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Sunday, December 24, 2006

Research Calls

Allahabad bank

Finquest recommends a "buy" on Allahabad bank at a price of Rs 90 with a twelve month target price of Rs 120. Allahabad bank is one of the oldest PSU banks with a large network of over 2000 branches and 149 extension counters catering to a diverse socio-economic client base.

The bank is thus well placed to leverage this facet in its drive towards expansion of business volumes. The banks credit to deposit ratio has significantly improved from 49 per cent in FY2002 to 60 per cent in FY2006.

The banks core business growth is expected to be robust in the next three years with advances and deposits estimated to grow at 28.3per cent and 19.8 per cent CAGR between FY2006-09E.

In the past two to three years the bank has streamlined its operations and brought down the Non Performing Asset level from 10.7 per cent in FY2002 to 0.8 per cent in FY2006.

This trend is expected to continue with Finquest estimating this ratio to further decline to 0.4 per cent by FY2009E. At Rs 90, the stock is trading at a P/E ratio of 5.7 and 4.6 times expected FY2007 and FY2008 earnings

Raipur alloys and Steel Ltd.

Networth Stock Broking has recommended a "buy" on Raipur alloys and steel ltd at a price of Rs 140 with a one year price target of Rs 200. RASL, an integrated steel plant located in Raipur is a part of the Sarda group. The company had received board approval in September 2006 for merger with two other group companies, CECL and Raipur gas.

The merger is expected to bring synergies to RASL in the form of captive power and coal.The Moreover the rights possesed over 6 iron ore and 2 coal mines could prove to be a significant element in cost saving in future.

Among the measures to increase operational efficiencies includes a 600000 MT pelletisation plant which would be set up by April'08.The company has also announced an ambitious expansion plan to ramp up both sponge iron and Steel ingot capacity.

Significant triggers include prospective development of MIDC land at Raipur and the revenue increments due to carbon credits earned.

At Rs 140, the stock trades at a P/E ratio of 9.3 times and 5.6 times estimated FY07 and FY08 earnings. The corresponding EV/EBITDA ratios are at 7.4 and 5.1 times estimated FY07 and FY08 earnings.

Essel Propack

ASK India Equity Research recommends a "buy" on Essel propack at a price of Rs 79 with a target price of Rs 98.

Essel Propack is the largest speciality packaging company in the world manufacturing laminated and seamless tubes catering to the oral care, cosmetics, personal care, pharmaceutical, food and industrial sectors.

It has a presence in 13 countries and in the past five years has been in the news for several transnational acquisitions.

With the increasing prospects of outsourcing design and manufacturing in medical devices in the US, Tactx medical, which Essel acquired could benefit with its strong research team. While the business plans over plastic tubes and speciality packaging are on track, the management continues to work towards achieving breakeven at Arista,UK which was acquired in August,2004.

According to ASK, Essel has the strongest leverage to improvement in margins and asset efficiency. Significant margin improvements could come from lamitubes, plastic and specialty packaging segments.

Though there are still concerns on execution regarding new initiatives, there remains value in the stock at the price considered. At Rs 79 the stock trades at a P/E ratio of 12.5 and 10.6 times estimated CY06 and CY07 earnings. The P/E ratio for estimated CY08 earnings stands at 8.1 times.

SREI Infrastructure Finance

Emkay Shares and Stock brokers recommend a "buy" on SREI Infrastructure Finance Ltd at a price of Rs 49 with a target price of Rs 70. SREI has a 30 per cent share in the infrastructure related equipment financing market with a network of 43 branches/offices spread equally across India.

The company which focuses on mostly small and medium enterprises has over the years turned itself into a one stop shop for all kinds of needs of its customers. This has enabled it to restrict the net NPA's to near zero levels despite serving what is considered a relatively riskier segment.

Also despite the constraints of being an NBFC, SREI has successfully been able to protect its NIM at 4.5 per cent plus levels. The company would benefit from the current infrastructure boom and according to Emkay research could witness its leasing assets book grow by 38.2 per cent CAGR over FY2006-09E.

At the target price of Rs 70, the stock would trade at 6.5 times its estimated FY2009 earnings.At a price of Rs 49, the stock trades at 6.5 times and 4.5 times its estimated its estimated FY08 and FY2009 earnings respectively.

Merril Lynch - Panacea Biotec

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Merill Lynch - Current Account Deficit

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HSBC - Apollo Hospitals

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ASEAN: Heading for a Soft Landing in 2007

Chetan Ahya and Deyi Tan | Mumbai

Cyclical growth story to face challenge in 2007. The ASEAN region has achieved respectable average growth of 5.6% over the last three years. However, in 2007, the ASEAN-5 countries are likely to remain middling performers in terms of their growth trend. The region is still struggling to stimulate internal demand on a sustainable basis, resulting in a high dependence on exports. With global growth likely to decelerate in 2007, the region is likely to lose support from its major growth driver — exports. We are looking for a global soft-landing scenario in 2007, with world GDP growth decelerating to 4.4% from 5% in 2006. Reflecting this trend, we expect ASEAN-5 GDP growth to decelerate to 5.1% in 2007 from 5.6% in 2006.

Not yet realizing its potential. The growth potential for this group, considering its demographic trend, is still very high. Indeed, the demographic trend for the region is as favorable as that in India and China. However, after the 1997 crisis, growth rates in the region have consistently been below potential. The most important challenge for the region (except for Singapore) is to build a stable political structure and a transparent institutional framework that will enable it to shift from an individual- to an institution-driven policymaking process.

Private consumption trend lacks vigor. The region’s overall efforts to pursue domestic demand growth strategies have not been very successful. Both Malaysia and Thailand, which had managed to revive domestic demand in the recent past, have witnessed a reversal in this trend. In Thailand, a lack of stable government has again made the economy dependent on export growth for sustaining its overall growth rates. In Malaysia, we believe the household balance sheet is already too stretched to continue with strong growth in private consumption in 2007. Indonesia is the only country in the region that should witness a meaningful improvement in private consumption in 2007, although from a low base in 2006.

Still struggling to revive domestic investment. The investment-to-GDP ratio for the ASEAN 5 has remained significantly below savings since the 1997 crisis. Apart from the unwinding of excess investments in the construction sector as one of the key reason for this poor overall investment trend, we believe the region’s private business investments have also been unable to fill the void. This is likely a function of the speed with which these countries are implementing structural reforms. In our view, Indonesia’s investment climate needs a major overhaul in the areas of infrastructure, tax and labour, whilst Malaysia needs to reform the softer institutional framework to push through higher productivity growth. On the other hand, Thailand continues to suffer from lack of stable political structure, which is necessary for pushing investments. For Singapore, the savings-investment gap is large, and investment is low by way of economic policy design and will likely remain so.

No major support from monetary or fiscal policy. Policy interest rates have peaked out but we are unlikely to get major support from rate cuts. We expect Thailand to start cutting rates in 1Q07 whilst Malaysia’s monetary policy will likely mirror the Fed’s. Only Indonesia is likely to see substantial cuts in interest rates in the near term. On the fiscal front, none of the ASEAN 5 countries is likely to pursue an aggressively expansionary policy. The interim government in Thailand is unlikely to take up the mega-infrastructure projects on the same scale planned by ex-PM Thaksin, and the Malaysia government is also planning to implement more disciplined fiscal policy to reduce its deficit in 2007. While the Philippines will see some increase in its deficit in 2007, it will most likely be marginal.

Thailandlikely to be worst performer in 2007. Indeed, specifically in terms of each individual country, we expect the growth trend for Singapore and Malaysia to be largely linked to global demand, given their degree of export orientation. On the other hand, domestic factors are likely to play a more significant role for Indonesia and Thailand, spurring growth in the former and constraining it in the latter. Prospects look most promising for Indonesia, where the government is likely to be successful in implementing structural reforms and reviving domestic demand. We expect GDP growth in Indonesia to be the highest in the region at 5.5% in 2007 and 6% 2008. Thailand will likely record the lowest growth at 4.5% in 2007 amid continued political uncertainty. For 2008, we believe that private consumption and investment should support a recovery in GDP growth to 5%, assuming elections are held by the end of 1Q2008. Lastly, the Philippines is likely to continue to deliver modest growth in the absence of major improvement in the pace of reforms.

Bottom line — moderation in external demand to cause a growth slowdown in 2007. ASEAN 5 GDP growth has increased at a respectable rate of 5.6% average over the last three years. However, over the next 12 months, as external demand moderates in line with global growth, we believe aggregate GDP growth for ASEAN 5 will dip to 5.1% in 2007.

