Oil Abundance or Addiction?
Mar 21, 2006
Gray Newman (New York) and Luis Arcentales (New York)
Just days before Mexico celebrated the 68th anniversary of Oil Expropriation Day on March 18, there was talk of the discovery of a giant new oil field, this time in the deep waters of the Gulf of Mexico. Although the state-owned monopoly Petroleos Mexicanos (Pemex) warned that more drilling was needed to confirm the size of the reserves, officials suggested that the new field could hold 10 billion barrels.
If true, the new field could provide a major boost to Mexico’s crude reserves, which have been declining in recent years. The latest data show proved remaining reserves at just under 16.5 billion barrels as of January 1, 2006, down from just over 17.6 billion the previous year. The decline in oil reserves comes amid conflicting reports over how much Mexico’s dominant oil field, Cantarell, can continue to produce and how easily Mexico can tap deep-water fields. Cantarell produces nearly 60% of Mexico’s 3.4 million barrels per day, but has already provided Mexico with some 11.5 billion barrels of crude since it started up production in 1979. Pemex estimates that Cantarell’s proved remaining reserves are just over half what has already been extracted. Amid of all the talk about whether Mexico should focus on deep-water sites or look to shallow-water and onshore fields, no one seems to focus on Mexico’s more serious fiscal problem: its oil addiction. It is remarkable how little the federal government has done during the past quarter of a century to reduce its dependency on oil. At the beginning of this year, oil revenues accounted for 36% of total public-sector revenues. This has been remarkably unchanged during the past 20 years, with oil on average representing 32% of total revenues since 1986. In the early 1980s, oil’s participation in public revenues soared, reaching 50% in 1983 before tumbling below 30% six years later. But during most of the past 20 years, oil receipts have fluctuated around one-third of total revenues. In contrast, Mexico’s private sector has done a remarkable job in creating alternatives to oil exports. Twenty-five years ago, in early 1981, oil exports represented nearly three-quarters of total exports from Mexico. By early 1983, that proportion had reached almost 80% before the collapse in oil prices and the boost in manufacturing goods toppled oil from its dominant perch. By the late 1990s, with oil prices depressed, oil accounted for only 6% of total exports. Today, even after oil prices have soared, oil exports account for only 15% of total exports. The decline in the importance of oil has come not simply as oil export production has fallen but as manufacturing has taken off. Indeed, oil exports in the 12 months ending in January 2006 reached just over $33.3 billion — nearly twice the peak seen in early 1983 of $17.4 billion. Nonetheless, oil today represents less than one-fifth of its former weight in Mexico’s export mix a little over 20 years ago. We are not hopeful, however, that Mexican policymakers will do much to wean the federal government of its oil addiction. Indeed, with oil prices at these levels the chances of meaningful fiscal reform are reduced. Whatever the intentions of one group of policymakers or another, the abundance in oil-related revenues is likely to make it very difficult to tackle Mexico’s fiscal challenges. That is a shame, especially given the political calendar in Mexico. The next administration will likely have its greatest store of political capital when it takes office on December 1, 2006. However, if oil remains high we are afraid that the next administration will have a difficult time pursuing the much needed fiscal reforms, ranging from tackling the public pension shortfall, boosting its inadequate tax base and tax take, correcting its pro-cyclical fiscal policy tendency and boosting public investment while protecting it from cyclical downturns. Mexicohas made some progress on this front. A budget reform, recently passed in congress, should help insulate the oil reference price from the current political jockeying in which the administration and congress negotiate on a final budget reference price each year. Under the new law, the reference price will be set by a formula looking at a blend of historical averages and future prices. Nonetheless, the new law, which enters into effect on April 1, provides only limited protection to prevent persistently high oil prices from producing permanently higher current spending. Mexico’s track record of the past five years, in which oil prices have surprised on the upside and provided an abundance of fiscal resources, has not been very encouraging. In the five years ending in December 2005, spending was up on average 5.3% in real terms, while public investment spending fell by 1.8%. Because only a portion of the PIDIREGAS (largely Pemex infrastructure investment projects) that is being amortized each year is included in the budget, the true public investment figures are not as bad as our first analysis suggests. Nonetheless, public investment remains inadequate and has suffered in recent years as abundance has been channelled into current spending and most often into public-sector payrolls. It is easiest to deal with transitory shocks, but shocks that turn out to be persistent but not permanent are perhaps the most difficult of all for policymakers. Mexico’s challenge is to ensure that the high oil prices of today are used to boost investment spending rather than finance recurring or current expenditures. Unfortunately, as we have seen in recent years, the abundance of convergence inflows — from the oil bonanza to strong worker remittances to foreign direct investment and tourism — has robbed Mexico’s policy class of the urgency to tackle Mexico’s competitive challenges, many of which require better use of public spending. Bottom line Whether or not the latest oil find turns out to provide Mexico with accessible crude that can be added to its proven reserves is ultimately the wrong question to be asking policymakers. The challenge for Mexico is to avoid the complacency caused by an abundance of inflows. We would like to argue that the next administration will tackle this problem and boost much-needed public investment, even as it works to wean itself off of Mexico’s oil addiction. But the experience of the past 20 years on that front has not been encouraging. We remain sceptical.
