Growth Surprise
Mar 30, 2006
Eric Chaney (London)
Although we focus mostly on the manufacturing section of monthly business surveys to assess the euro area outlook, it is worth keeping in mind that in Germany, the improvement in business conditions include the retail and construction sectors which, in recent years, were a significant drag on the overall economy. As my colleague Elga Bartsch has advocated for a while, German domestic demand seems to be currently taking off (see for instance “Whither the Saving Rate” and “Home, Sweet Home”, Elga Bartsch, March 17, 2006). Because domestic demand has been stagnant since 1999 in the largest European domestic market, a change for the better would have deep implications for the region.
Production has not yet caught up with demand Current production indicators rose in all countries but Belgium. The German indicator rose to 1.8 points of standard deviation above long-term average (p.s.d.), a level not seen since May 2000, while the euro area indicator rose from 0.7 to 0.9, its highest level since November 2000. While some factors might embellish the German indicator somewhat artificially (see the risk section below), the upward trend is also visible in other countries, suggesting that there is a common macro factor behind this positive trend. Surveys indicate that it must be demand. Indeed, demand has been improving faster and more steadily than production over the last few months, the euro area index now standing at 1 p.s.d., a level not seen since March 2001. Clear evidence that European companies were taken by surprise is their assessment on inventories, reported as significantly insufficient in the three last surveys. The regional pattern of demand trends is similar to that of production: Germany is capturing most of the apparent acceleration of demand. However, here again, a similar albeit not as strong trend is emerging in other countries. The most interesting case is Italy where, despite political uncertainties and competitiveness issues, demand is steadily accelerating. Monetary policy works, with time-varying lags That production is driven by demand in the short term may sound tautological, even though large terms of trade changes often blur the picture. Since terms of trade have been stable over the last six months, the next relevant question is what is the common factor fuelling demand growth? Global trade growth, although robust, has not accelerated, while the euro area demand indicator was up every single month but one since the May 2005 trough. Therefore the common factor must be domestic. In my view, the obvious suspect is credit. Although lagging one month behind surveys (still a much better performance than so-called hard data such as industrial production), credit numbers are strongly supporting the domestic demand driven recovery theory. Credit to the private sector accelerated from 9.9%Y in January to 10.6% in February, with loans to consumers cruising at 8.2%, housing loans at 11.8% and long-term loans to non financial companies at 10.2%. In the end, low real interest rates are positively impacting the real economy. The surprise is more about long time lags in the monetary policy transmission mechanism than in the macro impact itself. Unfortunately, time lags are not constant. In this particular cycle, I guess that the monetary policy stimulus applied by the ECB since the end of 2002 dissipated into corporate balance sheet restructuring in a first stage. According to our European Analyst Survey, two-thirds of listed companies had repaired their balance sheets by the end of 2004. Hence, it is only since last year that low rates started to stimulate real demand via the credit channel. If this is correct, then policy makers should be aware of possible asymmetries in the transmission mechanism: the time lag following a policy tightening might be shorter than the lag that followed the stimulus. A growth surprise in the second quarter too? Our quantitative tools confirm that GDP probably grew above trend in the first three months of the year: our early GDP indicator is still up 0.7% (quarterly rate) for that period. True, adverse weather conditions may alter the picture, but we believe that our survey-based indicators are giving a fair idea of the underlying trend. Looking forward, we thought that March surveys would announce a slowdown in the coming months. This did not really happen: while manufacturing production should slow somewhat, albeit still growing above trend, our early GDP indicator is up 0.6% in the second quarter, not a significant change from the first quarter and a rate far exceeding the paltry 0.3% to 0.4%Q recorded last year. Our Business Cycle Compass is even pointing to upside risks: in both February and March, it was comfortably settling in the “Strong and Accelerating” region. Are surveys disconnected from the real economy? Because the Ifo index is, at 105.4, in a region normally associated with annual German GDP growth rates around 4%, a performance that seems out of reach at this stage, many investors and policy makers have renewed doubts about the relevance of business surveys. Also, the very large gap between Ifo and surveys from other euro area countries is hard to explain. One thing is sure: the feel-good factor is back in corporate Germany, thanks to in-depth restructuring, buoyant demand for German brands, and, hopefully, the end of the decade-long recession in construction. However, what holds for German companies, especially manufacturers, does not necessarily apply to the economy at large. For instance, while the performance of German exports in recent years is widely recognised, it has been less noticeable that imports have followed the same path, although domestic demand has not (yet) given signs of life. Mind globalisation but do not jump on conclusions A possible explanation is that German manufacturers have led the pack in off-shoring key segments of their production lines, toward Eastern Europe in particular, in order to cope with labour costs inflated by the consequences of the unification. By cutting their cost base, this strategy is now paying off without necessarily implying a strong upswing in employment and, in the end, consumer spending. Time will tell us whether surveys are as reliable in predicting actual growth as they were in past cycles, before globalisation took the spectacular dimension if now has. In the meantime, we continue to trust them and think that euro area hard data will follow, after the usual rounds of upward revisions. Practically, risks to our 2006 GDP forecast for the euro area, 2.1%, are on the upside, if surveys still have any relevance.
