The Global Capex Debate
February 16, 2007
By The Global Macro Team | New York | London | Tokyo | Sydney
In keeping with our culture of collective engagement, our global macro team this week debated the capital spending outlook — a key ingredient in the overall growth prognosis. Like so many other factors in the modern, more subdued business cycle, a vigorous capex expansion has been so far missing in action, and not just in the US but globally. Harking back to our discussions at MacroVision in early 2006, however, most of the team remain resolutely optimistic. The bulls argued that the muted character of investment outlays globally would give way to strength. Among the reasons: Hearty growth, rising animal spirits and operating rates, easy money, aging populations, and the productivity and infrastructure imperatives. The bears, not surprisingly, stayed bearish: The need to outsource, business caution, and slower overall growth would keep capex outlays subdued, at least in mature, industrial economies. Who will be right? And what are the implications of these starkly different scenarios?
The outcome may lie somewhere between: The crosscurrents our team debates may net to a modestly positive capital spending prognosis, but there surely are downside risks. Moreover, while the outsourcing trend is intact, exactly who will be the capex winners and losers in a globalized world is unclear. Financial markets seem to be discounting the “just-right” scenario, assuming that businesses have found the capex sweet spot and will continue to maintain it. Change may be coming, however, and who is right matters for real interest rates and risky assets: A capex revival that absorbed global saving would push up real rates. And if the capital discipline that has boosted returns on capital erodes, that would be bad news for equity prices and possibly credit quality. In contrast, capex anorexia would limit today’s growth and could cap its potential, making the global economy more inflation prone. One thing is sure: The following debate won’t be the last word on this subject. As with any blog, in fact, it may be just the first installment. Gerard Minack: The global macro outlook remains benign and business sentiment generally remains upbeat — especially outside the US. For example, our (already-more-optimistic-than-consensus) economics team just revised up its forecast for European growth in 2007 to 2.3% from 1.9%. The stronger-than-expected December-quarter GDP data for Japan have reduced fears of a premature end to the Japanese expansion; capital spending accounted for roughly half of the acceleration. And even in the US, our team is looking for the proverbial soft landing, as the housing recession tapers off. As is the case with almost all the leading indicators that I follow, the signal is one of benign moderation, not collapse. Importantly, the corporate sector's optimism is leading to accelerating business investment spending. The OECD's estimate of real business investment growth hit a new cycle high in the September quarter, growing by 7½% over the year. This is noteworthy, as investment spending has been strangely muted through this cycle despite record-high profit margins and return on equity, as well as relatively low interest rates. Eric Chaney: Gerard's point about capex is important: The global capex cycle, which is still in an early stage in my view, was so far mostly driven by China. But two changes are underway. First, oil producers are now funneling excess cash into the real economy rather than into Treasury bills, as Serhan Cevik has documented in his piece ‘Tracking Petrodollars’ (February 14). Second, capital spending seems finally to be picking up in mature economies — that is at least something we see in Europe where rising capacity utilization rates have led companies to upgrade capex plans. This is particularly impressive in Germany where, on my estimates, manufacturing capacity increased by 2.3% (YOY) in the second half of 2006. In France, industrial companies have just raised their capex forecast from 4% to 7%. There’s an important lesson here: The global saving glut — the ex-ante imbalance between saving and investment — may be bridged by a rise of investment, which would not be a bad thing for the global economy! Minack: Eric, to follow on that point, perhaps what's good for the economy won't be so flash for markets. First, if the capex revival soaks up the ex-ante saving excess, it points to higher real rates. Second, the extraordinarily high returns on equity partly reflect what Dick calls ‘capital discipline:’ a combination of strong top-line growth and an unusually tepid capex response. But as capital (real capital, not financial flows to existing assets) heads to high-ROIC sectors, those returns will shrink. So, what’s good for the capex-producers — among them Germany and Japan — is not so good for asset-shufflers. Richard Berner: Gerard, I agree but only up to a point. Rising real rates aren't necessarily threats to risky assets; on the contrary, if they are the product of stronger growth they should indicate support. I’ll concede, of course, that the geographical distribution of growth may change: Recycling petrodollars into capital spending abroad rather than into US financial markets may push up our real rates and offset the benefits for our economy of stronger global demand. That would not be so bad either; it would enhance the process of global rebalancing. A darker threat might come from the erosion of capital discipline, as you imply — with the 1990s being the extreme, "field of dreams" example of that risk. As I see it, however, we’re far from that point, and even a strong, sustained pickup in capex might not push us to it. If anything, I think the slow pace of investment thus far stretches out the global expansion. Minack: I guess the theory is that high trend growth and high real rates go hand-in-hand. As an aside, that implies that from an equity perspective the benefit of higher trend growth will often be offset by higher real discount rates. The reverse – low growth, low real rates – helps explain why Japanese equity valuations appeared to stay so high through the ‘lost decade’. In practice, however, real growth and real rates can diverge for some time. The very best mix for investors — the one we’ve seen over the past few years — is high growth and low real rates. We’ve had the best of both worlds! Looking forward, even if growth holds up, the normalization of real rates should, at the margin, be adverse for asset valuations. I think that that’s particularly true in the current cycle given the leverage evident in investment markets. Some speculative positions would be very vulnerable to rising real rates, in my view. Robert Feldman: Don't forget global aging as a spur to investment demand. When countries try to maintain their standards of living in the face of aging populations, the only answer is productivity gains. In symbols, Y/P = (Y/L) * (L/P) Which means that the standard of living (Y/P), where P is the population and Y is GDP, is determined by productivity (Y/L) and the labor participation rate (L/P). Since L/P is bound to fall, the only way to maintain Y/P is a rise of Y/L. Raising Y/L requires a lot of work, including lots of capex. This is great for Japan, and I have been pushing machinery stocks as a theme for two years now. Steve Roach: A related and very important question: In a globalized world, who does the capex? Does it get done by those countries who provide this new source of labor supply — i.e., China and India — or does it get done by those who have had their labor forces priced out of global markets? I suspect the former — leading me to conclude that we can't look at closed models of capex anymore. In other words, why should the US put in new capacity at home if it is pushing employment growth and production platforms offshore? The same questions apply to Japan and Germany — although Feldman-san has made the very interesting point that demographically-induced shrinkage of labor forces in countries like Japan may lead to accelerating capital-labor substitution. A second and related question: Does the old cash-flow/depreciation model of capital spending still apply in a global setting? I’m suspicious of those who argue that strong cash flow and low ratios of capex to depreciation assure faster growth in capital spending. In a globalized world, it may well be that an increasingly large portion of corporate cash flow in high-cost developed economies goes to offshore investments in greenfield capacity in low-cost developing economies. That would imply that the domestic portion would then go to share buybacks or replacement of worn-out or obsolete capacity. Perhaps the