Morgan Stanley

Cross-border trade flows are the glue of globalization.� They are the means by which the world creates ever-virtuous circles of prosperity. The theory is simple: As poor countries enter the global supply chain, their increasingly prosperous workers eventually become consumers. Supply creates new demand, and the world is a net winner.� While it�s hard to argue with this theory, today�s world is having an increasingly difficult time in putting this theory into practice.� The global trade engine is at risk of being derailed.

That would come as a rough jolt to the world economy.� Indeed, there can be no mistaking the increasingly important role global trade has played in driving world economic growth in recent years.� By our estimates global trade in goods and services now amounts to 25% of world GDP, up dramatically from the 19% share just ten years ago and an 11% portion in 1970.� Over the past 17 years, 1987 to 2003, surging global trade has accounted for fully 33% of the cumulative increase in world GDP.� By contrast, over the 1974-86 period, trade accounted for about 17% of the cumulative increase in world GDP.� In other words, since the late 1980s there has been a virtual doubling of the role that trade has played in driving the global GDP growth dynamic.� There can be no greater testament to the power of globalization.

Yet there are worrisome signs that the trade dynamic is now going the other way.� After surging by a record 13% in 2000, global trade has entered one of its worst slumps in modern experience -- average gains of just 2% over the 2001-03 period.� That�s the weakest performance since the early 1980s and only a third of what we estimate to be a 6.5% long-term trend in global trade growth.� Coming in the context of one of the mildest global recessions in recent history, this shortfall is all the more disconcerting.� It suggests that there may be new forces coming into play that transcend the normal pressures of the business cycle.

What worries me most is that the recent shortfall in global trade may be a warning shot of even tougher times ahead.� Two key forces are at work:

The first is a new and powerful global labor arbitrage that has led to accelerating transfer of high-wage jobs from the developed world to lower-wage workforces in the developing world.� Enabled by the Internet and the maturation of vast offshore outsourcing platforms in goods and services alike, labor has become more �fungible� than ever. In a world without pricing leverage, the unrelenting push for cost control gives a sudden urgency to this cross-border arbitrage.� The outcome is a new and potentially lasting bias toward jobless recoveries in the high-wage developed world.� That brings the second major force into play -- a political backlash against the trade liberalization that allows such cross-border job shifts to occur.� It is the politics of this trend that disturb me the most as I peer into the future.

Insecure and scared workers tend take out their fears and frustrations on incumbent politicians.� To the extent that the IT-enabled global labor arbitrage represents a new and lasting threat to job security in the developed world, this political backlash is understandable -- albeit deplorable.� This backlash has now taken on a life of its own -- giving rise to what I believe is a �perfect storm� in global trade policy.� This storm is an outgrowth of five major setbacks on the global trade front -- the first and most worrisome being the breakdown in the WTO ministerial negotiations last September in Cancun, Mexico.� Tensions between poor developing countries and the wealthy industrial world came out in the open on such long-standing issues of agricultural subsidies, competitiveness and investment rules, and financial market transparency.� This failure is on a par with the WTO fiasco in Seattle in 1999 and all but rules out successful completion of the so-called Doha Round of multilateral trade liberalization originally slated for 2004.

The second is the mounting risk of a global trade war over steel. Motivated largely by domestic political considerations, the Bush administration raised tariffs on selected steel imports by up to 30% in March 2002, drawing justification from the WTO's so-called Safeguard Agreement.� The WTO has since found these measures to be illegal and has given the United States until December 15 to rescind them.� The European Union has warned of the imposition of $2.2 billion in retaliatory measures should that not occur.� Others, including most recently, Japan and Norway, have announced that they will follow suit.

Third, China bashing has taken an ominous turn for the worse.� The Japanese fired the first rhetorical salvos in this trade battle well over a year ago, accusing China of exporting deflation and hollowing out the Japanese economy.� America has taken the blame game to a new level. The Bush administration has just imposed quotas on imports of selected Chinese textile products, and legislation has been introduced in both houses of the Congress that would impose huge tariffs on all Chinese imports into the US -- 27.5% in the case of the Senate version and most likely even a higher tax in the House version.� The most worrisome aspect of these legislative threats is the broad bipartisan and ideological support they enjoy in the Congress.� Moreover, there is no effective political counterweight to America�s onslaught of China bashing.� The White House has put its protectionist cards on the table by actions on steel and Chinese textiles.� Nor have trade-intensive US multinationals spoken up -- hardly surprising in this post-Enron climate of political vindictiveness.

Fourth, trans-Atlantic trade tensions between the United States and Europe seem to have taken on a life of their own.� It�s not just steel.� It�s also disputes over genetically modified beef and other food products, agricultural subsidies, and a broad array of services.� Particularly contentious is America�s Foreign Sales Corporation tax law (FSC), some $4-5 billion annually of export tax subsidies.� The WTO has also ruled the FSC arrangements illegal, granting the EU up to $4 billion in remedial damages if these measures are not lifted by the start of 2004.� Cross-border US-European trade currently amounts to some US$400 billion annually, hardly a trivial mater.� With Europe and the US both facing intensified structural pressures on the job front, one of the pillars of the world trading system is at risk of crumbling.

