Sunday, December 24, 2006
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.
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.
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
Private consumption trend lacks vigor. The region’s overall efforts to pursue domestic demand growth strategies have not been very successful. Both
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,
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
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.
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.
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
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
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.
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
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
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 —
There is an added element of
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.
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
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
The scapegoating of
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
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
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.
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$110 billion.
Quantifying the impact of sterilization against the BoP surplus helps explain why the monetary tightening measures so far have not been sufficient to lift the cost of capital meaningfully, which we believe is vital in discouraging wasteful fixed investment. The bond issuance program has been far from aggressive in recent months, suggesting that the PBoC remains reluctant to lift interest rates significantly. We believe that this incomplete sterilization underpins the friendly liquidity environment in
Hong Kong — enjoying liquidity inflows, but wary of volatility. Liquidity conditions and asset market performance have a strong influence on real economic activity in
The expansion of Hong Kong’s financial asset base in the last few years has been driven by
We have seen robust pickup in consumption and investment on the back of asset appreciation and low interest rates in the last couple of years. Consumption has been lifted by the positive wealth effect, while employment, wages and household income have only been catching up in the last two quarters. Consumer businesses have also turned more positive on expansion plans amid stronger consumption. However, it worries us that, as a small, open economy with a fixed exchange rate,
The imminent crossing of the RMB/US$ 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
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
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,
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.
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.
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.
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
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
The case “for” decoupling. There are two key arguments supporting the case for decoupling. First, AXJ’s trade dependence on the
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
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
Accounting for 17% of the region’s GDP growth,
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
Michael Kafe | London
We expect 2007 to be another year of opportunities in
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).
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
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
As always, however, there are some risks. For 2007, we think the biggest risk is politics. This is not because we think
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.
Pasquale Diana | London
Across the region,
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.
After many years of seemingly unstoppable fiscal profligacy and a dismal track record of missing budget targets,
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.
Following a rise in headline inflation, a bout of SKK weakness and euro-unfriendly comments by the new SMER-led government,
The National Bank of
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
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.
Thomas Gade and Elga Bartsch | London
The land of positive surprises
The economy of
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
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
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
Thomas Gade | London
Strong growth and substantial risks
The Nordic economies (
Three factors suggests slower growth
With the exception of
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
Tight labour markets and little immigration
Labour markets are tightening across the Nordic region. Labour markets in
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
Stretched housing markets a major risk factor
Housing markets in the Nordics look increasingly stretched, with the exception of
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
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
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
Our central projection for the
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
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
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.