Rebalancing Legitimized!
Apr 28, 2006
Stephen Roach (Hong Kong)
At long last, global rebalancing is center stage in the world policy theater. That’s an important conclusion to take out of the results of April’s power councils — the G-7 meeting as well as the annual gathering of the full complement of some 184 members of the IMF. This is good news for an unbalanced world. It is not, however, the silver bullet for dealing with a very tough problem. The road to global rebalancing is likely to be long and arduous, and the new approach still has some problems. But as someone who has led the charge in worrying about the pitfalls of an unbalanced world, I am delighted that the Wise Men have finally seen the light.
Policy makers have always communicated in strange and almost ritualistic ways. That’s true at the national as well as at the global level. Statements typically are steeped in jargon and opaque phraseology. Nuanced language allows for multiple interpretations — providing the cover, or hedge, if things go awry. All those caveats aside, there can be no mistaking a very important message sent on 21 April by the G-7 finance ministers and central bank governors after their recent meeting in Washington: Global imbalances have now been officially anointed as a major concern by the stewards of globalization. Not only were they given prominent mention in the official G-7 communiqué, but they were also the focus of a rare “annex” to the statement. In G-7 circles, that’s about as loud as an alarm ever gets. The annex lays out three basic principles that shape the G-7’s approach to global rebalancing: One, it is a shared responsibility — an obvious but very important statement that readers of my work will also recognize. It is policy jargon for saying “no” to scapegoatting — pinning the blame unfairly on a nation like China. Two, rebalancing requires, first and foremost, a realignment of global saving and investment flows; this identifies disparities between current account surpluses and deficits as the major source of global instability — again, quite consistent with my own thinking and clearly putting the US, with its world record current account deficit, at the top of the problem list. Three, the G-7 annex stresses that rebalancing strategies must be designed with an aim toward maximizing sustained economic growth; in my view, that’s the weakest element of the G-7’s proposed strategy. While rapid growth is an understandable goal, its emphasis may obscure the heavy lifting that will ultimately be required of an effective global rebalancing strategy. This latter point deserves elaboration. Economic growth has become the elixir of political angst — the perceived remedy for all that ails a nation’s economy. Pro-growth politicians win elections — and re-elections — while the anti-growth set is doomed to a quick oblivion. Growth has become such an important part of the policy rubric that it has spawned its own theoretical framework — supply-side economics. A broad array of pro-growth policies — especially tax cutting — has come into fashion as the rising tide that lifts all boats. Supply-siders believe that self-financing budget deficits, narrowing income inequalities, and surging productivity are all part of the growth miracle. Never mind America’s gaping budget deficit and the recent widening of disparities in the US income distribution — the pro-growth principles of supply-side economics have taken on almost a religious fervor in Washington and on Wall Street. America’s current account deficit — the world’s most serious imbalance — is, first and foremost, an excess consumption problem. I make that statement on the basis of three facts: One, tradable goods imports by the US are currently 89% larger than its exports of tradables. That means exports now have to grow twice as rapidly as imports just to hold the US trade deficit constant. Two, import penetration has reached very high levels in America; tradable goods imports now account for a record 37% of US expenditures on goods. That means that the faster US domestic demand grows, the faster imports will grow — implying that faster growth begets an ever-widening US trade deficit and ever-mounting global imbalances. Three, US consumption is currently holding at a record 71% of US GDP — a huge breakout from the 25-year average of 67% that prevailed over the 1975 to 2000 period. These three points imply that it will be extremely difficult for the US to accept its role in the shared responsibility of global rebalancing without coming to grips with its excess consumption problem. And that, I’m afraid, could well spell slower economic growth in America. Such a conclusion not only flies in the face of the pro-growth principles of the G-7’s newly-articulated rebalancing strategy, but it is also very much at odds with the supply-side policy biases that currently dominate the Washington consensus. I don’t want to come across as too negative in assessing the implications of the G-7’s epiphany. As an unabashed champion of