Euroland
Resilience and Risks
February 15, 2008

By Eric Chaney | London/Paris

While the short end of the yield curve is pricing a high risk of recession in the euro area, incoming data continue to support our ‘soft decoupling’ scenario: Although slowing, GDP grew twice as fast as in the US in 4Q and data related to 1Q do not point to a significant slowdown. These pieces of news are unlikely to alter the ECB’s still relatively hawkish assessment of the balance of risks between inflation and growth.  Yet, some forward-looking indicators point to a slowdown.  The incoming credit data (especially new mortgages and loans to the non financial corporate sector) as well as leading business surveys (Ifo, Insee, Isae) could signal a tipping point for the ECB’s assessment on future growth.  Looking beyond the next few months, the dislocation of money and credit markets (not the US recession) is the main threat to growth, in our view.  The surprising resilience of continental economies thus far is suggesting that the impact of the credit crisis could be both milder in the short term but also stretched over a longer period of time than we have implicitly assumed.  For markets which anticipate an imminent recession followed by a rebound, this could be the main surprise. Let us now enter into the details.

4Q GDP in line with expectations
GDP slowed to 0.4%Q in 4Q07, after an exceptionally strong 3Q (0.8%Q). Demand details from some of the countries which have reported results (France, the Netherlands) or official comments about them (Germany) suggest that domestic demand may have slowed more markedly, possibly dragged down by a poor performance of German consumer spending, but still supported by corporate fixed investment (4.1%Y, 0.4%Q on our estimates). Both intra and extra EMU trade seem to have sharply slowed, a confirmation that global trade is slowing and, possibly, a sign that companies are becoming cautious on future demand and do not want to be left with excessive inventories.  This might explain the weakness of imports, since inventories have a higher import content than other demand items.

Nothing from Italy, big surprise from the Netherlands, Germany and France in line
Eurostat didn't have much information from Italy – Italian 4Q GDP results aren’t expected before April or May, once a major overhaul of Italian National Accounts is done. My colleague Vladimir Pillonca is estimating that GDP stagnated in Italy and we believe that Eurostat must have made a similar assumption. Given that Italy makes 20% of the euro area’s GDP, this might introduce a slight downward bias. The Netherlands reported a second in a row far above-trend GDP growth rate, at 1.2%Q after 1.9% in 3Q, while we had expected an outright correction. Indeed, domestic demand did correct (0.0% after 1.9%), which does not augur well for future growth, if EMU internal trade slows as we expect. Germany and France both reported 0.3%Q GDP growth, in line with our forecasts, with nevertheless a significant divergence in domestic demand trends, surprisingly weak in Germany and surprisingly strong in France. We would expect some convergence in the near future.

2006 and 2007: Two strong years
4Q GDPs temporarily close the books on a strong 2007 year, with GDP up 2.7%, only a notch below the 2006 performance (2.9%). GDP data will be revised several times before we get the real picture, and they are likely to be revised upward rather than downward, as is most often the case in the euro area. However, the outlook is certainly not as bright as the recent past.

The coming slowdown
Even though the credit market turmoil has not yet translated into a credit crunch, we continue to believe that domestic and external demand will slow in the coming quarters. Housing investment has already started to slow, especially in Spain, and will slow further as banks turn more restrictive on mortgage loans. The next shoe to drop should be corporate investment if, as we think, banks also turn more cautious on corporate credit risks. On the other hand, consumer spending should prove relatively resilient, with inflation due to decelerate in the course of the year, and wages to accelerate, as a lagged result of fast declining unemployment.

Risks: duration of crisis, more than depth
For the time being, we feel comfortable with our full-year 2008 GDP forecast at 1.6% for the euro area. Our survey-based early GDP indicator is pointing at 0.6%Q GDP growth in 1Q (2.2% annualised), while our macro forecast is more cautious, at 0.4% (1.4% annualised). On the other hand, we think that risks for our 2009 GDP forecast (2.2%) are on the downside, as we fear that the credit crisis is more likely to surprise by its length than by its depth. Our rationale is that, in contrast with US banks, which have written off a large part of their portfolios of credit products, European banks are moving more cautiously, despite vocal calls from the ECB.  It has often been argued that marking to market – the essence of the reform of accounting rules – may in some circumstances be pro-cyclical for the economy at large.  This is clearly the case in current circumstances, especially with markets practically closed for many synthetic credit products.  A wait-and-see attitude from European banks regarding their non-performing assets might reduce the depth of the credit crunch, but, symmetrically, it slows the return to normality in the financial system in the post-crisis period.  If anything, the persistence of a wide spread between risk-free short-term government bills (AAA 3M government bonds) and the 3M interbank money market rate is signaling that markets continue to have doubts about banks’ balance sheets.

Little impact on ECB’s assessment
Seen from the ECB’s vantage point, 4Q GDP results are unlikely to change significantly the balance between hawks and doves. Hawks are likely to stress that GDP growth was just in line with the trend over the last three quarters, which implies that the output gap was roughly left unchanged and that domestic inflationary pressures haven’t abated. Doves may note that domestic demand, the component that monetary policy is supposed to influence, is clearly slowing. Both camps should acknowledge that the credit crisis has not yet harmed capex, an important sign of resilience. In conclusion, the ECB will focus more on forthcoming data such as new credit and the key business surveys due at the end of the month. Given the surprising optimism reported in the Ifo and Insee survey in January, a correction on the downside could be in the offing, this time. Insee will report on February 22, Isae on February 25 and Ifo on February 26.

