United States
Don't Forget About Growth
May 19, 2006

Richard Berner (New York)

The shock waves from rising inflation and the potential consequences for monetary policy are still reverberating through financial markets, as investors now seem to fear that the Fed will have to crush the economy to cap inflation.  In contrast, I see the brewing market tensions through a different lens.  Financial market participants are now appropriately focused on inflation risks, in my view.  But it would be a mistake simply to assume that the economy is weakening and that further Fed tightening will throw it into a tailspin.  While there are signs of slowing growth in the current quarter, the long-awaited slowdown is still just a forecast.  In my view, the touted housing slump is underway, but the rest of the economy likely will grow strongly for the balance of this year.  A slowing to below-trend growth overall is a story for 2007.  Here’s why.

There’s no mistaking the sharp decline in housing activity, with April housing starts down 18.4% from a warm-weather-inflated January.  More is on the way: Housing affordability has tumbled to a16-year low, and the slide in prospective homebuyer traffic derived from a canvass of homebuilders sank in May to levels last seen in the 2001 recession.  Sales thus are likely to slip again over the spring months, and inventories were still rising in March.  As a result, builders are aggressively cutting production and prices of new homes to clear unwanted unsold homes; median sales prices for new homes are 2.2% under year-ago levels (note that this price gauge is distorted by changes in the mix of homes sold).  The likely effect on construction and related jobs and prices of existing homes won’t take long to show up.  In all, we estimate that declines in housing activity and the prospective deceleration in housing wealth will knock a percentage point off overall growth in the second half of this year. 

But there are powerful forces working in the opposite direction.  Among them: Healthy pent-up demand for capital spending, hearty global growth and sturdy job and income gains that likely will sustain US demand and provide sufficient consumer wherewithal concurrently to rebuild saving.  Thus, apart from the hit to growth from the recent escalation in energy prices and an incipient spring “payback” from unsustainable first-quarter strength, I continue to think that output will growth at a trend or above-trend pace for the balance of the year. 

Incoming data reflect that economic resilience.  Regarding capital spending, bookings for capital goods excluding aircraft in March stood almost 10% annualized over their first-quarter level, and unfilled orders are rising at a 12% clip.  Purchasing managers’ orders, especially outside manufacturing, remained strong in April, and the purchasing managers’ just-released semiannual outlook canvass hints at capex growth at a five-year high.  One-third of small businesses planned in April to step up capital spending, and 56% of the respondents to the Morgan Stanley Business Conditions survey plan to step up outlays for expansion.  With operating rates in manufacturing now 110 basis points above long-term norms — the fruits of past capital discipline — and markets still rewarding CFOs for growth, I think the capex environment remains extremely favorable.  Likewise, strong real exports — up 13.4% in March from a year ago — underscore the benefits to US growth from a vibrant global economy.  Our global economics term expects domestic demand in non-Japan Asia, Latin America and even Europe to grow faster this year than last year.  Finally, moderate job gains and accelerating wages have boosted real “core” income by 3% over the past year.

More recent data have begun to reflect the hit from higher energy prices, however.  Rising gasoline quotes in particular soured consumer sentiment in early May, and pushed up consumers’ near-term inflation expectations to 3.9%.  The jump in gasoline prices probably drained $69 billion annualized from consumer budgets over the second quarter.  Not surprisingly, weekly indicators of retailing activity indicate a significant deceleration in May from April’s level (and the warmest April on record may have boosted April’s pace).  And while business surveys in May remain at healthy levels, some — such as the Philadelphia Fed’s business outlook survey — are showing signs of a consolidation. 

Given the economy’s resilience, however, we view this spring deceleration as a temporary payback from the exceptional strength in the first quarter — now likely to be revised up to a sizzling 6% annual rate.  Any relief on gasoline prices should help growth pick up modestly in the second half of the year to a pace at or above trend, which I estimate to be around 3½% for real GDP.  And of course, whether growth is above or below trend matters for assessing economic slack, inflation risks and the direction of monetary policy.  With slack having narrowed in both product and labor markets, and companies having restrained the growth of capacity over the past five years, output growth above trend seems likely to increase upside risks to micro-level pricing power, and to inflation at the macro level.  Whether or not the Fed decides to pause in June, we think officials thus have more to do to cap inflation risks.

As I see it, this above-consensus outlook carries three implications for investors: First, inflation risks are not completely in the price.  It’s unlikely core inflation will continue to run above 3%, as in the past three months, but inflation has already picked up and growth has yet to slow.  Second, the Fed does not face the dilemma of tightening into a significant growth slowdown; the economy’s resilience and relatively low sensitivity to interest rates means that it would take much more tightening to “overdo it.”  Indeed, below-trend growth is now desirable, and has yet to appear.  Finally, crosscurrents in the economy likely will add to uncertainty about the outlook, translating into more market volatility and potential risk aversion. 