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Temporarily Lacking Excitement
Mar 30, 2006
Sharon Y Lam (Hong Kong) and Andy Xie (Hong Kong)
Bottom line: Overall fundamentals in Korea remain very solid. Export growth stays resilient but we are still waiting for a full-paced domestic demand recovery, which we believe will come in 2H06. In the meanwhile, we think investors are getting more concerned due to what we see as their premature hopes about Korea's domestic demand recovery. We believe we could see sentiment and growth momentum softening slightly in 2Q before picking up again in the later half of this year. Major Strength Still Coming from Exports: On a seasonally adjusted MoM basis, Korea’s industrial production fell 4.4% in February, turning around the sharp gains of 6% in January. Yet, we should take into account that production was frontloaded before the Chinese New Year (CNY) to catch the festival orders. The YoY growth is also affected by the CNY timing and therefore we have to combine the first two months’ data. Industrial production grew +12.7% in Jan + Feb, accelerating from 10.4% in 4Q05 and was also the highest since mid-2004. While domestic demand continues to pick up, economic growth is still more export-driven as witnessed in the continual out-performance of export shipments (+15% in Jan+Feb) over that of domestic (+7.5%). The reacceleration in China’s imports in the past few months contributed to Korea’s export strength, together with continual recovery in Japan. Capex is Needed in Korea: Capex has been missing in Korea since 2001 due to production relocation and the weak domestic economy. Yet we are now seeing the need for more capex in the near-term. Korea’s manufacturing capacity utilization level averaged 82% in the first two months of this year, the highest since 1996. 10 years ago capex grew at double-digits in Korea and the fixed investment-to-GDP ratio reached 38%, causing an overcapacity problem. Today, the economy is again running closer to full capacity level but capex growth has been sluggish in the past few years with fixed investment to GDP ratio now below 30%, the lowest since the mid-1980s. There has been no capex from past years to support today’s tightening capacity. Meanwhile, production growth is accelerating while inventory growth is decelerating (+1% in Jan+Feb vs. +4% in 4Q05), meaning demand outpaces production and therefore utilization level should continue to rise, making the case for more capex. A solid export outlook and a stabilizing won should facilitate this. Still Awaiting Capex Growth to Catch Up. Equipment investment grew 1.2% in Jan+Feb, much weaker than the exceptional growth of 7% in 4Q05. However, we believe we should see more upside on capex based on arguments above. Without capex, employment and wage growth will remain rather stagnant, in our view. Without meaningful improvement in labor market, consumption growth will lack catalysts. Therefore, capex growth is essential to sustain the domestic recovery in Korea. We should monitor closely the incoming data on capex. Consumption Cooling Down After Holiday Seasons: Consumption sales is receding back to trend growth after phenomenal gains during the holiday seasons as we expected (see “Export-Driven Growth” November 29, 2005). Retail sales growth slowed to 3.5% in Jan+Feb from 6% in 4Q. Sentiment was exceptionally upbeat during Xmas since it was the first positive holiday season after the credit card bubble burst in Korea. After a period of wilderness, we expect some normalization in sentiment. Meanwhile, the recent minor correction in the equity market is also reducing wealth drivers for consumption. Korea’s consumption growth is currently very much dependent on sentiment and unanticipated wealth gains, leading to concerns about the sustainability of consumption recovery. The source of this concern is because the permanent driver of consumption – wage growth – has not picked up yet in Korea. Labor market conditions in Korea now seem more closely related to service sector performance than export due to manufacturing hollowing out. As Korea is seeing service sector expansion, labor market conditions and wage growth should improve, except that the labor market always lags the overall economy by about 6-12 months. We should see more wage growth feeding through, probably in 2H06. Yet before then, we think it likely that we will see some more softening in consumption growth in the next 2-3 months. Growth Momentum May Soften in 2Q Before Acceleration in 2H: Good news is lacking in the near-term. Externally, there are more voices about Fed tightening more than expected. There is increasing concern over the decade-high level of unsold new homes in US and the consequent housing price decline. Internally, Koreans have not felt labor market recovery yet and polarization becomes a topic again as wealth and wage growth diverges. We therefore believe consumer sentiment in Korea may soften in 2Q. However, our US economist, Richard Berner, is confident about hearty growth continuing in US; while we are expecting labor market recovery in Korea later this year, and sentiment and growth momentum may pick up again in 2H06. Korean Won to Stay at Current Level in the Next 6 Months Before Appreciating Again by Year-End: We are unlikely to see more appreciation pressure on the Korean won in the near-term. We believe USD/KRW will stay at the current level of 970-980 for the coming months, and do not rule out the possibility of marginal weakening in the won. This is mainly due to signals from the Fed of further tightening, which will support the USD. Second, the current account surplus in Korea is declining, thereby reducing demand on the won. In February, the current account even posted a deficit of US$0.8 bn due to faster import growth in both goods and services. We should continue to see a low current account surplus, or even deficits, in March and April as these are the months for equity dividend payments, which will see income outflows from Korea. Finally, a temporary softening growth momentum in 2Q is also likely to cause less pressure for appreciation on the won, if not to weaken it, in the near-term. Towards the end of this year, however, USD/JPY is likely to fall due to possible completion of the Fed’s tightening cycle, while Japan may begin to raise interest rates. Asian currencies should see more appreciation pressure again by then, particularly so for Korea, as we expect domestic demand growth to accelerate in 2H06.