Korea: To Survive the Slowdown in 2007

Sharon Lam | Hong Kong

The Korean economic cycle is often perceived as volatile, and as a result it is common to see overly optimistic growth projections during an upturn and overly pessimistic ones during a downturn, in my view. The resulting adjustment to miscalculated forecasts will therefore often cause unnecessary disappointment, (which happened in mid-2006) or false excitement (which is happening now).

The Korean economy rebounded in 3Q as we had predicted, bringing positive surprise to the market, which led to more pundits looking for further acceleration of the economy. I believe, however, it is too late to look for further rebound in the economy. The export sector and liquidity conditions are turning less favorable, which will only weaken the economy.

We forecast GDP growth to slow from an estimated 5.1% in 2006 to 4.3% in 2007. We are sticking to this 4.3% forecast we set a year ago, and we think it still looks realistic, while throughout the year the market consensus has revised down its 2007 outlook from 4.8% in the beginning to 4.4%, meaning our view has become a consensus. We predict GDP to slow to 3.6% in 1H07 but to pick up to 4.2% in 2H07. We expect the recovery to continue into most of 2008 when we predict growth to be at 4.8%, i.e., slightly above trend.

Meanwhile, we expect inflation to tick up next year on the back of higher housing rent and an increase in service sector charges. The upside in inflation, however, will be offset by a strong currency and therefore we only foresee a moderate pickup in inflation from an estimated 2.3% in 2006 to 2.6% in 2007.

Export slowdown on the way. Exports have been the major growth driver throughout most of 2006. The rosy export picture, however, is likely to be reversed. Korea’s two most important markets, China and US, are both slowing down although it is expected to be a soft-landing in both countries.

Adding to the pressure is KRW appreciation, which is largely narrowing the price discount between Korean and Japanese products. KRW appreciation against other Asian currencies has got to a point that will begin to hurt Korea’s competitiveness, in our view, as Korea’s export prices in USD terms have already been rising faster than Japan’s and Taiwan’s. Korean products that compete directly against the Japanese and Taiwanese will be in trouble, in our view.

Apart from its impact on competitiveness, exporters’ earnings are also directly affected by KRW/USD, as most export items are priced in USD terms, thus leading to earnings lost after conversion into local currency. This was not a problem when export volume was good, but now volume is likely to turn down, and as a result, we believe Korean exporters will be facing double pressure on both volume and price.

Yet consumption may relatively outperform. Consumption generally cannot escape an economic slowdown. However, we believe the slowdown in consumption will be much milder than that in exports this time, implying consumption will relatively outperform next year.

First of all, Korean consumers did not overspend during the consumption recovery in 2005–06. The wealth multiplier on consumption is declining because the extra wealth is now saved for a longer life expectancy, lack of social security and higher property prices, in our view. Nevertheless, the good news is that a more conservative spending pattern has helped Korea to avoid overspending during the boom, and consequently there is no need for correction during the downturn. We expect consumption to remain stable going forward.

At the same time we do not see forces pulling down consumption next year. First, the wealth effect is still slightly positive as we believe property prices will be upheld next year. Second, wage growth and the labor market are stable. Third, there is no overheating in household credit cycle.

We forecast private consumption to slow only marginally from to 4% in 2007 from 4.2% in 2006, which is much milder than the slowdown in exports and overall economy.

And the government will strive to keep sentiment buoyant. There has been a lot of speculation about extra spending from the government to spur the economy before the presidential election at end of next year. If policymakers’ attention becomes merely election-focused next year, then Korea may see a U-turn in housing market regulations, i.e., from restricting to relaxing. This would be the most bullish case for 2007 outlook, yet it will at the same time increase chances of a hard-landing in 2008. Our core assumption is that the government will continue to keep the property market in check, yet instead of using tax measures we expected it to adopt what we see as a “win-win strategy” — increasing housing supply.

We believe property prices will remain strong next year as there is still a housing supply shortage. Meanwhile, new satellite town development will also prop up prices in the short term due to anticipation of a better living environment. We only see prices declining when more new housing is completed, which will be from 2008 onward. With housing prices staying strong next year, if not increasing, consumption growth will not deteriorate.

Whether the government delivers real supportive measures does not matter, in our view. What matters is there will be continuous supportive talk from the government to keep up market expectations. This will help consumer confidence to defy a slowing economy in the first half of next year.

However, do not hope for monetary easing. Cutting interest rates is another way to stimulate the economy next year, yet the property market issue has complicated an interest rates decision. If property market crashes when interest rates are too low to begin with, then the central bank will be left with no policy option to save the economy and a Japan-like recession could happen. We believe the Bank of Korea will keep interest rates unchanged in the next six months. We see chances of further interest rate hikes in 2H07 to cool down property prices.

2008 outlook — recovery to continue but rising risks of property market deterioration. We expect the economy to start recovering in 2H07 and into 2008 on the back of (i) pickup in construction activities as government pledges to increase home supply; (ii) stable consumption as we believe the government will strive to keep sentiment intact; and (iii) exports improving as the Beijing Olympic Games approaches, which will drive more demand for Korean-made chips, consumer electronics and automobiles.

However, we also see an increasing chance of property market deterioration in 2008 when more new housing construction is completed, exceeding demand. Careful control of the housing market to avoid excessive price increases should top the policy agenda in 2007.

China: Who’s Subsidizing Whom?

Stephen Roach | New York

Federal Reserve Chairman Ben Bernanke offered the Chinese much in the way of good advice in a speech he recently gave in Beijing as part of the newly-instituted Strategic Dialog discussions that were just held between the US and China (see “The Chinese Economy: Progress and Challenges,” December 15, 2007). Unfortunately, he also offered some very bad advice in assessing the ramifications and risks of Chinese currency policy. In essence, the Bernanke critique was a one-sided interpretation of a key issue that could backfire and lead to a worrisome deterioration in the economic relationship between the US and China.

The offensive passage in the written version of the Bernanke speech posted on the Fed’s website was the assertion that the current value of the Chinese renminbi is an “…effective subsidy that an undervalued currency provides for Chinese firms that focus on exporting rather than producing for the domestic market.” The use of the word “subsidy” is a highly inflammatory accusation — in effect, putting the Chinese on notice that America’s most important macro policy maker believes that RMB currency policy provides the Chinese with an unfair advantage in the world trade arena that fosters distortions in China’s economy, the US economy, and the broader global economy. In my view, this is a very biased assessment of the state of Chinese currency policy and reforms. It pays little attention to the context in which RMB policies are being formulated and, ironically, fails to provide any appreciation for the benefits that accrue to America as a result of this so-called subsidy. Moreover, Bernanke’s spin continues to downplay the role that the United States is playing in creating its bilateral imbalance with the China — to say nothing of the role the US is playing in fostering broader imbalances in the global economy.

The real question in all this is, Who’s subsidizing whom? Conveniently overlooked in the Bernanke critique is an important flip side to the “managed float” that continues to drive RMB policy — China’s massive purchases of dollar-denominated assets. The exact numbers are closely held, but there is close agreement that between 60-70% of China’s $1 trillion in official foreign exchange reserves are split between some $345 billion invested in US Treasuries (as of October 2006, according to the US government’s TIC reporting system) and a comparable amount held in the form of other dollar-based fixed income instruments. With Chinese reserve accumulation now running at over a $200 billion annual rate, that implies new purchases of dollar-denominated assets of at least $120 billion per year. Such foreign demand for American financial assets is absolutely critical in plugging the funding gap brought about by an unprecedented shortfall of domestic US saving — a net national saving rate that fell to a record low of just 0.1% of national income in 2005. Without China’s purchases of dollar-based assets — a key element of its efforts to mange the RMB in accordance with its financial stability objectives — the dollar would undoubtedly be lower and US interest rates would be higher. In effect, that means China is subsidizing US interest rates — providing American borrowers and investors with cut-rate financing and rich valuations that otherwise would not exist were it not for the dollar recycling aspects of Chinese currency policy.

There is an added element of China’s subsidy to the US. As a low-cost and increasingly high-quality producer, China is, in effect, also providing a subsidy to the purchasing power of US households. Close down trade with China — as many in the US Congress wish to do — and the deficit would show up somewhere else, undoubtedly with a higher-cost producer. That would be the functional equivalent of a tax hike on the American consumer — cutting into the subsidy the US currently enjoys by trading with China. The Fed Chairman is making a similar suggestion: By allowing the RMB to strengthen, China’s dollar buying would diminish — effectively eroding the interest rate and purchasing power subsidies that a saving-short and increasingly asset-dependent US economy has come to rely on.

