Inflation is coming
May 16, 2006
Andy Xie (Hong Kong)
The global liquidity boom is finally turning into inflation through three channels. First, the property boom inspired huge service demand in Anglo-Saxon economies and has led to tight labor markets there.
Second, the commodity bubble of the past three years has increased costs of production and living by over 5% of global GDP. Although commodity inflation has been absorbed through consumer borrowings and lower profit margins in the past, it is now turning into higher wages and core inflation. Third, China has kept the global cost of production artificially low by not paying for pollution and labor benefits. The political pressure within China is such that the government is normalizing production cost, which could boost global inflation. Globalization has slowed and stretched macro trends. Inflation is likely to follow the same pattern. Global inflation has picked up by 60 bps in the past four quarters. If the trend continues, as I believe, major central banks will have to focus on fighting inflation with little room for growth considerations. Moreover, this is just the beginning. Major central banks may have to focus on inflation for two years. Bonds are the first asset class to decline in value in this cycle. The trend is likely to continue, in my view. Declining bonds will eventually take down other assets. In particular, as the yield curve steepens, the commodity bubble can burst. The stock market will probably come down last. The world would then experience a period of all assets declining in value mirroring what has occurred in the past three years. This period could last for two to three years – afterwards, the bond market would recover first. Cyclical Inflation Is Coming Globalization has slowed but not eliminated cyclical inflation. Globalization has stunted wage inflation as the main transmission between monetary growth and inflation. Instead, excessive liquidity has been fueling asset markets to generate demand. As globalization spreads the demand growth around the world, inflation has taken longer than before to show up. The tech burst, 9/11, and the rapid relocation of factories to China caused sharp disinflation in 2002. The average inflation of the US, Europe, Japan and China decelerated from 3.2% in 2Q01 to 1.1% 3Q02. The deflation scare triggered the Fed to cut interest rates to 1% and the BoJ’s quantitative easing, which led to a massive liquidity boom. The liquidity boom has worked into demand through inflating asset markets. Property inflation has given Western consumers the spending power. Commodity inflation has given developing economies income to spend. Declining cost of capital from rising stock market and declining credit spreads has allowed developing economies to invest. Though inflation has doubled from 1.1% in 3Q02 to 2.2% in 1Q06 for the same sample, it remains low against three years of above-trend growth. Further, many would argue that much of the pickup is due to energy inflation and not in core. This argument is less effective than it sounds. Headline and core CPIs must converge towards each other. Unless the commodity bubble bursts soon, core CPI is likely to converge to headline rather than the other way around. Three Reasons for Higher Inflation Ahead First, wage inflation may be coming, especially in economies with high current account deficits. Globalization is effective at keeping inflation down when there is good substitution scope between services and manufacturing in labor markets. This effect dissipates overtime. For economies with large current account deficits, this substitution effect is likely to disappear first. Australia’s lingering inflation despite its sluggish economy is a case in point. Second, commodity inflation has not all hit headline inflation, as companies have absorbed some and governments have subsidized. Brent crude has averaged US$63.7/bbl in 2006 compared with US$25 in 2002. The increased cost for oil for the global economy between the two prices is US$1.2 trillion. Other energy resources (coal and natural gas) have roughly doubled in price during the same period and may incur about US$500 bn more. The extra energy cost is probably 4% of global GDP. A substantial portion of energy inflation is yet to show up in inflation. The inflation of other commodities adds at least another 1%. Third, China is normalizing its production cost. Manufacturing production has relocated to China on a massive scale in the past five years due to China’s cheap labor and lax enforcement of environmental standards. While the low labor-cost advantage is well understood, the lax environmental rules and their enforcement are not well understood and may have become more important than labor costs in attracting production relocation in the past three years. The world has dumped its pollution in China in the past five years. According to China’s EPA, China’s pollution is 12 times the world average per unit of GDP. The emission of sulfur dioxide is 22.5 mn tons compared to the maximum carrying capacity of 12 for the country. Two-fifths of the seven major river basins are severely polluted. 90% of the rivers running through cities suffer from severe pollution problems. 