 

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Currencies
Foreign Official Reserves Now Over US$6.4 Trillion
February 15, 2008

By Stephen Jen | London (Lisbon) & Charles St-Arnaud | London

Summary and conclusions
Total world official foreign reserves reached US$6.4 trillion around end-2007, and continue to grow at roughly US$150 billion a month, with Asia accounting for half of this growth, and oil exporters another third of this increase.  We pay particular attention to Japan’s reserve accumulation, which has been more rapid in recent months than can be explained by what we know about the asset composition of Japan’s reserves.  Rather than surreptitious interventions, as some have speculated, we believe that this is due primarily to the large EUR/JPY interventions in 2000, and the lack of rebalancing since then.  It is also possible that there might have been some EUR/USD purchases (i.e., dollar diversification) in 2007, by either the BoJ or the new division within the MoF that aims to enhance the return on Japan’s foreign reserve holdings.

Key features of the world’s official reserve growth
We make the following observations: 

·      Observation 1.  Total reserves are now US$6.4 trillion.  The world’s official reserves continue to grow at a rapid pace, reaching US$6.4 trillion around end-2007, from US$6.0 trillion in September 2007.  The average pace of the world’s reserves is around US$150 billion a month.  This is an acceleration: the average pace of the world’s foreign reserve growth was only about US$30 billion a month in 2005. 

·      Observation 2.  Asian exporters and oil exporters remain the key reserve accumulators.   Of the total stock of reserves, Asia and oil exporters account for US$3.9 trillion and US$1.2 trillion, respectively.  In terms of monthly growth, they account for US$75 billion and US$50 billion, respectively.  With US$1.57 trillion, China is the largest reserve holder in the world, followed by Japan (US$996 billion) and Russia (US$483 billion). 

·      Observation 3.  Interventions dominate reserve growth.  Of the US$150 billion in monthly reserve growth, making some assumptions, roughly 70% of the total may have come from outright interventions, while only 12% came from interest earnings on the underlying assets and 18% from valuation changes (i.e., EUR appreciation).  In particular, the pace of China’s interventions has most certainly accelerated recently, not ‘despite’, but because of, the acceleration in the pace of CNY appreciation.  As investors recognised Beijing’s new policy on the CNY in November, they stepped up their speculative buying of CNY, which meant that capital inflows actually increased, forcing the PBoC to intervene even more than before.  In other words, by accelerating the pace of CNY appreciation, Beijing may have introduced more inflationary pressures.  Similarly, the expectation that some of the GCC (Gulf Cooperation Council) members’ pegs may be brittle has meant that capital flows into the GCC have also accelerated.  

·    Observation 4.  Japan’s reserves are growing suspiciously fast.  Japan’s foreign reserves expanded from US$946 billion in September 2007 to US$996 billion in November, an increase of US$50 billion in four months.  Assuming a 2.5-3.0% return on the underlying assets, Japan should only be enjoying US$25-30 billion in annual investment earnings, or US$6-8 billion a quarter.  Further, it is widely assumed that Japan has the bulk (90%) of its reserves in USD, and the MoF never diversified away from USD.  With such low holdings of EUR, valuation changes – from the rise in EUR/USD – should not have been a major factor generating gains in reserves.  Indeed, what is embedded in our reserve tracker file  assumes 90% USD holdings.  Our presumptive calculations identified a US$13.7 billion gain during September-January due to the returns on the underlying assets, and another US$18 billion from valuation changes, leaving US$18 billion of the reserve increases unexplained by our metric.  Could the MoF have conducted secretive interventions worth US$18 billion?

The case of Japan
There are two possible explanations for such a rapid growth in Japan’s foreign reserves in the final months of 2007: (1) the MoF conducted stealth interventions in USD/JPY or EUR/JPY; or (2) Japan’s reserve holdings may not be as USD-biased as we had thought, i.e., the EUR weighting may be higher than the widely assumed 10%. 

We simply rule out (1), as speculating (1) would be tantamount to accusing the MoF of fabricating data, which is inconceivable.  The MoF publishes detailed daily data on currency interventions, which show that the last time it intervened was on March 16, 2004.  Not only is such a transparent policy commendable, but investors should also appreciate the monumental shift in the MoF’s philosophy towards currency intervention in general.  Under Mr Watanabe’s watch during July 2004 to July 2007, the MoF refrained from intervention as Mr Watanabe believed that decades of one-sided intervention actually damaged market psychology, and made the USD/JPY market one-sided, pitting private sector investors (or the market) against the MoF.  Stepping back and refraining from intervening would, Mr Watanabe believed, ironically allows there to be two-way risk/trade in the market, which should in turn obviate the need for intervention.  This strategy worked extraordinarily well.  Even when USD/JPY approached 100 in December 2004, Mr Watanabe did not intervene.  The Japanese economy was much weaker back then than it was in 4Q07.  If it didn’t intervene back then, it wouldn’t have intervened last quarter: we reject the speculation that the MoF conducted stealth intervention. 

