Currencies
Regionalization and the ‘Ballast Effect’
May 18, 2007

By Stephen Jen | London

Summary and conclusions

Recent large exchange rate movements have had surprisingly little effect on trade.  In this note, I propose one hypothesis that may explain this new conundrum. 

I argue that the concept of ‘trade globalization’ may need to be better defined.  While it is true that international trade has accelerated sharply in recent years, most of the incremental cross-border trade has been intra-regional trade rather than inter-regional.  Specifically, most of the growth in European countries’ trade is with each other while, in Asian countries, intra-regional trade has grown more than trade outside the immediate time zones.  The de jure and de facto economic unions have also nurtured and reaffirmed de jure and de facto monetary unions, leading currencies in the economic blocs to trend with each other.  This means that what may appear on the screens to be large movements in nominal bilateral exchange rates may mean very little in real effective trade-weighted index terms, and the impact on trade and inflation is therefore smaller than many might expect.  In turn, what this means is that exchange rate misalignments (especially PPP-based models) are more likely to persist and not normalize as quickly as in the past. 

Borrowing a term I first heard from a senior official on a related discussion, I call this the ‘Ballast Effect’.  In other words, being a member of a regional economic and monetary union, either de jure or de facto, protects that country from shocks from globalization.   

Elaborating on the notion of a ‘Ballast Effect’   

There are numerous oddities in the global economy and the world’s financial markets.  Many of these ‘conundrums’ — such as low inflation despite rapid global growth and oil price inflation, low long bond yields, buoyant asset prices, low capital expenditures, and global imbalances — are familiar to investors, though not all of them have found proposed explanations fully satisfactory.  I have been considering one more conundrum/puzzle, which is that exchange rate movements do not seem to have a big impact on trade, or that large misalignments in bilateral exchange rates do not seem to ‘want’ to trend toward their fair values. 

The notion of declining trade elasticities with respect to exchange rate movements in recent years has been well-documented, particularly for developed countries.  What this means is that, with globalization, the export demand curves have steepened, i.e., it now takes bigger price adjustments to induce a unit of change in real trade.  Several possible explanations have been proposed by academicians.  First, as countries move up the product ladder, products become more differentiated (the ‘heterogeneity’ argument) and therefore less price-sensitive.  Second, currency hedging may have retarded the responses in real trade as exchange rates change.  Third, global demand (the ‘income effect’) has been so robust recently that the slope of the export demand curve appears steeper, when in fact the export demand curve has ‘shifted to the right’ due to the strong income effect. 

In the last two decades, however, world trade has become more regionalized than globalized, in the sense that intra-regional trade has exceeded extra-regional trade.  We looked at how the directions of trade pattern have evolved since the mid-1980s.  Not only are European countries trading more intensively with each other, but so are the Asian economies.  During the last 20 years, intra-AXJ trade has risen from 15% of total trade in 1986 to 44% now.  At the same time, intra-regional exchange rate variability has also been low.  The combination of (i) a greater share of total trade being intra-regional and (ii) intra-regional exchange rate variability being lower than extra-regional parities suggests that a decreasing portion of the movements in bilateral exchange rates is reflected in the movements in the trade-weighted indices. 

The ‘Ballast Effect’ is not an identification problem but an accounting problem.  The part of a country’s trade that is exposed to exchange rate changes is much smaller than some may presume.  In terms of export demand curves, it is as though what we observe is a combination of two export demand curves: one extra-regional that is affected by exchange rate movements and another intra-regional that is close to vertical, i.e., not sensitive to exchange rate changes.  As the world has become more regionalized than globalized, the weighting on the second export demand curve has risen, giving the mis-perception that somehow aggregate export demand curves have steepened. 

Implications of this ‘Ballast Effect’

I highlight some implications of this effect: 

Implication 1.  EUR/USD and EUR/JPY can stay over-valued for a long time.  I am wondering whether, if trade is more regionalized than globalized, financial flows are more globalized than regionalized.  This implies that cross-border capital movements can drive exchange rates out of equilibrium, with the real sector having limited leverage in wrestling them back into equilibrium.  Large swings in EUR/USD and EUR/JPY won’t really hurt Europe, the UK, Sweden or Switzerland, since the currencies of these economies all move as a pack against the dollar and the JPY and trade intensively with each other.  In a way, they shelter each other from these price shocks.  The export demand curves are steep, relative to movements in the EUR against the USD and the JPY.  I have made the observation before that 62% of the BoE’s GBP TWI consists of other European currencies.  Movements in cable, for example, may hurt the UK’s exports to the US, but would not matter for 62% of the UK’s trade. 

