United States
Corporate Profits -- Deceleration Ahead
Mar 31, 2006

Richard Berner (New York)

Corporate profits boomed again over 2005, rising 14.6% (on a fourth quarter over fourth quarter basis) as measured in the National Income and Product Accounts (NIPAs) and 14.1% (per share) for the S&P 500.  The surge measured in the NIPAs took profit margins to a record high.  And 2005 marked the fourth straight year of double-digit gains in S&P operating earnings.  Given that we expect hearty economic growth in 2006 — indeed, stronger growth than in 2005 — it would be reasonable to think that we also expect double-digit earnings growth to persist in 2006.

It would also be incorrect.  In fact, we expect that profit margins will flatten and earnings will decelerate in 2006 to about 7.5% (again Q4/Q4).  The reasons: Fading operating leverage and rising unit labor costs and interest expense likely will promote convergence between the growth of earnings and the gains in nominal GDP or sales.  While we’ve been incorrectly expecting earnings growth to fade for a while, this time it’s for real.  Here’s why.

A look at the analytics of profit margins helps pinpoint the reasons for our call.  Profit margins have exploded since their trough late in 2001.  Measured as the quotient of “economic” profits to corporate GDP, margins rose by more than 500 basis points to a record of 13.8% by the end of 2005.  Five factors were at work: First, companies were able to exploit the high levels of operating leverage in their business.  High fixed costs — primarily for depreciation — have given Corporate America significant operating leverage.  When spread over a broader revenue base in recovery and expansion, such costs decline significantly in relative terms and contribute to a surge in margins.  Over the past four years, depreciation changes as a share of GDP have declined by 220 basis points.  In addition, corporate interest expense has declined as a share of corporate GDP by 170 basis points in the past four years, the product of both declining interest rates and CFOs’ efforts to clean up their balance sheets.  Third, record productivity gains kept unit labor costs either falling or subdued.  Over the past four years, productivity in nonfarm business rose by an annual average of 3.3%, restraining the rise in unit labor costs to an annual rate of 1.2%.  That helped keep compensation charges level as a share of GDP. 

More recently, earnings from overseas operations have improved significantly, net of payments abroad by 16.8% over the course of 2005.  With non-US growth improving, those results are likely to rise more strongly than earnings here.  And finally, pricing power is making a comeback; that has been a key investment theme for US equity strategist Henry McVey . 

Some believe that is mainly due to the relentless rise in energy prices.  After all, rising energy quotes accounted for about two-fifths of the increase in popular price gauges such as the CPI over the past year.  Correspondingly, the energy patch accounted for a major share of the growth in 2005 S&P earnings — 560 basis points of the 14.1% gain, according to our US equity strategy team.  But energy isn’t the whole story when it comes to pricing power.  The broadest price gauge and the one relevant for profits earned in the United States is the GDP price index.  Excluding food and energy, increases in that price index averaged 2.9% last year, the fastest pace since 1992.  That may exaggerate the improvement, which is far from ubiquitous, but a host of industry segments such as hotels, rails, construction, insurance, and healthcare have improving pricing power.

The upshot: While the first three factors that have lifted margins are now likely to fade, we expect that overseas growth and pricing power will continue to improve, limiting the margin compression.  As a result, fears of a sharp deceleration in earnings are overblown.  Our strategy team’s new Earnings Growth Leading Indicator suggests that earnings will grow just 2% in the year ahead.  In my view — and theirs — the direction of growth is right, but the indicator overstates the slippage (see “Modifying S&P 500 EPS and Sector Weightings, Henry McVey and team, March 23, 2006).

In contrast, Wall Street industry analysts’ estimates of earnings are consistently too optimistic, and current forecasts are exceptionally optimistic, implying that margins will continue to rise.  The bottom-up estimate of 13.3% over the four quarters of 2006 compares with our estimate of about 7.5% and the strategy team’s estimate of 9.4% (year over year).   Our earnings forecasts are hardly weak, but if we are correct, earnings growth shortfalls may come as a surprise to the consensus over the next few quarters. 

Although we see profit margins flattening over the course of 2006, our still-sanguine earnings prognosis clearly reflects our expectations for hearty growth.  The risk: Even slightly weaker economic growth would be a key challenge to the earnings outlook.  The combination of flattening margins and slower growth would scale back operating leverage and temper earnings growth significantly.

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Global
Foul Winds
Mar 31, 2006

Jeffrey Matsu (New York)

“I had a little bird,

  It’s name was Enza.

