United States
Review and Preview
June 17, 2008

By Ted Wieseman | New York

The front end of the Treasury market saw an epic collapse over the past week, driving the yield curve way flatter, as investors quickly set aside increased concerns about the economy caused by the prior week’s shocking spike in the unemployment rate and moved to price in a quick reversal of the Fed’s rate-cutting cycle starting in August.  Better-than-expected economic data later in the week hurt the market, but the reversal was well underway Monday after a huge sell-off that came despite any domestic economic or other news to prompt such a massive drop.  Instead, the main trigger for Monday’s plunge was an upside surprise in the UK PPI that prompted a collapse at the front end of the gilt market and a big hawkish repricing of the expected Bank of England path.  After this put the US front end under significant pressure, short-end losses sharply escalated as curve steepening positions were unwound en masse and the Fed path priced into futures was brought into line with the big adjustments in expectations for the ECB after President Trichet’s comments the prior week and the post-PPI BoE repricing Monday.  When Chairman Bernanke Monday night again stressed the importance of keeping inflation expectations in check while downplaying the importance of the unemployment rate jump in some brief comments on the current outlook ahead of a more theoretical speech on inflation forecasting, investors took his decision not to push back against Monday’s huge sell-off and Fed repricing as a green light to drive the trade further on Tuesday.  Following a relatively small rebound Wednesday, largely supported by severe weakness in financial stocks, domestic fundamental news contributed to a third day of severe losses Thursday.  The May retail sales report was much stronger than expected, largely as a result of big upward revisions to April and March before rebate checks were even distributed in any meaningful amount.  This upside, combined with significantly better-than-expected underlying results in the April trade report, led us to raise our 2Q GDP forecast over the course of the week to +0.8% from -0.7%.  As hugely underwater and pessimistic as the market was coming into Friday, apparently investors were bracing for a much worse CPI inflation report than economists expected, since results that were very close to consensus − big upside in the headline but a restrained core − prompted a rebound Friday morning, but even this had faded into more losses by the close.  The huge sell-offs on Monday, Tuesday and Thursday and more modest declines Friday, broken only by a small bounce Wednesday, left the Treasury market down massively for the week as a whole and the futures market pricing in the likelihood of a rate hike in August and 100bp of tightening by the January FOMC meeting. 

For the week, benchmark yields were an astounding 15-65bp higher, and the curve was at its flattest levels in five months.  The 2-year yield rose 65bp to 3.03%, the 5-year 53bp to 3.73%, the 10-year 32bp to 4.26%, and the 30-year 15bp to 4.80%.  In absolute terms, this was the worst weekly backup in the 2-year yield in 26 years.  The 2-year yield was over 14%, however, the last time its yield rose more in a week.  Relative to the level of rates, this was the 2-year’s worst week in its 32 years of regular issuance, just exceeding a 63bp backup in the week to November 16, 2001 (when rates were very close to current levels) when it became clear that the 2001 recession was ending.  The short end of the TIPS curve was pretty much assured of significantly outperforming such a massive sell-off in the nominal market, even as oil prices pulled back a bit from the record highs hit at the end of the prior week, with the July contract off US$3.68 a barrel for the week to US$134.86.  But the outperformance almost completely faded at the longer end.  The 5-year TIPS yield rose 41bp to 1.15%, the 10-year 31bp to 1.74%, and the 20-year 19bp to 2.32%. 

This collapse at the front end of the Treasury market was accompanied by just as big a repricing of the Fed, with a rate hike some seen as highly likely in August, at least 75bp expected by year-end and a decent chance of 100bp, at least 100bp by the January FOMC meeting, and 150-175bp over the next year.  A 5.5bp drop in the July fed funds contract to 2.055% even prices a not insignificant risk of a rate hike at the June 24-25 FOMC meeting.  The August contract lost 15.5bp to 2.175%, October 41bp to 2.485%, January 60bp to 2.855% − just barely favoring the funds target being at 2.75% instead of 3% at year end − and the February contract 66bp to 3.055%. Looking further into next year, the Mar 09 to Sep 09 eurodollar futures contracts led the collapse in that market, falling 80bp to 3.905%, 81.5bp to 4.105% and 78bp to 4.315%, respectively.  With our view that the economy will post negative growth in 4Q08 and 1Q09 after a small uptick in 3Q08, this new Fed pricing clearly looks way too aggressive to us.  But we very seriously doubt that the Fed, even with its more optimistic baseline outlook for growth in 2H, has any desire to be hiking rates as early as August.  With all the tough recent rhetoric aimed at reining in inflation expectations, however, it is very possible that the Fed could talk itself into a corner where it’s almost forced to hike rates if Fed officials don’t start toning it down a bit and giving more emphasis to their view that downside risks to the economy are still significant.  If they don’t, and they walk into the August FOMC meeting with the market fully pricing in a rate hike, as it already almost is now, it would be hard for them not to deliver a hike without having their credibility questioned. 

A horrible performance by financial stocks Wednesday helped Treasuries to their one day of gains during the past week, but otherwise narrowly mixed performances by most risk markets for the week had little impact on interest rate markets.  The S&P 500 ended flat even as the BKX banks stock index plunged another 4%, ending the week only slightly above the six-year low close hit Wednesday.  The S&P investment bank sub-index, though, had a stronger rebound off Wednesday’s four-year low, ending the week about unchanged, in line with the broader market.  Credit also was little changed.  In late trading Friday, the investment grade CDX index was 2bp tighter on the week at 114bp, though its HiVol subset was 9bp wider at 265bp.  The high yield index was 15bp wider at 620bp through Thursday, but the index was up about a quarter point late Friday, leaving it little changed on the week.  The leveraged loan LCDX index was 3bp tighter at 354bp through midday Friday, and all of the commercial mortgage CMXB indices ended the week about unchanged, with the AAA tightening 1bp to 112bp.  The subprime ABX market was a pronounced negative outlier compared to the flat performances across other risk markets, pointing to the possibility of another round of sizable subprime writedowns when banks close their quarters at month-end.  The AAA index dropped 3.04 points to 49.25, just above the all-time low close of 48.77 hit Wednesday after having now fallen 9 points in the past four weeks.  The AA index fell 1.24 points on the week to 11.71, an all-time low. 