I’d be the first to agree that there are some immediate downside risks to growth: Housing and home prices could fade more quickly than we project.  If it continues, the slide in equity markets could tighten financial conditions.  And energy markets are still vulnerable to supply disruptions that could produce another price spike.  But there are also factors contributing to upside risks, and they should not be ignored.  For example, the Fed’s April Senior Loan Officer Survey shows scant sign of any tightening in lending standards or reduction in willingness to lend to businesses or to consumers.  That’s one sign that credit availability is still ample.  In addition, energy prices may be topping out at lower levels than we have expected, so our near-term growth prognosis could be too pessimistic.

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Currencies
Tracking the Cyclical Dollar Correction
May 19, 2006

Stephen Jen (London) and Luca Bindelli (London)

Forecast updates

We still believe that the USD will correct this year for cyclical rather than structural reasons, and that, from the perspective of economic fundamentals, a correction against Asia makes more sense to us than further USD weakness against the European currencies. 

We incorporate two main modifications to our forecasts. (1) We believe that our long-standing year-end target for USD/JPY of 106 will likely be breached.  We remain bearish on USD/JPY but don’t yet have a strong view on whether 100 will be broken this year.  However, for 2007, we now believe that there is a good chance that we will trade into the 90s for the first time in over a decade.  (2) For EUR/USD, we are retaining our year-end target of 1.24 but are bumping up the intra-year path for 2Q and 3Q.  We believe we are witnessing a EUR overshoot, because the ECB and the Euroland economy will struggle to absorb a sustained rise in EUR/USD, in our view. 

We are turning even more bullish on JPY

We have been bullish on Asian currencies all year.   For USD/JPY, we have been stressing that the focus in the market would shift from ‘nominal’ variables to ‘real’ variables. 

The second half of 2005 was special for Japan.  It was a period when we temporarily had, on the one hand, a recovering risk-taking attitude among Japanese investors and, on the other, minimal risk of any change to the ultra-easy monetary policy.  The lag between the BoJ’s response and how Japanese investor sentiment was changing created a transitory situation whereby USD/JPY was pushed to above 120.   However, this was always going to be temporary, as it was only a matter of time before the BoJ would start normalizing rates.  Since the fair value of USD/JPY is around 100, according to our calculations, we argued that USD/JPY would reverse direction and reach 106 by end-2006.

There are several reasons why we now believe USD/JPY is likely to test 100 by year-end: 

• The BoJ is more hawkish than many believe. The output gap is already zero and there is limited room in which the BoJ can maneuver.  We are convinced that the BoJ is hawkish and believe USD/JPY is vulnerable because many investors, especially Japanese investors, don’t yet share our view on the BoJ. 

• The BoJ is not that hung up about August 11, 2000. We think this fixation on what happened in August 2000 is wrong.  First, the BoJ was not really wrong in that policy, in light of the distortions that ZIRP was creating. Second, central banks have long institutional memories. Moreover, the mistake that the BoJ made in the late 1980s in allowing the asset bubbles to emerge and grow is also firmly planted in the BoJ’s memory.  One may agree or disagree that there is inflation risk in Japan if the BoJ falls behind the curve, but our point is that what many think the BoJ should do is not what it will likely do.  The bottom line here is that the BoJ does not want to make any more policy missteps, and August 2000 is not the only past ‘mistake’ it wants to avoid.  Though the MoF will likely dissuade the BoJ from tightening too much too soon, we believe the BoJ’s view will prevail this time. 

• Japanese investors are all on one side of the boat. Since 2000, total cumulative Japanese securities outflows total some US$750 billion.  The fact that capital outflows have been large does not worry us as much as Japanese investors having very similar views about USD/JPY (bullish USD) and the BoJ (dovish).  We believe there are rising risks of lumpy repatriation flows pushing USD/JPY lower when Japanese investors start to revise their outlook for USD/JPY and the BoJ. 

• Little risk of MoF intervention.   There are many reasons why we see virtually no risk of MoF intervention north of 105, and even if 100 is tested, there is a less than 50:50 chance of actual intervention.  (1) One main reason we have turned so bullish on the Asian currencies this year is because the large Asian central banks have reached saturation points on their foreign reserve holdings. (2) As one of its top priorities, the Diet wants to contain the rise of public debt.  Since currency interventions are funded through public debt, there is much less political tolerance for currency interventions now than there has ever been.  (3) Mr. Watanabe — the Vice Minister in charge of international issues — simply does not believe in intervention. (4) Japan should do fine even with a double-digit USD/JPY.  Since January 2005, the real effective exchange rate of JPY has depreciated by 15%. Japan really has little to worry about, in our view. 