This leaves (2) as the remaining explanation.  If the exposure to EUR is higher than 10%, in contrast to the prevailing presumption, how did this come about?  One possible explanation is that, during 2000-03, the MoF conducted EUR/JPY interventions.  Indeed, according to the data published by the MoF, during this time, the MoF bought a total of €4.3 billion.  Without rebalancing, the appreciation in EUR/USD may have gradually pushed up the weight on EUR in the total reserve portfolio.

To assess the implied weighting on USD and EUR, we ran simple regressions in which we regress the change in foreign exchange reserves on the return on the underlying assets and currency valuation changes. We also include intervention flows to the model.  We find that during the ‘intervention period’ (up to 2004), the implied weighting on USD and EUR was 87.3% and 12.7%, respectively.  For the period after 2004 – which we consider the ‘non-intervention period’ – the implied weighting was 79.9% and 21.1% for USD and EUR, respectively.  (For the entire sample, the weightings were 82.5% and 17.5%.) 

Though this result is sensible and the explanation compelling, there is a slight wrinkle.  The residuals of these regressions spiked during 2007, suggesting that there might have been another break in the currency weighting in 2007.  We suspect one of two possibilities: 

The first hypothesis we have is that the BoJ may have begun to invest its share (around US$40 billion) of the official reserves more aggressively.  The BoJ now outsources some of its reserve holdings to fund managers, and it is conceivable that its reserves may have a higher exposure to EUR and/or not be entirely held in sovereign instruments.  However, the BoJ’s reserve holdings are too small to generate US$30-38 billion of ‘excess’ reserve growth in the recent months. 

Second, the MoF, in an attempt to enhance its investment returns so as to make it more difficult for a prospective SWF to justify managing a part of its reserve holdings, is now investing in a more proactive way.  (A new division has been set up at the MoF to day-trade its reserve holdings.)  It could have bought EUR/USD or have simply been a good day-trader, without significantly altering the USD:EUR weighting.  We suspect that this latter hypothesis is a more likely explanation of the anomalies in 2007. 

Bottom line
The world’s official reserves continue to grow very rapidly, by around US$150 billion a month, reaching US$6.4 trillion around end-2007.  In terms of both stocks and flows, Asia and the Middle East dominate official reserve holdings.  At the country-specific level, Japan’s rapid reserve growth in 4Q07 was a puzzle.  We do not believe that the MoF conducted stealth interventions, but suspect that it may have bought EUR/USD, i.e., diversified, and the rise in EUR/USD exposed the higher weighting on EUR, which we guesstimate to be around 21%, compared to what we had presumed to be the case (10%). 

 

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Currencies
JPY and AXJ Currencies: A Parting of Ways
February 15, 2008

By Stephen Jen | London (Lisbon) & Luca Bindelli | London

Summary and conclusions
After being positively correlated for one generation, the Japanese yen (JPY) and Asia ex-Japan (AXJ) currencies became negatively correlated in 2006, and this relationship intensified in 2007.  This negative correlation is not only distinct on an annual, or trend, basis, but is visible on a real-time (day-to-day) basis.  In this note, we argue that this will likely be the beginning of a structural trend, propelled by both real economies and capital markets.  We maintain a structurally positive outlook toward the AXJ currencies, led by the CNY.  However, even though the JPY is still slightly under-valued and could rally in 1H, on the back of temporary risk aversion- motivated flows back into Japan, we do not believe that Japan offers adequate, attractive enough assets to keep the JPY strong.  In other words, the JPY will likely significantly lag the AXJ currencies in the years ahead, mainly because Japan, as an economy, is unlikely to fully capitalise on the rise of AXJ, in our view.  The prospective decline in Japan’s financial ‘home bias’ will exacerbate these trends. 

Documenting the negative correlation
The five-year moving correlations between the JPY and selected AXJ currencies began to decline in 2006, and turned outright negative in 2007.

In real effective terms, the divergent trends have also been stark during the past 18 months.  With the exception of the Taiwanese dollar, all AXJ currencies moved in the opposite direction to the JPY during this period. 

For decades, the JPY had been the ‘core’ of the Asian currencies, much as the dollar remains the core of the currencies of the Americas and the euro is the core currency in Europe.  However, this relationship in Asia has broken down dramatically.

Our thoughts
We have the following thoughts on this important trend:

·      Thought 1.  Strong Japanese outflows to Asia, attracted by the solid fundamentals.  Cross-border capital flows within Asia have gone through a fundamental change in recent years: portfolio and FDI outflows from Japan, in general, accelerated starting in summer 2006.  But a good portion of these flows has stayed in Asia.  In particular, portfolio flows into AXJ equity markets have been very large.  According to Japan’s International Investment Position at Year-End 2006 – a research report published by the BoJ – direct investments to Asia rose dramatically in 2006.  The increases in the stocks of FDI from 2005 to 2006 were ¥1.0 trillion (US$9 billion) for North America, ¥3.3 trillion (US$31 billion) for Europe and ¥2.4 trillion (US$22 billion) for Asia. But as a percentage of the recipient countries’ GDP, the FDI flows into Asia were substantial.