best one can hope for in the mature countries is enough “replacement” spending simply to maintain the capital stock — hardly the grist for the powerful capex pickup that the bulls see as all but inevitable. Feldman: My answer to Steve's first question — who does the capex — is: Everybody. But this answer is based on a neoclassical model for the adolescent developing countries and a non-neoclassical one for the mature, demographically declining countries. The neoclassical answer is that the capex is more attractive in the labor-intensive countries because the rate of return on extra investment (i.e., the marginal product of capital) is higher there. That’s because the marginal product of capital — and returns to it — rise when capital is relatively scarce. (For example, when the Irish came to America, they built the railroads.) Thus, in countries like India and China, where labor is abundant, the marginal product of capital remains higher than in the US, Japan, Europe, and capex will be faster. Japanese machinery makers will do well as exporters. (Take the industrial sewing machine companies, like Juki and Pegasus and Janome, as examples.) For demographic decliners, a technology-based model is more appropriate. I cannot see the populations of these countries allowing demographics to worsen their living standards. They will fight such worsening with technology. First, a lot of capex is aimed at raising total factor productivity. Second, a lot of new technology is embodied in new machines, which simply cannot be upgraded. Note that this model has a political-economic component — i.e., the voters push for technology-enhancing structural reforms. There’s a dark twist as well: If the mainstream economists’ view that technology widens income inequality is correct (because highly-paid skilled labor is complementary to its use and because the productivity dividends accrue disproportionately to the owners of capital), then voters might approve protectionist and other policies that protect old jobs instead of creating new ones. Berner: I’m sympathetic to Steve's point about location. But portfolio diversification argues for not putting all investment eggs in the China basket. Moreover, in a further twist on Robby’s point, the threat of protectionism may inadvertently boost US investment by the foreign affiliates of Asian firms. On Steve’s second point, it is worth noting that, so large is the capital stock and so large is depreciation for today’s quickly-obsolete equipment that it takes roughly 7% growth in real equipment spending just to hold the US capital-output ratio constant. The capital stock of equipment and software has actually been declining in relation to GDP over the past four years. Real nonfarm business output rose by an average annual rate of 3.9% over that period, while the real stock of equipment and software rose by an average annual rate of 3.5%. Nonetheless, to achieve that, gross investment in equipment and software rose at an average 6.2% rate. Still, I’ve been surprised by the recent weakness in US capital spending. There’s no mistaking the distinct cyclical downshift in capex growth — especially in equipment and software — over the past three quarters. Such spending crawled at a miserable 1.4% annual pace over the last nine months of 2006, compared with a 9.5% annual rate over the previous two years. Ironically, perhaps, most of the slowing has occurred in low-tech equipment, especially in transportation equipment (excluding transportation, equipment and software outlays rose at a still-tepid 3.5% over that period). To be sure, some of the deceleration may represent a “payback” for the boost to spending from the “bonus depreciation” feature of the tax law that only expired for vehicles and other long-lived assets in January 2006, so the pace over last year was artificially depressed. But some of the slowing likely reflected uncertainty about the outlook, as uncertainty is often the enemy of growth. Near-term prospects aren’t buoyant, given the fact that core capital goods orders have declined at an 8% annual rate over the past three months. But because we believe that capex discipline has created pent-up demand for capital goods, we think the pace will quicken in 2007. Stephen Jen: I agree with your point, Steve, that capital spending is complementary to labor in some respects, so should expand in places that are supplying the additional labor. Two points seem relevant to me. First, China's massive capex binge makes sense. Rather than criticizing China's capex binge as something 'unnatural', we should acknowledge that such high capex growth is actually sensible. The problem is our doubts about the ability of the Chinese banks to intermediate capital and allocate capital in a way that is driven by the financial viability of the projects in question. But this is essentially a financial infrastructure issue, not a shortfall in capex demand. The real puzzle is why investment-GDP ratios have declined in most of Asia. After all, these countries have long since cleaned up the excesses revealed by the Asian financial crisis that began a decade ago. Nonetheless, the memory of that experience is one of several hypotheses. Other explanations relate to multinational firms' uncertainty about the Asian macro and geopolitical environment, and to their uncertainty about the global economic outlook. David Miles: I would go even further than Stephen Jen and draw a specific conclusion for China. That’s probably very foolish given that what I know about China could be written on back of a postage stamp ... anyway here goes: I imagine infrastructure (schools, power supply, roads, hospitals, etc.) in much of China is poor — probably very poor. In the light of that, a plausible central estimate of the internal rate of return on such investment might be high (though risky). Using a large part of the large trade surplus to buy low-yielding, US-dollar-denominated assets and holding them in the central bank seems a somewhat strange strategy. Arguably a better one is to invest even faster in domestic infrastructure — and in so doing run a much smaller trade surplus. Roach: Your postage stamp may be bigger than you think. This is precisely the point that Larry Summers made when he first raised this issue in a speech in India a year ago — a speech, by the way, that has resonated throughout the developing world. The point was a very simple one: Poor countries need high returns to meet the daunting social and economic imperatives that David notes above —and US Treasuries don't exactly fit that bill. In the end, strategies that lead to large trade surpluses and excess FX reserves that then need to be recycled into dollars for currency management purposes don't serve developing economies well. The move to GIC-type wealth management funds follows from this same line of thinking. Chaney: I’m a China ingénue too. But China cannot really invest more than the already huge investment that goes to infrastructure for lack of the political and financial networks necessary to channel investment to where the economic/social return is high enough. More bluntly: It’s better to use a portion of Chinese savings to buy Treasuries rather than giving the money to politically-motivated bureaucrats who have no incentive to allocate capital to its best uses. Better still would be to create markets and market mechanisms to do that job. Elsewhere, I agree with Robby’s point about demographic decliners. Yet, raising total factor productivity is not only a matter of capex. Philippe Aghion of Harvard and Daron Acemoglu (MIT) show very convincingly that for economies at or close to the world technology frontier, the marginal product of innovation is much higher than for economies far from it. Since aging economies are often those close to the technology frontier (Russia being the exception that confirms the rule), demographic decliners have a strong incentive to stimulate innovation, whereas investment-based strategies (capital deepening) seem a better option for catching-up economies such as China. Berner: I agree with Eric — productivity gains are about more than capital deepening. Aligning the right business model with the right people also matters. And I agree with Robby that productivity gains are essential for aging societies, especially as labor gets more expensive relative to capital. But at least in our aging, saving-short society, there will be another way to boost output: Work longer. The fourth leg of our retirement saving stool will be working well beyond the traditional retirement age. That's already happening in the United States, helping to boost labor force participation. The participation rate for the 55 and older crowd has risen by 800 bp in