Fifth, a darkening outlook for multilateral trade breakthroughs is being compounded by deteriorating prospects for less ambitious bilateral and regional agreements.� The just-concluded negotiations in Miami for the Free Trade Association of the Americas are a case in point.� The meetings adjourned with nothing of great substance accomplished other than an agreement to meet again next year.� The same snail-like progress has been evident with respect to the US-Central America Free Trade Agreement, as well as one with Australia.� In a jobless recovery that is now moving into the full force of the election cycle, the US Congress seems to have little appetite for either the large or the small milestones on the road to trade liberalization.

We all know the dark lessons of protectionism.� The odds of falling into that abyss remain low, in my view.� But support at the other end of the spectrum -- accelerated trade liberalization -- is slipping rapidly.� The lasting impacts of the global labor arbitrage are striking worrisome chords in the body politic of the rich, developed world.� That poses a serious challenge to the trade-led strain of global growth that has been such a powerful force is shaping the global economy since the late 1980s.

Fear lurks in all of history�s darkest corners.� Gibbons put it best in the Decline and Fall of the Roman Empire: �There exists in human nature a strong propensity to depreciate the advantages, and to magnify the evils, of the present times.�� To me, this encapsulates the resistance to globalization.� As these pressures mount, we can only hope -- perhaps demand -- that opportunistic politicians come to their senses. America�s role in sparking the backlash to trade liberalization is particularly disconcerting.� As the world�s unquestioned economic and military superpower, the United States is in real danger of squandering its leadership in the arena of globalization.� Perhaps I�m pushing Gibbons too hard on this point, but to me this dark side of America has some striking similarities with his description of Rome at its pinnacle, ��when the uniform government of the Romans, introduced a slow and secret poison into the vitals of the empire.� The minds of men were gradually reduced to the same level, the fire of genius was extinguished, and even the military spirit evaporated.�

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Global: False Dawn

Rebecca McCaughrin (New York)

Monthly US portfolio flow data rarely attract more than a cursory glance from financial markets, but the latest batch of surpr

Monthly US portfolio flow data rarely attract more than a cursory glance from financial markets, but the latest batch of surprisingly weak data sent ripples through markets this week.� The US Treasury release indicated that net aggregate portfolio inflows plunged to just $4.2bn in September, an even sharper slide than that in the aftermath of the terrorist attack in September 2001 and the lowest level since the LTCM crisis in late 1998.� In our view, September will likely prove an outlier, mostly reflecting a knee-jerk reaction by private investors to the G-7 communiqu�.� The massive inflows seen during May-June were also outliers we believe, and as we argue below, the current pace reflects a rebalancing, not an inflection point.�

But first, a few disclaimers on the data:� First, the monthly US Treasury data (TIC) include both official and private portfolio flows, but do not capture investment in short-term securities.� Second, the data tend to overstate foreign investment in US bonds and understate US investment in foreign equities.� Third, the regional data can be misleading because they represent the place of transaction, not the ultimate source, destination, or issuer.� Fourth, the data can be volatile and subject to revisions.� That said, with careful interpretation, in our view, the data still provide valuable indicators of capital flows between the US and the rest of the world.

The plunge in portfolio investment in September took place across most assets (excluding corporate bonds), and was triggered by a retrenchment by European, Asia ex-Japan, and �other� (mostly offshore) investors.� Thanks in part to Japan�s MoF intervention in September, funds from Japan were the only significant inflows recorded for the month.� While Asian central banks have helped to prop up foreign demand for US securities this year, the transatlantic axis still matters.� After averaging $28bn in net purchases of US securities during the first eight months of this year, Europeans suddenly switched gears in September, selling off $403mn.� The impact is a reminder of how critical Europe is to the pace of capital inflows.

Generally, such a dramatic month-to-month swing is accompanied by an external shock (i.e., September 11 attack, LTCM/Russian debt crises, corporate scandals, Iraq crisis, etc.).� The only key event this time was the issuance of the G-7 communiqu�, which was initially hailed as a mini-Plaza Accord.� US officials have since muted their rhetoric and the initial panic has subsided.� Official institutions appear not to have heeded the message in any case, hardly flinching and continuing to steadily increase their holdings of US securities.�

A closer look at the TIC data indicates that foreign official institutions actually stepped up their investment significantly during September.� More recent weekly custody holdings data (which capture both long-term and short-term securities) through November 19 point to a sustained accumulation of US government securities.� Private investors, however, were clearly spooked by the communiqu�s message -- gross private inflows slid to just $4.3bn for the month, down from $62.4bn the prior month and $40.4bn a year ago.� Private investors tend to be more fickle than official institutions.� They are also more important as a source of financing, and thus can spark sharp reversals.� Although central banks have played an important role in financing the deficit over the last year and a half, they are not the linchpin that they are often perceived to be, in our view (see McCaughrin, �What are the Options?� September 19, 2003).�

