A Time for Normalcy
Mar 07, 2006
Serhan Cevik (from Rotterdam)
The monetary tightening cycle is not over, but short-term rates are now closer to neutrality. The Bank of Israel kept short-term interest rates unchanged at 4.75% in March, after tightening by 125 basis points in the previous six months. Could this be the end of the monetary tightening campaign? Judging from inflation expectations derived from the capital market that have lately stabilised within the multi-year target range of 1-3%, the central bank’s decision to stay on hold may seem appropriate. However, even though the policy rate has moved closer to the neutrality zone, we believe that there is more — at least 50 basis points — adjustment in the pipeline. Actual inflation remains close to the upper end of the target range and is likely to accelerate in the coming months (simply because of seasonal factors and higher energy prices). Having said that, our expectation of further monetary tightening is based not only on short-term fluctuations in the headline inflation rate, but also on fundamental factors that lead to the narrowing output gap and an inflationary build-up in the Israeli economy.
The latest indicators show that the Israeli economy is growing at an above-trend pace. Real GDP increased by 5.2% last year, on top of 4.3% in 2004 and 1.7% in 2003. More importantly, output growth in the business sector accelerated from 2.5% in 2003 to 6.3% in the following year and then 6.7% in 2005. And there is no indication of a sharp slowdown in economic activity. In fact, all the indicators point towards the continuation of above-trend output growth. For example, the state of the economy index, a composite gauge providing reasonable guidance for the path of real GDP, posted an annual increase of 6.0% in January, up from 4.8% last year, thanks to strong expansion in services. Likewise, the purchasing managers index recorded an annualised increase of 16.5% in the first month of this year, mainly on the back of a marked improvement in the domestic demand component of the index. Indeed, both durable goods and housing sales recovered sharply in the fourth quarter of 2005, building a momentum that is likely to remain intact in 2006. All in all, the prevailing trends support our view that GDP is likely to expand by 4.5% in real terms this year. Even considering the slack in the labour market, that would mean further compression of the output gap and signal inflationary risks. Inflation is likely to remain close to the upper end of the target range in the first half of the year. The consumer price index posted a month-on-month drop of 0.3% in January, bringing the year-on-year inflation rate from 2.4% at the end of last year to 2.7%. Once again, the rise in inflation was — partly — a result of the lagged pass-through from higher energy prices and the shekel’s weakness. For instance, if we exclude the housing component, which is linked to the dollar and posted an annual increase of 6.1% in January, inflation stays at 1.9%, a touch lower than the mid-point of the central bank’s target range. Thanks to competitive pricing in global markets, sectors open to competition (such as clothing and footwear) continue to experience deflationary pressures. However, beyond the globalisation of disinflationary dynamics, core price indices, behaving reasonably well so far, are likely to show the accumulated effect of expansionary monetary policy. Despite the slow recovery in wages, the marked slowdown in productivity growth is putting upward pressure on unit labour costs, while the corporate sector gains pricing power, thanks to strong growth in consumer spending. We expect the normalisation of monetary conditions, not a ‘restrictive’ policy stance. In our opinion, structural reforms and fiscal consolidation allow the Bank of Israel to experiment with keeping real interest rates at a lower plateau, compared with the past. Nevertheless, even a ‘new paradigm’ would not justify maintaining an obviously accommodative monetary policy stance for an extended period. Like it or not, currency fluctuations play a significant role in determining both actual inflation (through the housing component as well import prices) and inflation expectations; and a significant deviation in interest rate differentials from the market’s tolerance level may result in an abrupt adjustment. This is why the central bank can never completely ignore what happens to the exchange rate. However, given that the shekel is already undervalued and Israel’s net international position remains strong, we do not see any justification for an aggressive tightening of monetary conditions, but just a gradual return to normalcy.
