Global Economic Forum
Jan. 9, 2004
Stephen Roach (New York)
In all my years as a Fed watcher, I have never seen US central bankers take to the bully pulpit as they have in recent days. In the first seven days of the New Year, six speeches were given by members of the Federal Reserve Board. I donít think these efforts are a coincidence. They smack of a carefully orchestrated campaign of economic cheerleading at a critical point in the US business cycle. Fed officials seem to be doing their very best to convince businesspeople, consumers, and financial market participants that this recovery is finally for real — and without serious risk. While normally reticent monetary authorities are to be commended for taking a strong point of view, I fear they may live to regret this exuberance.
In true military fashion, the chairman has led the charge. In a look back on his 16-year stewardship of the Fed, Alan Greenspan lays bare his philosophy and guiding principles as a central banker (see "Risk and Uncertainty in Monetary Policy," remarks presented at the meetings of the American Economic Association, San Diego, California, January 3, 2004). It is a veritable tour de force covering his views on the quest for price stability, crisis and shock management, and the role of asset markets in shaping monetary policy. In my opinion, the chairmanís most provocative insights come in his assessment of the Fedís response to the Great Bubble. His Fedspeak is uncharacteristically clear on this point. Now that the US economy appears to be on a solid recovery path, Alan Greenspan believes that vindication is in order. In his words, "There appears to be enough evidence, at least tentatively, to conclude that our strategy of addressing the bubble's consequences rather than the bubble itself has been successful." This single observation has enormous consequences for the macro debate — not just in the assessment of the Fedís performance in the recent past but also in terms of the prognosis for what lies ahead.
At the crux of this debate is the interplay between three powerful forces that have reshaped the macro climate over the past decade — the effective elimination of inflation, an accelerated pace of globalization, and dramatic IT-enabled technological change. One critically important result of this new macro climate has been the emergence of asset markets as a key driver of real economic activity. That follows from the sharp reduction in interest rates that has been spawned by dramatic disinflation, as well as from the perception of increased returns on financial assets stemming from an IT-led productivity boom. The ascendancy of asset markets has resulted in a significant shift in the mix of Americaís internally generated economic fuel — away from earned income toward the wealth effects derived from investments in stocks, bonds, and property. Globalization has only reinforced this shift, with an increasingly powerful global labor arbitrage impairing job creation and income generation in the high-wage US economy.
The newly ascendant prominence of asset markets changes the rules of the macro game — to say nothing of altering the role of central banks. Greenspan continues to resist this point in public, claiming in his January 3 opus that " most central banks have chosen, at least to date, not to view asset prices as targets of policy, but as economic variables to be considered through the prism of the policy's ultimate objective." But in this case his actions speak louder and clearer than these oblique words. Whether it was the stock market crash of 1987, the seizing up of capital markets in the aftermath of the failure of Long-Term Capital Management in 1998, or especially the burst equity bubble in 2000, the Fed has had little choice other than to take asset markets into explicit consideration in framing its policies.
That takes us to the main issue of todayís macro debate — the efficacy of post-bubble containment policies. From the start, the Fed made it quite clear that it would handle matters very differently than the Bank of Japan (see Alan Ahearne et al., Preventing Deflation: Lessons from Japan's Experience in the 1990s, Federal Reserve International Financial Discussion Paper No. 729, June 2002). Acknowledging that the perils of a burst asset bubble are especially acute at low rates of inflation, the Fed was determined to ease promptly and aggressively in order to avoid the Japanese-like endgame of deflation. And the US central bank certainly delivered by cutting its policy rate fully 13 times and some 550 bp over the 2001-03 interval. The FOMC rewrote the book on the conduct of monetary policy, and Alan Greenspan is now celebrating of the apparent success of this strategy.
Victory laps are dangerous sport in financial markets. Yet that danger has all but been dismissed in the giddiness over economic recovery. Lost in the celebration are the costs of this recovery as manifested in the form of serious and ever-mounting structural imbalances — namely, a rock-bottom national saving rate, record levels of personal indebtedness, a massive budget deficit, and record current-account and trade gaps. These imbalances are very much an outgrowth of the new macro climate and the Fedís post-bubble tactics. Asset-driven economies are biased toward increased debt and reduced income-based saving; lacking in domestic saving, the US has no choice other than to import surplus saving from abroad and run massive external deficits to attract that capital. Moreover, by keeping short-term interest rates low and signaling that it is inclined to do so for some time to come, the Fedís post-equity-bubble damage control tactics have led to a series of additional asset bubbles — property, refis, bonds, and credit instruments. The image of the Fed as a "serial bubble blower" is not that farfetched after all.
We have all been led to believe, of course, that imbalances donít matter. They havenít had much of an impact yet, goes the logic, so why should they matter now? Alan Greenspan goes even further in his January 3 speech, arguing (albeit in a footnote) that "when the next recession arrives, as it inevitably will, it will be a stretch to attribute it speculative imbalances of many years earlier." That remains to be seen. What Greenspan doesnít mention is the means by which these imbalances are being finessed — in large part through massive direct purchases of Treasuries by Asian authorities. The implicit contract: You (America) buy our goods and we (Asia) will buy your bonds — an arrangement that keeps US interest rates low and limits the appreciation of Asian currencies. And so the music plays on — at least for the time being.
The question we must ask is whether this arrangement is sustainable indefinitely. Three considerations suggest the answer is "no." First, America is putting more and more pressure on foreign central banks to up the ante on purchases of dollar-denominated assets. Not only is the current account likely to keep rising, but as private foreign demand for US assets now wanes — $59 billion of inflows in 3Q03 versus $212 billion in the first half — foreign official purchases must pick up an ever larger portion of the slack. Second, foreign central banks are also attempting to reflate their own economies; when they eventually achieve traction and domestic demand starts to recover, surplus saving will be absorbed in their home markets, leaving less available for the offshore purchase of Treasuries. Third, trade frictions and mounting protectionist risks lessen foreign appetite for dollars. In short, I think itís a foolís game to believe that the days of relatively costless external financing by the US will persist in perpetuity. A funding shortfall and concomitant implications for a weaker dollar and higher real interest rates are very real possibilities, in my view.
