to sell in 2008.  However, there is a technical barrier.  The developer will not give her the ownership certificate until the compound is fully developed.  Sue will get the certificate only in late 2007. I think the developer doesn’t want people like Sue competing against it in the market.

There are many Beijing property owners in Sue’s situation.  Wall Street has an opportunity to create a swap market for proud Beijing property owners to trade without ownership certificates.  Maybe, these properties could be packaged together and listed in Hong Kong.

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Brazil
Abundant Growth?
Feb 22, 2006

Gray Newman (New York) and Heloisa Marone (New York)

Brazil’s abundance story has never looked better from abroad.   Whether it is the central bank’s buying spree that has helped double international reserves or the finance ministry’s most recent buyback announcement which should go a long way to making Brazil’s net public external debt extinct this year, it should be hardly surprising to see upbeat investor sentiment pushing Brazilian markets higher (see “Brazil: Abundance is Just Beginning” in GEF, February 14, 2006).  Brazil’s Bovespa index has posted a 27% rise in dollar terms since the beginning of the year through February 20; meanwhile, Brazil’s currency, at 2.12 on February 20, is trading near a five-year high.  And debt markets are still digesting the news that Brazil’s external debt is rapidly becoming scarce.

Behind all of the euphoria, however, some Brazil watchers are wondering whether the news is too good to be true and are asking whether the abundance will translate into good growth in 2006.  With presidential elections set for the end of the year, many Brazil watchers are concerned that if the real economy does not show better signs of gaining ground, the political landscape could be upturned.  And with the currency having strengthened so much, the concern is that exporters are likely to suffer and pull the economy down with them before domestic demand has a chance to kick in.  Indeed, the slump in GDP during the third quarter, down 1.2% over the previous quarter after having grown for eight consecutive quarters, only added to the cautiousness.  Most of the industrial production reports in the third quarter and for the first two months of the fourth quarter also painted a lackluster picture. 

To those concerned about growth, we argue that the upturn in domestic demand appears to have already begun.   And fortunately, the downturn so long anticipated by the exporters has yet to emerge.  Indeed, at the beginning of 2006 we are seeing a remarkable upturn in export demand.  While we are amazed and somewhat perplexed at how well exports are doing given the nearly uninterrupted gains that the Brazilian real has made, the upturn in export demand should give Brazil’s domestic demand the time it needs to recover further.  The risk that export demand will collapse before domestic demand gains ground looks minimal from our most recent review of the economy—including near real time data measuring the first days of February.

Exporter Upturn

Perhaps the most surprising news from Brazil’s economy is that at the beginning of 2006, export demand is gaining ground.   This can be seen most clearly in primary good exports and in semi-manufactured exports.  Exporters of both primary goods and semi-manufactured goods have seen an improvement in export prices, and most importantly in volumes in the last months of 2005 and through January 2006.  As important, manufacturing exports — which account for more than half of all exports — have also seen a mild recovery in volumes after what had appeared in mid-2005 to be the beginning of a downturn.  As with all exports, manufacturing prices have also been rising sharply into the new year. 

While we doubt that the resurgence in export volumes is likely to continue, the uptick seen late in 2005 and into the beginning of 2006 may help explain why industrial production is now also showing some signs of improvement.   December’s industrial output release produced a very strong headline number: up 3.2% year-over-year and twice the pace most analysts were predicting.  Furthermore, the data also looked strong on a sequential basis: December industrial production was up strongly over November, which in turn had shown a strong uptick over October.  Indeed, in the three months ending in December, industrial output showed annual trend growth in the double digits, representing a sharp turnaround from flat to negative trend growth just a few months earlier.

We are hesitant to overplay the December industrial production report.   There appear to be some issues over whether an increased number of working days inflated the report and were not properly adjusted by the national statistical institute, IBGE.  But we suspect that better industrial production may be partially explained by producers approaching the end of a run down in inventories.  During 2005 and most pronounced during the second half of the year, Brazilian producers reduced inventories of both raw materials and finished good inventories at one of the most rapid paces that we have seen in the past six years.  We believe that this adjustment was in response to concerns that the strong real would limit the competitiveness of Brazil exports as evidenced by the softness in export volumes seen during much of last year.  The adjustment also had an impact on producing industrial output reports that were weaker than final demand as part of the demand was being met with a rundown in inventories.  With the rundown in inventories having largely run its course, we expect somewhat better production data in the coming months.

We don’t think it is a coincidence that the largest declines in inventories came among large companies where exporters tend to be concentrated.  The most recent survey of manufacturers by the national industrial chamber (CNI) found that large companies ranked the strength of the real as their third most pressing problem limiting growth, while small- and medium-sized companies placed the currency’s strength as eighth.  And interestingly enough, companies of all sizes appear to be more optimistic regarding the export outlook in the next six months.  This increase in optimism should temper the need to decrease inventory levels.

Agora é domestic demand

The good news is that we are seeing signs of a recovery in domestic demand as 2006 begins.   Whether we look at electricity usage, consumer sentiment, credit inquiries or vehicle sales, all are painting a picture of an economy where activity is once again gaining speed.

Electricity demand in January 2006 grew more than 4% relative to January 2005 and is 3.2% higher than the average in the second half of 2005.  Growth in vehicle sales have also picked up in late 2005 and early 2006 in both domestic and external sectors after a sharp dip in the period between August and November 2005.  With exception to of the three month-period ending in January 2006, domestic growth in vehicle sales has been growing on average one and a half times faster than the export vehicle sales suggesting that the external sector is not the main force driving the recovery in this sector in late 2005.

We are also seeing an improvement in consumer confidence in late 2005 and into early 2006 which, along with very strong consumer credit growth and good employment opportunities, should boost consumption.   The sharp increase in the number of inquiries over the use of  personal checks — 8.8% in the period between September 2005 and end of January 2006 — suggests the upturn has begun.

None of this should come as a surprise for those who believe that monetary policy is effective in Brazil, albeit with a lag.   With the central bank having cut by a total of 250 basis points in the past half year, we would be surprised if we were not seeing signs of a recovery in domestic demand.  It should come as little surprise that demand weakened last year. After all, the central bank had continued to hike interest rates until May when the benchmark overnight rate reached 19.75% and then stated that rates would need to remain unchanged for a “prolonged period.”  With the first overnight rate cut not coming until September — with a modest 25 basis point reduction — it is hardly surprising to see domestic demand weakened.

Bottom Line

The notion of a strong real and a weak economy makes for a nice cautionary tale.   The only problem is that the Brazil’s exporters have yet to show the kind of a downturn that we would have expected by now.  Indeed, as 2006 gets under way, export demand appears to be providing yet another boost to unsuspecting producers who have already run inventories down anticipating that the best days had past. 

With the real having moved in the past three years from one of its weakest level in nearly two decades to one of its strongest levels, we don’t doubt that some exporters will begin to feel the pain.   But with trade accounts producing a record $44 billion surplus we must ask whether the currency needs to adjust to keep the record surplus intact: we don’t think so.

The good news is that while the transition from external demand to domestic demand is unlikely to be smooth, it already appears to be taking place as domestic demand returns.  That should produce good growth in 2006 with limited risk that export demand dries up before domestic drivers have a chance to kick in.  That is crucial to the Brazil story: after all, without some of the abundance showing up in consumer pocketbooks, the gains in asset prices could turn out to be hollow and short-lived.

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