United States
Much Ado About HIA
Apr 07, 2006

Richard Berner (New York) and Sophia Drossos (New York)

Corporate America repatriated anywhere from $180 to $210 billion in retained overseas earnings last year as a result of the one-year tax break mandated by the American Jobs Creation Act (AJCA) of 2004.  What were the perceived and actual economic and financial market impacts of such ‘HIA’ (Homeland Investment Act) flows, and as they fade, will those effects run in reverse?

Investors perceived HIA flows to be a strong prop for the dollar in 2005, one that will fade as the tax window shuts.   In addition, some analysts believe that these flows boosted business investment and equity values, and as they ebb, could contribute to slower growth.  We think those claims are exaggerated in both directions.  In our view, both the economics and the accounting of HIA flows suggest that they contributed only marginally to the dollar, capex and stock prices, and thus the demise of HIA won’t materially weaken them. 

To set the stage, it’s important to define and assess the dimension of the flows.  The AJCA permitted US-domiciled companies to repatriate earnings retained abroad during a one-year window and pay only 5.25% tax on the repatriated profits, rather than the 35% net of foreign tax credits under current law.  The logic: High US tax rates discourage US investment, so a tax break to bring earnings home would shift overseas investment back home.  Thus, to qualify for the AJCA tax break, companies needed a domestic reinvestment plan for the repatriated profits.  The one-year window largely overlapped with calendar (CY) 2005, but companies could choose to make it coincident with their fiscal year.  Consequently, some flows will continue in 2006.

We estimate that HIA flows amounted to between $180 and $210 billion in CY 2005.  US balance of payments and flow of funds data both suggest a nonfinancial tally of about $180 billion, but do not seem to capture any repatriation by financial services firms.  Based on 10-Ks for the five largest firms, which account for about half the market capitalization of financial firms in the S&P 500 universe, we guesstimate financial services repatriation at $30 billion.  The flows underscore that the tax break on repatriated earnings was a gift to US multinationals, and that tax considerations do affect where companies book earnings.  But aside from that windfall, we believe the effects of HIA flows on the dollar, investment, and stock prices were small.  Here’s why.

Repatriation did not change the economics of the current account deficit or corporate profits.  Where earnings are generated, not whether they are repatriated, matters for the current account.  Likewise, CFOs of multinationals rightly look at the consolidated income statement to assess earnings, not just those booked or repatriated domestically.  That overseas earnings were “permanently” retained abroad to shield them from high US corporate tax rates eliminated the need (under GAAP rules) to account for any deferred tax liability against them, but most analysts believe that this accounting treatment overstated earnings and net margins (see Elmer Huh and Rebecca McCaughrin, “The American Jobs Creation Act of 2004: A Windfall?” November 19, 2004).  Accounting aside, we think that CFOs who repatriated and investors look at the economics the same way — the AJCA did create a one-time tax windfall, and it is that tax windfall, not the repatriated flows, that is the only economic boon for CFOs and their shareholders.

In other respects, accounting for these items reflects the economics of such flows; they have large and offsetting effects on components of the balance of payments, national income, and flow of funds accounts.  The HIA flows come from earnings that were counted “above the line” as an addition to exports whether they were repatriated or not; they were exactly offset by a decline in retained earnings abroad.  Likewise, financial reporting counts those earnings regardless of venue.  In addition, HIA flows did not “finance” the current account deficit; flows that are recorded “below the line” simply accommodate them.  The magnitudes are not certain because the balance of payments data do not allow us to separately identify HIA flows — or their financing through banks or securities flows — from the aggregates in which they appear.

But details of the international accounts offer some insight about the magnitude and timing of repatriation flows.   Dividends received by US companies from overseas affiliates are included as direct investment income receipts in the current account.  In the BOP accounting framework, an increase in dividend receipts from foreign subsidiaries raises distributed earnings and lowers reinvested earnings by equal and offsetting amounts.  Using the average of reinvested earnings in 2004 as a benchmark and looking at the quarterly change recorded in 2005 suggests a rough proxy for HIA flows.  This analysis would imply HIA amounts of about $18.2bn in Q1, $27.9bn in Q2, $72.8bn in Q3 and $58.7bn in Q4; for a total of about $178bn.  The Federal Reserve’s flow of funds data corroborate this evidence, showing a sharp decline in US foreign earnings retained abroad over 2005.  On the flip side, net dividends received from foreign subsidiaries posted a sharp increase, rising from an annual pace of $35.9bn in 2004 to $216.6bn in 2005. 

Finally, while flow of funds (FOF) data offer the clearest separation of the HIA from other flows, the FOF-based domestic measures of external financing needs in FOF accounting overstate corporate cash flow.  Because the financing gap accounts only for domestic cash flows, and because companies have offset one-for-one those foreign receipts by reducing dividends paid out of domestically-generated cash, the net impact boosts the domestic corporate cash flow measure and depresses the financing gap.  Conversely, as repatriations fade, the financing gap will rise.

More fundamentally, even if we could identify the flows, their impact on the currency and on other asset prices is ambiguous.   Small wonder: Investors regarded these flows as a prop to the dollar at a time when powerful fundamentals — interest differentials and a strong economy — moved in the dollar’s favor. 

HIA flows were perceived to be a large USD support in 2005.  But in fact, the actual flows appear to have fallen short of most estimates, including our own.  Moreover, of the $180-210bn estimated repatriated, the vast majority — about 70% — likely were already held in US dollars.  As a result, actual USD buying generated by repatriation was relatively small compared with the daily FX market turnover of $1.9 trillion.  We do not believe that HIA flows were the main factor driving USD strength last year, but flows do not necessarily need to be large to influence the FX market.  Sometimes expectations are more important in currency markets.  For example, suspicion that central banks were diversifying assets away from the US contributed to ongoing, broad dollar weakness in 2003 and 2004, even though official data do not show USD sales by foreign central banks in the aggregate.