I am not saying that exchange rate misalignments can henceforth move without bounds.  Rather, I am suggesting that the traditional mechanism through which misaligned exchange rates are brought back into line — through tradeable prices’ impact on real trade — may not be as powerful.  Another channel through which valuation discipline can be imposed may be the capital markets, i.e., ‘sticker shocks’ could stifle capital flows if certain foreign assets are deemed too expensive.  An example is the JPY.  Though retail outflows from Japan may continue as the ‘cultural change’ regarding risk appetite may keep lowering the ‘home bias’, there are anecdotal signs that some institutional funds in Japan may temper the pace of their outflows near the 121-122 levels in USD/JPY. 

Implication 2.  Exchange rate-based solutions to global balance may be less effective than traditionalists believe.  A smaller aggregate export price elasticity implies that exchange rates have less leverage on the overall balance of trade.  This also means that it is easier for countries to fail the Marshall-Lerner Condition (which stipulates that the sum of the absolute values of export and import price elasticities needs to be greater than 1 for currency depreciation to help improve the trade balance). 

Instead, relative incomes may be more powerful in effecting global balance.  With regionalization, country-specific data may exaggerate the role of net exports for growth, because part of the net trade is with other members of the same economic zone.  Euroland is a good example of this. Using country-specific data, it is not clear that domestic demand has been the main driver of overall Euroland growth.  However, netting out the intra-regional activities, the picture becomes clearer.  For 2007 and 2008, we expect net exports to contribute nothing to overall GDP, and therefore all of the 2.4% GDP growth is expected to come from domestic demand.  This is great for global balancing. 

Implication 3.  Regionalization could also help explain economic de-coupling from the US.  Lack of awareness of greater trade regionalization could also help explain why many commentators and investors were surprised by the ability of the world to de-couple from a slowing US.   

Bottom line

Contrary to popular presumption, trade is now more regionalized than globalized (while financial flows are more globalized than regionalized).  Greater regionalization of trade, coupled with low intra-region exchange rate variability, creates a ‘Ballast Effect’ whereby nominal bilateral exchange rate movements have limited effects on trade or growth, because others in the region act as a ‘ballast’ to balance out the shock.  This may also help explain why some bilateral rates are so far from their fair values

 

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Currencies
Hike on Potential
May 18, 2007

By Charles St-Arnaud | London

Canadian growth has remained broadly in line with the Bank of Canada expectations so far this year. However, core inflation has remained sticky at levels higher than the BoC expected. To explain the situation, the BoC revised its view of the economy, citing that it is now running a small excess demand due to slower potential growth.

In this note, we look more closely at the reason why potential output is lower and outline the risk that slower labour productivity growth in the near future will lead to a longer period of excess demand and, therefore, a prolonged period of higher-than-target inflation. In this context, the BoC will have to hike rates later this year, most likely in 3Q, to bring the economy into balance.  This would provide further support for the CAD. We currently hold a short GBP/CAD position in our model portfolio.

BoC’s outlook

In its Monetary Policy Report (MPR), published on April 26, the BoC presented its revised outlook for growth and inflation. Growth was viewed as unfolding broadly in line with its expectations, with domestic demand being the main driver, while the slowing US economy was a drag. For 2007, growth is expected to return to potential (estimated at 2.8%) at the end of the year, yielding 2.2% growth for 2007, by removing the excess demand from the system. Subsequent years should see growth remaining at potential.

On the inflation front, the BoC acknowledged that inflation has been higher then expected, largely because of greater-than-expected pressures on capacity. Core inflation in 1Q was 2.3%, compared to expectations of 2.1% in the January MPR update. Including the April core CPI at +2.5% y/y, 2Q is now tracking 2.4% compared to expectations of 2.2% in the April report (expectations were 2.0% in the January report). The BoC expects growth to gradually drift lower in 2007 as the output gap closes.

The real growth scenario outlined by the BoC is reasonable, in our view. However, we think that the assumptions on potential growth could be somewhat optimistic and there is a risk that potential growth will be lower than expected.

Risk to potential growth

First, it is important to mention that uncertainty around the estimation of potential output is large. This is why most central banks rely on various measures to evaluate the pressures on output capacity. Here, we will concentrate on the output gap, as it is well-known and widely used by the BoC in communicating its views.