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Addressing Backlash Against Reform
Mar 21, 2006
Andy Xie (Hong Kong)
Summary & Conclusions China is experiencing the most intense debate in a decade on the merits of its reform and open-door policy. Rising inequality and rising household financial burdens are the triggers. The debate is another factor that will shift China’s priority from growth to non-growth issues, I believe. The growth target in the 11th five-year plan (2006-2010) is 7.5%, compared with 9.5% for the past 25 years. By setting a low target, the government has room to focus on urgent issues, such as income inequality, education, healthcare, housing, and pollution. By addressing these issues, the Chinese economy will shift away from investment and exports to consumption, in my view. Debating the reform and open-door policy China’s GDP expanded by 57.3% in constant price terms and 83.8% in current price terms between 2000 and 2005, according to China’s National Statistics Bureau. Negative sentiment towards the economy has increased rapidly, despite the fast growth. The latest manifestation of this is the resurgence of anti-reform sentiment. Extreme income inequality and other ills in China’s economy have always elicited strong opinions. However, until recently, the reform and open-door policy had not been questioned seriously for a decade. The current debate centres on whether the reforms have caused the problems and have gone too far — that is, questioning the merit of the reform and open-door policy. One concrete example of the backlash is the negative sentiment towards the sales of state-owned assets to foreign capital. Private equity firms, for example, are facing more difficulty in acquiring state-owned enterprises. Even the IPOs of state-owned companies in Hong Kong are being questioned. The rallying cry is that China is selling its assets to foreign capital too cheaply. Concerns about structural problems in the economy are often linked to doubts about foreign capital, since the rising influence of foreign capital in China’s economy is one of the most visible signs of its open door policy. I estimate that one-fifth of China’s GDP (over half in the export sector) is produced by foreign-owned firms, which would make China the most open large economy in the world. Negative sentiment over foreign capital seems to derive mostly from a small elite, worried that foreign capital may be undermining the development of indigenous companies. The lack of internationally competitive Chinese firms has fanned the flames of such suspicion. The sentiment towards foreign capital among the population is mostly positive. Most local governments still tout the amounts of foreign capital that they attract to their populations. ‘Retreating is no way out’ China’s top leaders have reaffirmed their commitment to the reform and the open-door policy. The Premier has stated that retreating is no way out. The risk of a substantial policy reversal is still low, in my view. Despite the ills in the economy, most people are far better off than 15 years ago, when China was still quite closed. There is little popular support for a step backwards. While the public at large support the reform and open-door policy, they also want their concerns to be addressed. I believe the main concerns are (1) rural poverty, (2) rising income inequality, (3) escalating costs of education and healthcare, (4) declining property affordability, (5) pollution, and (6) work safety. Public demand for government action on these issues looks likely to escalate in the coming years. China’s economic policy has tended to be about sustaining fast growth. Whenever growth has looked like slackening, the government has introduced another wave of reforms to revive momentum. China has trusted in growth as the solution for the country’s problems. Developments in the current boom have shaken this faith in growth. Despite the magnitude of the boom, popular discussions about the economy relate mostly to escalating problems rather than the accomplishments of growth (e.g. infrastructure development). This shift in sentiment is likely to have a significant impact on China’s policy development in the coming years, I believe. The growth target in the 11th five-year plan (2006-2010) is 7.5%, compared with a realized growth rate of 9.5% over the past 25 years. The government’s aim in setting a relatively low target is to leave room to address non-growth issues. The 11th five-year plan is likely to be a period of consolidation for the Chinese economy, in my view. Over the next five years, I think the Chinese government needs to implement policies to address the issues that negatively affect livelihoods. If the problems continue to escalate, the doubts about China’s