Will the absence of HIA flows be USD negative?  The context may be the most important determinant. Over the next 6 to 12 months, the fortunes of the USD are likely to wane.  With the end of the FOMC cycle  in sight and other central banks still ramping up their tightening cycles, we believe the USD is moving out of its ‘sweet spot’.  Yet, we think USD weakness will be more contained than it was in 2003-4, given that US interest rates are significantly higher than during that period and also higher than those in other major markets.  Our year-end forecasts for EUR/USD and USD/JPY are 1.24 and 106, respectively.

HIA might have provided a boost for domestic capital spending, because to qualify for the AJCA tax break, companies needed a domestic reinvestment plan for the repatriated earnings.  However, in our judgment, the connection is weak.  Unlike other specific, investment-oriented tax breaks, such plans were vague and did not commit companies to earmark the funds for investment.  Moreover, Corporate America is still swimming in cash regardless of the source, and that hasn’t exactly burned a hole in CFOs’ pockets.  In fact, the “payback” from the sunset of another tax break —bonus depreciation — triggered a deceleration in US capital spending last year.  In contrast, we believe that pent-up demand and rising operating rates will contribute to an acceleration in 2006.

The market implications of this analysis are important as HIA flows fade in 2006.  If such flows weren’t a major factor supporting the dollar, capex, or stock prices, then their demise won’t be a significant negative.  Investors hoping for a weak dollar, slower capex, or declining stock prices may get their wish, but not from this source.

It is possible that anticipation of HIA-related flows affected market expectations more deeply than we believe.  In that sense the absence of this structural dollar buying, however limited, may embolden USD bears. But this needs to be balanced against the fact that US interest rates are among the highest in the G10, making the dollar an expensive short.

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Euroland
Euroland
Apr 07, 2006

Elga Bartsch (London)

No move in May

The ECB press conference following this week’s holding operation forced us and the markets to push back our estimates on the timing of the next ECB rate hike.   Until then, we and the markets had been looking for a move in May.  Now, a 25 bp rate hike at the ECB’s out-of-town meeting in June looks more likely.  The tone of the press conference was decisively more dovish than we and the markets had expected.  Not only did ECB President Trichet shy away from using the word “vigilance”, ECB code for an imminent rate hike, but he also went out of his way and stated that market expectations for a move in May were not in line with the ECB’s own assessment (see ECB Watch: No Move in May, April 6, 2006).  Yet the press conference left little doubt that euro area interest rates are likely to be raised again.  The ECB continues to monitor risks to price stability, which it deems to be on the upside, “very closely”.  The same phrase was used in January, two months ahead of the March rate hike.  If the Bank sticks to the same script, it will likely reintroduce “vigilance” at the May meeting and pull the trigger at the June one.

Why did we get it wrong?

As long as minutes of the ECB Council meetings are not published and moles in the Council’s meeting room cannot be planted, we can only guess the reasons behind this week’s surprise.   To begin with, we need to acknowledge that the ECB had never indicated that it was poised to hike interest rates in May.  On the contrary, the March press conference was disappointingly dovish (see ECB Watch: A Steady State of Mind, March 2, 2006).  In particular, the statement that the Council was in “the same state of mind as in December” suggested to us at the time that, contrary to our expectation, the ECB might not hike interest rates as early as May.  We felt, though, that the April meeting would have been a good opportunity to prepare markets for a May move.  However, the ECB Council decided not to make use of this occasion.  As a result, markets had to reassess the outlook for euro area interest rates.  But there is little reason to assume that the ECB itself had to reconsider the interest rate outlook.  The Council simply wanted to see more data points and a fresh set of staff projections. 

The lessons for ECB watchers

In my view, ECB watchers can take a number of lessons away from the week’s ECB debacle.   First, do not pay too much attention to individual data points.  It is the longer-term trend that matters for the ECB, rather than the marginal changes.  That is also why, we think, it would like to see a couple of new data points before it raises rates again.  Second, pay close attention to the wording of the introductory statement to the press conference.   There is a stringent logic behind the way in which the language is escalated in the run-up to a rate hike.  Our reading is that, to signal a rate hike at an upcoming meeting, the ECB has to be “more than vigilant”.  In the run-up to the December rate hike, the Bank used “strong vigilance” and in February “increased vigilance”.  Careful attention to the wording of the introductory statement will be essential at the June meeting to gauge the timing of another rate hike in 3Q.  Third, interpret statements by various ECB council members in between meetings as mainly reiterating what ECB President Trichet said at the previous press conference.  Individual Council members might add a personal flavour, but will not express a change in view at the Council. 

Is the euro to blame?

The recent rally in the euro and its potential repercussion on the ECB’s interest rate decisions has attracted a lot of attention.   For what it is worth, I do not believe that, until now, the euro has been a big factor in the ECB’s interest rate deliberations.  The move in trade-weighted index thus far is relatively contained by historical standards and is nowhere near the move seen in late 2004, which likely threw the ECB’s tightening campaign off track.  In addition, the strengthening of the euro in recent weeks could also argue in favour of hiking faster (and talking softer afterwards).  By doing so, the ECB would have the chance to normalise rates further before a big currency move was able to bind their hands.  Given that the ECB is concerned about excessive borrowing and risk-taking in the euro area, it probably prefers rate hikes to currency moves as a means to tighten monetary conditions. 

Where does this leave the bond market?

