Japan
Rolling with the Punches (Part II)
May 23, 2006

Takehiro Sato (Tokyo) and Robert Feldman (Tokyo)

Risks

As the growth driver shifts to domestic demand in the private sector, we believe that the overseas economic downturn will be less critical to the Japanese economy than at the time the IT bubble burst. Having said that, there is always a risk of growth deceleration caused by asset market corrections triggered by non-cyclical factors. Indeed, recently stock and commodity markets have been seeing corrections worldwide, and the spreads for emerging markets are expanding on the back of an unclear outlook for the G3’s future monetary policies and concerns about contraction of global excess liquidity. In other words, at the moment, risk premiums are expanding worldwide, in part affected by how FRB Chairman Bernanke has been communicating with markets since April. However, the fundamental principle of the FRB to aim for a soft landing instead of overkill has not changed under the new chairman. Therefore, as long as economic/price data follow the path expected, the new chairman’s communication skill should not become an issue.

Likewise, it is not necessarily appropriate to conclude that the contraction in excess liquidity originated by Japan or the BoJ has triggered a correction in the world’s asset markets. At the moment, there is no clear evidence of yen carry trade positions being accumulated on a massive scale. Moreover, now that the credit standing of Japanese banks has dramatically improved, the unwinding of yen carry trades built up to date is unlikely to heighten the volatility of the asset markets as happened in 1998.  The problem is that the markets have already discounted the end of the BoJ’s zero-rate policy this summer, and the future pace of interest rate hikes is unclear. This is the focal point for the BoJ’s dialog with the market from now on.

Meanwhile, there is political risk that the views of overseas investors on the direction of Japan’s structural reform will change according to the make-up of the next cabinet to be formed after September. Overseas investors’ views may shift depending on whether Chief Cabinet Secretary Shinzo Abe, who is expected to follow the current cabinet’s reform path, becomes the next prime minister as the consensus predicts, or whether former Chief Cabinet Secretary Yasuo Fukuda wins the position, having formed an anti-Koizumi coalition. Whether Heizo Takenaka, the Minister of Public Management, Home Affairs, Posts and Telecommunications, well-regarded by overseas investors, will remain in the cabinet may also have an important impact. On this point, Robert Feldman regards Mr. Abe as the most likely prime ministerial candidate.  However, the consensus for the next prime minister has been incorrect many times in the past, and the consensus evaluation of the fundamental policy of the next cabinet has often deviated from its initial view (e.g., in the case of the Obuchi cabinet). For this reason, we would refrain from overestimating political risks. The upper house election coming in summer 2007 is also important. If the LDP/Komeito ruling coalition does not get a majority, the next prime minister’s political life will likely be short, in our view.

Other than these factors described above, there are external risks, including: (1) a marked deceleration in economic growth for US and China; (2) an escalating rise in oil prices; and (3) further abrupt depreciation of the dollar.

Among these, we expect the impact from (1) to be only temporary as firms’ margins are solid at the present, even if the US is hit by some kind of shock. Indeed, US firms’ profit margin ratio continues to improve (13.3% in Oct-Dec 2005) despite the headwind of the sharp price rise in primary commodities. We think this is a kind of miracle brought about by improved productivity. Firms could overcome some shocks by adjusting production slightly without reaching the stage of cutting back labor and capital investment plans. Further, thanks to strong margins, pressure for transferring increased costs to product and service prices may not intensify as much.

As for (2), our global economics team has raised its forecasts further, and now estimates the average oil price for 2006 and 2007 at about $74 and $70 respectively. Our view is that the rise in oil prices, as long as it continues to be a demand shock, will lift up global demand another notch through oil-money recycling, as the track record of the world economy suggests. The question is whether the oil-money recycling that occurred when oil prices rose to $60 will continue to have the same effect under a rise to $70-80 or higher. In other words, the oil-producing countries’ marginal propensity to save may rise for a time. In this case, the world economy would be unlikely to benefit from oil-money recycling as before. However, we could probably expect reallocation of the production resources and technological progress in the world economy in response to entrenchment of high oil prices. We would look for productivity improvement through innovation to offset the impact of high oil prices.

