The world economy, as I see it, remains very much in a state of fundamental disequilibrium. A US-centric global growth dynamic has given rise to extraordinary external imbalances around the world. America, the world’s unquestioned growth engine, is facing unprecedented imbalances of its own; the national saving rate, current account, Federal budget deficit, and private sector debt ratios are all at historical extremes. And an increasingly powerful global labor arbitrage continues to keep high-wage developed economies mired in jobless recoveries. The result is a unique confluence of tensions that have left the global economy in a state of heightened instability. The venting of those tensions could well be the main event in world financial markets in 2004.

The case for global rebalancing has been an overarching theme of our macro call over the past year. The urgency of such a realignment in the mix of world economic growth has never been more compelling. Over the 1995–2002 period, the United States accounted for 96% of the cumulative increase in world GDP — basically three times its 32% share in the global economy. This was, by far, the most lopsided strain of global economic growth that has ever occurred in the modern-day post-World War II era. Two sets of forces have been at work in creating this unsustainable condition — a US economy that has been living beyond its means as those means are delineated by domestic income generation, and a non-US world that is either unwilling or unable to stimulate domestic demand. As a result, an unprecedented disparity has opened up between those nations with current-account deficits (the United States) and those with surpluses (Asia and, to a lesser extent, Europe). Such an unbalanced global growth paradigm is not sustainable, in my view. The debate is over the terms under which the coming rebalancing occurs.

The macro fix for a lopsided economy is very simple — it mainly entails a shift in relative prices. For a US-centric global economy, that implies a realignment in the dollar — the world’s most important relative price. In that vein, a weaker dollar needs to be seen as the principal means by which the tensions of an unbalanced global economy are vented. The broadest trade-weighted index of the US dollar is currently down about 11% in real terms over the past 23 months. History tells us that global rebalancing will undoubtedly require a good deal more dollar depreciation — perhaps twice as much as that which has already occurred. That poses the important question as to who bears the brunt of the dollar’s adjustment. The Europeans and Japanese believe they have suffered enough and are pointing the finger at others — mainly China — to pick up the slack. US politicians are also sympathetic to this line of reasoning. Consequently, the role that China plays in venting global imbalances is also likely to be a key issue in the year ahead. For what it’s worth, I think this debate overlooks a critical consideration: Europe and Japan are wealthy countries that have dragged their feet endlessly on reforms, whereas China is still a very poor country that has been aggressive in embracing reforms. Why should China be called on to compensate for adjustments that Europe and Japan are unwilling to undertake?

America must also bear its fair share in the coming global rebalancing. And the problem is that the US economy is not in the best shape to cope with the requisite adjustments. That’s because it has a record low saving rate, sharply elevated debt burdens, and massive trade and current-account deficits. Nor is growth alone likely to be a panacea for America’s shaky fundamentals. In fact, there are good reasons to worry that another surge of US economic growth could well exacerbate many of these imbalances The pivotal tension point in this regard is America’s anemic net national saving rate — the combined saving of households, businesses, and the government sector adjusted for depreciation. This key gauge measures the saving that is left over to fund the net expansion of productive capacity — the sustenance of any economy’s long-term growth potential. Unfortunately, in the case of the United States, there isn’t any — America’s net national saving rate fell to a record low of 0.6% of GNP in the first three quarters of 2003. To the extent that domestic income generation continues to lag — precisely the outcome in America’s lingering jobless recovery — another burst of private consumption, such as that now under way in the second half of 2004, can only push saving lower. That, in turn, puts greater pressure on foreign saving to fill the void — giving rise to increased trade deficits and private sector indebtedness.

Such an outcome only heightens the tension already bearing down on the US economy. A lasting recovery cannot be built on a foundation of ever-falling saving rates, ever-widening current-account and trade deficits, and ever-rising debt burdens. These tensions must also be vented if America’s nascent upturn is to make the transition to sustainable expansion. The bond market, in my opinion, offers the principal means by which this venting can occur. And the outlook for bonds is not good. A confluence of three bearish forces are at work — the Fed’s eventual exit strategy from a 1% federal funds rate, a weaker dollar, and America’s fiscal train wreck. Ironically, under these circumstances, you don’t have to be worried about inflation to be negative on bonds. At the same time, if financial markets ever did get a whiff of inflation, a real rout in bonds might ensue. Higher long-term real interest rates do not temper all the imbalances that are on America’s plate. But they could help — possibly a lot. The key impact would be a reduction in the growth of the credit-sensitive segments of aggregate demand. That would enable a long overdue rebuilding of domestic saving, which would then act to reduce America’s current-account and trade deficits. A lower pace of consumption growth would also go hand in hand with a reduced expansion of indebtedness. A tough bond market may be just the medicine an unbalanced US economy needs.

The global labor arbitrage is a third major source of tension bearing down on today’s global economy. The accelerated pace of replacing high-wage jobs in the developed world with low-wage workers in the developing world reflects the interplay of three mega-forces — the first being the maturation of outsourcing platforms in goods (i.e., China) and services (i.e., India) on a scale and with scope never before seen. The second factor at work is the Internet — providing ubiquitous real-time connectivity between offshore outsourcing platforms and corporate headquarters. In goods production, the Internet forever changes the efficiency of supply-chain management. But for services, the Internet is a transforming event — effectively converting the once non-tradable sector into a tradable global marketplace. With the click of a mouse, the knowledge content of white-collar workers can now be delivered anywhere in the world on a near-real time basis. The unrelenting push for cost control in a no-pricing-leverage world is the third leg to the stool of the global labor arbitrage. Such environmental imperatives only heighten the incentives for IT-enabled “offshoring.”

While the global labor arbitrage continues to push costs and pricing lower, it does have its dark side. Significantly, it continues to put pressure on job creation and income generation in the high-wage developed world. Largely as a result, consumers in the high-wage developed world end up defending their lifestyles by drawing increasingly on alternative sources of purchasing power, such as asset-driven wealth effects, increased indebtedness, and tax cuts. In my view, vigorous consumption cannot be sustained in the context of the profound income leakage that stems from the global labor arbitrage. That underscores yet another source of disequilibrium that must be vented. In this instance, the venting appears to be exacerbating the pressures bearing down on an unbalanced world. That’s because it has taken the form of heightened trade frictions and growing protectionist risks — developments that only intensify pressures on the dollar and the US bond market.

The means by which this confluence of tensions gets vented will likely be key for global economy and world financial markets in 2004. There are two conceivable paths to resolution, in my view — the benign soft landing and the ever-treacherous hard landing. Macro is not good at making the distinction between these two modes of adjustment. Instead, it basically identifies the forces that have given rise to disequilibrium and then depicts the possible adjustments that must take place to reestablish a new equilibrium. As always, the outcome is more dependent on exogenous shocks. In the current instance, the shocks that worry me the most would be those that might shake foreign confidence in dollar-denominated assets; intensified protectionist actions from Washington would be especially disconcerting in that regard. Equally worrisome is the magnitude of the current state of disequilibrium — and the distinct likelihood that these unprecedented imbalances can only be vented by big movements in asset prices. My deepest fear is that the longer the venting of these tensions is deferred, the larger the ultimate adjustments and the greater the chances of a hard landing.

Early next year, Congress will consider a piece of legislation that could have important implications for recipient countries of US foreign direct investment (FDI).  The legislation, known as the “Homeland Investment Act” (H.R. 767) and the “Invest in the USA Act” (S. 596), is part of the broader international tax bill, and  proposes to temporarily reduce the tax rate on US firms´ repatriated earnings from 35% to 5.25%.  If the legislation is passed ― and the chances are quite good, according to our government relations team ― the tax amnesty could affect those economies that are disproportionately dependent on reinvested earnings as a source of investment. 

The proposed legislation would offer a great boon for US MNCs.  Currently, the income earned by foreign subsidiaries of US corporations is subject to US tax only once it is repatriated, encouraging many multinationals to store their profits overseas in order to defer paying US taxes on their foreign-source income.  As a result, less than one-half of foreign earnings of US companies is returned to the US parent in any given year.  In 2002, for instance, US parents repatriated just 39% of the total $124 billion in profits from their foreign subsidiaries, reinvesting the remainder.  Over the years, this has resulted in the build-up of some $350-400 billion of profits parked overseas. 

No one knows for sure how large the potential windfall of repatriated profits would be if the proposed bill is passed, since not all companies will necessarily take advantage of the provision.  For instance, for companies with cash-strapped foreign affiliates or relatively more attractive overseas opportunities, no excess dividends, or with credits left over from prior years, the amendment might not be a sufficient incentive to repatriate.  In addition, while some overseas profits are stored in passive investments, like government securities, others may be tied up in equipment, property, or other less liquid investments that are not easy to repatriate. 

That said, there is clearly a host of companies that would profit from the legislation.  Indeed, a number of multinationals with significant overseas exposure, including Hewlett-Packard, Eli Lilly, Merck, Intel, Sun Microsystems, and Dell Computer, have formed a coalition to lobby in favor of the repatriation provision.  Congress's Joint Committee on Taxation estimates that the proposal would encourage US companies to repatriate roughly $135 billion in earnings; this is consistent with our own valuation team’s estimates.  There’s a wide range of other estimates in the market, some as high as $400 billion during the year in which the legislation takes effect. 

Outside of the direct impact on individual multinationals, there could also be an indirect balance of payments impact.  The income balance (one of the three components of the current account) would not be significantly affected by a repatriation of overseas profits, since this component only captures income earned during the current year, not the income that has accrued over the last several years.  Moreover, no distinction is made between earnings that are distributed to the parent and those that are reinvested; both have already been accounted for in the income balance.  However, to the extent the HIA provision encourages companies to repatriate more overseas profits and thus reinvest less in foreign subsidiaries, it could reduce the level of US direct investment abroad.  How so?  Reinvested earnings, which represent the value of retained profits in foreign subsidiaries that are reinvested in the host country, are one of the three components of FDI — the other two being intercompany loans and equity capital.  They are distinct from the other two components because they represent both affiliate income and capital flows.  The contribution of reinvested earnings to the overall level of US direct investment abroad is substantial, especially in the last two years, with profitability still on the mend, repayments of intra-firm loans to parent companies increasing, and equity markets still fragile. 

We had already expected reinvested earnings to come under pressure in the near term, since there has been a decline in the infusion of new equity capital in the last few years and thus a smaller pool of capital to reinvest.  With the added tax holiday, the pullback could be more pronounced.  To what extent?  Let’s suppose that the US invests a total of $140 billion of FDI in overseas markets and reinvested earnings represent 40% of that amount.  That’s roughly on par with average levels in the last five years.  If we assume, generously, that firms reinvest half of their earnings in order to avoid the tax incurred from repatriation and half is invested to take advantage of actual overseas opportunities; and if we also assume that nearly all of those firms that have sheltered their overseas earnings will take advantage of the tax amnesty, then repatriation could yield a 20-25% decline in US overseas investment (a bit less if equity markets continue to recover and companies become more willing to use equity capital as a means of financing). 

The impact on recipient countries would not be uniform.  Although reinvested earnings accounted for an average of 42% of total US direct investment outflows on a global basis during the last five years, this figure masks significant regional differences.  For instance, during the period 1998-2002 a number of European countries were disproportionately dependent on reinvested earnings as a mode of investment — i.e., the Netherlands (76%), Ireland (69%), and Switzerland (51%).  These economies are also more dependent on the US as a share of their FDI inflows from the rest of the world relative to other European economies where the ratio of reinvested earnings to FDI is lower, thus posing the possibility of a double whammy.  In Latin America, 31% of total FDI from the US was in the form of reinvested earnings during the same period.  Within the region, though, Argentina and Brazil were clear outliers, as foreign subsidiaries have posted losses in these economies in the last few years, so reinvested earnings have actually been negative.  By contrast, in Mexico, where US multinationals have rapidly expanded their presence in recent years, the ratio is at the high end, at 40%.  In Canada, the ratio of reinvested earnings to total FDI was close to the global average.  In Asia, reinvested earnings proved to be a key means of investment for Singapore (53%), Hong Kong (52%), and Taiwan (35%), but less so for Japan (25%), Korea (18%), and China (14%) during the same period.  We are not suggesting that countries that are more dependent on reinvested earnings as a mode of FDI will be disproportionately affected. Reinvested earnings also reflect confidence in a host country, and that may well outweigh other priorities, including a powerful tax incentive.  However, those countries where the incentive to reinvest earnings is driven more by a desire to defer tax payments rather than by profitability will more likely feel the effects of a pullback in US investment.

Bottom line: If the HIA legislation passes and has the intended effect of inducing US multinationals to repatriate a larger share of their overseas profits, the level of US direct investment abroad could decline, with those economies with a high ratio of reinvested earnings to FDI at greatest risk. 

We are updating our currency forecasts for 2004.  Our two-year-old call for a structural USD correction should continue to play out for a third year.  However, the overshoot in EUR/USD and GBP/USD is likely to be somewhat greater than we had expected, while the trajectories for USD/Asia, including USD/JPY, remain relatively unchanged from the previous forecasts.  Our end-2004 target for EUR/USD is now $1.23 (up from $1.22), and our new target for USD/JPY is ¥102 (down from ¥105).  The more significant change is that we now expect EUR/USD to continue to overshoot in Q1 up to $1.28, before declining gradually for the rest of the year.  With GBP and AUD also exhibiting this overshoot pattern, we anticipate the average value of the Fed's major USD index to decline by 9.5% during 2004, compared to the 4.1% we had expected previously.

Forecast Changes

New	Mar-04	Jun-04	Sep-04	Dec-04	Avg-03	Avg-04
EUR/USD	1.28	1.25	1.24	1.23	1.13	1.25
USD/JPY	105	106	103	102	115	105
EUR/JPY	134	133	128	125	130	131
Old	Mar-04	Jun-04	Sep-04	Dec-04	Avg-03	Avg-04
EUR/USD	1.16	1.20	1.22	1.22	1.13	1.20
USD/JPY	107	105	105	105	116	106
EUR/JPY	124	126	128	128	130	126

Source: Morgan Stanley Research estimates

 

The basic framework behind our previous forecasts

Underpinning our previous forecasts, which were published in September, we had several key thoughts.  First, the USD would remain structurally mispriced, on an index basis, and further correction of the USD index was inevitable.  Second, the rally in the EUR was excessive relative to the JPY: More generally, the Asian currencies needed to 'catch up' to keep the USD correction more balanced.  Third, emerging market currencies, particularly Latin American currencies, were lagging badly behind in the USD sell-off, and would likely catch-up with the majors.  Thus, we were looking for the USD to continue to correct, but for such a correction to be more balanced between Europe and Asia and between the major and minor currencies.

What has changed?

Three key developments since September have altered our outlook for 2004.

Change 1 — The de facto burial of the SGP and the strong EUR policy

The effective burial of the Stability and Growth Pact (SGP) on November 25 was a watershed in this structural USD correction, for it opened the way for EUR/USD to head higher.  Having had difficulties pushing headline inflation down below the 2.0% ceiling, the ECB has consistently opted for a strong EUR policy.  But the consequent spill-over effect of such a policy was to push Euroland into a technical recession in the first part of this year.  Since November 25, EUR/USD can head higher with impunity (since fiscal policy is now more able to compensate for currency strength and a weakening in the economy brought about by currency strength no longer endangers the pact).

Change 2 — Galvanised commitment in Asia to defend soft USD pegs

The G-7 Communiqué issued on September 20 in Dubai was effectively a round of verbal intervention to talk USD/Asia lower.  USD/JPY did decline, but the rest of Asia barely moved.  We are now back in a bi-polar currency world, with Asia running soft pegs to the USD.  In contrast to Euroland, Asia is very sensitive about the risk of a premature appreciation in their currencies undermining their economic recovery.  They are likely to maintain such soft USD pegs until inflation becomes a problem.  This means that Asia, led by Japan, will likely continue to resist the pressure for the USD to correct.

Change 3 — The gradual recovery in Euroland

The third event that changed our outlook on the G-3 currencies is that Euroland has also begun to recover, mainly on the back of the recovery seen in the US and Asia.  While the economic reasons for EUR/USD to rally sharply are not compelling to us, a stronger Euroland economy, even if it is primarily supported by external demand, should allow Euroland to absorb more EUR strength.  EUR/USD may rise by default, not by merit, and Euroland policy makers may have a misguided strong EUR policy, but the bottom line here is that a stronger Euroland will mean the economy can 'afford' to have a stronger EUR.

Our revised forecasts

Notwithstanding the developments mentioned above, our basic story on the USD index remains unchanged.  We still believe that, compared to the fair value that is likely to prevail at end-2004, the Fed's major USD index is around 5-10% overvalued.  The structural correction of the USD will, thus, be sustained well into 2004.  We continue to monitor all three aspects of the USD correction: magnitude, symmetry, and speed.

Our year-end forecasts for both EUR/USD and USD/JPY are not that different from the previous forecasts.  However, we are now looking for a further surge in EUR/USD in Q1.  Because of this prospective overshoot in EUR and GBP, the decline in the average rate for the major USD index is now 9.5% in our revised forecasts, compared to 4.1% previously.  On symmetry, we now look for further upside in EUR/JPY in the first part of 2004.  USD/JPY will likely lag behind EUR/USD in the first part of the year, but will likely continue its gradual decline throughout the year.  While downward pressures on USD/JPY likely will be great, we expect the MoF to continue to conduct massive interventions to smooth out the correction and support USD/JPY above ¥100.  On speed, we continue to look for an orderly adjustment in the USD index.  While some bilateral exchange rates (e.g., EUR/USD and AUD/USD) may overshoot, following Dornbusch's model of overshooting, we do not expect the USD index to do so.

Coordinated intervention a risk in 2004

In a previous note we pointed out that the four potential shocks in 2004 are (1) the US economy, in terms of both size and quality of growth; (2) a slowing China; (3) protectionism; and (4) geopolitics.  With EUR/USD overshooting like this, we thus add to this list the risk of coordinated intervention as the fifth potential shock that matters for the currency markets.  A USD correction concentrated against a few currencies is neither healthy nor sustainable.  It will, however, be difficult for Euroland to reverse its policy on the EUR or exert pressure on Asia for greater burden sharing.  The alignment of interests between various currency blocs will be an important issue in 2004.

While the market is fixated on EUR/USD at this moment, it is only a matter of time before the spotlight turns on USD/JPY.  The MoF may continue to be successful with its interventions in supporting USD/JPY at these levels for the time being.  However, over time, massive interventions could still fail if Japan’s recovery is sustained. We lay out a portfolio-based argument:

1. Japan has a huge amount of foreign assets. 

As a result of massive cumulative trade surpluses, Japan now holds a huge amount of foreign assets.  As of end-Q3 2003, Japan as whole held US$3.5 trillion (¥378 trillion) worth of gross foreign assets (GFA) and US$1.5 trillion (¥172 trillion) worth of net foreign assets (NFA).  

2. This is not a preferred portfolio mix, from Japan’s perspective. 

Japan has a strong ‘home bias’ for investment, which suggests that the large GFA and NFA positions in Japan may no longer be preferred.  In other words, if Japanese investors had their way, they’d prefer to have lower levels of foreign assets and more JPY assets, not from a carry perspective, but from the perspective of the stock of their portfolios. 

3. The idea of a ‘negative risk premium.’ 

The concept of ‘negative risk premium’ is essentially the point that, because of the aversion to further increases in Japan’s foreign asset position, foreign interest rates will need to be considerably higher than those in Japan to entice Japanese investors to send more of their capital overseas.  Japan’s interest rates have been persistently below those of most foreign countries.  We believe that two main reasons for this are (1) expected JPY appreciation (uncovered interest parity theory — Japanese rates can be below foreign interest rates since after accounting for currency appreciation, returns would be equalised) and (2) the negative risk premium (Japanese rates can be below foreign rates because Japanese investors would prefer not to further invest in foreign assets). 

4.  The yield curve in Japan should rise and steepen as the economy continues to recover. 

I have been arguing since early summer that Japan has seen its multi-year economic bottom.  As long as Japan continues to recover, there should be pressures for the long bond yield in Japan to go up.

5.  Massive MoF interventions in USD/JPY are not consistent with the whole picture. 

As the MoF resists the USD correction through intervention, it buys US Treasuries and helps keep interest rates in the US lower then they would otherwise be.  In addition, the more Japan recovers, the more Japanese interest rates tend to drift higher.  But, as a result, the compressed yield differentials may end up being too small to offset the combined effects of expected JPY appreciation and the negative risk premium.  Theory suggests that this should lead to less private capital heading overseas.  In turn, the Japanese long bond yield may also be kept artificially low as private capital is trapped in Japan.  In other words, the combination of (1) a declining USD, (2) a recovering Japan, and (3) intervention that is not consistent and not sustainable, continued official interventions would be offset by a reduction in private capital outflows.  This is one key structural reason why I believe continued massive intervention will fail eventually. 