Similarly, portfolio flows from Japan to Asia have been large, and accelerating.  The BoJ’s data show a sharp increase in equity outflows from Japan: ¥3.9 trillion (US$36 billion) to the US, ¥4.4 trillion (US$41 billion) to the EU, and ¥1.9 trillion (US$18 billion) to Asia.  Again, normalised into a percentage of the GDP of the recipient countries or the underlying market capitalisation, the flows into Asia were substantial. 

Further, if we look at recent portfolio flows, Japan has further intensified its investment in Asia in 2007 according to the balance of payments (BoP) data.  Indeed, we saw portfolio flows to Asia of ¥460 billion (US$4 billion) in 2007.  In light of the credit crisis in 2007, this is a large figure, compared to ¥660 billion in 2006 and ¥100 billion in 2005.  

Large capital flows into AXJ are easy to comprehend.  AXJ offers the highest-octane growth in the world, centred on China.  Japan is investing to not only gain market share on the supply chain for the world’s economy, but also to build up its presence in China and other countries in Asia in order to capitalise on the impending rise of the middle class. 

·      Thought 2.  Capital flows from Asia to Japan are very modest, discouraged by the weak fundamentals in Japan.  According to the BoJ’s IIP (international investment position) data, FDI inflows into Japan have been exceptionally modest.  Total FDI flows were a negative ¥342 billion (-US$3 billion) from the US in 2006, ¥511 billion (US$5 billion) from the EU, and only ¥193 billion (US$2 billion) from the rest of Asia. 

Unlike the US and Euroland, which are still very much the core economies of their respective regions, Japan is no longer a dominant force in Asia.  Demographic headwinds are an obvious challenge for Japan.  But there are other issues also.  For one, many corporations, and certainly the government, are still ruled by seniority rather than meritocracy, in stark contrast to China.  At the same time, gender equality may be more of an issue in Japan than elsewhere.  Japan, in theory, should fight the shrinking labour force and the aging population with regimes that further enhance the improvement of human capital and physical capital, and incentivise risk-taking.  But it is not clear that Japan has devised coherent economic policies aimed at tackling these problems.  Low P/Es themselves will not be enough to attract investment flows, though short-term speculative flows could materialise from time to time. 

·      Thought 3.  Declining financial ‘home bias’ of the Japanese retail investors.  While Japan’s overall financial ‘home bias’ – measured by the correlation between investment and savings across countries – may have declined in recent years, until mid-2006, this was due primarily to official currency interventions, rather than outflows from the private sector.  In fact, looking at some indicators of the portfolio holdings of Japanese retail investors, we believe that there is ample scope for Japan’s private sector to reduce its exposure to JPY assets and accumulate holdings of non-JPY assets in the years ahead.  The portfolio outflows we documented above between mid-2006 and mid-2007 marked the beginning of a structural/generational trend, in our view.  These flows will be temporarily interrupted by the global financial turmoil, but once the dust settles, we believe that these outflows will resume.  Japanese households control about US$13 trillion worth of liquid financial assets (i.e., excluding real estate holdings).  Of this amount, more than 50% is held in cash deposits, and less than 3% is held (directly) in non-JPY assets.  This extreme investment posture looks increasingly out of sync with the changing world.  As investment opportunities outside Japan become more evident and financial globalisation gains pace in general, we believe that Japanese retail investors will expatriate capital again, aggressively, in coming years. 

Bottom line
The correlation between the JPY and other Asian currencies began to decline in mid-2006 and turned outright negative in 2007.  We believe that this negative correlation is well-justified by the divergent economic fundamentals of Japan and the rest of Asia, and expect this trend to persist.   

 

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Currencies
Domestic Demand Holds the Key for Policy Rates
February 15, 2008

By Charles St-Arnaud | London

Summary and conclusions
Data flow from Canada has been relatively positive recently. However, I continue to expect Canadian growth to slow to 1.7% in 2008, from 2.5% last year. The anticipated recession in the US and an expected moderation of Canadian domestic demand should slow the Canadian economy. Growth should then rebound in 2H08. Core inflation is expected to gradually drift lower, reaching 1.0% in 2Q and staying lower than the BoC’s target for the rest of the year. I continue to think that, in response to slowing growth and inflation, the Bank of Canada will lower interest rates by 25bp at each of the next three meetings.

Numerous risk events over the next month could be potentially market-moving: CPI (February 19), retail sales (February 22) and 4Q GDP (March 3). We also have the first speech by BoC Governor Carney (February 18) and the monetary policy decision (March 4). In addition, the presentation of the federal budget (February 26) could trigger federal elections this spring.

Recent strong data
The data flow over the past month has been relatively positive in Canada. The most recent sign of strength came last week from stronger-than-expected employment growth and the upward surprise from the Ivey PMI. The strong labour figures will likely provide some support to consumer spending. Nevertheless, it is a lagging indicator of the business cycle. In addition, as pointed out by Governor Carney, “the BoC doesn’t adjust its outlook to individual pieces of information”. This means that the BoC will react more to changes to expected economic conditions than to present conditions, suggesting a forward-looking approach to monetary policy rather than a data-sensitive one.