In addition to the initial exaggerated reaction to the communiqu�, the fall-off in investment in September also reflects the rebalancing that took place following the post-Iraq relief rally.� The last three quarters were punctuated by very different developments: During Q1, geopolitical concerns weighed heavily on demand for US assets, as gross inflows slowed to $139bn.� Then in Q2, the relief rally following the Iraq invasion helped to unleash pent-up demand for US assets, resulting in a record $247bn in foreign inflows for the quarter.� Then, as perceptions normalized and the relief rally lost some momentum, inflows moderated to a still healthy $153bn in Q3.� September may have been an outlier, but so were the massive Q2 inflows. �All in all, factoring in growing outflows and September�s plunge, the US has still managed to attract $688bn in net aggregate portfolio inflows on an annualized basis this year, more than sufficient to cover the projected current account deficit of $600bn.�

While we doubt September�s pace will persist, there are three risks which could become more serious if foreigners were to continue to aggressively retrench from US assets.� First, US investment in overseas securities is rising, which is contributing to downward pressure on our net aggregate intake of capital.� After five years of subdued outflows, US investors are rediscovering overseas markets, primarily equities in Japan, Europe, and emerging Asia.

Second, more sluggish net aggregate portfolio inflows are of concern in light of the disproportionate composition of US financing. Foreign direct investment (FDI), the other key component of US capital inflows, offers little offset.� Ever since the M&A bubble burst, the external financing needs of the US have remained disproportionately dependent on portfolio flows.� Indeed, FDI has been a net drag on financing for the last eight quarters.� Higher frequency M&A data ― a rough proxy for FDI flows ― suggest that this trend is unlikely to change before year-end.

Third, while global investors demonstrate a greater preference for US assets relative to other foreign assets, this year their allocation has been especially disproportionate.� Looking strictly at portfolio flows into the US, Japan, and Euroland, US assets have attracted 71% of total foreign investment in these economies through the first seven months of this year, compared to 57% during 1998-2002.� Meanwhile, the allocation into Japanese assets has held steady at 5% of total investment.� Euroland assets have borne the brunt of the pullback, attracting 24% of the cumulative investment in these three economies so far this year, compared to 37% during 1998-2002.� A key concern is that foreign investors may respond to being �underweight� Euroland assets.

The sharp drop in portfolio inflows in September was partially a knee-jerk reaction to the G-7 communiqu� and partially an extension of the rebalancing seen in Q3.� A single data point does not signal a full-scale decamping from US assets, but it does remind us of the vulnerability of our external financing needs to private investors and the importance of the transatlantic axis.

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United States: Review and Preview

Ted Wieseman/David Greenlaw (New York)

The Treasury market saw modest 10-year led gains over the past week, taking yields at the longer end of the curve to their lowest levels since before the surprisingly strong September employment was released October 3. The gains came despite good results from various data releases and surveys that pointed to upside in the key employment, ISM, and motor vehicle sales reports due out the week after Thanksgiving. Investors were also able to brush off indications that disinflationary pressures -- and Fed concerns about disinflation -- are easing. Instead, the market benefited from a flight to safety following the terrorist attacks inTurkey, trade frictions that hit the dollar, and a drop in the stock market. The more negative geopolitical backdrop along with the ongoing pause in demand in the economy -- even as higher frequency data point to a reacceleration in consumer spending and the production recovery remains on track -- appears also to have increased anxiety among investors about the sustainability of the economic recovery. It was also a heavy week for spread product issuance, which dominated intraday market attention for much of the week, as issuers looked to get financing done ahead of what's likely to be very thin conditions in the coming holiday week.

Benchmark Treasury yields fell2 to 8bp over the past week, extending the 20 to 25 bp rally seen the prior week. The 10-year led the way higher, with 2's-10’s flattening 6 bp and 10’s-30’s steepening 2 bp on an 8 bp drop in the 10-year yield to 4.15%, a 2 bp dip in the 2-year yield to 1.80%, and a 6 bp fall in the long bond yield to 5.00%. The 5-year continued to perform relatively strongly on the curve, as its yield fell 7 bp to 3.13%, while the 3-year lagged, with its yield down 3 bp to 2.33%. Despite the generally strong economic data and more mixed comments from the large number of Fed speakers, the market continued to scale back the amount of Fed tightening priced into the futures market, as the April fed funds contract rallied 1 bp to 1.095% and the July contract 2.5 bp to 1.365%.