The knee-jerk reaction in the bond market was to buy bonds.  Only later did 10-year Bund yields started to rise again.  As the yield curve steepened, 10-year yields climbed above our June target of 3.85%.  Together with the upside risks to our and, we believe, the ECB’s growth outlook and an ECB that is likely to take more time to tighten, this leads us to raise our target for a peak in 10-year Bund yields back above 4% (see Confessions of a Bond-Market Bear, February 6, 2006).  We would now project 10-year yields to climb to 4.15% by September.  However, the risk, in our opinion, is that the bond market sell-off will not stop there once it gets going.  For now, the upward trend in bond yields still seems to be firmly in place.  But, equally, we will be watching out for signs of a turning point paving the way for a renewed bond market rally in the latter part of this year and into next year.  A peak in the Ifo business climate could be such a sign (see Inching towards a Turning Point, March 15, 2006).

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Germany
Small Should Be Beautiful
Apr 07, 2006

Elga Bartsch (London)

After years of underperformance, we expect German GDP to grow in line with the euro area average this year.   Such a performance would already be a major turnaround for the German economy, whose trend growth rate of 1.4% has been nearly one-third below that of the euro area over the last 10 years.  In our view, a pick-up in domestic demand will be the key driver of growth convergence with the rest of the euro area in the next 12 months.  The rebalancing of German GDP growth will not only have important consequences for Germany’s close trading partners, but also for smaller, more domestically oriented companies.

A shift towards a more broad-based economic upswing should benefit small- and medium-sized companies (SMEs) in particular.   SMEs depend on domestic demand to a greater extent than large companies.  The shift towards domestic demand and its repercussions for the SME sector is underpinned by improvements at SMEs.  These improvements are not only visible in the level of business confidence among German SMEs, but also noticeable in the business sentiment among large companies.  The sentiment gap between large companies and their smaller counterparts started to shrink last year, and is about to move into positive territory, according to the KfW-Ifo- Mittelstandsbarometer.  The improvements in SME sentiment hence even outpace the record gains recorded for large companies in recent months.  The relative SME business climate has been firmly in negative territory since the mid-1990s, with two brief exceptions — 1999 and early 2002, underlining that SME sentiment was trailing behind that of large companies.  However, it started to recover last year.  A rise in relative SME sentiment indicates that, irrespective of the overall cyclical situation, the SME sector is improving relative to that of large companies.  The full extent of the catch-up of SME sentiment becomes apparent from looking at the latest monthly data.  These already indicate that the gap in sentiment between SMEs and the overall business community has moved into positive territory in all sub-sectors of the economy except construction.  For the first time in four years, German SMEs rate their business climate more favourably than large companies do.  We expect this trend to continue as the domestic demand recovery gains momentum.

Corporate restructuring and continued wage restraint have boosted corporate profits as measured by the total economy’s gross operating surplus and mixed incomes.   Last year, the share of the gross operating surplus (GOS) in gross national income (GNI) climbed to its highest level since reunification.  The sector breakdown of the GOS margins shows that the rise in macroeconomic profit margins has largely been due to margin expansion in the manufacturing sector and to a lesser extent in trade, hotels and transport services.  However, we expect profit margins in Germany to come under renewed pressure as companies continue to invest more and start to recruit new staff, and as interest rates rise further.  The improvement in cost-competitiveness and profitability is the result of widespread micro restructuring rather than major macroeconomic reforms (see Macro Reforms Meet Micro Restructuring, August 24, 2005).  SMEs have also been at the heart of restructuring.  They have left the industry-wide wage bargaining system (Flaechentarifvertrag), which for many had become a straitjacket, more so than for large companies — especially in east Germany where the share of employees covered by such contracts declined to 41% in 2004, the latest available data, from 56% in the mid 1990s.  In west Germany, 61% of employees are covered by industry-wide contracts, a decline of 11 percentage points since the mid-1990s.  The ongoing erosion of trade union power will help to keep wage increases in check, we think. 

In addition, Germany is at the forefront of economic integration with central and eastern Europe (CEE) in terms of close trade relations and cross-border investment (see Merging Europe — A Primer on EU Enlargement, October 2, 2003).   Initially, large companies seem to have beaten a path to the fast-growing markets and cheap production platforms of CEE.  But larger SMEs are not far behind.  While half of all large manufacturing companies have already relocated their production facilities abroad, according to the Federation of German Industries (BDI), for larger SMEs (with more than 100 employees), this share could be reached within the next two years.  Smaller SMEs plan to double their offshoring in the next two years.  Due to Germany’s geographical position at the centre of Europe and its historical ties with CEE, German SMEs should find offshoring to CEE considerably easier than their western European counterparts.  Production facilities in the region can be managed at arm’s length from the German company’s headquarters.  In addition, risks regarding the infringement of intellectual property rights or unfair competition by heavily subsidised national champions are more limited because of the joint legal framework of the European Union and its Single Market.

Against rising global demand, record corporate profits and low interest rates, it is no surprise that corporate investment, both in machinery and equipment and commercial construction, has started to recover.   According to the biannual investment survey compiled by the EU Commission, German manufacturing companies intend to raise their nominal investment spending by 9% this year, after an estimated 6% decline last year.  This rebound will partly reflect more generous depreciation rules that became effective at the beginning of this year.  Interestingly, the investment plans are much more positive for SMEs (with up to 500 employees) than for large companies, according to the EU Commission survey.  While large companies with more than 500 employees plan to raise their investment spending by 3% this year, for smaller companies the projected investment spending growth in 2006 ranges from 5% to 13%.  The recent sharp rise in new loans extended to companies, which rose 29% year over year in January, suggests to us that the investment recovery is gaining momentum.

To sum up, a smart cyclical recovery, increasingly driven by domestic demand, should benefit SMEs disproportionately, in our view.   But there are a few factors to consider over the longer term:

First, a planned corporate tax reform in 2008 is likely to lower the tax rate paid on capital and entrepreneurial income compared with that on labour income.   Currently, 83% of German companies are not incorporated and thus taxed at the personal income tax rate.  As a result, the marginal tax rate on retained earnings for an incorporated company currently stands at 38.7%, while for a non-incorporated company it is around 45%.  Removing this asymmetry would incentivise SMEs to retain profits.