We see the current rally in EUR/USD as an overshoot

We like the JPY, but are unconvinced by the EUR.  EUR/USD is still mostly rallying by default, though, in contrast to late 2004, EUR/USD has strengthened on merit as well.  In any case, EUR/USD is rising deeper into overvalued territory.  With our quarterly forecasts, we do not try to capture market-driven overshoots.  The upward revisions to our June and September forecasts reflect our recognition that the Euroland economy has begun to recover.  However, like our European economists, we do not believe that this recovery is sustainable.  The overshoot in EUR/USD itself will play a role in depressing Euroland’s vibrancy later this year and in 2007.  This is why we are keeping our year-end target unchanged at 1.24. 

In my piece last week, I argued that the right way to think about the ECB’s tolerance is through the ‘MCI balance’.  In that note, I used the MCI trade-off ratio of 6:1.  However, our proprietary calculations suggest that, using more recent data, the MCI trade-off ratio for Euroland may have fallen to the 3-4 range.  This means that the impact from exchange rate changes on economic activity in Euroland has actually increased, relative to the impact of interest rate changes. 

Thus far, the European Finance Ministers and the ECB have remained relatively quiet.  We do not believe this will last and expect more ECB officials to start to complain about EUR/USD, once we enter the 1.30-1.32 area. 

There is a lot of talk in Europe that the sharp rise in EUR/USD ‘won’t hurt’ because the EUR TWI has risen only by 1% since the G7 meeting.  However, we are still of the view that the ECB’s refi rate path will be increasingly sensitive to EUR/USD as well as EUR TWI.  

How will the dollar respond to the Fed?

April CPI inflation was higher than expected, confirming a trend that we have seen in recent data that inflationary pressures may be mounting.  We have the following thoughts on how the dollar might be affected by the Fed: 

• The US Treasury does not have a weak dollar preference.   We strongly challenged this point, and argued that rising inflationary pressure was one key reason why such a policy would be counter-productive at this point. Also, we believe that the G7 really has a ‘strong Asian currency policy’, and the awkward nature of this policy stance has led to a lot of confusion in the market. 

• The Fed will not fall behind the curve.   Despite investors’ gripes about the Fed and Mr. Bernanke, we believe that the Fed will ultimately prove to be correct with its forecast of a slowdown toward trend by 2H, preceded by a temporary period of transitory inflationary pressure.   

• The cyclical dollar sell-off may pause as long as the Fed continues to tighten.  Since it is a certainty that inflation is rising, but only a possibility that there be a growth slowdown in 2H, it is likely that the Fed may tighten again at its June 28-29 meeting.  As long as the Fed keeps tightening, in our view, the USD’s cyclical descent may be arrested.  When the US starts to show genuine signs of a slowdown, that is when the USD should resume its depreciation. At the same time, the less credibility the Fed has, the less the dollar will be supported in the near term, since whether inflation is transitory or structural will be unclear for some time. 

Bottom line

We maintain our view that the USD will experience a cyclical correction this year, although our structural view on the USD remains constructive.  In other words, for the dollar, inflation, growth and the Fed matter much more than the size of the US current account deficit.  The dollar will likely weaken against the Asian currencies, especially the JPY.  EUR/USD is overshooting.  We maintain our year-end target for EUR/USD at 1.24, but are revising down our target for USD/JPY to 101 from 106.

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Currencies
The Real Diversifiers Are American, Not Asian
May 19, 2006

Stephen Jen (London) and Charles St-Arnaud (London)

Strong diversification by US real money investors

One of the key factors souring investor sentiment regarding the dollar in recent years has been the fear that large foreign reserve managers in Asia and the Middle East have begun (or will soon begin) diversifying out of the USD into EUR and other currencies.  We have long argued against this popular notion.  In this note, we point out that there is likely to be genuine wholesale USD diversification, but the biggest diversifiers may have been the US real money investors.  This suggests that the market’s fixation on foreign central banks may be misplaced, as the diversification that has taken place in the US should already be powerful enough to explain part of the trend in the USD in recent years. 

The lopsided debate on reserve diversification

It is widely believed that either (i) Asian and Middle Eastern central banks have already begun to diversify, wholesale, out of USD assets, or (ii) it is inevitable that they will one day dump the dollar.  Both the possibility (i) and the fear of this risk (ii) have fuelled the structurally negative market sentiment regarding the dollar. 