We can debate endlessly the appropriate valuation of the Chinese currency. Economic theory strongly suggests that economies with large current account surpluses typically have under-valued currencies. China would obviously qualify in that regard — as would, of course, Japan, Germany, and many Middle East oil producers. That fact that China is being singled out for special attention is, in and of itself, an interesting comment on the biases in the international community. Nevertheless, it is quite clear that China understands this aspect of the problem. By shifting to a new currency regime 17 months ago, Chinese policy makers explicitly acknowledged the need for more of a market-based foreign exchange mechanism. The RMB has since risen about 6% against the dollar — not nearly as much as many US politicians are clamoring for, but at least a move in the right direction. Risk-averse Chinese policy makers feel strongly about managing any currency appreciation carefully — understandable, in my view, given the still relatively undeveloped state of China’s highly-fragmented banking system and capital markets. The potential currency volatility that a fully flexible foreign exchange mechanism might produce could have a very destabilizing impact on an undeveloped Chinese financial system. And that’s the very last thing China wants or needs.

Chairman Bernanke’s criticism of the Chinese for subsidizing their export competitiveness by maintaining an undervalued RMB completely ignores the benefits being enjoyed in the US through equally important subsidies to domestic interest rates and purchasing power. Sure, a careful reading of the Bernanke China speech will find it laced with the typical caveats of Fedspeak that, in this instance, acknowledge America’s role as a deficit nation in contributing to this problem, as well as special considerations China deserves as a developing economy. But the tone and emphasis are clear: The Fed Chairman is paying no more than lip-service to the other side of the coin through his emphasis on a sharp critique of China’s monetary and currency policies. Particularly striking in this regard is Bernanke’s failure to acknowledge the extraordinary fragmentation of a highly regionalized Chinese banking system — dominated by four large banks that still have well over 60,000 autonomous branches between them. How a central bank gets policy traction with such a decentralized banking system is beyond me. Moreover, he basically overlooks another critical reason for China’s irrational investment process — the lack of well-developed capital markets and the continued reliance on policy-directed lending by China’s large banks. Instead, Bernanke suggests that a flexible currency is the best means to foster an efficient allocation of investment projects. In short, the flaw in the Bernanke critique is his failure to appreciate the very special transitional needs of a still blended Chinese economy — currently straddling both state and private ownership systems, as well as centrally-planned and market-directed allocation mechanisms. The Fed Chairman is offering advice as if China was a fully functioning market-based system — perfectly capable of achieving policy traction with the traditional instruments of monetary and currency policies. Nothing could be further from the truth for today’s Chinese economy.

This is not the first time Ben Bernanke has assessed an international financial problem with such one-handed analysis. In his earlier capacity as a governor of the Federal Reserve Board and then as the Chairman of President Bush’s Council of Economic Advisers, he led the charge in pinning the problem of mounting global imbalances on the so-called “saving glut” thesis — in effect, arguing that the US was doing the rest of the world a huge favor by consuming an inordinate surplus of saving (see Bernanke’s March 10, 2005 speech, “The Global Saving Glut and the US Current Account Deficit,” available on the Fed’s website). While a most convenient argument from the Administration’s standpoint, it downplayed America’s role in fostering the problem — unchecked structural budget deficits and a plunge in the income-based saving rate of US households. Lacking in domestic saving, the US must import surplus saving from abroad in order to grow — and run massive current account and trade deficits in order to attract the capital. This is quite germane to the debate over China. As noted above, the Chinese have emerged as important providers of saving for a saving-short US economy.

The scapegoating of China remains a most unfortunate feature of the global climate. US politicians want to pin the blame on China for America’s trade deficits and pressures bearing down on US workers. Now Ben Bernanke piles on by accusing China of using its macro policies as de facto export subsidies. Sure, China could do better on trade policy — especially in the all-important area of protecting intellectual property rights. But I think the world can also expect more of the global leader — like facing up to a very serious and potentially destabilizing saving shortfall that requires the rest of the world, including China, to subsidize its own profligate ways. The longer the US frames this debate in such a biased and one-sided fashion, the more difficult it will be for others in the world, like China, to accept a face-saving compromise.

There are some interesting footnotes to the Bernanke speech. Significantly, the Fed Chairman actually flinched when it came to the oral version of his speech — offering a last-minute substitution of the word “distortion” for “subsidy.” That may have saved him from an embarrassing moment or two on the stage in Beijing, but it did nothing to diminish the subsequent flap that has arisen over this accusation. Meanwhile, US politicians were quick to take the cue from Bernanke. Sander Levin, Democrat Congressman from Michigan and soon-to-be Chairman of the House Sub-committee on Trade, immediately threatened to re-introduce legislation that would require the US Commerce Department to cite Chinese currency manipulation as a violation of US anti-subsidy laws — thereby allowing US companies to seek the remedy of offsetting, or countervailing, tariffs. Moreover, while Bernanke may have stumbled on the word “subsidy” in public, it remains the operative concept on record in the official version of the speech on the Fed’s website. Sadly, as evidenced by the predictable reactions of Washington protectionists, the damage has already been done.

I have long argued that the US-China relationship could well be the most important bilateral underpinning of a successful globalization (see my March 20, 2006 Special Economic Study, “Globalization and Mistrust: The US-China Relationship at Risk,” presented to the 7th annual China Development Forum in Beijing). I worry increasingly that the economic tensions between these two nations are in danger of being politicized, with the nation-specific considerations of localization increasingly taking precedent over globalization. I am encouraged by US Treasury Secretary Hank Paulson’s attempts to put the China debate in a much broader context. Unfortunately, the Bernanke speech is a major step backward.

China: Liquidity, Liquidity, Liquidity

Denise Yam | Hong Kong

Liquidity trends appear to have dominated the discussion of macro outlook for the Greater China economies of late. The relationship between liquidity and each economy has rather different characteristics, and we offer a descriptive account of each of them in this note.

China— managing excess liquidity. The Chinese government has been claiming success in macro tightening, reporting slower economic activity in response to administrative controls in the last few months. However, China has not yet resolved the fundamental problem of excess liquidity from the large trade surplus and capital inflows. The cost of capital remains too low, leaving the economy vulnerable to a revival in overheated and speculative investment. Recent PBoC rhetoric has shifted the policy focus to liquidity management, through lifting reserve requirements and/or issuing bonds. In 2006, the PBoC has hiked interest rates twice and raised reserve requirements on Renminbi deposits three times. Meanwhile, issues of central bank bonds have been kept up to absorb liquidity from the banking system. However, these measures have not been enough to offset the supply of liquidity from the balance of payments surplus.

Each percentage-point increase in the reserve requirement supposedly locks up Rmb320 billion of banking system liquidity. However, financial institutions' deposits with the PBoC totaled Rmb3.8 trillion at the end of September, already covering 11.6% of total deposits, exceeding the requirement. In other words, the "required" ratio of 9% has not been a binding constraint on liquidity. In fact, subsequent to the sharp increase in reserve deposits in 4Q03 following the first tightening move (August 2003), which brought loan growth down effectively over 4Q03-2Q04, the actual reserve ratio has again drifted downwards since early 2005, allowing or possibly contributing to the reacceleration in loan growth.

Because the reserve requirement has not been a binding one, the total achieved sterilization (increase in actual reserve deposits and central bank bonds outstanding) has fallen short of the intended sterilization (increase in required reserves and bonds) as well as the BoP surplus. The BoP surplus of US$207 billion in 2005 met with only a US$146 billion (71% of the surplus) increase in reserve deposits and bonds. In 2006, sterilization remains incomplete, at 76% in 1H06 (US$122.1 billion BoP surplus vs. US$92 billion achieved sterilization) and worsened to 59% in 3Q06 (US$46.8 billion increase in FX reserves vs. US$27.4 billion sterilization). The unsterilized surplus since 2005 therefore totaled US$110 billion.

Quantifying the impact of sterilization against the BoP surplus helps explain why the monetary tightening measures so far have not been sufficient to lift the cost of capital meaningfully, which we believe is vital in discouraging wasteful fixed investment. The bond issuance program has been far from aggressive in recent months, suggesting that the PBoC remains reluctant to lift interest rates significantly. We believe that this incomplete sterilization underpins the friendly liquidity environment in China, leaving lending, investment and overall economic activity vulnerable to a rebound. Although government policy continues to target slower growth, ample liquidity amid incomplete sterilization of the expanding BoP surplus should limit the harshness of the deceleration.

Hong Kong — enjoying liquidity inflows, but wary of volatility. Liquidity conditions and asset market performance have a strong influence on real economic activity in Hong Kong. The influence has further stepped up this year on the back of the increase in large-size listings of Chinese enterprises in the Hong Kong stock market. The HK$-denominated financial asset base has grown significantly, powering monetary expansion far ahead of economic growth. Capital inflows, absorbed by the banking system in the form of an expanding net foreign asset position (US$25 billion over the 12 months ending Oct-06), have resulted in a downtrend in the HK$ loan-to-deposit ratio, and lower HK$ interest rates (against their US$ counterparts) in recent months, further supporting asset market valuations and gains.