Massive interventions are likely in 2004. 

The structural USD correction is not yet complete.  What the currency world needs, however, is a better balance between EUR and JPY and between the majors and the minors, during this structural USD correction.  If we assume that the JPY rises by another 10%, on par with the expected movement in the major USD index, USD/JPY would be below 100.  (This is a conservative assumption as I am not assuming any normalisation between EUR and JPY.)  The MoF will need to be prepared to intervene massively in 2004 to avoid 100 being broken.  But the amount of intervention necessary will have a meaningful effect on US interest rates, just as Japan continues to recover.  This will, as explained above, significantly discourage private capital outflows and raise the risk that such interventions may fail. 

Bottom line. 

The more the MoF intervenes, the more the Japanese private sector will hold back on their foreign investment, making the interventions themselves an exercise with diminishing returns.  Heavy intervention in 2004 will be necessary to hold USD/JPY above 100, but risks to USD/JPY will still be biased to the downside of 100. 

November’s shocking dip in “core” inflation measured by the Consumer Price Index (CPI) has reopened the twin debates about the inflation outlook and what it means for the Fed.  The November decline of 0.1% brought year-over-year core inflation to just 1.1% — the lowest reading since May 1963.  Moreover, the softness in pricing extended to both goods and services, with core commodity prices falling by 0.4% and core services flat.  And given lingering biases in the CPI, core inflation could be below the 1% to 2% range that represents the Fed’s presumed definition of price stability.  As a result, November’s reading seems to up the ante on the risks of an “unwelcome decline in inflation.”

While we are mindful of the downside risks, we disagree.  Core retail inflation probably has bottomed, in our view, as the case for a rebirth of pricing power is intact and signs of it are already visible at earlier stages of the pipeline.  It’s worth remembering that core inflation last declined on a monthly basis in December 1982; and that over the following year cyclical forces lifted core inflation to 3.9%.  Of course, that was then.  The economy and the forces affecting inflation have changed significantly over the past two decades, so over the course of 2004, only a slow rise is likely.  This inflation environment will reinforce the Fed’s determination to stay on hold in the face of strong growth.  While the Fed won’t likely tighten monetary policy soon, these crosscurrents underscore the importance of straight talk from the Fed about its longer-term game plan.

It’s a critical juncture for retail inflation.  At work are two sets of overlapping forces that have so far netted to declines.  The first set is disinflationary: It includes significant slack in the U.S. and global economies, three years of subpar economic performance, and growing supply from new outsourcing platforms in Asia.  One measure of that slack, the so-called “output gap” (the difference between actual and “potential” GDP) currently stands at about 2% of GDP, a spread that in the past has been associated with declining inflation.  And despite the 21% decline in the dollar’s value on a trade-weighted basis against major currencies, prices of imported consumer goods have until very recently declined.  No doubt, the fixity or slow appreciation of several Asian currencies against the dollar and the desire of other exporters to keep US market share has suppressed that “pass through.”

There’s no mistaking the fact that inflation is at historical lows by any measure.  However, just as the CPI may have overstated the slight rise in core inflation in 2000-01 by a factor of two, it likely has overstated core disinflation in the past two years.  Core CPI inflation rose by nearly a percentage point in the earlier period, while it declined by about 160 basis points over the past two years.  In contrast, the core personal consumption price index, which is the Fed’s preferred inflation gauge, showed an acceleration of half a percentage point in 2000-01, and a deceleration of 90-100 bp — as best we can judge given incomplete official revised data — over the past two years.  Equally important, just as the core CPI overstated the rate of inflation in the earlier period, it may slightly understate it currently.  Three factors are especially important in accounting for the divergence between the two indexes: a difference in coverage, the use of alternative price gauges for some spending categories, and the methodology used to calculate each index.  For instance, shelter accounts for 31.7% of the CPI, but little more than 15% of the PCE price index (for details, see “Will the Real Core Inflation Measure Please Stand Up?” Global Economic Forum, July 16, 2001). 

Looking ahead, we expect that cyclical reflationary forces will begin to gain the upper hand and gradually lift inflation, however it is measured.  Corporate America has reduced capacity; for example, manufacturing capacity apart from motor vehicles and information technology contracted by half a percent over the past two years.  That helps explain why operating rates have jumped by 160 basis points in the past six months on the back of moderate production gains.  Monetary policy is clearly reflationary, evidenced partly by the dollar’s ongoing, orderly decline.  The effects are beginning to show up clearly: For example, non-energy import prices rose by 1% in the year ended in November, the fastest pace in five years.  Finally, above-trend growth is beginning to close the output gap.  Even if potential growth is 4%, if our growth prognosis is close to the mark, the gap will have closed by more than a full percentage point by mid-2004.  And we believe that both the change in the gap as well as its width bear on future inflation. 

But uncertainty clouds our appraisal.  We’ve already noted that, despite improvements, statisticians still measure inflation imperfectly, so we’re not quite sure where we are starting from.  For example, the Schultze report argues cogently that the CPI may understate some important price measures (see At What Price? Conceptualizing and Measuring Cost-of-Living and Price Indexes, ed. Charles Schultze and Christopher Mackie [Washington, DC: National Academy Press, 2001]).  Second, we’re still guessing at potential growth past and future, so the size of the output gap and how fast it will close are unknown.  For example, if potential growth was half a percentage point higher than previously thought over the past four years, the gap would be 4% of GDP, not 2%.  Indeed Fed staff research suggests that errors in measuring the output gap have at times been larger than the gap itself.  

While the Fed won’t likely tighten monetary policy soon, in this uncertain environment the Fed owes market participants and the public at large an explanation of its future game plan.  Three issues are important: Where policy is, where it will ultimately go, and how fast it must get there.  In our view, monetary policy is extremely — and appropriately — accommodative, with the current real Federal funds rate essentially zero.  However, monetary policy is a long way from a “neutral” setting; in a high-productivity growth economy, the “natural” or real long-term Federal funds rate is probably about 3%.  In our view, policy should be back to neutral when the output gap has vanished, as the Taylor Rule suggests.  But there’s no chance that the Fed will feel compelled to return policy to neutral in a hurry.  With ultra-low inflation and only a gradual rise likely, a return to policy neutrality could take two years or more.

Fed officials have recently made progress in communicating that strategy through speeches and statements.  Indeed, the line of reasoning just outlined is consistent with the FOMC 's reference to the fact that "economic performance in line with their expectations would not entirely eliminate currently large margins of unemployed labor and other resources until perhaps the latter part of 2005 or even later" (see the October 28 FOMC minutes).  But that statement, especially on the heels of the FOMC’s shift in its inflation risk assessment, did create confusion.  Some read this passage as an indication that the Fed planned to avoid hiking rates until 2005 or beyond.  In fact, it actually seems to be nothing more than a reasonable assessment of the point at which the monetary authority will need to have a neutral (or close to neutral) policy stance in place. 

From our standpoint, while Greenspan & Co have certainly sent some confusing signals in recent weeks, a careful reading of the FOMC statement and the October minutes does send a clear message.  The FOMC linked the “considerable period” to circumstances, not just the calendar.  The minutes clearly note the differences between today’s too-low inflation environment and those of the past, with straightforward implications for policy.  Yet financial market participants also compounded the problem by misinterpreting a relatively innocuous reference to the output gap. 

Fed officials have convened yet another committee to offer suggestions on how to improve communication of policy strategy and intent.  From that process, more changes are likely, and, we are certain, straighter talk.  We hope the committee will adopt some suggestions we’ve offered before:  Keep it simple.  Be clear about goals.  State what you just did and why.  Clearly state the main medium-term risks to the outlook.  State your policy bias: Are you north or south of equilibrium?  Finally, speed up the release of the minutes, to the end of the second week after the meeting (see “Transparency, Targets and Rules in Monetary Policy,” Global Economic Forum, September 5, 2003).  We think a growing number of Fed officials agree that early release of the FOMC minutes would be helpful.  In a November interview, Fed Governor Bernanke stated: "I would be in favor of moving up the release date of the minutes from the FOMC meetings and thus getting out more timely information about the Fed's deliberations. That would provide much more forward-looking information and reduce the burden on the statement that follows the meetings."

After the dramatic improvement in Brazilian asset prices during 2003, it may seem hard to imagine that there is still more good news to come from Brazil. But we believe that there is: We expect 2004 to be the year of a full-fledged recovery, producing the best growth — real GDP up at least 4.4% — in five years. Indeed, the good news is that the recovery in Brazil has already begun. The first signs of the recovery have come from durable goods consumption, brought about by the combination of enormous pent-up demand and an improvement in consumer confidence as the authorities have begun slashing interest rates. The pent-up demand is hardly surprising. After all, during the past five years, with the exception of 2000, Brazilians have suffered from a weakened economy. The improvement in confidence is also hardly surprising. After a dramatic contraction in private consumption at midyear — consumption saw its sharpest quarterly drop during the second quarter of the year in more than a decade — the central bank has cut interest rates by 1,000 basis points and is likely to continue well into the first half of 2004, as we expect the Selic target interest rate to fall to 14%.

Brazil enters 2004 not only with an unusually effective combination of macro policies, but also with a positive progress report card on structural reforms. On the macro front, the authorities have been able to use tight monetary policy to control inflation while maintaining a strict commitment to fiscal responsibility. The payoff is now coming, and we expect it to be abundant during 2004 as the easing cycle supports an incipient consumption-led recovery. Unlike the aborted recovery in 2001, this time Brazil finds itself with a much more solid external position. Indeed, Brazil will end this year with a record trade surplus near $24 billion, sufficiently large to allow for growth without a significant deterioration taking place. Finally, on the reform front, in an unprecedented move, controversial social security and tax reforms have passed Congress simultaneously.

Notwithstanding progress on growth and reforms, Brazil still needs to address enduring questions over its medium-term outlook. The challenge for Brazil is how to deal with improved fiscal revenues that are likely to accompany the return to growth. While the administration has underscored its fiscal austerity credentials with a larger primary surplus than was ever achieved during the past administration, good growth and improved investor sentiment can be seductive. The magnitude of Brazil’s debt is such that debt reduction must remain the principal priority of the fiscal authorities. Of course, policies designed to produce growth are crucial in order to have the resources to tackle the debt burden, and indeed one should lead to the other, but that vulnerability can easily be overlooked in the midst of a growth rebound.

Part of our cautionary note on Brazil in 2004 stems from the track record of Mexico in dealing with its abundance. The oil windfalls of 2000 and 2003 have largely gone to fund current expenditures rather than being used to fund a well-designed oil stabilization fund. Mexico’s strength has been in dealing with adversity: It has shown the prudence to tighten its belt and endure the fiscal pain. Brazil’s recent experience suggests that it has learned the same lesson. However, the jury in both countries remains out on whether they will respond to the good times. The abundance of growth in Brazil is likely to be cheered by investors in 2004; how Brazilian policy makers deal with it, however, will determine whether the cheer remains in 2005.

After running on one cylinder for most of the past three years (with modest consumer demand hampered by the lack of job growth), we are beginning to see solid evidence of a recovery in Mexico’s real economy. We expect the evidence we are now seeing to allow the debate over whether the “link is alive” between the US and the Mexican economies to be put to rest. However, we are unprepared to forecast a return to the robust growth last seen in 2000 because of our residual concerns over the quality and sustainability of the US recovery. The problem of whether the link is alive had reared its head during the second half of 2003, when the headline reports from the US showed an economy on fire while Mexico’s GDP showed little or even negative growth during the third quarter. The problem, of course, is that the US manufacturing sector — precisely where the link between the US and Mexico is strongest — had lagged the broader US recovery. That, plus differences in how the growth rates in the two economies are reported and the bias of much of the first signs of the turnaround in US manufacturing toward high-tech (where links with Mexico are weaker) raised the inevitable question whether China had so damaged the link between the two countries that a US recovery could leave Mexico without growth.

At the end of 2003, however, the first signs — initially on the trade front and now in industrial production — were visible that the US recovery is indeed spilling over into Mexico’s manufacturing sector. In fact, October’s industrial production report—once properly adjusted for seasonality — marks an extremely positive break with the weakness of recent months. Further, October’s trade report, as well as the September report in our analysis, provide strong support that the improvement in US demand seen in the third quarter has begun to spill over into the Mexican economy. And with Mexican consumers in better shape after the recent downturn than coming out of any past downturn — thanks to low inflation, they have not seen their purchasing power destroyed — consumption is set to benefit further.

The problem in Mexico remains that the policy-making class appears unwilling to move forward on a host of reforms that are crucial for Mexico to boost its competitiveness. Investors initially thought the “convergence” thesis held great promise for Mexico. Unfortunately, convergence has become a safety net. Thanks to the forces of integration with the US economy, Mexico continues to enjoy a steady flow of foreign investment. The stability of those flows, accentuated by strong oil prices, tourism revenues, and ever-growing remittances from Mexicans working abroad, have a pernicious side:  They have reduced to urgency facing Mexican policymakers to tackle the competitive impediments facing Mexico.

The good news in Mexico is that by the fourth quarter of 2003, the Mexican economy had begun to respond to the US recovery. Consumers, who so far have kept the economy afloat thanks to credit and modest real wage gains, are now likely to find improvement on the jobs front as well. The cyclical upturn is likely to cause some of the concerns over the threat that China represents to Mexico to recede. That in many ways is a shame. The greatest threat to Mexico, in our view, remains the failure of policy makers and politicians to leverage Mexico’s integration story. In the difficult months of 2003, when many Mexico watchers were concerned that China’s competitive challenge might have severed the link between the US and Mexico, the policy making class in Mexico failed to make progress on the reform front. If strong capital inflows robbed Mexico’s politicians of any urgency to act then, what can we expect now that a cyclical recovery is under way? Not much, I’m afraid. It is hard to be too upbeat on Mexico’s medium-term macro prospects, even if I am wrong for being too cautious regarding the sustainability and quality of the US recovery. Yes, it is true that a turnaround in Mexico is in the works. Much of the growth in 2004 will depend on how strong the US recovery is. But the longer-term challenges for Mexico — challenges highlighted by China’s and India’s ascension — are not being addressed. That should give pause, even as the cyclical upturn begins to gain ground and gives investor reason for good cheer.

We expect Chile’s economy to continue to gain ground in 2004 with growth near 4.5% — its strongest performance since 1997. With real wage growth fairly constant, near 2% per year, Chile’s consumer has benefited from the improvement on the jobs front as well as from greater access to credit. Unemployment is now at its lowest level in five years. Meanwhile, we expect another strong year on the credit front as banks are preparing for an aggressive increase in consumer lending, which has been growing in the double digits during 2003. The prospects for copper prices are also set to benefit Chile in 2004. Our metals team now expects copper prices to average $0.95 per pound in 2004, an 18.8% jump from the $0.80 forecast for 2003. And there are signs that there could be upward pressure to the copper forecasts: By mid-December copper prices had broken above $1.00. Unlike Mexico, which appears to be on the wrong side of the ongoing debate over the importance of China, Chile has benefited from stronger Chinese demand for its commodity exports from copper to pulp and forestry products.

In addition, the prospect of a boost in activity from the free trade agreement with the United States set to go into effect on January 1, 2004, along with the outlook for another strong year of growth in Argentina and a robust recovery in Brazil, should also benefit Chile. While the direct impact from the reduction in trade tariffs from a free trade agreement with the US is likely to be limited — we have seen estimates that it can add anywhere from 0.2% to 1.2% of GDP — secondary benefits from greater market access and increased investment flows are likely to enhance the impact further. But of greatest benefit to Chile in 2004 is likely to be the improvement in the economic conditions of its neighbors. While imports of consumer goods from Argentina and Brazil have risen by nearly one-third in the first half of the year, the benefits from a recovery in both countries are likely to more than offset the additional competition facing Chile’s manufacturing base.

While the rebound in Chile’s real economy for the most part has been anticipated by Chile watchers, the big surprise has been how much ground the currency has gained. Part of the recent rebound in the Chilean peso — from near 700 in late August to 598 by mid-December — appears to be the flip side of the excessive weakening seen during the latter half of 2002 and the first months of 2003, when the exchange rate broke above 750. But if there is a surprise in store for Chile watchers in 2004, we think it is that the Chilean peso is likely to remain strong. After all, the currency has suffered six years of decline. Today, the economy is showing virtually no current-account deficit, unlike its position during 1998 when the deficit exceeded 6% of GDP. With sound fiscal, monetary, and debt fundamentals and its commodity-linked export base, Chile appears to be ideally positioned to benefit from US dollar weakness and the rebalancing of global demand.

The weakest link is the lack of progress in boosting total factor productivity, which raises some concerns about the magnitude of the peso’s upside. Indeed, were it not for our concerns over the progress of global rebalancing, we would be even more optimistic on Chile for 2004. We are not in the camp that expects a global derailment, but we are not ready to embrace an uneventful, smooth recovery in global trade. Unlike Brazil and Argentina, which we expect to post strong growth in 2004 as part of a rebound, our forecast of 4.5% growth for Chilean GDP in 2004 is all the more impressive because it is coming off a good year in 2003.

It should come as little surprise that Argentina is leading the way in the rebound in activity in Latin America. After all, the robust growth of 2003 comes after having suffered a dramatic collapse of nearly 20 percentage points of real GDP between late 1998 and 2002. But perhaps more surprising is that Argentina is likely to have a repeat of strong growth in 2004, despite the lack of resolution of a host of issues stemming from Argentina’s default and devaluation two years ago. Indeed, we expect real GDP to grow by 6.0% in 2004.

The magnitude of the rebound is largely a function of Argentina’s large output gap, which combined with a competitive currency, low interest rates, and greater room for fiscal stimulus is likely to produce the second consecutive year of the strongest growth since the beginning of the era of convertibility in 1991. Thanks to the large output gap, Argentina should be able once again to post dramatic growth in 2004 without a significant pickup in investment spending. There is little agreement on the size of the output gap in Argentina. We have seen a wide range of estimates for 2004, from 6% (assuming growth near 7% in 2003) to 14% and some as high as 20%. Even at the low end of the range, however, our 6% growth estimate for GDP in 2004 appears plausible with only limited investment.

During the past year, the motor of growth in Argentina’s economy has rapidly changed from net exports to investment (largely residential construction) and now has moved to private consumption. The move to stronger consumer-led growth should ease some of the concerns that the output gap is quickly evaporating. Relative to net external demand, domestic demand is satisfied with a greater amount of services versus goods. While both industrial output and the services sectors fell by roughly 10% in 2002, industrial output has soared, up 17.3 % in the first half of 2003, while services has so far lagged, up only 2.2%. The lag on the services front suggests that there is significant room for growth in Argentina before capacity constraints become an issue.

The turnaround is also be supported by a very competitive currency. With inflation having rapidly come down from 41% in December 2002 to under 4% now, while the currency has depreciated by 65% since the break with convertibility, Argentina’s currency remains substantially undervalued. Again, we have seen a range of measures of just how undervalued the Argentina peso is; what seems clear, however, is that the currency is likely to continue to provide a substantial boost to import-substitution industries and to aid net exports.

While it is hard to be critical of the much-needed rebound in the real economy, we would highlight three risks that today’s temporary boost to activity poses for long-term growth prospects. First, with a repeat of strong growth in 2004, there is the risk that the political will to move forward on the debt restructuring process may be reduced. While it is difficult to imagine that policy makers or politicians can mistake the bounce-back in 2003 as the beginning of a sustainable growth path, we fear that another year of good growth may reduce the incentives to tackle the difficult challenges surrounding debt restructuring. That, in turn, can be expected to delay the recapitalization of the banks. With an economy growing without any significant financial intermediation from abroad or from local banks, it may be easier for politicians to postpone the issue of how to finance long-term growth. Second, good growth may create an additional stumbling block to progress on the debt front as bondholders demand higher recovery values for the defaulted debt. The longer and stronger the recovery in the Argentine economy, the greater the demands of bondholders are likely to be. Finally, good growth (helped along by new distortional tax measures and a reduced interest burden) may delay the day that policy makers tackle Argentina’s fiscal challenge, which requires a rethinking of the revenue sharing arrangement with the provinces.

At the core of Argentina’s fiscal challenge of living within its own means is to revamp the relationship between the provinces, which dominate government spending, and the federal government, which dominates the tax base. This imbalance provides provincial governments with few incentives to moderate spending, while attempts by the federal government to increase taxes often create a new entitlement to the provinces. Unfortunately, policy makers may feel less urgency to tackle the politically charged issue with the provinces given the jump in revenues tied to growth and new distortional taxes.