the past decade, erasing the decline of the previous two decades, and over that ten-year period, the geezer cohort accounted for more than half of the growth in the overall labor force. Their skills may be valuable as complements to high-tech investment. I think there's more to come globally. Minack: That’s exactly what we’re seeing in Australia. In the 1970s-1990s labor participation saw two big offsetting trends: rising female participation, versus falling participation amongst older workers. The latter reflected the trend to early retirement — remembering that these were the lucky buggers who were on defined-benefit pensions and received state pensions that (at that stage) were not means-tested. Now the current cohort is realizing that their life expectancy at retirement is 20 years or so, and their skimpy defined-contribution pensions aren’t going to be enough. So they’re not retiring. That’s produced a big supply shift in labor, and one that I think is not particularly wage-sensitive (that is, it’s not principally a response to rising real wages — quite the reverse, the supply curve is moving out and flattening wage growth). Our team is ever mindful of risks: With most investors convinced that a capital-spending acceleration is likely, a key risk is that investment gains will fall short of expectations. Conversely, the capex quickening could easily be stronger than expected. But be careful what you wish for: Capex vigor has the potential to extend the economic cycle, but could — via its impact on rates and returns — create headwinds for the financial asset cycle.
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TIC Tock
February 16, 2007
By Stephen S. Roach | New York
The US Treasury’s latest report on international capital flows came as a shocker. Net foreign inflows into longer-term US securities fell to just $15.6 billion in December 2006 -- the weakest monthly reading in nearly five years. This stands in sharp contrast to America’s enormous external financing needs -- about $3.5 billion of foreign capital inflows each business day required to fund a current account deficit that was running at close to an $875 billion annual rate in the first three quarters of 2006. Does an external financing shortfall of this magnitude finally spell trouble for the seemingly Teflon-like US dollar? Probably not -- or, at least not yet. The monthly Treasury International Capital (TIC) data are not exactly the most reliable piece of intelligence in the US statistical system. The figures are extremely volatile -- expect a big bounce-back next month -- and quite often they do not match up well with capital flow data provided by other nations. In addition, the coverage pertains mainly to foreign investment in longer-term securities -- thereby ignoring the nearly 15% of overseas holdings in instruments with shorter-term (less than one-year) maturities. Moreover, as others have pointed out, the TIC data suffer from major classification biases that often confuse foreign sourcing between official and private investors (see Martin Feldstein’s op-ed in the 10 January 2006 Financial Times, “Why Uncle Sam’s bonanza might not be all that it seems”). Notwithstanding these flaws, the TIC data should not be ignored. Over time, the Treasury statistics do a reasonably good job in tracking the international investment transactions embedded in the US balance of payments. As such, TIC reports can be helpful in pinpointing the tensions arising between America’s external financing requirements and foreign willingness to provide the requisite capital. And there can be no mistaking a worrisome build-up of tensions on several fronts: First, the United States has made no effort to reduce its chronic saving shortfall. Reflecting persistent structural government deficits and the first back-to-back years of negative personal saving since the early 1930s, the US net national saving rate has held at a record low of 1% of national income over the past three years. Lacking in domestic saving, America has placed heavy demands on the rest of the world -- absorbing about 70% of global surplus saving over the past couple of years -- to fund its ongoing economic growth. Second, the rest of the world is waking up to the notion that there are alternatives to low-yielding dollar-denominated assets. That’s especially the case in the poor countries of the developing world, who collectively hold over $2.5 trillion in excess foreign exchange reserves -- that is, reserves above and beyond those which would be required to pay off some $550 billion of short-term external indebtedness. A year ago, former US Treasury Secretary Larry Summers gave a speech in India that challenged reserve managers in the developing world to seek higher returns on their increasingly large asset pools in order to help meet urgent social and economic imperatives (see “Reflections on Global Account Imbalances and Emerging Markets Reserve Accumulation,” L. K. Jha Memorial Lecture, Reserve Bank of India, March 24, 2006). The Summers message galvanized attention on this issue -- especially in Asia, where the bulk of excess reserves are held. Talk of portfolio diversification intensified, ultimately culminating in China’s recent announcement that it would allocate around $200 billion of its more than $1 trillion in reserves toward the start-up of a Singapore-GIC-style multi-asset fund. With most reserve managers having massive overweights in dollar-denominated assets, such diversification strategies can only complicate America’s external financing needs. Third, Washington continues to flirt with a protectionist response to America’s outsize bilateral trade imbalance with China. I spent some time in Washington this week discussing trade issues with congressional leaders, and I came away with the distinct impression that the die is cast for a much more aggressive approach to US-China trade policy (see my 13 February Special Economic Study, “The Politicization of the US-China Trade Relationship”). Under Democratic leadership, there is a higher probability that ongoing Chinese trade frictions could result in more serious legislative efforts than was the case when the Republicans were in control. Moreover, with such initiatives enjoying broad-based bi-partisan support, the only real question, in my view, is whether the margin of passage will be large enough to override a likely presidential veto. Should such legislative “remedies” be enacted, I have little doubt that Chinese participation at upcoming Treasury auctions would be sharply reduced -- a hugely negative development for the dollar. There are, of course, many other considerations weighing on the dollar -- ranging from a likely narrowing of cross-border interest rate spreads and relative equity returns to reserve diversification strategies of Middle East and other Asian reserve managers. At the same time, the three largest surplus savers in the world -- China, Japan, and Germany -- are all hard at work trying to stimulate internal consumption. To the extent those efforts bear fruit -- and, in my view, it’s only a matter of when -- they will then draw down their surplus saving and have less excess capital to send America’s way in the form of investments in dollar-denominated assets. Despite these dollar-bearish conclusions, I stand by my view that a currency realignment should not be viewed as the principal means to rebalance an unbalanced world (see my 9 February dispatch, “The Currency Foil”). Instead, significant adjustments are needed in the mix of global saving -- more from the US and less from China, Japan, Germany, and the Middle East. A currency realignment is, at best, a circuitous route to such an endgame. At the same time, I still believe that the day is coming when the dollar will be hit by global portfolio adjustments, as foreign investors demand significant financing concessions -- either in the form of a weaker dollar and/or higher longer-term real interest rates -- for their heretofore open-ended buying of dollar-based assets. A monthly TIC report can hardly be viewed as a decisive verdict on anything. But the December collapse in foreign demand for longer-term US securities also coincided with a sharp widening of the monthly trade deficit to $61 billion -- drawing the narrowing trend of the preceding three months into question. With America’s external financing needs remaining huge by any standard, it becomes tougher and tougher for the US to attract the requisite capital inflows under the best of conditions. It may well be that we will look back on the December 2006 TIC report as a warning shot of what was to come -- an increasingly difficult external financing climate for a saving-short US economy. The clock is tic(k)ing.