The expansion of Hong Kong’s financial asset base in the last few years has been driven by China’s increasing appetite for international capital. The performance of the asset markets is not so directly representative of Hong Kong’s domestic economic fundamentals, but ironically has become the driver of monetary conditions and economic sentiment. Stock market capitalization has surged to HK$12.1 trillion, more than 8 times GDP. In other words, each 1% rise or fall in the stock market represents an amount equivalent to 4% of broad money M3, or 8% of GDP.

We have seen robust pickup in consumption and investment on the back of asset appreciation and low interest rates in the last couple of years. Consumption has been lifted by the positive wealth effect, while employment, wages and household income have only been catching up in the last two quarters. Consumer businesses have also turned more positive on expansion plans amid stronger consumption. However, it worries us that, as a small, open economy with a fixed exchange rate, Hong Kong’s strong leverage on liquidity conditions and asset market performance results in volatile business cycles driven by non-domestic factors.

The imminent crossing of the RMB/US$ and HK$/US$ exchange rates upon further RMB appreciation has lifted expectation that the HK$ will follow. We sympathize with the psychological impact of the RMB breakthrough on the HK$, but believe it will prove to be temporary. We believe that the expanding HK$ financial asset base is the dominant factor behind the current low interest rate environment, meaning that low interest rates could be sustained even beyond the speculation for HK$ appreciation subsides. While we are reluctant to make purely speculative forecasts on further deviation of HK$ interest rates from their US$ counterparts (hence sustained strength in asset prices), it is quite possible that anomalous monetary conditions sustain for even longer.

Taiwan— reliant on foreign liquidity. Amid sluggish domestic demand and continuous outward investments by local enterprises and individuals, asset markets in Taiwan have been supported by loose monetary conditions, made possible by the accommodative stance of the central bank, the current account surplus, and sustained foreign interest in Taiwan’s financial assets. Balance of payments trends clearly demonstrate Taiwan’s increasing dependence on external demand and foreign portfolio investment. The persistently large current account surplus, likely to reach 6% of GDP in 2006, reflects the output gap amid structural weakness in domestic consumption and investment. In the financial account, Taiwan has been a net exporter of direct investment capital, totaling US$10.7 billion since 2004 and US$20.7 billion since 2001. Portfolio flows, on the other hand, are characterized by local investors investing increasingly abroad but partially cushioned by foreign investments in Taiwan equities. Foreign portfolio inflows totaled as much as US$13 billion in 4Q05, buoyed partly by the MSCI re-weighting, but these have been offset by accelerated outbound investments by locals since 2004, leaving the overall financial account barely in balance since 2004. The overall balance of payments surplus since 2001 has contributed a great deal to the easy monetary conditions in Taiwan and the recovery in asset prices. Ample liquidity in the banking system has kept interest rates low. Rates are low even at the long end, with the 10-year government bond yield hovering around 2% at present, keeping financial assets afloat even amid a weak domestic economy.

Nevertheless, easy monetary conditions and low rates should not be assumed indefinitely. Foreign capital inflow is a crucial factor in the current delicate monetary balance. Monetary conditions, and, hence, asset prices, are extremely vulnerable to an abrupt turnaround in foreign portfolio flows. The size of and swings in short-term capital flows have increased significantly in the past decade amid increasing global financial integration. Quarter-on-quarter swings in short-term capital flows could be as great as 20% of GDP and could be extremely destabilizing for financial markets. Needless to say, measures to slow the pace of capital exporting by local investors or even encourage repatriation of earlier outflows would be ideal, although the unfavorable political climate and business uncertainty prior to the drawing up of a concrete roadmap governing cross-strait exchanges are to be blamed for the persistence of the outflows at present. Fortunately, in Taiwan’s favor is the buffer of excess liquidity stored in NCDs (outstanding NT$3.74 trillion, or US$113 billion), which the central bank can release to the money market to maintain accommodative conditions and low interest rates in the face of unfavorable capital flows. Moreover, the US$260 billion-strong foreign exchange reserves provide an additional shock absorber.

The 2007 outlook for all the three Greater China economies is very much dependent on global liquidity trends. The correction in commodity prices and apparent taming in inflation expectations have caused markets to expect a more dovish monetary policy stance from the major central banks. Specifically, our US economists now believe that the Fed is done with tightening, and easing could kick in as soon as 2H07. Nevertheless, it would still be irresponsible to deny the growing risk of a contraction in global liquidity that could have a greater impact than in the past. Upside surprises to inflation continue to haunt the industrialized world, heightening risks of further tightening. In the much-feared scenario of global stagflation, investment fund flows to emerging markets will unlikely avoid an adverse turnaround, drying up funds for China’s investment, and forcing asset prices to correct in Hong Kong and Taiwan.

Japan: If Prices Were To Decline Again ...

Takehiro Sato | Tokyo

Prices could contract again if the core of core does not rebound soon

What we outline here is a risk scenario, not our main one. Nevertheless, we do not think it is a low-probability scenario, considering that the latest reading on price growth is very low, at just 0.1% YoY. In light of oil price trends, the Japan-style core CPI could contract again YoY in 2007 H1, contrary to our constructive economic outlook.

We currently do not expect such a development for our main scenario; rather, we assume the core of core (excluding energy, broadly defined utility charges, and other special factors) will rebound solidly. In the six months through October, however, the core of core vacillated around -0.1% YoY.

Meanwhile, BoJ officials appear to be expecting the November nationwide CPI, to be announced on December 26, to show no negative contribution from declines in mobile phone rates, as in the past year, and they appear to have more or less given up on a rate hike in December and instead to be leaning toward a rate increase in January. The November nationwide core CPI, however, is likely to be up only 0.1% in light of the November decline in gasoline prices, the indications in the November Tokyo-area CPI of an impact from price declines for winter clothing owing to the warm winter, and the weakness in the core of core figure.

We doubt the core of core CPI will suddenly rebound in the next few months; if it is flat YoY, the Japan-style core CPI may contract starting around April-June, or even earlier because the contribution from oil prices may turn negative.

BoJ’s view on output gap based on revised GDP figures

The recent, substantial, retroactive GDP revisions confirm the weakness in the core of core CPI. For the F2006 national accounts, real GDP was revised downward by 0.9 ppt to 2.4%, which should have more than a negligible impact on estimates of the output gap since the economy’s potential growth rate is just shy of 2% at best. Based on the revised GDP data, the pace of the contraction in the output gap in F2006 declines by almost 1 ppt. If the improvement in the output gap is only modest, the spillover effect on prices would naturally be that much weaker.

BoJ officials, however, believe the output gap is not affected because the GDP revisions also lower the potential growth rate, or that the output gap has nothing to do with the GDP revisions because it is calculated from capacity utilization, rather than the divergence between actual and potential GDP. We doubt we are the only ones who sense sophistry in this argument. The output gap is traditionally calculated as the difference between actual and potential growth, the latter based on inputs of capital and labor using the historical averages for capacity utilization and labor participation rates. If actual GDP declines substantially, the potential growth rate also declines, but to an extent that is negligible. Rather, we think it would be prudent for policymakers to focus on the substantial slowdown in the pace of improvement in the output gap stemming from a decline in actual GDP. Under such conditions, market participants find it difficult to understand the BoJ’s concern more for the future upside risks to prices and asset prices than for the near-term downside risks to prices.

Worst-case scenario: Downturn in prices after another rate hike

Let us consider what might happen if the risk scenario does play out. Even with the slump in prices we mention above, much depends on whether the BoJ raises rates for a second time by January. We assume it does for our main scenario, but the likelihood has lessened somewhat, considering the weak extent of the positive spillover from the corporate sector to the household sector. The following scenario is thus a worst-case one. If the Japan-style core turns negative several months after the next rate hike, it would be easy to imagine the BoJ being in a politically difficult situation in terms of putting a crimp in the Cabinet/ruling coalition’s pro-growth policies. Governor Fukui would not likely have to resign, but the choice of his successor after his term ends in March 2008 could be affected to some extent. To be more specific, Deputy Governor Toshiro Muto, who is currently widely expected to be the next governor, may be less likely to be promoted and the government and the ruling coalition may instead look for a candidate outside the BoJ. Leading candidates in that case would be money-focused Heizo Takenaka, the former FSA minister, and Takatoshi Ito, a member of the Council on Economic and Fiscal Policy and an advocate of inflation targeting. If someone with a strong monetarist bent is named to be the next governor, Japan could be stuck in an ultra-low rate environment for a long time, with price growth hovering very low. If policy is focused on an increase in money supply, the BoJ may increase the supply of reserve deposits and put the policy rate back to near 0%.