the imperatives of global rebalancing for longer than I care to remember, I believe the 21 April communiqué was something close to an historical breakthrough. Moreover, it was followed by an equally impressive effort from the IMF at its companion annual meeting — an endorsement of the principles of “multi-lateral surveillance and consultation.” This is policy jargon for a big change in the modus operandi of the Fund, which has long conducted its work mainly on the basis of single-country missions and consultations. By taking its functionality to the multi-lateral level, the IMF is accepting the very important task of coming to grips with the “spillovers” across nations that arise from imbalances of trade and capital flows. The surveillance aspect of this task essentially empowers the IMF to sound warnings when multi-lateral imbalances reach dangerous levels — a welcome development for a world that is inclined to ignore such problems until it is too late. The multi-lateral consultation function will undoubtedly be a good deal thornier to execute, since it could conceptually involve arbitrating the costs and benefits of a shift in US fiscal policy versus structural reforms in Europe, weighing in reserve management practices of the oil producers and Asian exporters, and so on. Globalization is not just about integration — it is also about navigating the ever-contentious waters of cross-border structural and policy tradeoffs. For the IMF, this new role could well be a key to its survival as a relevant global institution. In my view, it is unconscionable that the stewards of globalization could have allowed the world’s imbalances to reach such dangerous proportions. The Fund will now be able to demonstrate if it is up to the challenge of its mandate. The IMF, in effect, has been charged with the execution of the G-7’s newly stated principles of global rebalancing. By accepting this important responsibility, the IMF has the opportunity to provide an unbalanced world with legitimate hope on the road to rebalancing. Success could lay the groundwork for a major breakthrough in the reform of the world’s policy architecture. Failure could spell curtains for the IMF as we know it — portending a painful slip into the obscurity that Governor Mervyn King of the Bank of England has raised as a worrisome possibility (see my 24 April dispatch, “Time for a New Global Architecture”). There’s one element of this new rebalancing agenda that continues to gnaw at me — the insistence on Chinese currency flexibility as an important element of the global adjustment process. I definitely believe that China has an important role to play in global rebalancing. I also think that China accepts its responsibility to do just that. As I have noted, the newly enacted 11th Five-Year Plan has rebalancing written all over it, as China attempts the Herculean task of shifting the mix of its economic growth from exports and investment to private consumption (see my 24 April 2006 Special Economic Study, “China’s Rebalancing Challenge”). Instead of fixating on the currency as the main lever of rebalancing — and implying that a sharp revaluation of the RMB is needed — the G-7 and the broader global policy councils need to give China credit where credit is due: China is attempting to do something that Japan, Korea, and the rest of the so-called Asian dynamos have utterly failed to do — embracing and delivering on a pro-consumption growth strategy. Success of this plan will turn China into a very positive force in the rebalancing sweepstakes. Conversely, large currency movements — especially for a poor country with a still shaky financial system — borrow a page right out of the script of the “yen blunder” that Japan acceded to in the 1980s (see my 21 April dispatch, “Bad Advice”). Global rebalancing needs enlightened policies from China — not a replay of the painful mistakes that led Japan astray 20 years ago. Globalization is a complex and challenging transformation of the world order. The stewards of globalization have been asleep at the switch — allowing unprecedented imbalances of trade and capital flows to mount. The G-7 and the IMF have finally come together to recognize the dangers of these problems. In doing so, they have rejected (thankfully) the “new paradigm” views of those who argue that imbalances are a perfectly sustainable attribute of a new world order. The long march down the road of global rebalancing may have just begun. Notwithstanding some of my quibbles noted above, this is excellent news for an unbalanced world. If the G-7 strategy works, it is also good news for financial markets. In particular, a successful rebalancing should lower the risks of a global hard landing — tempering the fears of a crash in the US dollar and/or a related sharp increase in real long-term US interest rates. So far, the hope is all on paper — buried in the rhetoric of a communiqué. Now it’s time for the heavy lifting.
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Slowdown? What Slowdown?