Macro tells us little about the timing of such an endgame. Thatís more a by-product of the proverbial exogenous shock. But hereís what macro does tell us: The greater the imbalances, the more combustible the flashpoint — suggesting to me that the day of reckoning could be sooner rather than later. Such an endgame would be all the more treacherous for an increasingly asset-based, wealth-dependent US economy. To the extent that a resolution of Americaís imbalances results in higher real interest rates, then the popping of more recently formed asset bubbles becomes a distinct possibility. Thatís when the Fedís bluff is finally called. At todayís exceedingly low levels of nominal interest rates, the options narrow: It would be exceedingly difficult for the central bank to implement another post-bubble damage containment program. This key risk seems all but forgotten in the hubris of the Fedís victory lap.†
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Currencies: A Policy Clash at the G-7 Meeting in February?
Stephen L Jen (London)
There is a distinct risk that, going into the G-7 meeting on 7 February, Japan may adopt a much more hawkish USD/JPY stance, which would severely complicate Euro area exchange rate policy. Even if the wording of the Communiqueís currencies paragraph is not significantly altered, lack of policy agreement between the G-3 will become clear to the market I believe. As a consequence, economic pain from the USD correction will be concentrated on Euroland.
Policies now play an important role. In my view, the sentiment on the USD is so negative that the ascent in EUR/USD may not stop on its own, and can only be halted by policies (intervention and/or rate cuts) or if the Euroland recovery falters.
Two differences between now and the last G-7 meeting
First, compared to the September meeting, the Japanese Ministry of Finance (MoF) now has a much more hawkish stance having announced their intention to secure additional funding for another •61 trillion of intervention capacity. Second, the US is likely more pleased with currency market trends than it was in September. The US continues to experience uncomfortably low inflation (and hence would likely welcome currency weakness) and, so far, the USD correction has been orderly. I believe that as long as inflation remains low and the US bond and equity markets remain stable, there will not be coordinated intervention involving the US.
This will put the ECB in a bind. The combination of a hawkish Japan and a neutral US will put Euroland in a difficult situation:
Scenario 1. Dovish-Dovish
This is the scenario in which both the ECB and the MoF permit the USD to decline. From the perspective of the structural USD correction, this is the best scenario, as it would permit equal burden sharing between Asia and Europe. This is also the scenario favoured by the ECB.
Scenario 2. Dovish-Hawkish
This is the scenario in which the ECB accepts that a further USD correction is inevitable, but the MoF insists on pushing the JPY weaker through intervention. EUR overshoots against both the USD and JPY. Eurolandís recovery could falter, triggering a sharp correction in EUR/USD and EUR/JPY. I personally believe that this is the most likely future scenario.
Scenario 3. Hawkish-Dovish
This scenarioís improbable nature makes it uninteresting.
Scenario 4. Hawkish-Hawkish
If the ECB takes the hawkish stance of the MoF as given, it would then face the prospect of single-handedly absorbing the pressures arising from a falling USD. It isnít difficult to imagine that, at extreme levels of EUR/USD and EUR/JPY, the ECB and the EU finance ministries could also turn hawkish on the falling USD. Coordinated intervention between the ECB and the MoF is what I have in mind in this scenario.
Shift from Scenario 1 to Scenario 2
Right after the last G-7 meeting, we were in Scenario 1. Since November 25, however, a shift from Scenario 1 to 2 has already occurred, with the massive intervention ëarms build-upí and aggressive intervention by the MoF. As I mentioned above, the MoF is likely to enter the February G-7 meeting with a much more hawkish stance on USD/JPY. European officials will have to think hard about how they respond to this change in stance by Japan.
Shift from Scenario 2 to Scenario 4 very unlikely
A call on how the ECB will respond is essentially a call on whether we will see a move from Scenario 2 to 4. I believe this is unlikely: First, it is possible that the ECB does not have the confidence to conduct unilateral intervention to cap EUR/USD or align itself with Japan to support the USD. Even if it is worried about EUR/USD, it is far from clear that the ECB has the confidence to threaten the market, as long as it thinks that the US will not participate in a joint intervention. Second, the ECB genuinely believes that the Euroland economy will continue to recover. This improved economic outlook should elevate the threshold of tolerance for EUR/USD. The risk here is that the economy turns out to not be strong enough to absorb the strong EUR. Two interesting implications of remaining in scenario 2 are that, (1) EUR/USD and EUR/JPY will overshoot further, undermining the recovery in Euroland, and (2) the ECB may be compelled to cut rates before intervening. On (2), it is not even clear if rate cuts would be effective in capping the EUR.
Bottom line
With the US being understandably pleased with the current trends in the currency markets and Japan being determined to support USD/JPY, EUR/USD and EUR/JPY are likely to overshoot, jeopardising the recovery in Euroland, which would likely trigger a sharp correction in EUR/USD.
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United States: Oil and the Dollar -- Regional Discrimination
Richard Berner (New York)
Iíve gotten a lot of pushback on my argument that OPEC is acting as if the loss of purchasing power from a weaker dollar is prompting it to raise oil prices (see "Critical Macro Challenges for 2004," InvestmentPerspectives, January 8, 2004).† Despite statements from the 11 OPEC oil ministers affirming that strategy, clients who know the energy business better than I do tell me that currency doesnít matter.† And it appears that my colleague Stephen Jen logically has shot my argument down in flames.† In my view, however, the argument still has validity.† Todayís asynchronous global recovery is allowing OPEC to raise prices more in dollars than it could otherwise.† So while the purchasing-power argument may be an excuse for OPEC action, dollar-denominated energy prices may still rise as the dollar weakens.