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AXJ: Who’s Afraid of Large Capital Inflows
February 16, 2007
By Stephen Jen | from Tokyo
Summary and conclusions Financial globalization by definition implies large cross-border capital flows. While some emerging economies welcome these capital flows, others, such as Thailand, have felt uneasy enough to impose capital controls on inflows, knowing full well that these measures could have lasting consequences. In this note, I take a first look at the general issue of capital inflows into Asia ex-Japan (AXJ) and some of the policy issues these inflows raise. My own view is that it’s different this time, capital inflows are benign and structural in nature, and the risk of a ‘sudden stop’ to these flows is very low. Policies should not be aimed at blocking these flows, but capital outflows should be liberalized to better balance capital flows in the short run, and allow residents to build a more diversified portfolio of financial assets in the long run. How large are portfolio flows into Asia? Foreign direct investment is still very welcome in Asia, since it generally embodies technology and know-how that the recipient countries find useful from a long-term perspective. However, portfolio flows, even equity flows, are sometimes deemed to be de-stabilizing at best and predatory at worst. Before I discuss whether these inflows are benign or malign, I first assess the size of these inflows. Except for the Asian Financial Crisis in 1997, net portfolio flows into AXJ have been positive since 1991. GDP-weighted portfolio inflows as a percentage of AXJ GDP surged from slightly negative levels (-1% of GDP) in the late 1980s to a high of 8% of GDP in 1994 and 1996, right before the crisis. The sharp cessation in portfolio flows into Asia is distinct, with the trough of these flows reached during the Russian Crisis and LTCM in late summer 1998. Thereafter, net portfolio inflows into Asia have been strong, hovering within the 4-5% of GDP range over the last three years. I make the following observations. 1. Net portfolio inflows are large currently, but are two-thirds of the size of inflows 10 years ago. From 1994-96, net portfolio flows into AXJ averaged some 6.4% of GDP, compared with 4.4% during 2004-06. Portfolio inflows into AXJ have been large in the last three years, but not that large. 2. Some countries are worried because the pattern of flows is similar to that seen before the Asian Financial Crisis. What worries some governments (e.g., Thailand) is that this pattern of inflows and overwhelmingly positive investor sentiment toward AXJ assets is reminiscent of what happened 10 years ago, when strong capital flows suddenly stopped, triggering the crisis. In fact, one of the key reasons why the Bank of Thailand imposed the URR (unremunerated reserve requirement) in the middle of last December was its recognition of this distinct pattern of hot money inflows. Back in 1997, while Thailand’s asset prices and its macroeconomic variables looked good so long as these inflows continued, when the ‘music stopped’, Thailand was left to face the consequences alone. Thailand’s decision in December 2006 to repel these capital inflows is entirely a legacy effect from 10 years ago, in my view. 3. There is quite a wide disparity within Asia on these portfolio inflows. As a net saver, Singapore has, not surprisingly, experienced persistent capital outflows. On the other hand, except for a brief lull during 2002-04, Hong Kong has been by far the largest recipient of net portfolio inflows. That a major financial center as the gateway to China is able to attract such a large amount of flows might not really be that surprising. However, it is interesting that net flows into Hong Kong during the post-Asian Financial Crisis and in the period leading up to the IT bubble were so massive (averaging 20% of GDP) that the large IPOs in 2006 were only able to push up the average inflows during 2005-06 to less than half of this amount. In contrast, the SE Asian economies (Indonesia, Malaysia and Thailand) saw large net outflows from 1998-2001 (the period when Hong Kong received massive inflows), suggesting that not only did SE Asia not get much of a ‘rebound’ in inflows post-crisis, but it completely missed out on the IT craze then. In the past two years, however, Thailand has received quite a large amount of foreign portfolio inflows, which, according to the Bank of Thailand, were the main factor behind the outperformance of the THB in 2006, when it surged by more than 15% — the largest appreciation in Asia. The point here is that the capital flow story is quite different across countries in Asia. Policy considerations Large capital ebbs and flows could clearly be highly disruptive for a small economy. These flows complicate monetary policy making, could lead to asset bubbles and, in general, impose an immense amount of stress on economies whose corporate sector and labor market are not flexible. However, I believe that there are major differences between now and a decade ago. Policy makers should not fear capital inflows now, and should further liberalize capital outflows, in my view. I make the following points: • Point 1. Capital inflows now are benign and structural in nature. I believe that the types of capital inflows to Asia now are not as speculative and ‘short-termish’ in nature as the flows we saw a decade ago. Capital inflows to Asia are also a reflection of a genuinely robust global economy and the fact that Asia has benefited immensely from globalization. Even back in the mid-1990s, a large amount of the flows were not that speculative, except for those into Thailand. The collapse in the Thai financial system and the THB triggered an intense wave of contagion: even countries such as Korea and Indonesia, which should not have experienced speculative attacks, suffered. However, I don’t believe that contagion is a worry now. Idiosyncratic shocks are no longer likely to trigger region-wide contagion. The lack of spillover effects from Thailand’s decision last December to impose the URR is one test: no other country in Asia saw outflows last December; in fact, there were signs that some flows that would have gone to Thailand were diverted elsewhere in Asia. • Point 2. The risk of a ‘sudden stop’ is low. Asia’s financial ‘cushion’ is substantially thicker now than it was a decade ago. I don’t need to repeat how much Asia’s official reserves have grown. Asia is a capital-exporting region that is receiving further foreign capital inflows. The positive balance of payments surpluses have forced the central banks to intervene. Simultaneous current and capital account surpluses, as well as massive official reserves, make Asia that much less vulnerable to a ‘sudden stop’. In turn, because Asia is perceived to be less vulnerable, stampedes out of Asia by foreign investors have a lower probability of occurring