Apr 28, 2006
Eric Chaney (Paris)
Until the release of the April business surveys, we thought that the peak of growth in the nascent European recovery was probably behind us. European companies tell us we were wrong. Production is gathering momentum, not decelerating, say the Ifo, Insee, Isae (and their like) surveys of more than 10,000 companies. True, our Compass had repeated its ‘Strong and Accelerating’ diagnosis in March, but we doubted that it would sign in for a third month. Actually, this is what happened. The scenario that seems to be unfolding is interesting: While German production indicators have stabilized, they have jumped in Belgium, Italy, the Netherlands and France. Since German demand indicators have risen further, the most likely explanation for this geographical pattern is that Germany’s trade partners are starting to benefit from the German recovery. If confirmed, the rebalancing of the sources of growth in the euro area bodes well for the sustainability of the recovery and has important consequences for policy makers. Production is fuelled by unexpectedly strong demand. Current production indicators rose in all countries but Germany, where the index was stable at 1.8 points of standard deviation (psd) above the long-term average, a level now matched by Belgium, which posted a spectacular acceleration from 0.2 to 2.3 psd. Companies gave a convincing explanation for the acceleration of growth: demand is stronger than expected and inventories are insufficient. Demand actually accelerated from 1.0 to 1.3 psd, led by Germany, where the indicator is now more than 2 psd above the long-term average (2.1), an event with a probability of less than 5%. Regarding inventories, companies confirmed their previous month’s assessment: they are insufficient, even slightly more than one month ago. Inventories are now significantly insufficient in Germany, Italy and Belgium. In the latter, the indicator moved from -1.1 psd to -1.4 (a minus sign means ‘insufficient’ with regards to demand trends). In the past, we have observed that the Belgium indicator was a reliable leading indicator of the euro area inventories indicator. Hence, April results are suggesting that, taken by surprise by the strength of demand, companies may have to draw further on inventories in order to meet demand in the coming months. From monetary policy transmission to trade links. In last month’s Business Cycle Watch, I argued that the recovery of Euroland demand was a natural consequence of the long-lasting monetary stimulus applied to the economy by the ECB since January 2003, as confirmed by strong credit data. April surveys suggest another dimension in the ongoing recovery: trade links. It strikes me that demand reported by German companies is flying far above other countries, with Belgium coming a distant second (indicator at 1.3 psd). Having restored their competitiveness and being specialized on products benefiting from a strong global momentum (capital goods), it is logical that overseas (read extra-EMU) demand for German products is stronger than for it is for others. However, the recent increase in the gap between Germany and its neighbors cannot be explained only by the competitiveness factor, which is more structural than cyclical. Since the production gap seems to be closing, the best explanation is that German domestic demand is recovering, as indicated by consumer and retail industry surveys from this country. Because Germany is absorbing roughly 30% of its EMU partners’ exports, a rebound of German demand has an immediate impact on exports and thus production. Policy implications: higher interest rates and lower budget deficits. Although the ECB has acknowledged that growth was firming up, the Council did not seem fully convinced of the reality of an endogenous rebound when Jean-Claude Trichet downplayed the possibility of a rate hike next week. Although the rise of the euro might have played a role in this decision to communicate (see Is the Euro Back in the Policy Equation, Eric Chaney, April 7, 2006), worries about the state of the real economy were probably dominant. Our analysis of April surveys indicates that obstacles to a further step in monetary normalization would not harm the economy. Other things being equal, our early GDP indicator is consistent with a 2.5% annual clip for GDP growth this year, implying a significant reduction of the output gap, lower unemployment and lower budget deficits, provided that governments let automatic stabilizers play, which they have done so far. If we are right, this is a refreshing macro landscape for Europe.