reform and open-door policy could spread from a small elite to the masses. Diverging trends of economy and household welfare The fixation with growth is to blame for many of today’s problems. To mobilize resources to support investment-led growth, central and local governments have been shifting financial burdens to the masses. Education, healthcare and housing are the most important items. Merely 10 years ago, most people took for granted that the public sector would finance these three necessities. Today, they have come to represent the biggest outlays in household expenditure. This is why, despite income growth, most people feel under more pressure than they did 10 years ago. As the state sector has shed its burdens, it has used its improved financial situation to list assets on the stock market and increase investment. The rise in expenditure on infrastructure, for example, is due partly to the state sector shifting its financial burdens to the household sector. The privatization of the housing market has played an important role in increasing investment. Sales of residential properties increased from 2% of GDP in 1998 to 6.2% in 2005. As household income is about 56% of GDP, this implies that property purchases equate to around 11.1% of household income. The fear of rising property prices is a major driver of rising demand for properties. This item clearly features very prominently in household expenditure, but did not exist 10 years ago. The 1Q06 central bank survey on urban consumption and saving behaviour showed that willingness to consume has reached a historical low and education expenditure is the principal deterrent against consumption. China’s education system has a serious flaw, in my view. Schools are state-owned monopolies, but have flexibility when it comes to charging students. Considering the importance that Chinese households attach to education, schools have great pricing power to raise charges on all sorts of pretexts. Chinese schools behave neither like public schools, which have a mission to serve, nor private schools, which must compete to succeed. The latest report from the World Health Organization ranks China fourth from bottom among over 190 countries on social equity of healthcare. China had a healthcare system completely funded by the government only 10 years ago. The dramatic reversal has had a traumatic impact on livelihoods. Similar to schools, Chinese hospitals are state-owned monopolies that have pricing flexibility. In healthcare, the bargaining position of the patient is essentially nil. It is not surprising that the current system is the cause of considerable resentment. The new and large burdens from shouldering education, healthcare and housing expenses explain why China’s impressive growth has not generated the same increase in household welfare — because the growth has taken place partly at households’ expense. The China Youth Daily recently published a survey showing that 85.3% of the population feel a heavier financial burdens now than 10 years ago. The contrast between economic growth and household welfare is due to the three ‘mountains’ of education, healthcare and housing, which weigh down on household pocketbooks. Indeed, one major reason behind China’s fast economic growth is the shift in these financial burdens from the state to the household sector. Policy implications Change appears to be in the air. The recently completed National People’s Congress focused on the big social issues rather than growth per se. I expect most policy changes in the coming months to address the imbalances in China’s economy. The first area likely to see action move is minimum wages. The city of Shenzhen has just announced an increase in its minimum wage from Rmb 690/month to Rmb 800/month. Senior government leaders are increasingly expressing support for increased minimum wages. I see this as a key ingredient in addressing China’s economic imbalances. More affordable housing is the next objective that needs to be met to increase household welfare, in my view. Many cities are talking about this, but not doing enough, because such a solution is not sufficiently profitable for either property developers or city governments. I would expect to see some new policies implemented this year. The central government is targeting commercial corruption in hospitals and schools as a temporary measure to respond to popular unhappiness. However, reforms are necessary to make these two sectors function efficiently on their own. I believe China needs to introduce government-funded basic education and healthcare and to promote private capital market competition as much as possible to make these two industries efficient.
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Whither the Saving Rate?