Rather, the real risk is that the oil market will be visited by a supply shock due to geopolitical event risks like the problem with Iran, but this risk cannot be measured. Also, we expect an abrupt decline in oil prices to occur in 2007, partly based on our assumption that economic growth in China will decelerate, but there is also a risk that the Chinese economy will not decelerate as we expect. We also need to consider the possibility that oil prices will not decline as much during 2007.

As for (3), yen appreciation is already coming to the fore, but as long as this is not rapid in the near term, it should not hold back the economy, as Japan’s past economic development has shown. In real effective terms, appreciation in Asian currencies and the euro has in fact left the yen weaker than in April 1990, when it stood at ¥160 to the dollar. We estimate that the breakeven currency rate in Oct-Dec 2005 was in the region of ¥102, whereas the spot rate was ¥117 to the dollar. Since input costs sink when the yen is strong, this breakeven rate changes as the spot rate moves in the direction of yen appreciation. However, the point is that as long as the yen strengthens gradually, companies have time to adjust, and therefore it is not necessary to be preoccupied by the assumed rate in corporate earnings plans in the Tankan, for example (this was ¥110.60 in the March survey).

In sum, we think that Japan’s economy has become more resilient in the face of external shocks, and that the risks above should not have the potential to overturn our basic scenario.

Fiscal and monetary policy outlook

Fiscal debate about the consumption tax is likely to be stepped up after the new cabinet is formed in September. However, the summer upper house election means that a draft proposal for a hike would be submitted in the second half of F2007, putting the earliest implementation date at October 2008 (it does not seem logistically possible to ram this through in April 2008). If the elections were to spell trouble for the ruling coalition, the timing could be pushed back further. Therefore, we have not included the impact of a consumption tax hike within the period covered by our economic forecast this time.

On the monetary policy front, we are expecting the zero interest rate policy to be jettisoned in the summer (at the July 13-14 Monetary Policy Meeting, to be precise). The issue is how fast rates will subsequently rise, but for the time being we are looking for a measured pace of increase roughly every six months, rather than the quarterly increases of 25bp that the market is discounting. Our reasons are: (1) general prices are likely to remain stable against a backdrop of improving productivity; (2) normalization of the fiscal situation is set to become a more urgent policy issue from the early autumn, leaving the BoJ gradually more marginalized; and (3) as the US rate increase cycle enters its final phase, it will become more difficult to increase interest rates in isolation. As a result, we do not expect Japan’s policy rate to rise to a neutral level (2.5-3% for a prevailing potential growth rate of 1.5-2% and a target inflation rate of 1%), and we look for the onset of fiscal tightening from F2008-2009.

Important Disclosure Information at the end of this Forum

Hong Kong
Ex-Housing Inflation Is Mild
May 23, 2006

Denise Yam (Asia)

CPI inflation at 1.9% YoY in April.  According to the new 2004/05-based CPI series (for details on the latest revision in CPI weights, please refer to Rebased CPI Shows Milder Inflation, April 28, 2006), inflation accelerated to 1.9% YoY in April, compared to 1.6% in March, driven primarily by the rise in fresh vegetable prices (+5% YoY in Apr versus -9.2% in Mar) and the cost of package tours (+9.4% YoY in Apr versus +2% in Mar), for which the YoY price comparison was biased upwards by the timing of the Easter holidays (mid-Apr in 2006 versus late Mar in 2005).  The upward adjustment in private housing rent (+5.9% YoY) also continued to contribute to overall inflation (+1.4 percentage points, versus 1.3 ppts in Mar).

Excluding housing, inflation is still mild.   Rising residential rents have been the key driver behind reflation over the past 15 months.  Many expect that price increases should accelerate in other sectors as goods and services providers pass on higher costs (rentals of office and retail premises) to consumers.  However, we remain wary that steep increases in housing rents over and above wage growth may crowd out consumption in other categories, limiting pricing power in consumer goods and services.  CPI inflation ex-housing actually eased back below 1% YoY since March 2006, unseen since April 2004 (excluding Lunar New Year-affected months), from an average of 1.5% (under the old base) in 2005.

Further RMB appreciation remains the biggest upside risk to inflation.  We have yet to see any significant impact of the RMB revaluation on Hong Kong’s import prices.  Hikes in minimum wages in Chinese cities expected this year should also add to production costs in China.  Although we maintain our conservative view that intense competition among Chinese producers will limit the pass-through of the revaluation to consumers, this remains the biggest upside risk to Hong Kong’s inflation, in our view.  We continue to see inflation trending upwards in the short term, but stabilizing in 2H06; we forecast 2% inflation in 2006 (+1.1% in 2005).