Many analysts have argued that if the dollar falls by X percent, given the large reserve holdings of these central banks, they would stand to lose Y percent of GDP’s worth of wealth.  The fear of such a scenario justifies an inevitable stampede out of US Treasuries and the US dollar.  US long bond yields should spike higher, coinciding with a collapse in the dollar. 

This theory is intuitive and somewhat sensible, except that we believe it has many serious flaws.  We will not repeat the arguments we have made in the past in trying to challenge what we see as this misguided fatalistic view on the USD, except to stress that there is no hard evidence supporting this view, and all large reserve managers themselves have consistently disputed it.  

US real money investors are bigger

We believe that the market has not paid enough attention to the diversification that has taken place among the US real money investors themselves.  We make the following points: 

• Point 1.  US real money under management is seven times larger than Asian official reserves.  According to the Fed’s Flow of Funds data, as of end-2005, total US real money under management was US$17.7 trillion:  US$4.4 trillion for life insurance companies, US$6.0 for mutual funds and US$7.3 trillion for the private and public pension funds.  This is almost seven times the size of the total official reserve holdings by the Asian central banks (US$2.6 trillion as of March 2006).   Tracking their diversification pattern is more important because they are just so much bigger.  Further, doing so is arguably easier because they are not as secretive as some of the foreign central banks. 

• Point 2.  US pension funds began to diversify in 2004.   In an attempt to assess the extent of the diversification away from USD assets, we focus on the investment strategies of US private and state pension funds.  According to a report from Greenwich Associates, US pension and endowment funds raised their exposure to foreign equities from 11.1% in 2002 and 2003, to 13.3% in 2004 and 13.9% in 2005.  Using the data from the Fed, this translates into nearly US$440 billion worth of foreign equities over 2003-05. 

If we extended these trends to apply to all real money under management (US$17.7 trillion), total implied diversification outflows during 2003-05 were US$1.1 trillion, with about half of that (US$567 billion) taking place in 2004 alone, presumably propelled by the intensely USD-bearish sentiment that dominated the market back then.  This US$1.1 trillion total value of foreign equity allocation happens to be roughly the same size as the net increase (US$1.2 trillion) in the total stock of Asian foreign reserves.

• Point 3.  The EUR, the JPY and the GBP could all have been major beneficiaries of this type of diversification.   It is not straightforward to document where exactly the equity outflows went.  According to Fed data, the UK and the Caribbean financial centres account for close to 60% of all the real money outflows from the US.  Clearly, much of these funds are subsequently invested in markets other than the UK and the Caribbean markets.  As a rough guess, if we assume that these funds were allocated in a way not too different from the market capitalisation of the more liquid markets, the EUR (36%), the JPY (18%) and the GBP (26%) should, in principle, have been the primary beneficiaries. 

The observed outperformance of the EUR and the GBP, despite the cyclical weakness of the UK and the structural problems of the EMU, seems to be consistent with our hypothesis that diversification by US real money managers has been more important than that by foreign central banks.  For the JPY, the story is more complicated, as it always is. 

Bottom line

In the past three years, the real dollar diversifiers are US real money investors, rather than the Asian or Middle Eastern central banks.  The fixation on the latter is misplaced and has diverted attention from the former.

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Japan
Wages, Productivity, and Data-Driven Monetary Policy
May 19, 2006

Robert Alan Feldman (Tokyo)

What’s new

The key factors for Japanese monetary policy going forward are wage and productivity growth. The BoJ is a pessimist on both. I am on optimist on both.

Conclusion

If the BoJ is right, a continued program of hiking rates is the correct policy. If not, I believe that continued rate hikes will eventually become a policy mistake — even if the first one or two do not matter much.

Market implications

In my view, the first rate hike — likely to be 25bp in July — should not damage the economy. Nor should a second 25bp hike, perhaps in the autumn. However, further hikes risk harming market sentiment, if such moves are inconsistent with wage and productivity growth.

Risks

Wages are subject to upward risk from tighter labor markets, and downward risk from post-retirement rehiring. Productivity growth is subject to upward risk from more restructuring, globalization and technology, but downward risk from exhaustion of excess capacity.

Pessimists versus optimists

The current debate on Japanese monetary policy is boiling down to a question of balance. The issue is the balance between wage growth and productivity growth — i.e., the likely trend of unit labor costs (ULC).

The Bank of Japan has taken a pessimistic stance on ULC, from both wage and productivity viewpoints. In a speech last Monday, Governor Toshihiko Fukui mentioned his concerns about how tighter labor markets might lead to wage pressure. He also expressed concern that productivity growth might slow. The result would be higher ULC, and therefore higher inflation pressure.