Argentina is unlikely to relinquish its status as the fastest growing major economy in Latin America in 2004. Ultimately, however, we believe that Argentina needs to address the residual damage of the meltdown two years ago, starting with debt restructuring, a new agreement with the utilities, and a plan to recapitalize the banking system. It also needs to deal with one of the sources of the meltdown — the asymmetric relationship between the provinces and the national government, which prompted it to live beyond its means. Otherwise, the rebound that we expect to continue in 2004 is likely to turn into a growth trap and leave Argentina ill-prepared for the future.

The euro area is entering 2004 at a fast speed

Our business-cycle indicators recently converged to acknowledge that the euro economy is eventually picking up steam.  On our estimates, GDP growth accelerated from 1.5% (quarterly annualized) in the third quarter to 3.0%, at least, in the fourth one.  This bodes well for growth and corporate profits.  Indeed, we expect GDP to grow 2.2% in 2004 (on a non-calendar-adjusted basis), the fastest speed since the bubble year 2000.  Even though the recovery was kick-started by a spectacular acceleration in global trade growth in late 2003, that was then, and looking forward we think that domestic demand will be the main driver of growth in 2004.

We count on consumers to fuel domestic demand

After the burst of the technology bubble, which had fuelled both consumers’ appetite and ambitious capital spending plans (remember the 3G frenzy?), domestic demand slowed down very sharply, from 3.2% on average in the 1998-2000 period to 0.9% on average in 2001-2003.  Squeezed between debt and deflation, companies cut capital spending and as well as headcount, wealthy consumers were hit by stock market debacles and wage earners were scared about their jobs.  Since then, corporate restructuring has gone far and fast, and companies are in better position to anticipate the recovery, increase spending and, in some cases, start to hire workers.  In addition, the rise of the euro since late 2002 is a lasting powerful disinflationary force, to the benefit of consumers.  We expect consumer spending, which already surprised on the upside in 2003 (1.3%), to accelerate further to 2% in 2004, thanks to stable labor market conditions, stronger purchasing power stemming from lower inflation (not higher wages) and, last but not least, income tax cuts in Germany and France worth €17 billion or 0.3% of GDP.

Euro and corporate debt will cap the capex recovery

We are not as sanguine about the next large component of domestic demand, i.e., investment.  Sure, capex will recover in 2004, as new investment opportunities stem from stronger demand and better profits.  This has already started, according to our proprietary European Analysts Survey, which, in its December edition, confirmed that large companies have already started to upgrade investment plans.  However, the capex cycle will be constrained by the strength of the currency, which will translate into lower profitability, and the necessity to reduce further the debt overhang from which large companies linked to the telecom sector are still suffering.  As soon as the euphoria created by the acceleration of growth in the US and Europe is over, we fear that the complacency still prevailing in credit markets might be replaced by scare.  Then, over-leveraged companies would have to refrain from investing as much as they would like to.  With operating profits, measured by the gross operating surplus, up 2.6%, we believe that the traditional recovery script, marked by double-digit capex growth, is not the most likely one: Whereas the so-called accelerator effects are likely to kick in, the other key factor for capex decisions, profitability, is not strong enough.  On balance, we see corporate investment up 3% next year, after a 7% contraction in 2002-2003.

Exiting the zero real interest-rate policy

In many respects, the economic and market environment facing the ECB now is the exact mirror image of the environment it faced a year ago.  Back then, the imminent threat of a war in Iraq, plunging equity markets and a weakening global economy were weighing heavily on the growth outlook and pushed inflation expectations lower.  Consequently, the ECB slashed interest rates by a total of 125 basis points between December 2002 and June 2003.  Now, a strong global economy and buoyant equity markets point to a decent economic recovery, and bond markets have moved to price in inflation above the ECB 2% ceiling in the longer term.  Consequently, we expect the ECB to end its policy of zero real interest rates — which was entirely appropriate in the zero real GDP growth environment of 2003 — and to start nudging policy rates higher during 2004. 

Watch excess liquidity, the euro and politics

As we see it, provided that the economic recovery proceeds roughly as described above, the timing and the extent of the monetary tightening will be largely shaped by the interplay of three factors: (1) the need to mop up some of the excess liquidity that the ECB has pumped into markets before it starts to spill over into prices; (2) the unpredictable gyrations of the euro’s external value; and (3) the potential impact on inflation expectations from the suspension of the Stability and Growth Pact (SGP) and from any political attempts to change the ECB’s mandate.

Money and credit growth will matter again

For more than two years now, the ECB has not only accepted but — by cutting interest rates — actively nurtured M3 money supply growth well in excess of the 4.5% reference value.  Until recently, the Bank has argued that excess liquidity was not a concern for price stability because strong M3 growth was partly due to temporary portfolio shifts into liquid assets, reflecting high equity market volatility and declining stock prices between 2001 and mid-2003, and because the weak economic environment would keep price pressures muted.  However, with stock markets having risen sharply since the spring and the economy now on the recovery path, the ECB is likely to become increasingly concerned about a potential build-up of inflationary pressures resulting from ample liquidity over the coming quarters.  Thus, the stronger M3 growth remains and the more credit growth picks up in the upcoming economic recovery, the earlier the ECB is likely to start tightening the monetary reins again.

At least one eye on the euro

Another important factor determining the timing and the extent of any monetary tightening in 2004 will be the gyrations of the euro.  Our currency team is looking for a further moderate appreciation of the euro in the next few months, followed by a correction later in the year, which would leave the euro’s trade-weighted index up some 3% in 2004 compared to the 2003 average.  If the euro were to appreciate significantly more sharply over the next few months, the ECB would likely react by reiterating that it is interested not only in a “strong” but also a “stable” euro and by putting any deliberations of an early rate hike on the back burner.  Moreover, the ECB may well decide to surprise markets by forex intervention if the euro rises too fast, too soon.  Conversely, a correction in the euro (which, given the almost uniform consensus for a further appreciation, could be quite sharp) could provide the trigger for an earlier-than-expected rate hike because it would be seen by the ECB as adding to the upside risks for price stability over the medium term. 

The political wildcard

Third, but not least, the outlook for ECB monetary policy is clouded by the emerging threat to Europe’s ‘stability culture’ from recent political developments.  First, the de-facto suspension of the SGP by the ECOFIN softens the constraints on fiscal policy, which may well result in a loosening of the fiscal policy stance in some member countries in the year(s) ahead.  If so, the ECB would have to consider this when setting its monetary policy stance with a view to preserving price stability.  Second, while initial proposals that allow for the amendment of the ECB’s statute by a simplified procedure (no longer requiring the ratification of changes to the ECB’s statute by all national parliaments) were not included in the draft of the EU constitution, some politicians (most prominently the Italian Premier Berlusconi) have recently floated the idea of changing the ECB’s mandate to a Fed-type model that would require the ECB to target not only inflation but also growth or employment.  Following the burial of the SGP, a broadening of this debate could easily lead to a rise in long-term inflation expectations and would thus become directly relevant to the ECB’s monetary policy decisions.

Moderate ECB tightening from the spring, unless the euro overshoots

Taken together, with growth likely to surprise on the upside in the next several months, inflation sticky at around 2%, liquidity abundant and a conflict between the ECB and governments brewing, we expect the ECB to start raising rates from the spring of this year.  However, given the potential upward pressure on the euro and the structural factors weighing on labor costs and core inflation, we do not expect an aggressive tightening cycle.  In total, we see the refi rate rising by 75 basis points to 2.75% during 2004 and thus less than halfway back towards what we deem a roughly neutral rate of 3.75% (2% potential GDP growth plus a 1.75% inflation objective) for the euro area.  Bond yields should push higher during the first part of the year, testing the 5% threshold at some stage, but should settle back close to what we deem as fair value of around 4.75% during the second half.  But again, if the euro were to overshoot significantly, rate hikes would likely be postponed and, depending on the impact on the economy and the inflation outlook, rate cuts might event reappear on the agenda.

Mind the euro, global trade gyrations and interest rates, but trust consumers

We see three main downside risks to our macro forecast.  First, our working assumption is an average euro/dollar exchange rate at $1.23 and, more importantly a 3% appreciation of the euro, on a trade-weighted basis.  In other terms, we have assumed that the spirit of the G-7 agreement in Dubai would be respected.  A lasting overshoot of the euro vis-à-vis the US dollar and the yen would probably be fatal to our recovery scenario, and we would not exclude a “triple dip”.  Second, an early global trade downturn would undermine business confidence before the recovery becomes self-sustainable.  Third, the loss of fiscal credibility might push long-term rates higher than what we have assumed, harm the capex recovery and depress housing investment.  However, to end this outlook on a brighter note, we also see an upside risk to growth: Consumers could be the trump card of the euro zone.  As they get more used to euro-denominated price tags, realize that inflation is declining and that pension reforms are making their future less uncertain, they could well produce a surprise by breaking open their piggy banks.

At first glance, Europe seemed to be in complete disarray at the end of 2003, after the divisions provoked by the war in Iraq, the suspension of the Stability and Growth Pact (SGP) and the failure to reach an agreement on the Constitution.  However, seen from a longer-term perspective, these events look less salient.  Just before the six founders of what are now the EU-15 initiated the negotiation of the Rome Treaty in 1954, a much deeper crisis had shaken the continent, namely the failure of the European Defence Community, at that time actively promoted by the US.  For those who remember the “empty chair” policy of General De Gaulle, or Lady Thatcher repeating at every single meeting “I want my money back”, or, more recently, the apocalyptic predictions that preceded the introduction of the euro, 2003 was, after all, just an ordinary bad year for this European unification project Sir Winston Churchill had described with almost perfect foresight in 1946.

Call it optimism or stubbornly out-of-consensus thinking, but I believe that, in 2004, there will be significant breakthroughs to make the EU more flexible and the euro-area economy, more stable and growth-oriented.  I will concentrate o the latter point in this note.  At the top of my agenda — but not yet at the top of politicians’ — is the drafting of a sound Stability and Growth Pact. I will call it SGP II.

The Pact was neither economically sensible nor politically enforceable

In 2002, when some politicians first considered ways to fudge the Pact, my position was: better to comply with the Pact in a co-operative fashion than to let deficits slip or try to change the Pact hastily (see The Arithmetics and Politics of the Stability Pact, September 2, 2002).  Political realities were not favourable to these views and, in the end, the two heavyweights of the euro club, Germany and France, chose the worse exit path.  Without acknowledging it, they let their deficits slip in 2003 and 2004 and, in the end, they orchestrated a diplomatic coup to shelve the SGP, creating a dangerous judicial vacuum.

Before going further, it is worth asking why these countries, which have a long-standing culture of fiscal stability, as testified by their relatively low level of public debt (in 2002, 60.8% for Germany and 59.1% for France), made such a choice.  Beyond political considerations, I believe that the answer is simply that the Pact was neither economically sensible nor practically enforceable.  Conceived by Theo Waigel, then German finance minister, as a marketing tool designed to sell the euro to a German public scared by the prospect of sharing its currency with Italy, it was from the beginning a grossly pro-cyclical instrument.

By pro-cyclical, I mean that in good times such as 1999-2000, the Pact did not provide incentives to save for a rainy day, whereas in bad times such as 2002-2003, the enforcement of the Pact implied higher taxes and/or lower spending, making the downturn even worse, as Portugal has learnt the hard way.  In 2002, Germany tried to respect the Pact.  As a result, the contraction of German domestic demand pulled most of the euro zone into stagnation.  Defenders of the Pact would probably argue that it is just a question of precaution and that a balanced budget over the cycle would prevent such fiscal misfortunes.  This is wishful thinking in my view.  Swedish academics have calculated that for a country such as theirs, where automatic stabilisers (i.e., taxes and government spending) are high, it would be necessary to run a permanent surplus of 3% of GDP in order to avoid reaching the -3% limit, would a downturn occur.  I wonder if the authors of the Pact have meditated on the political feasibility of running permanent surpluses in democracies.

A new Stability Pact is indispensable

To make a long story short, the Pact fell victim to its built-in flaws, and that should not be regretted from an economic standpoint.  However, clear fiscal rules are necessary in an economic area which does not have the powerful shock absorber provided by fiscal federalism, as in the US, and does not want it.  In such a framework, there will always be a temptation to run free-rider fiscal strategies in order to benefit from the low interest rates provided by the currency union, without incurring sanctions from currency markets. This is all the more important since the euro club will welcome many new members in the next ten years. On which principles should an SGP II be founded?  I see three main guidelines to judge fiscal sustainability and correct potential deviations.

Three principles for a SGP II

1.  Retain the nominal anchors set up by the Maastricht Treaty, i.e., deficits below 3% of GDP and debt below 60%.  Arbitrary as they may appear (they are not totally arbitrary, in fact, but that is another story), these values have the great benefit of being well known by the public; also, they were widely accepted by all during the EMU negotiation — having been technically involved in that process, I do not remember serious quarrels about them.  However, SGP I has demonstrated that these ceilings must not be taken rigidly.  In fact, the words “reference value” used in the Maastricht Treaty should be preferred to the word “ceiling” associated to the famous “Drei Komma Nul” trumpeted by Theo Waigel in 1997.

2.  Take into consideration both initial debt levels and trend growth rates.  In good theory, fiscal sustainability is about stocks (i.e., debts), not flows (i.e., deficits).  This is also how markets would rate issuers of debt in the corporate and sovereign worlds.  Clearly, Finland, with a debt of 42.7% of GDP in 2002, or the Netherlands (52.6%) should not be treated similarly to Italy (106.7%) or Belgium (105.3%).  Equally, the trend growth rate of each country should be one of the parameters used when judging fiscal positions.  A temporary rise of the public debt in a high-growth country, say Spain for example, is less destabilizing than in a slow-growth one, such as Germany.  Similarly, the public pension liabilities that national accounts cannot take into account should be added to the traditional debt estimates.

3.  To keep structural deficits in check, enforce a spending target rule.  The main flaw of SGP I was its pro-cyclical nature.  In economic jargon, SGP I did not let automatic stabilisers play freely, i.e., did not let cyclical deficits increase in bad times, nor forced governments to let cyclical surplus grow in good times.  The best way to restore the full use of automatic stabilisers is to agree on public spending growth targets and have these targets respected.  If, for instance, GDP growth unexpectedly dropped below trend, then the cyclical deficit would automatically rise, as tax receipts would decline.  As long as the government would respect its spending growth target, this should not be a problem, even if its deficit exceeded 3% of GDP.  If, on the contrary, GDP growth accelerated above trend, tax receipts would naturally grow fatter and generate surpluses, as long as public entities respect spending targets.  The irresistible political pressure to “spend the surplus” would be eliminated by the respect of the spending rule.  In addition, spending is easy to monitor and check, whereas tax receipts are so notoriously volatile than even national Treasuries cannot accurately forecast them.  Hence, the spending rule has the double advantage of being stabilizing and pragmatic.

For aging countries, spending targets must be below trend growth

However the spending target rule is established economically, it leaves open the most difficult question: What should this target be?  From an economic standpoint, in a region where populations are rapidly aging (Spain, Italy and Germany being at the forefront), most countries (not all), should aim at reducing the size of their debt relative to their GDP.  This implies that nominal spending targets should, in most cases, be lower than trend nominal GDP growth and, in the case of highly indebted countries, significantly lower, in order to guarantee a self-sustainable reduction of the debt.  I guess that the most difficult part of any negotiation would be to agree on spending targets, based on propositions made by the Commission.  I know that most governments would be reluctant to accept such constraints on their fiscal sovereignty.  However, since the spending rule would reduce the natural pro-cyclicality of fiscal policies and thus give more freedom to governments, reaching an agreement should not be as difficult as it looks.  Note that countries wanting to reduce their own tax burden in order to foster long-term growth would be free to set their own spending targets below the rule commonly agreed.

I have left aside many important aspects of what should make SGP II a success.  How to decide and implement sanctions is certainly one of them.  In addition, public spending items that generate significant externalities, such as environment or defence, do not necessarily qualify for the spending rule.  I leave these issues for another forum.  A more important question remains:  Will the political environment push the Commission and governments to review their copy and work on a serious and sound Stability and Growth Pact, Version II?

The negotiation will start in one of the next three EU presidencies

In a better world, the EU Commission would have anticipated the events that led to the suspension of the Pact on November 25 and proposed a renegotiation before being defeated by a coup orchestrated by the four big states (yes, Italy and Britain were part of the plot).  This did not happen, unfortunately.  However, 55 years of European negotiations in peacetime demonstrate that good things normally emerge from bad experiments, and it is not too late to start doing the right things, given the complacency I still see in bond markets.  Most policy makers, although not all, are convinced that the Pact will have to be reworked, the most important exception being the European Central Bank which, it must be reminded, has no mandate concerning fiscal policies.  My hope and my conviction is that reason will prevail and that, in one of the next three six-month presidencies, i.e., the Irish, Dutch and Luxembourg ones, the real work will start.  During the course of 2004, I am convinced that fiscal issues will attract a lot of attention in financial markets and that cynical views such as “the SGP is dead, let’s forget it” will not help in making optimal investment decisions.

At the height of the Iraq war back in March, I wrote a note arguing that the idea of an ever-closer political union culminating in the United States of Europe always was and would always remain just a pipe dream (see The Dis-United States of Europe, March 24, 2003).  At that time, the public debate was dominated by the discord between “old” and “new” Europe on the involvement in Iraq.  But I argued that this was only one of several political dividing lines within Europe, which would become increasingly apparent over time.  However, I had no idea that this issue would come to the fore with a vengeance already in the final two months of 2003, when the de facto burial of the Stability and Growth Pact (SGP) caused a major rift between governments and when the EU Summit on the proposed EU Constitution failed miserably. With hindsight, 2003 was the year when serious cracks in the European political compound became apparent.  Looking ahead, I believe 2004 could be the year when markets begin to price in some of dire consequences of the Disunited States of Europe — the return of the country factor in bond markets; the weakened position of the ECB, which might be pressurized into producing higher inflation; and a higher risk of EU secession and EMU break-up. 

Conflict over fiscal policy is here to stay

As I see it, the conflict over fiscal policy and the SGP that erupted in 2003 is unlikely to go away anytime soon.  Many of the small countries (plus Spain) that have pursued a more virtuous budgetary policy in the past several years are seriously angered by the slippage in budget deficits in large countries such as Germany and France.  This is because rising budget deficits in the large countries, due to their sheer size, are seen as raising the borrowing costs for all governments within EMU, irrespective of the consolidation efforts that the smaller countries have made.  It is important to note that the SGP was suspended exactly at the point when the EU Commission proposed to make binding recommendations on fiscal policy to Germany and France.  This underscores the basic fact that the larger member states are simply unwilling to accept any serious interference in their sovereignty over national fiscal policy.  It is difficult to see how a re-writing of the fiscal rules, now being discussed widely, could overcome this basic fact.  In any case, devising and negotiating a new SGP is a matter of years, not months, and even if a new, better Pact could be agreed upon, it would hardly be credible, given the sobering experience with the old Pact.  In my view, it might be better to do away with any attempts to coordinate and restrain fiscal policy on a euro-wide basis altogether and rely on national electorates and discriminating bond markets (helped by rating agencies) to punish fiscally profligate national governments.  I will come back to this point below. 

Battles about redistribution ahead

Another area of discord, as illustrated by the failed EU Summit last week, is the distribution of voting rights and thus the distribution of power in an enlarged EU of 25 members.  The Summit failed because Spain and Poland were unwilling to give up the disproportionately high number of votes (relative to the size of their population) accorded to them in the Nice treaty several years ago — both so far have 27 votes against 29 votes for the four largest countries.  The deeper issue here is, of course, that the voting influence will be crucial for them (and other members) in the upcoming battle about a new key for the distribution of EU agricultural and structural funds in EU-25.  These negotiations about the EU budget for the seven-year period starting in 2007 will kick off in 2005 at the latest.  Presently, it looks unlikely that the EU Constitution can be agreed upon before late 2004, and even that is uncertain.  The longer this process drags on, the more likely it is that the negotiations on the Constitution will be complicated further by the upcoming re-distributional struggle about EU funds.  Thus, the present draft Constitution may turn out to be just that forever — a draft.

Disunited we stand

All of these dividing lines in Europe serve to illustrate an important point: Europe is unlikely to move closer to the EU founding fathers’ ideal of a United States of Europe in the foreseeable future.  Decision-making in an enlarged EU of 25 members, with the current rules in place, will be highly complicated, and there are plenty of areas where member states simply won’t be able to agree.  Thus, from a political point of view, question marks will continue to hang over how effectively the European Union will be able to operate in the future.