than 10 years ago. • Point 3. Go along with financial globalization, don’t resist it. The world’s capital being allocated to Asia is a part of the process of financial globalization. Virtually every country has seen its collective financial portfolio being diversified. Japan’s capital outflows should be seen in this structural context, not just as simple-minded carry trades. The US real money accounts’ USD diversification in the past three years and central banks’ current moves toward sovereign wealth funds are also part of a bigger trend of financial globalization, in my view. The world has begun to build diversified financial balance sheets to match its internationally diversified real activities. Small, open economies should react to large capital inflows with efforts to further liberalize capital outflows. China and Korea have made great efforts in this area in recent months, and have refrained from blocking capital inflows. This, I believe, is the correct policy reaction. Bottom line While large capital ebbs and flows usually cause complications for monetary and exchange rate policy in small open economies, I believe that the capital inflows these days are benign and structural in nature, very different from the situation prior to the Asian Financial Crisis in 1997. Asian countries are no longer vulnerable to contagion, and the risk of ‘sudden stops’ is low. Asian central banks should not try to block capital inflows, in my view. Rather, they should further liberalize capital outflows, as China and Korea have done.
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KRW: Equity Outflows versus Forward Hedging
February 16, 2007
By Stephen Jen | from Tokyo
Summary and conclusions In this note, I highlight the two key tensions that impinged on the USD/KRW rate for much of 2006, and argue that whether USD/KRW trades higher or lower in 2007 will be predicated on how this tug of war between equity outflows, on the one hand, and forward hedging, on the other, will be resolved. I continue to bet that the latter will overwhelm the former, to drive USD/KRW to 900 by year-end. Examining Korea’s 2006 BoP carefully The underlying forces buffeting USD/KRW have changed significantly over the past four years. The best way to see this is to look at Korea’s balance of payments (BoP). There are several features in 2006 that are worth highlighting. (1) The fact that the KRW kept strengthening in 2006 had little to do with Korea’s C/A surplus, which registered only US$6.1 billion — the lowest level in the past four years. (2) But Korea’s combined current and capital account (K/A) surplus was a huge US$24.7 billion, due primarily to a very large net K/A surplus of US$18.6 billion — a 10-year high. (3) What is most remarkable is that the K/A surplus was so large despite the fact that net portfolio flows registered a deficit of US$22.6 billion (a record high), driven primarily by equity outflows. (4) The single-biggest entry in Korea’s BoP is ‘loans’ of US$56.4 billion — also a record high. Two items make up ‘loans’. About two-thirds of these inflows reflected the counterpart of banks’ transactions associated with the forward sales of USD/KRW by Korea’s exporters. Large ship-builders and other exporters received massive forward orders and they decided to sell USD/KRW forward. (Specifically, in 2006, orders from the Middle East for large oil and natural gas tankers were reported to be huge.) The rest of the ‘loans’ were related to non-won-denominated loans taken out by various types of entities, some of whom used the proceeds to invest in Korea’s real estate market. The irony here is that it is the exporters themselves — the very entities that have been complaining about the strong KRW — who were the ones aggressively selling USD/KRW forward. Incidentally, back in 1997, it was also the exporters who were behind the up-trend in USD/KRW. Exporters aggressively bought USD/KRW using the excuse that they needed to hedge against their external debt. The difference between 1997 and 2007 is that, back then, what the Treasury departments were doing did not conflict with what the manufacturing side of these companies had preferred. In any case, 2006 was essentially dominated by a tug-of-war between large equity outflows by Korean investors and these forward USD/KRW sales. Considerations for 2007 Examining Korea’s BoP, it is striking how drastically various items have changed over the past four years, with several entries moving in opposite directions, offsetting each other. How the KRW will perform this year will be a function of how some of these variables will evolve. Here are my key considerations. • Consideration 1. Korean investors’ equity investments abroad could continue to rise rapidly. Korean investment in foreign equities rose from US$3.6 billion in 2003 to US$15.2 billion in 2006. This is potentially a very important trend. What I have in mind is that, similar to the large retail investment outflows we are witnessing in Japan, these outflows from Korea could reflect a structural shift in Korean investors’ investment pattern. One possibility could be that Korean investors have finally decided to build an internationally diversified financial portfolio, rather than one that is overly exposed to Korean assets. This is a sensible trend, as Korea’s real sector is increasingly exposed to international forces. Therefore, it would only make sense that the private sector in Korea decides to have a financial portfolio international enough to match the real sector. Another hypothesis I have is that this motivation to invest overseas could be a result of demographic trends. Like Japan, Korea’s population is ageing. There is a strong consensus in academic research that ageing should generate an equity risk premium, as people saving toward retirement should be, ceteris paribus, more risk-averse, and should therefore show a preference for bonds over equities. However, what we have observed in Japan and Korea is precisely the opposite: people approaching retirement and those already in retirement are taking more, not less, risk. One way to explain this greater desire to take risk could be longevity. As life expectancy improves, and if workers still want to retire on time, the low-return environment has forced these savers to take on more risk. For 2007, I am assuming that Korean equity investments abroad will show a continuation of the current trend. • Consideration 2. Foreign portfolio inflows should recover in 2007. Between 2003 and 2006, foreign portfolio inflows collapsed from US$21.5 billion to close to zero. KOSPI was a ‘front-runner’ in Asia as the global economy began to recover in 2002. But it gradually fell out of favor as other markets in Asia outperformed. 