Second, the discussion about the introduction of minimum wages constitutes a risk for SMEs.   More than their large counterparts, SMEs have opted out of the industry-wide bargaining system, which today effectively determines the minimum wage in a sector (see Putting a Floor Below Wages, April 14, 2005). 

A third risk factor is the three-point VAT hike planned for January 2007.   It will likely affect SMEs more severely because of their higher exposure to the domestic market.  As exports do not carry VAT, the higher the share of overseas sales and the lower the share of domestically generated value added, the smaller the likely impact of the VAT hike. 

Fourth, the reduction in social security contributions planned for 2007 will likely at least partly provide an offset to the VAT increase.   Any meaningful net reduction in social security contributions — almost equally shared between employers and employees — would benefit those companies with a high proportion of employees in Germany.  As 70% of employees in Germany work for SMEs, they should be the main beneficiaries of a reduction in non-wage labour costs.

Last but not least, a change in SME financing could potentially improve the ability of SMEs to grow in the long run.  The OECD finds that the main difference between the US and Germany lies in the company-specific rates of expansion.  US start-ups expand much more rapidly.  The US financial system encourages risk-taking, thus enhancing financing options for small, innovative firms, which tend to have limited cash flows and a lack of collateral.

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Japan
Sayonara Yn30 Trillion
Apr 07, 2006

Takehiro Sato (Tokyo)

Key Points

What’s new: The current account balance held at the BoJ fell below the ¥30-trillion level again on April 5, and there is no outlook for a near-term return above ¥30 trillion this time.  However, various technical factors might interfere with the steady decline in the current account balance from June anticipated by the Bank. 

Conclusions: We advise against jumping to the conclusion that the Bank will not reverse ZIRP simply because of difficulty reducing the current account balance to the ¥6 trillion of required reserves.  A rate hike would quickly reduce the current account balance, which might not decline at a zero rate, to required reserves.  We think investors should be ready for a rate hike at any time from the monetary policy meeting in June. 

Investment implications: We are still optimistic about pace of subsequent rate hikes given our outlook for stable prices.  The next key point is whether the CPI reading for April released on May 26 remains high as the Bank expects.

Risks: The bond and stock markets might rally and the dollar/yen rate could rise from investors anticipating slower rate hikes if the inflation rate drops in line with our outlook.

Detail

Preview of the MPM on April 10-11

We expect the Bank to maintain the status quo (zero interest rate) at the monetary policy meeting on April 10-11 as the first meeting after reversing quantitative easing.   It will be releasing the Monthly Report on Recent Economic and Financial Developments for April, a precursor to the Outlook Report due out on April 28.  We think the April monthly report will slightly raise its economic assessment in light of March Tankan survey results and lay the groundwork for the month-end Outlook Report.  We believe the latter is likely to take an overall hawkish stance, listing asset bubble concerns as a risk factor, raising the official opinion on the economy’s potential growth rate, and setting an aggressive F2007 price outlook.  Meanwhile, the Financial Markets Department, an operational division, should steadily lower the current account balance at their discretion since this amount no longer has the status of a policy guideline. 

Sayonara ¥30 trillion current account balance

The current account balance stayed above ¥30 trillion on April 3 and 4, the first days of the new fiscal year, but fell to ¥29 trillion on the 5th and ¥27.7 trillion on the 6th and we expect a decline to ¥27.0 trillion on the 7th.   There is no outlook for a near-term return above ¥30 trillion.  Hopefully it will not be necessary during an economic recession in the distant future to raise the current account balance to ¥30 trillion again. 

The current account balance could drop at an unexpectedly rapid pace if the Bank does not conduct funds supply operations in April and May judging from the recent outstanding balance of funds supply operations.   The operation team of the Financial Markets Department has indicated to market participants that they intend to promptly reduce the current account balance to about ¥15 trillion by June. 

The main issue is what happens next.   The same team members explain that the Bank will proceed cautiously with reductions from June based on conditions in the short-term money market.  They also stressed that the pace of reducing the balance will not have any policy implications. 

However, it is unclear whether the current account balance will steadily decline from June as anticipated by the Bank.   The March 9 statement asserts that the Bank will encourage the uncollateralized overnight call rate to remain at effectively zero percent.  Yet we estimate that potential required reserves are considerably higher than the ¥6 trillion in legally required reserves.  This means that the Bank might have to supply additional funds to satisfy the directive for a zero interest rate if the current account balance drops below ¥15 trillion.  There is a possibility of this technical dynamic preventing a decline in the current account balance from June. 

We attribute the higher level of potential required reserves to the zero interest rate delaying an adequate recovery of money market functions.   There is no guarantee of a pick-up in market transaction activity simply because the current account balance contracts, since 1) the current account held at the BoJ replaced the call market function during the past five years of quantitative easing, reducing credit lines and operation teams at market participants, 2) opportunity losses from retaining excess reserves remain small under a zero interest rate, and 3) the decline in loan-to-deposit ratio at major banks has evened out funds distribution among market participants.  We think market participants will retain excess reserves from lingering concerns about the smoothness of short-term money market transactions.  We hence do not foresee a substantial drop in the current account balance below ¥10-15 trillion from June. 

Meanwhile, these problems could be naturally resolved with a hike of the policy rate and normalization of the yield curve for short-term rates.   In fact, market participants would no longer be able to ignore opportunity losses from retaining excess reserves if the overnight rate increases from 0.001% to 0.25%, forcing a resumption of transactions.  We think steepening of the yield curve and resumption of yield-curve plays by major banks in the short-term money market might revive transactions. 

In this regard, we advise against jumping to the conclusion that the Bank will not reverse ZIRP simply because of difficulty reducing the current account balance to the ¥6 trillion of required reserves.  A rate hike would quickly reduce the current account balance, which might not decline at a zero rate, to required reserves.  We think investors should be ready for a rate hike at any time from the monetary policy meeting in June.