Diversity should be bullish for competition and growth

From an economic point of view, however, a diverse union may not be such a bad thing after all.  As I see it, Europe’s political, cultural and economic diversity has always been a strength rather than a weakness as it provides for a healthy competition of political economic and systems catering to their local voters and to internationally mobile companies.  Yes, this kind of competition may look messy or even chaotic at times, some countries may run in the wrong direction for a while, and internal disagreements and even institutional crises in the EU will ebb and flow.  However, as long as the common market for goods, services, capital and people rules, this kind of competition should produce better economic outcomes than a single government for the whole union, which would be far detached from its diverse citizens in 25 or more member states (I first laid out this argument in an article in the Financial Times on December 22, 1997 entitled “One Money, but Many Nations”).  Countries that pursue the right tax, welfare and labour market policies in this set-up will be rewarded with capital inflows, stronger growth and lower unemployment and will serve as a role model for others that are doing less well.  Eventually, the process of “dynamic benchmarking” will lift the boat for all members willing and able to play the game and should result in a less regulated and faster-growing European economy.  Hence my optimism on the long-term growth prospects for Greater Europe.

The return of the country factor 

The prospect of a disunited and diverse EU has some important consequences for financial markets, however.  First, the country factor is likely to become more important again in determining bond and, possibly, equity prices.  Growing divisions on budgetary policy and the de facto burial of the SGP could lead to a significant widening of government bond yield spreads between the more and the less virtuous countries.  Partly, this would reflect the actual fiscal policy divergences and partly it would reflect the markets’ assessment that a financial bailout for a member state running into serious fiscal difficulties will be less likely in a disunited Europe.  In thinking about the potential for a widening of bond yield spreads between national markets, it is important to keep two points in mind:  First, by joining the euro, national governments have given up the option to resort to the printing press in order to finance deficits.  This would only be possible again if a country decided to leave EMU or if the ECB could be pressurized into printing money to bail out a government.  Second, the “no bail out clause” in the Maastricht treaty stipulates that no member state can be forced to step in for the obligations of another member state.  Both provisions together imply that, in theory, the credit quality of a fiscally profligate country could deteriorate quite significantly (to illustrate at the risk of exaggerating, think of European government bonds as the equivalent to municipal bonds in the US) and could lead to a significant widening of government bond yield spreads with more fiscally virtuous member states.

Pressures for higher inflation 

Second, a disunited Europe won’t make the job for the ECB any easier.  While the ECB has no policy instrument to address economic divergence between the euro participants, a growing divergence of budgetary and general economic policies would likely lead to increased political pressures for an easier monetary policy to grease the wheels.  Whether the independent ECB would cave in to such pressures is uncertain.  Yet history shows that even the most independent central banks are not immune to the political environment in which they operate. Thus, my guess is that a disunited Europe would, over the longer haul lead to higher inflation in the euro area.

The risk of E(M)U break-up 

Third, in this changed environment, markets will have to attach a higher probability to a break-up of EMU and/or the EU at some future date.  While I believe that the economic benefits from participating in both are sufficiently large to make such an event unlikely, we simply cannot neglect the possibility of fraction and secession any more.  In my view, as the economic divisions within Europe are likely to become larger rather than smaller in the future, investors should start to factor in this risk.  These worries — an inflationary outcome coupled with a heightened risk of E(M)U break-up — lie at the heart of my very contrarian view on the euro, which I personally expect to trade significantly lower than presently in 6-12 months time, and they contribute to my bearish view on European bonds both in absolute terms and relative to US bonds.  

The 2004 EU enlargement is more significant politically, and in its effects on EU governance, than economically. 

With the accession of 10 new countries to the European Union, less than half a year away, enlargement is bound to become one of the defining themes in 2004 and beyond.  The failure to agree on a new constitution at the Brussels EU summit in mid-December underscores the fact that streamlining the decision-making process and reducing the over-representation of small countries will be among the biggest challenges (see Joachim Fels's comment Disunited We Stand in this issue).

Impact on GDP growth likely to be small in the EU-15 ...

Empirical studies suggest that the cumulative effect of enlargement on real GDP in the EU-15 by the end of the decade is likely to be an increase of less than 1%.  However, we believe that enlargement will increase the pressure towards economic and labour market reform in the EU.  In addition, the effect is likely to be larger in those countries that are more affected by the flow of goods, investment and labour vis-à-vis the 10 accession countries (AC-10) — Germany and Austria in particular.

... but potentially large in the accession countries. 

Some of the benefits from EU accession were brought forward by a surge in bilateral foreign trade and inward foreign direct investment (FDI) during the second half of the 1990s.  Going forward, the impact on investment and productivity growth will still be significant, in our view.  Income convergence is likely, albeit not guaranteed.  It depends crucially on the ability of the accession countries to leverage the EU funds and to maintain exchange rate competitiveness and relatively sound public finances.  Should these conditions be fulfilled, we would expect the four central European countries (Czech Republic, Hungary, Poland and Slovakia) to experience an average real GDP growth rate of 4.2% in 2004-2010.

Trade and investment linkages with the EU to deepen.

The degree of foreign trade and investment integration between the EU-15 and the accession countries is already high, thanks to increased vertical integration within industries and low labour costs and access to local markets.  Post accession, the adoption of the single market and the recent elimination of residual tariff barriers by the AC-10 will probably lead to a further increase in trade.  While inward FDI as a share of GDP may not sustain the peaks of 2000-2001, it is nevertheless likely to remain high, as higher income levels open new local market opportunities and European medium-sized companies gain confidence.

Migration flows will initially be small, but they will grow in the next decade. 

Free movement of labour from the AC-10 to the EU-15 will be restricted during a seven-year transition period.  Once the restrictions are lifted, we reckon that the inflow of workers from central Europe is unlikely to exceed 0.4% per annum of the EU-15 labour force, due in part to a decrease in the per capita income gap between the existing and the new EU member states.  That said, the immigration flows are likely to be more meaningful in Germany, due to geographic proximity with the AC-10.

Enlargement will pose a challenge for the ECB, but not necessarily through higher interest rates. 

If the AC-10 were to adopt the euro relatively early, that would impart an inflationary bias and make it more difficult for the ECB to achieve its “below but close to 2%” inflation target.  The experience of the existing euro zone points to higher inflation rates in countries with relatively lower per capita income.  The same can be expected to occur in central Europe.  However, enlargement should also make the product and labour markets of the EU more competitive, which could lower the average euro zone inflation rate and pave the way for lower interest rates.  Secondly, the ECB is likely to continue to focus on the weighted average inflation rates in the euro area.  Given the relatively low relative weight of the AC-10, the effect on ECB policy may be limited.

EU institutions insist that the AC-10 not rush to adopt the euro. 

The European Commission, the ECB and member states have urged the AC-10 to make further progress on economic convergence and structural reforms before joining the single currency.  We think even the current pressure to reform the Stability Pact should not be viewed as a sign that euro applicants would be excused for not satisfying the fiscal convergence criteria.

High budget deficits are the main hurdle, but fiscal consolidation is likely to be gradual. 

EU accession should lead to increased government outlays in the AC-10 in the form of public investment and contributions to the EU budget.  Meanwhile, tax revenues risk being curtailed by increased corporate tax competition among the central European countries and political pressure for lower personal income taxes.  With higher indirect taxes the only partial offset, fiscal consolidation is likely to proceed gradually, relying primarily on the fiscal dividend of faster economic growth.

While some smaller AC-10 may adopt the euro in 2007, larger ones will probably wait until the end of this decade.

Given their current fiscal, inflation and exchange rate positions, it is conceivable that Slovenia, Cyprus and the Baltic Republics could adopt the euro in January 2007.  Hungary has a 2008 target, which we believe has more than a 50% probability of being realised.  Our best guesses on the other countries are 2009 for Poland and 2010 for the Czech Republic and Slovakia.  That said, if strong economic growth is achieved in 2004-06, that could create greater political momentum to adopt the euro in 2008 in all four central European countries.

Ahead of their May 1 accession, the EU's ten new members are already making their presence felt politically.  Poland's role in the acrimonious collapse of the EU's constitutional negotiations underlines that it remains unlikely to take up President Jacques Chirac's recommendation that the applicants should know their place.  Many of the smaller new entrants also appear uncomfortable with an integration plan perceived as favouring the larger states.  Economically we think the outlook for the major applicants remains bright in the short term, more because of the incipient Euroland recovery than because of any changes brought by EU entry.  Rising political tensions risk slightly reducing the promised increase in redistribution to eastern Europe after 2007, and further delaying the entry of the larger central European states to the euro, but the convergence story is not entirely off the rails.

Further indications that Euroland recovery is under way bode well for central European growth and current accounts in 2004.  With a strong EUR/USD, EU industrial production surprising on the upside, an eighth successive monthly rise in the IFO business survey, and at least partial agreement on German tax reform, the external environment for the CE4 looks the most favourable since 2000.  We expect the Czech Republic and Hungary, the most exposed to the Euroland cycle, to be able to maintain output growth just as indirect tax and administered price rises squeeze real household income growth.  In Poland and Slovakia, we see more upside for domestic demand but presently low current-account deficits leave room for sustainable expansion.  The combination of EU recovery and EU entry should see a recovery in direct investment into the region as easier border crossings make the region more attractive to smaller investors and outsourcers.  With slightly easier labour movement, Poland in particular is likely to benefit from growing remittances.  We see room for a resumption of currency strength in Poland and Slovakia next year, both of which look likely to take an increasing share of inward FDI, and to remain the fastest-growing economies in the CE4.

The most widely anticipated change next year, access to EU structural and agricultural funds, is unlikely to be significant in the short term, unless in disappointing inflated popular expectations.  We do not expect net transfers from the EU to exceed 0.5% of GDP in central Europe next year, rising to a maximum of 1.2% of GDP in Poland by 2006 on the optimistic assumption that Poland meets the related administrative requirements.  Under the EU's 2007–12 budget new members will have been hoping to move up towards the 2–2.5% of GDP net transfers currently enjoyed by Greece and Portugal.  With the failure of the constitutional talks, it will now be harder to separate the issues of financing and voting power, with net EU contributors more determined to limit the cost of being outvoted by the major recipients.  The Spanish-Polish alliance may prove short-lived in this area, but we would expect Spain to suffer more than Poland from any move to limit overall EU spending.  From the German government's point of view, it may look both cheaper and fairer to satisfy Poland's aid aspirations.

Other areas that could be threatened by further large/small member acrimony or a move to a two-speed Europe include further waves of EU and Euro-area enlargement.  The Balkans already risk delaying EU membership with the election of a post-fascist government in Croatia and a likely nationalist victory in Serbia.  Similarly on Euro entry, while it will be hard to argue that the Baltic states or Slovenia do not meet early entry criteria, fiscal developments in Poland, the Czech Republic, and Hungary have only helped the case of those on the current EU side who may prefer to see the CE4 delaying membership.  The ECB and EC have reserved substantial discretion on the interpretation of exchange rate stability criteria.  While in the past this discretion has tended to favour the applicants there is a risk this may not be the case in the current political environment.  The collapse of the Stability and Growth Pact may also reinforce doubts over entry among both current EMU 'outs' and eurosceptics in countries like the Czech Republic, particularly as the Maastricht entry conditions will not be relaxed.  In the CE4 we continue to expect the 2005-6 round of parliamentary elections to take priority in the short term over the fiscal tightening needed for early EMU entry.

Yet the outlook is by no means all gloomy.  Hungary appears to be making use of 2004's political window to move further towards fiscal tightening.  While the current Polish government appears to be in extended death throes, we believe a PO-PiS led government is likely to be able to use a still-strong growth environment to begin tightening in 2005.  Despite rising inflation, we expect rate cuts to resume or continue in 2004 in Hungary, Poland and Slovakia, particularly with currency appreciation in the latter two.  It is harder to be optimistic on Czech interest rates, with Euro entry this decade still highly unlikely, but a likely move to Eurobond issuance should help keep funding relatively cheap.  While the market exuberance that followed the EU's Copenhagen summit this time last year is unlikely to be repeated, and rising Euroland rates will provide a challenging backdrop, we believe there are still opportunities in convergence.

For many years, the UK economy has benefited from the tailwinds of market-oriented reform in the 1980s and early 1990s, as well as from the shift to a more credible monetary regime, which led to a permanent decline in interest rates.  However, with interest rates now on the rise and the government shifting resources from the private into the public sector, consumer spending is unlikely to remain the driver of growth in 2004 and beyond, in our view.  Our main case is that external demand and investment are likely to take over as the engines of growth.  However, the risk is that this rebalancing will not succeed and that the economic recovery will sputter.  Well aware of this, and with CPI inflation well below the new 2% target, the Bank of England is likely to tread cautiously in 2004.

The success story continues

UK GDP growth returned to an above-trend rate in the third quarter of 2003 and looks set to maintain this pace into 2004, in our view, when we see GDP expanding by 2.7%, compared with our 2003 estimate of 2.0%.  Looking back over the past year, the UK economy has exhibited an impressive degree of resilience in the face of weak equity markets and geopolitical turbulence, especially when compared with its European peers.  As we see it, there are three reasons for the UK’s economic outperformance.  First, a buoyant housing market encouraged and enabled consumers to maintain a pace of spending above the growth rate of real disposable income.  This trend was reinforced by the Bank of England’s rate reductions in February and July, which fuelled household debt accumulation further.  Second, fiscal policy continued to be expansionary, with the structural general government deficit widening by about 1 percentage point of GDP in 2003.  And third, sterling weakened by about 4% on a trade-weighted basis during the first half of the year, providing a fillip for the manufacturing sector, which emerged from a multi-year recession during the year. 

Successful rebalancing crucial for continued growth

Looking into 2004, we see a very different combination of factors propelling economic growth.  While some of this year’s policy stimulus is still in the pipeline and will provide momentum going into 2004, fiscal policy is likely to be at best slightly expansionary in 2004, the Bank of England looks set gradually to remove the monetary stimulus, and sterling is likely to be stronger rather than weaker (our currency team is forecasting a 4% appreciation of the trade-weighted index in 2004).  Moreover, we assume a gradual cooling of the housing market boom that is likely to make consumers more cautious and should lead to a further slowing of household spending growth to around 2% in real terms in 2004.  The new drivers of growth in 2004 will be exports and capex, we think.  Export growth should benefit from the pick-up in world trade growth and from the gain in price competitiveness due to sterling’s depreciation earlier this year.  The same factors should help produce a recovery in corporate investment.  The outlook is therefore for more balanced economic growth in 2004 compared with the past few years, with consumer spending slowing and exports and investment gathering steam.  This should also be accompanied by a narrowing of the gap between a bubbling services sector and an ailing manufacturing sector over the coming year. 

Underwhelmed by household debt

The continued rise in private household debt and its potential implications for consumer spending are likely to remain the key issue for UK financial markets in 2004.  With the debt level mounting to a record high, many observers have concluded that the UK consumer is ‘an accident waiting to happen’.  We disagree.  The demographic trend towards increasing owner-occupation rates, the (permanent) decline in interest rates due to a more credible monetary policy regime, rising household assets, and a more competitive credit market go a long way in explaining the increase in debt-to-income ratios.  And, despite higher ratios of mortgage equity withdrawal, un-drawn housing equity as a percentage of total housing equity has risen to more than 75% as housing wealth increases have outpaced the rise in mortgage debt.  Clearly, higher interest rates will eat into consumer’s purchasing power.  However, to push debt servicing costs as a share of disposable income (close to historic lows right now) anywhere close to the high levels seen during the early 1990s housing bust and recession, we estimate that the Bank of England would have to raise rates to around 8% — hardly a realistic presumption, in our view.  In short, while high debt levels will be a factor weighing on consumer spending in a rising interest rate environment, they are unlikely to spell disaster for the UK economy. 

The bigger risk: sterling and the global economy

The bigger risk to our benign outlook for a rebalancing of UK growth, in our view, emerges from external developments.  Should the global economic recovery falter yet again, or should sterling appreciate very sharply, the transition to export-led and capex-led UK growth would not materialise.  Further, as the Bank of England would likely keep rates lower than otherwise or even cut them again in such an environment, private household borrowing and spending would be stimulated further, risking an unsustainable boom in consumer spending followed by a bust at a later stage. 

More rate hikes, but no overkill

Another key theme for UK markets in 2004 is the speed and extent of further base rate increases.  In our view, rather than hiking rates aggressively as it did in past tightening cycles, the Bank of England will tread cautiously in raising interest rates, for three reasons.  First, the Monetary Policy Committee (MPC) is concerned about the build-up of household debt.  Given the uncertainty about the distribution of debt among households, the Bank is concerned that, despite the relatively low average level of debt servicing costs, aggressive rate hikes could lead to a sharp retrenchment of consumer spending by certain highly indebted groups of households.  Second, although most business surveys portray a smart recovery in the manufacturing sector, manufacturing output, exports and capex have all disappointed recently.  Given the still-fragile state of the manufacturing recovery, the Bank will not want to risk a strong sterling appreciation, which could result from faster rate hikes.  And third, despite record-low unemployment, wage pressures have remained relatively subdued in the private sector so far, suggesting that the link between resource utilisation, wages and prices might have changed.  Moreover, there is a possibility that the recent change in the bank’s inflation remit to a CPI inflation target of 2% from the old 2.5% RPIX inflation target will change the public’s inflation expectations and thus dampen wage demands.  While, as we explain below, this would be entirely unwarranted, such a reaction cannot be excluded a priori. 

A higher inflation target in disguise

The change in the Bank’s inflation remit to a 2% target for the CPI (the index formerly known as HICP) from a 2.5% target for the RPIX is more than a technical change, in our view.  While looking like a reduction in the inflation target on the surface, a 2% CPI target is roughly equivalent to a 2.8% RPIX target and thus implies a higher rather than a lower sighting shot for inflation.  This is because the long-run difference between the RPIX and HICP inflation measures is around 0.8 percentage points (pp), with 0.5 pp resulting from a different method used to aggregate individual prices and 0.3 pp largely resulting from the long-run trend in house prices (which are excluded from the CPI, but are included in the RPIX via the housing depreciation component).  Thus, the new target implies that the Bank of England will have to keep monetary policy slightly more expansionary for some time in order to engineer the transition to what is a de facto higher long-run inflation rate.  This is yet another reason why we think the Bank will nudge up rates fairly cautiously during 2004.

Some have suggested that rate hikes spell disaster for the UK consumer — that with the UK consumer heavily indebted, increases in interest rates could push household spending over the edge.  While we look for the UK consumer to continue to slow in 2004, we do not share the view that Bank of England rate hikes spell disaster.  In our view, the Bank would need to hike rates to somewhere near 8% (from 3.75% currently) to approach “danger levels.”  This does not seem realistic to us.

Consumer to slow. 

We look for 2.1% growth in household final consumption in 2004, after 2.3% growth in 2003 and following actual consumption growth of 3.6% in 2002.  We see several factors driving this slowdown into 2004, including a gradual cooling of the housing market boom and monetary policy tightening from the Bank of England.

Previous spending ‘busts’ triggered by rate hikes. 

We look for a further 75bp in rate hikes in 2004, having seen a first 25bp hike in November already.  These rate hikes would dent consumer spending by raising the amount of money UK households spend servicing their debt.  Given, however, that the UK’s last “bust” in household spending in the late 80s/early 90s was triggered by massive rate hikes, it is key to consider just how sensitive to rate hikes the UK consumer is likely to be this time around.  Given high household debt levels (at 88% of GDP, compared to a ratio of 75% in 1990 and euro area levels closer to 60%), some make the case that rate hikes could send the UK consumer over the edge.

But rate cycle will likely be less aggressive and debt service looks manageable. 

The UK’s rate hiking cycle is unlikely to be aggressive, and is certainly unlikely to be as aggressive as in the late 80s (when rates were hiked from 8.5% in 1988 to 15% in 1990).  Further, debt servicing is currently at very low and manageable levels, in our view, such that it would take quite an increase in rates to reach the kind of danger levels seen in the 1980s.  To try to quantify the impact on debt service we took two approaches:

1) Debt service ratio ‘danger level’ would need rates at 8%. 

In the late 1980s, the ratio of interest payments to disposable income reached highs of 15% in 1990.  We are currently at levels of around 7%.  Using the assumption that disposable income grows a conservative 0.6%Q through end-2004 and that household debt continues to grow at a substantial pace despite the rate hikes (we assume 3.0%Q), by end-2004 our ratio would be at only around 9.3% on our rate-hike assumptions.  In fact, to reach 15%, on the income and debt assumptions above, we would need to see interest rates rise to just over 8%.  While not inconceivable, with interest rates currently at 3.75%, with growth around trend, and with inflation some 0.7pp below target, it seems very unlikely to us.