In the last MPR, the BoC substantially revised lower its estimate for potential growth:  “…the bank currently estimates that average growth in potential output over 2004-2006 was 2.6%.  This is somewhat lower than the 2.8% to 3% that had been assumed in projections of potential output growth over that period”. The lower potential output largely reflects slower labour productivity growth, which was not offset by higher labour input growth.

Labour productivity growth in Canada has slowed since the beginning of the century. From an average growth rate of 1.5% during the 1991 to 2006 period, labour productivity growth has slowed to 1.1% during the 2001 to 2006 period. In March of this year, StatCan published an article to explain recent weak labour productivity growth in 2006 and to provide background as to why productivity was low earlier in the decade.

In 2001, labour productivity declined because of cyclical factors. As production slowed, employers did not lay off workers as much as they cut production, expecting a pick-up in demand.   In 2003, labour productivity slowed again due to a series of negative shocks (SARS, power outage in Ontario, mad cow disease, and a hurricane in Nova Scotia), which disrupted production.

The 2006 slowdown is a different story. There was no special factor disrupting production, and the slowdown of the Canadian economy was mild. In its study, StatCan points to some explanation for the current situation. First, the tight labour market and the lack of qualified workers mean that employers need to hire less experienced or qualified labour and therefore spend more time training them. Second, some investment projects take longer to be fully productive while employees are being hired. An example of this would be the oil sands projects. Finally, growth is shifting toward resource-exploitation industries where productivity is declining (e.g., mining). The big question here is how much of the recent slowdown in labour productivity is temporary and how much will be more permanent. Based on data for the first quarter, the sharp increase in employment is likely to mean another quarter of weak labour productivity.

Scenario for the output gap

The BoC expects the current low labour productivity growth episode to be temporary and sees labour productivity rebounding in 2007, bringing potential output to 2.8% for 2007 and 2008, before decelerating to 2.7% in 2009 on slower labour input growth. What if this episode of low labour productivity is more permanent? What then would be the impact on the resulting output gap?

We conduct some basic simulations using the BoC’s outlook for growth and its historical measure of the output gap. The base case scenario is the output gap from the outlook contained in the May MPR. In our first scenario, we supposed that labour productivity growth will remain lower permanently, bringing potential growth down by 0.2 percentage points to 2.6% in 2007 and 2008, which was the BoC’s estimated potential growth for 2004-2006, and to 2.5% in 2009.  The resulting output gap remains positive in 2007, before moving deeper into positive territory in 2008 and 2009. 

In the second scenario, we suppose labour productivity growth remains low in 2007 before accelerating to the BoC’s expectations in 2008 and 2009. This would bring potential growth in 2007 to 2.6%, before a rebound to 2.8% in 2008 and 2.7% in 2009. The result is an output gap that remains in positive territory, but stable, over the whole projection period.

These scenarios highlight the importance of the current labour productivity slowdown for Canadian monetary policy. A persistently positive output gap will likely mean that the BoC will have to increase interest rates in the future, and this is likely to be supportive of the CAD.

 

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Currencies
Dealing with China’s BoP Surplus: Not Straightforward
May 18, 2007

By Stephen Jen | London

Summary and conclusions

The CBRC’s recent announcement to liberalize outward investment by the private sector in China is a modest step in the right direction, in my view, and the immediate impact on capital outflows and China’s balance of payments (BoP) is likely to be limited.  Nevertheless, further relaxation in restrictions on capital outflows is almost a certainty, and will have positive long-term consequences. 

Currently, however, one of the biggest economic challenges China faces is the large BoP surplus.  There are still no straightforward solutions to this issue, at least not through a maxi-revaluation of the CNY.  Political pressure for China to accelerate the rate of crawl of USD/CNY will no doubt continue to mount.  Beijing is, however, likely to only contemplate a modest acceleration in the rate of the CNY crawl.  In other words, it is likely that the US will be forced to take the next step, as China is unlikely to pre-empt the process by accelerating the CNY crawl enough to appease the US.   