Economic outlook
I continue to hold the views expressed in my note on the Canadian economic outlook for 2008. I expected growth in Canada to average 1.7% for the year as a whole, down from 2.5% in 2007. The expected recession in the US will be the main drag on the Canadian economy in 1H08, while domestic demand should moderate somewhat. Growth should rebound in 2H, when stronger demand from the US could remove some of the negative impact from net exports.

On the inflation side, however, the profile was revised following the lower-than-expected CPI numbers for December, as the impact from the past appreciation of the Canadian dollar and the competitive pressures coming from it were stronger than expected. As a consequence, I now forecast core inflation to fall to close to 1.0% in 2Q, compared to 1.5% previously. I expect core inflation to remain below the Bank of Canada’s target of 2% throughout the year.

Monetary policy outlook
Against the current backdrop, I continue to think that the Bank of Canada will remain in a cutting mode, something that was also highlighted in the last BoC policy statement: “further monetary stimulus is likely to be required in the near term”. This position was reiterated by Governor Carney at the latest G7 meeting. We are now in a period where the cost in terms of inflation from cutting interest rates is outweighed by the cost in terms of growth coming from not cutting interest rates. In addition, inflation expectations in Canada remain well anchored close to the BoC’s target. I therefore expect the Bank of Canada to cut rates by 25bp at each of the next three meetings, bringing policy rates to 3.25%.

The shock to the Canadian economy, coming from slower US growth, is mainly external. This means that the policy response will mainly be to limit the impact on the domestic economy and prevent it from spreading to other sectors of the economy. Therefore, we should not expect major rate cuts by the Bank of Canada, unless one thinks that the negative impact of the US recession will spread to household consumption and/or business investments. In addition, the very strong starting point for domestic demand (strong corporate profits, high employment levels) could make the Canadian economy more resilient to the US slowdown.

This means that views on the policy rate are highly dependent on the prospects for domestic demand. On one hand, signs of a sharper slowdown will likely trigger a more aggressive response from the Bank of Canada, as it is the offsetting force to the slowdown in the US. Considering this, the probability of a 50bp cut at one of the next meetings cannot be ruled out. On the other hand, continued strong domestic data would only prevent a rate cut if it is coupled with stronger data from the US. With inflation expected to be lower than the BoC’s target and to be back to target only in 1H09, the BoC has room to buy some insurance against the slowdown by cutting rates now and raising them more rapidly later if domestic demand does not slow. The risks for the policy rate are, therefore, tilted to the downside.

The arrival of Mark Carney at the head of the Bank of Canada could also change the way the central bank conducts monetary policy. Mr Carney already said in interviews that he intends to modernise the Bank of Canada and that he wants to refocus the institution to pay closer attention to global financial markets. I suspect that he may be more market-friendly and active than his predecessor, which could mean more action in the money market (including term repo) in case of renewed market friction. However, changes are likely to be gradual and measured, as the rest of the BoC’s Governing Council have not changed and have been in the institution for many years. Indeed, his recent comments at the G7 over the weekend also point in that direction. In any case, his first speech on February 18 shall prove to be informative.

Upcoming risk events
Between now and the next Bank of Canada rate decision on March 4, there will be many risk events that could potentially be market-moving and that could also alter the market views on the Canadian economy.

On economic data, we have CPI (February 19), retail sales (February 22) and 4Q GDP (March 3). The January headline inflation number will include the impact of the one percentage point cut in the GST. Core is likely to continue its gradual decline and is expected around 1.4%. Retail sales will give a glimpse of how consumer spending is holding up at the end of the year, and should set the tone for the beginning of 2008. 4Q GDP growth is expected to be 1.4% q/q ar., a marked deceleration from the 2.9% q/q ar. growth seen in 3Q. A negative contribution to growth from net exports and an inventory correction should be mitigated by consumer spending and business investment.

As previously mentioned, the first speech by the new governor of the Bank of Canada on February 18 will be important, as it will set the tone for the March 4 monetary policy decision. I expect the Bank of Canada to lower interest rates by 25bp at this meeting, while some market analysts expect 50bp. As said previously, the aggressiveness of the Bank of Canada will depend on the resilience of domestic demand.

The upcoming federal budget
Finance Minister Flaherty will present his budget on February 26. Mr Flaherty already warned that he does not have the margin to provide more tax cuts to support the economy. The budget surplus for the first eight months of the fiscal year is C$6.7 billion and would be on track to reach C$10 billion if we do not include the impact from the GST cut and the C$1 billion aid package announced to help some industries. If we include these, the surplus is likely to be around C$7 billion. However, my estimate does not take into account the impact from the slowing economy and some other fiscal initiatives, which will lower the government revenue in 2008.

Opposition parties have already hinted that they could vote against the budget, as they would like more measures to help the industries negatively affected by the weaker US economy and the strong Canadian dollar. The vote on the budget should be held around March 3. This means that, if the opposition parties vote against it, federal elections could be held on April 14. If we have elections in Canada this spring, the probability of election of another minority government in Canada is very high. In addition, whoever forms the next government, fiscal surpluses in Canada are here to stay, as the political cost for the party who would bring the country back into deficit is extremely high. The IMF’s Managing Director Strauss-Kahn’s push for expansionary fiscal policy is unlikely to find strong support in Canada, in my view.