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Economics Drive USD, Politics Drive CNY
Apr 28, 2006
Stephen Jen (London)
Economic fundamentals will remain key for the USD The market’s reaction to the G7 Communiqué to sell the USD has been surprising and remarkable. Though the G7 statement was in a way a trial balloon for assessing the market’s bearish sentiment toward the USD, I believe that economic fundamentals will ultimately be the dominant driver for the USD, not rhetoric from the G7 or the US Treasury. For USD/Asia, however, currency politics may still matter more than economic fundamentals. My view on exchange rates remains unchanged — the USD is likely to weaken with the US housing market, and the biggest beneficiary is likely to be the JPY rather than the EUR. My thoughts: • Thought 1. China may have made a strategic mistake in not allowing USD/CNY to break below 8.00 last week when President Hu was in the US. I suspect that China’s inaction on CNY last week also played a role in the G7’s decision to mention China in the context of global imbalances. Even though I believe that Beijing has been working hard to implement reforms as rapidly as possible, the more recalcitrant China appears to the world, the more the situation will deteriorate, as a golden opportunity to diffuse Sino-US trade tensions may have been missed. • Thought 2. The G7 statement was much more about the CNY than the USD. First, the Annex suggested that the G7 may have elevated global imbalances as a risk that is more important than others such as high oil prices. Second, far from a statement about a preference for the USD to go lower, the G7’s policy recommendations included, among other things, a desire to see the CNY be traded more flexibly and appreciate further. Third, it is remarkable that the G7 decided on a currency policy for countries that were not present at the meeting, when the country with one of the weakest currencies around (Japan) was not included in the list of currencies that need to appreciate. In a way, the G7 statement acted as a green light for the speculative community to target the AXJ currencies. • Thought 3. The strong market expectation that EUR/USD should rally hard is more of a misunderstanding. To me, the G7 and the US effectively have a ‘strong Asian currency’ policy, not a weak dollar policy. EUR/USD is already in shallow over-valued territory. Our calculations show that a 20% rise in EUR/USD could essentially push the ECB to adopt ZIRP, ceteris paribus. Germany seems to have embarked on a sustainable recovery, but I’m more uncertain about how the rest of the Eurozone will fare. First, so far, the ‘soft’ data continue to paint a bullish picture that is not yet validated by ‘hard’ data. Second, inflation pass-through in Euroland may be higher this time around, and some investors are getting excited about the ECB actually hiking rates at the May meeting. Third, I continue to challenge the prevalent view that the Middle East and Asian central banks are diversifying wholesale from USD to EUR. This is pure speculation, not validated by the IMF or any other data. • Thought 4. US economic fundamentals will drive the USD, not speculation. Growth in the US remains robust, in light of the recent data. However, our central case remains that there will be a gentle deceleration. But we need to keep in mind that the Fed will be data-dependent. If the Fed does pause after its May 10 FOMC meeting, it will still be likely that it can tighten further if justified by data and, specifically, if inflationary pressures do come through to justify further Fed action. • Thought 5. USD/JPY remains the most exciting trade in the G7 space. Investors do not appreciate how hawkish the BoJ really is. Many commentators and investors are still not sufficiently sensitive to the BoJ’s desire to avoid being too far away from the ‘neutral rate’, if the economy is indeed on a sustained recovery path and the output gap is already close to zero. Our valuation work shows that the fair value of USD/JPY is around 101. While non-Japanese investors have been bearish USD/JPY, they have not really been fully invested due to the high cost of carry. Japanese investors, on the other hand, have placed a much greater emphasis on the cash yield differentials, and less on the possible capital losses through USD/JPY movements. This is a highly unstable situation, with the risk unambiguously biased to the downside for USD/JPY. Bottom line The G7 Communiqué was not intended to convey a weak USD preference, but was more focused on CNY. I believe that the trajectory of the USD will continue to be driven by economic fundamentals, rather than what the G7 says, or what the market presumes the large reserve holders may be doing with their reserves. On the other hand, for USD/CNY, currency politics will continue to be a key driver.
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Macro Tightening, Property Bubble and Systemic Financial Risk
Apr 28, 2006
Andy Xie (Hong Kong)
China is tightening to deal with overheating. The measures include interest rate rises by the central bank and measures to cut industry overcapacity by the NDRC. Further measures may include restricting land hoarding, limiting property pre-sales, and raising tax costs for short-term property holdings. These measures may cool lending and investment growth in 2Q06. However, like the tightening in spring 2004, they will not solve the fundamental problem – excess liquidity due to booming exports and expectations of currency appreciation. Short of dealing with excess liquidity, the most important challenge is to contain the systemic risk to the financial system in this surplus-liquidity environment. China’s property market has formed a bubble, I believe. The sustainable level of property demand on urbanization and income growth is much lower than the current level. Macro factors and the lending practices of Chinese banks have caused the bubble. China’s macro today resembles that of Southeast Asia ten years ago: (1) Booming exports and expectations of currency appreciation are sustaining massive surplus liquidity in the banking system; (2) Banks