Stephen Jen argues that because OPEC acts to maximize revenue, a weaker dollar and higher dollar-based oil prices would merely shift the mix of its global revenue but not the total.† Assuming that the price elasticity of demand is 1.0 in both markets (a 1% price hike leads to a 1% drop in demand), more crude at lower prices goes to countries whose currencies rise (Europe and Japan) and less at higher prices to weaker-currency regions (the U.S. and China).† And if OPEC producers were price-discriminating monopolists, then they would raise prices more for European buyers than for those in dollar-bloc economies.† Thatís because, courtesy of high specific energy taxes, European buyersí price elasticity of demand for finished energy goods is lower than it is in the United States.† So, Stephen says, the argument is wrong; the global recovery is simply allowing OPEC to raise prices.† The dollarís slide just happens to be tempering those price hikes for European and Japanese buyers (see his "On the Fallacy of OPECís Justification for Price Hike," FX Pulse, January 8, 2004).†
We agree that OPEC is raising prices because it can, and that OPECís regional price setting seems precisely the reverse of price discriminating behavior.† But I still think that the dollarís slide matters for how much OPEC can raise prices and therefore increase revenue.† My argument has two parts.† First, the price elasticity of demand for energy is significantly less than 1.0 in the short run (say one-four years) because it takes time to switch to energy-conserving cars, airplanes, houses and equipment; most estimates are around 0.1-0.3.† Regardless of location, therefore, as long as price is the only influence on demand, higher crude quotes will boost OPECís revenue in the short run.†
Second, of course, prices also influence demand indirectly: Higher energy prices also reduce real incomes like a tax hike.† And that influence of incomes on demand is much more potent in the short run than is the direct effect of price hikes.† It happens that the strongest-growing economies today are dollar-bloc countries, notably the U.S. and China, whose currencies are weakening on a trade-weighted basis.† Knowing that obvious fact, OPEC is raising prices in markets where growth is strongest and thus economies are better able to absorb the price hikes.† In contrast, courtesy of the strengthening euro and yen, oil producers are merely preventing prices from falling in weaker-growth areas like Europe and Japan.† This subtle form of discrimination on the basis of income rather than price sensitivity will actually increase OPEC's total revenue because oil producers are effectively "taxing" the affluent.
Of course, OPEC has more going for it than rising demand.† Although it has less than 40% of global oil production, OPEC only has control over oil prices today because so far, other producers outside OPEC are running at capacity and cannot raise production to steal market share.† While that may change over the next two years — the U.S. Energy Information Administrationís just-released forecasts suggest that OPEC will lose a percentage point of market share by 2005, primarily to Russia — OPECís control over production would still keep prices and thus revenue high.† In addition, OPEC still has the whip hand on proven reserves, with more than two-thirds of the global total.† Absent these factors, OPEC could not raise prices in any currency.
When thinking about revenue maximization, OPEC must worry that long-run price elasticities of both demand and supply are much closer to 1.0.† Both mattered in the 1970s, when sustained high prices encouraged conservation and triggered non-OPEC exploration, sowing the seeds for periodic collapses in price as in 1986.† But as my colleague Eric Chaney has noted, as a rational oligopoly for an exhaustible resource with a strong preference for current income, OPECís strategy of keeping prices high today should more than offset future losses in market share, maximizing the present value of its future income stream.†
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Germany: Will Godot Ever Show Up?
Elga Bartsch (London)
Vladimir: That passed the time.
Estragon: It would have passed in any case.
Vladimir: Yes, but not so rapidly.
-- Samuel Beckett, Waiting for Godot
Waiting for the consumer recovery in Germany bears more than just a passing resemblance to sitting through Samuel Beckettís play Waiting for Godot.† This week weak November retail sales and a significant downward revision to the October data hinted at downside risk to our consumer spending forecast of 0.4%Q during the final quarter of last year, which we probably have to cut by half.† In addition, retailers donít seem to be too happy with the Christmas sales, the income tax cuts implemented this year are slightly smaller than previously envisaged, and some health-care providers, at least for now, seem to be reluctant to cut contribution rates.† So, is it time to abort our call for a consumer recovery in Germany? The much-awaited Godot, after all, never shows up.†
Not so fast.† While we were clearly too optimistic on Q4 consumer spending, thinking that the prospect of significant tax cuts would already propel purchases in the run-up to Christmas, we still feel the conditions for a consumer recovery remain in place.† In fact, given the recent gyrations in the euroís external value, the consumer recovery might end up as the only recovery story in town.† This is because the consumer cycle tends to be largely insulated from exchange rate movements as the impact from a rise in real income caused by a stronger currency typically is more or less offset by slightly softer labour market conditions.† The capex cycle, by contrast, seems to be a lot more sensitive to foreign exchange gyrations.† In addition, consumer spending and retail sentiment might be two completely different pairs of shoes.† This holds even more so in Germany, a country whose retail sector is characterized by low entry barriers and excess capacity.† Consequently Germany witnesses tough price competition and low profit margins. †The price war that broke loose on German high streets in the run-up to the festive season might be bad news for retailers.† But it is certainly good news for price-sensitive German consumers.