 

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Japan
Still Going Down
February 15, 2008

By Takehiro Sato/Takeshi Yamaguchi | Tokyo

Decoupling hypothesis dismissed

The decoupling hypothesis, which contends that demand from emerging economies would support global economies during a US economic downturn, has already faded. Complete decoupling is impossible since trade expansion has strengthened links within the global economy. In fact, signs of weaker domestic demand are surfacing in emerging economies as the US slowdown trims exports. Financial markets have been exhibiting strong correlation even if economic trends have decoupled. Japan has a high beta value toward the global economy with its growing dependence on external demand and faces heightened risk of two straight quarterly declines for industrial production, the primary indicator of the economic cycle. The “errant policy-induced slump (kansei fukyo)” is also taking a toll on the economy. These realities are making it increasingly difficult to envision a convincing upside scenario for Japan. We aggressively lowered Japan’s growth outlook for 2008 (F3/09) to around 1% in December and now keep the forecast despite robust growth in the Oct-Dec quarter, discounting for a dual recession both in the US and Japan during 1H08. While our US economics team raised the 2008 outlook to 1.3% based on the emergency economic measures, Japan’s outlook virtually remains intact (real growth: unchanged for C2008 and F3/08; nominal growth: slightly down for C2008, but unchanged for F3/08). The recession should end quickly with a rebound by the US in 2H08, but sluggish domestic demand is likely to curtail momentum in Japan.

There is a risk scenario of zero growth from a combination of major setbacks for the US and China, higher crude oil and rapid yen gains. However, this scenario assumes a simultaneous downturn for all key factors and the chances of this happening are currently low. Slower momentum for the global economy is likely to soften crude oil prices, and the repatriation of capital flows to dollar assets in response to a US recession might provide support for the dollar. We also think that healthy balance sheets at Japanese firms, which have already dealt with the three excesses (i.e., excess debt, capacities and labor), will limit the scale of the recession. Yet it is time to tighten seatbelts since the economy and markets have already started a rapid decline following our December warning.

US entering a recession and pullback risk for Japan too

Our US economic team is already projecting negative GDP growth for two straight quarters in Jan-Mar and Apr-Jun, led by weaker capex.  This constitutes a mini-recession for the US economy in 1H08 by definition.  Japan’s growth rate has risen sharply in Oct-Dec 2007 with support from external demand and capex.  Yet this is likely to be a peak followed by a pullback in Jan-Mar 2008 similar to the US.  GDP, however, is not a good indicator of the economic cycle in Japan since it varies significantly each quarter. The primary indicator is the direction of industrial production. We anticipate weaker output in Jan-Mar.  Further, our auto industry analyst sees the risk of a production downturn in Apr-Jun due to an inventory adjustment in North America. Transportation equipment, including automobiles, accounts for 11.3% of output and 15.0% of shipments in Japan’s industrial production data even excluding steel vessels and rolling stock. The broad scope of this industry causes a substantial impact on related areas as well. Reduced automobile output hence could put downward pressure on overall industrial production. We think, therefore, that a dual recession might occur in Japan and the US during Jan-Mar and Apr-Jun this year.

Key word: Liquidity constraints

Liquidity concerns are likely to restrict near-term economic activity both in Japan and abroad. A severe liquidity crunch in US and European money markets during December crippled the CP market and disrupted corporate finance. Companies shifted from direct financing to bank commitment lines, and bank balance sheets remain bloated. Banks are taking a stricter lending stance in this environment. Credit events, such as credit-related costs, could expand the liquidity crunch into a full-blown credit crunch. Europe is facing a setback in financial intermediation capacity with the erosion of bank balance sheets by subprime-related losses. Japan’s experience in 1997-98 highlights the fragility of economies confronting liquidity constraints. Corporate efforts to retain liquidity by freezing or delaying capex can substantially curtail economic activity. We expect downside for the Japanese economy too if this happens.

The overheated Chinese economy also presents a risk. Our economist covering China expects an “imported soft landing” from a slowdown in export activity. Weaker external demand could be just right for China amid overheated internal demand led by fixed investments. However, snow damage coupled with the impact of volume restrictions on bank lending and other measures aimed at curtailing total demand is creating some shortfall risk even for the robust Chinese economy. We anticipate considerable emphasis on near-term liquidity issues, given this environment. Yet our China team asserts that financial authorities could simply start loosening restrictions if signs of an economic slowdown emerge and the government has room for fiscal stimulus measures. We therefore maintain our official estimate for China at +10% in 2008 despite sharp reductions in G3 economic outlooks. Investors should still be aware of triple-recession risk including the US, Japan and China, if the Chinese economy slips more than expected, since it is hard for macro policies to have an immediate effect (as in the metaphor of pushing on a string) once demand starts weakening. The Japanese economy could even contract if China and other Asian economies rapidly lose ground.

Prolonged errant policy-induced slump

Japan’s “errant policy-induced slump” is already widely acknowledged among investors as “Kansei Fukyo”. The three main components are 1) heightened liquidity concerns for SMEs with de facto volume restrictions and caps on the loan interest rate for consumer financing and a shared responsibility program launched by the Credit Guarantee Corporations (CGCs) in October 2007, 2) a sharp downturn in residential investment under the revised Building Standards Law, and 3) diminished investment in risk assets following implementation of the Financial Products Transaction Law. We are not criticizing these policies as mistaken in themselves. However, poor implementation of new regulations based on schemes devised by bureaucrats is already having enough of an impact to put the economy in jeopardy of missing the government’s initial F3/08 economic outlook.