lend mainly against collateral, especially land, which channels a rising share of the excess liquidity into land, causing land inflation. The land inflation increases the value of the collateral, which causes more liquidity to flow into land; (3) Low interest rates cause speculative demand for property with a large foreign component; and (4) Property inflation causes ordinary households to advance purchase decisions for fear of higher future prices. Two unique factors are making China’s property industry grow faster than in that of Southeast Asia ten years ago. First, declining profitability in the manufacturing sector is a push factor that causes manufacturing companies to enter the property business. Second, government ownership of land increases the speed of property development. To safeguard China’s financial system, I believe that the central government should tighten prudential lending practices. First, the loan-to-value ratio for lending against land should be low and strictly enforced. Second, banks must ascertain that the equity capital of their borrowers is genuine. Third, banks should ensure that loans for non-property purposes are not diverted to property. The ultimate solution is to deal with the factors behind the liquidity surplus. There is a huge subsidy component in China’s production cost, including low environmental standards, limited worker benefits, poor working conditions and tax privileges for export production. Were China to normalize the cost of production, it would increase the real effective exchange rate, which would slow down export growth and diminish expectations of currency appreciation. At the same time, this approach would shift income to labor, boosting consumption during a period of investment slowdown. The band-aid approach to macro management China is unleashing a wave of tightening measures to deal with overheating. The central bank has just raised the 1Y lending rate by 27bp to 5.85%. The NDRC has announced policies to decrease overcapacity in the aluminum, cement, ferrous alloy and charcoal industries. Further measures are expected in the coming days to tackle land hoarding and property speculation. Some tightening measures are from local governments. The Shenzhen government is considering raising downpayments on property purchases to 40% from 20%. Other cities such as Guangzhou and Beijing may introduce measures to cool property speculation. Such measures have both real and psychological effects. The latter might be more powerful in the short term. However, these measures limit access to liquidity, but do not solve the fundamental problem of excess liquidity. The expectation of currency appreciation is the key driver in that regard. The current band-aid approach to macro management exposes the financial system to prolonged systemic risk. In my view, it is far more important to implement measures to contain the systemic risk to the financial system in the excess-liquidity environment. I believe that limiting banks’ involvement in the property sector is key in this regard. Is property a bubble? As China’s property market heats up again, the debate over whether China’s property boom is a bubble is also growing. As Alan Greenspan famously stated, one can never prove that a boom is a bubble until it bursts. However, there are benchmarks and signs that could increase the odds that a boom is turning into a bubble, or is already one. There are many factors to support a fast-growing property industry. Urbanization is the most important. For example, the latest population data show that Beijing’s population has risen at 2.2% per annum and Shanghai’s at 1.2% per annum over the past five years. Income growth is another factor. As people make more money, there is a natural desire to upgrade housing conditions. Finally, the government has severely limited public housing availability. While the positive factors are real, they have always been there. We must ask why the market has developed so fast in the last few years. Residential properties under construction grew at 21.5% per annum in volume between 2000 and 2005, compared with 9.9% in the previous five years. There are two major macro differences between 2000-05 and 1995-00. First, China’s export growth accelerated from 10.9% to 25.0% per annum between the two periods. There was massive relocation of electronics production to China during the second period. Second, expectations of renminbi appreciation became a powerful force in channeling capital into China. The two factors led to surplus liquidity in China’s banking system. What China is experiencing is quite similar to what occurred in Southeast Asia ten years ago, in my view. The combination of economic development and a powerful global economic cycle has caused rapid economic and monetary growth. The favorable economic conditions have triggered expectations of currency appreciation, adding more liquidity to an already favorable liquidity environment. The practice of lending against collateral naturally channels surplus liquidity into the property market, as land or property is the most common form of collateral. Land inflation follows, which increases the value of the collateral and more lending against the same asset. The combination of the exceptional liquidity environment and such lending practice has led to the formation of a property bubble. By way of example, Bangkok’s residential property production increased by 59.6% in volume between 1992 and 1995, dropped by 81.4% by 2000, and has since recovered to about 40% of its peak level. It appears that the current level is sustainable, and the high level ten years ago was a bubble phenomenon. Similar to the situation that occurred in Bangkok ten years ago, Shanghai’s residential property production increased by 60.4% and Beijing’s by 47.5% between 2002 and 2005. Like Bangkok then, the two cities are witnessing buyers from all over the country and substantial participation by foreign capital. While volume growth does not necessarily imply a bubble, stretched affordability, widespread speculative demand and massive foreign capital inflow do usually coincide with