2) Increased debt service would not take an unmanageable slice of average disposable income. 

We calculate that average net household financial liabilities are around £39,420 per UK household.  A 100bp increase in the interest rate paid on debt would thus raise interest payments by some £394 a year.  This extra payment amounts to around 1.3% of household disposable income.  However, note that this calculation assumes all borrowing is floating rate, so this may be an overestimate.  Hence, while such a repo rate increase would put a dent in consumer spending, any effect should be relatively limited on an aggregate economy basis.  Further, the kind of economic environment we see justifying 100bp in rate hikes would be one where above-trend growth generates additional disposable income via employment growth and higher wages, again suggesting consumer spending would be unlikely to crash.

Highly indebted groups may suffer, but this could help the Bank stay cautious. 

The risk we see is that certain highly indebted groups of households will be very adversely affected by moderate rate hikes and that these households may also be responsible for a disproportionate degree of consumer spending growth.  November’s sharp slowdown in retail sales volumes might even be taken as early evidence of this by some.  However, the Bank of England appears to be conscious of this risk.  In the November MPC minutes the need to be cautious on raising rates due to uncertainty on the response in consumption was highlighted.  Hence, the existence of such indebted groups would anyway be one further reason to look for nothing further than a gentle rate hike profile from the Bank. 

Bottom line. 

“Disaster scenarios” for UK consumer spending look unrealistic to us without aggressive rate hikes.  One risk might be the existence of highly indebted groups of influential consumers.  However, the existence of such groups would, in itself, help ensure only a gentle path for rate hikes.

Nach dem Spiel ist vor dem Spiel. 

Sepp Herberger (German National Soccer Coach 1936 to 1964)

2004 will mark the fiftieth anniversary of Germany winning its first soccer world cup after the Second World War.  In a cliffhanger final in Switzerland on July 4, 1954 -- later dubbed ‘the miracle of Bern’ — the German team beat Hungary 3-2 (for details see http://www.wunder-von-bern.de/).  The victory came as a momentous event for postwar Germany.  In fact, some historians view it as ‘the true date of birth’ for the Federal Republic of Germany.  Fifty years on, the comments made by the coach of the German team, Sepp Herberger, after the spectacular victory are an apt description of the challenges facing the German economy over the next 12 months. Herberger reminded players that ‘after the game is before the game’, adding that ‘the next game is always the hardest’.  In my view, exactly the same applies to progress of reform in Germany:  To paraphrase the legendary German coach:  After the reform is before the reform.  And the next reform is always the hardest.

It was only in late December that a compromise was reached over which measures of the government’s ambitious reform agenda to implement on January 1, 2004.  Despite the income tax cuts eventually agreed on, at €15 billion or 0.7% of GDP, being slightly smaller than previously envisaged, we still expect the economy to expand at an above-trend rate of 2.1% in 2004.  But together with the stronger euro exchange rate and a potential slowdown of the Chinese economy, the scaled-down income tax cuts could shift the balance of risks to our forecast to the downside.  That said, the downside risks should be relatively small — accounting for up to two-tenths of a percentage point, on our estimates.  In addition, with the remaining income tax cuts now becoming effective in 2005, a similar upside risk arises to our 1.8% GDP growth forecast for that period.  If our 2004 GDP turns out be to close to the mark, next year could mark the end of Germany’s multi-year underperformance vis-à-vis its neighbours.  Yet such a vigorous recovery might in fact pose a risk to the longer-term growth outlook for Europe’s largest economy. 

Having been bombarded with an unprecedented number of reform proposals this fall, the public — and even more so their elected representatives — start to show first signs of reform fatigue.  A robust cyclical recovery might give rise to the illusion that enough reforms have been implemented to revive the economy on a lasting basis.  This could not be further from the truth.  There can be no mistaking that Germany’s ailing economy needs further reforms to raise the rate of its potential (or trend) output growth.  Instead of waiting for the next multi-year mini-recession to push through with additional reforms, the government might want to use the tailwinds of cyclical upswing to get additional reforms under way.  Pressures for improvements in the cost-competitiveness of the German economy will likely come from both a stronger euro and from EU enlargement, which will add ten new countries to the single market in May of next year.  In my view, rising to these competitive challenges requires a more flexible job market and more moderate labour cost increases.  Contrary to many other countries, in Germany the government must not interfere with the bilateral negotiations between the trade unions and the employer federations on wages, benefits and working conditions.  However, the government can change the institutional framework under which these negotiations take place. 

On my report card of German labour market reforms, there are still three to-do items.  First, the government should provide a clear legal framework for so-called opening clauses, which would allow individual companies to deviate from industry-wide contracts.  Unfortunately, the government resisted pressure from the opposition parties in the recent mediation talks to legally enforce such clauses, hoping that the negotiating parties would voluntarily agree on the clauses.  If these hopes turn out to be misplaced, legislative action would be required.  Second, the Guenstigkeitsprinzip, which stipulates that deviations from the industry-wide arrangements are only permissible if the deviation is favorable for the employee such that they foresee higher wages or benefits, should be redefined to also include job guarantees — even if these are given in exchange for concessions on pay.  Third, the straightjacket of the industry-wide wage contracts could be eased further by lifting the Tarifbindung, which still commits a company to the industry-wide agreement even if it has cancelled its membership with the employers’ federation, and allowing companies to negotiate individual wage deals with their workforces (and their trade union representatives), effective immediately.  Together, these measures would ensure that the silent erosion of the industry-wide wage agreements, observed over the last decade, gains more momentum.

In many respects, the wage round in the metal industry, which is just getting under way, could be seen as a bellwether for changes in the overly rigid labour market institutions.  Having suffered a major defeat in a conflict over working hours in Eastern Germany this summer, unwavering IG Metall trade unionists are now demanding a 4% pay-rise for the 3.5 million workers in the sector from January onwards.  With the labour market still in the doldrums, metal workers are unlikely to get much more than half of what they demanded, however, and will possibly have to make concessions on working hours, too.  The latter actually hints at an interesting avenue to improve cost competitiveness.  It seems that companies find it easier to convince their workforce to put in longer hours without being fully compensated for the additional time than to negotiate a pay cut or a pay freeze.  The path of least resistance has two branches: raising the average work week or cutting holiday allowances.  The public sector, where finances are stretched to the limit, has already started to introduce a longer work-week.  Now the private sector needs to follow suit.

To contain the unrelenting upward pressure on non-wage labour costs, it will be vital to keep pension and health-care contribution rates in check.  To this effect, a bipartisan healthcare reform passed last fall will likely result in somewhat lower healthcare contribution rates (equally split between employers and employees), through cutting medical expenses and introducing patient fees.  Now a pension reform is in the making, which aims at improving the long-term sustainability of public finances by freezing pensions, raising the retirement age and strengthening incentives for individual pension savings through phasing in deferred taxation for such savings.  As part of a general overhaul of taxation, we also might see a major cutback of tax breaks in exchange for a simpler tax system with lower income tax rates.  While such a tax overhaul would likely reduce the distortions caused by the present tax system, it is unlikely to match the tax relief implemented by the Schroeder government over the past few years.  In fact, further consolidation on the expenditure side is needed to ensure that the budget deficit eases back to 3% of GDP in 2005. 

Last but not least, the political horse-trading between the regional states and the federal government in the mediation process about implementing Chancellor Schroeder’s reform agenda these last few months underscores the fact that Germany’s federal political system urgently needs to be streamlined.  In particular, the fiscal responsibilities of the federal government have to be more clearly separated from those of the regional states in order to prevent potential reform blockages in the future.  In addition, Germany is still lacking a national stability pact that breaks the fiscal commitments under the Stability and Growth Pact down into pledges for the different layers of government.  In preparation for a reform of the political system, a government-appointed commission will report about reform proposals by mid-2004.  Such a reform should ensure that Germany’s decentralized political system, which aside from the principle of representative voting is a cornerstone of its post-war constitutional set-up, becomes fully functional again.

To sum up, with GDP likely expanding at a 2.1% rate next year, Germany is clearly set to move up from the bottom of the European growth league tables. But the remarks of the ‘soccer philosopher’ Sepp Herberger half a century ago highlight that there is no time for complacency — even after a victory much greater than the recent reform compromise. After the reform is before the reform.

This past year was the worst for France since 1993 from a growth and public finances standpoint.  I believe that growth has already resumed at the end of 2003 and that 2004 will be much more favourable for French companies and workers than was 2003.  Our 2.1% GDP growth forecast is still above the consensus, and yet I think that risks are evenly balanced.  On the one hand, cyclical forces are, as always, probably more powerful than we are assuming; on the other hand, the rise of the euro, if not checked, might choke the recovery later in the year, when companies’ profits start to suffer.  In this regard, I would notice that the French economy is less sensitive to the euro exchange rate than, for instance, Germany, because French exports are more oriented towards Europe.  However, the themes that will matter in 2004 are more likely to be political and structural ones, in my view.  Important midterm regional and European elections will take place in a few months, which might either consolidate PM Raffarin’s government or, on the contrary, trigger a cabinet reshuffle under another premier.

Whereas the public debate in France will focus on political and sociological issues, such as how to help the Muslim community integrate into French society and accept its secular laws, financial markets will be more interested in seeing how the heavy lifting of the over-regulated French economy undertaken by the government in 2003 will continue and bear fruit for the corporate sector.  Even though the proximity of midterm elections is not propitious for ambitious reforms, I believe that, bumpy as the road might be, reforms will go ahead on three tracks: reform of the healthcare system; reform of wage negotiation rules, and privatisations.

Reforming the healthcare system — a top priority

With hindsight, the main reason behind the spending overshoot in public finances last year was the uncontrolled spiralling of medical and hospital spending.  The particularity of the French system is that most doctors are independent workers but, since patients are reimbursed by the national healthcare fund, free access to doctors is guaranteed and almost fully subsidised.  Clearly, this system has become over-generous and has generated a lot of excesses.  The reform promised by the government will embrace both hospitals and reimbursement rules.  Since it will be negotiated with unions and doctors, it will be even more difficult to push through than the pension reform.  I would expect significant breakthroughs only after the elections.  In the short term, the main task is the reduction of public deficits in 2005.  In the medium run, it is the reduction of the tax burden and the cost of labour, since a part of healthcare costs is still financed by payroll taxes. 

Reforming wage-setting rules — a discrete but ambitious reform

At the end of 2003, Minister of Social Affairs Francois Fillon unveiled a very ambitious project that would radically change the relationship between employees and employers.  In a nutshell, M. Fillon has proposed to decentralise and make more flexible the current system by allowing companies to have direct negotiations with their workers, instead of complying with branch agreements.  Not surprisingly, unions rejected the idea.  More curiously, employers did not seem interested either.  My impression is that M. Fillon has carefully thought out his plans and wants to capitalise on the success of the pension reform last year.  Knowing that healthcare reform will be the most difficult part of the government’s agenda, he will probably be keen on succeeding on labour markets.  At stake is nothing less than the employment performance of France, which, after having been artificially boosted by the unfortunate 35-hour regulation, has been quite disappointing over the last two years.

Privatisation — the safest way to increase flexibility and cut debt

Because deficits have soared in 2002 and 2003 and have accelerated the rise of the public debt, the government will be interested in accelerating its privatisation program.  Francis Mer’s track record has been good so far: The Treasury took markets by surprise on several occasions.  I believe that this year we will see the beginning of much larger privatisation operations concerning large public utilities.  In reality, the government has almost no choice, given the poor state of public finances and the commitment to open domestic energy and postal markets.  If, as our equity strategists believe, European stock markets are well oriented in the first half of the year, be prepared for other surprises.

The year ahead will have several challenges for the Italian economy.  Some of them will be in common with the rest of the Euro area; others will be more specific to Corporate Italy.  Will the upswing be sustainable and turn into a phase of mature expansion?  Or will a super-Euro dent the competitiveness of export-led businesses?  Will uncoordinated fiscal and monetary policies derail the recovery train?  At home, will PM Berlusconi manage to keep the many voices of his coalition in tune?  Or will the wave of social unrest that is opposing pension reform open new cracks within the government coalition?  Notwithstanding the importance of all these issues, we concentrate on one topic: the unexpectedly strong performance of the labor market and, in particular, its prospects looking forward.

Impressive numbers

According to data from the quarterly labor survey, nearly two million jobs were created between January 1999 and July 2003.  That is almost 10% of total employment in a matter of three and half years.  The annual employment growth rate, which peaked at 3.2% in early 2001, was still running at a very decent 1.1% during the first three quarters of this year.  Over the same period, the unemployment rate dropped all the way down from a ridge of 11.9% to the current 8.8%, the lowest rate since National Statistics ISTAT started conducting the survey in 1993.  Numbers from quarterly national accounts show a similar, although somewhat smoother, profile.

The extra boost came from South

From a geographical standpoint, the improvement kicked in the wealthy Northern and Central regions as early as 1995-6, on the back of the powerful cyclical upswing that followed the last period currency of devaluation and then extended well into the following years, despite the anemic underlying economic performance.  But the extra boost that turned a gradual improvement into a real ‘job miracle’ from 1999 onward came from the South, the area where the unemployment rate is highest.  Progress has petered out in the North, where the unemployment rate, at 3.8%, has probably reached, and possibly exceeded, its natural limits, we believe, but continues relentlessly in southern Italy.

Flexibility: yes, but… 

“Flexibilization” has played a role.  In response to legislation that made the use of part-time and temporary positions easier, firms have relied more significantly on these flexible jobs.  According to national account data, the share of part-time over total employees moved from 5.2% in 1999 to 6.3% during the first half of this year, while the share of temporary positions moved from 9.5% to 9.8%.  Yet, these statistics are still quite unimpressive when compared to the average Euroland numbers.  Data from the OECD Labor Force Statistics show that the share of temp jobs, although declining due to cyclical factors, is still nearly 13% on the continent.  Even bigger is the gap in terms of part-time positions that, in Euroland, exceeds 16% of total employees, a share almost three times as large as the Italian one.

…bonus on new hires is the key factor

In fact, about one million jobs added to the economy since 1999 are traditional permanent full-time positions.  How could that happen during a period of major economic deceleration?  Firing rigidities may justify some resilience during downturns, but certainly fall short of explaining such progress.  More likely, we think, tax breaks for new hires introduced with the 2001 budget are the major factor behind the rise in permanent jobs.  These incentives were temporarily suspended in 2002 in an effort to contain the budget deficit within the 3% Maastricht threshold, but they have been reintroduced this year and extended through 2006.

Too good to be true

Among all these numbers, there is a productivity puzzle though.  Throughout the 1999-2003 period, GDP growth barely averaged a meager 1.5%, two-tenths short of the 1.7% employment growth rate recorded over the same interval, leaving marginal labor productivity rates in negative territory.  A larger share of flexible positions, which normally coincide with lower-skilled workers, may have done the trick, but the mild rise in these jobs, as shown above, cannot be the main culprit.  We prefer to think that a shrinking underground economy, which in 1998 was estimated as 27.8% of GDP, is behind the puzzle.  While, to our knowledge, no recent estimates are available on the evolution of these figures, such a large ‘shadow economy,’ together with a low participation rate (still below 62% for the entire population and 56% among women) and the southern bias in the recent progress, are all compelling evidence of the role that these incentives have played and could keep playing in the future.  Add some cyclical upswing and the impact of the new Biagi reform and there are ingredients for further impressive gains in the year ahead.  But don’t complain about weak productivity.  All these new hires have now appeared in statisticians’ books, but who knows for how long they were already there.

 

Still the growth stalwart

The Spanish economy has remained the European growth stalwart in 2003, and we expect it to continue to outperform its European neighbors well into 2004.  In an adverse global environment, strong economic growth could only come from domestic sources. Income tax cuts and healthy job creation supported household spending, while negative real interest rates continued to boost construction spending.  In 2004, we look for these trends to remain in place. Household consumption should stabilize as job creation gains further momentum and construction investment should slow marginally, as we envisage only a gradual increase in interest rates. Finally, with a general election scheduled for early 2004, some further boost to the economy should come from government consumption. While we remain bullish on the Spanish economy, we think that the housing and the construction sector demand close monitoring

 

But what about buoyant house prices?

Spanish house prices were up almost 120% in nominal terms between 1990 and 2002. In 2002, prices were 85% higher than in 1995 and a large part of the increase occurred between 2000 and 2002, when prices rose 16% a year, by far the highest observed in the Eurozone and even higher than in the UK.   Recent figures from the European Mortgage Federation suggest that in early 2003 there were no signs of moderation and, if anything, house prices accelerated further, rising at above 17% compared to a year earlier.  Given that real estate is the main household asset, changes in house prices might have important implications for households investment decisions and financial positions.  Macro econometric estimates from the Bank of Spain suggest that real house prices are roughly 10% overvalued compared to a long-term fair value.  The issue here is whether this pace of increase in house prices is sustainable and, if not, what could trigger a trend-inversion?  Sustainability depends on trends in house prices determinants over the coming years, we believe.

 

The dynamism of Spanish house prices in the second half of the nineties is likely the result of an excess of demand, fuelled partly by demographics changes, strong employment growth, and mainly by the large decline in the cost of mortgage lending.  Interest rate on house mortgages fell from just above 10% in early 1996 to 3.4% in October of this year.  Income tax breaks on mortgage financing have also encouraged households to take on more debt.  As a result, household indebtedness rose from 43% in 1996 to 67% of GDP in the first quarter of 2003 and is now 10% higher than the Eurozone average (58%).  Mortgage lending as a percentage of GDP rose from 30% in 2000 to almost 40% of GDP in September of this year while it remained stable in the Eurozone

 

Demand to remain strong but supply is catching up

Demand for new houses rose quickly during the 90s fuelled by a 20% increase in people between 24-39 years (the first-time buyer age bracket), a rising proportion of single households (due to a higher divorce rate and people leaving home earlier), and strong immigration flows (around 1.2 million). These trends should remain in place over the next five years, supporting demand for housing and hence prices.  We estimate that demand for new houses should average roughly 400,000 as the number of single households rises further and immigration flows are sustained (estimated at 175,000).  During the 90s, supply of new houses has been lagging demand partly due to the constraints arising from the Ley del Suelo, which creates a significant lag between applying for planning permission and receiving the approval.  However, housing starts skyrocketed in the last two years, reaching a peak of 640,000 in 2003.  The increase in supply should contribute to a gradual moderation in the pace of increase house prices.

 

Interest rates are on the rise… 

In a rising interest rate environment, the responsiveness of house prices and consumption to changes in nominal rates becomes a key element to assess macro risks for the economy.  The sensitivity of housing consumption to changes in interest rates is known to be much higher if mortgage lending is at variable rather than fixed rates, and this is indeed the case for the Spanish economy. Roughly, all mortgage lending is at short-term rate, adjusted every 12 months, as opposed to the majority of other European countries where house financing is at fixed long-term rates.  What matters is the affordability of mortgages as interest rates rise.   The European Mortgage Federation shows that a 100 basis points change in interest rates translates into a 20 bp increase/fall in mortgage lending rates in the same quarter and is fully passed through the next year.  The impact of a change in interest rates on mortgage payment is estimated to have been negligible on the ratio of interest payments to GDP.  As we only envisage a 175 basis points increase in the ECB refinancing rate over the next two years, the impact on household finances and house prices should be limited.  A 50 basis point increase in interest rates will nevertheless have a significant impact on first-time buyers, who generally borrow between 75% and 80% of the value of the property and for whom the BBVA estimates affordability) to be close to 50% already in 2003.  First-time buyers have a crucial role in the Spanish housing market has they buy at the bottom of the property ladder, allowing home owners to trade up and thus driving demand all the way up.

 

…but the impact should be limited for now

While the recent trend in Spanish house prices does not look sustainable in the medium term, we do not expect to see a sharp correction in the next year as the dynamics of supply and demand remain favourable and interest rate should rise only gradually. That said the later the inversion in the observed trend occurs, the sharper the adjustment and the larger the impact on the economy.

After recording its sharpest slowdown in around 20 years, the Dutch economy should finally turn a corner in 2004.  Following average annual GDP growth rates of 3.6% in the second half of the 1990s, the economy came to a virtual standstill in 2002, before likely recording its first annual contraction in two decades in 2003.  Having fallen into recession territory at the end of 2002, the economy finally inched back into positive territory in the fall of 2003. We think the economy should pick up modestly going into 2004. The wage freeze for 2004 and 2005 agreed by the social partners should help to bring the much needed turnaround in cost-competitiveness and corporate profits, though substantive austerity measures by the government will continue to weigh on the economy.  Growth will likely still remain well below trend, at 0.9% on our forecasts, thus continuing to fall well short of the euro area average, which we see growing by 2% next year.