In addition to the cuts in income taxes and health-care contribution rates, disposable income growth —the main driver of consumer spending — will largely depend on wage developments and employment trends.† Starting with employment, there have been several items of good news this week.† For starters, it turned out the previous estimates of job losses incurred last year were exaggerated by a considerable margin and that a contraction of 1% for the full year seems more reasonable than the 1.4% the previously released data were suggesting.† In addition, our composite employment indicator, which in the absence of timely payroll data provides information on recent employment trends by aggregating survey data on employment prospects in manufacturing, construction and services, has posted another marked gain in December.† But while available data point to a slowdown in the pace of job losses towards the end of last year, it is probably still too early to look for job growth just now.†
That said, the prospects for job growth to resume in the course of next year are good.† First, German companies have regained the cost-competitiveness lost against their euro area peers in first half of the 1990s.† Second, lower health-care contribution rates, half of which are borne by the employers, should help to lower non-wage labour costs as these reductions should be gradually phased in during 1H.† Third, lifting firing restrictions for smaller firms with up to ten employees at the beginning of this year will likely make hiring easier too. †However, itís not all down to the business cycle and government policies. †Bilateral negotiations between trade unions and employer federations are vital determinants of the labour market outlook too.† They not only determine the size and the structure of wage increases, but also non-wage labour costs such as benefits and bonuses.† In this context it is astonishing to find that more than half of the non-wage labour costs are due to voluntary agreements, not imposed by government regulations.† Now companies are increasingly waking up to the fact that a large part of the cost burden and the institutional ridigities are self-inflicted.† Only this past week a leading German bank and a large insurance company announced major cut-backs in pension benefits.† Similar cost-cutting efforts can be observed elsewhere in both the public and the private sector when it comes to holiday and Christmas bonuses.†
In my view, the most promising avenue to improve cost-competitiveness though is through greater flexibility with regard to working hours by either raising the average workweek or cutting holiday allowances.† For starters, such flexible arrangements allow companies to react to demand fluctuations without incurring hiring and firing costs.† In addition, raising the number of hours worked without fully compensating staff for the additional effort, is a great way to boost cost-competitiveness in the face of a rising euro and EU enlargement. †It seems that workers find it easier to put in the extra hours than to accept a pay cut.† The metal sector wage round is a case in point.† The dispute over wages as such is unlikely to make headlines this winter.† IG Metallís demand for a 4% pay rise for the next twelve months isnít too far away from the 1.4% that the employers deem as the upper end. †Hence, the probability of seeing industrial action once the contract ends at the end of February is small, especially after IG Metall burned their fingers last summer when they suffered a major defeat following an all-out strike in eastern Germany. Negotiators will meet again on January 23 and 28. †The juicy part of the negotiations will be about working hours.
Bottom line
Even though — like the play by Samuel Beckett — the German consumer recovery might leave you with the impression that time is passing very, very slowly, donít give up on the idea of seeing one.† Eventually you might even find yourselves watching Happy Days. †
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Japan: Interpreting CRIC Cycle -- Policy or Inventory Cycle?
Takehiro Sato (Tokyo)
My view of the current point in the CRIC cycle coincides with that of Robert Feldman — for now
My colleague Robert Feldman argues that we are in the Complacency phase of the CRIC cycle (see "CRIC Risks Turn Worse," Global Economic Forum, January 6, 2003), which brings our interpretations of where we stand in the cycle into alignment for the first time in a long while. However, we still have different views about the length of the cycle and the characteristics of its phases, and the coincidence of our interpretation at this point may be comparable to the way in which a broken watch tells the right time twice a day. From our various discussions, it has become clear that Robert and I have different interpretations of the CRIC cycle. Robertís view is that politics and policies determine the direction of the economy and markets. I believe, however, that though policies matter, politics have hardly any impact on the economy, which is mostly determined by the classical inventory cycle. Furthermore, based on the inventory cycle, the crisis phase will not occur in 2004, but will likely be postponed to 2005.
Are the factors determining the CRIC cycle internal or external?
According to Robert, who devised the CRIC framework, the cycle has become somewhat compressed, and has gone through the four phases of Crisis, Response, Improvement and Complacency in a single year in 2003. On this interpretation, we might expect the next crisis to be brief too. However, Robert sees the upcoming crisis as a political one. He interprets the phases of the cycle flexibly, based on how the psychology of the market and human players measure up against events, but the drawback to this type of assessment is that it can appear somewhat arbitrary. However, I am not willing to view a political crisis as a crisis for Japanís economy. Economic performance in a "reptilian economy" such as Japanís is less determined by internal factors such as politics than by external shocks to foreign demand.
From the viewpoint of an inventory-cycle approach
I must change my view of this cycle, however. Previously, I have seen the CRIC cycle in terms of the global inventory cycle (the Kitchin cycle) and as having a duration of about three years. According to Robert, however, this does not represent the relationship between politics and the economy, and hence this may not be strictly speaking a view on the CRIC cycle.
In very rough terms, though, it is also true that since the bursting of the bubble we have been through inventory adjustment phases at approximately three year intervals in 1995, 1998, and 2001, and that these have closely coincided with crises in the stock market. Thus, from this perspective, I have previously automatically viewed 2004 as a year of inventory adjustment coinciding with a crisis for the markets, but due to a technical rather than an arbitrary approach.
However, I concede that the above interpretation is not wholly convincing in light of the current buoyant overseas demand and low levels of inventory, and the cautious stance on inventory management by firms that has been showing up in the production data over the last several months. Low inventory levels at present do not necessarily mean that the risk of future inventory adjustment is correspondingly low, but even so, businesses still do not appear to have overcome the trauma of the collapse of the IT bubble and despite solid overseas demand, there is little sign of planned build-up in inventories. Although this will limit the vigor of production increases ahead, it may also mean the recovery — though tepid — is long-drawn-out.
In thus attempting to avoid arbitrariness in papering over cracks in an analysis, we end up with a somewhat mechanical interpretation that stretches the credibility of the cycle itself. There are clearly limits to a straightforward approach to economic cycle forecasting based on three-year rotations, and that is why I have been avoiding CRIC cycle references of late.
Nevertheless, analyzing the Japanese economy with a quasi-CRIC-cycle approach can be helpful in some cases. While the recession from late 1997 through 1998 was marked by stock-market and financial-system instability caused by instability in the Asia ex-Japan economies, the recession that occurred from late 2000 to early 2002 had its roots in the bursting of the IT bubble. The gap between the two recessions was roughly three years, which is consistent with the textbook inventory cycle. The gap since the previous mini-recession in the first half of 1995 was just under two years, but again, the gap between this and the prior recession (start of 1991 to end of 1993) was roughly four years. After every recession (Crisis phase) it is also true that policies for financial stabilization were implemented (Response phase). Judging from this, I think it relatively safe to interpret the CRIC cycle as being functionally the same as the inventory cycle. Even so, I have to agree that it is impossible to describe this as strictly a three-year cycle.