The CBRC’s announcement

On May 10, 2007, China’s CBRC announced that the investment scope of the overseas wealth management business of commercial banks would be liberalized, in order to permit Chinese investors to indirectly invest in overseas equities and equity derivatives products.  I have these thoughts:

Thought 1.  The quotas at present are still very restrictive.  Though the market got very excited about this announcement, for justifiable reasons, the short-term impact is likely to be modest.  For one thing, the 18 commercial banks that have the QDII licenses have an aggregate quota of only around US$14 billion.  Since only up to 50% of the products offered to private wealth customers can be in foreign equities, the theoretical maximum outflows into foreign equities would be just US$7 billion.  However, at present, there is minimal interest among Chinese investors in investing in foreign bond instruments, mainly because of the buoyant domestic investment opportunities (in Chinese equities and property markets) and the expectations of further CNY appreciation.  Equity outflows will be restrained by the lack of interest in bond outflows.  In other words, until there is an interest in foreign bonds, any desire to invest in foreign equities will be restrained by the 50% allocation cap. 

Thought 2.  But Beijing is likely to further liberalize these quotas.  There are two main reasons why I think it will be in China’s interest to encourage private capital outflows.  First, the BoP is still massively out of balance.  Official reserve growth is large and growing larger.  After averaging US$221 billion a year during 2004-06, China’s foreign reserve growth exploded in 1Q to an annualized pace of US$544 billion.  In the long run, China should try to effect a more balanced BoP, by encouraging private capital outflows.  Second, at present, more than 90% of China’s foreign asset holdings are in the hands of the public sector.  Over time, it makes sense for China gradually to allow the private sector to build up foreign asset holdings, as a ‘hedge’ against their economic activities.  In other words, increasingly, China’s economic activities are exposed to the global economy.  Yet, this increasing dependence on foreign demand is not reflected in the private sector’s financial portfolio.  Opening up capital outflows should help to resolve this distortion. 

Thought 3.  Whatever China does on this front, it is not likely to stop the protectionist movement on Capitol Hill.  While, in theory, large private capital outflows could eventually obviate the need for any official currency intervention, a balanced BoP position per se, with such a large C/A surplus, will not temper the angst on Capitol Hill.  This is why Japan’s Ministry of Finance, which has not intervened since March 16, 2004, is still in the cross-hairs of the US politicians.  In other words, a balanced BoP position would obviate the need for the PBoC to intervene to soak up excess supply of dollars (‘currency manipulation’), but it would not put to rest the belief held by some US politicians that the CNY is mis-priced (‘currency misalignment’).  Ultimately, China’s savings-investment surplus is still the core issue, regardless of whether private capital outflows could rise enough to offset the C/A surplus.

Thought 4.  Sovereign wealth funds (SWFs) are likely to dominate in the medium term.  The C/A surplus that the private sector cannot recycle will need to be taken care of by the official sector.  I suspect, for China, the PBoC will likely continue to be the buyer of USD of last resort.  This means that reserve accumulation will remain massive.  What will be different, starting this year, is that the marginal dollars accumulated will be increasingly invested in riskier assets (i.e., non-sovereign bonds) through China’s SWF.  At this point, China’s SWF (possibly, but not definitely, to be called the Huei Lian Company) is still in its design stage.  The issues of the size, the modus operandi, recruiting, outsourcing and transparency are not yet determined.  My guess is that this fund will be massive in size, with US$300 billion or so of seed capital, but could grow by US$250 billion annually.  Some operations will be kept in-house, but some (especially the equity portion) will likely be outsourced on efficiency grounds.  The emergence of the SWF in China and other SWFs elsewhere will likely lead to other political issues including financial protectionism. 

China’s BoP surplus a key policy challenge

China’s C/A surplus reached 7.0% of GDP in 2006, and is likely to exceed 8.0% this year.  To understand why Beijing and Capitol Hill don’t see eye-to-eye on the CNY and trade imbalances, we need to take a step back and try to understand each party’s perspective.  I may be over-simplifying, but the US’ view could be characterized as the ‘traditional trade equation’ approach, whereby imbalances are driven by exchange rates and relative incomes.  China’s view on imbalances, however, is quite different.  It is based more on the savings-investment (S-I) gap approach.  These distinct perspectives naturally lead to a currency-centric solution for the former and a non-currency-centric solution for the latter.  This is at the core of the debate.

Despite a high investment rate, China still has an excess savings problem.  The biggest increases in net savings in recent years have not come from the household sector, but rather from the enterprise sector. Enterprises save an equivalent of 20% of GDP, and are contributing an increasing portion of China’s net savings surplus, and therefore its C/A surplus, in the form of retained earnings.  One of the reasons for this is the fact that state-owned enterprises (SOEs) don’t need to surrender their dividends to the central government. Profits have been so rich for these SOEs in recent years that they have been able to finance expensive capex projects and still enjoy solid net savings positions.  Retained dividends by these enterprises have been a primarily financial source of capex, and have made it difficult for monetary policy to restrain capex.   