Data releases and surveys out the past week pointed to solid results for key economic data due after Thanksgiving. Jobless claims posted a surprising 15,000 decline to 355,000 in the latest week (which coincided with the survey week for the November employment report), taking the 4-week average to nearly a 3-year low of 367,250. This compares with 4-week averages of 393,500 in the October survey period and 411,250 in September. We expect November nonfarm payrolls to rise 175,000, excluding any temporary strike impact, which would be the strongest gain in three years. TheCaliforniagrocery strikes could reduce the actual gain by 50,000 or so, but we will wait until the release of the BLS's monthly strike activity report to incorporate this into our estimate. Regional manufacturing surveys were mixed but generally indicated that the production rebound remains on track. Looking at rebased and weighted composites of the activity indicators, an ISM comparable version of theEmpire Statemanufacturing survey would have risen to 61.6 from 59.1, while the Philadelphia Fed survey would have fallen to 56.2 from 58.5. We look for the November ISM to tick up a half point to a four-year high of 57.5. Finally, Morgan Stanley auto analyst Steve Girsky expects November motor vehicle sales to rebound to a 16.3 million unit annual rate from a 15.6 million unit annual rate in October. Combined with recent positive indications from weekly chain-store reports, this would point to a reacceleration in consumer demand heading into the key holiday shopping season from the September/October pause that followed the surge in spending over the April to August period.

Meanwhile, the CPI report indicated that disinflationary pressures may be ebbing as demand has surged over the past six months. Core CPI inflation collapsed in the first part of this year as demand again relapsed ahead of the war, rising only 0.6% annualized in the four months through April -- down sharply from the +1.9% rise in 2002. Over the past six months, however, core inflation seems to have stabilized near +1 1/4% to +1 1/2%. While this is still below the 2% or so that appears to be the consensus preferred rate at the Fed, comments from several Fed officials during the past week indicated lessening fears of a further "unwelcome fall in inflation." We do not believe the FOMC will alter its official stance at the upcoming meeting, but Fed officials appear to be moving closer to adopting a more neutral risk assessment and policy statement in the months ahead.

Key data releases this past week included business inventories, CPI, and housing starts:

* Business inventories posted a surprising 0.3% increase in September, with the retail component up 1.0%, wholesale up 0.4%, and manufacturing down 0.4%. Within retail, autos rose 1.5%, in line with industry data, while the ex auto component jumped 0.8%, the largest gain in three years. With business sales up 0.6%, the inventory/sales ratio held at a record low 1.36 for a third straight month. Upside in September wholesale and retail inventories indicates that restocking in response to the Q2 and Q3 surge in demand started somewhat earlier than previously believed, pointing to a smaller inventory decline in Q3 and upward revision to GDP. We expect this process to continue in the months ahead and significantly boost Q4 growth.

* The consumer price index was unchanged in October, as an even bigger than expected plunge in energy prices (-3.9%) offset a larger than expected 0.2% gain in the core. The core was boosted by a 0.4% rise in the key shelter category, half of which was accounted for by a 2.3% jump in hotel rates that contributed 0.1 percentage point to the overall core CPI increase. This upside will likely be largely reversed in coming months. Otherwise, trends in key core components were little changed, with some upside in services offset by continued goods price deflation. Excluding the hotel distortion, the core CPI was up 0.1%, in line with the trend seen the past six months, as underlying inflation has stabilized near 1 1/4% to 1 1/2% after plummeting in the early part of the year.

* Housing starts posted a surprising 2.9% gain in October to 1.96 million units, a nearly 18-year high. The key single-family component jumped 5.7% to a record high 1.617 million, while the multi-family component fell 8.5% to 343,000. Surprisingly, the strongest region was the West (+17.7%), where we expected the fires inSouthern Californiato depress activity. Going forward, rising apartment vacancy rates may continue to weigh on multi-family starts, but high homebuilder sentiment, still low rates from a longer-term perspective, improving consumer income, low inventories of unsold homes, and a sharp rise in backlogs of permitted but unstarted houses (+21% year/year) point to solid underlying support for single family activity.

A bunch of economic data releases and a 2-year auction will be squeezed into the shortened upcoming week ahead of an early Wednesday close, the Thanksgiving holiday Thursday, and another early close Friday. Due out on Tuesday are revised GDP, Conference Board consumer confidence, and existing home sales. Wednesday looks like it could be messy, with durable goods, jobless claims, personal income and spending, Michigan consumer confidence, new home sales, Chicago PMI, and an early 2-year auction (which we expect to be unchanged in size at $26 billion) all crammed in before the 2:00 PM close:

* Figures for construction spending and inventories came in above the BEA's assumptions. So we look for an upward revision to Q3 GDP to +8.0% from the initial print of +7.2%. The reading for final sales is also likely to be boosted to +8.0% (versus the prior +7.8%).

* We forecast October existing home sales of 6.40 million units. Resales soared to another new all-time high in September. The fundamental picture for real estate markets remains quite healthy, but with mortgage application volume edging a bit lower in recent weeks, it looks like we may be past the absolute peak. So we look for sales to slip by about 4% to a pace that is still 7% above the 12-month average.

* We look for the Conference Board's measure of consumer confidence to rise to 86.0 in November. TheUniversity of Michigansentiment gauge posted a 4-point gain in early November. Since the Conference Board measure places more emphasis on labor market conditions, we expect to see a somewhat larger advance (the index was 81.1 in October).

* We expect October durable goods orders to tick up 0.1%. Although surveys point to a pick-up in the underlying pace of order volume, a partial retracement of the surge in motor vehicle bookings seen in September should help restrain the headline figure this month. Meanwhile, the key core category -- nondefense capital goods excluding aircraft -- is expected to post a solid gain (+0.7%), which would mark the fifth rise in the past six months.