2007 could very well be a different story, as Korea’s stock market — just like Japanese equities — could fall back into favor, due to valuation and other markets slowing down. In the first weeks of 2007, net foreign equity inflows have already begun to recover. If this trend continues, which I suspect it will, net foreign equity inflows should turn north. • Consideration 3. Will the USD/KRW forwards be rolled over? This is not a straightforward call to make, as the Treasury departments of these large exporters in Korea will form their decisions based on their expectations of the state of the US economy, the Fed, the trend in USD/AXJ, the JPY and other factors. Expectations, rather than current variables, will drive loans, which makes it potentially unstable. I am guessing that loans will not decline too much. First, with the global economy staying strong, Korea’s exports should continue to grow. Second, both USD/CNY and USD/JPY are likely to end the year lower than where they are today. I firmly believe that the general trend in USD/AXJ will remain downward. This will have the obvious spillover effects on USD/KRW. Third, the economic fundamentals of Korea will be just fine this year, contrary to some views in the market that Korea (and much of Asia) will slow drastically in 2007. The BoK will most likely refrain from tightening for some time, as inflation has drifted below its target range. In short, Korea will look more ‘Goldilocks’ than it did in 2006. A U-shaped trajectory in USD/KRW I suspect that we may see a U-shaped trajectory in USD/KRW over the medium term. While USD/KRW could potentially trade down to 880 some time in 2008, if the equity outflow story is correct, USD/KRW could start to drift higher in 2008, when Korea’s recent decision to liberalize capital outflows could have a more powerful effect on USD/KRW. Bottom line USD/KRW has not been driven by Korea’s C/A balance for some time. In 2006, the primary drivers of USD/KRW were (i) Korean equity outflows and (ii) forward USD/KRW sales. How USD/KRW performs in 2007 will be a function of the tug-of-war between these two variables. My guess is that the latter will win, again, driving USD/KRW to 900.
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Tax Debate Heats Up
February 16, 2007
By Robert Alan Feldman
The tax system debate has heated up recently, in particular with respect to both corporate income tax and financial income taxes. Indeed, the very fundamental principles of taxation in Japan are now under debate. Until a few months ago, the Government Tax Commission (GTC) was under the jurisdiction of the Ministry of Finance, and doggedly stuck to the three old principles of ‘fairness, neutrality and simplicity’. After years of political compromise, however, these three principles had become a sham. Moreover, the slowness of the tax reform process was undermining confidence in the process of tax policy, and the narrow interests of the two main participants became a problem. The ruling party’s tax committee has historically been concerned chiefly with how tax changes affect political fortunes, not the economy. Even though things improved with the retirement of tax strongman Sadanori Yamanaka in 2004, the strong political character of the LDP tax committee remains. On the other hand, the GTC was under the jurisdiction of the Ministry of Finance, and typically centered on how to raise taxes, regardless of economic impact. In the past, the LDP tax committee usually won when there were fights over tax policy. In fact, Mr. Yamanaka’s most famous bon mot was, “I don’t scorn the GTC. I ignore it.” Then, last autumn, PM Abe changed the game. He transferred the jurisdiction of the GTC to the Cabinet Office, with the explanation that the tax system rightfully belonged where the entire government — not just the tax authorities — could participate in the debate. After one GTC chairman resigned in December, PM Abe then appointed Mr. Yukaka Kosai, one of the country’s best economists and a member of the Takenaka ad hoc committee on financial reform, as the new GTC chairman. The debate on rebuilding the system has started. Kosai has already said that the GTC’s old principles need review, and has suggested “honesty, simplicity, and vitality” as a potential alternative. (There is a translation problem. The original principles used the term ‘kohei’, and Kosai used the word ‘kosei’. Both can be translated as ‘fair’. However, by changing words, Mr. Kosai is trying to move the basic principle in the tax system toward equality of opportunity, and away from equality of outcome.) The key word is vitality. In the context of the pro-growth policies of the Abe government, Kosai’s suggestion means that tax system revisions will be pointed toward enhancing growth. If actions are taken, this is good news for financial competitiveness. The most frequently heard complaint about the Japanese tax system from potential entrants to the Japanese market is that the corporate tax rate is too high. The Abe government is already aware of this, and has begun to move toward proposing a cut of the corporate rate to 30%. Prior to the Upper House election in July, this agenda item is likely to remain just that. It will be hard for PM Abe to go to the voters and say that corporate taxes should be cut, when corporate profits are at an all-time high, and when wage growth has been slow. However, the global standard on corporate tax rates is now moving toward 30%, and it will be hard for Japan to resist — without risking further hollowing out of domestic production. Hence, after the election and after Kosai’s committee has had the chance to gather hard data from around the world, the corporate tax rate is likely to be cut, in my view. In addition to the corporate tax cut, however, there are several other tax issues. One is the introduction of a national taxpayer ID scheme. The lack of such a scheme has made income hard to trace, and has reduced confidence in the honesty of the tax system. Such a scheme would also make it easier for Japan to track income across borders, and control money laundering. In addition, the tax rate on domestic financial income could be reduced, in order to encourage domestic capital formation. Already, taxation of dividends has been reduced to 10% as a temporary measure, and this could be extended yet again. Moreover, the LDP is also proposing much faster depreciation of capital investments in the budget for the new fiscal year. Simplification remains an important goal, and would have the add-on benefit of encouraging faster computerization and automation of tax filing and processing. Investors have been ignoring tax issues recently, in light of the focus on earnings announcements, geopolitical developments in North Korea and GDP statistics. However, now that these factors are passing, a new focus on structural reform is likely. Tax reform will play a major role. So far, the Abe administration and the LDP are moving in the right direction, in my view. If these moves are sustained, the investors could raise the grades they are giving to the momentum of reform.