2004 likely to be another year of Complacency
Robert cites a possible political upheaval as the main event risk for 2004. Certainly, another major setback for the LDP in the Upper House elections would lend weight to the old guardís calls for Koizumiís head. The results of the election hinge upon the economy, however. When the Hashimoto cabinet was in power, the economy had been in recession for more than a year prior to the election, and stocks had been on the decline, so comparing the two cabinets is a little problematic. Also, the old guard effectively has the power to veto critical policy measures, so the Koizumi cabinet may not really be all that relevant to discussion of the economic outlook. In the recent general election, the LDP scored a modest victory, but political decisions made at the end of the year suggest that reform is not accelerating; on the contrary, our impression is that it is in retreat. Thus, my personal view is that political change is unlikely to bring about economic crisis. Although political change may shorten the political life of Prime Minister Koizumi, it may well have no wider impact.
In the same way, the problems in the financial system will likely become less of a market theme. Usually, during a cyclical recovery, there is a decline in the downward migration of debtorsí status, and at some point this is likely to put a stop to further deterioration in bank capital, at least for a brief period. In addition, with the approach of the total elimination of "payoff," set for April 2005, the financial safety net is likely to be strengthened further, via the new legislation that makes possible the injection of public capital into legally "healthy" banks. It is possible that a number of small and medium-sized financial institutions will effectively go under when they confront the elimination of "payoff." But we do not expect this to become a systemic crisis. I think it will be a controlled crisis. In general, the serious crises are unforeseen, and it is truly hard to foresee the crisis. In my view, however, the coming financial problems can be anticipated and dealt with, in both political and monetary terms.
For my part, I think 2004 is likely to be a year of continuing Complacency rather than Crisis. Complacency periods are distinguished by better-than-expected improvements, both in the economy and in the markets. 2003 was certainly such a typical year of Complacency. As 2004 will mark the third year of economic recovery, there will naturally be some skepticism as to its sustainability. In fact, our main scenario envisions a mild economic slump in the second half of 2004.
However, considering 2004 overall, I would have to say that in the near future the risks lie more on the upside than the downside. Exports tend to be led by certain manufacturing sectors, in the traditional pattern. The cyclical aspect will remain strong, of course, but despite the complacency we have seen some structural improvement in terms of reductions in excess capacity. In the manufacturing sector in particular, we see a clear commitment to use the cash flow generated by cyclical recovery to finance structural adjustments, including the elimination of excess capacity. As a result, the sense of over-capacity and over-employment as measured in the Tankan DI has now fallen below its previous bottom reached in September 2000.
Because the pressures forcing structural adjustments will also act to restrain capex momentum and asset prices, I do not anticipate a strong recovery coming, and we will likely see a continuation of the deep-rooted deflationary pressure on general price levels deriving from the deflationary pressure on asset prices. The risks of yen appreciation and geopolitical upheaval cannot be eliminated. Geopolitics, combined with terror threats, are likely to remain as market themes. But given the stability generated by advances in structural adjustment in manufacturing and the benefits of the safety net for the monetary system, I would hope that coming adjustments do not cause the kind of severe economic contractions that we saw in 1998 and 2001. In this sense, 2004 is likely to be another year of muddling through.
2005 likely to be the year of crisis
As I have discussed before, I view the CRIC cycle as more prolonged than does my colleague Robert Feldman. He argues that this is just an inventory cycle and not the CRIC cycle; in this case I will readily accept such criticism. And if the improvement-complacency phase continues through 2004, the next Crisis period could be postponed until 2005. The 2005 crisis could take the form of a traditional inventory adjustment brought on by a contraction in external demand, possibly caused by a decline in fiscal spending (including tax cuts) after the US presidential election. Alternatively, continuing dollar weakness throughout 2004 could destabilize the global economy. Our currency economics team projects a rate of •90/$1 by year-end 2005. This would clearly be beyond the bounds of an orderly currency adjustment, and could cause a repeat of the 1995 pattern, when the strength of its currency threw Japan into recession. Nor can the risk of inventory adjustment be ignored.† The political and financial crisis of 1998 and the collapse of the IT bubble in 2001 were ultimately caused by inventory adjustments in the manufacturing sector. You do not need Marxís terminology to realize that politics and finance are like the upper stories of a building, sitting on top of the lower story, i.e., the economy. If the economy is sound, politics and finance should muddle through somehow, even if they remain a bit fragile. But if the bottom story is inadequate, then the upper stories are going to start leaning, no matter how well-built they are themselves.
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Japan: "Pragmatic BoJ" -- Toward Phase 2
Takehiro Sato (Tokyo)
The ongoing game of chicken
The F2003 supplementary budget draft already allows for an additional FB issuance of •21 trillion on top of •79 trillion to fund the currency market intervention. However, as a result of the ongoing large-scale intervention, the current allotment for F2003 FB issuance has been nearly depleted.† The supplementary budget cannot pass the next ordinary session of the national Diet until late January at the earliest.† To prepare beforehand for the possibility that issuance amounts will be fully used, foreclosing this method of market intervention, on December 26 the government and the BoJ concluded an agreement on swapping yen for foreign bonds held by the government foreign exchange special account, to supply some financial and psychological support as the yen appreciated around year-end.† But in a "show-me-the-money" market, the restraining effect is currently limited.†
By early next week, the MoF will likely have to use its swaps to secure yen.† As a result of the large-scale interventions that depleted the budgetary allowance framework, for December alone about •2.3 trillion was supplied to reserve accounts of the counterpart private commercial banks.† But due to capital drain operations, the current-account balance held at the BoJ has remained stable at around •30 trillion, virtually the middle of the target range since October 10.† Perhaps for this reason, overseas investors increasingly ask whether BoJ intervention is sterilized or not.† Top government officials and investors are showing renewed interest in the slowdown of monetary base and monetary supply over the past few months. Somehow, the forex markets and the monetary authorities seem to have begun a new round in the ongoing game of chicken.