* We forecast a 0.4% rise in October personal income and a 0.1% increase in spending. The October labor market report points to a modest acceleration in income growth relative to the recent pace. Meanwhile, a fall-off in unit sales of motor vehicles and sluggish non-auto retail sales imply only a fractional rise in overall consumer spending for October. Consumption appears to have downshifted to a +1.5% growth rate in Q4. Of course, this comes on the heels of a better than 6% rise in Q3. In general, it appears that consumer spending has been running at an underlying pace of 4% over the past few quarters. We expect this trend to continue into 2004.

* We forecast October new home sales of 1.15 million units. In recent months, sales of newly constructed residences have edged down only slightly from the all-time record peak of 1.20 million units set back in June. The latest homebuilder survey -- though down a bit from the peak -- points to a continued high level of optimism. So we look for sales to edge up by about 0.5% in October. Note that the expected result would be more than 8% above the average recorded over the prior year.

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Currencies: What an Equity Market Revival Would Mean for G10 Currencies

Karin Kimbrough (New York)

Bucking Conventional Wisdom

In this note, we re-examine the conventional wisdom that a strong domestic equity market will benefit the domestic exchange rate, especially where the equity market is well developed. In fact, we find the counter-intuitive result that strong equity markets are associated with currency depreciation. A second surprise is that the more developed the equity market is, the more the currency depreciates.

Surprise 1: A Strong Equity Market Does Not Lead to Currency Appreciation

We examined the correlations between excess stock returns and foreign exchange returns on a monthly basis for the G10. We find that the correlation between monthly excess stock returns and currency returns is negative. In other words, the higher the excess equity return in a market, the more that local currency depreciates. This bucks the conventional wisdom that a strong equity market corresponds to currency appreciation. The countries most likely to see currency depreciation associated with strengthening equity markets are the EMU, Switzerland, and Canada. Curiously, the NZD actually benefit from relatively strong equity markets while Norway and Australia stand out as more immune to this negative relationship. (Other literature has found this true for Australia and Japan in the past*). In sum, a relatively strong equity market is more likely to lead to currency depreciation. This is also the case for excess equity returns relative to the euro area and the EUR. We consider why this should be in the next section.

Surprise 2: The More Developed the Equity Market Is, the More the Currency Could Depreciate

A second surprise popped up when we considered the growing importance of integrated markets and the close correlation between US and G10 equity markets. Arguably, increased equity market development in a country could lead to more sensitivity to equity markets and thus currency appreciation. But, in fact, we found that the more developed the local equity market is, the more we can expect to see exchange rate depreciation go hand in hand with stronger equity markets. We proxy the degree of stock market development with the size of the market capital relative to GDP. By contrast, less developed equity markets are not as susceptible to the negative correlation in Surprise 1. Translating this into country-specific results, we find that Switzerland and the EMU are the least likely to benefit from an equity market revival while New Zealand, Norway, and Australia are perhaps the most likely to benefit.

Explaining the Surprises with Liquidity

In our view, liquidity probably explains much of this inverse relationship. Less liquid markets have fewer participants, may involve more risk, and have less-developed equity markets relative to the rest of the G10. As a result, a local equity market revival in a less-liquid market induces investors who may not be invested heavily to participate even when equity prices have already started to climb. By contrast, where markets are more liquid, an equity market revival only makes the price look more expensive and therefore investors prefer to wait for cheaper levels. Of course, this analysis only discusses equity market flows because they are typically unhedged and thus have a greater potential impact on currencies than bonds. Yet, an analysis of the bond returns and currencies confirms the intuitive result that higher relative yields are associated with currency appreciation. In addition, we put to the side the outstanding and serious question of endogeneity -- that currencies and capital flows drive each other simultaneously.

Conclusion

Our takeaways from this are twofold. First, in an equity market revival, don't look for currency appreciation unless that market is relatively underinvested or has a low benchmark weighting. G10 markets where we could expect appreciation are New Zealand and Norway but possibly also Australia and Sweden. Second, while equity portfolio flows do matter for exchange rates in the short term, there is more to exchange rate appreciation than the flows. As this analysis suggests, liquidity and expectations also play a role.

*These results are consistent with and follow an earlier analysis using daily, monthly and quarterly data. See H. Hau & H. Rey, "Exchange Rate, Equity Prices and Capital Flows" NBER WP 9398, 2002.

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Europe - All: From Flexibility to Relapse

Vincenzo Guzzo (London)

European finance ministers will gather early next week in Brussels in a meeting that could shape the future course of the Continent�s public finances. They will be asked to vote on the Commission�s recommendations that expect Germany and France to drive their deficits back below 3% by 2005. Recent comments in the press from EU sources suggest that chances of a minority block overruling the proposals are rising and have now become the most likely scenario. This event would further water down the content of the requests and lead to sustained imbalances in Europe for an even longer period of time, in our view.

What is the Commission asking?