We still see a number of factors dragging on the economy in 2004, in particular substantial fiscal tightening from the government and likely further increases in pension contributions. Despite substantive austerity measures implemented in 2003, the budget deficit is likely to have come very close to the 3% Maastricht limit. The government has planned further drastic measures (amounting to around 1.8% of GDP) for 2004.  Though the Central Planning Bureau has now estimated that the budget deficit could breach the 3% limit in 2004, we don’t think the government is likely to implement additional austerity measures. The Dutch government has two options within the Maastricht framework to avoid the excessive deficit procedure being started, without the necessity of additional austerity measures (see European Economics Comment: Netherlands: Deficit Estimated to Breach 3% Limit in 2004, December 4, 2003). Next to that, consumers and employers are likely to see further hikes in contributions rates by pension funds. Pension funds are still in the process of restoring their coverage ratios, which were hit in the equity market slowdown of previous years.

The Dutch economy is emerging from its worst recession in two decades as we write. After already dipping into the red sporadically from 2001, the economy moved deep into recession territory at the end of 2002, contracting by a cumulated 1.2% up to the middle of 2003. But after being on a steady downtrend since the end of 1999, Dutch GDP growth finally seems to have found a bottom now. For 2003 as a whole, the economy likely shrunk by 0.7% and the output gap widened to 3.8 percent on our estimates. The output gap is set to widen further in 2004 to levels last seen in the recession of the early 1980s, as growth likely still remains well below trend next year. With GDP growth not likely to return to the buoyant levels of the late 1990s, it will take a number of years for the output gap to close completely. We have previously noted that the marked widening of the output gap in the Netherlands points to a sharp fall in inflation over the next few years (see Dutch Economics: Deflation – Who’s Next? August 5, 2003). The wage agreement for 2004 and 2005 will likely add to the deflationary pressures.

The Netherlands have laid the foundation for a turnaround in the economy with the recent agreement between the social partners to freeze contractual wages in 2004 and to keep contractual wage growth close to zero in 2005.  This tackles one of the main culprits of the economic downturn over the last few years, namely the marked loss of competitiveness which was largely caused by the surge in unit labour cost growth from 1999.  A tight labour market led to excessive wage growth in the latter part of the 1990s. In combination with dropping productivity growth, as companies held on to their workers into the downturn due to previous difficulties in hiring workers in the tight labour market, unit labour costs shot up.

Similar to the economic situation in the early 1980s, the Netherlands are returning to a policy of wage moderation in order to bring the economy out of a deep recession.  In the ‘Wassenaar agreement’ of November 1982, the social partners agreed on moderate wage growth. Back then, the Dutch economy posted two consecutive annual contractions. As a result of the moderate-wage-growth strategy pursued after the ‘Wassenaar agreement’, the growth rate of compensation per employee plunged from 6% in 1982 to 0.5% in 1984. Over the same period, unit labour cost growth for the total economy fell from 4.2% in 1982 to -2.8% in 1984. On the back of the accompanying recovery in employment growth, the economy returned to average GDP growth rates of just over 3% in the second half of the 1980s.

This time around, the social partners have agreed on a wage freeze for 2004 and ‘close to zero’ wage growth in 2005. As some wage contracts for 2004 had already been negotiated before the agreement, the moderation in compensation per employee is likely to be more pronounced in 2005. This moderation in wage growth should bring excessive unit labour cost growth down markedly in the next few year. Wage moderation will affect two key components of the economic recovery, namely the price competitiveness of exports and corporate profits. Regarding the first factor, the Central Planning Bureau, a government sponsored think tank, estimates that the prices of domestically produced goods have outpaced the relevant world trade price by a cumulated 8.5% since 2001. Similarly, corporate profits were hit markedly by excessive unit labour cost growth. Profit margins (the ratio between output prices, measured by the GDP deflator, and input prices, measured by unit labour costs) have contracted over the last three years. A marked easing in unit labour cost growth is key to turning around these factors, which have been weighing on the Dutch economy over the last few years.

So while the wage freeze is a key factor in the recovery of the Dutch economy next year, a number of other factors weighing on the economy should keep GDP growth below trend. Our view of a continued underperformance of the Dutch economy is supported by business survey evidence so far, which still shows a marked underperformance of the Netherlands compared to the remainder of the euro area. Our coincident survey indicator, which takes into account information on output expectations, current output, inventories and demand, still lies well below the euro area indicator. This supports our view that the recovery in the Dutch economy is likely to be much more subdued than in the remainder of the euro area. But after all the gloomy titles to our notes on the Dutch economy over the last few years, we are looking forward to some slightly more upbeat news in the new year. The fallen angel finally seems to be rising from the ashes!

After outperforming many of its euro area peers on the growth front in 2003, the Belgian economy is likely to rejoin the pack again in 2004, growing in line with the euro area average. But this would see the economy returning back to trend in 2004, after three years well below potential. On the fiscal front, Belgium has also been one of the more prudent governments in the last few years. The government budget balance may even have remained in surplus for a fourth consecutive year in 2003. However, as we explain below, this is largely due to one-off revenues related to a payment received for the takeover of a pension fund from a state-owned company. Whether these revenues will indeed enter the calculation of the budget balance is still in the hands of Eurostat, the Statistics Office of the European Commission.  Therefore the starting point for the 2004 budget balance remains unclear. However, it is likely to record a deficit whether the pension fund revenues are counted or not.

Belgium was one of the few countries in the euro area to record an acceleration in GDP growth in 2003. Next to cuts in both income and corporate tax rates, the two-year wage agreement reached at the beginning of the year helped domestic demand to recover.  This more than offset the drag from weak global trade on the export-oriented Belgian economy. As a result, Belgium outperformed the euro area by a half point in terms of GDP growth.  In 2004, the economy should be able to tap into the global trade recovery again. Next to that, the moderating effects of the wage agreement should continue to boost the economy. In addition, the government is planning cuts in non-wage labour costs of around 0.2% of GDP. These factors should give further support to the recovery in domestic demand that kicked off in 2003. We think this boost from both external and domestic demand should bring GDP growth up to 2.0% in 2004, from the 1.1% likely recorded in 2003.

On the fiscal front, the Belgian government could be helped by a payment relating to the takeover of a pension fund. The government is assuming responsibility for the liabilities of the Belgacom pension fund.  The pension scheme was a funded scheme with dedicated assets.  Instead of transferring the funded scheme, the assets were liquidated and paid to the government in cash.  As the assets do not fully cover the future liabilities, which the government has estimated at ˆ5 billion, Belgacom will likely make an additional transfer of cash to cover the difference. The transfer of the cash relating to the assets (amounting to around ˆ3.5-3.7 billion, or 1.3–1.4% of GDP) would enter the calculation of the 2003 balance.  Meanwhile, the cash relating to the additional shortfall (around ˆ1.4 billion or 0.5% of GDP) will likely be booked in the 2004 budget, if accepted by Eurostat.  Without these extra revenues we estimate that the Belgian budget balance would move from a slight 0.1% of GDP surplus in 2002 to a 1.2% of GDP deficit in 2003.  With the economy likely to pick up markedly next year, we would then expect the deficit to shrink slightly to 1.0% of GDP in 2004.  If the government is allowed to take the payments from Belgacom into account, the budget balance could post a slight surplus again this year.  In 2004, the budget would then likely move back into the red, with a deficit of 0.5% of GDP, on our estimates. However, first indications from Eurostat suggest that they are reluctant to take the payment into account for the calculation of the budget balance. A final decision from Eurostat is expected in early 2004. 

The impact of the payment on debt dynamics is also still unclear. The payment is to be transferred to the ‘Zilverfonds,’ a fund set up by the government to be used to meet the future costs of the aging population.  According to the Belgian government, funds accumulated in the Zilverfonds, which are invested in government bonds, are classed as debt reduction under the European accounting rules.  Together with favourable debt dynamics, we estimate that the ˆ5 billion payment could bring the Belgian debt level down from 105.8% in 2002 to around 103% of GDP in 2003 and possibly even below the 100% mark in 2004.  While these one-off payments would help to bring the excessive Belgian debt level down faster toward the 60% Maastricht limit, with favourable effects on interest payments, we think the government should rather focus on structural measures to bring its budget into balance and its debt level down.

With the economic developments in Belgium largely in line with those seen in the rest of the euro area, fiscal policy and the accounting issues related to it might in fact turn out to be the most striking feature of the Belgian economy in 2004.

For the Swedish economy the few last years were very much dominated by international factors, such as the new economy boom and bust and the question as to whether Sweden should or should not join EMU.  In the coming year, the themes for the Swedish economy will likely refocus on domestic issues.  Here, a convergence of GDP growth with the rest of Europe could lead to a re-assessment of the relative growth potential of the largest Nordic economy, we believe. 

After an impressive outperformance of the Swedish economy vis-à-vis the euro area of a cumulated 2.5 percentage points over the last two years, GDP growth rates between the two regions are likely to converge again.  Our Swedish 2004 growth forecast for 2.5% GDP growth is only slightly higher than the non-workday adjusted Euroland forecast of 2.2% (see Eric Chaney and Joachim Fels’s comment elsewhere on these pages).  Compared with an average growth rate of 0.5% in the euro area and of 1.5% in Sweden during 2003, this implies a more moderate recovery in Sweden than the one we foresee in continental Europe.  A large part of this divergence is due to the consumer cycle.  Whereas consumer spending in the euro area is likely to be propelled by a combination of pent-up demand, income tax cuts, normalizing inflation perceptions, and a robust job market, Sweden has seen a large part of the consumer story already over the last two years, thanks to substantial income tax reductions and interest rates cuts.  The Swedish recovery will rely to a larger extent on export demand and investment spending.

Against the background of a headline GDP growth rate that probably won’t be too dissimilar from that of the euro area next year, will come as a timely reminder that the same actually holds for potential output growth. Most forecasters would put the potential growth rate — i.e., the growth rate that is sustainable in the long-run — at around 2.25% for Sweden and slightly below that for the euro economy.  This implies that in contrast to the euro economy, there isn’t a lot of spare capacity in the Swedish economy at the moment.  For me, this — together with potential upside surprises on growth outside Sweden — is the main reason why the Riksbank will likely be reluctant to cut interest rates again.  Instead I see the Bank being on hold well into next year before eventually starting to embark on a gradual tightening campaign, nudging interest rates toward a more neutral level.  That said, the minutes of the Riksbank’s executive board meeting in December, which showed a slim 4 to 2 majority in favour of steady rates, highlights that the call for an unchanged repo rate of 2.75% has become a close one.  But in my mind it would be a mistake for the Riksbank to give in to the pressure created by repeated calls for lower rates from both government politicians and trade unions.

In gauging the likelihood of a Riksbank rate cut in early 2004, we will need to keep a close eye on the incoming activity and inflation data, as well as the currency and the weather reports.  While the former will be influencing import price developments, the latter will be determining the electricity price trajectory this winter.  Base-effects from last year’s electricity price explosion could push UND1X inflation to less than 1% — the Riksbank’s lower tolerance level — in early 2004.  Yet, the Bank is likely to look through these energy-related gyrations in inflation and has in fact started to emphasize UND1X excl. energy recently.  Instead the Bank will pay more attention, we think, to the upcoming multi-year wage round to gauge potential inflationary pressures emanating from labour costs in the medium run.  We therefore believe that the short end of the Swedish market is getting a bit ahead of itself on hopes for another Riksbank rate cut — especially now that currency seems to be trading down again. At the same time, the long end of the Swedish bond market seems to be fairly valued against 10-year German Bund yields. If anything, the Bank could remain on hold for longer than our present forecast, which pencils in a first 25 bp rate hike in the second quarter, indicates.

Recognising that the potential growth rate of the Swedish economy seems to be relatively low compared with the average growth rate recorded over the last five years, the government headed by Prime Minister Persson is planning to embark on a pro-growth initiative in 2004.  A key event in putting together a reform agenda will be marked by a Social Democratic party conference in early April, where new recipes to revive growth on a sustainable basis will be presented.  In this context, a proposal to significantly reduce, if not totally abolish, the wealth tax is likely to make headlines in the financial press.  This proposal could already be included in the Spring Budget Bill and as such could turn out to be a trigger for renewed SEK strengthening.  Our currency team sees the SEK strengthening against the euro toward 8.70 by mid-year, from 9.07 today.  That said, we believe that a lower wealth tax is primarily a token gesture.  Just check with you millionaire friends in Stockholm, and you will find that hardly anyone actually pays wealth-tax.

 

Our macroeconomic prognosis for the region is favourable. 

With the exception of Russia, which should nevertheless maintain a solid performance, we expect economic growth in EMEA to accelerate over the next two years.  Inflation should continue to trend down, largely because we expect Russia and Turkey to make further progress in reducing inflation, probably achieving single-digit rates in 2005. 

Current account and fiscal positions manageable. 

Current account positions will probably continue to differ quite significantly across the region, but we expect that both central Europe and Turkey will benefit from recovery in the European economy.  Budget positions should either improve or stabilise in 2005 after worsening moderately in 2004.  We expect the improvement in fiscal performance to be due mostly to favourable cyclical conditions. 

US dollar likely to weaken further. 

The significant appreciation of the euro against the dollar has been a key factor supporting disinflation in Turkey and South Africa and allowing the central European currencies to regain competitiveness without importing too much inflation via their exchange rate to the dollar.  The projections of our currency team suggest that this will remain an important factor in 2004 and 2005, as the dollar keeps weakening against the euro and the yen.  However, they expect the extent of the dollar’s fall to be smaller than in 2002 and 2003.  We see some additional margin for the central European currencies and the Turkish lira to weaken against the euro (gaining competitiveness in their main export markets) while remaining stable or perhaps even rising vis-à-vis the dollar.  This is also a key factor in forecasting the paths of the rouble and the rand in 2004 and 2005.

Oil price outlook favourable, especially for Russia. 

With Brent oil trading above US$30/bl, energy prices are higher than expected earlier in the year, and most forecasters now believe elevated oil prices could be maintained at least through 2004.  Prices should remain high enough to boost growth in Russia and other oil-producing countries, but not too high to stifle growth and boost inflation in oil-importing countries (especially considering the weakness of the dollar).

Russia: only a moderate deceleration in 2005. 

Real GDP growth slowed from a peak of 7.1% in 2Q03 to 6.2% in 3Q03.  The latest data, however, suggest that industrial production and business confidence have moved up slightly in 4Q03.  As a result, we have raised our estimate for 2003 from 6.2% to 6.6%.  Largely because of growth in the energy sector, we expect that next year the economy at large will expand by less than in 2003.  Still, our new 5.5% 2004 real GDP growth forecast is significantly higher than our previous estimate of 4.6%.  We do not expect the Yukos affair to derail Russia’s economic recovery and the reform plans of the Putin administration.  For 2005, we have tentatively pencilled in a 4.5% real GDP growth rate to reflect both the risk that oil prices may ease somewhat and our Oil & Gas team’s expectation that production growth will slow further to around 5%. 

European recovery and exchange rate competitiveness should support growth in central Europe. 

We think the main drivers of growth dynamics will be the EU recovery, changes in exchange rates and pressure to correct recently over-loose fiscal policies.   The Czech Republic and Hungary are most exposed to the Euroland recovery.  In each, domestic demand is likely to slow in 2004 as indirect tax rates are raised and higher inflation lowers real household income.  But, as the 2006 elections approach, with both governments facing difficult election campaigns, we expect the pace of fiscal tightening to slow, particularly in Hungary.  While Poland is slightly less exposed to global growth, the zloty is increasingly competitive, and parliamentary and presidential elections in 2005 argue for little fiscal tightening in the short term.  Oliver Weeks expects a new government to begin tightening only late in 2005, and real GDP growth to remain among the strongest in the region, at around 4.8% in 2005.

Strong growth and continuing disinflation expected in Turkey. 

Serhan Cevik is quite optimistic on the outlook for the next two years, forecasting 5.5% real growth in 2004 and 6.4% in 2005.  In his view, continuing productivity gains should hold down unit labour costs.  Owing to a pick-up in global trade and in European imports, this should lead to increases in Turkish exports of 10.5% next year and 11.4% in 2005.  However, the leading engine of Turkey’s growth in the next two years will be final domestic demand, in our view.  Despite continuing fiscal austerity, Serhan foresees a gradual recovery in consumer spending, up 5.2% in 2004 and 6.0% in 2005, following a 4.8% rise this year.  He also believes that improving corporate profit margins, rising productivity and the declining cost of funding should lead to a sharp increase in business investment.  Core price indices show no underlying inflation build-up, and the gradual recovery in domestic demand should not disturb the disinflation trend.

South Africa: recovery under way, as domestic demand stays strong. 

Economic growth this year has slowed down markedly, to around 2%, from 3.6% in 2002.  We estimate that the 4Q02/4Q03 increase in real GDP will be an even lower 1.3%.  The main cause for the slowdown has been a sharp worsening in the net trade position on the back of the rand’s appreciation.  Looking forward, the 550 basis points of cumulative interest rate reduction engineered by the Reserve Bank since June, the stimulative stance of fiscal policy, and the beneficial effect of lower inflation on real disposable income, will probably keep domestic final demand strong.  With export markets recovering and some contribution from inventories, we expect growth to accelerate in 2004 to an average of 2.8%.  2005 will probably see stronger growth, and slightly higher inflation.  Based on our expectation that the rand will depreciate in 2H04, we expect average real GDP growth to accelerate further in 2005, to 3.7%.  Coming months will probably see a further decline in year-on-year CPIX inflation to a low of 3.8% in January and then a moderate increase over the course of 2004, due in part to base effects.  We expect CPIX inflation to remain within the 3-6% target range in 2005, but hovering close to the upper limit of that band.  Against this backdrop, we expect a moderate tightening in monetary policy commencing in 2H04.

2003 will likely be remembered as a year of considerable achievements for South Africa in terms of macroeconomic stability, particularly in terms of declining inflation and interest rates.  A year ago, the inflation rate measured by the CPIX, the index of consumer prices excluding mortgages, stood at 10.8% year-on-year, and the CPI inflation rate was 12.5%.  We estimate that 2003 will end with a 4.1% CPIX inflation rate (unchanged from November) and a zero CPI inflation rate.  In line with this improvement, interest rates have fallen sharply, with the repo rate of the South African Reserve Bank (SARB) falling by a total of 550 basis points.  This was all made possible by a strong recovery in the rand exchange rate, which, similarly to 2002, exceeded even the most optimistic expectations. 

The other side of the coin is that South Africa’s economic and employment growth performance has been rather disappointing this year.  We estimate that 2003 will close with a 1.9% average real GDP growth rate and a meagre 4Q/4Q growth of 1.3%.  Even assuming that the official figures are later revised up, we do not think that the estimated growth rate will significantly exceed 2%.  Meanwhile, according to official statistics, non-agricultural private-sector employment contracted by 0.6% in the first quarter, and the overall unemployment rate rose to 31.2% in March, from an average of 30.0% in 2002.  Given that the economy slowed down further in the second quarter before slowly recovering in the second half of the year, the annual unemployment rate will be probably higher than in the first quarter.

Against this backdrop, the official projections of the South African National Treasury are for a significant acceleration in economy growth in 2004–06, and a return to jobs creation.  The Treasury’s latest projections call for a real GDP growth rate of 3.3% in 2004, 3.7% in 2005, and 4.0% in 2006.  With fiscal policy much more stimulative than in recent years and easier monetary policy, we believe the policy mix is the right one to deliver stronger growth.  The improvement in the global economy adds credence to the Treasury’s projections.  Our own prognosis for 2004 is less positive than the Treasury’s, although this week we raised our real GDP growth forecast to 2.8%.  On the other hand, we concur with the Treasury’s view on 2005 growth. 

The key issue, though, is whether the rand exchange rate will weaken enough to allow the traded sector of the economy to return to a healthy growth rate.  While this will depend in part on domestic developments, the most critical factor will be the trend in world commodity prices (notably metals), not only because of their importance in South Africa’s output and exports, but perhaps more importantly because such prices represent the key factor determining how international model-driven investors trade this currency.  Our macroeconomic projections are heavily influenced by our expectation that the Bull Run in metals prices will run out of steam over the course of next year, and this will allow the South African policy authorities to engineer a soft landing of the rand exchange rate.  If that failed to happen, though, we would expect a significantly worse economic performance in the next two years than suggested even by our own forecasts, particularly in 2005.