The symbolic meaning of unsterilized intervention
For some time the media and some market participants seem to have entertained misunderstandings about the effect of unsterilized intervention.† In particular, as the dollar purchasing intervention of April-June 2003 (about •4.6 trillion) in general matched the increase in current-account target announced after the appointment of Governor Fukui, the idea seems to have spread that BoJ yen intervention was unsterilized.† The BoJ itself did not deny such a speculation, possibly for producing an announcement effect.† However, there is no particular theoretical ground to expect unsterilized intervention to be effective in a zero interest rate environment.† This is because the only impact of unsterilization is to lower interest rates by expanding the supply of capital.† The related arguments have at times tended to bore domestic investors, as well as us.†
However, even if the discussion appears to be meaningless, one must realize its symbolic significance.† Governor Fukuiís case is an example. The policy change on October 10 reflected the diplomatic ineptitude of Japanese currency and monetary authorities at the Dubai G-7 meeting in September.† This was reflected in the contradictory upward revision of the economic outlook combined with a kind of monetary easing.† However, for stock market investors, there has been a steady flow of symbolic news that the government-BoJ structure of cooperation is working smoothly, and that the BoJ is steadily providing a lavish flow of liquidity.† This has likely been important for limiting downside risk.
BoJ could once again embrace "pragmatic" response.
Since the Dubai G-7 meeting last September, the forex trend shifted from one of isolated yen appreciation towards that of general dollarweakness.† However, in real terms the effective yen rate has remained comparatively stable, so in the current case there is probably no imminent reason to worry excessively about excessive yen strength/dollar weakness.† However, as we approach the summer Upper House election, the government is likely to focus on financial stabilization and maintenance and strengthening of corporate and employment safety nets.† There will likely be more opportunities to make demands on the BoJ without regard to usual niceties.†
Traditionally, the BoJ has a tendency to avoid the impression of changing monetary policy triggered by the currency market instability.† Even more, Governor Fukui is likely to try to avoid leaving the impression that he is acting under pressure from the government and the market.† So, beforethe BoJ gets too tightly encircled — as early as January 18-19, or else on February 5-6 in the regular monetary policy meeting (directly before the next scheduled G-7 meeting in Florida) — the BoJ might once more adopt a pragmatic response by raising the current-account target.† This would be "pragmatic," because it would put priority on coordination with the government and the markets, even if the action has only limited impact and is near to theoretically meaningless.
Exit policy fading away
Notions of an exit policy were temporarily foreclosed at the October 10 policy meeting when the definitions for escaping deflation and the condition to lift the current policy framework were toughened.† In fact, even though the nationwide CPI inflation rate touched positive territory in October, expectations that zero interest rates would continue were not disturbed, thanks to the BoJís strong commitment.† Furthermore, we have a sense that the BoJ is now increasingly in a difficult position to pursue an exit strategy due to the rise of the yen, considering the MoFís decision to stem the yenís ascent by unprecedented massive intervention.† Having additionally raised the current-account target, which produces no specific result, the BoJ finds that it is not easy to withdraw, as has happened with MoFís market interventions.† Escaping this blind alley would require some catalyst, such as a reversal in the weak-dollar trend, or stock prices breaking out past the TOPIX 1,200 level.† But this does not seem likely until the April-June quarter at the earliest.† The stock and forex markets are likely to remain in a tough situation during January-March period, also partly as anomalies.
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Global Emerging Markets: In a Sweet Spot
Riccardo Barbieri (London)
In retrospect, 2003 was a very good year for the global emerging markets (GEMs), on both the equity and the fixed-income front. The MSCI Emerging Markets Free Equity Index (EMF) gained 51.6% in dollar terms, following an 8.0% contraction in 2002. On the bond side, the Morgan Stanley's Sovereign Index rose 25.4% in dollar terms (and on a total return basis), after a 13.1% gain in 2002. The question on every EM investor's mind is whether this strong performance points to the risk of a major correction in 2004, or whether we should expect further gains instead, albeit more modest ones than last year.
Economic fundamentals support this exuberance
We leave the critical issue of valuation and asset price forecasting to our strategist colleagues. From an economic standpoint, though, we believe that, while several countries are still in fragile economic and financial condition (notably in Latin America), on the whole, GEMs are currently in a sweet spot. Our main concern remains event risk, particularly in the form of terrorism. Apart from this factor, which is very hard to quantify, we believe that the world economy will experience strong growth this year, perhaps even beyond the latest Morgan Stanley projection of 4.2% growth in world GDP (up from an estimated 3.2% increase in 2003). In my view, the key features of the scenario painted by the Morgan Stanley forecast is the strong average growth projected for the American economy, and a return to growth for all the regions of the world, Latin America included. Our colleague Andy Xie expects China to slow somewhat, but China's growth inertia is such that it will take a while before the slowdown being engineered by the policy authorities starts having a meaningful impact on its industrial activity and on its call on global resources.
Commodity prices likely to stay elevated, though certain precious metals may drop in due course
Commodity prices are a key factor for Emerging Markets, especially in the fixed-income sphere (the largest components of the global index are resource-oriented economies). Commodity prices rose very strongly in 2003, particularly precious metals. We believe that the trend in commodities, and particularly metals, has been driven by large inflows into specialized investment funds, and that the surge in metals prices exceeds what could be explained by final demand considerations. However, given a very inelastic supply, the current state of affairs may continue for some time. We would expect that as and when US monetary policy returns to a more neutral stance (and fiscal policy is tightened), precious metals prices will decline from their elevated levels. Alternatively, one can imagine a bursting of the precious metals bubble along the lines of what we saw for tech stocks in 2000-2001. For the broader universe of industrial and food commodities, though, the pick-up in the global economy and the weakness of the dollar suggest to us that prices will probably stay high over the next two years compared with their long-term averages.