In contrast, my colleague Takehiro Sato and I have taken an optimistic stance on both wage growth and productivity. There has been no noticeable acceleration in wage growth since the move to about a 1% year on year rise in wages per hour in spring 2005, despite the shift to labor shortage (for all sizes of firms) in the BoJ Tankan. Personnel costs per employee continue to be negative — although less so than in 2004. On the productivity front, output per hour continues to grow at about 2% year on year. Looking forward, the question is whether the drivers of wages and productivity will change pace.

Wage drivers

The standard model of wages posits that wages accelerate when labor markets are tight, and decelerate when labor markets are loose. There is no doubt that labor markets are tighter than two years ago. However, whether they are tight enough to warrant a fear of wage-led inflation pressure is questionable. For example, a simple regression of annual increases of wages per hour on BoJ Tankan measures of labor market tightness and capacity use suggests that wage increases were abnormally high in 2005 (relative to improvements of labor markets and capacity use), and thus that there will be a deceleration from 1.3% in 2005 to 0.5% in 2006 — despite higher bonuses.

The forward-looking part of the labor market is much more difficult to assess. One fear is that the large retirements of baby-boomers over the next few years will sharply reduce labor supply, especially of some skilled workers. Another fear is that the dispersion of wages among sectors shows increasing mismatch (particularly for IT workers); sector bottlenecks may lead to higher inflation. On the other hand, labor productivity remains extremely low in many industries, such as construction — which continues to employ nearly 9% of workers. Shifts of workers to other industries would raise average productivity. Gender discrimination is also seen by many as a constraint on productivity, but such discrimination is breaking down. Finally, participation rates have been rising, and so the labor supply is proving more flexible than initially feared.

Productivity

Recent news on productivity has been quite good. Defined as real GDP/worker, worker productivity has reaccelerated over the last few quarters, and grew by 2.5% year on year in 1Q06, compared with 1.4% year on year in 1Q05. However, some concerns also exist. The decline of idle capacity may have allowed quick production increases, giving the appearance of productivity gains. Moreover, in the 1Q06 GDP data, the growth of worker compensation outpaced that of nominal GDP for the second straight quarter.

Again, the forward-looking aspect of productivity is harder to assess. In my view, there are three drivers of productivity growth in Japan in recent years — IT, globalization and restructuring. The surge of IT applications shows no sign of abating. Indeed, it may be accelerating, due to network economies of scale. Globalization also seems likely to continue, especially the growth of China and India as production platforms for Japanese firms. The restructuring trend, shown by the high pace of M&A transactions, is if anything likely to accelerate. Nevertheless, there are reasons for caution. The rush of factories to China in the electronics business seems to have slowed. Moreover, the reduction of idle capacity could reduce the ease of productivity gains. Also, there is likely to be a shift of demand toward service industries as the economy ages; to the extent that productivity in services is lower than in manufacturing, aggregate productivity may fall. That said, the retirement of many workers in low-productivity sectors such as construction and agriculture will automatically raise average productivity.

BoJ’s judgment call

Even if the backward-looking components of judgment on wages and productivity were consistent, the forward-looking ones are not. In the end, expectations about wages, productivity and hence about ULC are judgments. Thus, when deciding monetary policy, the BoJ must make judgments. At the moment, it has decided to be cautious about both wages and productivity.

In the short run, even if one or two rate hikes turn out to be unjustified, the damage to the economy is likely to be small. Profits are high — even for small firms — and the pass-through of higher market rates into higher borrowing rates will take time. However, if the BoJ blindly sticks to a path of rate hikes on the expectation of higher ULC when in fact it is not rising, I believe there will be damage to the economy. In this case, it seems likely that the Diet would take action to alter the way monetary policy is determined.

Fortunately, statements by senior BoJ officials over the last few weeks have been somewhat less hawkish about rate hikes. The combination of yen strength, weakness in global and domestic equity markets, and concerns about the US economy has changed the tone of debate. The conclusion is that investors will likely perceive BoJ policy to be more data-dependent than investors heretofore thought.

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Japan
Nice Deceleration
May 19, 2006

Takehiro Sato (Tokyo)

1Q GDP showed a clear slowdown to +1.9% SAAR over buoyant 4Q growth (+4.3% SAAR). We chalk this slowdown up for the most part to sampling bias in the personal consumption data, as well as a reactionary rebound in imports, meaning no real issues.  In all, domestic private demand continues on a moderate growth course, and the output gap seems to be narrowing moderately.

The most remarkable elements this time are the capex and the GDP deflator. Capex showed a nice rebound of +5.8% SAAR. Capex plans that were brought forward to the second half of last year resulted in pent-up demand at the end of F2005 in 1Q.  Going forward, with companies focusing increasingly on investment efficiency, capital spending continues at a gradual pace. While aggressive capex plans in the auto industry have been one of the few bright spots, other manufacturing industries remain lackluster, and so we expect infrastructure-related demand in the energy and non-manufacturing industries to underpin capex. 