300 million rural residents have no access to purified water. One-third of China’s territory suffers from the effects of acid rain. Two-thirds of the population suffers from poor air quality. China’s environmental catastrophe is a poorly understood factor in the global disinflationary trend. If the relocated factories had to subscribe to the same environmental standards as in the OECD countries, goods made in China may not have been so cheap. My guesstimate is that the lesser costs for pollution have been more important than cheap labor in the disinflationary pressure from China. China is waking up to the need to normalize pollution costs. Guangdong Province may close thousands of businesses that do not meet environmental regulations. The NDRC just issued tightening instructions on the carbide-based PVC industry that creates serious pollution. China’s policies to increase wages (see ‘Raising Wages, not Currency’, 12 May 2006) will increase China’s export price substantially, by 20-30% for industries like knitwear. The normalization of pollution standards could do the same for many chemical products. Normalization of China’s production is a major source of cyclical inflation. Part of the unsustainable disinflation between 2002-05 has to be regurgitated. A Protracted Bear Market for Bonds Ahead Global inflation is likely to sustain its trend of ticking up 5-6 bps per month. This slow grind is due to financial globalization that can spread inflation in one country to the world through currency markets and current account balances. The pace may accelerate from here, as the room for labor substitution between service and manufacturing is exhausted in Anglo-Saxon economies. The slow wage response to the liquidity boom is a unique feature in this cycle. The raison d’être of rational expectation economics is that workers who are also consumers understand that excessive monetary growth will lead to inflation and, hence, demand wage growth when they see above-trend monetary growth. This dynamic has not been working due to two factors. First, outsourcing has increased job insecurity and made goods cheaper. Second, property appreciation and easy credit have made it easier to defend lifestyle with debt. As both factors exhaust their effectiveness, wage demands could escalate. 2006 may see the revenge of monetarism. While the central case is for inflation to tick up slowly, the possibility exists for inflation to flare up sharply.
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Abundance of Dollars
May 16, 2006
Gray Newman (New York) and Heloisa Marone (New York) and Franklin Adatsi (New York)
It may seem like currency déjà vu. After rallying for the past month and a half to reach the strongest level in five years, Brazil’s real has come under pressure, and last week gave up a month’s worth of gains. While last week’s move from near 2.05 to just over 2.14 is in itself very modest, especially in light of the currency’s three and a half year rally, the sharp move has once again raised the usual concerns. Locals are blaming the central bank, which in the first two weeks of the month accelerated its dollar purchases, exceeding those made during the entire month of April. Meanwhile, foreign players are wondering if the recent turmoil in commodity, equity and US Treasury markets is likely to take its toll on risk taking and, with it, the Brazilian real. While a bout of risk reduction is certainly possible, we would argue that any sell off in the real is likely to represent an opportunity. Indeed, we suspect that the most likely outcome is that of the Brazilian real trending stronger in the coming months. By mid-year we suspect that the real will be trading below 2.0 and closer to 1.9—a level that could persist for months to come. Our bullish real view is based on three elements. First, inflows remain extremely strong. Brazil’s trade surplus in the twelve months ending in April stood at $45.5 billion, slightly higher than where it ended 2005. Second, the only reason the real has not been even stronger in the past seven months has been the aggressive intervention on the part of the central bank. Third, we suspect that even if the central bank continues its current interventions, it is likely to provide a boost to the real at the end of the month when the central bank announces a more cautious stance on the pace of monetary easing. Even if the central bank cuts by 75 basis points on May 31 instead of the 50 basis points we are now expecting, we expect the minutes set for release on June 8 to be even more explicit that the central bank is weighing in either a pause or a slower pace of rate reductions going forward. What trade blues? For all of the talk that the strong real is damaging Brazil’s competitiveness, Brazil’s trade surplus is showing little loss. As of the end of April, Brazil’s twelve-month trade surplus stood at $45.5 billion, just shy of the new record set the previous month and still above the 2005 close. Although export growth has slowed in recent years, exports continue to grow, clocking in nearly 17% y-o-y during the first four months of this year. And although much of the uptick in export levels has been price related, we have yet to see a decline in volumes whether we look at exports of primary goods, semi-manufactured goods or manufactured goods. We are not trying to argue that, because the trade balance has remained strong in the first months of 2006, it will continue uninterrupted. It is hard to imagine that the real can continue to strengthen, or even remain at its current level, without a downturn in export volumes and a further uptick in imports. Instead, our point is that the turn has yet to take place. Furthermore, even when the trade balance does begin to deteriorate, we would argue that after an initial bout of currency weakness, it is hard to argue that the currency adjustment would need to be permanent. Brazil needs a currency that is consistent with a financeable current account deficit, not a currency that maintains a current account surplus. It’s true that import demand is gaining ground even as export growth is slowing. Brazil’s three-month trend import demand increased from 11% through January to just over 