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Productivity Revival
Mar 30, 2006
Serhan Cevik (London)
Despite recent disappointments, the Turkish economy remains on a robust growth path. Global capital markets have faced a burst of volatility in recent times, partly because of higher interest rates in developed countries channelling portfolio allocations away from ‘riskier’ assets like emerging markets. Along with increasing risk aversion, the Turkish government’s disappointing performance in dealing with the appointment of a new central bank governor and with microeconomic challenges of globalisation resulted in a depressing mood among market participants. Although, as we argued in our previous dispatches, politicising the central bank and fiscal deviations harm the country’s institutional credibility, there is still no convincing evidence suggesting economic deterioration at macro level. Indeed, defying sceptical assessments of macroeconomic normalisation, the above-trend increase in labour productivity in the manufacturing sector supports our view that the Turkish economy will continue enjoying strong income growth and disinflation towards the ‘price stability’ range. Productivity growth accelerated to an annual rate of 8.5% in the last quarter of 2005. Factor accumulation, without accompanying efficiency gains, cannot bring sustainable economic growth. In Turkey’s case, however, productivity improvements, one of the most underappreciated aspects of the post-crisis performance, have been the principal driver of the longest stretch of uninterrupted output growth in history. Output per worker, for example, surged at a year-on-year rate of 8.5% in the fourth quarter of last year, up from 6.1% in the third quarter and 3.8% in the first half. Even in terms of output per-hour worked, the rate of productivity growth accelerated from an average of 4.7% in the first half of 2005 to 7.2% in the second half (and 8.4% in the last three months) of the year. The sustained productivity acceleration, providing greater impetus to output growth, has also facilitated disinflation towards single-digit territory. In our view, prudent policies and structural reforms, functioning like a technological innovation, have set the stage for above-trend growth in productivity as well as in real gross domestic product (see Stabilisation as Innovation, May 9, 2005). The rise in output per hour-worked in the manufacturing sector, reaching 38.5%, on a cumulative basis, in the post-crisis period, has clearly outpaced the 32.5% rise in real GDP and become a major source of disinflationary pressures in the economy. Productivity gains improve the quality and sustainability of output growth. According to our projections, the upward shift in the underlying productivity trend will remain intact and keep pushing the country’s production frontier higher. Thanks to a lower cost of capital and the moderation of the business cycle, greater investment appetite in the corporate sector supports this positive feedback loop. In particular, the 187.7% real increase in business investment spending on machinery and equipment — compared to a 24.2% increase in construction expenditures — increases the capital/labour ratio and thereby should help to maintain higher trend productivity growth in the longer run. Indeed, we believe that these efficiency gains, going beyond labour input, as Turkey’s total factor productivity growth accelerated from an average of 0.5% a year in the 1990s to 4.8% in the post-crisis period, will continue improving the quality and sustainability of non-inflationary output growth. Institutional deficiencies and microeconomic bottlenecks result in sectoral divergences. Despite all these gains at macro level, there are significant industry-level divergences. Traditional sectors like textiles and clothing, in particular, have long suffered from a downward trend in productivity that, coupled with the rise in the minimum wage, resulted in higher unit labour costs. The clothing industry, for example, experienced a 9.8% decline in output per worker, even with a 3.0% drop in employment, last year. This is a complex problem that cannot be explained away by the lira’s strength. In our view, institutional shortcomings and technological backwardness, especially among small and medium-sized firms, not the level of the exchange rate, are the real problem (see Of Lemons and Dinosaurs, March 1, 2006). And the situation would only get worse if the authorities fail to accelerate structural reforms and to deal with institutional deficiencies and microeconomic bottlenecks of the economy.
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