Policy and market implications

We cannot rule out the possibility of ZIRP reversal during Jul-Sep given these conditions.   The earliest possible change would be July 13-14.  We think August 10-11 would be inauspicious and September 7-8 could be too late with political events.  However, we are still optimistic about pace of subsequent rate hikes given our outlook for stable prices. 

The next key point is whether the CPI reading for April released on May 26 remains high as the Bank expects.  Bank officials are bullish about prices from April with micro-level price adjustments at the beginning of the new fiscal year and higher hourly wages for dispatched workers in addition to large companies.  Yet the bond and stock markets might rally and the dollar/yen rate could rise from investors anticipating slower rate hikes if the inflation rate drops in line with our outlook.

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Japan
Japan
Apr 07, 2006

Robert Alan Feldman (Tokyo)

Currently, there seems to be no significant bias in the Japanese consumer price index.

— Bank of Japan, March 9, 2006

A stormy debate has raged over which price index to use in judging price stability.  Those who favor an early rate hike tilt toward using the standard consumer price index, which is a Laspeyres — the global standard in consumer price indices.  Those who favor a more cautious approach tilt toward the GDP deflator, which is a Paasche index — the global standard for deflators from the national accounts (such as the GDP deflator and the personal consumption deflator).

My claim is that both types of index are wrong.  The problems with both the Laspeyres and Paasche indices are not only practical (such as composition of the indices and weighting of different components), but theoretical.  In particular, the mathematical formulae for these two are not solidly grounded in the behavior of consumers.  Therefore, the Laspeyres and Paasche formulae themselves bias the calculations, even before the actual measurement starts.  There is, however, one formula that avoids bias, a weighted geometric formula.

Price Indices: Beauty and the Beasts

What characteristics are needed in a price index? The answer depends on the use.   In the case of standard price indices, however, the basic need is to create a summary of prices that reflects whether nominal income is keeping pace with prices.  In other words, the price index should show us how much more money is needed to buy a given level of utility, as prices change. 

Real income should rise or fall on the basis of a broad set of economic fundamentals.  The point here is that the change in income should be compared to an index of prices that adjusts for the natural substitution among goods as prices fluctuate.  In short, the price index should be utility-neutral.

At the initial period, both beef and pork are priced at $100/unit, and the consumer eats 0.667 units of each, at the initial income level of $133.3.  The utility level, assuming weights of 2/3 for beef and 1/3 for pork, is 0.667.  Then prices change sharply.  Beef plummets, and pork surges.  Given the new prices and the utility curve, the consumer now eats only 0.264 units of pork but eats 1.059 units of beef, at the original utility level.  Interestingly, the substitution away from pork is so strong that the consumer now needs only $105.75 to achieve the original  utility level.  Required income falls by 20.7%.

Now comes the crucial question: Is there a price index that tracks this drop of required income exactly? Fortunately, the answer is “Yes, the geometric average does so”.  Note that the other types of price indices give the wrong answer.  The arithmetic average detects no change of the general price level at all, while the harmonic average exaggerates the decline.  Only the geometric average tells us what we really want to know.

Back to the Japanese Price Debate

What does all this have to do with the Japanese price debate? The answer comes from looking at the characteristics of the two major contenders in the debate, the Laspeyres and the Paasche price indices.  The Laspeyres index is an arithmetic average.  The Paasche index is a harmonic average.  Neither is geometric, and thus neither will tell us what we really want to know.

There are many other sources of potential bias in the CPI, related to measurement.  However, the bias from measurement — while extremely important — has nothing to do with the bias from the formula.  Rather, the bias arising from an arithmetic formula instead of a geometric one constitutes an entirely different source of bias.

Since the Japanese CPI is a Laspeyres index, it is natural to ask how bad formula bias really is.   In order to make the estimate, I took all 598 components of the CPI and created arithmetic and geometric averages, both weighted with the actual weights of the standard CPI. The differential between the year to year growth rates of the two calculations has averaged about 0.3%-pts since 2003. 

Conclusion

Thus, contrary to the view of the BoJ Monetary Policy Board, my view is that there are significant biases in the Japanese CPI.  Although recent estimates of the measurement bias are lower than those of earlier years, these estimates do not include the formula bias.  Once the formula bias of about 0.3% is added to the other measured biases in the CPI, the total bias is non-trivial.

Since the BoJ Policy Board believes that there are no significant biases in the CPI, the Board is likely to move toward ending the zero interest rate policy over the next few months, as pointed out by my colleague Takehiro Sato.  When they do so, the result will likely leave the real interest rate somewhat higher than the BoJ (which uses standard CPI measures) believes.  The difference is not likely to be a major problem for the economy in the short run.  However, if ignored over the long run, the difference could make monetary policy tighter than the BoJ intends, and thus have an adverse effect on the economy.

Proposals

(1) The Statistics Bureau of the Ministry of Internal Affairs and Communications (the agency that calculates the CPI) should publish geometric averages of prices.   Optimally, these would be calculated with moving weights. 

(2) Price stability should be defined as a situation in which the movements of prices of individual products require no change in nominal income, at a given level of utility.  (This definition contrasts with all three definitions of price stability given by the BoJ in the March 9, 2006 policy statement. The price index formula that most closely measures this concept of price stability is a moving weight, geometric average.

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Asia/Pacific
Another Growth Spurt
Apr 07, 2006

Andy Xie (Hong Kong)

Summary and conclusions

Even though the current trade boom has lasted twice as long as the previous three booms, it is picking up again, driven predominantly by recovering demand in Japan and Europe.  The forward-looking surveys in Europe and Japan suggest that the momentum could last through 2Q06.