If the economy and stocks do well, a rate hike would be positive for the Administration

The above is essentially a mental exercise. After all, a prolonged, ultra-low rate environment would not be positive at all for the ruling coalition’s base of support. Rather, if the economy and stocks do well, a rate hike would be beneficial for the government and the ruling coalition. In fact, LDP officials, who had continued to try to check the BoJ’s moves, ended up embracing the BoJ’s moves in March to July, resulting in an end to ZIRP. Moreover, politicians and the media have generally reacted positively following increases in deposit yields.

A decline in the Japan-style core CPI would stem from a decline in oil prices and boost consumers’ real purchasing power, albeit not to the same extent as in the US. The US-style core CPI is likely to rebound moderately even if the Japan-style core CPI is weak. Also, the GDP deflator is likely to turn positive YoY around April-June, in a good contrast with the core CPI. Hence, assuming the government and the BoJ are at complete odds while prices are declining, such a scenario would likely be criticized for evidencing a lack of composure. To avert such a standoff, we think it would be natural for the BoJ to extend a certain amount of consideration and thereby protect its independence as well in an environment of price stability.

The market has priced in expectations of a rate hike roughly every six months, but we think the pace of rate hikes could be more moderate as a risk scenario, in which case medium-term yields would decline noticeably and the yen would continue to depreciate in real effective terms. Such a development would be generally positive because the stock market is concerned about a prompt rate hike while the economic data are weak. However, we find it paradoxical that stock investors, who had been so eagerly looking forward to a rise in rates, are now concerned about a rate hike.

Japan: Buy Mr. Abe on Dips

Robert Feldman | Tokyo

I think PM Abe will be an effective reformer, although the signs may be hard to read. His agenda is market-oriented and supported by the public. He has the political skills and support to push this agenda. Equities, the yen, and real estate should benefit from more reform. The rise of interest rates and yields will be modest, in light of low inflation and falling fiscal deficits. The main risk is complacency, in public and corporate sectors.

First, it is important to recall the reality of the Koizumi years, not the rose-colored memory. There were many compromises along the way to reform. Second, PM Koizumi was continuously bashed by the media and resisted by anti-reformers in his own party. So will it be with Mr. Abe. Mr. Koizumi had the philosophy and fortitude to persist. So does Mr. Abe.

The real problem — efficiency. Japan’s efficiency agenda remains unfinished. The one and only solution to demographic and fiscal problems is higher productivity. This applies to both public and private sectors, and requires more policy push on public sector reform, technology, and resource reallocation.

The public wants reform, and has voted for it. Investors want higher earnings, both from corporations and from fixed-income investments. The only path to such higher earnings is higher efficiency.

Growth philosophy — rising tide to 4% GDP growth. Thought leaders in the ruling party have an agenda to address these issues, the Rising Tide Theory. They are pushing for greater innovation, more flexible labor markets, a tight fiscal/loose monetary policy mix, and fair income distribution. The result, they claim, would be nominal GDP growth of 4%, with only 1% inflation — i.e., 3% real growth.

So far, opponents of the Rising Tide Theory have only been able to criticize, not offer alternatives. Thus, the Rising Tide theory is winning the public debate.

Execution — ambition versus disappointment. That said, the political economy of execution has a key contradiction. To achieve lofty goals, one must set ambitious targets. On the other hand, falling even slightly short of targets typically generates sharp criticism. Thus, setting ambitious targets undercuts the credibility needed to achieve the targets. The only answer is to stick firmly to policies, and appeal to the public on the basis of the outcome. PM Koizumi was a master of this. He never achieved 100% of his goals, but even 70% was major progress. The public rewarded him at the polls.

PM Abe has taken up the challenge. He has defined an ambitious agenda in education, innovation, tax reform, labor reform, pension reform, trade reform, medical reform, and other issues. He has created competition between task forces in the PM’s office and the bureaucracy. If anything, the press is criticizing him for not being tough enough, which only strengthens his hand. Facing an election next July, even foot-draggers in the LDP will be forced to go along.

Japan’s efficiency agenda remains unfinished. The public wants reform, and PM Abe has defined an ambitious agenda.

Market implications. For markets, more successful reform means positive surprises for growth and an end to deflation. Both near-term and long-term earnings are likely to beat expectations. This combination implies that equity prices and the yen should be strong, and that real estate will continue to recover. Yields should rise, but modestly, due to progress on fiscal consolidation.

The big risk — complacency. If market pressure on government and board rooms is ignored, then Japan’s future is dim. Fortunately, such pressure seems to be working. “What will foreign investors think?” is the mantra among both domestic investors and government officials. For this reason, “buy on dips” seems like sound advice for those concerned about PM Abe’s commitment to reform.

Asia: Asia's Decoupling Story -- The Litmus Test

Chetan Ahya | Mumbai

Decoupling debate back to forefront. The increasing level of globalization has meant that cycles in both real economies and financial markets in Asia and the US have tended to move in a synchronous manner. However, major strengthening of Asia Ex-Japan’s balance sheet over the last few years is fuelling expectations of a decoupling from the US economic growth. In 2006, AXJ’s nominal GDP is estimated to increase to 45% of US’s GDP from 33% in 2000. The debate is intensifying as recent data from the US indicate a potentially significant deceleration in America’s growth trend. Indeed, our US economics team now expects GDP growth there to slow to a 15-quarter low of 2.2% YoY in 1Q07. The key question for the markets in 2007 is whether AXJ will follow the US in the ensuing downcycle or will it emerge as a “decoupler”?

The case “for” decoupling. There are two key arguments supporting the case for decoupling. First, AXJ’s trade dependence on the United States has been declining gradually over the past few years. This is evidenced by the fact that the US share of AXJ’s exports decreased to 17% in 1H06 from 22% in 1998. Second, the rise in nominal interest rates in AXJ has been slower than the rise in interest rates in the US in the current cycle. Since the US Federal Reserve began its tightening campaign in June 2004, average nominal short-term rates in AXJ have risen by only 85 basis points (150 bps, excluding China), while US short-term interest rates have risen by almost 380 bps.

Evidence suggests linkages remain strong. The actual trend for AXJ export and GDP growth indicates that these economies remain highly correlated with US GDP growth. Since a period of divergence during 1997–98 (when AXJ’s growth decelerated sharply due to the Asian crisis), AXJ has been closely coupled with the US. Moreover, AXJ equity markets have also exhibited a tight correlation with those in the States. Indeed, over the trailing 24 months, monthly returns in Asia ex-Japan have shown a correlation of 0.8 with returns in the US.

We view 2007 as a testing year. For AXJ to decouple, the single-most important factor will be its ability to stimulate domestic demand (the major components being fixed investment and private consumption). In AXJ (excluding India), fixed investments are made with an eye on potential future global demand rather than domestic consumption. Hence, the fixed investment trend has tended to follow the region’s export and global growth cycle. The structural dynamics of private consumption are also uninspiring. Already decelerating, the private consumption trend in the region is unlikely to accelerate much in 2007, barring a sharp cut in interest rates. Indeed, a slowdown in US consumption would only reduce the region’s trade surplus and therefore lessen support provided by excess liquidity. Even though nominal interest rates in the region have lagged the Fed, short-term real interest rates have been rising and are now almost converging with those in the US.

Accounting for 17% of the region’s GDP growth, India is so far the only large economy in the region to have successfully stimulated private consumption growth. However, a large part of the country’s consumption growth is debt funded and dependent on global liquidity trends. Consumption growth in India is now beginning to reflect the rise in interest rates, which in turn have been influenced by the US monetary policy. We believe that the lagged effect of higher interest rates will further slow India’s consumption growth in 2007.

Bottom line — case for decoupling is weak. Although the jury is still out, we believe the case for AXJ decoupling remains weak. Exports and export demand-dependent fixed investment continue to be the key anchors of AXJ’s growth story. In the absence of structural reforms, private consumption is unlikely to take charge any time soon. We believe the case for decoupling is not convincing as we see little indication that AXJ economies can stimulate internal demand enough to offset a potential slowdown in the US.

South Africa: Opportunities Galore

Michael Kafe | London

We expect 2007 to be another year of opportunities in South Africa. Four major risk events to watch out for are (i) the South African Reserve Bank (SARB)’s first monetary policy meeting on 14 February; (ii) a peak in the inflation cycle during the first half of 2007; (iii) developments in the country’s current account deficit composition towards the middle of the year; and finally, (iv) the ANC’s party presidential elections in December.