one. In a recent study, Beijing’s Normal University pointed out that the average property price was 13 times Beijing’s average household income, twice as high as in most major cities in the world. Non-locals account for about 40% of the property purchases in Beijing. The numbers for Shanghai are quite similar. By value, the two cities accounted for 30.4% of national sales of primary residential properties last year. Containing financial risk The lesson from Southeast Asia is that banks cannot be too careful when the property market is growing rapidly. The practice of collateral-based lending is very bad for banks when an economic cycle is at a high. Japan, Hong Kong and Southeast Asia experienced dramatic fluctuations in their land prices during their economic development. China suffered the same fate ten years ago. Surplus liquidity pushes banks to lessen their lending criteria and increase their loan-to-value ratios to maximize short-term profits. However, when the cycle turns down and bad debts mushroom, governments can become responsible for the losses. This is why the Chinese government needs to tighten lending conditions now. First, I believe that the central government should severely limit the loan-to-value ratio for lending to businesses against land, property and shares as collateral. In the case of land or property, 50% is probably high enough. In terms of shares, the ratio should be even lower. Such restrictions are harsh by international standards. However, considering that China’s system has too many loopholes and the current environment is too overheated, such an approach may be the best way to contain financial risk. Second, banks need to assume responsibility for ensuring that equity capital is genuine. China’s businesses often have complicated holding structures and debt at one business entity can show up as equity at another. This magnifies the risk to banks enormously. While Chinese banks are aware of the risk, they sometimes stick to pro forma requirements and ignore this risk in their lending decisions. In my view, the government should lay down hard rules for banks to take responsibility on this issue. Third, the complicated structure of Chinese businesses can shift loan capital to purposes other than those agreed with the lending bank. A large number of manufacturing businesses, for example, engage in property production. They include overseas Chinese export businesses and state-owned enterprises. It is quite possible that they have borrowed for property investment through their manufacturing businesses. The lenders, therefore, are taking on risks that they did not intend to. This also raises the possibility that Chinese banks’ exposure to the property sector is much higher than 14.8% of their loan book. Eventually, I believe that Chinese banks should shift to cash flow-based lending. It is much safer for banks and prevents excess liquidity from flowing into asset markets. Obviously, cash flow-based lending is much more complicated than collateral-based lending. Chinese banks are only in the early stages of commercialization. It will take time for Chinese banks to achieve the sophistication required to implement cash flow-based lending properly. Dealing with surplus liquidity Tightening prudential lending practices would contain the systemic risk to the financial system at the micro level. As long as the macro environment of excess liquidity remains, it will be difficult to contain the financial risk. All financial crises follow a period of loose liquidity and vice versa. It is difficult to contain financial risk with micro policies in an environment of excess liquidity. Two related factors — booming exports and expectations of currency appreciation — are the fundamental causes of China’s surplus liquidity. I see only three possible ways for the situation to turn. First, the global cycle turns down sharply and China’s exports decelerate with it. The deteriorating export performance would reverse expectations of currency appreciation, too. However, this scenario is outside China’s control. The most likely trigger for this scenario is a sharp downturn in the US housing market. US consumption, which drives global trade, is dependent on property appreciation. Second, China can appreciate the currency to meet expectations. The market expects China to appreciate the currency slowly to Rmb7 to the dollar in five years, or by 2.4% per annum. Such expectations are keeping China’s interest rates that much lower and driving the liquidity boom. China could appreciate its currency quickly to eliminate these expectations. There are two considerations that mitigate this approach. First, a sudden rise in interest rates may cause a hard landing. China’s businesses are highly leveraged, with business debt at over 100% of GDP. A big increase in interest rates could be quite destabilizing. Second, the speculative capital in China’s property market could pull out to take profit, which could cause a hard landing. In short, revaluation carries too much risk of a hard landing. Third, China can increase the cost of production to increase the real effective exchange rate. There are many subsidy elements in China’s production costs, such as preferential tax treatment for export production, poor benefits and working condition for workers, and low environmental standards, which could be removed. This would be equivalent to increasing the effective exchange rate, which would slow down export production and decrease expectations of currency appreciation. This approach would also increase interest rates. However, it would shift income from businesses to households and government. Their spending from higher income could support the economy during the investment slowdown in response to a higher real currency value and higher interest rates. The cushion from extra household and government demand could help the economy achieve a soft landing. In summary, China is in a macro trap. The excesses in the economy are still expanding. The risk to the financial system is also rising. I believe that it will take considerable policy adjustments – and soon – to avoid a hard landing.