Mar 21, 2006
Elga Bartsch (London) and Thomas Gade (London)
A standout feature of the German economy is the marked rise in the household saving rate since late 2000, which has exacerbated the consumer crisis beyond the already meagre disposable income dynamics. In our view, the household saving rate should start to come off its recent peaks in the course of this year, underpinning the consumer recovery and demand for consumer credit. The decline in the saving rate will be driven by an improvement in the government’s budget position, more favourable terms of trade, a gradual decline in inflation and a turnaround in the labour market. In addition, the prospect of a three-point VAT hike in 2007 will likely induce consumers to bring forward discretionary, big-ticket purchases to 2006. Over the longer run, an ageing German society should also weigh on the saving rate. The outlook for a consumer recovery in Germany is the brightest it has been since the boom year of 2000, we believe. The impressive corporate restructuring over the last few years should soon spill over into stronger job growth, thus further feeding into consumer confidence and raising the propensity to buy. Rise in saving rate exacerbated consumer crisis. One of the standout features of the German economy is the marked rise in the household savings rate in the last few years. Over this time-period, the household saving rate in Germany rose from 8.9% of disposable income in 3Q 2000 to 10.8% in 4Q 2005. As a result, household debt excluding mortgages dropped from 43.3% of disposable income in 1999 to less than 38% recently. The cumulative rise in the saving rate of nearly two percentage points over the five-year time span is at the heart of the stagnation in consumer spending over that period. The consumer-spending crisis was especially marked in the consumer-durables components, where the restraint was even more pronounced than for overall spending. A rise in the saving rate should gradually start to reverse. The rise in the German household savings rates stands in a marked contrast to the steady decrease seen the previous decade, when the saving rate fell from 13.2% in 3Q 1991 to 8.9% in autumn 2000. We think the household saving rate should start to come off its recent peaks in the course of this year. The underlying trend might be distorted by the planned VAT hike, which could cause considerable gyrations in the near term. The VAT hike, which will raise the main VAT rate by three percentage points to 19% in January 2007, should induce consumers to bring forward purchases of big-ticket items such cars and other consumer durables into the second half of 2006. At the same time, consumers will likely return temporarily to their previous restraint in early 2007. Looking at the fundamental factors … Often, saving rate dynamics are linked to changes in household wealth. The observed relation, however, is probably at least partially spurious. This is because of measurement issues (notably the potential bias in the household savings rate caused by the asymmetric treatment of capital gains, which are not considered part of household income but are part of the tax bill that gets deducted when calculating disposable income). In addition, changes in the composition of household wealth are likely to be more important than changes in overall household wealth levels, in particular when asset classes perform differently. A number of empirical studies show that the propensity to consume depends on the type of wealth effect (equity versus housing wealth, for instance) and on whether the rise in wealth is regarded permanent or transitory. We therefore focus on fundamental factors other than wealth effects in trying to identify the drivers behind the recent saving rate dynamics in Germany. … reveals a number of different drivers We consider the government budget balance, the old-age dependency ratio, the real interest rate, the terms of trade, inflation and labour productivity growth. In a cross-country analysis, the OECD finds that, of the 5.5 point drop in the German savings rate between 1995 and 2000, 3.0 points could be attributed to an improvement in the government budget position, 1.1 points to a deterioration in the old-age dependency ratio, another 1.0 points to a deterioration in the terms of trade and a drop of 0.4 points to a decline in the real interest rate. Inflation and productivity did not have any measurable impact. 1) Government deficit: Since 2000, we have observed a marked deterioration in the German budget situation as the budget deficit fell from a surplus of 1.3% of GDP in 2000 (related to UMTS auctions) to a deficit of 3.9% of GDP in 2004. This deterioration likely accounts for most of the rise in the saving rate observed. The public perception of the deterioration in the budget deficit position might have been exacerbated by the discussion about the Stability and Growth Pact, after Germany repeatedly showed budget deficits in excess of the 3% ceiling. We project the budget deficit to fall further from the 3.3% of GDP recorded last year and see downside risks to our 2006 projection of 3.1%. We would not rule out that the 3% requirement of the Stability and Growth Pact could already be met this year. Everything else being equal, a one point improvement in the budget balance should lower the saving rate by around three-quarters of a percentage point. 2) Old-age dependency ratio: According to UN population projections, the old-age dependency ratio (the share of the population above 65 years in relation to the working population aged 15-64 years) should rise markedly in the coming years, from a current ratio of 28.1 to an expected peak of 51.3 in 2038. As the individual saving rate typically displays a hump-shaped pattern over the course of a lifetime, a higher share of retirees in the population should, on balance, lead to a lower saving rate. Assuming unchanged behaviour within each age group, the savings rate should ease by 0.1 percentage point every five years based on the demographic drift, we estimate. This is probably at the lower end of a likely range of estimates, as the OECD finds that between 1995 and 2000 the rise in the old-age dependency ratio lowered the saving rate by 1.1 percentage points. 3) Terms of trade and inflation: Changes in the terms of trade, the ratio between export and import prices, tend to correlate positively with the savings rate. This is because the terms of trade affect the nation’s income. Over the last few years, Germany experienced a noticeable deterioration in its terms of trade due to a weakening currency and rising oil prices. Because the propensity to consume is smaller than one, consumption will typically retrench less than income, thus resulting in a small decline in the savings rate. This behaviour is in line with households’ tendency to smooth consumption overtime. While we expect the currency to strengthen gradually and oil prices to eases, the VAT hike will likely dent national income again in 2007. Similarly, a gradual decline in inflation measured by the consumer spending deflator is likely to increase consumer’s purchasing power and lead to a marginal decline in the saving rate. Near-term consumer outlook The outlook for a consumer recovery in Germany is the brightest it has been since the boom year of 2000. The strong German export performance together with a pick-up in gross fixed investment is gradually filtering through to the German labour market. A rise in private-sector vacancies and sharp increase in corporate hiring intentions argue in favour of improving labour market conditions, we believe. A further pick-up in job growth together with a slight acceleration in wages and salaries will likely cause both disposable income and consumption to expand at a higher rate in 2006. Our call for a consumer recovery in 2006 is underpinned by a marked rise in January retail sales, a continued increase in consumer confidence and in purchasing intentions, as well as sentiment in the retail sector, which have already lifted German confidence indicators back to or above the euro-area average.