Incoming economic data were not a major focus for the market during most of the week, but upside surprises in the retail sales report helped drive Thursday’s leg of the sell-off, while a CPI report that was in line with the economists’ consensus but apparently not nearly as bad as the market feared helped temporarily stem the losses Friday.  The upside in retail sales combined with a significantly better-than-expected trade report and a slightly lower estimate for headline PCE inflation on the CPI report led us to boost our 2Q GDP forecast to +0.8% from -0.7%.  About two-thirds of the revision came from a significantly stronger estimate for consumption and the other third from a much larger expected contribution from net exports.

Retail sales surged 1.0% overall in May and 1.2% excluding autos, and results for April and March were revised significantly higher.  Only a small part of the broadly based gain in ex-auto sales in May came from a price-related gain at gas stations (+2.6%).  Sales excluding autos and gas gained 1.0% on top of a 1.1% increase in April.  General merchandise (+1.2%) and clothing store (+0.5%) sales were significantly better than implied by the sluggish chain store sales results.  Housing related sectors – furniture (+0.4%), electronics and appliances (+0.7%) and building materials (+2.4%) – all showed very surprising strength.  Restaurants (+0.8%) were up sharply for a second month, as were non-store (mostly internet) retailers (+1.6%).  The key retail control grouping gained a better-than-expected 1.1% in May and, more important, April (+0.8% versus +0.3%) and March (+0.9% versus +0.5%) were revised significantly higher.  In addition, we adjusted our forecast for headline PCE inflation in May marginally lower to +0.46% from +0.50% after the CPI report.  As a result, we boosted our 2Q consumption estimate to +1.7% from +0.2%. 

The trade deficit widened to US$60.9 billion in April from a downwardly revised US$56.5 billion in March, with exports gaining 3.3% and imports 4.5%, each more than reversing sharp declines the prior month.  Nearly half the import gain reflected a price-related spike in petroleum products to another record high, but capital goods, consumer goods and autos also showed surprising upside.  Export strength, which was all in volume terms and not price-driven, was broadly based, with good gains in capital goods, industrial materials, consumer goods and autos.  Real goods imports gained 2.9%, but real goods exports rose an even larger 4.5%, keeping the real deficit steady after a significant decline in March.  The April real deficit was smaller than we expected.  This outcome combined with the better starting point provided by the March revision led us to boost our estimate of net exports contribution to 2Q GDP growth to a huge +1.2 percentage points from +0.6 percentage points.

Inflation results were as economists expected in May – big upside in the headline, contained core – but apparently the market was expecting a worse outcome.  The consumer price index surged 0.6% in May for a 4.2%Y rise, as energy prices jumped 4.4% on upside in gasoline (+5.7%) and utilities (+2.3%). Gasoline prices are likely to rise even more in June, as a sharp rise in actual prices is added to by a seasonal factor that looks for a decline this time of year.  Food (+0.3%), on the other hand, moderated after posting its sharpest gain in 18 years in April.  Excluding food and energy, the CPI gained 0.2%, and the annual pace held steady at +2.3%.  Much of the upside in the core came from a jump in hotel rates (+1.3%) that partly reversed a big decline last month.  Otherwise, major categories were well contained.  The key owners’ equivalent rent category only rose 0.1%, and medical care ticked up 0.2%.  Core goods prices were restrained by small declines in clothing (-0.3%) and new vehicle (-0.1%) prices.  Incorporating these results, our preliminary forecast for the core PCE price index (which we will update after the upcoming PPI report) is +0.16%.  This would keep the year-on-year pace steady at a slightly elevated +2.1%.

Meanwhile, inflation expectations at the consumer level remained elevated in early June, but at least they didn’t deteriorate further from May.  The University of Michigan survey’s median 1-year ahead inflation forecast dipped to 5.1% in early June from the 27-year high of 5.2% hit in May.  The median 5-year forecast was steady at +3.4%, a 13-year high.  The rise in longer-term expectations in this survey is clearly worrisome to the Fed and has been repeatedly alluded to recently as Fed officials have noted some deterioration in long-term inflation expectations and vowed to fight any further increase.  Upside in expected and actual inflation continued to crush consumer sentiment, with the Michigan index falling to 56.7 from 59.8, a low since 1980 and within 5 points of an all-time low.  With surging energy and food prices weighing heavily on real income, 60% of respondents said that their financial situation had worsened in early June, the highest reading in the 60-year history of the survey.

It’s already time to start looking ahead to the early round of key June economic data.  Initial claims in the coming week will cover the survey period for the June employment report.  The sharp rebound in initial claims this week after what now looks to have been Memorial Day seasonal adjustment problems and yet another multi-year high for continuing claims at this point provide every reason to believe that there will be another decline in payrolls in the June employment report.  In addition, the Empire State manufacturing survey Monday and Philly Fed Thursday will set initial expectations for the next ISM survey.  Other key data releases due out include PPI, housing starts and IP Tuesday and leading indicators Thursday:

* We expected the producer price index to be up 0.9% overall in May and 0.2% excluding food and energy.  Hefty increases in quotes for a wide range of energy-related items should lead to a sharp jump in the headline PPI this month.  Meanwhile, the food category is expected to show a modest rise – driven mainly by higher prices for beef and milk – following a flat result in April.  The core reading should be better behaved than last month, since the rather bizarre jump in SUV prices is unlikely to be repeated.

* We look for May new home sales of 990,000 units annualized.  A pullback in the volatile multi-family category after last month’s 36% surge is expected to contribute to a 4% decline this month.  Single-family starts, which have fallen 62% from the January 2006 peak, are also likely to extend their string of declines to 13 months.  We look for about another 30% drop in single-family starts to bring inventories of unsold new homes back into better balance by the first part of next year.