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The Peak Is Behind
Apr 28, 2006
Sharon Lam (Hon Kong)
Output slowed, though still solid. Korea’s industrial production growth came down slightly in March to 10% YoY compared to 13% in January and February but similar to 10.4% in 4Q05. In line with the output trend, shipment also slowed to 7.1% in March from 10.3% in January and February. Shipment for export (+10.9%) continued to outperform that of the domestic market (+5.5%). The slower output growth in March was not consistent with the acceleration in export and domestic consumption, implying that producers could be trimming down production in anticipation of cooling demand ahead. Nonetheless, output growth at 10% should still be regarded as solid. We believe that the coming adjustment will be very mild. Output-inventory cycle indicates that the economy could be approaching the peak. While output cooled slightly, inventory growth is picking up, implying that output has grown faster than demand. Inventory climbed 3.4% YoY in March, up from 1.4% in January and February but similar to 3.6% in 4Q05. Slowing output and climbing inventory is often a sign that the economy is approaching the peak. Indeed, we have been predicting that the economy will moderate in 2Q. The leading indicator index also slowed for the second straight month in March. The index leads GDP growth by approximately one quarter. Nevertheless, given a positive outlook on global demand and Korea’s capex recovery, we believe that the current slowdown will soon be followed by solidified growth again in 2H. Korea is likely to see a longer-lasting boom in this cycle, in our view. Is Korea at the turning point? Answer lies in capex. Without capex, productivity gains will be mild, and employment and wage growth will remain rather stagnant, in our view. Without meaningful improvement in the labor market, consumption growth will lack catalysts. Therefore, capex growth is essential to sustain the domestic recovery in Korea. We believe that Korea will see more capex growth this year. Facility investment indeed jumped to 10.3% in March, compared with 1.3% in January and February and 7% in 4Q05. The manufacturing utilization rate is hovering close to its historical high, averaging 82% in 1Q06 (or 81.5% in March). The capex growth trend in Korea, however, has been flat since 2001, leading us to believe that there is not enough capex created to support the rising utilization today. Korea needs more capex, in our view. Machinery orders also jumped sharply in March, with those for the domestic market soaring 43% YoY. Orders from the government plunged in 1Q, yet those from private enterprises were on the rise; this is an important indicator that companies in Korea are investing again. Meanwhile, a business survey shows that Korean companies are planning to raise their equipment investment gradually. We believe that this capex recovery will not be sharp, but it will be sustained for longer than Korea’s average cycles, which is important for labor market improvement. Meanwhile, machinery orders from overseas also surged in March, though this is partly attributable to vessel orders. We believe that China’s reaccelerating growth has played an important part in lifting Korea’s machinery orders in the last quarter. We have argued since the end of last year that Korea’s export growth will remain steady due to a reaccelerating China. In particular, we emphasized earlier this year that China’s growth would directly benefit Korea’s equipment and machinery exports, since the Chinese reacceleration this time is brought about by loosened loan growth, which is leading to more fixed asset investment in the country. Looking ahead, however, we believe that machinery orders from China will decline in the near term as China’s bank lending appears to have frontloaded in 1Q while the Chinese government is stepping up tightening measures again. However, we believe that China’s latest tightening is only symbolic, and the psychological impact may not be long-lasting. Therefore, we cannot rule out the possibility that Korea’s machinery exports will pick up again in 2H06 as China’s economic policy appears to be stop-and-go while liquidity in its economy is still strong. Consumption recovery remains on a gradual track and big-ticket focused. Wholesale and retail sales growth in Korea climbed to 3.9% in March, up slightly from 3.5% in January and February but lower than 4.5% in 4Q05. This came in line with our prediction that consumption would normalize after the last Christmas season, when sentiment in Korea was the most upbeat after the credit card bubble. We believe that Korea’s retail sales growth will linger around 3% in the near term, which is only a trend average. To break though that average growth, Korea needs labor market improvement and wage growth, which we believe will come in 2H following the capex recovery. Before wage growth picks up in 2H, Korea’s consumption growth will continue to be dependent on