More Turm(oil)
Apr 27, 2006
Serhan Cevik (London)
The rise in energy prices increases Turkey’s import bill and slows the pace of disinflation. The recent spike in crude oil prices to over $74 per barrel — bringing real energy quotes alarmingly close to the peak in the 1970s — presents new challenges to oil-importing countries around the world. Over the course of the last decade, the global demand for fossil fuels has increased at an unprecedented rate, outpacing the expansion of the worldwide production capacity, and the resulting ‘imbalance’ has of course led to a sustained increase in oil and natural gas prices. However, the characteristics of the energy shock have lately started changing, with political tensions and supply constraints emerging in a number of oil-producing countries. Unlike a gradual demand-driven adjustment in energy prices, the possibility of major supply-side disruptions opens the door to fear and speculative behaviour and may therefore cause more damage to oil-dependent economies. In view of such an ‘endogenous’ energy shock, Morgan Stanley’s global economics team has revised its oil projections from an annual average of $61.3 per barrel to $73 in 2006 and from $47.9 to $68.5 in 2007 (see Oil Alert: No Relief on Supply, Eric Chaney and Richard Berner, April 21, 2006). Though we still expect a ‘correction’ towards an average of $52 per barrel in 2008, sustained higher energy prices could have knock-on effects on Turkey’s economic performance.
Oil prices are the main culprit, but it would be a mistake to overlook other factors. The price Turkey paid for a barrel of crude oil increased from an average of $17 in 1999 to $49.8 last year, pushing the country’s fossil-fuel import bill from 2.7% of GDP to 6.2% over the course of that period. Unfortunately, Turkey’s growing dependence on energy imports has already lowered its real GDP growth rate and put upward pressure on domestic production costs, although the most significant impact of higher energy quotes has so far come through a marked widening in the trade deficit. And the latest figures and projections point to a sharp jump, at least, in the energy category of producer and consumer prices. Indeed, the pace of disinflation has already slowed, with an average year-on-year increase of 8.1% in the consumer price index in the first quarter of this year — practically unchanged from 8.2% last year and 8.6% in 2004. In our opinion, the rise in energy prices is the main culprit, contributing as much as 150bp to headline inflation in 2005 and approximately 100bp in the first three months of this year. Despite the lira’s strength and having a large tax wedge, recent increases in the ex-refinery price of petroleum products are likely to have more pronounced effects in the coming months. Having said that, it would be a mistake to overlook other factors that have contributed to the slowdown in disinflation. In addition to the long-lasting inertia in rental prices, the categories of unprocessed food and alcohol and tobacco in the CPI basket posted cumulative increases of 5.1% and 4.8%, respectively, in the first quarter. Likewise, the staggering increase in the price of gold (which actually has a marginal weight in the CPI) contributed 20bp to Turkey’s headline inflation last year and 30bp so far this year. Core measures of inflation show limited second-round effects of higher energy prices. Core inflation excluding energy and unprocessed food declined from an average of 10% in 2004 to 8.3% last year and 7.3% in March. Though we do not want to create an unrealistic measure of core inflation, an alternative index excluding alcohol and tobacco prices along with the energy and food components reveals an uninterrupted trend towards price stability. This is not a surprising development, in our view, since prudent policies and structural changes limit the indirect effects of higher energy prices. As the latest figures confirm, producer prices have lagged well behind increases in the price of inputs and, more importantly, intensifying competitive pressures keep a tight rein on the pass-through to consumer prices. In other words, Turkey’s disinflation process, though experiencing some exogenous obstacles, remains broadly intact. The outlook is now more challenging, but we see no reason for significant adverse shifts. Following revisions to our oil price projections, we have adjusted our inflation forecasts upwards — from 4.8% to 5.4% at the end of this year and from 3.6% to 4.0% in 2007 — largely due to first-round effects. According to our estimates, the Turkish economy is still operating with an output gap and productivity gains, well in excess of real wage growth, will help to weather the negative supply-side effects of the oil shock. The monetary implication of these changes is not straightforward and depends on a number of conflicting factors. For example, the increase in energy costs may also have disinflationary effects by reducing the real income of consumers and firms. Therefore, the central bank should respond to the inflation threat caused by an energy price shock only if it leads into second-round effects on the behaviour of inflation. On the other hand, even though such an adverse shift in long-term inflation expectations is unlikely to take place and we still see room for further interest rate reductions in the second half of this year, easing the monetary policy stance at this stage would not be a wise decision, in our view.