  I opened the window,

  And in-flu-enza.”     (Children’s rhyme, Spanish Flu pandemic of 1918)

Since its outbreak in mid-2003, the H5N1 virus has affected poultry and wild birds in a total of 45 countries across Asia, Europe, the Middle East, and Africa.   This has led to the death or culling of over 160 million birds, yet surprisingly little is understood about the transmission mechanism of the disease.  Until recently, it was widely assumed that wild waterfowl (i.e., ducks, geese and swans) carried the virus only in its low pathogenic form.  This was thought to limit the geographic reach of H5N1, hence increasing the efficacy of containment strategies should an outbreak occur among domestic flocks.  The virulence and rapid spread of highly pathogenic avian influenza (HPAI) in birds worldwide, however, suggests that migratory birds may be capable of traveling long distances with the virus.

Over the past three months (January-March 2006), wild bird infections have appeared in 18 of the 31 countries reported as newly infected.  In late February, France announced the first case of HPAI to hit domestic poultry in the European Union, followed shortly thereafter with the fatal infection of several domestic cats in Germany and Austria.  To date, there have been 186 confirmed human cases of avian flu and 105 deaths in eight countries across Asia and the Middle East.  While the primary route of human transmission has been direct contact with infected poultry, or the ingestion of infected birds in the case of cats, these isolated instances increase the opportunities for the H5N1 virus to mutate genetically over time into a form that is more easily communicable intra-species — the tipping point of a pandemic.  In this regard, seasonal migratory patterns underscore the important role wild birds could play in sparking the geographic spread of HPAI.

Migratory patterns of birds are not random.  Instead, they follow well-established global flyways.  Of the eight major flyways in the world, infections have thus far been concentrated along the East Asia corridor, which stretches from Australia up toward eastern Siberia and then into Alaska.  The recent global spread of HPAI among wild birds appears consistent with these migratory routes, moving in a northwesterly direction via the Central Asia, East Africa, and Black Sea/Mediterranean channels.  Western Europe lies on the fringes of the Black Sea/Mediterranean flyway, where exposure has generally been limited to wild birds that likely carried the disease back during last year’s wintering season.  It is important to note that countries to the south such as Egypt, Nigeria and India have detected H5N1 outbreaks only in poultry flocks.  This raises the question of whether migratory or domestic birds are primary transmitters of the disease.  As waterfowl commence their spring migration to reproductive areas in the north, countries and entire regions along their flight routes are now on heightened alert for potential outbreaks. 

These concerns are well taken.  Wild waterfowl are natural carriers of all influenza A viruses.  However, of the 16 H subtypes and nine N subtypes of influenza, only the H5 and H7 strains have the known potential to cause HPAI.  While yet circumstantial, there is strong evidence to suggest that migratory birds pass a low pathogenic form of the virus to domestic poultry primarily through their feces.  Through a process of “reassortment” with existing viruses found in the local population, an entirely dissimilar and lethal strain such as H5N1 can emerge.  It is also possible that a second round of gene mutation occurs, from domestic to wild birds, before the manifestation of HPAI.  Three characteristics of the influenza virus are particularly noteworthy in this regard: (1) it can survive in bird feces for over a month, (2) it spreads well in water (e.g., ponds, wetlands, rice paddies), and (3) it is easily transmitted via a variety of locomotives (e.g., contaminated trucks, farming equipment, animal cages, clothing).  Cross-contamination can be greatly reduced by limiting the movement and interaction of domestic flocks and humans with these environments, and following strict disinfection protocols whenever contact does occur.

Until recently, migratory birds found infected with H5N1 were either moribund or dead, often in isolation or small clusters and within flight range of a poultry outbreak.  Since unhealthy birds would be unable to carry the virus over long distances, the assumption was that the disease could somehow be localized and contained (see my dispatch from 28 February 2006, “Pandemic Fallout,” as to why this in itself would be a formidable challenge).  This changed in the spring of 2005, when an unprecedented 6,345 birds from five migratory species were found dead along the shores of Qinghai Lake in central China.  Given that the nature reserve is far removed from any poultry farm, the outbreak offered fresh evidence of HPAI transmissibility across long-distances and, more importantly, between migratory birds.  This was supported by research published by scientists from the University of Hong Kong (Proceedings of the National Academy of Sciences, February 2006), which found that the H5N1 virus could be isolated from apparently healthy migratory birds in southern China.