For the first time in this cycle, demand growth is pushing up bond yields everywhere, suggesting that excess liquidity has been tapped out.   Central bank tightening, therefore, should have a meaningful effect on bond yields, in our view.  This also suggests that the current growth spurt is the final leg in this cycle.  Bond yields should tell us how long the growth momentum will last.

Growth picking up in 1Q06

Japanese imports grew by 14.7% YoY in dollar value in the first two months of 2006, compared with 7.3% in the last two months of 2005.   Eurozone imports also accelerated to 16.4% YoY in dollar value in January 2006, from 1.7% in the last two months of 2005.  US imports accelerated to 18% YoY from 15.7% during the same period.  It appears that the global economy is recovering from the soft patch in late 2005.

Considering that the current trade boom has resulted in above-average growth for three-and-a-half years, twice as long as in the previous three cycles, the growth recovery is remarkable.   The forward-looking surveys in Europe and Japan suggest that the growth momentum could last through 2Q06.  If the momentum does last through 2Q06, it would constitute four years of above-average growth, which has not happened in recent memory.

Renewed speculative excitement in high-beta assets reflects fresh investor confidence in economic growth.   After the lull in February and March, commodities, emerging market stocks and currencies are coming back into favor again. 

The white knight of the global economy

We think four factors explain the exceptional longevity of the current growth cycle: Japan’s zero interest rate, China’s cheap labor, Anglo-Saxon consumerism, and financial globalization.   China’s surplus labor has been a major force in keeping inflation down, which has allowed central banks around the world to adopt a gradual approach to tightening.

Anglo-Saxon consumerism has led to a debt-led demand boom in those economies, which has been the main demand driver in this cycle.   We estimate that the Anglo-Saxon economies (US, UK, Australia, NZ, plus India) are running a current account deficit roughly equal to 2.5% of global GDP.  This excess demand has allowed emerging economies to run current account surpluses, which has decreased interest rates in these economies and, hence, triggered a domestic investment boom.

The stability of the current growth model depends on the global financial system delivering cheap money to Anglo-Saxon economies to finance their current account deficits.   This is where the combination of Japan’s zero interest rate and financial globalization becomes critical.  Traders have become the white knights of the global economy in this growth cycle.  Whenever an economy needs money, they deliver.

The global financial system has been giving money to high inflation economies.   For example, Indonesia is facing an inflation problem and its central bank has kept interest rates high by global standards but below the inflation rate.  The global financial system has been sending money to Indonesia to profit from the high interest rates, while the inflow keeps its currency strong.  As long as the foreign flows persist, Indonesia’s currency could rise sufficiently to bring down its inflation.  The global financial system is essentially solving Indonesia’s problem by flooding it with money.

India recently experienced a liquidity problem, which caused interest rates to rise substantially in its money market.  The liquidity problem caused some jitters over India’s growth momentum.  The global financial system again played the white knight to bail it out.  Foreign capital gushed in to take advantage of the country’s high interest rates.

When economies face inflationary pressure, their central banks do not have to raise interest rates by as much as before, because the global financial system does half the job by pushing up their currencies, which essentially transforms inflationary pressure into current account deficit.   The global financial system is maximizing global growth by spreading inflationary pressure across the world.

Globalization of production has decreased inflationary pressure, and globalization of finance has made current account deficits easy to finance.   The combination is behind the longevity of the current cycle.

Four possible endings for the current cycle

As cheap labor and cheap money are necessary conditions for the current boom, the disappearance of either could end the cycle.   China’s factory labor cost is rising, due mainly to rising living costs along the coast from land, food, and energy inflation.  In addition, the Chinese government seems committed to increasing minimum wages to ease income inequality.  While cheap labor is becoming less cheap, the process is gradual.

The market expects the Bank of Japan to raise interest rates in September 2006.   This could be the first step towards ending cheap money.  But, like other central banks, the BoJ is likely to act gradually.  So, like cheap labor, cheap money looks set to vanish, but slowly.

The reversal of risk appetite could end the cycle from two angles.   The global property bubble is mainly a phenomenon of excessive risk appetite.  If it turns, the global property market could turn down and, with it, the Anglo-Saxon consumption demand. 

The easy financing for the Anglo-Saxon current account deficits also reflects excessive risk taking — i.e. money is available for a small interest rate premium that will not kill the economy.   However, the recent experiences of New Zealand and Iceland suggest that the financial markets may switch their focus from interest rates to sustainability.  Australia is likely to come under the pressure before the US, we believe.  The latter has the privilege of printing the world’s currency and enjoys an unnatural advantage.

Finally, speculative demand for inventory (e.g. property, copper, oil) could exhaust liquidity, and the resulting high bond yields could bring down growth.   Inventory accumulation appears to be a major factor in the upward trend of bond yields at present. 

The final frenzy

The longevity of the current cycle has led to extremely low risk premiums.   Financial markets are now in a dangerous phase, in our view.  Concepts have taken over investment decisions, we think.  The best concept is seen as being something that 1.3 billion Chinese consumers might buy.

Property, for example, is one such concept.   There are two ‘sub concepts’ regarding Chinese property.  One is that 1.3 billion people want to buy, in which respect the property business is like internet business in 2000.  The other is that the prices in China’s cities will converge to levels in North America or Europe.  Both, we believe, are just bubble talk.

Housing affordability in China is extremely low.  Beijing Normal University recently published a research report that showed that Beijing’s average property price in the primary market was 13 times average Beijing household income.  At such a high level, the sustainable sales volume is quite low.  Yet, Beijing sold 1.15 mn sq m (about 1.4 mn flats at 80 sq m per flat) between 2001 and 2005, and had 73 mn sq m (about 900,000 flats at 80 sq m/flat) under construction at end-2005.  Beijing has about 5 mn households.  The massive volume and high prices are not consistent with each other — hence we do not see this situation as sustainable.