* We forecast a 0.1% rise in May industrial production.  A snapback in motor vehicle assemblies relative to an extremely depressed level seen in April should provide a significant boost to factory production.  However, much of this swing is likely to be offset by a sizeable decline in utility output tied to milder than usual temperatures across much of the nation.  So, overall IP is expected to post only a slight uptick.  Finally, the key core category – manufacturing excluding motor vehicles – is likely to edge down 0.1%, consistent with the results of the labor market report.

* Based on the components available at this point, the index of leading economic indicators is likely to be flat in May, with positive contributions from the yield curve and stock prices offset by negative contributions from the real money supply, consumer confidence and jobless claims.

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Europe
Europe: 1992-2008 – Will History Repeat Itself?
June 17, 2008

By Eric Chaney | London

This is an excerpt from ‘1992 Redux’, a 32 page report dated June 13, 2008 and authored by Morgan Stanley economists, banks analysts and strategists.

In August 1992, the US dollar slipped to 1.35 against the deutschemark.  A few weeks later, the British pound, the Italian lira and the Spanish peseta were massively devalued and core Europe slipped into recession.  Today, the dollar would trade even lower against the DEM, at 1.25.  Transatlantic tensions are probably even higher than they were then.  Obviously, there will be no currency crisis in the euro area, for lack of currencies, and the pound has already sharply declined vis-à-vis the euro.  Yet, tensions will not disappear into thin air; they will evaporate through other macroeconomic channels within the euro area and probably find some fault lines in the new periphery of core Europe, like central and eastern European economies.  In this article, we look at the similarities and the differences between 1992 and 2008 and try to understand which macro adjustments are likely to take place.

Back in September 1992

Back in 1992, the strength of the German mark was a by-product of a sharp divergence between the US Federal Reserve and the German Bundesbank, and the other European central banks in Europe that had pegged their currencies to the DEM.  The Federal Reserve was still busy bailing out the US banking system, devastated by the burst of a property price bubble, and helping an economy barely recovering from the 1991 recession.  In Europe, the Bundesbank was fighting fiercely to cool an overheating German economy.  German inflation reached 6.3% in March 1992, not far off the rates recorded after the second oil shock.  In order to preserve currency pegs, other central banks were facing a tough alternative: either follow the Buba or give up their peg.  In fact, the stress on the exchange rate mechanism of the European Monetary System was so extreme that four countries could not stand it: on September 16, nicknamed ‘Black Wednesday’, a successful speculative attack on the pound forced the Bank of England to let the currency float freely.  Because of the high indebtedness of British households (mostly in mortgages), defending the currency by raising short-term interest rates enough to discourage speculation was not an option.  Italy and Spain were in similar positions, although the indebted agents in these countries were governments, not consumers. 

That was then.  Back to the present, we see three main similarities and two main differences with 1992.  The similarities are policy divergence between the US and Europe, rising inflation and large current account divergences within Europe.  The main differences are the origin of inflation and the euro.

Similarity #1: Monetary Policy Divide

While the Fed and the ECB fought the liquidity crisis in credit markets with the same determination and, eventually, similar instruments, the two institutions took opposite views when weighting the relative risks of recession and inflation.

As for the Fed, board member Frederic Mishkin gave the strategic rationale in a paper he presented at the 2007 Jackson Hole Symposium: “Because central banks are in the business of managing the level of aggregate demand…to produce desirable outcomes for both inflation and employment, it makes sense for them to respond to home prices, to the extent that these prices are affecting aggregate demand and resource utilization”.  From this angle, the aggressive rate cuts by the Fed since August 2007 were nothing other than the implementation of a strategy aimed at stabilising aggregate demand rather than dealing with inflation risks.

Turning to the European Central Bank, this excerpt from the January Monthly Bulletin says it all: “Given the very strong monetary and credit growth in an environment of already ample liquidity, a cross-check of the economic analysis with that of the monetary analysis supports the assessment that upside risks to price stability prevail over the medium-to-longer term”.  If money markets had paid more attention to what the ECB was saying six months ago, they would not have priced rate cuts as they did then.  In fact, since the beginning of the credit crisis, the ECB has been very clear about its priorities:  taking bold and quick measures to inject liquidity into distressed capital markets and, at the same time, focusing on inflation risks, rather than supporting real domestic demand.

In reality, domestic demand has started to slow in the euro area, although this happened later than in the US, and from a slower growth rate.  Today, the two domestic economies are growing at about the same speed: in the first quarter of the year, final domestic demand (i.e., consumption and fixed investment) was up 1.7% from one year ago in the euro area and up 1.5% in the US.  Yet, with house prices still rising in the euro area, inflation accelerating much faster than expected, and robust credit growth, a very sharp slowdown in domestic demand would be needed to convince the ECB to follow the Fed.  We are obviously not there.

Similarity #2: Rising Inflation

Inflation in the euro area started to climb significantly beyond the rate associated with ‘price stability’ by the ECB over the course of 2006.  Since then, fuelled alternatively by energy prices or by agricultural product prices, inflation has ridiculed most forecasters, who believed that the ebb was just around the corner.  Inflation is likely to prove stubbornly resilient, as higher input prices pass through to retail prices, even partially, thus pushing core inflation higher, before a growing slack in the domestic economy eventually tames domestic prices (see The Long Shadow of the Energy/Food Spike, Carlos Caceres, May 19, 2008).

Yet, the macro factors fuelling inflation in the euro area today are very different from those the Bundesbank had to fight in 1992.  Then, inflation was a by-product of an overheated economy, where domestic demand exceeded production capacity.  This was the direct consequence of the large-scale fiscal stimulus that followed German unification.  What fiscal policy had inflated – for understandable political reasons – monetary policy had to deflate.  This time, euro area inflation is mostly imported and will not require the same kind of tough medicine used by the Bundesbank, and unwittingly transmitted to its EMS partners through the currency pegs.