We think that liquidity restrictions from cutbacks in consumer credit and loans guaranteed by the CGCs, though for very different reasons than in the US and Europe, might be interfering with corporate activity in Japan as well. The scaled-back credit guarantee program is not having a major impact yet since the changes were accompanied by transition measures to cushion the blow. Last-minute guarantee applications submitted through September 2007 prior to changes also alleviated downside. Transition measures include a continuation of full guarantees (safety-net guarantees) for industries with 5%Y sales declines in recent months. Safety-net guarantees will be sustained for the construction industry through the end of March and are likely to continue in Apr-Jun 2008. This support reduced the number of construction industry bankruptcies in December. Yet the transition measures are not permanent and SMEs will gradually feel the effects of tighter liquidity. Small businesses lack the resources to increase wages and capex, with labor’s rising share of capital and the erosion of terms of trade from higher raw material and energy costs. We expect SME problems to remain a drag on the economy in this environment.

We do not foresee a quick rebound in residential investment, which has sharply declined with the revised Building Standards Law, particularly for core condominium starts. The problem has supply and demand roots. The steep climb in land and housing prices over the past 2-3 years, despite sluggish nominal wages, has significantly reduced affordability for households. The condominium contract rate in the Tokyo area hence slipped below 60% in December. The growing number of finished unit sales in the condominium (in contrast to pre-sold units) clearly indicates a supply-demand imbalance. We think that the downturn in residential investment involves more than just a policy mistake by the Ministry of Land, Infrastructure and Transportation.

Supply hurdles are unresolved too. The bottleneck in construction review procedures remains due to an overwhelming shortage of personnel qualified to handle a secondary check for structural calculations. Standalone housing starts had largely recovered to the July 2007 level prior to the revisions impact by December 2007 since these projects do not require complicated structural analysis. Yet core condominium starts are unlikely to fully recover from last year’s setback during 2008, given ongoing demand and supply issues. The residential investment recovery will take even longer at the GDP level since activity is booked on a progress basis. We hence only predict a 3% increase in F3/09 residential investments that works out to an L-shaped trend versus the V-shaped recovery on a 9% gain in the government’s economic outlook. Continuation of the current situation could lead to broader downside for the economy that goes beyond bottlenecks with liquidity bankruptcies for small construction firms and weaker housing-related consumption.

The Financial Products Transaction Law, which was adopted to protect consumers and investors, is interfering with investments in risk assets and having a very different outcome than the government effort to encourage a shift from savings to investments. We do not cover this issue in detail here, considering substantial feedback from front-line operations for investment fund and other product sales.

Inflation finally arrives, but is not welcome

Real income is headed lower in Jan-Mar 2008 with sluggish nominal wages and income while the inflation rate rises due to higher crude oil and food prices. Core CPI is likely to increase by about 1%Y in Jan-Mar, exceeding our cautious outlook and a fairly strong pace, given investor familiarity with price movements in the 0% range in the past few years. Yet the much-awaited inflation gain simply reflects cost-push inflation and is very different from overcoming deflation through a demand-pull dynamic. Recent price increases are undermining consumer and small-business sentiment. The current direction DI in the economic watchers’ survey for January 2008 was even lower than during the economic trough in January 2002. Watcher responses stress a negative impact on consumption demand from repeated food price hikes. While the food price hikes are not having a major impact on overall prices thus far, they appear to be taking a toll on consumers and small businesses. Price hikes normally accelerate consumption, but the upturn without support from higher income is leading to weaker consumption.

The core of core CPI, which had been the foundation for our conservative price outlook, is either exhibiting higher increases or narrowing declines in a wide range of areas, and turned positive for the first time since 1999 in October 2007. However, we maintain our existing cautious price expectations since weaker demand at the macro level as price inflation undermines real income places adjustment pressure on prices for goods and services. The upswing in food product prices hence weighs on demand for other goods and services and thereby causes price adjustments that cancel out the impact on general prices. We do not expect much increase in the core of core CPI and predict a slower core CPI inflation rate toward the end of 2008 given these factors.

Assessments of whether prices can sustain upward momentum must go beyond an emphasis on recent examples of price increases. Many of these increases are the first change in more than a decade, and isolated hikes can be largely overlooked from the standpoint of CPI weight and industry share. However, we would not be able to ignore the impact on consumer prices of frequent price hikes. Price trends hinge on whether these price hikes are accepted by final retailers and service firms and result in multiple increases. We think that this pattern could emerge if nominal wages move higher. Yet it is likely to take until at least 2009 before we observe such activity on a macro basis.

We expect the sharp rise in crude oil prices to delay the timing for the GDP deflator to turn positive on a year-on-year basis. The earliest timing would be Oct-Dec 2008, putting confirmation in actual data in February to March 2009. The domestic demand deflator, meanwhile, should remain near 0%.