The Commission acknowledged that France has taken no effective action in response to previous recommendations, while those taken by Germany are proving inadequate. As a result, in two nearly identical communiqu�s, it is asking for further reductions in the structural deficits of the two countries next year, while offering them an extra year to correct their imbalances within the 3% reference value. The resulting expected structural consolidation is about 1.5% for France and 1.3% for Germany. In order to avoid the risk of further slippage, the Commission believes that the bulk of the correction should cautiously take place in 2004 and applies the �two-thirds� rule. In other words, two-thirds of the consolidation is expected for the year ahead, leaving a smaller residual effort for 2005.

What are the countries saying?

The two countries are planning corrective measures that falls short of the Commission�s requests.� France is targeting in its 2004 budget a correction worth 0.7% of GDP. Germany is planning a reduction of its structural position of around 0.6% for the same year. Paris has made clear in recent days that the extra �4-5 billion required to achieve the new target would not be raised within the budget bill, already endorsed by the National Assembly, but has shown some willingness to fill at least a fraction of that gap through other initiatives. Berlin does not seem to be inclined to compromise at all.

Anatomy of a vote

The ECOFIN Council will take a decision by a qualified majority of two-thirds of the member countries with weights (approximately) proportional to the population sizes of the countries. Germany and France will be excluded from their respective votes. Countries will be asked to vote twice. They first will have to say whether Germany and France have failed to take effective measures in response to the deterioration in their budgets (ex art. 104[8]) and then express their judgment on the specific consolidation path recommended by the Commission (ex art. 104[9]). Note that the second section will be reserved to �participating member countries� which, in Brussels� jargon, means the economies that have adopted the common currency. Put simply, UK, Sweden, and Denmark will be excluded from the vote.

Toward a blocking minority

In this second controversial vote, if France and Germany were to team up with a large country, say Italy, which has openly expressed disagreement with the idea of further tightening measures, and one of the smaller countries, they would build up a minority block sufficient to oust the Commission�s proposal. We now attach a subjective probability significantly higher than 50% to this event. A qualified majority would then be required to pass an alternative proposal. And, note, this would have to happen with the approval of the Commission, which, in principle, could withdraw its new set of recommendations and expect the original, more austere conditions (i.e., deficits below 3% by next year), if the suggested changes were regarded as excessive. The bottom line, we believe, is that the Council and the Commission will agree on some sort of compromise with the content of the requests being watered down further.

Markets not willing to be tolerant forever, in our view

We believe the conclusion is straightforward: Deficits will stay higher for longer. In our view, the Stability Pact will be perceived less and less as a binding constraint and governments will progressively test the patience of financial markets, which have so far ignored the issue. This is clearly still a second-order problem when compared to the US imbalances, but we think there must be a European budget deficit for which markets will start expecting some form of additional risk premium. Bear in mind three key points. First, unlike 2001-2, Europe will likely approach the second half of the electoral cycle with high deficits. Second, baby-boomers will kick in shortly thereafter. Last but not least, because of the very nature of EMU, several countries will find free riding more convenient than fiscal consolidation. This unavoidably will lengthen the process of economic policy coordination.

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Hong Kong: Monetary Implications of Renminbi Banking

Denise Yam (Hong Kong)

Four Renminbi Businesses to Be Launched in January 2004

Hong Kong banks will start to offer selected renminbi (RMB) services next year, covering deposits, exchange, remittance and credit cards. A clearing bank (CB) will be appointed by the People’s Bank of China (PBoC) in the near future to be responsible for overseeing RMB clearing transactions in Hong Kong. Settlement of RMB-HK$ transactions with the PBoC will be handled by this CB at the China Foreign Exchange Trading System (CFETS) based in Shanghai, at which the CB will become a member.

Meanwhile, the Hong Kong and Mainland authorities are also working toward permitting the use of RMB-denominated credit and debit cards issued by banks in the Mainland for consumer spending in Hong Kong, which could be implemented before the other services as it does not require settlement through the RMB CB. The rationale and the mechanics of the new services were discussed in our earlier report, “Another ‘Goodie’ Realized – Renminbi Banking,” November 19, 2003. In this report we investigate the monetary implications of introducing these RMB services in Hong Kong, and the implications of further relaxation in China’s foreign exchange policy in the longer term.

Initial Impact – Slower HK$ Deposit Growth and Reduced Appreciation Pressure at the Margin

As RMB services at the outset will be limited to four selected areas, the monetary implications will be limited, in our view. We discuss the effects of each service.

(1) Deposits. The deposit-taking mechanism is intended as the first step in absorbing the RMB cash circulating in Hong Kong into the official banking system for channeling back to the Mainland. Estimates a few months ago of RMB cash circulating in Hong Kong ranged from Rmb40 billion to Rmb100 billion, but this could have increased recently amid the influx of Mainland tourists. Much of this cash is held by individuals who frequently travel to the Mainland for business and leisure, and at unofficial exchange counters that act as key intermediaries for various businesses and help ensure effective arbitrage versus the official exchange rate. Retail outlets that receive RMB from Chinese tourists frequently exchange their proceeds into HK$ at the counters.