Similarity #3: Current Account Divergences within Europe

Before the fall of the Berlin wall, Germany was running a current account surplus of 5% of GDP, which was eventually fully recycled to support demand in eastern Germany.  Today, Germany is, again, accumulating large trade surpluses: over the last nine months, its current account surplus has reached a record level, at 7.7% of GDP.  Symmetrically, Spain, which had a current account deficit of 4% of GDP in early 1992, is now in a much more impaired position, with a double-digit deficit (10.5% of GDP in the year ending March 2008).  This would have been impossible within the monetary framework of 1992: the capital inflows necessary to fund the deficit would have already dried up, as investors would have started to question the sustainability of the Spanish balance of payments.  The same holds for Portugal, which also had a current account deficit of 10.5% of GDP at the end of 2007.  A more recent member of the euro club, Greece, is running an even larger deficit, at close to 14% of GDP (13.6% in the year ending March).  The UK is also posting a significant deficit, more than 4% of GDP, but this time the pound is floating freely, a major difference with 1992.

Even though there are significant differences between today and 1992, the same fundamental macro tensions are at work.  Back in 1992, the Bundesbank went for a last rate hike in July 1992, which was the trigger for the currency crisis, two months later.  This time, what could be a trigger for a 1992 redux crisis?

An ECB Rate Hike in the Next Few Months Is a Possibility

As its President Jean-Claude Trichet publicly acknowledged, the debate within the ECB’s Governing Council has heated up over the last six months.  In January, its most hawkish members pleaded for a rate hike but they did not manage to build a majority.  At that time, inflation had broken the 3% line and was accelerating.  At the same time, the Euribor/refi rate spread was shrinking, as the tensions created by end-of-year operations started to ease.  This is precisely the kind of cocktail that could give an edge to the hawkish camp in the coming months, maybe as soon as July.  This time, President Trichet’s warnings went a step further, letting the markets conclude that a rate hike, if not a series of hikes, was firmly planned.  The new increase in crude oil prices that has resulted from the rising tensions between Israel and Iran could push the headline inflation rate at or above 4% and will probably accelerate second-round effects, such as companies starting to pass the increase in input prices onto customers.  This would imply that real short-term interest rates would fall, something that even more dovish members of the Council might find inadequate.  If, at the same time, the US economy experiences a double dip, as our US economist Richard Berner is expecting, after a temporary rebound in the third quarter, the Fed might have to ease again, especially if the incumbent administration has not managed to fix the sub-prime housing market problems.  There is no doubt, in that case, that the US dollar would slip again vis-à-vis the euro, we believe.  Since history likes repeating itself, this could trigger another ‘catastrophic’ event.  Could the monetary union itself be at risk?  We do not think so.  But there are other possible outcomes.

The Monetary Union Is Not at Risk

Leaving EMU is not likely to be a serious option for any of its members, for Italy even less than for others, given the large size of its government debt, mostly in euros.  Moreover, and despite its high sensitivity to imported fossil energy, Italy has a small current account deficit (2.4% of GDP in 2007) thanks to the robust performance of its exporters, and the weakness of its domestic demand.  At this stage, we believe that no country has any interest in leaving EMU, which has proved to be a powerful shock absorber against external shocks, such as the sharp fall of the US dollar.  One might argue that Germany would benefit from a re-evaluation of its currency, as its growing current account surplus is suggesting.  However, this is likely to happen smoothly thanks to wage increases, which would engineer an appreciation of the real exchange rate of the country, after the artificial devaluation caused by the increase in the VAT rate in early 2007. 

Instead, Watch Relative Asset Prices within EMU

If EMU is not at risk, how will these unsustainable divergences be solved?  Our thesis is that, since macro tensions cannot be vented through currency adjustments, they are likely to cause changes in real demand and in relative asset prices.  Starting with the real economy, domestic demand in high-deficit countries is likely to slow sharply, as financing conditions become more restrictive.  This should initiate a self-correcting mechanism, made of lower fixed investment and lower relative real wages.  While the former would reduce the current account deficit, itself the mirror image of the imbalance between savings and investments, the latter would improve the competitiveness of domestic producers.  Yet, real adjustments, which have started in Spain, are slow-burning processes, and, because they imply higher unemployment and slower domestic spending, they are politically unpalatable. 

This is why we think that macro tensions are likely to take another channel, namely relative asset price changes.  Within asset classes, we believe that property is the most at risk, since neither equity prices (linked to the intrinsic value of companies) nor government bonds (linked to fiscal sustainability) fit with the adjustment script.  Because foreign direct investment is supporting property markets in high-deficit countries such as Spain and Greece, the process could soon become self-fulfilling, once foreign investors start having doubts.

Risks Are Rising at EMU’s Periphery

At the periphery of EMU, Latvia, Bulgaria, Estonia and Romania are all running considerable current account deficits (from 15% to 25% of GDP), financed by a mix of foreign direct investment (in property markets in particular) and short-term borrowing, often in euro, yen or Swiss francs.  Officials believe that, because their countries will join the euro in due time, they are ‘protected by the future’.  We are less confident.

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Switzerland
Switzerland: Inflation Dilemma
June 17, 2008

By Luca Bindelli | London

We now think that oil price inflation will push Swiss inflation to 3% this year, and that the decrease below the 2% mark should materialise in late 2009 only. However, despite the possibility that the ECB will hike at its next meeting in July, we expect the SNB to remain on hold for the remainder of the year. The reasons are twofold: First, Switzerland still enjoys a lower inflation rate (currently 1% lower than the EU). Second, due to specific inflation dynamics, the SNB has a longer inflation horizon and can therefore allow itself more time to consider the future inflation-output trade-off. Key risks remain the future of the oil price path and the extent of the global growth slowdown.