Further, another factor that has artificially supported these SOE profits is the lack of regulations on the environment and pollution.  The cost structure confronted by these SOEs is therefore artificially low, compared to those of their competitors outside China. 

In a paper by L Kuijs of the World Bank, it was shown that the configuration of China’s net savings position by sector (by HH, enterprises and the government) cannot be explained by demographics or other macroeconomic characteristics of China.  Rather, policies have had a lot to do with the high net savings rate.  One policy option to contain enterprise savings and excess investment is by re-instituting the dividend surrender requirement for the SOEs.  But this is politically ‘tricky’ to implement.  Another policy option is to impose some costs/taxes on pollution to make the cost structure confronted by these enterprises better reflect the true (‘green’) costs. 

In short, while it is also in China’s interest to resolve these structural distortions that are fueling excessive capex and a burgeoning BoP surplus, through the S-I perspective, the solutions to the large external surplus position do not include a maxi-revaluation of the CNY.  This is why China may have appeared to be recalcitrant to some in the West when, in fact, the appropriate solutions are just not straightforward. 

In turn, because of the difficulties of resolving these structural issues, China has had to take baby steps — including the latest announcement from the CBRC — to alleviate some pressures from the system. 

Bottom line

The latest announcement by the CBRC does not change our overall view on the CNY.  We see a modest acceleration in the rate of crawl of USD/CNY this year.  China will likely not pre-empt mounting pressures from the US for China to accelerate the pace of CNY appreciation drastically.  The US politicians, therefore, will be forced to take the next step, whatever that may be. 

 

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Euroland
Electricity Futures and Inflation: Big Rise, Small Effect
May 18, 2007

By Thomas Gade | London

Electricity price futures have risen close to 60% from their February levels. This indicates that electricity spot prices could increase by a similar magnitude over the summer. Financial markets focused on inflation are starting to gauge the possible inflationary pressures stemming from electricity prices. The risk is that they are overestimating the effect. Our analysis shows that short-term volatility in electricity prices at the energy exchanges is not reflected in end-user price volatility. The effect on general consumer prices from the rise in futures prices will likely be limited. Average electricity spot prices this year are still below average electricity spot prices last year. The de-link between electricity price inflation for consumers and electricity spot price inflation could even suggest lower inflation pressure. We would therefore caution against placing too much importance on the recent rise in electricity futures, even if spot prices follow suit.   

Futures not leading spot prices

Our analysis shows that in general electricity futures prices do not lead electricity spot prices. Instead, spot prices seem to be the driver of futures prices and there is a high degree of contemporaneous correlation. Spot prices have also risen some 40% from their February lows, but three-month futures prices have been driven higher primarily as markets are speculating on the likelihood of a record hot summer combined with already low water levels in rivers and reservoirs as well as rising CO2 costs. Although this may be part fact, driving the spot price, and a legitimate concern, pushing up futures prices even further, the risk of these developments ultimately ending up in end-user electricity prices is limited and, if anything, significantly delayed.

Regulated electricity prices

Electricity prices for households are regulated in many European countries. Utility companies can change prices for consumers only at a certain frequency in many countries. In Italy, electricity prices for households to a large extent are changed at a quarterly frequency, while in Germany and Spain they are changed at an annual frequency. In France, end-user electricity prices change at an even lower frequency. Given these regulations, short-term volatility in electricity spot prices does not show up in end-user price volatility, although end-user price changes can be significant when they happen. Moreover, it means that sustained changes in spot prices are passed on to consumers with a significant delay in many countries.

A low weight in the consumer price index

The weight of electricity in the consumer price index ranges from 1.5% in Italy to 2.5% in Germany, while the average for the euro area is around 2%. The pass-through into consumer prices will not only be direct through the ‘housing, water, gas, electricity and other fuels’ component of the consumer price index. It will also occur indirectly through a cost-push in other components of the consumer price index such as hotels, and restaurants in particular, whereby the technical weight in the consumer prices index to some extent underestimates the full weight in practice. Volatile movements in spot prices similar to the recent rise are common. In theory, a 50% rise in end-user electricity prices could add a full point to euro area inflation. In practice, the delayed pass-through is much less. Despite the recent rise in spot and futures prices, average spot prices are still below the average spot price last year and still deflationary on a year-on-year basis. The upward pressure on end-user prices therefore remains limited, we think.

Easing and not rising electricity price inflation?