The Macroeconomic Dynamics

This week, we took a final look at our macroeconomic forecasts for 2007. We revised our 2006 GDP growth number from 4% to 4.9%, thanks largely to historical data revisions by Statistics South Africa, but we have kept our 2007 forecast unchanged at 4.3%. Quite importantly, we look for consumption growth to slow down to 4.5% by the end of next year, as the 200bps of tightening seen earlier this year takes its toll on consumers. Also, Gross Domestic Capital Formation (GDFI) will likely decelerate from 13.8% in 3Q06 as private investment slows, but should remain above 8% — supported in large measure by investment spending under the government’s capital expenditure program. The external sector is also likely to show some improvement, with the current account deficit coming in only marginally above 5% of GDP as exports see some volume growth, thanks to capacity enhancements, and as the import bill sees moderate relief from low oil prices. Finally, a continuation of sound fiscal management will likely result in a government budget surplus in 2007. With the government already sitting cash-flush, we expect central government borrowing to shrink. Positive sentiment here could place a cap on bond yields.

Curve Normalization (Bull Steepening) in 2007

With the above scenario in mind, we do not see justification for any further rate hikes in 2007. However, the market is still pricing in a 50bps rate hike in February. We would seriously regard this as an excellent trading opportunity to receive ZAR rates. We look for the SARB to be on hold for the greater part of the year, and expect it to consider easing no earlier than December 2007. But if our view on declining oil prices and benign food inflation in H2 2007 is correct, then the market could start discounting prospects of easier money long before it actually happens. Importantly, therefore, we expect the next big move in South African interest rates during 2007 to be a normalizing yield curve (bull-steepening). Timing the move is always tricky, but one should consider looking for entry opportunities from as early as February/March 2007 (i.e., just before inflation peaks).

Positive Metamorphosis in Current Account Mix

Another important thing to watch is the external accounts. In 2007, although lower oil prices will no doubt take some pressure off import spend, we expect the country’s import bill to remain under pressure as the government’s capital expenditure program kicks off in earnest. The government plans to spend R372bn on infrastructure over a three-year horizon. With the first year already behind us, it is clear that it will need to step up its act in 2007. This means we could see some huge increases in capital imports over the course of next year, particularly given that the import penetration ratios for some of the projects (especially railways and ports) are as high as 40–60%. The bigger question though, is, will the market still penalize South Africa for running a current account deficit that is in excess of 5% of GDP as it did in 2006? Or will the switch in the current account mix, from consumption goods to capital goods that have positive implications for the country’s growth trajectory placate the market? Also important is the funding of the deficit. Will the huge net outflows that were reported on the FDI line of the capital accounts this year continue into 2007, forcing further downward adjustments in the currency?

Morgan Stanley’s view is positive on both counts. We expect the market to become more sympathetic as it gets its mind around the composition of the current account deficit. We also expect the haemorrhage in FDI to dry up next year as local companies slow their foreign acquisition drive, and as private equity inflows gather steam. At the same time the ‘sweeter’ carry in the interest rate market as South African rates rose in the second half of 2006 should continue to attract more offshore portfolio inflows. Against this background, we have revised our outlook for the Rand, and are now looking for no more than 6.5% depreciation next year — down from 8% previously.


As always, however, there are some risks. For 2007, we think the biggest risk is politics. This is not because we think South Africa is headed for a political stalemate — as a matter of fact, there is no shortage of able leadership in South Africa. Even so, we think that uncertainties surrounding important political events could send some jitters through the market.

First is the ANC’s Economic Policy Congress in June: The market is likely to be concerned that the African National Congress (ANC) will give in to rising pressure from labour, particularly in the wake of the Jacob Zuma saga. We don’t think they will.

Second is the ruling ANC party’s presidential elections in December: The elected president of the party will in all likelihood become the next president of the country following national elections in April 2009. Key issue of concern here would be whether the left succeeds in pushing ousted deputy president Jacob Zuma into the top seat.

Third, an appeal by Zuma’s alleged accomplice-in-crime was dismissed in November 2006, thereby opening the way for the National Prosecution Authority (NPA) to reinstitute corruption charges against Zuma. A re-opening of the case will likely be resisted by the trade unions, and union attempts to either challenge the validity of the charges or to influence the outcome of his trial could send wrong signals that upset the currency markets. Conversely, and perhaps more importantly, any reluctance on the part of the NPA to pursue the case could also be viewed negatively by the international community.

Central Europe: Continuing Progress on the Path to Convergence

Pasquale Diana | London

For Central Europe, 2006 was another year of strong growth, with GDP growth surpassing analysts’ expectations across most of the region. For next year, we expect a benign outlook for Eurozone growth and supportive domestic demand dynamics to bode well for continued above-trend growth in the region, with the exception of Hungary, where growth looks set to slow dramatically due to the fiscal package.

Poland: strong fundamentals to support the zloty and cap monetary tightening

Across the region, Poland is probably the country that enjoys the most favourable fundamentals. Investment-led growth has raised the country’s growth potential and inflation has remained well under control. Continued fiscal discipline should lead to a narrowing of the budget deficit (from around 4% of GDP this year to 3.7% next year), and the current account, whilst likely to widen on the back of strong import growth, should remain capped at around 3% of GDP, mostly financed by net FDI. Whilst politics are likely to remain shaky, our base case is that the PiS-led coalition will hold together and there will be no early elections. With this backdrop, we believe that the pressure on the zloty will be to appreciate, and we see EUR/PLN trending towards 3.65 by end-2007.

On the monetary policy front, the NBP is expected to come under pressure to raise rates as early as Q1, as inflation rises above 2% due to base effects and some regulated price adjustments. However, we would argue that the scope for rate hikes is quite limited, as a strong zloty and favourable base effects should keep headline inflation below the 2.5% target. In addition, we note that the end of Balcerowicz’s term as Governor of the NBP (he will be replaced by the less known Mr Sulmicki) in January 2007 is likely to result in an even more dovish skew on the board. Our outlook is for Polish rates to rise at most 50bp in H107, and then hold at 4.50% for the rest of the year.

Hungary: fiscal progress to pave the way for rate cuts in H22007

After many years of seemingly unstoppable fiscal profligacy and a dismal track record of missing budget targets, Hungary seems to finally have embarked on a credible path of fiscal consolidation. A large dose of fiscal tightening should drive the fiscal deficit down from over 10% of GDP this year to around 7% of GDP next year. The impact on growth will be large, though some degree of consumption smoothing should cushion the effect on household consumption. We expect overall GDP growth to slow from this year’s 3.8% to just over 2% in 2007, and see the current account deficit narrowing by nearly two points, to 5% of GDP. While Hungary’s imbalances remain large, we believe that what will drive markets next year will be recognition that the country’s fundamentals are at last improving. For this reason, we are constructive on the HUF, which we see appreciating to around 245 against the euro by end-2007.

In terms of interest rates, large increases in regulated prices should push inflation up sharply in Q12007, to around 9%. We expect this spike to keep the NBH on edge, and perhaps to trigger another hike, to 8.25%. That said, with growth and inflation slowing during the course of the year and the fiscal numbers showing signs of improvement, we believe that the second half of the year will be characterised by rate cuts. Also, we note that the departure of some hawkish MPC members from the MPC will likely further increase the number of doves on the Council. We see Hungarian official rates at 7% by end-2007.

Slovakia: advancing steadily towards the euro

Following a rise in headline inflation, a bout of SKK weakness and euro-unfriendly comments by the new SMER-led government, Slovakia’s chances of meeting the Maastricht criteria looked seriously in danger earlier this year. However, a drop in oil prices and renewed SKK strength have dramatically improved the country’s chances of meeting the inflation criterion, which in our view was (and remains) the most challenging. In addition, a relatively conservative 2007 budget and a favourable fiscal starting point imply that the chances of keeping the deficit below 3% of GDP in 2007 are good.

The National Bank of Slovakia increased official rates by 175bps in 2006, in an effort to tighten monetary conditions to rein in inflation. We believe that the combination of higher rates and a firmer SKK (currently roughly 10% stronger than the ERMII parity) have tightened monetary conditions sufficiently and that the NBS will refrain from hiking again. In addition, a sharp improvement in the current account due to auto exports coming on the market should keep the market biased towards SKK strength in the quarters ahead (we expect an exchange rate of 33.5 against the euro by end-2007), which would also support disinflation. It is worth bearing in mind that more pronounced SKK appreciation might even test the lower end of the +/-15% ERM2 band, with the NBS forced to intervene or revalue the central parity, or even cut rates.

Czech: economy still in good shape despite lack of leadership

The June elections delivered an inconclusive outcome, with both factions winning exactly 100 seats. To date, no cabinet has yet been able to gain a confidence vote in parliament, and early elections look like the only sensible way out (other than a German-style grand coalition between centre-right ODS and the Social Democrats). Meanwhile, the economy has shown no sign of weakness yet, with growth on track to be around 6% this year and to slow down marginally to 5.5% next year, still above potential. While the growth outlook is positive, we note that, in contrast with the rest of the region, there are signs of fiscal slippage. The 2007 budget envisages a deficit of CZK91bn, up from this year’s upwardly revised target of 83bn. In ESA95 terms, the deficit next year could be as high as 4% of GDP. Note that, unlike in the rest of the region, the Czech Republic still has to approve the pension reform, which will add to the deficit in the short-medium term.