Epidemiological data indicate that viral samples taken from the most recent outbreaks around the world are nearly identical to those found at Qinghai Lake.  If migratory birds are the primary culprits in the long-distance transmission of HPAI, the virus could work its way up the East Atlantic flyway this spring, much as it did last summer along the Central Asia route into Siberia and parts of Kazakhstan.  The western coasts of Africa and Europe would be particularly susceptible, as the virus then pushes its way into all of Scandinavia.  Denmark and Sweden have already reported isolated cases of infections in wild birds.  At this junction, the East Atlantic flyway diverges westward to northern Canada and eastward over Siberia, overlapping with other north-south routes — fertile breeding grounds for interaction with a host of other migratory species.  The two of primary concern are the yet unaffected flyways of the Atlantic and Pacific Americas, both of which stretch the entire length of coastlines from Canada down to Argentina.  Each flanks the Mississippi flyway, so it is within reason to believe that an outbreak on either coast could lead to widespread continental infection in the Americas by the fall of this year.

Given the complex overlapping of flyways and limited knowledge of the migratory species involved, it is important to emphasize a broad health safety strategy aimed at minimizing the interaction of wild birds, domestic poultry and humans.  Unless every chicken, duck and other related domestic farm animal is kept contained in a biosecure area, it will be nearly impossible to track the primary source of HPAI infection.  The evolution of H5N1 since its outbreak in mid-2003 suggests that migratory birds serve an important link in the spread of the virus, but there are other factors to consider.  These include commercial poultry shipments, the use of tainted agricultural products such as manure-based fertilizers, and the thriving global market for wild animals (which according to the Wildlife Conservation Society includes some four million birds).  Rapid urbanization has also brought wild and domestic animals in closer contact with each other, disrupting migratory routes and increasing the possibility of contagion.  Since it is not feasible to control the spread of HPAI in migratory birds due to logistical, environmental and biodiversity reasons, the focus must be on prevention (i.e., routine testing and vaccination), detection and containment (i.e., culling) in domestic flocks.

Understanding migratory behavior and the major flyways involved is a key element of any global early warning system.  Effective surveillance, early detection and rapid intervention require that governments be transparent in their communications with the public and international agencies such as the World Health Organization.  To enhance our global understanding of HPAI’s transmission mechanism, the scientific community must put aside their national research agendas and openly share viral samples taken from the latest outbreak sites.  While there is little that can be done to prevent migratory birds from landing on our shores, being prepared for their arrival is perhaps the best defense.

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China
Sino-US Trade
Mar 31, 2006

Andy Xie

The US threat of trade sanctions against China lacks credibility: Chinese exports to the US are OEM products shipped on an f.o.b. basis.  The proposed 27.5% tariff on Chinese imports would imply a cost to US companies of over US$60bn, which could trigger a stock market crash and a recession.  This threat is not credible, in my view.

Chinanow is not Japan of the 1980s: US companies have outsourced production to China for profit maximization.  The trade relationship between China and the US is complementary, unlike that between Japan and the US in 1980s.  The US cannot punish China without punishing itself.

The solution to the trade imbalance between China and the US may take five years: As the Fed continues to raise interest rates and the Bank of Japan joins in, US bond yields should increase, US asset prices should soften, and the US trade deficit should decline.  China is boosting minimum wages, social spending and rural support to decrease its savings rate.  

The US Trade Deficit with China Reflects Production Relocation to China from other Asian Countries

Summary & Conclusions

The US Senate appears to be pulling back from imposing a 27.5% tariff on Chinese imports.  I believe the threat has never been credible.  Chinese exports to the US are mostly OEM products on f.o.b. contracts.  The tariff would hit US importers, which are mostly prominent listed US companies.  In turn, this could cause the US stock market to crash and the US economy to slide into recession.

The belief that the US trade deficit with China may be addressed through Chinese currency revaluation is fatally flawed, in my view.  I think the solution must entail a rise in the US savings rate and a fall in China’s savings rate.  Neither can be accomplished through an adjustment of China’s exchange rate.

Increasing the US savings rate requires high real interest rates and lower asset prices in the US.  Decreasing China’s savings rate requires China to increase minimum wages, reform education and healthcare finance, contain the property bubble, boost social spending, and return government-controlled assets to the population.

The Fed rate hikes have already stopped US property prices from rising.  However, asset prices are still too high to reverse the US trade deficit.  US bond yields must rise substantially to reverse US asset prices, which requires other central banks to tighten also.  As the BoJ begins to raise interest rates, the US bond yield could rise substantially, and the US trade deficit could finally reverse its upward trend.