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Strong March Performance Poses Upside Risks to 1Q GDP Advance Estimate
Apr 27, 2006
Deyi Tan and Denise Yam (Hong Kong)
Strong March performance. Production momentum moderated somewhat from February’s 37.2% YoY but still rose a strong 25.2% YoY in March. This brought 1Q’s production growth up to 20.0% YoY (versus 17.4% YoY in the Jan-Feb period). Excluding biomedical, manufacturing production rose a slower 14.8% YoY (versus 1Q’s 15.1% YoY). Biomedical segment was strong, but only growth in the transport segment accelerated in March. Dissecting the numbers, the biomedical segment (+97.0% YoY) drove the strong performance. In particular, pharmaceuticals rose 147.4% YoY as the output mix changed. Production in the transport segment also accelerated to 52.3% YoY on the back of stronger marine and offshore engineering (+81.9% YoY). However, performances in the other segments moderated slightly compared to February. Growth in the electronic segment subsided to 7.7% YoY from 17.8% YoY, mainly as data storage production continued to shrink (-38.3% YoY). 1Q GDP likely to be much stronger than the 9.1% advance estimate. March’s strong industrial production implies upside risks to the advance estimate of 9.1% released earlier this month, which was based on a 16% YoY rise in the manufacturing sector. Factoring in the latest production numbers, the upside risk runs to the tune of 1.0ppt, all else constant. However, to put things into perspective, the historical CAGR of the biomedical industry has averaged 16.7% YoY for the past six years (versus 47.3% YoY in 1Q06). Hence, we could expect downward volatility in the pharmaceutical industry to cause a moderation in economic momentum going forward.
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25bp Rate Hike After March Inflation
Apr 27, 2006
Deyi Tan and Denise Yam (Hong Kong)
25bp rate hike. Bank Negara raised the overnight policy rate (OPR) by 25bp to 3.50%, contrary to our expectation that rates would be kept on hold until after the GDP report. Responding to rising inflation. The decision is likely in response to rising inflationary pressures as seen in the March inflation data, which shows CPI jumping from 3.2% YoY (in February) to 4.8% YoY on one-off factors, i.e., a 19-23% rise in the fuel price at end-February. However, liquidity conditions remain accommodative, with real interest rates (3M interbank rate minus inflation) falling lower in the negative range. Despite acknowledging the loose conditions, Bank Negara continues to convey the message that further tightening would be contingent on economic developments, remaining non-committal to the steady tightening by other central banks. Moderation on base effects ahead, but note the secondary effects and one more inflation factor. The government has stated that it will not raise retail fuel prices until next year, which would mean a moderation in inflationary pressures ahead on base effects in May and August, when fuel subsidies were reduced in the corresponding period a year ago. However, we note that the government has already raised fuel prices five times since mid-2004. Hence, the accumulated lagged impact from secondary effects and likely utility tariff hikes (11.4%, according to our utility team), which could add about 0.3ppt to the headline number assuming full pass-through, might somewhat offset the moderation from base effects. Some monetary tightening from currency strengthening. With real interest rates low, rate hikes not having any discernible impact on overall or consumer lending so far, inflationary pressures evident and likely reasonable growth in 1Q06, we believe that Bank Negara could hike rates again at the May meeting after the GDP report. By year-end, we expect OPR to reach 4.0%. We think that one reason why Bank Negara might not be more aggressive on rate hikes is because some monetary tightening has been/will be seen on the currency front as the ringgit moves towards fair value from an undervalued fixed peg previously.
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Still in a Good Shape
Apr 27, 2006
Sharon Lam (Hong Kong)
1Q GDP Growth Beats Expectations. Korea reported preliminary 1Q06 GDP growth at 6.2% YoY, up from +5.3% in 4Q05, which is the strongest gain since the credit card boom period in 2002. Today’s number came in higher than expectations (MS: 6%, Consensus: 5.8%). On a seasonally adjusted QoQ basis, 1Q GDP rose 1.3%, down from 1.6% in 4Q. Exports continued to be the major growth driver, posting the strongest QoQ growth among all GDP components in 1Q. Domestic demand recovered further but the pace came in below market expectations, again. If we take out the nonproductive component – inventory changes – domestic demand’s contribution to GDP growth was similar to 4Q05, meaning there has not been much upside. Nonetheless, we believe domestic demand will continue to recover as we are positive on capex growth. We expect domestic demand to be the largest contributor to growth starting in 2H. We believe the Bank of Korea will continue to raise interest rates, as the current rate at 4% is still below neutral levels, despite the fact that the economy is growing above trend. With this stronger-than-expected GDP report, we believe the central bank will raise interest rates by 25 bp at their next monthly meeting on May 11. Currency appreciation could be a complication, but we believe the won will stabilize very soon, which should clear obstacles for rate hikes. We had been looking for a total 75 bp rate hike for Korea in 2006 (with 25 bp done in February already). Our call has been more aggressive than the market. We understand that BoK’s tightening is pre-emptive, targeting the housing market and inflation. Only recently has the market started to price in a total of 75 bp for this year, as the central bank appears more hawkish towards the housing market lately. We now see upside risks to our original rate call. Interest rates are very likely to rise beyond 4.5% after the