27% through April, while export growth is moving in the opposite direction going from just under 25% growth in three-month trend through January to 16% by April. Even if the pace of import demand continues to gain through the rest of the year and export demand slows further, we would still end up with a trade surplus by year-end near $39 billion. A simple but perhaps extreme extrapolation—working from the most recent three-month trends—and extending to the end of 2007 would lead to the trade surplus shrinking to roughly $12 billion by the end of next year. But even in that case, the current account balance would turn to a deficit only of roughly 2% of GDP, hardly a level that should be difficult to finance. Another buying spree After accumulating nearly $12 billion in the last three months of 2005 and another $10 billion in the first four months of 2006, the central bank appears to have accelerated its pace in early May. As the real broke through 2.10, the volume of intervention picked up sharply. We estimate that in the first two weeks of May, the central bought up nearly $4.1 billion: up sharply from a monthly average of $2.5 this year. While we believe the central bank when it argues that it is not targeting the exchange rate, its moves almost guarantee that market participants will begin to re-examine the currency and ask whether the central bank has a currency target. Add to that recent statements from the finance ministry that have been interpreted by many in the market as signalling that the central bank has the currency in mind as it builds reserves, and it is not hard to see how the markets view the reserve accumulation policy. By so aggressively accumulating reserves—reserves net of the IMF nearly doubled last year—at such a significant cost, investors are bound to be asking how much longer the reserve build-up can go on. Rate reduction pace to slow Finally, we expect the central bank to adopt a more cautious stance on the pace of monetary easing. The authorities have two opportunities in the coming weeks to do so. They can either reduce the pace of easing from 75 basis points to 50 basis points on May 31 when the Copom next announces a decision or the authorities can release a more explicit statement warning that smaller cuts or even a pause are in the works with the release of the minutes on June 8. While the inflation scenario has been doing remarkably well—headline IPCA stood at 4.6% in April and is likely to fall below the year-end target of 4.5% in May—we expect the central bank to slow the pace of rate cuts. As the central bank noted in its last minutes, the lagged effects of past rate cuts and fiscal stimulus are likely to feed into aggregate demand and could add to inflationary pressures in the months to come. The uncertainty from the inflationary consequence from these lagged effects should increase the central bank's conservative stance. Especially, as the central bank highlights that the Selic rate is approaching a "medium-term equilibrium". Bottom line Once again the spectre of risk reduction raises its head and threatens the Brazilian real. We don’t want to appear heroic and certainly would not ignore the turmoil in global markets in recent days. But short of a major repricing of risk, we suspect that Brazil’s currency is still attractive and if anything, in the coming months, should tend to appreciate further. With a powerful trade surplus and a central bank likely to signal that its rate cutting is likely to be tempered, we doubt that currency intervention alone from the central bank can keep the real from breaking below 2.0.
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The Burden of Dirigisme
May 16, 2006
Serhan Cevik (from New York)
Turkeymust break the shackles of dirigisme in order to grow and improve living standards. Turkey’s liberalisation endeavour started 25 years ago, after the much-admired import substitution industrialisation model steered the country to economic collapse and social unrest. Although the economy has come a long way, especially in the past four years, thanks to political stability, the statist tradition inherited from the Ottomans is still alive and hinders economic rationalisation and institutional modernisation. Statist policies promoted by the political elite ignored economic consequences and created an unbalanced, rent-seeking structure. As a result, with ideological polarisation and vested interests accumulated over the decades, every reform effort has led to a clash between the status quo and the demands for institutional progress towards liberal democracy and greater integration with the global economy. The latest example of such a confrontation, in our view, is the presidential veto of parametric reforms aimed at reducing the pension deficit. Unfortunately, like protectionist development strategies and the judicial resistance to privatisation, President Ahmet Sezer’s philosophical/legalistic arguments are, in our opinion, factually misinformed and fundamentally misguided. The president’s objections disregard economic and demographic realities. Even though the pension reform is one of the most important initiatives Turkey has ever introduced to guarantee the sustainability of public finances and economic stability, its legal treatment is based on a dated point of view that downplays economic and demographic realities. For example, the president argues that the ‘social state’ is required to finance a pension deficit and hence objects to increasing the minimum contribution period from 7,000 to 9,000 days and reducing replacement rates. Beyond the rationality of such an assessment, even the constitution emphasizes the importance of maintaining the system’s actuarial balance. Since