The GDP deflator was still in negative territory at -1.3% YoY, but a slight improvement on 4Q. The surge in oil prices and weak yen caused the import deflator to surge, but the domestic demand deflator’s slide basically stopped. Housing and public investment deflators turned positive have remained at positive rates QoQ for four straight quarters, and the personal consumption and capex deflators have basically stopped declining. Also, the overall domestic demand deflator turned slightly positive, which is symbolic as an end to deflation.

Following the GDP data, however, we have tentatively made a technical revision to the base effect.  As such, based on the 1Q GDP results and our current official forecasts, we have to tentatively lower our F2006 real GDP growth outlook to +2.6% (previously +3.0%; our respective C2006 outlook moves down from +3.2% to +2.6%).  The possible downgrade to our outlook from the lower base effect would not signal a shift in our stance on the economy though, and should not be viewed as problematic.

Policy implications

The government’s declaration of the escape from deflation is likely to be delayed into August, due to the nominal growth rate coming in shy of 2% and the negative GDP deflator trend. However, if the potential output growth rate is at the high end of the 1-2% range, we think this will be a tailwind for the BoJ since the output gap is expected to continue to contract moderately. With BoJ Governor Fukui having squelched rising expectations for a June rate hike last week, our main scenario remains for a July rate hike after the June Tankan on July 14. Going ahead, we still look for a more moderate pace of rate hike, say a semi-annual pace, than the market consensus of quarterly rate hikes, for the following reasons: 1) The core CPI is likely to remain stable thanks in part to the quiet productivity revolution; 2) Policy debates towards fiscal tightening are likely to be more active under the new Cabinet from September or October; and 3) The Fed is likely to stop tightening towards the end of this year, according to our US economics team. 

Market implication

The stock market is concerned that the excess liquidity worldwide might dry up (the unwinding of the yen carry trade) due to simultaneous tightening by the G3’s respective central banks, and also about the conservative corporate profit outlook for this fiscal year and the accounting scandals of some small-mid names. As for the former, we remain sceptical as to whether such a global carry trade position was really accumulating like that in 1998. As for the latter, moderate upward revisions towards the end of F1H06 are expected, and concern regarding the accounting issue in some mid-small market is an individual issue, far from the macroeconomic issue at all. Thus if there is further weakness due to the aforementioned concerns, we think it would provide good opportunities to buy on dips.

The bond market is likely to remain top-heavy (rates entrenched at lower levels) due to rising concerns about an early rate hike. But the market is likely to rebound after that, possibly in July if a rate hike is announced (and ZIRP ended), since this would mark the last of the bad news, and could herald a phase of buying aimed at carry trades. Going forward, assuming that our cautious-on-prices economic scenario is correct, we look for the long-term rate to fail to rise much above 2% in 2006, then edge lower in 2007 as concern about overly aggressive rate hikes fades.

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China
Fixing the Property Market
May 19, 2006

Andy Xie (Hong Kong)

The State Council has issued six guidelines to local governments and ministries to cool the property market:

(1) increase supply of affordable housing (e.g., small units, low-rent investment properties) with numerical targets;

(2) leverage tax, credit and land policies to guide demand (e.g., raising down-payments for investment properties);

(3) rationalize speed of resettlement to smooth forced demand;

(4) organize and regulate the property market and stop unauthorized development alterations, illegal transactions, land hoarding and price ramping;

(5) accelerate development of low-cost housing to meet demand from low-income families; and

(6) increase disclosure, improve market transparency, ensure timely and accurate disclosure of relevant information.

Implementation measures from relevant ministries and local governments should follow the State Council guidelines.  Considering the political gravity attached to the issue, policy development in the coming days should be sufficient to cool the housing market for the time being, in my view.

The measures, however, do not address the root causes of the property bubble: (1) excess liquidity and (2) the dependency of local governments on property for development funds.  When the central government expresses serious alarm, local governments try to comply with the spirit and letter of the central government instructions.  When the attention of the central government wanes over time, local governments tend to find ways to maximize their revenues again.  This ‘cat-and-mouse’ game between the central and local governments is not good for China’s healthy development.

Addressing excess liquidity requires international cooperation on currency expectations, which is unlikely.  In my view, China can take two measures to ensure a healthy property market.  First, it should allow local governments to issue development bonds backed by future revenues under the supervision of the central government.  Second, it should create a capital gains tax structure to minimize speculative demand and maximize home-ownership.  One possibility would be to set capital gains tax at, say, 80% for sales within the first year of purchase and reduce this by ten percentage points for every extra year of ownership.