Price convergence between Chinese and US/European cities is merely a pipedream, in our view.   China’s per capita income is 5% of that in the US and 6.5% of that in Europe.  Even though China is growing at a much faster rate, any kind of income equalization is likely to take decades.  China’s property prices can only realistically catch up with those in the US and Europe if its per capita income levels do too.

We believe Chinese property stocks share some characteristics with internet stocks in 2000.  Speculation has exaggerated their earnings to unsustainable levels, in our view — i.e. the concept that earnings will grow quickly and for a long time is a myth.  Faith, however, appears to be more powerful than reason in the current market.

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Korea
No Rate Hike Today, but More to Come
Apr 07, 2006

Madhava Kumar (Mumbai)

Quick Comment: In line with expectations, the Bank of Korea (BoK) kept its overnight call rate unchanged at 4% at its monthly meeting today.  The central bank has made it clear that tightening will continue, but we believe it passed on the rate hike today due to the less-than-satisfactory macro data in the past month plus milder-than-expected inflation.

We had been expecting a total 75bp rate hike this year (with 25bps already done in February, and another 50bps to come).   Our call had been more aggressive than the market prior to the recent speech by the new central bank governor, which led the market to believe BoK will be more hawkish than previously thought.  The market is now starting to price in another 50bp rate hike for this year, meaning our call is becoming the consensus. 

The BoK is starting to appear more hawkish given its increasing concerns over the housing market.  We maintain our central case call for 50bp more this year, but with big risk skewed to the upside.  We now assign a 30% chance to the possibility that Korea could see another 75bps in rate hikes this year, meaning that the interest rate could reach the neutral level of 4.5% before year-end.

We think a rate hike next month is likely.  We expect an upbeat response to 1Q GDP data — due to be released on April 25 — as we think 1Q growth could be as strong as 6%.  The key remains the inflation data, to be released in the first week of May, which we believe is likely to show slight acceleration amid higher oil prices.  As a result, we see a high chance of a 25bp rate hike at BoK’s next meeting on May 11.

The interest rate, now at 4%, is still accommodative, but Korea is clearly moving towards a neutral rate level by the end of this year, by our reckoning.  There are increasing concerns over rising property prices.  The government has failed to cool housing prices despite three anti-speculation packages in the past nine months.  Strong liquidity is the major driver behind the price increase, in our view.  We believe the policy focus will shift to monetary tools to slow the housing market.  If the Korean government and central bank leave the housing market untouched, we think housing prices could get out of control given strong liquidity growth and the low interest rate.

We do not believe Korea is in a massive property bubble, and do not expect a crash.  We believe further tightening is imminent in order to help preempt a bubble and stabilize the housing market.  This is essential to ensure growth solidity, and would therefore be positive for the economy. 

Opposition on tightening comes from concerns that more rate hikes would halt the consumption recovery.   However, we believe that even with another 100bp hike, the impact on consumption would be limited because consumption growth this time is not dependent on credit. 

On balance, we believe further monetary tightening is in the economy’s interest.

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Currencies
Beijing in the Driver?s Seat in the 'Year of the CNY'
Apr 07, 2006

Stephen Jen (London)

The ‘Year of the CNY’

I still believe that this will be the ‘Year of the CNY’.   My targets for USD/CNY remain unchanged at 7.50 for end-2006 and 7.00 for end-2007. 

Beijing continues to accelerate the pace of USD/CNY decline.  I have proposed that there would be a 'CNY event' in the weeks leading to President Hu's visit to DC on April 20-21, and that the 8.00 parity would qualify as a 'CNY event'.  It appears that we are very quickly heading toward that goal.

I make the following points. 

1.   The pace of USD/CNY crawl has indeed been accelerated.  The 'first gear' lasted from July 21, 2005 to around January of this year.  The 'second gear' lasted from January to March.  We appear to be in 'third gear', and I believe Beijing will continue to up-shift for the rest of the year, surprising most investors. 

To illustrate how the rate of the crawl in USD/CNY could really matter, we have calculated the USD/CNY rate that would prevail at end-2006.   If Beijing had been stuck in first, second or third gear, the USD/CNY would be respectively 8.00, 7.90, and 7.72.  To reach our year-end target of 7.50, therefore, Beijing will need to shift into fourth gear  later this year, which we believe is probable. 

2.   Rate of crawl dominates the damping factor.  There have been two shifts in Beijing’s policy regarding CNY.  First, the relationship between the actual spot rate and the trajectory of the underlying basket reference rate has weakened over time.  Second, as mentioned above, the rate of crawl has been accelerated.  Right now, the rate of crawl seems to be the only important driver of USD/CNY, suggesting that Beijing is trying to prove something to the US. 

3.   Not a major move, in absolute terms.  I agree with many commentators who reject the notion that Beijing would let USD/CNY collapse and I point out that, in absolute terms, the movement in USD/CNY is still tiny, compared with the volatility of any of the other exchange rates we watch.  But, relative to the volatility/crawl of USD/CNY in the past, and relative to the consensus view both at the beginning of the year and now, the current pace is substantially faster. 

What is important for trade is the real effective exchange rate of the CNY, but what the market and policymakers seem to be more focused on is the nominal bilateral rate of UDS/CNY.   2005 is a good example of this.  Even though USD/CNY declined by only less than 3%, the REER actually appreciated by 9.7%.  This year, the CNY appreciation in REER terms corresponding to my year-end forecast of 7.50 is likely to be much more modest than we experienced last year. 

4.   This is the best political environment for Beijing to earn credibility.   With Senators Schumer and Graham having backed off, and the US Treasury unlikely to mention China in its forthcoming Currency Manipulation Report, this seems to me to be the best political backdrop for Beijing to really make a strong statement and guide USD/CNY lower.  This is an insurance payment against protectionism, as it should quell some of the angst on Capitol Hill and allow the discussion to move more toward ‘trade’ rather than the exchange rate policy.  After all, the primary issue between the US and China is trade, not the CNY. 