Slower Growth in 2009 

The 1Q08 GDP figures show that the financial sector is starting to feel the pinch of the crisis, and that exports’ growth contribution is slowing as well. We expected the financial sector to shave off 0.6pp from 1Q growth.  The reality was only marginally better than anticipated, as financial intermediaries alone cut 0.5pp from growth (falling from 0.9%Y to 0.4%Y).  Incoming news suggests that financials will remain under pressure, putting Swiss growth at risk. The good news is that consumption is holding up well, supported by a still robust labour market. Having said this, the higher inflation rate will likely erode real income and we should expect domestic consumption to moderate somewhat more meaningfully going into 2009. On the external front, both our US and EU economics teams have revised their growth forecasts lower for 2009.  Our US team now expects growth to average 0.9% in 2009, while our European team now foresees EU growth at 1.0% in 2009. This will imply additional downside risks for the domestic economy. Accordingly, we now forecast growth of 1.3% in 2009 compared with 1.7% previously. We expect such a slowdown to reinforce the disinflationary path we envisage starting in 4Q08.

Inflation Will Likely Reach 3%

The record-high May CPI figure (2.9%Y) came mainly on the back of the surge in oil-related products (especially heating oil). Further, rental price inflation rose again, as several cantons raised their mortgage reference rate. We believe that this latter effect will persist throughout 2Q, before probably easing slightly in 2H08. It is worth mentioning that if the SNB were to decide to hike rates, the risk of further increases in mortgage rates – and hence house rental inflation – would increase again, as the tight housing market across Switzerland would facilitate the passing of higher mortgage costs to renters.  

Our new inflation forecast assumes that oil prices follow the IPE futures market pricing (as of end-May).  According to this scenario, oil prices should remain elevated for longer, and this will make it more likely that the pass-through of input prices to CPI will persist for a while. We now expect inflation to peak in 3Q at 3%, before initiating its descent towards 1.8% in 4Q09. In other words, while the disinflationary process will start by year-end, inflation will likely decline below target in 18 months’ time.

SNB Likely on Hold

Despite this higher inflation profile, we believe that the SNB will likely maintain the Libor rate at 2.75% for the remainder of the year. Our reasons are twofold: First, while both institutions share a similar policy objective, the SNB still faces a lower inflation rate than the ECB. Swiss inflation is indeed about 1% lower than in the EU, as of May (this also roughly corresponds to the average difference over the last eight years). Second, the SNB faces longer lags of transmission of monetary policy to the real economy, and ultimately inflation. This explains why the SNB has a longer inflation forecast horizon than the ECB (or other G10 central banks in general).   We suspect that this will give the SNB more time to assess the recent market developments and their eventual repercussions on Swiss inflation.

Admittedly, the worsening balance between slowing growth and sticky inflation now leaves less room to manoeuvre for the SNB. The key question remains whether inflationary pressures will be driven by oil prices mainly, or if so-called second-round effects will provide longer-lasting inflationary pressures. Our econometric simulations suggest that the inflation profile in 2008 and 2009 would not be impacted significantly if the SNB were to hike in June. Indeed, compared to a stable rate outlook, the inflation profile would remain broadly unchanged until late 2009, and decrease by about 0.1% in 2010.   This suggests that the main push for inflation is attributable to the future profile of energy prices. On the other hand, the disinflationary path in 2009 and 2010 should mainly be growth-led. Therefore, we suspect that the SNB is more likely to maintain a cautious stance and wait for more evidence of the development of the policy trade-off.

We Do Not Exclude a 25bp Hike

In line with the recent hawkish tone of central banks (e.g., the Fed and ECB in particular), over the last 10 days, we have seen a substantial increase in the Swiss 3M Libor, to 2.90% currently. Not surprisingly, most of this increase took place on June 6, right after ECB President Trichet’s speech, and we saw the Swiss Libor move broadly in line with Europe’s short-term rate. Because the SNB policy rate is 3M Libor, one could argue that the SNB is unperturbed by this rise. In other words, the SNB appears comfortable with the idea of raising the middle target to 3.0% at its next meeting. Such a scenario would suggest to us that the SNB prefers to buy insurance against risks owing to inflation expectations becoming entrenched into futures prices and wages. 

This would come at the expense of triggering more downside risks to growth in 2009 and 2010. While we acknowledge that this risk is significant, we believe that the increase in 3M Libor may also be somewhat distorted by renewed stress related to financials. Indeed, precisely around the same dates (June 6-9), we saw financials being caught up in further speculation around resurfacing problems. Presumably, if the 1W repo (the main instrument used by the SNB to steer 3M Libor) were to be left unchanged in the coming days, this would increase the likelihood of a hike. However, we do not believe that such an outcome would mark the beginning of a tightening campaign.

Risks to Our Scenario

The current inflation forecasts are highly sensitive to the energy price profile. The more persistent the oil price increase is, the more likely it will be to pervade quickly and durably into CPI inflation. In those circumstances, we believe that the SNB would act and raise rates. Downside risks to growth are still concentrated on the external sector and financials. We have already seen financial activity slowing substantially over 1Q and cutting a massive 0.5pp from growth. We expect this trend to persist, but the uncertainty surrounding the fallout from the crisis on financials makes it difficult to infer how deep and lasting the impact on the real economy will be.

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Latin America
Mexico: Time to Hike
June 17, 2008

By Gray Newman & Luis Arcentales | New York

In recent weeks, the Calderón administration has called on Mexico’s central bank to consider lowering interest rates.   On Friday, June 20 – after seven months of holding the overnight interbank rate steady at 7.5% – we expect Banco de Mexico to act, but with a rate hike rather than a cut.  The central bank’s move may fuel new talk of tensions among policymakers in Mexico.  That would be a shame.  In fact, as odd as it may seem to public opinion, nothing the central bank can do is more likely to help Mexico achieve lower real and nominal interest rates in the medium term than hiking overnight interest rates this week and possibly again next month. 

Accordingly, we are revising our interest rate forecast to reflect two 25bp hikes between now and year-end to bring interest rates to 8% compared with our previous, long-held forecast that Banco de Mexico would keep interest rates on hold at 7.5% during 2008.  The move higher is indeed remarkable.  Less than three months ago, when most market participants were anticipating significant rate cuts in Mexico, we argued that Mexico’s central bank was unlikely to join the Fed’s easing cycle (see “Mexico: No Hurry to Ease”, This Week in Latin America, February 4, 2008).  We argued then that it was difficult to imagine that Banco de Mexico could ease its tone, much less interest rates, ahead of the May-June period when inflation would appear to be on the rise.  Furthermore, Mexico’s central bank found itself facing much less pressured to ease than the Fed. While the Fed was battling an economic downturn in the US, it was also facing the specter of a much more challenging environment for the financial system. In contrast, Mexico’s banking system was well capitalized and was facing no sub-prime turmoil.    