Important Disclosure Information at the end of this Forum

Malaysia
Rates Left Unchanged
May 23, 2006

Deyi Tam (Singapore) and Denise Yam (Singapore)

Rates left unchanged. After two consecutive hikes of 25bp each, the central bank (BNM) left the overnight policy rate unchanged at 3.5% at its meeting today. 

Limited second-round effects and demand-side pressure. The central bank pointed to “limited evidence of secondary-round effects and the lack of indications of demand-induced inflation pressures” as the reason for the pause.  We believe that recent strong intervention to ‘manage’ currency appreciation could be another reason.

Tightening unlikely to be aggressive. We do not expect the BNM to be aggressive in the tightening cycle for a few reasons.  First, the central bank is not overly concerned about inflationary pressures to the extent that it is due to changes in administered prices. Second, the BNM probably has a greater tendency than other central banks to use monetary policy as a means to increase growth thresholds.  This would also mean that it is keenly aware of the impact of too aggressive a tightening on indebted consumers.  Third, our currency team has boosted its MYR forecasts, expecting it to come to 3.40 by year-end.  Continued strengthening on the currency front would reduce the need for further tightening.

25bps hike per quarter likely. The central bank believes that inflationary pressures will taper off in 2H06.  Admittedly, pressures are contained, as 15% of the CPI basket has administered prices, and fuel prices have been capped for the rest of the year.  Nonetheless, we reiterate that utility tariff hikes (which are to be discussed by the cabinet next Wednesday) could add about 0.3 ppt (assuming an 11.4% hike) on full pass-through and somewhat offset the moderation from base effects expected in May and August.  We believe that a 25bp rate hike every quarter is a reasonable expectation and would translate into a 25bp hike at each alternate meeting.

Important Disclosure Information at the end of this Forum

Brazil
Trade Abundance Ends?
May 23, 2006

Heloisa Marone (New York) and Gray Newman (New York)

The past week saw fears over an inflation surge in the US and around the globe, combined with uncertainty over the Fed’s next move, produce a new bout of market volatility.  Along with the sell-off in higher-risk assets, commodity prices also suffered as copper, oil and gold prices fell sharply by the end of last week.

As investors wonder whether this is a short-lived event linked to an unwinding of speculative pressures or a new recognition of slower growth, we have decided to review how Latin America would respond to a sustained drop in commodity prices.  In Brazil, one wonders whether the next piece to fall could be the trade balance.

Overall, Brazil’s trade surplus continues to surprise, despite the increasing discontentment among exporters.  The trade surplus hit a new record high of nearly $46.3 billion in the twelve months through March even as the Real remains strong.  Indeed, a review of the past three years perhaps best sums up the paradox: even as the Brazilian Real has strengthened in real (inflation-adjusted and trade-weighted) terms by a whopping 90% in the past three years, the trade surplus has increased about threefold.

Part of the answer for this paradox is that Brazil has benefited from strong global demand and high commodity prices. Whether we look at exports of primary, semi-manufactured or manufactured goods, global demand seems to have aided both export prices and volume in all sectors, which in turn has helped to sustain a prolonged period of what seems to be a puzzle: a strong trade surplus and a strong currency.

During the past year, however, manufactured export volumes have stagnated.  The uptick in manufactured exports values is largely thanks to prices, which are up 4.2% so far this year.  The upturn in prices appears to be the result of continued strong global demand, as well as in part exporters’ ability to adjust the dollar price of their goods to help offset losses caused by the appreciation of the Brazilian Real.  But the signs appear clear: for the vast majority of Brazilian exports, the currency is producing a loss in competitiveness which is first being reflected in stagnating volumes.  Only a prolonged bout of price gains has obscured the fact that manufactured good exports appear to be losing steam.

Primary goods, which account for roughly one-quarter of all exports, are showing stronger signs of weakening in volumes.  After growing by almost 19% between October 2005 and January 2006, primary good export volumes growth dropped by 14% between January and April 2006. While the Brazilian Real appreciated by approximately 6.5% in that period, we believe that the 2% drop in export prices is likely to have been the main driver for the loss in primary good export volumes. Unlike manufacturing, the concentration of exports is greatest in primary goods where six items – soy products, iron ore, chicken, coffee, beef and crude oil – account for just over three-quarters of all primary exports.