China’s central government has already recognized that the investment- and export-led model has run its course, because the export base is too high to sustain the past growth rate.  Further, the model has led to income and wealth concentration that now threatens social stability.  China is adopting policies to boost consumption and improve production efficiency.  I believe it may take five years for China to achieve balanced growth, whereby fixed investment is below 40% of GDP, exports are below 30% of GDP, consumption is above 60% of GDP, and the current account is in balance.

The bottom line is that the solution to the imbalance between China and the US is in sight.  It will just take time.

The Phoney War

Senators Charles Schumer and Lindsey Graham introduced a bill to impose a 27.5% across-the-board tariff on Chinese imports unless China revalues its currency by a similar amount.  The two senators recently visited China.  Media reports suggest that the view of at least one of the senators has changed and the bill is likely to be postponed.  This has been portrayed as a trade war averted.

I have never viewed the threat as credible.  China today is not Japan in the 1980s.  China’s exports are mostly OEM products shipped to the US on an f.o.b. basis.  The US companies that design, brand, and distribute such products in the US own the products.  If a 27.5% tariff is suddenly introduced, the US cargo owners will have to pay first.  They are mostly prominent companies listed on the stock market.

US customs reported US$243 bn of imports from China in 2005.  A 27.5% tariff would amount to US$69 bn, or 10% of the earnings of the S&P 500 companies, mostly to be paid by US listed companies.  This could lead to a US stock market crash and cause a recession in the US.  The bill is just too damaging to the US itself to be a credible threat, I believe.

I am not trivializing the trade friction between the two countries.  The US elite is very concerned about the US trade deficit.  As the US runs the biggest bilateral deficit with China, China is an easy target.

Senators Charles Grassley and Max Baucus are pushing a separate bill that would focus more attention on currency policies, but would stop short of threatening tariffs on imported goods.  It would introduce another tool to ratchet up rhetorical pressure on China.

I think the reality is that a trade war between China and the US is highly unlikely.  In the 1980s the US was importing Japanese products, made by Japanese companies, that were competing against similar products produced domestically by US companies.  Stopping Japanese imports was a credible threat.

In contrast, US companies are in charge of the China trade.  They own the brands and distribution channels, and reap most of the profits from the trade.  They outsource their production to China as part of their profit maximization.  The companies that own factories in China are mostly foreign, too.  It is impossible to hurt China without hurting the US.  The two countries are truly joined at the hip in the global production chain.

Recognizing the inseparability of interests between the two countries is key to finding a rational solution that eases the current tension.  Moreover, in terms of the Sino-US trade and the tension from the imbalance, the interests of China and the US are aligned. 

The Tension

The large and rising US trade deficit is the origin of the tension between China and the US.  The US reported a US$766 bn (6.1% of GDP) trade deficit in 2005 up from US$651 bn (5.5% of GDP) in 2004.  The intellectual, business, and political establishment in the US is showing alarm over the size and direction of the deficit.

Some politicians are portraying the US trade deficit as a China problem.  US Customs recorded a US$202 bn trade deficit (26% of the total) with China in 2005.  Many US politicians have jumped on this and reached the simplistic conclusion that the US trade deficit is due to unfair trade practice by China.  They have focused on pushing up China’s currency value as the solution.

The view that China is the main reason for the US deficit is quite naive.  As global production has moved to China in the past ten years, US companies have been buying more from China-based factories.  However, these factories import components and raw materials from elsewhere.  China runs a big trade surplus with the US but a big trade deficit with the rest of the world.  China reported a US$101 bn trade surplus last year or half of the US’s trade deficit with China.

The relocation of production to China explains the US trade deficit with China.  However, the overall US trade deficit may have benefited from this.  The US trade deficit with East Asia accounted for 38.6% of its total trade deficit in 2005, about the same as five years ago, but sharply lower than the 62.3% in the 1990s.  China’s low-cost production has decreased the US trade deficit, even though it has increased the bilateral trade deficit with China.

Raising the prices of Chinese imports would not do anything to decrease the US trade deficit.  It would increase it.

The other goal of the US policy on China’s currency is that a Chinese revaluation would cause China to buy more from the US.  This is again naive.  There are powerful structural reasons behind China’s high savings rate.  Currency revaluation is unlikely to decrease China’s savings rate, I believe.