Rationale for Hiking

We highlight three factors that have caused us to conclude that the balance of risk on the inflation front in Mexico has deteriorated to the point that a failure of Banco de Mexico to raise interest rates could put at risk the centrality of its 3% inflation target. 

First, we believe that Banco de Mexico’s decision to revise upward its inflation path for 2008 (and 2009) and the subsequent May inflation reading – which showed it at the upper range of the new forecast path – has contributed to a worsening in the balance of risks for inflation.   Recall that in late April, Banco de Mexico moved its inflation path for the second and third quarters of 2008 from a 4-4.5% range to a 4.5-5% range once it was clear that inflation would breach the path’s upper limit.   May’s inflation reading, in turn, showed headline inflation running at 4.95% and core at 4.86% – both running against the upper range of the new path. 

Of course, we believe that Mexico’s central bank is right to note that inflation is likely to show an improvement after peaking at mid-year. In addition, Mexico is hardly alone in dealing with rising food prices which largely reflect an external shock, rather than a response to domestic demand pressures. Further, nowhere is the US slowdown likely to be felt more acutely than in Mexico.  After all, while Mexico is likely to show resilience in the face of the US slowdown, it is not immune.   Indeed, Mexico’s economy is already showing signs of slowing.  After running from October to February at a 4.5% monthly clip, we estimate that monthly GDP growth slowed to an average of only 0.7% in March and April.

It is not difficult to imagine that the combination of moving the inflation path significantly away from the central bank’s target of 3% and the subsequent May inflation reading, which suggested that the central bank’s late April forecast were at risk of being overtaken, could contribute to a worsening of the balance of inflation risks in Mexico. 

Are the central bank’s actions and the recent May inflation report enough to justify a hike in interest rates?  Perhaps not.  But they come amid other worrisome signs on the global and domestic inflation fronts.

Second, there are signs suggesting that a prolonged period of inflation farther from the central bank’s 3% inflation target is taking its toll of price formation.   While the number of items in Mexico’s consumer price index basket that are posting price increases above the 3% target have been on the rise since late 2006, most of the uptick appears to be from localized processed food.  However, there are a growing number of items outside food that also appear to be moving farther from the target. To be fair, it is difficult to make too strong of a call with the data available.  After all, while there has been some uptick in service inflation, some of the uptick in the housing component also appears to be related to higher metal costs embedded in building materials.  And it is difficult to know if the uptick in services represents a new trend or simply volatility within a range seen in recent years.

The same can be said of the wage data. While the 4.7% increase in May contractual wages appears to be bad news – particularly because the uptick comes in a context of rising inflation and ahead of important negotiations in July such as Pemex’s – in the past two years monthly spikes in wages have coincided with months when only a relatively small number of workers negotiate wages such as May, June and December.  In addition, May’s pressures did not seem to be generalized as wages in services remained well behaved at 4.3% – in line with the January-April average – while those in industry were pushed higher by outsized moves in mining (5.9%). 

And the same can be said for longer-term inflation expectations, which have risen modestly from 3.39% at the beginning of the year to 3.46% in May, but remain below levels seen in 2H07 (3.53%).  At the very least, these factors suggest that Mexico does not appear to be on a clear path to lower inflation. Indeed, it is not hard to imagine that this combination of factors suggests that price formation is at greater risk today than a few months ago.

Third and finally, the recent disorder in Mexico’s interest rate markets suggests that if Banco de Mexico were to maintain policy interest rates unchanged on June 20, such a decision could be misread as a sign of the central bank’s complacency with even higher inflation.   While Mexico has had no monopoly on disorderly interest rate conditions during the first half of June, Mexico’s abrupt upward move nearing 70bp in 10-year rates during the past two weeks has been pronounced.  Part of the sell-off in the long end of the curve, as well as the lack of liquidity, likely reflects the disorder seen in US and global markets. But we are concerned that home-grown factors have also played a role. The decision of Banco de Mexico in late April to change its inflation path higher without raising policy rates has left some residual uncertainty among market participants.  But we believe that the series of declarations from the most senior level of the Calderón administration suggesting that it is time to reduce interest rates has created additional uncertainty. If Mexico’s central bank keeps interest rates on hold in June, we are concerned that the long end of the curve could face new pressures as a fresh round of questions arise regarding the monetary authorities’ decision-making process.

Caveats

It might seem odd to many that we expect Banco de Mexico to hike interest rates even as we foresee Mexico’s economy to slow further.  And there is little that Mexico’s central bank can do to stop a cascade of higher food prices by hiking policy rates by 25-50bp.  But we believe that both criticisms miss the critical point of Banco de Mexico’s actions.  The coming hikes from Banco de Mexico are aimed at controlling inflation expectations and price formation at a time when both are facing extraordinary risks.  The goal is to respond to reduce the risks that a series of external shocks go beyond an adjustment in relative prices and begin to contaminate broader pricing decisions.

If Banco de Mexico hikes as we expect and the economy also continues to slow during 2008, we believe that Banco de Mexico will be able to take back the interest rate hikes in 2009 or even later this year.  Accordingly, we are keeping our 2009 interest rate forecast at 6.75%.

Some may criticize the central bank for hiking when faced with a slowing economy and then possibly removing the hikes as soon as six months later.  Some may argue that this is evidence of a policy mistake.  We disagree.  Hiking interest rates in Mexico today is akin to buying fire insurance: the subsequent absence of a fire is hardly valid criticism of the decision to purchase insurance in the first place.

We are also using this opportunity to adjust upward our inflation forecasts for 2008 to 4.3% from 3.8% and for 2009 to 3.5% from 3.3% previously.   Our inflation models have been slowly creeping higher since we last published a forecast review last year.