In our view, weaker commodity prices and a slowdown in global growth will likely affect export sales in Brazil and, most likely, break the puzzle that has been sustaining unexpected strong trade surpluses in the last few months. But we suspect that the impact of the recent correction in commodity prices in Brazil export sales should be contained. 

Are we there yet?

This past week, commodity prices witnessed a sharp drop, led by a sharp decline in the hard commodity prices. Gold prices fell about 10% from the 26-year high of $730 a troy ounce on May 12, silver dropped 20% from the 26-year high on May 11, and copper dropped more than 14% from its record ten days ago.  

In contrast, soft commodities presented a much less sharp movement in the last two weeks. The CRB livestock and products index, for instance, remained practically unchanged in this period. While there is a general understanding that global demand is likely to present a moderate slowdown in the months to come, there is little belief that the prospect of this slowdown could itself explain most of the sharp drop in commodity prices observed during this last week. Instead, we suspect that markets are also reacting to what could be the bursting of a speculative premium in commodities.

If one believes that this story is true and that commodity prices are going to suffer a large correction in the near term, the natural question to ask is how vulnerable Brazil’s export sector is to a sustained sharp move in commodity prices?

We estimate that commodity-related products account for as much as 60% of total exports. While primary goods (that comprise basic commodity products) account for roughly one-quarter of total exports, we estimate that about 35% of semi-manufactured and manufactured export goods are commodity-based products and should therefore also have their prices affected in the case of a sustained drop in global commodity prices. However, it is worth mentioning that Brazil’s main export commodities, with the exception of iron ore, are soft commodities, with the two most important being soybeans and sugar cane. Prices of iron ore, which we estimate account for less than 6% of total exports in its raw state (and about 10% when including semi-manufactured and manufactured iron ore-based products), are contracted annually. Recent turmoil in commodity prices should therefore have little impact on iron ore export volumes, at least in the near term.  In the long-term, however, iron ore prices appear to be strongly correlated with the CRB metal price index.

Given the strong Real, we believe that export sales are likely to respond strongly to an eventual sustained decline in commodities and non-commodities international prices.  But we suspect this is likely to be a gradual process.

Indeed, when we look at the primary goods export volumes, we find that the correlation between the exchange rate and volumes dropped significantly in the period between January 2005 and April 2006, while the correlation between prices and volumes increased in the same period. With a strong currency already squeezing profit margins, lower prices will only accelerate the decline in export volumes and with it export sales.

We reemphasize our view that a weakening in Brazil’s external position during the course of next year should hardly be reason for concern.  We are not arguing that Brazil needs to run a current account surplus of the sort seen during the past year or even that it needs to run a surplus at all.  But we would warn against extrapolating from the fact that Brazil has managed today to have such a strong currency and such a spectacular result on the trade and current account front.  Behind that result lies an unusual confluence of strong global demand, high prices and lags in export decision making.

One positive development should pay off

During the recent boom period, Brazil’s export concentration has fallen as a more diverse group of products as well as a more diverse group of destination countries have characterized Brazil’s export picture.  Although part of the reduction in the geographical concentration of Brazil exports may be simply a reflection of greater internationalization of the production process around the world, the fact that product concentration is also falling suggests that Brazil is gaining access to new markets. Diversification is important because it decreases the country’s export sector vulnerability to external shocks.  And although commodities account directly or indirectly for almost 60% of Brazil exports, we believe that soft commodities could suffer a different adjustment in prices than we are seeing in metal commodities.

Bottom line

Weaker commodity prices and slowdown in global growth will likely have an impact on export sales in Brazil and, most likely, break the paradox that Brazil has been living of a strong currency and massive trade surpluses. Yet, we believe that the impact of recent movements in commodity prices should be contained.  Although commodities accounts directly or indirectly for almost 60% of Brazil’s exports, a great part of Brazilian commodity exports are soft commodities whose prices appeared to have been less affected by the recent sell-off in the commodity market.  We believe that a rather diversified export basket should help to tame all but the most pessimistic outcomes, at least in the near term.