In our view, transactions balances held by individuals may not be effectively drawn into the deposit system at a low deposit interest rate, and before withdrawals can be conveniently be made at cashpoint machines. The RMB deposit rates to be offered at Hong Kong banks will be capped by that offered by the PBoC on the CB’s clearing account. This is yet to be determined, but the 1.89% rate that the PBoC currently pays on reserve deposits of Mainland banks will likely serve as a guideline. Compared to deposit rates offered in China, those in Hong Kong are unlikely to be higher, possibly because of additional administrative costs. Nevertheless, given the near-zero rates offered on HK$ deposits at present, a premium on RMB deposits and continued optimism on the future value of the RMB may induce deposit switching to a certain extent. HK$ savings and time deposits at licensed banks totalled HK$1,694 billion at the end of September; the switching of 1% of this would amount to Rmb18 billion (US$2.2 billion).

In addition, although the RMB deposit service is initially intended for individuals, consumer outlets that accept RMB sales likely will set up personal deposit accounts. Having a RMB bank account would mean such outlets were no longer in a rush to exchange their RMB sales proceeds at unofficial exchanges on a regular basis in order to deposit into their bank accounts, and might make them more willing to accept RMB. Although this may only delay rather than do away with the conversion, should the RMB in fact help pay for part of their cost base, the availability of the RMB deposit service could potentially save on HK$-RMB exchange transactions.

(2) Exchange. With a quantitative restriction placed on cash exchanges at licensed banks for non-deposit holders (maximum Rmb6,000 per transaction), businesses and individuals that frequently exchange large amounts may decide to stick with the unofficial exchanges that likely offer more competitive rates. In particular, individuals engaged in illegitimate transactions may prefer not to disclose their identity as required by banks. Nevertheless, the convenience of the integrated one-stop exchange and deposit service and deposit-switching (up to Rmb20,000 per day) should be attractive to many. We expect the banks to absorb a meaningful portion of the exchange business with their widespread geographical network, although the unofficial exchanges could still retain significant business flows.

(3) Remittance. Remittance represents an integral part of the efforts to channel offshore RMB circulation back to China. While cash deposit-taking helps direct RMB cash back to China, remittance enables the actual geographical transfer of the RMB assets of individuals. The initial stage serves as facilitation for businessmen and other frequent travelers, but opportunities will be much greater when this is open to business accounts in the future.

(4) Credit Cards. The use of debit and credit cards issued by Mainland banks in Hong Kong is expected to give a boost to Chinese tourists’ expenditure at restaurants and retail outlets. Retailers in Hong Kong estimate, based on the incidence of tourists foregoing purchases due to insufficient cash, that visitors would likely spend 20-30% more with the added convenience of cards, which will essentially quash the current Rmb6,000 limit on cash spending. The substitution by credit card spending may slow the influx of RMB cash to Hong Kong, which supposedly should ease the appreciation pressure on the HK$. Nevertheless, we should not neglect that the increase in overall visitor spending will boost Hong Kong’s exports of goods and services and hence enlarge the current account surplus. Mainland visitors’ spending is expected to reach HK$50 billion (US$6.4 billion, 4% of GDP) this year, with shopping, meals and entertainment accounting for nearly 80% of the total. A 20% increase in these discretionary expenditures would add HK$8 billion (0.6% of GDP) to the demand for Hong Kong’s goods and services.

Meanwhile, Hong Kong banks will also issue RMB-denominated credit cards for use in the Mainland. While this may not be particularly appealing to travelers, as other credit cards are already widely accepted in China, it provides an additional means to repatriate offshore RMB as cardholders run down their RMB balances in Hong Kong to settle their bills.

Overall impact. The imminent introduction of RMB deposit, exchange, remittance and credit card services in Hong Kong primes the evolution of the RMB toward becoming a more widely accepted medium of exchange and store of wealth. Reduced need for HK$ for transactions should ease the recent appreciation pressure on the HK$, while RMB deposit-taking could slow HK$ deposit growth at the margin, with these effects partially offset by increased tourist consumption through credit cards.

The impact on the RMB/US$ exchange rate would be limited, in our view, since RMB transactions in Hong Kong are very small compared to China’s current account transactions, for which the PBoC continues to guarantee exchange at the official rate. China’s total trade of goods alone is expected to approach US$840 billion (Rmb7 trillion) this year, 100 times that estimated to be circulating in Hong Kong. Arbitrage with current account transactions has been and will likely continue to be effective in ensuring limited deviation from the official rate for these comparably smaller capital account transactions (reported as “financial account” in the balance of payments). The readiness of the PBoC to offer the fixed rate for participants and/or their counterparties in offshore transactions should ensure the liquidity in the arbitrage process.

What Next? Geographical vs. Capital Account Controls

What are the next steps for Hong Kong in RMB financial services? With the infrastructure set up for the settlement of RMB cash transactions between the banking networks on both sides of the border, Hong Kong seems ready and eager to embrace new opportunities upon further relaxation of China’s capital controls. In addition to extending the scope of eligible customers -- from individuals to businesses -- and easing quantitative restrictions on the approved service areas, the gradual relaxation will take place on 2 fronts:
(1) easing the geographical limitation of RMB transactions (not involving forex), and (2) capital account convertibility (forex transactions). In our view, easing geographical limitations on transactions that do not involve currency exchange (a-e) could come through much more readily than the transition towards a more open capital account (f).