Bottom Line

The specter of imported inflation is likely to prompt Banco de Mexico to abandon its stance over the past eight months of holding policy rates steady.  With inflation in Mexico still relatively benign, it might seem odd that we expect the central bank to hike interest rates.  After all, Mexico’s inflation rates are likely to fall short of US headline inflation in the coming months.  Further, Mexico’s economy is likely to slow further going forward.  And, in addition, senior policymakers are calling on Banco de Mexico to cut its policy interest rate.  We certainly agree that Mexico needs lower interest rates. Ironically, perhaps the most powerful support that Banco de Mexico can give to produce lower interest rates is to act today by hiking its policy rate and in the process reaffirm its commitment to price stability.

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Latin America
Colombia: Between a Rock and a Hard Place
June 17, 2008

By Boris Segura | New York

Latest inflation releases in Colombia have been disappointing. After rising steadily to 6.3% in February, annual headline inflation experienced a relief over the next two months. However, it went back up to 6.4% in May, and looks set to increase even further in the near future. This deterioration has been faster than we anticipated earlier (see “Colombia: Inflation Pressures Ahead”, This Week in Latin America, May 19, 2008).

Even when food prices have influenced higher inflation prints, we suspect that inflation pressures are more broadly based. In fact, inflation ex-food and other measures of core inflation, as well as inflation expectations, are heading upwards and are unlikely to ease in the second half of the year.

This situation puts the Colombia’s central bank in the proverbial “between a rock and a hard place”. From a strict monetary policy point of view, the central bank should hike its intervention rate as soon as this month’s monetary policy meeting set for this coming Friday, June 20. However, there are other considerations that are likely to keep Banco de la Republica from hiking this month, which we proceed to assess in this piece.

Inflation Is Not Only Food-Led

Food prices have been pushing up headline inflation everywhere; Colombia is no exception. Besides world ‘agflation’, the current winter in Colombia has been harsh, with rainfall above average. Food prices in Colombia have risen by 9.4% year-to-date, almost double headline inflation for the same period (5%).

Inflation ex-food is no longer inside Banco de la Republica’s target. Even when the central bank targets headline inflation, it implicitly showed relief when inflation ex-food did not breach the upper bound of its inflation target. That is no longer the case; in May annual inflation ex-food printed at 4.8%, and looks poised to breach the 5% level in the coming months.

Regulated prices have also been behind the recent spike in inflation. As there are indexation clauses embedded in the setting of utility rates, regulated prices inflation has been slowly increasing since September 2007.

But measures of core inflation remain stubbornly high, above the 5% level. In particular, there is a core inflation gauge that we (and Banco de la Republica) like to track: non-tradables inflation excluding food and regulated prices. This is a gauge of aggregate demand pressures on inflation; it rose in May to 5.25% but, more importantly, is likely to settle above the 5% level for the foreseeable future.

Inflation expectations are also on the rise. Particularly worrisome is the latest figure coming out of the expectations survey published by Banco de la Republica: 12-month ahead inflation expectations rose to 5.33%, the highest level since late 2004. A measure derived from breakeven inflation shows a similar rising pattern.

We are revising our year-end inflation forecast to 6.8%, from 5.6%. Given disappointing inflation prints the last two months, plus lingering inflation pressures in the pipeline, we now expect inflation to end the year above Banco de la Republica’s target (4% +- 50bp). In fact, the June-October period looks challenging from an annual inflation perspective, as during that period last year Colombia experienced food deflation, with headline inflation averaging only 0.05% on a monthly basis. 

A rate hike of 25bp as soon as the June 20 monetary policy meeting seems fully justified. Banco de la Republica should not risk inflation expectations, which have been relatively well behaved in recent months, becoming unhinged. Also, a rate hike would strengthen the central bank’s credibility, in an environment where it is likely to miss its inflation target for the second year running.

A hike of reserve requirements on bank deposits could be a compromise decision by Banco de la Republica in its upcoming meeting. Even when domestic credit has been showing signs of deceleration for a while now, this measure could be construed as monetary tightening without actually hiking rates, thereby helping to curb peso appreciation (more on this topic below).

The Economy Is Decelerating

There are growing signs of an ongoing economic deceleration. For example, and even adjusting for the “Holy Week effect” and the strike at the Cerromatoso mine, industrial production shows a clear deceleration. The same observation applies to retail sales.

Banco de la Republica is struggling with how to interpret incoming economic activity data. This is clear from its lengthy discussion during its May monetary policy meeting. The board states that “available information shows a stronger-than-expected moderation in economic growth”, but that it is difficult to extrapolate one month of bad economic activity data into the future.

The market has been expecting an economic deceleration and an inflation slowdown, without validation so far. For example, when the consensus had a deceleration in GDP and domestic demand growth in 4Q07, actual figures surprised to the upside, driven by strong private consumption and a surge in public works.

But more importantly, the Colombian economy still needs to work out a positive output gap. Despite higher potential GDP growth, sturdy domestic demand is still posing inflation pressures throughout 2008 (see “Colombia: Inflation Pressures Ahead”, This Week in Latin America, May 19, 2008). According to Banco de la Republica’s own estimates, the output gap will only close by late 2008.

The risk to our rate call for the upcoming monetary policy meeting consists of economic activity data to be published in the next few days. In particular, stronger-than-expected industrial production and retail sales for April, which are set to rebound after dismal March readings, could finally force Banco de la Republica’s hand in going for a rate hike at its next meeting. But this is not our base case scenario.

The super COP

We sense that a strong peso is a factor holding back Banco de la Republica from further monetary tightening. The Colombian peso is the best-performing emerging market currency so far this year. We recently highlighted that, along with better-than-expected terms of trade, strong foreign direct investment flows into Colombia are clearly supportive of this trend (see “Colombia: Abundance of FDI Continues”, This Week in Latin America, April 14, 2008).

This peso strength has not gone unnoticed by authorities. The Ministry of Finance has reacted to it by announcing swaps (into peso-denominated cash flows) of multilateral debt payments and further tightening capital controls.