5.   USD/AXJ doing just fine.  If I am correct that 2006 will be the year of the CNY, and that USD/JPY will trade lower toward 100, the risk to USD/AXJ is heavily biased to the downside this year, regardless of the domestic fundamentals.  We believe that IDR and TWD should be the ‘fast-trackers’, but all the Asian currencies should perform well against the dollar later this year. 

CNY is not that mispriced

I should stress that the CNY is not greatly undervalued, at least not as much as some people claim, only about 10%.   The absolute value of the bilateral US-China trade deficit is around US$200 billion and expanding.  As a share of the US’s overall trade deficit, however, the part of the deficit run against China has been stable at around the low-20% for the past 15 years.

This call of mine on USD/CNY, therefore, should be seen in the context of China’s balance of payments surplus and currency flexibility, rather than something that should be used to resolve the trade imbalance with the US. 

Bottom line

We are on track with our relatively aggressive call on USD/CNY.  USD/CNY will likely breach below the 8.00 mark soon and this should be the CNY event that I have been looking for.  With Senators Schumer and Graham softening their position, this is a particularly opportune moment for Beijing to earn credibility with Washington.  My year-end target for USD/CNY remains 7.50.

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Currencies
Dollar-Bearish-but-not-Too-Bearish
Apr 07, 2006

Stephen Jen (London)

Why are we changing our forecasts?

Our year-end targets for EUR/USD and USD/JPY remain unchanged at 1.24 and 106, respectively, but the quarterly profiles have been tweaked slightly.   We still see a modest rise in EUR/USD rather than a huge surge, and continue to believe that a more meaningful downturn in USD/JPY makes greater sense from the perspective of valuation and economic fundamentals.  For the commodity currencies, we now believe that there is a bit more downside risk than we had envisaged back in December, particularly in the second half of the year. 

I believe it is crucial for us to distinguish cyclical from structural factors in thinking about the dollar.   The dollar will likely weaken because of the way in which various central banks may respond to their business cycles, but I continue to reject the notions that the dollar will lose its hegemonic status, that there will be wholesale diversification from USD, or that the Bush Administration will adopt a weak dollar policy.  Fears for the latter may be temporarily negative for the dollar, and the dollar may underperform relative to our forecast trajectories.  However, the targets we show are what we believe should take place, rather than what will likely take place, which is sensitive to sharp swings in investor sentiment. 

Our thesis this year is unchanged

(1) The USD index is fairly valued. 

(2) The dollar is structurally sound.   In addition to valuation, I remain a strong believer in the concepts of the ‘de facto dollar zone’, excess savings in the rest of the world, and the USD as the hegemonic currency in the world.

(3) So far this year, the global economy has continued to impress.   The global economic backdrop is not only robust, but growth is broadening out away from the US, and oil shocks no longer look so scary, as investors have come to understand that they are mostly demand-driven. 

(4) Monetary normalisation is a major theme this year, particularly the fact that there is a discrepancy between the timing of the normalisation by the capital deficit countries, which are near the end of their tightening cycles, and that by the capital surplus countries, which are only beginning to tighten.   This will likely lead to the currencies of the capital deficit countries weakening against the capital surplus currencies.

(5) We still like Asia.   Both the CNY and the JPY are likely to appreciate meaningfully against the dollar later this year, in our view.  In this US-Europe-Asia triangle, we are more excited about Asia outperforming than the USD weakening.  Both USD/JPY and USD/CNY are mispriced, and the Asian central banks are having serious second-thoughts about unconditional reserve accumulation. 

Our forecast updates

For EUR/USD, we see it rising steadily to 1.28 by mid-2007, before reverting to what we believe to be a more reasonable long-term equilibrium of around 1.20, as the US slowly deals with its C/A deficit.  In my view, EUR/USD already set a low for the cycle at 1.16 in November 2005.  The risk is, to me, clearly biased to the upside.  However, I am less bullish on EUR/USD than many investors are.  For USD/JPY, I remain structurally bearish, and believe 121 reached in early-December last year was the cycle peak.  It will be difficult to get the timing right on the prospective sell-off in USD/JPY, but I believe the risk is heavily skewed to the downside.  Importantly, we stand by our forecast for USD/CNY to decline to 7.50 by end-2006 and 7.00 by end-2007. 

Compared with our view in December, we are less positive on commodity currencies.   Although global growth will likely remain robust, it is unlikely to accelerate further later this year.  The scope for commodity prices to continue to surge higher may be limited.  We now see USD/CAD ending 2006 at 1.22, rather than 1.16 in the previous forecast.  For AUD/USD, we now have a year-end target of 0.67, compared to 0.70 previously. 

Some key themes in the market now

•      Issue 1.  Is Euroland catching up with the US?  Euroland is recovering, but so is every other country in the world.  If the business cycles in the US and Euroland, and therefore the FFR and the refi rate, continue gradually to converge, EUR/USD could drift higher.  In fact, this has been our view since last December, when we announced an upward trajectory reaching 1.28 by mid-2007. 

•      Issue 2.  Wholesale diversification from USD assets.  My view on this debate is clear: the dollar will remain the hegemonic currency for a very long time.  Wholesale diversification by Asian central banks or the oil-exporting countries does not make sense, and will not happen. 

•      Issue 3.  Will the Bush Administration abandon the strong dollar policy?  Absolutely not, is my call.  It is true that almost every policy shift on the dollar has occurred in conjunction with a change in the US Treasury Secretary, but from an economic perspective, such a policy shift would not make sense. 

Bottom line

Our year-end targets for EUR/USD and USD/JPY remain unchanged at 1.24 and 106, respectively, but the quarterly profiles are tweaked slightly.  Our main theses remain unchanged: the USD should experience a gentle downturn this year, but more against the Asian currencies than against the EUR.

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