sentiment and wealth gains, in my view. Wealth growth leads consumers to spend more on luxury and big-ticket items. This is evidenced in the sales growth of durable goods (+11.6%) in March outperforming the semi-durables (+6.5%) and non-durables (+0.7%). We believe that this trend will continue until the latter half of this year. Current account balance to weaken, yet liquidity growth unlikely to ease until year-end. Korea recorded the second straight month of current account deficit in March at US$0.4 billion, though narrowing from the US$0.8 billion deficit in February. The trade surplus actually bode well in March due to export strength, yet the dividend payment made to foreigners in March and April caused the income account to dip into deficit and to drag down overall current account balance. This seasonal impact will continue into April to pull down Korea’s current account into a third month of deficit, in our view. Looking ahead, we believe that Korea’s current account balance will be reduced this year due to high oil prices and rising imports brought about by domestic demand recovery. Yet, at the same time, higher oil prices should reduce Koreans’ overseas travel while resilient global demand should sustain Korea’s exports. As a result, while we expect a lower current account surplus, we do not expect deficits to continue after March and April. Korea’s current account balance leads money supply growth by around 3-4 quarters. We therefore believe that the reduction in the current account balance will not impact the economy until the end of this year. Indeed, there could be another spike in liquidity growth in the coming months, brought about by the surge in current account surplus at the end of last year. Korean won to stabilize in near term, but could appreciate again by year-end. We expect the won to stabilize or even slightly reverse its gains in the next three months due to the latest data on the current account deficit, USD depreciation and concerns about the economy peaking out. However, we believe that the Korean won will appreciate again towards year-end as we expect more domestic demand recovery, which would bring up inflation. We believe that the Bank of Korea will therefore continue to raise interest rates in 2H of a magnitude that could be bigger than market expectations, thereby causing the won to appreciate. Meanwhile, we also expect external conditions in 2H to push up the won; these could possibly include the end of the Fed rate hike, the beginning of a BoJ rate hike and more RMB revaluation.
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Rebased CPI Shows Milder Inflation
Apr 28, 2006
Denise Yam (Hong Kong)
Hong Kong rolls out newly based CPI. Utilizing results from the Household Expenditure Survey (HES) that is conducted once every five years, Hong Kong has just released its newly rebased CPI series. The newly assigned weights in the CPI basket have resulted in milder inflation readings in recent months. Composite CPI inflation averaged 1.6% YoY in 1Q06 under the new statistics, against 2% estimated previously, while the reading is revised downwards also for 4Q05, from 1.8% to 1.3%. More focus on utilities and services, less on consumer goods and housing. Partly driven by diverging price trends, and partly by the genuine increase in services consumption (fundamental improvement in standard of living), utilities (from 2.98% to 3.59%) and ‘miscellaneous services’ (from 14.42% to 16.15%), which include education, entertainment, package tours, telecom services, household services, etc., gained share in the composite CPI basket. Housing (from 29.91% to 29.17%), clothing and footwear (from 4.13% to 3.91%), durable consumer goods (from 6.24% to 5.5%) and miscellaneous goods (from 5.7% to 4.78%), which include jewelry, cosmetics, toys, newspapers and magazines, etc., now claim a smaller share. Changing expenditure patterns across income groups. The changes in consumption weights across income groups show interesting differences. First, the nominal household expenditure ranges for CPI(A), CPI(B) and CPI(C) all shifted downwards amid general price deflation over the five-year period. The low-income group (bottom 50%) sees the sharp rise in housing rents and utility costs crowding out other spending; these items now claim 30.54% and 4.84% of the new CPI(A) basket, respectively, versus 29.13% and 3.99% previously. While the mid- and high-income groups both spend noticeably more on miscellaneous services, only the highest income group affords more spending on alcohol and tobacco, clothing and footwear, durable goods and transport. Nevertheless, all income groups are spending more on eating out, consistent with the structural upgrade in living standards. Full details will be available in June; we maintain our forecasts for now. A full report on the HES and the rebasing of the CPI will be published in June. We maintain our forecast for 2% inflation in 2006 for the time being.
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