As mentioned above, this week we raised our 2004 real GDP forecast from 2.5% to 2.8%, and announced a new 2005 forecast of 3.7%.  The main reasons for the upward revision to the 2004 estimates are that the latest demand-side national accounts data showed stronger domestic final demand than we anticipated, and there were upward revisions to the back data.  We feel that this strength is sustainable, given the sharp decline in bank lending rates and continuing fiscal stimulus.  (Government spending should rise further as a share of GDP in the 2004/05 fiscal year, before levelling off in 2005/06.)  In addition, there has been an encouraging improvement in business confidence in 4Q03.  This leads us to believe that gross fixed investment will continue to grow in coming quarters, albeit at a slower rate than in the days of the weak rand. 

The worsening in South Africa’s net foreign trade should also diminish, as the world economy recovers, thus creating better export opportunities for South African firms.  Going into 2H04, we expect these factors to be compounded by a weaker rand (see below).  Our 2004 real GDP forecast would be even more optimistic if we assumed a larger contribution from stock building and, on the supply side, a very strong rebound in agricultural production after this year’s drop.  For 2005, our positive view on South African growth stems from our expectation that, in addition to continuing strength in domestic demand, the economy will also benefit in full from a more competitive exchange rate while interest rates rise only moderately.

We have also upped our rand forecast.  The weakening of the rand against the US dollar over the past few days could signal a turning point for this currency (similar to what happened in the opposite direction at the end of 2001).  However, we expect that the rand’s correlation with metals prices (see Exhibit 1, which is based on computations by our colleague V.R. Chandramouli) will reassert itself in 1Q04.  We expect the rand/dollar exchange rate to test the 6.0 level once again in 1Q04.  In the absence of unforeseen domestic problems or policy mistakes (which have become rather unlikely, in our view), the rand will probably stay strong until the current rally (or, should we say, bubble?) in metals prices comes to an end. 

We believe that the key factors that could bring about such turn-around are the slowdown in Chinese growth expected by our Asian colleagues and the beginning of a policy tightening by the US Federal Reserve, which our US economists believe will occur in 3Q04.  We also continue to think that the South African authorities will be more inclined to accommodate or promote a gentle weakening of the rand after the general elections (in April) and key wage negotiations (in May and June) are out of the way.  Changes to our forecasts are particularly significant with respect to the next two quarters, as we expect the rand (currently at 6.60 against the dollar) to strengthen to 6.5 at the end of March and weaken to 7.0 at the end of June.  Our previous March and June forecasts were 7.0 and 7.5, respectively.

South African interest rates are close to the cyclical bottom, in our view.  The South African Reserve Bank (SARB) surprised us on the downside, by cutting its policy rate by only 50 basis points on December 11 (although we agree completely with the move from a normative point of view).  Given our bullish near-term rand scenario and positive expectations for inflation in the coming months, it makes sense to us to expect one last 50 basis-point cut at the February meeting.  After that, we believe the SARB will be on hold until the 4Q04.  At that stage, with the rand moving to 7.8 by end-September and both current and projected CPIX inflation rising above 5% (and perhaps even closer to the upper limit of the 3–6% inflation target range), on our forecasts, we would expect the SARB to hike its policy rate by 100 basis points.  This would be followed, in our view, by a further 50 basis points of tightening in 1Q05.  Alternative rand scenarios from the one we have outlined would obviously lead to significantly different interest-rate decisions by the SARB.  South Africa will no doubt remain a very interesting economy to watch.

Japan faces a year of truth in 2004. A positive outlook for financial markets requires faster reforms and more restructuring. I believe that both will occur.

Macro Reforms Move Faster

The political stars are aligned for faster reform, in my view. First, political power struggles are over. On the right, PM Koizumi has won a new three-year term as LDP party head, and the recent general election eliminated a number of anti-reform members from the party. On the left, the far-left splinter parties were devastated in the general election, leaving the center-left Democratic Party of Japan as the dominant voice of the opposition. Second, in the general election, the voters demanded change. With an Upper House election coming next July, both parties must focus on policy.

The pension issue is most pressing, and much progress has occurred. The LDP has decided to push payouts as low as 50% of income (compared to more than 59% now), and to cap contributions at about 18 1/2% of wages (compared to 13 1/2% now). This result reversed a high-tax, high-spend proposal from bureaucrats, and thus bodes well for other fiscal reforms.

Financial sector reform remains difficult. The recent failure of a large regional bank showed that the authorities have teeth. However, many more financial sector problems remain, e.g., how to treat deferred tax assets, how to improve loan classification, how to raise bank profitability, and how to avoid a credit crunch. Moreover, I believe financial system reform is doomed to fail without progress in shrinking government lenders.

Spending policies carry similar challenges. Even huge cuts of public works would not suffice to restore fiscal soundness, because public works comprise only about one-quarter of general government spending. Large cuts of current spending are crucial. Pensions are one part, but healthcare (especially for the elderly) and unemployment insurance also demand attention. FY04 budget decisions will be finalized in February-March, and will have many clues on the speed of reform.

Tax reform, which had stalled over the last two years, may now accelerate. The LDP’s Tax Committee saw major personnel changes when some anti-reform members lost their seats in the recent general election.

Privatization will also be high on the agenda, particularly that of the Japan Highway Corporation. Further Postal Savings reform will be debated through the year. But privatization will not end with these two trophy cases. The difficult fiscal situation argues for aggressive asset sales.

Deregulation is less eye-catching, but just as vital. Action on special economic zones must accelerate, and ministries must cooperate more with the PM’s wishes. Such cooperation is more likely now that the anti-reform head of a major public enterprise has been fired.

Corporate Reform:  Asset Reallocation Proceeds

While policy makers push macro reform, management pushes micro reform. Already, recurring profits are higher as a share of GDP than the average level of the past 20 years. Labor costs have come down as a share of sales, while restructuring activity abounds. Balance sheets are both smaller and less leveraged. However, much work remains. For example, although profits are high relative to GDP, the return on assets (RoA) for non-financial firms remains below 3%, well below the 4% average prior to the 1990s. Although the profit margin (profits/sales ratio) has risen significantly, turnover (sales/asset ratio) remains mired near 1.0x, compared with 1.4x prior to 1990.

With both the need and the ability to reallocate assets, a quickening of corporate restructuring seems likely. There are some parts missing, however. First, corporate revitalization requires realization of losses. Enhancement of both carrots (such as better tax treatment of losses) and sticks (such stricter oversight of bank loan classifications) will be important signposts. Second, the partnership between business, banks, and the newly formed Industrial Revitalization Corporation of Japan (IRCJ) needs to be strengthened.

Cyclical Backdrop: Goldilocks Needed

For micro and macro reforms to work, the cyclical position of the Japanese economy must be strong enough to avoid paralysis, but weak enough to avoid complacency. Fortunately, the business cycle is likely to tread precisely this “goldilocks path.” Capex is likely to grow, but not strongly; consumption to be stable, but not weak; and foreign demand to rise, but not surge. Although Japanese growth on balance is likely to slow, it is not likely to collapse, and thus not likely to endanger reform efforts.

Markets in the Year of Truth

In this environment, the equity market is likely to rise moderately in 2004, as my colleague Naoki Kamiyama points out. However, due to reforms, there could be further distinction between winners and losers. Nor are the currency markets likely to be affected heavily by the reform agenda. Rather, as pointed out by my colleague Stephen Jen, the theme in currency markets will be the fall of the dollar, with a very modest further appreciation of the yen against it likely.

Risks in the Outlook

Most of the risks are negative. In the policy arena, the major risk is political. If the opposition parties prove ineffective, then pressure on the LDP may subside, and reform may slow. From the global economy, there are growth risks in both the US and China. Also, continued high oil prices could raise costs — although a stronger yen would cushion some of the pain. At home, financial shocks could occur, as bad loan disposal proceeds.

Is the consensus correct?

While the markets are discounting global tightening in 2004, we think investors should question this consensus. Our US economic team is forecasting that the Fed will move into a tightening phase from July-September 2004, and recent steady improvement in economic data and the FOMC’s return to a neutral stance in December support this view. At the same time, however, US core CPI fell MoM in November for the first decline since December 1982 and recorded the lowest YoY result in 40 years since May 1963 despite a sharp decline in the dollar’s value. Although the FOMC statement raises the pricing outlook to equal risks of an unwelcome fall and a rise in inflation, recent price developments run contrary to the Fed conclusion. The optimistic interpretation is that it is not unusual for a supply shock from productivity improvement to apply downward pressure on prices during the initial stage of economic recovery. Yet we believe Japan’s past two short-lived cyclical recoveries confirm the extreme vulnerability to negative shocks of economies experiencing disinflation with high levels of debt. We doubt whether the Fed has any basis to rush into tightening in the current economic environment. (This assertion fully recognizes the risk of going beyond our coverage, however.). Similarly, our European economic team sees an increased likelihood of a move up of the tightening schedule by the ECB in reaction to fiscal expansion policies being promoted by the German and French governments that undermine the Stability Pact. Recent gains that have taken the euro into new territory, however, raise questions about this outlook. Our currency economist team envisions a sustained, large decline in the dollar into 2005. If this aggressive forecast is accurate, tightening may not necessarily be the next action.

Fed impact on BoJ exit strategy

We expect the monetary policy stances of US and European central banks to influence the BoJ’s exit strategy. Just as the Fed has closely studied the BoJ’s failure and steered clear of unconventional policies (thereby avoiding the morass of quantitative easing), the BoJ is closely watching the Fed’s exit strategy. We think it is fairly evident that Japan is likely to be the last major country to raise rates. Yet if the Fed launches a tightening campaign, we expect increased speculation about a BoJ exit strategy and a very different market environment in the second half of 2004. Advocates of tighter monetary policy could unnerve bond market optimists. However, speculation about an exit strategy may subside if foreign central banks show less inclination to make rate adjustments amid the current disinflation trend. Currency rates are also an issue. While recent yen strength is only having a limited impact on corporate earnings, we anticipate a deflationary impact if the rate takes hold at a level sharply below ¥100/US$1, as happened in 1995. Even stronger reasons for our outlook of no significant change in Japan’s monetary policy during 2004 are: 1) little chance of the core CPI rate stabilizing in positive territory during 2004-05 (the explicit hurdle for an exit strategy); and 2) the growing requirement for the BoJ to support the financial system, since passage of the proposed new law allowing preemptive public capital assistance is unlikely to restore financial health at regional financial institutions, and the schedule for adopting payoff in April 2005 is much too tight. We think the consensus view of adopting the payoff system as a condition for dismantling ZIRP is unrealistic. There is actually a possibility of the Bank conducting the symbolic easing by raising the current-account target depending on currency market trends. Market fears are unlikely to materialize in 2004, and we anticipate an ongoing policy gridlock.

ZIRP worries persist with disinflation

While the policy rate slipping into the 1% range should effectively cripple monetary policy, judging from Japan’s experience as the frontrunner in global deflation, the recent strong rebound by the US economy is contradicting our cynical view. Decisive differences in the performances of the two economies are deflation in Japan vs. disinflation in the US and whether widespread asset price deflation exists. Yet we think it is too early to rule out the zero-interest-rate threat. Even in Japan’s case, it took just under four years for the policy rate to drop from the 1% range in 1995 to zero. Following the exhaustion of the inventory cycle as in the 1996 recovery from a boom in IT-related capex, and the negative cycle of financial instability and credit contraction in 1997-98, the BoJ finally found it necessary to implement ZIRP in early 1999. While the Bank considered a rate hike in summer 1996, it backed off this stance as recovery momentum slumped. Japan’s record highlights the vulnerability of economies with high levels of debt to negative shocks, even in the case of disinflation rather than deflation. We cannot say conclusively that the G-3 central banks no longer face the threat of ZIRP.

A hiccup to come, but then a renewed recovery

We are expecting external demand and capex to drive a continuation of the moderate recovery during the first half of 2004, but as deteriorated terms of trade hurt corporate profits and exports slow down under a strong yen and cooling in the China economy, we think the second half of 2004 will bring a downturn. Our view is that this will be shallow and short-lived, however, as overseas economies should keep rebounding and a severe inventory adjustment is likely to be avoided, allowing the economy to resume its steady recovery in 2005. Our real GDP growth forecasts are 2.0% in F2003, 1.7% in F2004, and 1.8% in F2005; for calendar years, our projections are growth of 2.2% in 2003, 1.9% in 2004, and 1.5% in 2005.

Reasons to expect the recovery to last in the near term include (1) continued growth in exports as overseas economies keep rebounding, (2) an ongoing pick-up in production and capital investment reflecting improved business confidence and export expansion, (3) support for consumption from a gradual upturn in incomes. However, concerns further out have not been cleared up, and the structural problems that beset Japan’s industries make it very unlikely that consumption or business investment will boom.

From the second half of next year, meanwhile, we look for the economy to turn down again. This is because (1) worsening in the terms of trade from a lull in the restructuring effects amid deflation and higher prices for energy resources will weigh on corporate earnings, (2) the export driver may lose momentum as the effect of yen appreciation shows through after a time lag and China’s economy slows, and (3) a drop in domestic and overseas demand would create inventory adjustment pressures. Japan’s consumers have been running down their savings for several years and will need to redress the balance, so consumption is likely to stay level even if incomes edge higher, and as Japan moves down the path of fiscal restraint, public spending will continue to cramp the economy. Housing investment is another area where we do not expect sustained upside given the uncertainties households confront, despite the extension of tax breaks.

That said, we think a severe downturn will be avoided and see the period of slowdown in the second half of 2004 as just a hiccup during the cyclical rebound. The first reason is that export growth, although it decelerates, should continue. The US economy should maintain a rapid pace of growth in 2004, with tax cuts still boosting consumption and latent demand for investment breaking out after the progress in scrapping excess capacity. The impact of tax concessions will fade in 2005, resulting in slower growth that year, but this would simply be a reaction to front-loading of demand in 2004, not a sign of a significant retreat in the US economy. As for China, the impact of tighter monetary policy is a concern, but even if domestic demand there cools, the effect on Japan’s exports should be comparatively slight, since many of these are supplies of components for local assembly at Japanese plants, whose final destination is outside China. The second reason is that inventory adjustment pressure in the downturn should be limited, since the rebound was tepid to begin with. Third, the long period of stagnation after the bubble collapse should mean a considerable amount of pent-up and replacement demand. Fourth, the provision of safety nets has created a system where crises can be forestalled.

Structural problems likely to return to the fore when cyclical recovery dies down

Although various pressures from structural problems have been blunted by the ongoing cyclical recovery, we expect the market to focus once more upon the obstacles that structural problems pose to a true recovery, at the same time that the cyclical recovery starts to lose steam in F2H04. A number of reform milestones are set for around this time, so the government cannot afford to slack off on structural reform. At the same time, the Diet elections in July 2004 and the lifting of the payoff ban in April 2005 will make it difficult for the administration to do anything that causes pain, such as job losses or corporate bankruptcies. Thus, the government’s reform path will likely be one of incremental inching-forward, so unfortunately we see little chance that Japan’s structural issues will be resolved swiftly, or that the economy will trace a V-shaped recovery trajectory. Of course, we look for the trend for private sector firms to nurse themselves back to health to spread, and we are heartened that the foundations are being laid for a sustained economic expansion further down the line.

Looking for balanced growth that is less dependent on external demand

Morgan Stanley’s global economic outlook now calls for global growth to accelerate to 4.2% in 2004, and then to drop off to 3.7% in 2005. The main culprits behind the decline are expected to be the US and Asia, which are the chief importers from Japan, and as the yen continues its rise, it is inevitable that doubt will be cast upon the sustainability of an export-led recovery in Japan’s economy. Certainly, exports have fueled the current recovery, but domestic demand is starting to pick up steam and the tolerance for slowing external demand is strengthening of late. Rising capex is the other cornerstone of the recovery, as it may also reflects an increase in capex connected with export goods, so some are of the opinion that the reliance on overseas demand will not change. However, the October machinery order data pointed to a simultaneous strong increase in domestic demand amid a slowdown in overseas demand, indicating that the recovery is becoming broader-based. Industrial shipments also pointed to improvement in domestic demand: Although in 2002, shipments for export increased 9.5% YoY, domestic shipments declined 2.1% on average over January-September 2003, while export shipments rose 3.0% YoY, whereas domestic shipments increased 2.9%. As the recovery shifts from being driven by external demand to more balanced growth, we expect Japan to ride out downturns in the global economy and the impact of a strong yen, and stay on a recovery track in 2005.

Asian economies experienced a massive swing in 2003.  The looming war in Iraq cast a long shadow over the region at the beginning of the year and threatened its trade-led recovery.  Then the SARS epidemic engulfed the region in the spring and activity practically came to a stop.  Domestic demand began to collapse in most of the region’s economies, even as exports held steady.  The SARS epidemic began to burn out in May, as the extreme caution taken by the public and governments nipped the epidemic in the bud. 

The shocks, however, only delayed the powerful recovery in the global economy that was already under way.  The massive monetary and fiscal stimuli that governments around the world instituted after the IT bubble burst and September 11 were working into the global economy.  The delay only made the recovery more powerful.  By the middle of the year, financial markets were waking up to a dramatic global recovery.

By the fall, the financial markets had already priced in a vigorous global rebound.  The third quarter turned out to be the strongest for the global economy in decades, which validated the market optimism.  The dramatic strength in the third quarter was due to pent-up demand that built in the pipeline as businesses and consumers postponed spending in response to SARS and the war in Iraq.

China was the key difference in this year’s global economy.  Its imports are likely to increase by US$120 billion in 2003, more than the increase in US imports at about US$100 billion.  Over 80% of the increase in China’s imports was in raw materials and equipment.  The surge in Chinese demand for such products pushed up prices for most commodities.  Nickel has led the pack and appreciated by 80% this year.  Copper, tin, and lead prices have appreciated by over 40%.  We have seen tremendous appreciation in the commodity currencies.

The surge in China’s equipment imports was the most important factor in the revival of Japan and Korea’s exports.  Equipment exporting economies in Europe also benefited significantly from the surge in Chinese demand.  It was probably the most important factor in the earnings revival among equipment producers around the world.

In addition to China’s demand for materials and equipment to power its production machine, the US consumer has remained a major engine for the global economy.  Imports from China have accounted for 28% of the increase in US imports this year, mineral fuel another 42%.  Most Chinese exports to the US are consumer products distributed through well-known chain stores.  A buoyant US consumer continues to drive its import dynamics.

The potent cocktail of the US consumer and Chinese producer have been powering the global economy.  But their combined strength in the second half of 2003 was probably exaggerated by the pent-up demand from the first half.  Further, China is trying to slow its economy to a sustainable pace as it faces up to resource constraints and structural imbalances.  There should be less fuel for the global economy next year.

Nevertheless, the low base from the first half of 2003 will likely deliver impressive year-on-year growth rates for most Asian economies in the first half of 2004.  Korea’s credit bubble burst this year, pushing some pent-up demand into next year as well.  This is why we expect next year’s growth rate to be stronger than this year’s for most economies, with the exception of China.

Global financial markets, especially in Asia, are simply euphoric, in my view.  We are probably witnessing another equity mania.  Foreign funds have flowed rapidly into Asia, especially from the US.  Initial public offerings are experiencing dotcom-like surges on their first day of trading.  Investors are buying because they expect others to do the same.  The ‘greater fool’ game is at play again.

Loose Fed policy is the cause of it all, in my view.  As the Fed is reviving the US economy without structural adjustment to cure the excesses, it has to keep its monetary policy looser and for longer than usual.  The spillover into emerging markets is creating bubbles around the world, which may cause excesses and lay the foundations for future problems.  When the Fed has to reverse its policy, we may see financial crises again.

Successful Transition from Isolation to Integration

The economic reforms that began in F1992 (YE March) have successfully enabled the Indian economy to transition from a shackled environment to a deregulated, globally integrated market.  Average GDP growth in F1993-F2003 accelerated to 6% (per capita growth of 4%) compared with 5.8% (per capita growth of 3.1%) in the 1980s.  Continued healthy growth in the past 10 years has helped expand the Indian economy to US$512 billion in F2003 from US$258 billion in F1993.

Rising Up the Curve of Emerging Market Lifecycle

While economic reforms implemented in the past 10 years have not meaningfully helped accelerate GDP growth, the big difference has been the improved macro stability imparted by an increasingly market-oriented structure supported by an institutional framework.  While inherently unstable government pump priming supported growth in the 1980s, during the 1990s growth was driven by inducing private sector investment, deregulating industrial activities, and liberalization of foreign trade and capital flows. These reforms have positioned India on the rising path of the emerging market lifecycle.  The key question now is not the sustainability of current growth, but whether India can manage to accelerate growth to 8% in the next three years.