Following large rises in electricity spot prices through 2005, electricity spot prices remained broadly stable through 2006, looking through the increased volatility. Electricity spot prices have now settled below the 2005 and 2006 average. The delayed effect of rising energy prices has continued to feed through into consumer prices though most of 2006, which may be the reason why electricity price inflation for the consumer has de-linked from electricity spot price inflation. Contrary to the view in inflation-linked markets, the risk is therefore more that electricity price inflation will ease instead of rise going forward.

 

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Turkey
Coining Disinflation
May 18, 2007

By Serhan Cevik | London

The introduction of the new lira was the right move, but it may have had inflationary effects. The introduction of the new lira at the beginning of 2005 eliminated the last six zeros on the currency and symbolized Turkey’s progress towards price stability and economic normalization. With high and variable inflation for more than three decades that turned the ‘old’ lira into funny money, Turks had become used to billions, trillions and even quadrillions in measuring economic values and financial transactions that were truly absurd to outsiders. Consequently, the Turkish lira lost its appeal as a medium of exchange as well as a store of value, encouraging residents to dollarize their financial holdings and even their monthly income flow. Indeed, the degree of dollarization reached more than 50% of financial assets and distorted decision-making processes throughout the economy (see, for example, Sweet Smell of Dollars, April 9, 2003). This is why the lira’s redenomination was a turning point, just as inflation has moved towards the single-digit territory. However, we wonder whether the introduction of the new lira may have also had unintended inflationary consequences.

The ‘rounding up’ effect works differently in Turkey, compared to the euro’s introduction. Before the adoption of the new lira, we thought that the effects of rounding on consumer prices would not be inflationary as with the euro’s introduction. The state of the domestic economy at the time and intensifying competitive pressures left little room for arbitrary price increases. In fact, consumer price inflation kept declining from an annual rate of 9.4% at the end of 2004 to 7.9% in March 2005. And on a seasonally adjusted basis, the annualized rate of change over three months showed a significant easing from 10.6% in December 2004 to 5.4% by the end of 1Q05, confirming our view that the new lira did not lead to higher inflation. However, unlike the one-off ‘rounding up’ impact on consumer prices in Europe, we think that the Turkish case involves the effect of regular price increases, especially in low-cost categories, that are being rounded up. Let’s give an example. If you go to a market or a restaurant in Turkey, you would notice that prices are not usually ‘attractive’, ending with a 5 or 9, like 1.95 lira for toothpaste or 6.99 lira for a combo of kebab and ayran. Instead, prices are mostly ‘round’ without decimals. Such a way of pricing goods and services is not surprising, given the history of high inflation and all those zeros on the currency. However, it may have become a constraint in a low inflation environment, as price increases are also rounded up to the nearest lira. When inflation is at 80%, no one would notice an increase in the price of a good or service from 8 million lira to 9 million lira, but when you have an inflation target of 4%, raising the price from 8 to 9 lira would imply a 12.5% increase.

Small change has become a big problem in terms of pricing behavior and consumer habits. The Turkish Institute of Statistics publishes only the average of raw price data, not the breakdown of underlying prices. Likewise, the weights of individual items in the CPI basket are not publicly available. As a result, we cannot calculate, for example, what percent of prices in Turkey are round or attractive. Nevertheless, the existing, publicly available dataset allows us to make an informed assessment. More than half of the items in the CPI are low-cost, with a price tag of less than 10 lira, and items costing between 10 and 20 lira account for another 13% of the basket. In our view, pricing behavior in these low-cost categories is a source of unintentional inertia and thereby a challenge to disinflation. After decades of high and volatile inflation, consumers remain less attentive to incremental price changes and do not have the habit of using coins. Indeed, even though the authorities have reintroduced kurus — the smallest coin — that disappeared from circulation in the 1980s, the share of all coins declined from a mere 2.1% of currency in circulation in 2005 to 0.6% last year. In other words, small change has become a big problem in terms of pricing behavior and consumer habits, just as it has happened to many other countries (see The Big Problem of Small Change by Thomas Sargent and Francois Velde, Princeton University Press, 2002). In our opinion, with further progress towards price stability, firms should discover the attractiveness of ‘attractive’ pricing, while consumers become more sensitive to small change.