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Getting Spring-like
February 16, 2007
By Takehiro Sato | Tokyo
Raising our GDP forecast in light of improvement in global economy We raise our forecast for Japan’s F3/08 real GDP growth from +2.2% to +2.4% to reflect the better-than-expected performance of the US and other major economies and the sharp rebound in the preliminary 4Q GDP figures. Last December, we lowered our growth forecast from 2.3% to 2.2% mainly due to exports because we turned cautious on the outlook for overseas economies. We now effectively take back this downward revision and expect further upside. However, our expected scenario remains unchanged. We think the economy’s direction, toward a breakaway from deflation led by domestic demand, particularly capex, remains intact. As we see it, however, the risks for exports are to the upside rather than downside, considering the US economy’s solid growth despite the housing market downturn, and the yen’s depreciation on a real effective basis. We see a number of nagging issues, however. The YoY change in the core CPI could turn negative soon because of the decline in oil prices, but the index could stay out of negative territory if oil prices rise sharply again. However, they would need to rise to US$80 or more, a scenario that looks unrealistic to us. From a top-down perspective, we expect the core CPI to remain low and stable because a low and stable labor’s share of income should contribute to sustained productivity improvement. Consumer spending is likely to come out of last year’s slump and normalize somewhat thanks to a modest rebound in wages, but will probably still lack momentum. Following the downward revision of our prices outlook, we lowered our forecast for the GDP deflator because of a weaker personal consumption deflator. Accordingly, we maintained our F3/08 nominal growth forecast of +2.8% (+2.5% for C2007). At the start of the year, we expected 3% nominal growth, which we do not consider a pie-in-the-sky number, and would still look realistic if we have slightly stronger real growth or more favorable prices. Main scenario for Japan’s economy The economy came out of a soft patch in the latter half of 2005, but ran out of steam and hit an air pocket in the first three quarters of 2006. Growth was fairly strong in 4Q, following a weak 3Q, but has not recovered fully, in light of the trend in consumer spending so far this quarter. The prospects for a consumer spending-led recovery look doubtful, considering the downward pressure on wages from globalization and the aging population. The number of regular employees is growing by more than 1% a year, but mainly in low-wage sectors. As a result, employees’ incomes are not growing as fast. As employees’ income rises only in line with economic growth, partly owing to a low and stable labor share of income, then the dichotomy between a robust corporate sector and a weak household sector is unlikely to fade away easily. A lack of sufficient confidence in the future trend in social security benefits and burdens is also holding back a rebound in consumer sentiment. Past hysteresis has led to deep-rooted deflation expectations among consumers and a tendency for spending on run-of-the-mill manufactured goods to be put off. That said, the near-term upside for the economy looks likely to come from exports and capex, in light of the prospects for continued strength in corporate earnings, thanks to capital’s high share in contrast with labor’s low share, the resulting strength in capex, and the rebound in overseas economies and the yen’s depreciation on a real effective basis. This scenario of export-driven upside is unaffected by the recent turnaround in the yen’s value because exchange rates affect the real economy with a 12-18-month lag. Meanwhile, consumer spending is likely to pull out of its major slump last year to some extent. Although it is likely to grow by only 1-2% a year, we raise our forecast for consumer spending because the further benefits for corporate earnings from exports and a decline in oil prices should spill over into the household sector, even if just slightly. The consumption improvement is meager, in light of the structural issues noted below. Having said that, these problems may be an excellent opportunity for companies to improve their cost structures. Likelihood of decline in prices The absence of notable growth in wages suggests that labor productivity growth remains strong. This productivity growth and the supporting high levels of capex could heavily restrain price increases. Also, since the economy’s supply capacity is growing about 2% per year, about in line with actual conditions, and spending lacks momentum, the improvement in the output gap tends to be sluggish and prices tend to be low and stable over an extended period. From a bottom-up perspective, the decline in broadly defined utility charges from lower mobile phone rates and deregulation, frequently mentioned at one time, is not a temporary one. In a trend that has sustainability, productivity has been improving in the quasi-public sector thanks to private- and public-sector reform efforts in the past few years. Without noteworthy improvement in the so-called ‘core of core’ CPI, the YoY change in the core CPI could be 0% in the Jan-Mar quarter this year and turn slightly negative in the Apr-Jun quarter because of the decline in oil prices. We think the figure could be negative starting with the March reading (scheduled to come out in late April) and be negative for the rest of 2007 or F3/08. While we expect prices to decline, we do not anticipate a reversion to deflation. Whereas the BoJ overestimates the impact of the productivity deterioration (the rise in unit labor costs) on prices, i.e., it underestimates the underlying strength of the quiet productivity revolution going on in the economy, we see room for further improvement in productivity. Based on our global economics team’s oil price and exchange rate assumptions, we expect the GDP deflator to turn positive in the July-Sept quarter owing to an improvement in the domestic demand deflator and a decline in the import deflator, and lead to the first unwinding of the reversal of real and nominal growth in 13 years. This outlook is one quarter later than we previously expected, because of our downward outlook revision for the personal consumption deflator, in addition to the price outlook. An end to deflation is old news for the market, but it remains to be seen whether the government will officially affirm this in 2007, considering the high possibility of a decline in the CPI. Policy and market implications The government currently appears passive on the issue of a consumption tax increase because it aims for fiscal reform without tax increases, but debate on the issue is likely to heat up after the upper house election this summer, regardless of how well the ruling coalition does in the election, because the election results will probably lead the ruling coalition to recognize that a stable foundation for the social security system is the public’s biggest concern. However, the actual tax hike is likely to be pushed back to F3/11-F3/12, because it would be politically impractical to raise the tax in F3/10, considering that a general election comes up in the summer of 2009. We accordingly do not factor the impact of a consumption tax increase into our forecasts. In light of the likelihood of the change in prices turning negative in the Apr-Jun quarter of 2007, we think it will be increasingly difficult for the BoJ to justify a rate hike in April or later if it passes on one in February and March. We thus expect the BoJ’s target policy rate to be no higher than 0.50% by year-end (or the end of F3/08), even if the BoJ raises rates in February or March. With the economy likely to be on the strong side, led by exports, and the BoJ’s monetary policy likely to become even more accommodative, trends typical of the early phases of bubbles (e.g., outperformance by the stocks of companies with substantial land assets on their balance sheets) are already apparent and may gain momentum. Risks The scenario we outlined is an economically ideal soft landing, although the market implications are a separate issue. Risk factors for a Goldilocks economy, with stable growth on par with or better than the potential output growth rate and low and stable prices, include the following: 1) A deterioration in market sentiment if the change in the core CPI turns negative: Prior to the G-7 meeting last weekend in Essen, Germany, US Treasury Secretary Henry Paulson said the yen’s weakness is based on economic fundamentals. We think the comment is nothing but an acknowledgment by the US government of the weakness of Japan’s economy. A decline in prices could also make overseas investors more cautious on Japan’s economy. 2) A sharp rise in oil prices: Our scenario for the CPI is premised on stable oil prices. If the improvement in the global economy leads to an unexpectedly strong bounce-back in oil prices, the negative core CPI could be for only a short time, which may result in accelerated rate hikes by the BoJ. 3) Re-emergence of inflation concerns in the US: In line with the Fed’s outlook, inflation in the US is settling down while the momentum in demand is recovering despite the housing market downturn. Cost-push inflation concerns could re-emerge, in light of the domestic demand growth of 4% SAAR, which is on the strong side, and the pick-up in wage growth. An unexpected shift by the Fed toward a hawkish stance could lead to a rise in long-term yields, a pullback in stocks, and a dampening of economic sentiment.