On the policy front, the CNB has raised rates twice in 2006, to 2.50%, in response to fears about the inflationary consequences of expansionary fiscal policy and possible second-round effects from hikes in regulated prices, which will take place in 2007. With inflation currently already tracking 0.5% below the latest CNB estimates, we believe that the CNB will not hike again until March at the earliest. In total, we believe that a favourable growth-inflation trade-off will limit the scope for hikes to 50bps next year.

Sweden: Hot or Not?

Thomas Gade and Elga Bartsch | London

The land of positive surprises
The economy of Sweden has expanded at impressive rates during recent years. Going forward, we expect a gradual slowdown in GDP growth from 4.5% this year to 3.3% in 2007, and slowing further to trend growth of 2.6% in 2008. On our forecasts, the Swedish economy continues to outpace that of the euro area. The risks to growth are on the upside, we believe. Inflation on the favourite Riksbank’s measure, UND1X, will likely remain subdued throughout the forecasting period and head above the official 2% inflation target towards the end of the forecast period only. On our baseline scenario, a combination of continued withdrawal of monetary stimulus by the Riksbank, gradual strengthening of the Krona, as well as a cyclical slowdown in productivity growth will weigh down on growth. Meanwhile, the lowering of income taxes as announced in next year’s public budget proposal will likely sustain private consumption growth going forward. In our baseline case we continue to expect a gradual normalization in house price appreciation. However, the increasingly stretched housing market remains a significant risk factor. The second key risk will once again be developments in productivity growth. We expect a gradual slowdown in productivity growth, but we wouldn’t rule out further upside surprises.

Withdrawal of stimulus, but a change in pace
With nominal GDP growth likely at around 5.7% this year, the current monetary policy rate of 3.0% remains quite expansionary and well below neutral, we estimate. The period of very accommodative monetary policy has been one of the main drivers of demand, we believe. Throughout 2007 we expect the Riksbank to continue withdrawing monetary stimulus at a gradual pace. Depending on the future developments in consumer price inflation and house price inflation, we expect the Riksbank to continue towards a neutral rate, which we estimate to be around 4.5%. From the end of 2007 and onwards, we expect the Riksbank to continue removing monetary stimulus, but at a lower pace.

Inflation on both the CPI and less so the UND1X measure will be constrained through 2007 by a series of politically induced one-off effects. These one-off effects will unwind in 2008 and inflation should rise. UND1X inflation continues to be the favourite Riksbank measure. This could possibly create slight pitfalls in monetary policy going forward, since UND1X and the formal CPI target measure will continue to diverge. The latter, which is important for inflation-linked bonds, does not strip out interest payments on mortgages, while the UND1X measure does, so the two will likely continue to diverge as the monetary policy tightening continues. The key risk factors next year for the Riksbank will be the outcome of the large rounds of wage negotiations, productivity growth, and developments in house prices and household debt. Wage demands and the possible outcome (although still high) already seem to settle slightly below our expectations of 4% on average, so the key risk factor for inflation will once again be productivity growth, we believe.

The all-important productivity growth

The recent period of high GDP growth and subdued inflation in Sweden has been largely driven by a high rate of productivity growth. Should higher productivity growth remain sustained, Sweden could be in for several years of above-trend growth. Meanwhile, wage growth has been high in an international context in recent years and looks likely to remain on the high side for the next three years. This is indicated by initial wage demands set out before the large 2007 wage negotiations. A subdued rate of growth in unit labour costs (ULC) and inflation will be contingent on a continued high rate of productivity growth. Should productivity growth slow as we are expecting, then growth in unit labour costs will be on the rise (See Sweden Economics: The 2007 Wage Negotiations - Expectations and Implications, Nov. 21, 2006).

More specifically, we expect cyclical productivity growth to slow going forward as hiring and employment pick up. Structurally, productivity growth is benefiting from a growing ICT sector and capital deepening associated with the use of ICT equipment in other sectors from an early stage. The Swedish economy has enjoyed both a higher capital-to-worker ratio as well as a relatively higher degree of ICT penetration. In this way the Swedish economy resembles the US economy. Efficiency gains from capital deepening may raise the productivity level permanently, but boost productivity growth only temporarily. Thus productivity growth will likely abate as the efficiency gain from the use of new technology starts to level off. However, structural productivity growth need not necessarily slow going forward provided there is ongoing innovation in ICT equipment. Nevertheless, other regions, particularly the euro area, in which capital deepening started at a later stage, may start to catch up and experience higher productivity growth and lower ULC growth going forward. Thus there is a risk that the competitive position of the Swedish economy could slip going forward.

Potentially a poisonous cocktail for exports

The key factor needed for controlling growth in unit labour costs (ULC) is a sustained high rate of productivity growth. In particular, as the preliminary wage demands suggest, the 2007 wage negotiations will likely result in wage growth somewhere around the expected 4% on average over the three years traditionally governed by the wage contracts. Should wage growth rise by half a point on average from the previous years’ level and productivity growth slow to around 2%, unit labour costs could rise by 2.5% in the years ahead. Add to that a potential strengthening of the trade-weighted exchange rate (TWER) of 4% in 2006 and about 1% in 2008, as projected by our currency economists, and this combination has the potential of significantly hampering export growth and manufacturing and service sector revenue and profits in the years ahead.

Bottom line - Hot or Not?
The answer is: it depends. It depends on productivity growth. The Swedish economy is likely to slow, while staying above trend and above Europe. Domestic demand growth will be sustained by private consumption growth as disposable income will see a significant rise due to lower income taxes and higher employment. Investment spending growth will likely continue due to high capacity utilization, but the investment spending momentum may slow as the Riksbank continues to withdraw monetary stimulus, we think. Indeed, demand-driven growth appears likely to stay hot. Inflation will gradually creep higher as we expect cyclical productivity growth to slow. However, we cannot rule out further positive surprises in productivity growth. Should that be the case, Sweden may once again be in for high growth and low inflation.

Nordics: Sweet Dreams or Nightmare?

Thomas Gade | London

Strong growth and substantial risks
The Nordic economies (Denmark, Finland, Norway and Sweden) continued to pace ahead during 2006. On aggregate, we expect the Nordic region to expand by a staggering 4.2% this year, slowing to 2.9% in 2007 and further to 2.4% in 2008. Despite variations within the Nordic economies, growth in the Nordic region remains above that of the euro area on our forecasts. The Nordic economies in general have benefited from high productivity growth, strong foreign demand and increasing domestic demand, fuelled by a prolonged period of expansionary monetary policy and significant wealth effects. The key risk factors going into 2007 are increasingly stretched housing markets in Denmark, Norway and Sweden, as well as very tight labour markets in Denmark and Norway and a still loose but tightening labour market in Sweden.

Three factors suggests slower growth

With the exception of Norway, we expect the Nordic economies to slow during over the forecast horizon. The three main factors driving the slowdown will be a continued withdrawal of monetary stimulus, a gradual currency strengthening and — more fundamentally — the increasingly scarce labour resources. As small open economies, the Nordic economies are sensitive to developments in the global economy, in particular to developments in the euro area. On the upside — although it is not our baseline case — sustained structural productivity growth and increased immigration could subdue some of the expected growth slowdown and abate otherwise increasing wage pressures. On the downside, a more abrupt slowdown in house price growth — not to mention a drop in house prices — could significantly hamper household consumption going forward.

Loose monetary policy still fuels demand
Although monetary policy is still expansionary and spare production capacity increasingly scarce in the Nordic region, the continued withdrawal of monetary policy by Riksbanken, Norges Bank and the ECB is likely to gradually slow investment spending growth throughout the region. Despite ongoing monetary policy during 2006, monetary policy remains accommodative in all the Nordic countries. As Finland is a member of the euro area and Denmark has a fixed exchange rate towards the euro, the monetary tightening will be determined by the ECB (see Elga Bartsch’s note in this publication). In Norway and Sweden, we expect Norges Bank and Riksbanken to outpace the ECB through 2007 and to continue to withdraw monetary stimulus possibly through 2008 also. Financial conditions are likely to tighten further by a gradual currency strengthening. This will particularly be evident in Norway and Sweden, we think.