 

 

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Japan
Maintaining Real Growth, Cutting Nominal Forecast
May 18, 2007

By Takehiro Sato | Tokyo

Forecast for real GDP growth unchanged; nominal growth forecast lowered

We bumped up our forecast for real GDP growth in F3/08 to +2.4% in February, and are now reaffirming that outlook. Despite the healthy growth in the January-March quarter we are preserving this view in light of the risk of a modest slowdown in the summer. The summer soft patch was already in our forecast from February, however, and it looks as if the US economic growth pulled out of a trough in January-March and should creep up toward its trend growth rate from the April-June quarter. So we have not changed our core scenario in this update. We still expect Japan’s economy to pull gradually out of deflation, driven by domestic demand, and in particular capex.

Meanwhile, we do need to tweak our outlook for prices, such as the GDP deflator forecast, in view of the current high plateau in energy prices and the ongoing depreciation of the real effective yen rate and the like. While keeping our real growth forecast intact, therefore, we have to peg back our nominal growth forecast to +2.2% for F3/08 due to a lower outlook for the GDP deflator. Specifically, we have pushed back the expected timing for the reversal of nominal and real growth rates by a quarter to Oct-Dec 2007, and the timing for nominal growth to flip back above real growth annually to F3/09.

Main scenario for Japan’s economy

Japan’s economy encountered some turbulence in the June and September quarters of 2006, but then bounced back with high growth in the December quarter and kept this up in the first quarter of 2007. Seemingly slack personal consumption in the June quarter, however, suggests that the economy has not yet been restored to tip-top shape.

(1) Risks of a slowdown in personal consumption: There are uncertainties in the consumption outlook. The first concern is accelerated consumption of spring items as warm winter temperatures brought sales of spring clothing forward into Jan-Mar. Feedback in the Economic Watchers Survey reported sluggish demand for spring products in March with the return of colder weather. The backlash from accelerated sales might continue in Apr-Jun. The second concern is an effect on disposable income from a technical discrepancy in the timing of tax payments. The transfer of tax sources to regional governments from F3/08 has reduced the national income tax burden by ¥150 billion per month (¥1.8 trillion annualized), even after discounting the elimination of the special tax-reduction measure, temporarily lifting disposable income. Yet this means that disposable income should decline from June when taxpayers face higher resident taxes, comparable to the reduction of national taxes. We estimate a substantial ‘tax hike’ of ¥300 billion per month (¥3.6 trillion for the full year) in regional taxes, including removal of the special tax-deduction measure, from June. Households might limit spending from the summer in reaction to lower disposable income if they went ahead and spent extra disposable income from January. This would obviously not be an issue if wages and job growth exceeded the tax increase. However, monthly labor data reports a stronger downward trend in wages from January.

The prospects of a consumer spending-led recovery look doubtful for Japan, considering the relentless downward pressure on wages from globalization and the aging population.  Indeed, the number of regular employees is growing by more than 1% a year, but mainly in relatively low-wage sectors.  Given also the increase in ‘limited’ part-time workers following shorter working hours as the supply of part-timers has dwindled, employees’ incomes are not growing as fast as overall employment.  Also, the government’s target to cut total personnel costs by 5% in the coming five years means that efforts to cut wages/employment in the public and quasi-public sectors (education and healthcare) will begin in earnest soon.

Under such conditions, we expect growth in employees’ incomes to be in line with, or even below, economic growth, and with labor’s share of income low and stable, the dichotomy between a robust corporate sector and a sluggish household sector is unlikely to dissipate easily.  Further, the issue of a consumption tax hike should move to the government’s front-burner after this July’s Upper House elections, regardless of how the ruling party fares, yet a lack of confidence in the future trend in social security benefits and burdens could also harm consumer sentiment, if the consumption tax debate is reignited.

(2) Risk of a slowdown in the corporate segment:  The vibrant corporate segment is also grappling with downside factors for the future. Industrial production strengthened moderately in Oct-Dec 2006 to +2.2% QoQ (after applying the annual revision for 2006), led by higher automobile output. However, we saw a 1%+ QoQ dip in Jan-Mar 2007 in a backlash from robust activity in the previous quarter, chiefly due to a decline in automobile output.

We expect a restoration of production growth in Apr-Jun, yet some risks factors are emerging that might unexpectedly weigh on output from April. The primary concern is that the sub-prime loan situation could prompt lenders to tighten their credit stance, and it could affect auto loans and other related lending. In this context, our autos industry analyst also warns that automobile output expansion could ease from Apr-Jun, with the exhaustion of last year’s compact car boom and sub-prime loan issues. In this regard, the recent BoJ Tankan survey actually reports a gradual rise in ‘excess’ inventory sentiment in the autos industry. Considering the role of automobiles as a leading export driver in 2006 and heavy consumption of electronic parts by the automotive industry, a major setback in automobile output could combine with IT adjustments to weaken overall manufacturing activity.