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Pursuing a Balanced Agenda
February 16, 2007
By Deyi Tan | Singapore
FY2007 budget announced The government announced the FY2007 budget yesterday. The measures taken were mostly line with market and our expectations. The FY2007 budget shows the government continuing to focus on staying competitive and nimble in the global landscape. However, the government is also trying to balance the need to stay competitive with increased allocation to meeting rising social needs. We highlight three key themes. I) Focused on economic competitiveness The government continues to improve economic competitiveness by reducing direct taxes, such as corporate tax (from 20% to 18%). Singapore already has one of the lowest corporate tax rates in Asia Pacific. This round of cutting will bring the corporate tax rate to just 0.5ppt shy of the 17.5% rate in Hong Kong. Corporate tax rate cuts are necessary as Singapore does not have natural advantages such as critical mass in terms of domestic demand. This means that the government has felt the need to intervene in economic infrastructure and regulation such as taxes. This is likely why corporate and personal income tax rates have been reduced by 6ppt and 8ppt, respectively, between 1997 and 2006. The downside to this, however, is the toll on revenue. Operating revenue as a percentage of GDP has fallen from 20.3% in FY1997 to about 14.1% in FY2006. The share of corporate income tax has fallen from 4.7% to 3.9%. Expenditure as a percentage of GDP has been affected as a result, falling from 16.0% to 14.4%. Unless cuts in the corporate rate and further tax exemptions for certain segments can grow the economy at a disproportionately fast rate, the need for fiscal sustainability will likely require tax hikes in other areas. II) Maintaining the austerity mode In keeping with its austerity mode, the gist of the budget did not deviate from the government’s stance of keeping the fiscal account in balance over the five-year election cycle. The FY2007 budget is expected to be in slight deficit of S$0.7 billion, compared with the -S$1.3 billion in FY2006. In reality, however, the government balance is considerably better if one includes capital revenue (from land sales) and investment income from past accumulated surpluses, which the government excludes in order to maintain fiscal discipline and to keep growing the pool of accumulated surpluses. Nevertheless, to keep fiscal sustainability in the government’s definition of budget balance, the cuts in corporate tax rates and partial tax exemptions have necessitated a hike in the Goods and Services Tax (GST) from 5% to 7% to mitigate revenue losses. In addition, the government is also trying to unlock more investment income as budget revenue in a gradual manner. Currently, the government can use up to 50% of realised net investment income as revenue for budgetary purposes, although the specific share that the government uses each year is not revealed. As recently as before FY2000, net investment income did not count as budget revenue. A formula to unleash more of the overall government surplus is still being decided upon. III) Strengthening ‘social security’ Lastly, the government is also attempting to strengthen the social security system by taking the following measures. First: A higher GST rate hike with effect from July 1, 2007 will affect the lower-income decile more as its expenditure share of income is higher. To cushion the economy from the rate hikes, the government is providing S$4 billion in GST credits and other offset measures (e.g., senior citizens’ bonus, property tax rebate and top-ups to post-secondary education accounts). Second: The government has raised the employer’s Central Provident Fund (CPF) contribution rate from 13% to 14.5%, bringing the total CPF contribution rate to 34.5%. The employer’s contribution rate has been reduced from 16% in 2001 to 13%. Additionally, the wage ceiling below which the contribution rate applies has also been reduced from S$6,000 to S$4,500 over 2003-06. Hence, this step represents only a slight reversal compared with the cuts over the past six years. However, with the government preferring to maintain to the 30-36% range, this move will provide more flexibility to reduce contribution rates again in future economic downturns. Third: To improve the employability of older and lower-wage workers, the increase in employer’s CPF contribution will not be applied to them. For such workers, CPF contribution rates will be reduced but supplemented by Workfare Income (cash payments and government contribution into CPF accounts) conditional on regular work. We acknowledge the contribution of Tanvee Gupta to this report.
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January Rebound on LNY Effect
February 16, 2007
By Deyi Tan | Singapore
Lunar New Year effect: January trade data showed a rebound from December. In our view, this is due to more working days compared to January 2006 (Lunar New Year holidays). The general trend likely remains one of deceleration, as signalled by the US ISM. Specifically, exports rose 15.2% YoY (versus -4.0% in December). Imports rose 12.0% YoY (versus +7.6% in December 2006). The trade balance stood at S$6.8 billion, up from S$2.5 billion in December. Non-oil domestic exports rebound: Non-oil domestic exports rose 11.1% YoY (versus -14.2% in December). Electronic NODX rose 2.1% YoY (versus -19.3%). Most segments showed positive growth, with the exception of disk drives (-8.4% YoY versus -41.1%). ICs and PC parts rose 0.5% and 3.3% YoY respectively. Non-electronics NODX doing well: Non-electronics NODX did well at 18.8% YoY (versus -9.7% in December). Petrochemicals rose 26.4% YoY (versus -1.1% YoY) and pharmaceuticals rose 12.6% YoY (versus -33.0% YoY). Mixed trends in export markets: In terms of end markets, NODX to US was particularly strong at 44.6% YoY, boosted by stronger electronics sales. However, NODX demand from the EU and Japan declined -8.5% YoY and -6.3% YoY, respectively.
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