The Solution May Take Five Years

Balancing the US-China trade will probably take five years, in my view.  The macro and structural policies are already at work to achieve such an outcome.  The key to containing the US trade deficit is to contain the borrowing binge by US households.  This borrowing binge is made possible by high asset prices.  Low real interest rates have caused US asset prices to remain high.

The Fed has raised interest rates from 1% to 4.75% since mid-2004.  The increase has stopped property prices from rising.  However, the asset prices are still high enough to keep US consumption going and, hence, maintain the high US trade deficit.  As the Fed continues to tighten and the Bank of Japan joins in, US treasury yields should rise significantly, finally reversing the house price trend and, with it, the US trade deficit.

China is introducing structural reforms to boost consumption.  The government is likely to sustain a 15% growth rate for rural support.  Minimum wages are rising at a double-digit rate.  The government is shifting fiscal spending to education and healthcare to ease the household financial burden.

Reforms are on the way to address household insecurity about unforeseen expenditures.  Lack of healthcare insurance, for example, threatens bankruptcy if someone contracts a serious illness.  China could look to introduce a market-based solution in that regard.

I believe both China and the US are moving in the right direction.  The pace may be frustrating to some.  But, a quick solution is simply not possible.

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Japan
Mixed Bag, but Stably Low
Mar 31, 2006

Takehiro Sato (Tokyo)

Nationwide core CPI growth in line with January, but the “Takenaka CPI” gains steam

The February nationwide core CPI was +0.5% YoY, representing four consecutive months of growth, although a shortfall in the baseline (the core of the core) figure kept the nationwide core CPI growth rate below our forecast.  However, the US-style core CPI (known as the “Takenaka CPI”) posted higher growth than last month, with the nationwide index at +0.2% YoY (vs +0.1% in January).  Our overall impression was a mix of both positives and negatives.

Doubts about the weaker nationwide baseline growth

Recent special factors in the nationwide core CPI (fuel, rice, and broadly-defined public service rates) were largely as expected.  Growth in the baseline CPI though, adjusted for special factors, tapered off to +0.09% YoY (January: +0.17%).  Oddly, though, the only category in the nationwide baseline CPI with narrower growth was foodstuffs excluding fresh foods (difference between February YoY contribution and January YoY contribution was -0.02ppt).  Last month’s January data showed a dearth of stand-out categories, despite higher baseline growth, but we find nearly the exact opposite phenomenon in the February data.  This suggests that tabulation errors can be surprisingly large in the CPI data, which round figures to the nearest 1/10th.  We are thus resigned to +/-0.1% approximations that disregard contributions based on 1/100th of a point. 

Median CPI: Both headline and core flat YoY

We take note of the median CPI in order to get a better description of the prices trend.   The nationwide median CPI, which measures YoY changes in median prices for all 598 components of the CPI, stood at 0.0% YoY for both headline and core figures, unchanged from the previous month.  The margin of decline in median prices had widened over the four months up to and including last November, but stabilized since December.  Also, the improvements seen in the median CPI look more moderate than the normal core CPI and the US-style core CPI.

Since the medium CPI filters out much of the noise in the price stats, it is considered the superior base for arithmetical mean comparisons and as an indicator of turning points and inflection points.   That the median CPI is stably trending near 0% indicates that thanks to the revolution in productivity, the real price trend is extremely stable, despite the superficial noise created by regulatory easing, budget cuts, and energy demand, and also the high real economic growth of +3%.

Core and headline look to switch positions

We expect growth in the core CPI to be solidly positive through F1H06, but a number of new factors with price implications are appearing.   On balance, we see them weighing on prices in 2H.

In broad outline, we envision the core CPI inflation rate from F2006 as showing a series of downturns in the growth rate.  Although the Jan-Mar core inflation rate was pushed up to +0.5% by the spike in crude oil prices that in turn pushed up gasoline/kerosene prices and electricity/gas rates, we expect this impact to disappear from Apr-Jun, dropping the growth rate to +0.3%, then to +0.2% in Jul-Sept/Oct-Dec, then to +0.1% in Jan-Mar 2007.   Ultimately, we expect the core CPI rate for F2006 to be +0.2%, much lower than the BoJ’s projected +0.5%.

Based on a simulation analysis of the nationwide headline CPI, assuming constant fresh food prices, we expect the relationship between the headline CPI and the core CPI to reverse starting in June because fresh food prices were relatively low in the summer of 2005. A reversal of the relationship would mean a weak core CPI and a comparatively strong headline CPI starting in 2H, which some believe would have certain implications for monetary policy.