Important Disclosure Information at the end of this Forum

Disclosure Statement

The information and opinions in this report were prepared or are disseminated by Morgan Stanley & Co. Incorporated and/or Morgan Stanley & Co. International Limited and/or Morgan Stanley Japan Securities Co., Ltd. and/or Morgan Stanley Dean Witter Asia Limited and/or Morgan Stanley Dean Witter Asia (Singapore) Pte. (Registration number 199206298Z) and/or Morgan Stanley Asia (Singapore) Securities Pte Ltd (Registration number 200008434H) and/or Morgan Stanley & Co. International Limited, Taipei Branch and/or Morgan Stanley & Co International Limited, Seoul Branch, and/or Morgan Stanley Dean Witter Australia Limited (A.B.N. 67 003 734 576, holder of Australian financial services licence No. 233742, which accepts responsibility for its contents), and/or JM Morgan Stanley Securities Private Limited and their affiliates (collectively, "Morgan Stanley").

Global Research Conflict Management Policy

This research observes our conflict management policy, available at www.morganstanley.com/institutional/research/conflictpolicies.

Important Disclosures

This report does not provide individually tailored investment advice. It has been prepared without regard to the circumstances and objectives of those who receive it. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages them to seek a financial adviser's advice. The appropriateness of an investment or strategy will depend on an investor's circumstances and objectives. This report is not an offer to buy or sell any security or to participate in any trading strategy. The value of and income from your investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized.

With the exception of information regarding Morgan Stanley, reports prepared by Morgan Stanley research personnel are based on public information. Morgan Stanley makes every effort to use reliable, comprehensive information, but we do not represent that it is accurate or complete. We have no obligation to tell you when opinions or information in this report change apart from when we intend to discontinue research coverage of a company. Facts and views in this report have not been reviewed by, and may not reflect information known to, professionals in other Morgan Stanley business areas, including investment banking personnel.

To our readers in Taiwan: This publication is distributed by Morgan Stanley & Co. International Limited, Taipei Branch; it may not be distributed to or quoted or used by the public media without the express written consent of Morgan Stanley. To our readers in Hong Kong: Information is distributed in Hong Kong by and on behalf of, and is attributable to, Morgan Stanley Dean Witter Asia Limited as part of its regulated activities in Hong Kong; if you have any queries concerning it, contact our Hong Kong sales representatives.

This publication is disseminated in Japan by Morgan Stanley Japan Securities Co., Ltd.; in Canada by Morgan Stanley Canada Limited, which has approved of, and has agreed to take responsibility for, the contents of this publication in Canada; in Germany by Morgan Stanley Bank AG, Frankfurt am Main, regulated by Bundesanstalt fuer Finanzdienstleistungsaufsicht (BaFin); in Spain by Morgan Stanley, S.V., S.A., a Morgan Stanley group company, which is supervised by the Spanish Securities Markets Commission (CNMV) and states that this document has been written and distributed in accordance with the rules of conduct applicable to financial research as established under Spanish regulations; in the United States by Morgan Stanley & Co. Incorporated and Morgan Stanley DW Inc., which accept responsibility for its contents. Morgan Stanley & Co. International Limited, authorized and regulated by Financial Services Authority, disseminates in the UK research that it has prepared, and approves solely for the purposes of section 21 of the Financial Services and Markets Act 2000, research which has been prepared by any of its affiliates. Private U.K. investors should obtain the advice of their Morgan Stanley & Co. International Limited representative about the investments concerned. In Australia, this report, and any access to it, is intended only for "wholesale clients" within the meaning of the Australian Corporations Act.

Trademarks and service marks herein are their owners' property. Third-party data providers make no warranties or representations of the accuracy, completeness, or timeliness of their data and shall not have liability for any damages relating to such data. The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of MSCI and S&P. Morgan Stanley bases projections, opinions, forecasts and trading strategies regarding the MSCI Country Index Series solely on public information. MSCI has not reviewed, approved or endorsed these projections, opinions, forecasts and trading strategies. Morgan Stanley has no influence on or control over MSCI's index compilation decisions. This report or portions of it may not be reprinted, sold or redistributed without the written consent of Morgan Stanley. Morgan Stanley research is disseminated and available primarily electronically, and, in some cases, in printed form. Additional information on recommended securities is available on request.