Even so, with capital’s high share of income, we expect capex to hold strong overall, and drive the Japanese economy basically on a stable growth track.  We look for growth this summer in the 1% range, avoiding a major slowdown.  As the real impact of higher resident taxes marginally recedes in the October-December quarter and beyond, we expect a self-sustaining increase in personal consumption, at around 2% annualized, after a slowdown this summer. US economic growth hit the trough in January-March, but we look for gradual acceleration from April-June in the neighborhood of the potential growth rate. 

Risk of negative prices throughout the year

Stagnant growth in nominal employees’ incomes (+1-2%), despite stable annualized economic growth of around 2%, means that labor productivity (reciprocal of unit labor costs = nominal employee incomes / real GDP) will continue to expand gradually.  This increase in productivity and the supporting high levels of capex should squash any upward price pressure for final demand goods going forward.  Also, since the economy’s supply capacity is growing at about 2% per year, and seemingly near current economic growth, the improvement in the output gap will likely be sluggish and prices should generally be low and stable for an extended period of time. 

From a bottom-up perspective, the decline in broadly defined utility charges triggered by deregulation, including mobile phone rates frequently mentioned at one time, is not a temporary one.  In a trend with staying power ahead, public utilities charges are falling as productivity has been improving in the quasi-public sector thanks to private- and public-sector reform efforts in the past few years.  Also, the increase in private rents (including imputed rents), which carry the greatest weighting among the CPI, currently are lagging behind land price increases, and even seem to be correlating more closely with slack wage growth.

Without noteworthy improvement in the so-called ‘core of core’ CPI, we look for the YoY change in the core CPI, which recently turned negative again, to be negative at around -0.4% toward the July-September quarter as the impact of high crude oil prices one year ago recedes, and could stay sub-zero through October-December.  This forecast depends heavily on oil prices, exchange rates, and core of core CPI trends.  But over the past nine months, the core of core CPI has been down 0.1-0.2% YoY.  There have been several anecdotal signs of price increases, including for food products (mayonnaise, orange juice, etc.), tissue paper and cab fares.  But few seem to be catalysts that can entice a strong rebound in the core of core CPI.   We are accordingly more cautious than before and forecast core of core CPI in January-March 2008 of +0.1% at most.  This puts our core CPI outlook at -0.1% YoY for F3/08 (-0.2% for 2007).  On average for the year, prices are primed to stay negative.  This scenario is no longer a risk scenario, but instead seems fairly likely. 

While we expect prices to decline, we do not anticipate a reversion to deflation.  Whereas the BoJ overestimates the impact of the productivity erosion (the rise in unit labor costs) on prices, i.e., it underestimates the underlying strength of the ongoing steady productivity revolution in the economy, we still see plenty of room for productivity gains.

Policy/market implications

The consumption tax debate has receded temporarily thanks to a sharp improvement in the primary balance, reflecting currently sound tax revenues. But this is merely pre-Upper House election reticence. Regardless of the July election outcome, the consumption tax should replace the constitutional amendment debate after the elections as the hot issue. However, a consumption tax hike on the MoF’s target of April 2009 would be difficult politically if the next general election is indeed held in summer 2009. A more realistic scenario seems to be April 2010 or 2011. Therefore, our current projections do not factor in the swing in demand that a consumption tax hike would provide.

Meanwhile, the BoJ is working feverishly to decouple the latest negative price trends from its policy maneuvers.  But the impending summer slump in the economy and prices makes some impact on shaping policy inevitable.  The derivative (OIS) market puts the odds of an interest rate hike at the BoJ’s September Policy Board Meeting at more than 70%, but we continue to see a possibility of a hike being pushed back until the start of 2008 into the Jan-Mar 2008 quarter. Certainly, negative prices alone wouldn’t be a sufficient reason to hold off on normalizing interest rates.  But if the expected continuation in negative trends into the second half of the year is coupled with an economic slowdown this summer, the BoJ may be forced to move away from its forward-looking stance. 

The asset class most likely to outperform under these macroeconomic circumstances (though we would hesitate to proclaim it) is JGBs. The end of deflation is already a tired story in the stock market, but it will be hard for the market to have much confidence in that until concrete proof is soundly present in the CPI, GDP deflator and unit labor costs.

 

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