The property market is already vast

China sold 1.8 billion sq m of residential properties between 1998 and 2005, with 1.3 billion sq m under construction at end-2005, according to government statistics.  The government statistics also state that the average selling price in the primary market was Rmb 3,000/sq m in August 2005.  This would suggest that the properties sold since 1998 are worth Rmb 3.8-4.3 trillion (assuming that the average value of the past eight years has depreciated by 20-30% versus new buildings).

Chinese cities may have around 12 billion sq m of residential space from old buildings (mostly public housing units built during the planning era but sold to tenants at notional prices since 1998), based on historical statistics.  Their average selling price is about one-third that of new build units sold since 1998, mostly representing the value of the land on which such buildings sit.  On this basis, the old buildings should be worth roughly Rmb 8.4-9.6 trillion. 

1.3 billion sq m under construction at end-2005 would be worth Rmb 3.9 trillion at last year’s average selling price.  Adding that to newly sold and old properties, the total value of the urban residential properties could be Rmb 16.1-17.8 trillion — 89-98% of 2005 GDP or 200-220% of 2005 urban disposable income.  These numbers are already comparable to those in developed economies and seem high relative to the short history of China’s property market.

Moreover, the reported data on the property market are likely understated.  As the central government is wary of the sector, local governments have strong incentives to play down both investment and price.  Assuming that average prices are understated by 20-30% —   which is probable, in my view —   China’s urban properties could be worth nearly 300% of urban household disposable income.  That would put China quite close to economies with very high property prices, such as Australia and the UK.

Property may cause an economic hard landing

Investment in property development reached 8.6% of GDP in 2005, from 4.9% in 2000, and may reach 9.3% in 2006, based on extrapolation of 1Q06 data.  The official statistics showed 1,277 million sq m of residential properties and 367 million sq m of commercial properties under construction at end-2005.  Their market value upon completion should be around Rmb 5.1 trillion, or 28% of 2005 GDP, using 2005 average selling prices.

Again, I think the above data could be understated by 20-30%.  These data suggest that China’s economy is more dependent on property than any major economy in modern history.  Property growth is not a bad thing per se.  Unfortunately, all rapid property growth stories have turned out to be bubbles.  The high dependence of China’s economy on property and its likelihood of being a bubble imply a substantial probability of a hard landing, in my view.

China is suffering from overcapacity in a wide range of industries.  The National Development and Reform Commission (NDRC) recently singled out the aluminum, cement, iron alloy, coking coal, coal and carbide-based PVC industries for restructuring.  One aim is to decrease overcapacity.  Overcapacity is widely recognized in the auto and steel industries, and light manufacturing has suffered overcapacity for a decade.

This overcapacity has pushed the economy towards property.  Manufacturing companies that suffer from low profit margins are looking to property as a potential source of profit.  They use their existing businesses as a platform to raise funds to enter property development.  The vast number of such entrants continues to push up land prices.  Without property prices rising, they cannot make profits.  As long as they have liquidity to hold inventories, they will sell only at higher prices.  That is why high inventories and rising prices often go hand in hand.

Land inflation has opened up a new channel of funds for city development.  Local governments control all the land.  They have powerful incentives to promote the property sector as a means to raise revenues to accelerate urban development.  I estimate that as much as 30-40% of local government revenues could originate from property, either directly or indirectly.  As long as banks have excess liquidity, local governments will likely keep driving the property market, in terms of both quantity and price, to increase revenue.  In this sort of dynamic, almost all the excess liquidity ends up in property.  If the government does not change the dynamic, the economy could ultimately suffer a severe hard landing.

Reforming local government finance is key

The guidelines from the State Council this time are much better than before, in my view. The package addresses demand, supply and market transparency.  However, as local governments control land and property is local by nature, their incentives will ultimately determine whether the property bubble cools off gradually to prevent a hard landing.

This round of tightening should have a significant effect in the short term.  Local governments tend to comply with the letter and spirit of central government instructions when the central government focuses on an issue.

It remains to be seen whether or not these measures are sufficient to contain the bubble for good.  They do not address the two fundamental causes of the bubble: (1) excess liquidity and (2) the dependency of local government revenues on property.  As long as these two factors remain in place, the bubble may flare up again.

Addressing excess liquidity requires the elimination of currency appreciation speculation.  This, in turn, needs international cooperation, which is unlikely.  However, it is still possible to contain the property bubble despite the excess liquidity.  But for such measures to work, local governments need to have the right incentives to cooperate.