the average replacement rate stands at 96% — approximately 50% higher than the European average — parametric adjustments are not just economically justified but also constitutionally required. President Sezer is also against raising the retirement age to 65 by 2048, as he claims that life expectancy is, on average, 66 years in Turkey. However, there are two main problems with that argument. First, life expectancy at birth is actually 71.3 years according to the Turkish Statistical Institute. Second, what matters for the pension system is life expectancy at the age of retirement and that stands at 79.3 years. Moreover, it will likely increase to no less than 85 years by 2048. In other words, when new rules become effective, a new retiree would still receive pension benefits for, at least, 20 years — much higher than the average of 15 years in Europe. Turkeyhas a demographic window of opportunity to design a sustainable pension system. Turkey’s pension crisis is not a result of the ageing of the population, but a consequence of populist decisions, such as reducing the retirement age to 38 for women and 43 for men. No wonder, the number of active workers for each retiree declined from 9.7 in 1965 to 1.7 last year (compared to 5 workers per pensioner in Europe). Even though Turkey, with a young and growing population, still has a window of opportunity to design a sustainable pension scheme, time is running out. Demographic shifts like decreasing fertility rates and rising longevity will bring significant changes in the age structure of the population. Indeed, the total fertility rate already declined from 5.3 children per woman in 1965-1970 to 2.2 in 2004 and will soon move below the replacement rate of 2.1 children per woman. As a result, we will see a marked increase in the share of population over 65 from 5.7% today to 20% by 2050. The widening pension deficit is a significant threat to economic and financial stability. Turkey’s social security deficit widened from 0.3% of GDP in 1990 to 4.8% last year. If we include the cost of financing for the Treasury, transfers from the central government budget to the pension system actually reached 66.5% of GDP, on a cumulative basis, in the last 15 years. This is a burden that no country, however affluent, can carry forever. And the situation is getting worse every day. The pension shortfall increased 32.5% year on year in the first four months of this year and reached 43.7% of the year-end target in the budget. At this rate, the social security system is likely to have a deficit of 5.2% of GDP by the end of this year. Therefore, without a comprehensive reform, unfunded pension liabilities would become even a bigger threat to economic and financial stability in the future.
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1Q06 Slowdown
May 16, 2006
Deyi Tan (Indonesia) and Sharon Lam (Indonesia)
1Q slowdown on monetary tightening: The economy rose 4.6%YoY in 1Q06, representing a slight slowdown from 4Q’s 4.9%YoY. On a sequential annualized basis, the economy rose 8.3% (vs -8.5% in 4Q). Wage rise and compensation payouts failed to cushion consumer spending: Consumer spending weakened to 3.2% in 1Q (vs +4.2%YoY in 4Q), cutting the contribution to headline growth from 2.6%-pt to 1.9%-pt. This is amid slowing consumer credit growth as banks raised lending rates following the Central Bank tightening. From the start of the year, civil sector pay and minimum wage has been raised by 20% and 17% respectively. Compensation payouts have also been disbursed. However, these have failed to cushion the reduction in purchasing power. Government spending to further pick up pace: Public consumption rose 14.2%YoY in 1Q (vs +30.0%YoY in 4Q), contributing 0.9%-pt to growth. This is on the back of material expenditure, which expanded 48.4%YoY. Meanwhile, momentum in personnel expenditure remained steady at 2.0%YoY. Fixed Capital Formation accelerated slightly despite high rates: Strong capital imports translated into a slight acceleration in fixed capital which picked up to 2.9%YoY (vs +1.8%YoY in 4Q) despite the high base. Specifically, building investment (+7.2%YoY) and investment in foreign transportation (+43.7%YoY) showed signs of improvement. Meanwhile, gross capital formation rose 0.9%YoY (vs -10.5%YoY in 4Q). External balance improvement from fuel imports cutback: Fuel price adjustments helped the external balance as fuel imports contracted by 3.2%YoY from an average of 61%YoY in 1Q-3Q05. Meanwhile, with oil and non-oil exports keeping up pace and bringing overall export growth to 10.8%YoY, the external balance contributed a larger 2.6%-pt to headline (vs +1.9%-pt in 4Q05). A recent government proposal to cut oil imports by 30-35% could sustain this positive trend. Implied inflation measured by Deflator eased in 1Q: Nominal GDP rose a slower 21.9%YoY (vs +24.4%YoY in 4Q), partly due to lower volume and partly due to slowing deflator growth (+16.6%YoY vs +18.6%YoY in 4Q). Meanwhile, terms of trade did not improve further from 4Q despite currency appreciation. Subdued 2Q06; 2H06 to improve: Going forward, 2Q growth could continue to be hampered by weak consumer spending amid continued tightening. However, we believe investment sentiments could pick up ahead of the infrastructure summit scheduled for November and with investment and labour law regulations underway and the progress report seemingly strong. In addition, fiscal stimulus could also lend added strength as 0.5% of GDP worth of undisbursed government allocations would be carried over from 2005 and government expenditure typically gears up towards year-end. Our forecast for 2006 stands at 5.1% YoY.
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