So Far India Is Following a Different Growth Model

Annually, India adds about 167,000 engineers and 2.2 million English-speaking graduates (with 15 years of basic education), giving the country a distinct advantage to participate in the fast-evolving global trend of skilled labour arbitrage.  While most other Asian countries have taken advantage of globalization in manufacturing, India has relied on the high value-added services sector to accelerate growth. India is becoming the services workshop to the world. We believe that Indian IT services and ITES (IT enabled services) have the potential to earn annual export revenue of US$33.8 billion (4.2% of GDP) by F2008, up from US$9.5 billion in F2003.  We estimate the contribution of these exports to GDP growth to rise to 0.6% point by F2008 from 0.25% point in F2003.

But a Niche in Services May Not Be Enough

While we see great potential for India to be the destination for outsourcing services, this won't be sufficient to accelerate overall economic growth to 8%, in our view.  We believe that to sustain growth of 8%, manufacturing growth must also take place.  An increase in investment in this sector would also be necessary to create employment for the fast-growing, semi-skilled, non-English-speaking workforce.  According to official figures, of the 400 million-strong workforce in India, about 30 million are unemployed.  However, we believe that the disguised unemployment levels are significantly higher.  Hence, simultaneous progress in manufacturing will also be necessary for balanced development that ensures the participation of lower-income earners in economic progress and social stability.

Can Manufacturing Growth Revive?

After the reforms initiated in 1992, manufacturing growth accelerated from -1% in F1992 to 12.3% in F1996.  However, since then it has tended to be in the range of 3-8%. Average manufacturing growth over the last five years was 5.1%. Overall employment in the organized sector has declined by 1% per annum (pa) in the five years ended F2002 compared to growth of 1% pa in F1993-96.  We believe that to accelerate manufacturing growth on a sustained basis to 10% and above will be a challenging task considering the current investment trend.  India's aggregate investments slowed to 22.4% of GDP in F2002 from 26.9% in F1996 due to the lack of a supportive environment for investment.

The environment for investment in the manufacturing sector appears constrained by factors such as risk of possible significant reduction in tariff protection (which is currently at an average of 33%), unfavourable labour laws, a cumbersome administrative framework, and the inability to develop quality infrastructure facilities at a reasonable cost.  Recently, the government took several steps to improve infrastructure, but progress remains slow.  The government's consolidated fiscal deficit at 11% of GDP is also constraining it from spending aggressively on infrastructure. While improving infrastructure across the board is likely to be difficult, we believe that in the short term the government should aim to create special economic zones (SEZs) near coastal areas with state-of-the-art infrastructure and minimal administrative interference.  Unfortunately, the government has made no major effort to set up SEZs with world-class infrastructure.

Low Savings Rate Could be an Additional Constraint

Even if the government improves the environment for manufacturing, capital accumulation could be restrained by low domestic savings. India's saving rate is still lower than that in most other Asian economies.  One of the key reasons for the high growth in Asia ex Japan (excluding India) has been saving rates of around 35% of GDP.  However, in India saving rates are 24% of GDP, and the FDI inflow is less than 1% of GDP, restricting capital formation at about 25% of GDP.  Given India's average incremental capital output ratio (ICOR) of about 4%, it would be difficult to see sustained GDP growth of above 6-6.5%.  We believe that in the near term a policy change targeting an increase in public saving and higher foreign direct investment could help augment investment rates and consequently growth rates.

The bottom line: We believe that India will see acceleration in its average GDP growth to 6-6.5% pa over the next three years compared with the average rate of 5.5% over the last five years.  However, for growth to take off to 8% or above would require a significant improvement in the policy environment, especially for the development of infrastructure and to increase investment in the economy.  Although this goal is possible, the government's efforts at implementation have been less than aggressive so far.  

Cyclical Parties

The global economy is increasingly afflicted by ‘party syndrome’.  Central banks around the world frequently resort to easy monetary policy to solve cyclical woes.  The present liquidity-driven ‘party’ and economic recovery is a case in point.  It is perhaps working as the global economy is responding to positive doses of monetary drugs; however, this cannot constitute a structural solution.  In our view, the world economy is confronted with significant structural impediments that over time cannot be resolved by such simple monetary tools.

The ‘Number One’ Macro-Structural Impediment

In my view, the world is experiencing the greatest welfare transfer ever seen across geographical regions and across generations.  Such ‘transfers’ are embodied in an economic dynamic that has been characterized by a process in which Asia’s gigantic export machine has ensured that trade and current account surpluses have been finely balanced against the global imbalance in savings.  For the last several decades, Asia has aggressively exported to the US and the world, but passively accumulated savings chiefly in US Treasuries and other foreign assets.  This facilitates the US and some parts of the developed world’s enjoyment of excessively stronger currencies and lower domestic interest rates, which in turn have fuelled these countries’ private consumption. 

In a nutshell, Asia’s obsession with exports and savings has enabled present generations of the US and some parts of the developed world to sustain an unusually high present rate of consumption, at the expense of present generations in Asia.  This is because Asian exchange rates are artificially low and exports are artificially cheap, and Asia has suppressed its present consumption to subsidize buyers of its exports.  It also comes at the expense of future generations of the American economy and some parts of the developed world.  At some point, present consumption in these countries would have to give way to saving to restore macro imbalances, and future generations would have to bear the economic burden of an aging population, as well as the devaluation of their currencies and retirement of their public and private debt.

The twin global imbalances of trade and savings have exacerbated the third global imbalance — pricing power disparity.  The biggest misfortune of Asia is the negative effect on output prices caused by Asian firms’ obsession for export volume and their ‘price-taking’ (i.e., no pricing power) approach to outsourcing work for multinationals and, as a consequence, depressed input prices for Asian labor and low returns on Asian capital.  Asia/Pacific countries are primarily in the business of supplying manufactured goods, agricultural products and natural resources to the rest of the world.  International prices for these goods directly affect returns for Asian companies and the wages of Asian laborers.  On the supply side, surplus capacity means that reduced prices do not discourage Asian manufacturers and producers from supplying the global market.  On the demand side, any abrupt change in demand results in violent price swings rather than on quantity produced as companies typically sell more in a rising price environment and sell even more in a declining price environment.  The bottom line is that Asia/Pacific’s terms of trade worsen every time global demand for electronics, agricultural products or primary commodities goes into a downswing.

Probable Structural Solutions

There are three probable structural solutions to overcome the number one structural impediment:

(1) Revaluation of Asian currencies against the US dollar and currencies of the parts of the developed world that also experienced such imbalances;

(2) An ‘institutionalized’ rise in Asian wages relative to the US and the developed world;

(3) Structurally boosting domestic demand in Asia.

While solutions (1) and (2) are being perceived by some quarters of the policy-making and economist professions as the right structural answers, they are rather impractical solutions because of two difficulties.  First, they are hard to implement, and second, they are rather blunt macro instruments as they are likely to exert an indiscriminate impact on the Asian economies, causing misallocation of resources and micro-macro pains.  However, I believe the third proposition has more merit and deserves careful consideration.

Overcoming the Most Pressing Impediment

There are two misconceptions about a structural rise in domestic demand in Asian economies.  First, many regard Asia as incapable of generating a structural rise in domestic demand because of its dependence on exports.  Second, many consider a structural rise in domestic demand as being tantamount to a mere cyclical spurt in private consumption or an unsustained rise in government spending.  Both views are false, in my view.  I believe Asia can indeed shed its excessive dependence on exports and create structural resilience in domestic demand.

Southeast Asia as a region, in my view, particularly needs to address the ‘number one’ structural impediment elaborated upon above because the impediment perpetuates Asia’s dependence on external demand and FDI by MNCs.  However, compared with other parts of Asia, Southeast Asia can ill afford to perpetuate such dependency.  Southeast Asia’s economic living space is increasingly squeezed by the reconstructing of multinationals’ global supply chains, as such reconstruction decisively favors China and India.  China is sailing through the successful EAEM (East Asia Economic Model) — the single track development path that leverages FDI by MNCs and mass manufacturing for export — that is no longer very relevant to Southeast Asia.  The rise of India as the number one choice for services outsourcing for multinationals is also likely to be at the expense of Southeast Asia both in terms of FDI inflow, MNC jobs and services revival.

As China and India are able to expand their living space, Hong Kong and Taiwan are integrated into the Greater China economic sphere, and Japan and Korea leverage their technology and global market share, the ‘skin-deep’ industrialization of Southeast Asia will be put to the test.  Consequently, we believe Southeast Asia must engineer a successful structural lift in domestic demand in order to shed its excessive dependence on exports.  In the process, the region must work towards restoring its share of global imbalances.  This can be achieved through the implementation of the dual track strategy as its dominant economics strategy and the rise of social capitalism as the dominant social-political-economic complex.

Dual Track Economic Strategy Shifts

Mr. Thaksin’s dual track development strategy implemented in Thailand over the past three years, in my view offers the first concrete case of a successful structural lift in domestic demand of a Southeast Asian economy.  One must first understand that the dual track strategy means erecting a second track of growth engine working side by side with the traditional first engine of growth — the mass manufacturing based export engine.

The second track has two dimensions.  The first dimension concerns policy initiatives aimed at producing a structural lift in domestic demand.  This would alter the mix of external and domestic demand in terms of contribution to growth as well as overall output.  In the context of Thailand, it takes the form of efforts to shed excessive ‘single track’ dependence on mass manufacturing for export: we call this the ‘domestic demand element’ of the second track.  The second dimension concerns creation of a ‘local enterprise element’ of the second track consisting of local enterprise and product development alternatives to mass manufacturing for export.  Local enterprises would not only produce for local demand, but also their indigenously created and developed products would help to open new export markets by leveraging the country’s indigenous and unique skills and resources. 

Thailand’s ability to generate good growth through its newfound vigor in domestic demand while retaining export competitiveness over the past three years owes a great deal of credit to the dual track strategy, in our view.  It demonstrates that a structural lift in domestic demand can happen in Southeast Asia and that this does not necessarily come at the price of destruction of export capability, or through revaluation of currency or an indiscriminate rise in wages.

Social Capitalism a Larger New Complex

I believe a new development thesis as well as a new social-economic-political complex for the Developing World is emerging — ‘social capitalism’.  The rise of such a new thesis can be traced to the failure of the capitalist development model — the development apparatus adopted by most developing countries — to create sustained and even growth for the Developing World over the past several decades.  We shall first examine the background and causes of the perceived failure of the capitalist development model, and defer the formal definition of social capitalism to the end of this article.

Before we analyze why the capitalist development model appears to have failed in the developing world, one must first appreciate the big picture of economic development history.  Such a history is dominated principally by the crash of the developed world — the capitalist, free enterprise market model and the central planning communist-socialist model. 

In a nutshell, while capitalism has triumphed over communism after the fall of the Berlin Wall and almost a century of ‘political-economic’ struggle, the Keynesian model of a ‘mixed economy’ has hardly any relevance for the developing world economies.  The Keynesian mixed economy is primarily a domestic economic policy model adhered to by Western democracies.  It is designed for the Developed World masses who had found a way to ‘appropriate’ economic profits and rents from the capitalists and other privileged classes of their societies.  As the Developed World is prosperous — it possesses the majority of the economic wealth of the world — its governments are able to operate a ‘socialist’ redistributive apparatus to balance the excessive ‘profit’ quest of their corporate-capitalists, and the ‘social welfare’ needs of the not-so-well-off in their societies.

The economic development model adhered to by the Developing World, however, remains decisively ‘capitalist’ in nature: there is no Keynesian redistributive channel whereby the Developed World is ‘obliged’ to share its excessive profits and wealth with the developing world.  This is despite the fact that the Developed World’s profit and wealth accumulation has a great deal to do with its Developing World production sites and its access to Developing World markets, savings and resources.  Indeed, the aid and low-cost loans made available to the Developing World appear puny compared with the Developed World’s ‘windfalls’ derived from its investment and trade with the Developing World. 

In consequence, the Developing World has been an unhappy lot.  From the end of the Second World War to the present, out of a hundred or more Developing World nations that have emerged, few have truly attained ‘developed’ status.  South Korea and Taiwan, and the atypical Singapore, which owes much of its prosperity to its ‘middleman’ roles in Southeast Asia, are the few exceptions.  Yes, there is GDP growth and a concomitant rise in nominal income in the Developing World, but the vast majority of its residents remain in relative poverty.

Three Shortcomings in a Capitalist Development Model

The capitalist development model is the mode of interaction between the Developed World economies and the Developing World economies.  Such economic interaction is conducted primarily via two channels — investment and trade.  Both channels are intertwined and are driven by the ‘quest for profit’ by the corporate-capitalist class of the Developed World, represented chiefly through MNCs.  Investment by the Developed World is carried out largely in the following three major forms of investment activity:  (1) the outsourcing of mass manufacturing activities taking advantage of cheap labor or investment incentives; (2) the exploitation of resources (primary commodities and agriculture) used either as productive input or for consumption by the Developed World; and (3) the penetration of Developing World domestic markets either in goods or services (see our report First Step in Dismantling the East Asia Economic Model, May 16, 2001). 

Proponents of such a capitalist development model argue that it is the only way the Developed World can help the Developing World to attain economic growth and prosperity.  This is too vast a subject for the scope of this paper.  However, such a capitalist development model has three major shortcomings, in our view.

First, the Developing World is deprived of indigenously owned capital

This is because the initial capital for industrialization and the production capacity that is subsequently developed are supplied and controlled by Western capitalists.  The outsourcing of MNC production in the Developing World is contingent on the ‘obedience’ of political regimes as well as favorable investment incentives catered for by such regimes.  Tax, labor, local market penetration and export promotion are key features of such incentives.  We see other significant disadvantages associated with such an ‘FDI by MNC’ development model: production capacity concentrates on either mass manufacturing that forms part of the global supply chains controlled by Western companies, or on the exploitation of Developing World resources (such as primary commodities and agriculture).

Second, the Developing World does not enjoy pricing power for its output and exports

As production capacity, production decisions, volumes and terms of trade are dictated by Developed World corporate-capitalists and their distribution chains, Developing World products and exports have not developed genuine pricing power, despite being a critical part of global production chains.  Under-investment in ‘intellectual capital’ has compounded the problem.

Third, the Developing World experiences an uneven and inequitable development path under the capitalistic route

As the capitalist development strategy is to build factories and to move surplus labor from rural and agricultural sectors to production capacity based in the cities, income and wealth inequality have typically worsened.  Indeed, over-development of industry and urban sectors often comes at the expense of the development potential of the rural, agricultural, resource and SME sectors. 

Social Capitalism Attempts to Address Capital and Pricing Power Impediments

‘Social capitalism’, or the social-capitalist development model, thus aims to address these shortcomings by creating indigenously owned productive capital and attaining pricing power for the Developing World.

Much of the foundation of social capitalism is laid down by Hernando De Soto, a Peruvian development economist, alongside a score of other development economists who have paid close attention to the development obstacles confronted by Developing World economies.  Their main thesis suggests that substantial ‘dead capital’ resides largely in rural and informal sectors; policy makers, by devising ‘capital creation’ mechanisms can convert this dead capital into ‘legal’ and Western-style capital for development needs.

The other critical dimension of social capitalism lies in balancing past excesses — such as excessive dependence on external demand, mass manufacturing and other FDI by MNC-driven economic activities — with a strengthened development platform via programs to structurally lift domestic demand and develop domestic enterprises.  We think this is particularly relevant for ex-China, smaller developing economies in Southeast Asia that are suffering both a deterioration in pricing power and a shrinking role in the global mass manufacturing supply chain.

It is important to note that the rise of social capitalism entails a new social-economic-political complex encompassing the second track economic phenomenon.  Social capitalism is not a wholesale rejection of capitalism or the existing capitalistic development model.  It would be entirely impractical for the Developing World to reject free trade or FDI, or to circumvent a Western capital- and technology-led development path.  In our view, integration with the Western economy must remain the ‘core’ development thrust of social capitalism.

Mr. Thaksin’s Experiment with the Dual Track and Social-Capitalist Development Model

Over the past three years, Thailand under the leadership of Prime Minister Thaksin Shinawatra, has been the only country in Asia to initiate a full-scale experiment of social capitalism — i.e., through the dual track development model (see my report Twin Dimensions of Mr. Thaksin’s Dual Track Model, May 7, 2003).  In our view, Mr. Thaksin’s dual track development model is the closest approximation to practical social capitalism: it is structurally reducing Thailand’s dependence on MNCs and strengthened domestic demand, and at the same time is ‘creating’ capital and ‘improving’ pricing power.

Mr. Thaksin’s first track continues to encourage FDI — but only quality FDI that makes sense to the Thai economy — and pushes for export growth and globalization.  The continued integration with the West and the world should ensure that the Thai economy remains competitive and relevant.  The SMEs and services sectors promoted under the second track are pro export as well.

Other than the twin dimension of the second track that we elaborated upon above, it is important to appreciate that integral parts of the dual track strategy are initiatives to ‘create’ capital to facilitate the ‘development’ of local enterprises with niche pricing power.  Over the past three years, various ‘capital creation’ projects are being conceived and put in place, aimed at converting ‘dead’ capital into productive capital or at enabling the capital-deficient sectors to form capital.  Such capital-deficient sectors include urban poor, rural, resource, SME and the government sectors.  In a short span of 32 months, numerous ‘capital’ projects have been either aggressively implemented or creatively conceived.  These include the Village Fund project launched in 2001, the Capital Creation scheme conceived in 2002 (see my report Capital Creation — The Next Step Up, January 16, 2003), housing projects for state workers and for the masses (see This Siam House Is Different, May 16, 2003), various SME initiatives introduced since 2001, the state enterprise privatization program, and the latest Vayupak Mutual Fund initiative (see Vayupak, November 7, 2003.)

Bottom Line: Second Track and Social Capitalism could Be Southeast Asia’s Answer to Global Imbalance and Shrinking Living Space

The recent global recovery is just another party created by monetary excesses of global central banks.  Asia’s excess saving and obsession with exports have enabled present generations of the US and some parts of the developed world to enjoy welfare transfers from present generations in Asia and future generations of the US and the developed world.  There are three probable solutions to overcome this perpetual global imbalance: (1) revaluation of Asian currencies against the US dollar and currencies of the parts of the developed world that also experienced such imbalances; (2) an ‘institutionalized’ rise in Asian wages relative to the US and the developed world; and (3) structurally boosting domestic demand in Asia.

Southeast Asia as a region, in my view, particularly needs to address the ‘number one’ structural impediment elaborated upon above because the impediment perpetuates Asia’s dependence on external demand and FDI by MNCs.  However, compared with other parts of Asia, Southeast Asia can ill afford to perpetuate such dependency.  Southeast Asia’s economic living space is increasingly squeezed by the reconstructing of multinationals’ global supply chains as such reconstruction decisively favors China and India.  China is sailing through the successful EAEM (East Asia Economic Model) — the single track development path that leverages FDI by MNCs and mass manufacturing for export — that is no longer the forte of Southeast Asia.  The rise of India as the number one choice for services outsourcing for multinationals is also likely to be at the expense of Southeast Asia both in terms of FDI inflow, MNC jobs and services revival.

In consequence, we believe Southeast Asia must engineer a successful structural lift in domestic demand in order to shed its excessive dependence on exports.  In the process, it must work towards restoring global imbalances through implementation of the dual track strategy as its dominant economics strategy and the rise of social capitalism as the dominant social-political-economic complex.  Thailand’s ability to generate good growth through its new-found vigor in domestic demand while retaining export competitiveness over the past three years gives a great deal of credit to the dual track strategy, in our view.  It demonstrates that a structural lift in domestic demand can happen in Asia and that it does not necessarily come at the price of the complete destruction of export capability, or through revaluation of currency or an indiscriminate rise in wages.

The rise of social capitalism entails a new social-economic-political complex encompassing the second track economic phenomenon.  This is not a wholesale rejection of capitalism or the existing capitalist development model.  Social capitalism’s main objective is to correct the inadequate and imbalanced development path by reviving ‘dead capital’ and to balance past excesses — excessive dependence on external demand, mass manufacturing and other FDI by MNC-driven economic activities, and industrialization at the expense of proper development in rural, agricultural, resource and SME sectors.  It aims to do this with a strengthened development platform via programs to lift domestic demand structurally and to develop domestic enterprises.

Social capitalism is a bigger phenomenon than the second track strategy shifts because as well as encompassing economic changes promoted by the second track, it is promoting wide and sweeping change in the social-economic-political complex.  For example, the rural sector is no longer perceived as a development burden but rather as a new source of economic strength.  Concomitantly, there is a rise in the rural economy and rural political power, as well as the elimination of the informal economy through the creation of capital among the capital-deficient sectors.  There is also the creation of a new mass capitalist class that is drawn from SME and rural enterprises that leverage on indigenous skills and resources at the expense of the ‘rent-seeking’ crony capitalists.