The weak dollar augurs well for a further decline in interest rates in local markets
The 1997-2001 period was marked by a strong dollar exchange rate, huge capital inflows into the US, and repeated currency crises in the emerging markets. The dollar correction of the past two years has allowed Latin American and EMEA currencies (notably the rand and the Turkish lira) to recover and has thus paved the way for lower inflation and interest rates in those countries. This very much remains a theme for 2004, in our view. Although the easing process is nearing an end in several countries, e.g., South Africa and Poland, in Brazil and Turkey — to mention the two most significant cases — we expect that exchange rate stability and continuing disinflation will lead to further significant rate cuts over the course of this year.
Weak-dollar environment also likely in the medium term
Whatever the timing and extent of the adjustment in Asian currencies, one important conclusion seems to hold: the weak dollar phase will probably last for several years. Significantly tighter US fiscal policy would help reduce the US current-account deficit and thereby alleviate the need for a weaker exchange rate. Otherwise, to the extent that the rest of the world cannot or does not wish to continue to accumulate US assets, we believe the dollar will have to remain weak enough to cause a sharp improvement in the US current account. As for the length of the adjustment, considering that we are only two years into the dollar's decline and that only in 2003 has the dollar left overvalued territory, in my view it would not be surprising if the weak-dollar phase lasted until at least 2006.
Oil prices are also supportive
Two major EMs — Russia and Mexico (36.4% of the bond index) — are major oil exporters. Needless to say, high oil prices have been a key driver of the rise of these two countries from restructuring or default to investment grade — particularly Russia. At the same time, due to dollar weakness, oil prices are not abnormally high when translated into third currencies, e.g., the euro. High oil prices in dollar terms and a weak dollar are thus a happy medium for both producing and (at least some of the) importing countries. The oil market is telling us that prices will remain elevated over the course of this year. As we write, the June Brent contract is trading at US$29.33/bbl, only a little lower than the US$31.1/bbl spot price. Our global economics team has adopted an oil price scenario that is only a touch lower than current market pricing. The average forecast for Brent oil is US$28.7/bbl in 2004 and US$26.9/bbl in 2005.
G-3 central banks likely to stick to reflationary policies for quite some time
The key question for GEMs is, when will the US Federal Reserve signal a change in its policy bias and, later on, start hiking the Funds rate? The latest statements by Fed officials suggest that a change in the policy bias is still some months away. Our US colleagues have been predicting the first tightening move for the third quarter of this year. Meanwhile, the debate on the ECB has shifted to whether it ought to cut interest rates to offset the rise in the euro. In Japan, no change is expected on the part of the BoJ. If this scenario does play out, we have 3-6 months before the markets face concrete prospects of a G-3 rate hike. Moreover, according to the Morgan Stanley forecast, US monetary policy will not return to neutrality (i.e., to a funds rate in the 3% area) before late 2005.
Country-specific factors the main caveat
Experience tells us that emerging markets are more likely to come under pressure during phases of strong dollar and/or high interest rates and/or weak commodity and energy prices. If the above analysis is broadly on the mark (and we have not touched on aspects relating to capital flows, which are also very supportive for GEMs), then we should not be overly concerned about one of the leading EMs experiencing a major shakeout or crisis in the short run. However, the experience of Brazil in 2002 illustrates how abruptly confidence can falter for political or economic reasons. As we write, Turkey has just issued a 30-year dollar bond at a yield of 8.23%, while the stripped spread for the Turkish Eurobond market over US Treasuries is at a historical low. This comes just days after the government granted an outsized wage increase to public-sector employees and delayed any further fiscal policy tightening until after local elections in the spring. Something tells me that when the global liquidity cycle turns, country-specific factors will be back with a vengeance and life will be a lot more difficult for highly indebted countries. However, it seems to me that this is mostly a 2H04, if not a 2005 story.
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Turkey: Marxís Revenge
Serhan Cevik (London)
The lowest inflation rate in the last three decades is a harbinger of stabilisation. The consumer price index increased by 18.4% last year, down from 73.2% at the beginning of 2002. The outcome is slightly better than our estimate of 19.0% and shows an outperformance of the official inflation target for the second consecutive year. The pace of disinflation in terms of wholesale prices has been even more spectacular, declining from 92.0% in 2002 to 13.9% last year. These figures validate our view that the inflationary behaviour of the Turkish economy has undergone an amazing transformation and that the case for single-digit inflation is no longer a mental exercise. There are numerous factors contributing to rapid disinflation, but the key driver, in our view, has been the declining share of labour in national income and the resulting ëdemandí gap.
Seasonally adjusted data point to rapid disinflation towards a single-digit figure. According to our calculations, the CPI recorded a seasonally adjusted month-on-month increase of 1.0% in December, which implied an annualised inflation rate of 9.0% over three months, down from last yearís peak of 34.4% in March. In a similar fashion, the WPI posted a seasonally adjusted annualised inflation rate of 8.3% last month, down from 45.3% in February. Crucially, core price indices that measure the underlying inflation rate have remained significantly below the central bankís moving targets. Our computations show that private-sector manufacturing prices registered an annualised increase of 10.3% in December, down from 40.2% in February. Likewise, the annualised rate of change in the ëcoreí CPI declined from 27.7% in April to 16.2% at the end of last year.