However, we believe recent CPI readings have less important implications than before because the BOJ is shifting from a backward-looking framework based on the realized core CPI rate to a more forward-looking one. If we assume constant fresh food prices longer term, then theoretically the core and headline CPI should converge. We accordingly do not think it is very productive to distinguish between core and headline CPI in gauging the outlook for monetary policy.

CPI revision to result in smaller YoY margin

The outlook above is for the CPI index prior to the benchmark year and weighting adjustments coming up in August. We estimate the revisions will have a 0.1-0.2ppt negative impact on the core CPI’s YoY change.

Some believe that this year’s revisions will not be as substantial as the ones in August 2001 and that the impact will be negligible or positive because of the limited number of items measured using the hedonic method. Certainly, the 2001 revisions had a 0.3ppt negative impact mainly because PCs were newly added to the basket of goods. Actually, even if the hedonic method is used for flat-panel TVs and other digital consumer electronics in the upcoming revisions, we think the impact will be less than in 2001.

However, the Cabinet Office has already indicated that for the upcoming revisions, it intends to revise the sampling for airfares, electricity, mobile phone charges, and accident insurance to better reflect discounts.  It plans to use appropriate methods other than the hedonic method for adjusting for changes in quality and other factors besides price changes; and revise the sample area and sample stores to include large, suburban stores and thereby better reflect changes in consumer purchasing patterns . These three changes would exacerbate price declines.

In addition, we think important implications stem from the fact that the head of the Ministry of Internal Affairs and Communications, which compiles the CPI statistics, is Heizo Takenaka, who reined in the BOJ in a previous role. We do not find it hard to imagine the core CPI being calculated more as it is in the US, under pressure from Takenaka, and think the revisions will have a downward bias on the CPI, although they may not constitute statistical manipulation.

We accordingly believe the risks of the core CPI weakening in 2H are still high. We should also note that gasoline and kerosene prices are wildcards for the scenario we outlined above. They are likely to bolster the core CPI through April-June, but then weigh on it, assuming they decline by just 10-20% on a softening of crude oil prices and a reversal of the yen’s depreciation. In any case, they could easily be negative factors for the core CPI in F2006 H2.

However, this is not to say that we expect another onset of deflation. Prices should be stably low in the near future mainly because of the prospects for improved productivity in the public sector, broadly defined. Or, as a result of productivity improvements, the economy’s potential growth rate could be 1ppt higher than the BOJ’s or our assumption. Otherwise, with prospects for a third straight year of 2-3% real economic growth, it becomes difficult to explain consistently the virtual lack of response so far in general price levels.

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Taiwan
Mild Rate Hike Consistent with Exchange Rate Policy
Mar 31, 2006

Denise Yam

CBC hikes rediscount rate by 12.5 bps at 1Q06 policy meeting:  In line with market and our expectations, Taiwan’s Central Bank of China raised interest rates by another 12.5 bps at the March 30 monetary policy meeting.  The latest policy statement contained very similar language to the previous one in December 2005.  Steady economic expansion on the back of robust exports to developed markets, further improvement in labor market conditions and sustained upward pressure on prices justified the rate hike.  In contrast to our conservative view on domestic demand, the CBC is optimistic that private sector fixed investment will turn around and more than offset the expected dip in consumption amid consumer credit woes. 

Monetary policy remains loose:  Including the latest hike, the CBC has raised rates by only 100 bps since September 2004, compared to the Fed’s 375 bps since June 2004, widening the gap significantly, and helping to limit the appreciation in the NT$.  We have been more conservative than consensus on growth and inflation over the medium term for Taiwan, and believe that loose monetary policy and weak currency are key supports to the economy.  Real interest rates (when deflated by core CPI) have stayed low over the past few years and have not yet rebounded with GDP growth.

Monetary conditions – gradually normalizing:  Money market interest rates have been trending upwards very gradually as engineered by the CBC through market operations using NCDs, the outstanding stock of which (NT$3.43 trn, equivalent to 14% of total deposits and 20% of total loans) remains an effective liquidity buffer and gives the CBC considerable capacity in steering money market rates.

Gradual monetary policy neutralization to continue:  The CBC reiterated its intention to neutralize monetary policy gradually further.  With US rates forecast to rise by 75 bps in 2006, we see the CBC raising the rediscount rate by around 50 bps for the full year.

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