China’s local governments are not allowed to borrow money.  In reality, they already do so on a vast scale through the companies under their control.  China has been experiencing excess liquidity in the past three years.  Local governments control land and have been developing property to turn that excess liquidity into urban development.  This situation has evolved owing to the nature of the political structure and the liquidity situation.  Now, local governments have become so dependent on property that it makes it hard for them to be impartial in property development.

I believe that China needs to develop a municipal bond market as the main source of financing for urban development.  One advantage of this approach would be to make local finance transparent, as financial markets would have to follow local finance closely to determine bond prices.  Were local governments to have a ready source of finance for development, they would have a strong incentive to create a rational and transparent property market.

Controlling speculative demand

All East Asian economies have suffered from property bubbles in the past and paid heavy prices afterwards.  While speculation is a necessary part of a market economy, property speculation has turned out to be overwhelmingly negative.  The main reason is the heavy involvement of bank credit.  As governments guarantee bank deposits directly or indirectly, banks take excessive risks during a property bubble for profits and worry less about downside than they should.  It makes good economic sense to contain speculative demand through regulations.

Expectations of quick profits drive speculation.  High capital gains taxes could eliminate short-term profit.  In an extreme case, a 100% tax on capital gains would eliminate speculation completely, regardless of whatever other factors may exist.

China also needs to encourage home-ownership, in my view.  Property represents one-third of household wealth in the developed economies.  It is the foundation for household financial security.  Social stability in a market economy is supported by a high level of home-ownership. 

Around 85% of China’s urban households live in old ex-public housing units.  They aspire to upgrade to better-quality housing.  It would seem to make economic and political sense to ensure that properties are affordable and grow steadily.

To contain speculative demand and encourage home-ownership, China has very high capital gains tax for short-term transactions or ‘flipping’ and very low capital gains tax for long-term ownership.  I think China would benefit from the introduction of an 80% capital gains tax for property sales within the first year of ownership, with decreases of ten percentage points for every extra year of ownership until the rate reaches zero.

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Taiwan
Economy Slowed in 1Q06
May 19, 2006

Denise Yam (Hong Kong)

Real GDP growth slowed to 4.9% in 1Q06.  Taiwan’s economy slowed in 1Q06.  Real GDP growth slipped to 4.9% YoY from 6.4% in 4Q05, though it is still stronger than the 4.1% rate for 2005.  The rise in import prices again ate into national income in nominal terms; the implied GDP deflator fell 1.4% YoY amid the 2.9% loss in terms of trade (goods and services) (-1.6% in 4Q05), trimming nominal GDP growth to 3.4%, a sharper slowdown (from 6.4% in 4Q05) than in real terms.

Weaker consumption contributed little to the slowdown…  Household consumption growth slowed in 1Q06, in line with expectations amid credit card woes, to just 2.1% YoY in real terms (+2.8% in 4Q05 and 3% in 2005), the weakest since 3Q04.  However, contrary to public opinion that it would be the key drag on growth in 1Q06, it contributed only 0.2 percentage points to the overall slowdown.  Meanwhile, the sharp drop in private-sector fixed investment appears to have abated, in line with the smaller declines in capital goods imports.  Private capex fell 3.9% YoY, easing from the 18% plunge in 4Q05.  The public sector, however, cut capex by 4.2% YoY (+4.2% in 4Q05).  Positive inventory accumulation (0.4% of GDP) represented a reversal from the destocking in the year-ago period (contributing 0.6 percentage points to overall growth).  Overall domestic demand in fact turned around the 2.6% YoY drop in 4Q05 and rebounded by 1.3% in 1Q, contributing 1.2 percentage points to overall growth (-2.4 percentage points in 4Q).

… which should be attributed to the smaller trade surplus expansion.   Structural weakness in domestic demand has made Taiwan dependent on the export sector for growth in the past several years.  Import compression and the huge expansion in the net exports position in 4Q05 (8.8 percentage point contribution to growth) helped offset the contraction in domestic demand.  This driver made a smaller contribution in 1Q06 (+3.7 percentage points) as imports rebounded with domestic demand.

Cyclical outlook — stable for now, but limited upside.  Export growth appears well supported in the short term amid stable demand from developed markets.  Capex has probably bottomed out but we only expect mild growth for the year, in light of the trends in capital goods imports and continued capital outflow by domestic investors.  Amid the uncertain outlook associated with macro tightening in China, we see limited upside surprise to growth this year for Taiwan.  Although the central bank has reiterated that interest rates ought to be “normalized” to a higher level, monetary policy stance has remained accommodative so far to support growth, with real rates trailing at historical low levels.

Maintaining conservative forecasts.  We are leaving our economic forecasts unchanged at this stage, maintaining our conservative 3.6% real GDP growth forecast for 2006.

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