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A Clear and Present Danger
Mar 21, 2006
Serhan Cevik (London)
Inflation has already moved above the upper limit of the central bank’s target range. Together with higher energy prices, the accommodative monetary policy stance has clearly moved the Israeli economy out of the deflation zone into an inflationary environment. The consumer price index, for example, increased by 0.6% month on month in February, bringing the year-on-year inflation rate from 2.4% at the end of last year (and 2.7% in January) to 3.1% — the highest reading in the last three years. The latest figure even exceeds the upper limit of the central bank’s target range of 1-3% and presents a new challenge to price stability in an increasingly risk-averse world. Even though seasonal factors as well as higher energy quotes and the lagged pass-through from the shekel’s depreciation to domestic prices made a significant contribution to the rise in inflation, we cannot dismiss the acceleration in inflation rates as a temporary phenomenon. As argued in our previous reports (see, for example, A Time for Normalcy, March 6, 2006), there are a number of underlying factors that have started energising inflationary pressures. Fundamentals, not just currency fluctuations, drive the inflation process. The shekel’s valuation against the dollar plays an important role in driving the headline inflation rate through housing prices and in shaping market expectations. Therefore, the shekel’s weakness was an important factor in driving the inflation process. Lately, however, the dollar’s weakness in global currency markets has turned favourable and is likely to have disinflationary effects in the coming months. Nevertheless, overlooking inflationary pressures arising from fundamental developments in the Israeli economy would be a serious mistake. Indeed, even if we exclude exchange rate-linked pricing in the housing market, which increased by 5.8% in the last 12 months, the country’s inflation rate surged from 1.3% at the end of last year to 1.9% in January and 2.4% in February. In our view, this is not a surprising development, since the central bank’s expansionist stance has supported an (export-led) above-trend output growth and contributed the upward shift in inflation dynamics. With robust GDP growth and the labour-market recovery, the output gap is no longer deflationary. Although disinflationary effects of globalisation are still a good barrier against inflationary shocks, domestic fundamentals slowly gain an overwhelming influence on ‘core’ prices. With above-trend GDP growth and the sustained labour-market recovery, the output gap is no longer at a deflationary level, in our opinion. Real output growth in the business sector, for instance, accelerated from 2.5% in 2003 to 6.3% in 2004 and 6.6% last year — in line with our projections, but much higher than consensus and official estimates. Furthermore, the unemployment rate, improving from the peak of 10.9% in 2003 to 9.9% in 2004 and then to 8.8% in end of last year, declined to 8.7% of the civilian workforce in January. And the latest indicators, such as the state of the economy index, which posted an average year-on-year increase of 5.6% in the first two months of the year, confirm the persistence of this trend that will, on our estimates, bring about a 4.5% increase in real GDP this year. In other words, we expect the output recovery process to become a proper economic expansion and lead to further reduction in excess supply over demand. Today’s economic and financial conditions warrant a tighter monetary policy stance. There is still no widespread pressure on wages, but the productivity slowdown, coupled with higher commodity prices, is enough to produce a rise in unit labour costs and to push producer prices higher. Indeed, the producer price index posted a year-on-year increase of 8.2% in February, up from 5.9% in January and 5.3% at the end of last year. Even though we do not expect an immediate pass-through from producer prices to the CPI, today’s economic conditions tolerate greater pricing power in the corporate sector and fuel the rise in ‘core’ inflation. This is why the Bank of Israel is likely to raise short-term interest rates from 4.75% towards 5.5% in the coming months. In our view, such an adjustment would normalise the monetary policy stance, but still keep real interest rates well below the historical norm, thanks to structural improvements and fiscal correction. Given the shekel’s significant undervaluation and Israel’s favourable net international position, the return to normalcy will help maintaining price stability and keeping the economy on a sustained growth path.
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