Disinflation has not taken place just because of exchange rate valuation. After suffering the painful side effects of artificial remedies, the Turkish authorities have finally been able to disinflate the proper way — that is, through monetary discipline supported by fiscal austerity and structural reforms. Still, many observers believe the "miracle" is simply an illusion created by exchange rate appreciation. Without doubt, the US dollarís weakness and the liraís real appreciation have supported the disinflation process, but we believe there have been other — more important — reasons in accelerating the pace of disinflation. Institutional factors such as central bank independence, fiscal improvements, and the advent of greater globalisation and competition have made notable contributions to disinflation dynamics. Even the favourable currency pass-through effect is a result of cyclical and structural improvements such as productivity-driven export growth and a rebalancing of domestic portfolio allocations and firmsí working capital.
Surging productivity growth has accelerated the pace of disinflation, in our view. Labour productivity in the manufacturing sector rose by 8.0% in the third quarter of 2003, up from an average of 3.9% in the first half. On a seasonally adjusted basis, the underlying growth of labour productivity increased to an annualised rate of 13.5% in the third quarter, from 9.4% in the first half of 2003. Although cyclical factors have played an important role, one should not underestimate the influence of structural elements. Total factor productivity, which reflects improvements due largely to structural factors, accelerated from an average of 0.5% in the 1990s to 4.7% in the last two years. Turkey is at last in a position that should allow it to reap the benefits of economic liberalisation. The customs union agreement with the EU, for example, exposes Turkish firms to greater international competition. Indeed, increasing competitive pressures since 1996 have put profit margins on a secular downward trend.
The output gap can help us to gauge the temperature of the economy. As argued above, there are a number of factors that influence price changes, such as peopleís expectations for future inflation, exchange rate movements, wage and fiscal developments, import prices, and productivity growth. However, empirical studies show that the state of the business cycle is one of the most important of these influences. When the economy is experiencing a period in which resources are underutilised, there tends to be more disinflation pressure than inflation pressure. On the contrary, when the economy is going through a period in which resources are heavily used, the balance of pressure tends to push inflation rates up. Our estimates for Turkeyís output gap — the difference between actual and potential level of output — continue to point to ample slack in the economy. The output recovery process has so far helped to recoup only 35% of the cumulative output gap created by the 2001 crisis, and the acceleration of productivity growth restrains aggregate domestic demand in the short run.
Effective economic slack may be greater than what output gap estimates suggest. The output gap is a conceptually useful way of thinking about the inflationary pressure coming from the domestic economy, but measurement errors can occur if the economy is going through a period of structural reforms that lead to higher productivity growth. Moreover, there is the possibility that above-trend growth may simply be occurring because of excess capacity in the economy, which also strengthens disinflationary pressures. In fact, labour-market developments point in this direction. A positive output gap should produce employment growth, but the latest figures show a cumulative job loss of 422,000 in the first three quarters of last year.
Labourís share of national income might be a better measure of the ëdemandí gap. In our opinion, the share of labour in national income is an important variable in explaining inflation variation in Turkey. With declining real wages and employment, the labour share of GDP declined from 30.7% in 1999 to 26.7% in 2002 and, on our estimates, to 25.6% last year. Meanwhile, the 30.4% rise in labour productivity led to an unprecedented 37% reduction in unit labour costs. Of course, productivity gains take a while to feed through to higher growth of labour compensation. In fact, productivity gains are not raising demand as much as might have been expected and may even have been delaying the recovery of investment by enabling firms to increase output without expanding capacity. As a result, declining employment and labour income have created a ëdemandí gap and effectively accelerated the pace of disinflation despite rapid economic growth in the last two years.
A ëminií shock may turn into an obstacle for the disinflation programme. Income policies that are consistent with the key targets of the economic stabilisation and disinflation programme would help to channel inflation expectations in the desired direction. Unfortunately, the government, focusing on the forthcoming local elections, increased the net minimum wage by 34% for the first half and pension salaries by 21.0% for the whole of 2004. Indeed, even with this hike, the net minimum wage is 23.5% below the subsistence level. Nevertheless, not only do these hikes represent a significant deviation from the 12% year-end inflation target and bring back backward-looking wage indexation schemes, they increase the cost of labour and thus put the onus on productivity growth to maintain the countryís competitiveness. In addition, salary adjustments have an unaccounted fiscal cost amounting to no less than 1.0% of GDP this year. Spending cuts and revenue measures may fund the new budget gap, but it will worsen the already-bulging pension deficit and transmit conflicting signals to economic agents. Though a 20% real increase in the minimum wage may arguably influence voter behaviour in favour of the ruling party and reduce political fragility in the future, it is likely to lead labour unions to demand similar wage adjustment for other sectors of the labour market and accordingly cause an adverse shift in inflation expectations.
Conflicting policy signals may limit the central bankís ability to ease short-term rates. Even though economic slack should safely allow the central bank to reduce short-term interest rates without endangering its ambitious disinflation programme, the political decisions regarding the incomes policy have introduced unexpected risks to an otherwise encouraging financial outlook. Having said that, we still expect further rate cuts, but they may not come as early as we initially thought. Even so, on a long-term view, the monetary policy rate will respond to productivity gains and the ëdemandí gap. In other words, the policy rate will trend down towards its long-run equilibrium level determined by the underlying rate of productivity growth and the central bankís inflation target. This is why we believe long-term — particularly, above two-year — bonds look under-priced.
The death of inflation would mark a historic turning point. Turkey has suffered from high and variable inflation rates for over three decades, and thus achieving a single-digit inflation rate would signal the arrival of economic stability. Of course, the end of the road is still far away, and achieving price stability in a country with structural infirmities and a long history of macroeconomic instability requires policy consistency. Nonetheless, macroeconomic developments have shown that the country has an exciting long-run capacity for economic growth, and a benign global outlook should help to maintain an above-trend job-creating expansion and disinflation in the direction of the year-end inflation target. However, to sustain the growth and disinflation performance of the last two years, the authorities must keep implementing economic and institutional reforms.
© 2004 Morgan Stanley
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