Tight labour markets and little immigration
Labour markets are tightening across the Nordic region. Labour markets in Denmark and Norway look particularly tight, while some slack remains in the labour markets in Sweden and Finland, we estimate. In Denmark and Norway, a rising proportion of companies are reporting labour shortage in several sectors ranked from construction and financial services through manufacturing. It is striking that the tight labour markets in Denmark and Norway has not led to a higher degree of wage inflation yet. Part of the explanation can be found in an increasing degree of flexibility in the labour markets, which has also resulted in a low rate of structural unemployment. Second, parts may be assigned to a higher degree of off-shoring. On our measure of structural unemployment (NAIRU), only the unemployment rates in Sweden and Finland are above the structural unemployment rate at present. Unemployment below the NAIRU in Denmark and Norway will likely cause upward pressure on wage growth over the forecast horizon.

Whether labour markets remain tight and result in increasing wage pressure will also depend on the labour supply from the new EU member states in particular. In recent years, a rise in the inflow of labour supply has been significant in Sweden only. Obtaining larger inflows of labour supply from the Central and Eastern European economies will become increasingly important to abate some of the labour market pressure in Norway and Denmark. On our baseline scenario, we would however still expect wage compensation and unit labour costs growth in Denmark and Norway to outpace wage growth in Sweden and Finland. Increasing the labour supply is especially important today. Facing an aging society across the Nordics, it is not a short-term issue. Depending on the developments in labour supply, we see significant downside risks to growth in the years ahead — particularly in Denmark and Norway.

Stretched housing markets a major risk factor
Housing markets in the Nordics look increasingly stretched, with the exception of Finland. In a recent OECD study, three of the Nordic countries are unfavourably ranked in the top-seven with respect to the probability of house prices ‘nearing a peak.’ In particular, the Danish housing market — ranked first among the OECD countries — looks prone for a potentially sharp adjustment. Across the Nordics, the rise in house prices over the last 10 years has been accompanied by a similar build up in household debt. Meanwhile, interest payments as a percent of disposable income have declined over the same period of time.

The drop in the ratio of interest payments to disposable income may not only be explained by decreasing interest rates over this period of time. Particularly in Denmark, the drop may have been exacerbated by an increasing share of short-term maturity and flexible rate borrowing. As such, Danish households, with the highest debt to income ratio in the Nordics, have become increasingly sensitive to developments in short-term interest rates. In Denmark, the unwinding of the house price bubble could be severe. As our colleagues David Miles and Melanie Baker recently pointed out in a study on the UK housing market, a large part of current UK valuations can be explained by expectations of further price rises only. Valuations are therefore very much dependant on expectations and could potentially be volatile (See UK Economics: How Did We Get Here? Nov. 22, 2006). Although this may also be the case in Denmark, a revaluation would still need a trigger. The massive rise in the number of houses for sale during recent months and stagnating sales prices may be exactly such a trigger. On balance, the potential abrupt slowdown in house prices constitutes a significant downside risk to consumption demand for Sweden and Denmark in particular. Meanwhile, our baseline case for Sweden and Norway remains for a gradual slowdown in house price appreciation. This may hamper consumption growth, but in Sweden this will likely be offset by the expected rise in household disposable income growth, induced by lower income taxes and employment growth.

Bottom line — Sweet Dreams or Nightmare?
The Nordic economies have shown impressive growth rates during recent years. In particular, demand has been fuelled by a very expansionary stance of monetary policy, but also productivity growth has been impressive on the supply side. Monetary policy is being gradually tightened, and the currencies are gradually strengthening. We therefore expect the economies to gradually slow, but for aggregate growth to remain above that of the euro area. Two risk factors in particular need to be addressed: labour markets and housing markets. Labour supply will need to be increased. In Sweden, this is already happening through increased immigration flows and changes in the tax base. The remaining Nordic economies are lagging behind in this respect. Housing markets look increasingly stretched; in particular, for Denmark, the unwinding of the housing bubble could be severe. There is still scope for sweet dreams in Sweden, but be prepared for potential nightmares in Denmark.

UK: Benign Central Case Belies the Risks

David Miles and Melanie Baker | London

We end 2006 with the economy and financial markets having had another decent year. GDP has risen consistently and, for the year as a whole, at marginally above what we estimate is the trend rate. Interest rates — in nominal and especially in real terms — remain low, and the exchange rate has been relatively stable on a trade-weighted basis, though on a more volatile upward path against the dollar. Unemployment has edged up but so has employment, while stock prices and house prices have moved higher over the year. But inflation ends the year substantially higher than at the start of the year, and we expect it to rise a little further early in 2007. There is a real risk that this triggers an acceleration in wage settlements; if RPI inflation is close to 4% in the spring, then no change in the pace of earnings growth would mean stagnant real incomes. Zero real wage growth is not implausible — in fact it is quite likely. But there are obvious risks that wage rises move up and interest rates are increased to reduce the chances of above target inflation becoming persistent. Even without interest rate rises, house prices look vulnerable in the UK. However, we are not convinced that falling house prices — themselves likely at some point — need trigger a sharp slowdown in consumer spending.

Central GDP projection: solid but lacklustre

Our central projection for the UK economy is for solid, but slightly sub-trend, growth in 2007. After 2.6% real GDP growth in 2006, we project 2.3% in 2007 and 2.5% in 2008. This forecast, however, embodies two key assumptions. First, potential growth has not risen and does not rise significantly; second, export-weighted global growth slows (very moderately). On the first, we assume that the pace of immigration seen in the UK since 2004 does not continue at quite such a high rate and that productivity growth remains rather disappointing. There has been no sign of any increase in the rate of productivity growth in the UK in recent years — indeed, the evidence, if anything, is to the contrary. On the second, our global economics team regards risks to the global outlook as skewed to the downside.

Components of GDP growth: a sluggish consumer

We continue to think that consumer spending will not pick up significantly in 2007, keeping overall growth subdued. Household savings still look on the low side, debt levels and debt service levels remain high, and risks are skewed to the downside in the housing market. Arguably, the low volatility environment we’ve seen in the UK over the past decade may have helped sow the seeds for a more volatile period ahead. Less fear of sharp gyrations in the economy has likely been a factor behind households building up very high levels of debt (which may leave the economy less able to weather shocks, such as a sharp move in interest rates or deterioration in the labour market, in 2007). With slower global growth, investment spending growth may decline a touch and the contribution from net exports may be marginally negative. Against that backdrop, growth slightly below the pace of 2006 seems likely to us in 2007.

Inflation: risks on the upside

In our central forecast, we see year-on-year inflation rising into the turn of 2006 before gradually declining towards 2.0% (the Bank of England’s target). We believe it is likely that GDP growth runs slightly below potential in 2007 and that current upward pressures on inflation, from factors including electricity and gas bills, diminish and then fall out of the year-on-year comparison. However, two main factors suggest that inflation risks lie more on the upside than the downside of that profile: 1) we think there is little spare capacity in the UK economy; and 2) wage increases may become more inflationary. So far, wage growth has been very benign, but a number of factors are coinciding at an important time for wage negotiations (the turn of the year). These give us some cause for believing that wage growth risks are on the upside across a range of sectors and job types. First, RPI inflation (more important in wage negotiations than CPI) is likely to rise towards 4.0% year on year by the beginning of 2007; second, the minimum wage rose 5.9% in October 2006; third, discretionary income (the amount of money households have left after paying taxes and energy bills and after debt repayments) has been squeezed, which may persuade some to push hard for higher wages; and fourth, profit growth has been relatively strong in the UK in 2006.

Interest rates: on hold with upside risks

With a central profile of around trend GDP growth and inflation remaining above target, but gradually declining over 2007, our central (single most likely) scenario is that interest rates remain on hold throughout 2007. However, with inflation risks still on the upside, we think that the risks to this profile for rates are skewed more in the direction of further rate rises rather than further cuts. Bond yields, however, end the year at levels that seem to imply little chance of interest rate increases of all but the most minor and temporary sort. Given that situation, we believe that gilts will move lower (yields move higher) in 2007. Equity prices seem more fairly to reflect risks and stock market valuations are more robust to the impact of a possible pick up in inflation and interest rates.

Politics: Continuity, despite changes

Tony Blair looks set to step down as Prime Minister some time in the first half of the year — probably close to the 10-year anniversary of his leadership in May. It is overwhelmingly likely that his successor will be Gordon Brown, who will inherit a substantial parliamentary majority and who will, as a result, be under no pressure to call an election. (There need be no election until 2010 so, in principle, the new Prime Minister will have almost three years before needing to face opposition parties at the polls; in practice, it is likely that an election is called before 2010). Since Brown has been in charge of the overall direction of economic policy for several years, the thrust of fiscal and monetary policy — including the policy of simply ignoring the option of adopting the Euro — looks set to continue. The strategy on spending and taxing will continue to be one where expenditure rises only marginally above 40% of GDP. But that will be a very tough strategy to implement — particularly with the 2012 Olympics approaching and significant infrastructure spending still required. Keeping overall government spending contained may prove very tough.