(a) ATM withdrawals and network linkage. Hong Kong banks would attract a lot more in RMB deposits if withdrawals could be made more conveniently at automatic teller machines (ATMs), initially in Hong Kong, and possibly at a later stage, also in Mainland China. Hong Kong’s Joint Electronic Teller Services Co. (JETCO) already gives its cardholders access to RMB cash (debiting HK$ accounts) at China UnionPay ATMs in Guangdong, and accepts cards issued by member banks of China UnionPay at its Hong Kong ATM network for HK$ cash withdrawals. Standard Chartered Bank and HSBC, which operate the other two ATM networks in Hong Kong, are also looking to develop cooperation plans with China UnionPay. The extension of local and cross-border ATM services to RMB deposits in Hong Kong will be a natural and meaningful next step, in our view.

(b) RMB interbank transactions. The four selected services at the initial stage involve no interbank transactions, except cash settlement between individual licensed banks and the CB. Nevertheless, the infrastructure could be easily upgraded to handle electronic interbank payments. Connecting this to the Real Time Gross Settlement (RTGS) systems for HK$, US$ and Euro that are already in place will enhance Hong Kong’s position as an international financial center.

(c) RMB checking and large RMB-denominated transactions. Electronic interbank payments will enable the clearing of checks and the denomination of large transactions (including the trading of securities and other assets) in RMB.

(d) RMB lending. The Mainland authorities have so far been skeptical about allowing Hong Kong banks to lend RMB, amid concerns that leverage provides the means to speculative transactions against the currency, and the possible disruption to monetary policy upon establishing an additional channel for money creation. The eventual approval to Hong Kong banks for RMB lending will open opportunities for the asset side of the balance sheet besides the clearing account with the CB, and offer them much heftier interest margins on their RMB business.

(e) Geographical transfer/consolidation of banks’ RMB assets and liabilities. Remittance of RMB deposits is limited to that instructed by the customers initially. The next step could be to give banks more flexibility in managing their RMB assets and liabilities on opposite sides of the border. For example, banks could be allowed to take RMB deposits in Hong Kong and make loans in the Mainland, making this a much more profitable opportunity for the banking sector, although this will require much enhanced balance sheet risk management measures.

(f) Progressive opening of China’s capital account towards RMB full convertibility. Hong Kong’s sound financial system has played a key role in raising international capital for Chinese enterprises and accelerating China’s development over the last decade. Progressive opening of the capital account will further enhance the fund-raising mechanism. It will also be a promising opportunity for the Hong Kong financial sector to help mobilize China’s huge stock of savings into sensible investments. Although it could be years before China fully opens its capital account, Hong Kong’s experience and expertise in international investments should make it a priority destination for China capital, and the natural location for the eventual establishment of an offshore RMB trading center.

Long-Term Implication – Marginalization of the HK$?

The structural trend towards closer economic, financial and monetary integration between Hong Kong and China over the long term is undisputable, in our view. Amid increasing cross-border linkages and progressive relaxation in China’s foreign exchange controls, we believe the prevalence of RMB as an accepted medium of exchange in Hong Kong will all but diminish.

We continue to hold to our view that capital account convertibility of the RMB will be achieved only gradually, primarily due to the lingering problems of the NPL-laden financial system. Full convertibility should take place only after successful financial reforms that stop the creation of bad debts. This is undoubtedly years away, but this eventual development should enable the RMB to become a credible store of wealth. This is when the RMB could be widely circulated in Hong Kong and the HK$ will be more sensibly linked to the RMB instead of the US$, leaving Hong Kong’s monetary policy in the hands of the Chinese authorities instead of the Federal Reserve. Needless to say, the HK$ could be naturally marginalized by the RMB over the long term, and it is only then that we would see the final stage of price alignment in Hong Kong against the Mainland, upon the removal of the remaining uncertainty regarding the exchange rate between the two currencies.

Conclusion

The imminent rollout of the initial list of four RMB banking services likely will slow HK$ deposit growth and ease the recent appreciation pressure on the HK$ marginally. The exclusion of RMB lending and hence the multiplier effect on money growth prevents complications to monetary and exchange rate policies on both sides of the border. Nevertheless, before the progressive relaxation in China’s foreign exchange controls in the capital account, which will likely take many years, Hong Kong can look forward to ready opportunities in the lifting of geographical restrictions on RMB transactions that do not challenge capital account convertibility. ATM services, interbank transactions, checking, lending and cross-border management of banks’ balance sheets are the natural next steps, creating valuable opportunities for the financial sector and advancing the evolution of the RMB toward becoming a more widely accepted medium of exchange and store of wealth. Over the long term, the HK$ could be naturally marginalized by the extensive circulation of a fully convertible RMB.

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