Slower jobs market

We are also paying close attention to employment data. The unemployment rate dropped to 3.8% in December 2007 after reaching 4% in Oct-Nov, but the effective job openings ratio has moved below 1x since November 2007 at 0.98x. Although we think that some of the downturn in the job openings ratio since mid-2007 stems from stricter oversight of job opening content by local labor authorities, it is difficult to distinguish between this impact and true weakness in employment conditions. The labor force survey, meanwhile, clearly shows a slowdown with a softer environment at SMEs (rather than large companies), for women (rather than men), and part-time and day jobs (rather than full-time jobs). These trends indicate weaker employment for marginal segments with the most vulnerability to adjustment pressure. Small businesses, which account for 70% of employment, are unable to raise wages as faltering margins maintain a high labor allocation rate. Adjustment pressure quickly affects employment when companies sustain wage levels under these circumstances. We do not foresee a short-term solution since higher resource and energy prices are squeezing margins at SMEs more than at large companies, as evidenced by price DI results in the BoJ Tankan. Declining income at SMEs responsible for 70% of overall employment will hamper consumption as long as this situation persists.

If supply and demand for labor continues to ease, business investment would also be negatively affected. We have tracked the correlation between the job offers-to-applications ratio and capex ratio for the last 30 years. This shows that as labor supply and demand tighten and the marginal productivity of labor worsens, companies have a rising incentive to make capex. But if labor market conditions ease, companies will have less incentive to make fresh investment in additional capacity and labor saving. In Aichi prefecture, for example, the job offers-to-applicants ratio has now dipped from a level above 2x to the 1.8x range. The auto industry has been building up production in other regions due to the difficulty in obtaining factory sites and labor in Aichi, but with demand for autos expected to decline, any loosening of the tight employment markets will dilute the incentives to invest more in plant capacity. Despite this, we are not forecasting a large downturn in domestic capex, as in non-manufacturing industries, especially transportation and electric power, demand for investment in equipment replacement should remain brisk. But with pressure in money markets in the US and Europe sending short-term interest rates up and causing planned capex to be delayed, it is possible that liquidity constraints will take spending plans back to the drawing board in some cases. There would be some negative impact on capital goods exports from Japan in that event too.

Risks

Our revised forecast uses optimistic assumptions that crude oil prices will peak in the near term as the global economy slows and that the dollar market will settle down despite a narrower interest rate gap. Yet we do not project a steep decline in crude oil, given supply restrictions. The risk scenario would be a further upswing in energy prices and rapid yen appreciation accompanied by a prolonged slump.

In this risk scenario, Japan’s growth could decline to 0% in 2008. Higher energy prices could seriously hurt SMEs, which are already struggling, through a further deterioration in the terms of trade owing to margin deterioration. The yen appreciation may mitigate the worsening of the terms of trade and benefit the economy, but deflationary effects are likely to take precedence because of faster initial yen appreciation than corporate cost improvements. Also, a slowdown in China’s economy could seriously hurt Japan’s Asia-dependent economy. Our China economics team expects that economy to continue to grow at a double-digit pace even if the US economy slows sharply, but we see a risk of correction in the Chinese economy as a result of a deterioration in returns on investment because of overinvestment. This scenario, however, requires several worst cases to materialize at the same time, and seems for now a low-probability event. If emerging economies slow, oil prices should increasingly adjust and slow the dollar’s slide, since the dollar’s weakness has been the flipside of high oil prices. In this regard, the worst-case scenario is logically inconsistent. We subjectively give it a probability of only 30%.

Possible positive surprises include another bout of euphoria in the asset markets if policymakers in major countries succeed in containing the crisis by boldly easing monetary conditions and providing liquidity. Thanks to the strong performance of emerging economies, new risk money in search of the next profit opportunities may continue to gravitate toward markets with high expected returns. The economic outlook might improve if crude oil prices fall more than expected on the prospect of slower global economic growth by diluting the tax-hike effect in major economies. We think that lower oil prices would contribute to an improvement of consumer and SME sentiment in Japan, which has slipped recently in reaction to higher prices.

Corporate profits to fall marginally

In this round of outlook revisions, we tentatively keep our top-line profit growth forecast for F3/09 (MoF corp stats base, excluding financials, firms with more than JPY 1 billion in capital) at 2.5%Y, as the nominal growth outlook is virtually unchanged. Meanwhile, we look for the rise of CGS due to the price hike of raw materials and intermediate goods, by which corporate earnings are likely to be squeezed. Also, as the nominal income growth remains sluggish, the pass-through to the finished goods and services prices is likely to be fairly limited as well; therefore, we do not look for primary products inflation to lead to major top-line growth. After all, corporate earnings are likely to become slightly negative in F3/09 at -3.0%.

For forex, we are forecasting near-term mild yen appreciation, but the benefits of the previous depreciation will continue to take effect with a time lag. There is no call at this point to forecast a large direct negative impact from a stronger yen, and the effect of slowing demand at trading partners will be much more influential. We also predict that the dollar will settle down despite a narrower interest rate gap, led by repatriation of external assets by US investors with the end of global excess liquidity and diminished risk tolerance as argued by our currency strategy team. We hence do not foresee significant earnings-decline pressure from the forex situation. However, companies are typically conservative and should present weak bottom-up outlooks for F3/09 around May. We expect sales and recurring profit rebounds in F3/10 as the US and global economies recover, however.

 

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