end of this year. 2Q to Soften; 2H to Improve. After strong growth momentum in the last two quarters, we believe we will see some slowdown in 2Q as global demand could be disrupted by rising oil prices, which in turn could negatively affect Korea’s consumer sentiment. Nevertheless, growth around the world continues to look solid. In particular, China — Korea’s key growth driver in the recent years — is likely to see further above-trend growth this year as lending was loosened at the beginning of the year. We therefore believe export orders for Korea will stay resilient after a short-lived cooling in 2Q. On the domestic demand side, we believe consumption recovery will continue, but not in the V-shaped manner that Korea used to enjoy during previous booms. Wealth inequality and relatively sluggish income growth are the biggest obstacles to consumption growth. To sustain the domestic demand recovery, Korea needs more capex. Capex growth in 1Q was a bit weaker than expected, as public investment shrank and won appreciation cast concerns over profitability. Yet, cyclically, Korea needs more capex due to a pickup in the service sector and high utilization rates in the manufacturing sector. We believe capex will revive again when currency movements stabilize in the near term. Growth Drivers and Sustainability- A Glance at GDP Breakdown Trade: Exports showed the strongest growth among all GDP components at 3.2% QoQ in 1Q06, after a seasonal adjustment. On a YoY basis, exports grew 11.5% in 1Q compared to 10.4% in 4Q. The rebound in exports was an upside surprise to some at the beginning of the year as the market in general has focused more on domestic demand growth rather than exports. We had been advocating that Korea’s growth would remain export-driven in 1Q before a full recovery in domestic demand to come in later this year. The export outlook in the current quarter appears more uncertain due to soaring oil prices. Yet, we continue to have faith in solid global demand throughout this year and therefore do not expect any significant export slowdown. Export growth will remain steady in 2H after a possible small slip in 2Q, in our view. Meanwhile, imports also picked up significantly by 4.1% QoQ in 1Q or 11.8% YoY. Import growth rose faster than the pace of domestic demand, which we believe can be explained by won appreciation as imported goods became cheaper. We expect imports to continue to advance as demand picks up further while the won is unlikely to depreciate over the medium-term. As a result, the net export contribution to GDP growth will come down in the coming quarters despite robust exports. Private Consumption: Since the beginning of 2005, the market has been expecting a sharp rebound in consumption. Many had hoped that private consumption growth would reach 6-7% as it did in the last boom period of 2001-02. Unfortunately, it has not happened in this cycle and we do not think it will. As we had been emphasizing since last year, Korea’s consumption recovery will be mild and gradual only. Private consumption growth climbed to 4.7% YoY in 1Q06, up from 4.2% in 4Q05 and 4% in 3Q05, painting a U-shaped recovery. On a seasonally-adjusted QoQ basis, private consumption rose 1.2% in 1Q, similar to the gain of 1.1% in 4Q. It is reported that private spending is concentrated in purchases of durables and semi-durables. We believe this trend will continue in the near term as the current consumption recovery is driven mainly by the wealth effect (with gains from the stock and housing markets), which caused consumers to purchase more luxury and big-ticket items. Until wage growth picks up, which we expect to happen in the latter half this year, Korea’s consumption growth will remain concentrated in the high-end and durables sector, in our view. A broad-based consumption recovery should come in 2H. Facility Investment: Capex trends in Korea have been flat since 2000 due to post-crisis corporate restructuring, manufacturing hollowing-out, and a domestic slump after the credit card bubble. Yet, capex finally showed signs of picking up since the end of 2005, as was visible in strong machinery orders, machinery imports, and physical expansion in the service sector. Capex growth in 1Q, however, came in slightly below expectations, falling 0.7% QoQ. On a YoY basis, growth also slowed to 6.6% in 1Q from a phenomenal 10.2% in 4Q, though 6.6% should still be regarded as a very solid number. Less investment by the government was one factor. Meanwhile, we believe won appreciation could also have discouraged capex as exporters’ profitability came under pressure. We have been citing capex as the wild card for growth this year. We believe the impact from currency on capex will be short-lived. We expect the capex recovery to continue, which will help sustain the economic recovery through job creation and productivity growth. Construction: The construction sector has been sluggish since the government has focused on dampening the housing market. Construction investment grew 0.3% YoY in 1Q, down from 0.9% in 4Q. It also declined on a QoQ basis. Investment in residential projects was lackluster as expected, yet there was a pickup in the construction of offices, factories and warehouses, which should be interpreted in line with the capex recovery. The government is likely to continue with a tough stance towards the housing market. Further anti-speculation measures will not be surprising. Increasing housing supply is part of the government’s plans. Should the government introduce more satellite towns, construction activity will likely pick up. We believe Korea is near the bottom in terms of construction investment. Indeed, construction orders and permits granted have been on the rise recently. All in all, the Korean economy is still in a good shape. Further domestic demand recovery is expected, while exports should be supported by strong demand from China. Korea will see above-trend growth throughout this year, we believe.
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