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Downgrading GDP on Political Uncertainty
Mar 07, 2006
Andy Xie (Hong Kong) and Deyi Tan (Singapore)
We are lowering our 2006 Thai GDP forecast to 4.9% from 5.4% on political uncertainty, which we expect will delay investment recovery for two quarters at least. The risk is that the political uncertainty will last into 4Q06 or beyond and its impact on the economy will be greater than we currently expect. We are raising our inflation forecast to 5% from 4.5%. The Thai economy is operating near full capacity. We think energy-led inflation is likely to spread more than is generally expected. We expect the Bank of Thailand to raise the 14D repurchase rate three times this year by 75 bp to 5%. The 4Q05 GDP growth rate was 0.9% QoQ vs. the market’s expectation of 1.4%. This confirms the slowing trends in consumption and property in response to rising interest rates and high energy prices. The trends are likely to continue as the high capacity utilization levels keep inflationary pressure high and interest rates rising. Investment recovery is a necessary condition for the Thai economy to reverse the trend. That is unlikely to happen until the political uncertainty ends. We are not revising our 2007 forecast yet, because we believe that the political uncertainty should dissipate by then. If the situation does not ease in the coming months, we may have to revise our forecast again. Reaching full capacity Recent data suggest that the Thai economy has reached full capacity. Further growth requires capacity expansion through investment. The Bank of Thailand reported the capacity utilization level in January 2006 at 73.3%. The average capacity utilization in 2002 was 63.6%. The export recovery and fiscal stimulus caused rising capacity utilization and economic recovery. This low-base-led recovery has ended. High capacity utilization changes inflation dynamics. Rising energy prices are considered the cause of the high current inflation rate (5.9% in January and 5.6% in February 2006). High capacity utilization allows inflation to spread more easily. In Northeast Asian economies, such as Korea and Taiwan, broad price gauges (e.g. the GDP deflator) rise much more slowly than the CPI. In Thailand, the GDP deflator has been rising in tandem with the CPI, indicating a more serious inflation problem. The government believes that headline CPI inflation will fall sharply in 2H06 as energy prices level off on a year-on-year basis. This expectation may be too optimistic, in our view. As the political uncertainty delays capacity expansion, inflation could stay higher and last longer than the government or the market expects. The Bank of Thailand has kept real short-term interest rates negative for three years. This made sense during a period of low capacity utilization. However, as the economy reaches full capacity utilization, the central bank will need to keep real interest rates positive or risk inflation accelerating out of control. We believe that the Bank of Thailand will raise interest rates by 75 bp to 5% before the end of 2005. Headline inflation may decelerate to 4% by the year-end. This would still leave real interest rates quite low. We see the potential for further rate hikes in 2007. Consumption, property and exports have slowed 4Q05 GDP growth was 0.9% quarter on quarter, vs. the market expectation of 1.4%, due to consumption and property weakness. This is to be expected as interest rates and oil prices have risen considerably. As long as the economy is at full capacity, interest rates will need to rise further. Hence, consumption or property recoveries are not likely this year. The retail sales index has been decelerating sharply for eight months. Rising energy prices are a major factor. Energy imports reached 11.8% of GDP in 2005, from 8.1% in 2004 and 6.3% in 2003. The extra money for energy bills has come out of consumption mostly. Anecdotal evidence suggests that the housing market is cooling. The approvals for new property construction dropped by 13.6% in 2005, compared with a 22.2% increase in 2004. This suggests that property developers are anticipating slower property sales in a rising interest rate environment. The government has announced its intention to invest Bt 200 bn in low-cost housing over three years. Thailand badly needs affordable housing to improve housing conditions for the general population. The property market that affects macro conditions has little to do with the average citizen. As with other mega projects, we think the low-cost housing push may also be delayed. Political uncertainty is likely to delay investment The political uncertainty in Thailand will last for another two quarters, we believe. The risk is that it lasts throughout the remainder of the year. The parliament from the April 2 election should last for a few months, but we think another election before the year-end or in early 2007 is likely. The political uncertainty could considerably delay investment recovery, which is badly needed to sustain economic growth in a fully employed economy. The government has recently cut its predicted Bt 250 billion (3.5% of 2005 GDP) of investment into government-initiated mega projects to Bt 150 billion due to political uncertainty. As that uncertainty has worsened considerably in recent days, we think the outlook for the mega projects in 2006 is now much dimmer. In addition, private sector investment, especially that complementing the mega projects, could be delayed also. The cooling housing market has already slowed private investment considerably. The outlook for investment is quite poor this year, in our view. One glimmer of hope is that Thailand’s solid export performance could push the private sector to invest in building capacity regardless of the political environment. However, such a mitigating factor is unlikely to reverse the decelerating trends elsewhere.
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January Exports Eased Slightly
Mar 07, 2006
Deyi Tan (Singapore) and Denise Yam, CFA (Hong Kong)
Exports eased slightly: Exports rose 11.7% year on year (YoY) in January (vs. 13.2% YoY in December). Imports expanded 9.2% YoY (vs. 8.1% YoY in December). Trade balance stood at RM9.3 billion (vs. RM9.4 billion in December). US demand continued; China demand faltered: ASEAN (+11.3% YoY), the EU (+9.0% YoY) and the US (+25.4% YoY) were the leading growth markets. Exports to the US contributed the most to growth at 4.5 percentage ponits. Meanwhile, exports to China disappointed, growing at 6.1% YoY in January (vs. 42.8% YoY in December). Exports to Japan, the third-largest export market, maintained a 5.6% YoY pace (5.6% in December). Major exports continued to be electrical and electronic products (47.4% of exports) and resource commodities, such as crude petroleum (+6%) and natural gas (+5.2%). However, in terms of growth, electrical and electronic products seem to have slowed markedly (+2.5% YoY vs. 16.8% in December), although the two resource commodities expanded by 25.8% (vs. +56.1%) and 28.8% YoY (+11.1%), respectively. Capital intake up; consumption imports still chug along: Intermediate goods imports were relatively weak (+3.5% YoY) in January. After registering a series of contractions (-4.8% YoY) in 4Q05, the capital goods intake was up (+25.4% YoY). Consumption goods remained at 10.8% YoY, indicating a private consumption strength that is still running in high single-digit territory (+9.0% YoY in 4Q05). Rising trajectory remains but recovery could be more shallow: We expect the rising trajectory broadly to remain in 1H06, although the recovery this time around is likely to be more shallow than that of 2004, when high commodity prices and IT demand simultaneously buoyed trade. This time, we expect semiconductor demand to normalize from the 28% pace we saw in 2004 to 10% (vs. 7% in 2005). The YoY increase in oil prices, which is what matters for trade growth, is likely to moderate, given the high base.
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