There is heavy lobbying for a weaker peso by labor-intensive tradable sectors. Industrial and export lobbies have been particularly vocal, calling for further subsidies from fiscal authorities and for no more rate hikes by Banco de la Republica. In a somewhat contradictory statement, the Ministry of Finance announced budget cuts equivalent to 0.3% of GDP for 2009, but also stated that “it would provide further help to labor-intensive export sectors in a magnitude proportional to observed appreciation”. We suspect that future fiscal tightening with open-ended subsidies will not have a significant impact on the currency debate.

The fear of increasing the peso’s carry could keep Banco de la Republica from hiking its reference rate this month. Even when capital controls effectively shield portfolio inflows from entering the country, still a higher carry could attract foreign players via the NDF market. 

A Divided Board?

There is a clear divide inside the board of the Banco de la Republica. This is clear from the discussions over the last few monetary policy meetings and from remarks by board members.

In particular, there is a minority that is vocally pushing for lowering rates. Those board members see a major deceleration of the economy, and highlight the negative effects of the peso appreciation on several sectors and on households (via lower peso-denominated remittances). We suspect that this stance should not get additional traction inside the board, but could be more of a ‘pre-emptive strike’ against more hawkish board members.

The rest of the board is more cognizant of the need to keep actual inflation and inflation expectations well anchored. However, they seem inclined to wait for further information to establish the inflation and (lower) growth risks for 2008 and 2009 before modifying the stance of monetary policy. In a sense, this position allows them to delay rate hikes. The risk embedded in this strategy is that upcoming (bad) inflation prints cause further deterioration in inflation expectations, and that Banco de la Republica  could be seen as falling ‘behind the curve’, requiring more aggressive monetary tightening down the road.

Pressures on the Central Bank

There is pressure building up on Banco de la Republica not to hike rates. Exporters and industrial lobbies are pushing for not a weaker peso, but also no further rate hikes by Banco de la Republica. We sense that high-level authorities are echoing these concerns, and are publicly putting further pressure on the central bank not to hike rates, so as to not weaken economic activity and to avoid additional peso appreciation.

These pressures are becoming more evident. A few days after the higher-than-expected May inflation report was released (up 0.93%M, bringing annual inflation to 6.4%), the president convened an emergency meeting and argued that, given the need to increase food production, the central bank should cut rates, offsetting such a move with a hike in reserve requirements, so as to keep monetary policy tight. We suspect that any such move would be badly taken by the market, at a point where Banco de la Republica needs to assert its inflation-fighting credibility.

This discussion takes added significance in view of upcoming new appointments to its board.  Two board members are set to be named by the administration in February.  Together with the current minority, there is concern that the two new members could tilt the central bank into the dovish side, at a potential cost to the institution’s inflation-fighting credentials.

Bottom Line

After last month’s much higher-than-expected inflation release, Banco de la Republica should be seriously considering further tightening monetary policy. This stance takes more relevance in view of inflation pressures in the pipeline.  But we sense that the central bank is facing political pressures not to hike its reference rate.  Those opposed to further hikes argue that tightening monetary policy further would only bring a stronger peso and cripple the economy. The majority of the board has given itself some room to wait for further evidence regarding the deceleration of the economy. Given economic activity and currency trends, we suspect that the option of cutting rates is almost out of question at this point.

But this strategy is not without risks. If Banco de la Republica does not bring inflation decisively under control, we fear that inflation expectations could become unhinged and the central bank could be forced to execute a stronger monetary response down the road.

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Japan
A Fresh Chance – A Japan-Style Homeland Investment Act
June 17, 2008

By Takehiro Sato | Tokyo

Potential for a Japan-Style Homeland Investment Act

Measures to promote repatriation of overseas retained earnings (a sort of Japan-style Home Investment Act), which METI has mentioned as part of its vision for tax code revisions in F3/10, could have a positive knock-on effect on Japan’s national income through dividends and share buybacks, capex and R&D spending and wages. At the end of 2007, Japanese companies had JPY14.9 trillion in retained earnings overseas (which is described as reinvestment profit in the balance of payment statistics). Given that this retained profit has grown at a rate of about JPY2-3 trillion per year since 2005, we would estimate a figure of about JPY17-18 trillion for the end of 2008. Unlike the US, it looks as though a Japan-style Homeland Investment Act would probably not be a piece of temporary legislation, so we would not expect its introduction to result in a sudden surge of JPY18 trillion in retained profit flowing back into Japan over a limited period of time. However, it also seems fair to conclude that it would have some effect. In particular, where there is ample retained profit overseas, even companies whose domestic parents are showing losses and having difficulty paying dividends, could find themselves without one reason for turning down investors’ demands for higher dividends, for example.

METI’s Vision for Tax System Reform

On May 9, METI stated that it would like to see the MoF implement tax system measures aimed at promoting repatriation of profit generated by Japanese companies’ overseas subsidiaries. If the vision for tax system amendments in F3/10 passes successfully through the MoF screening and is opened up for debate by the government and ruling party tax councils, all going smoothly the issue could be debated in the regular Diet session convening in early 2009, and a new tax system could come into effect from April 2009.

Various media commentaries (such as the Nikkei Shimbun of May 4, 2008) have outlined the content of METI’s vision for tax system amendments as follows. Currently, where repatriation of profit from Japanese companies’ overseas subsidiaries is concerned, sums arising from differences between overseas corporate tax rates and Japanese corporate tax rates are taxed in Japan using the foreign tax credit method. For example, the effective corporate tax rate in Singapore is 18.0% versus 40.7% in Japan, working out to a simplified gap in tax rates of 22.7%, which is then levied by the Japanese tax authorities on remitted profit. It is argued that this method of taxation has become an impediment to repatriation of earnings as Japanese companies have raised overseas production ratios and generated more and more of their profit overseas. With countries particularly in Asia cutting corporate tax rates to entice businesses, making effective corporate tax rates in Japan look relatively high by comparison, companies basically have a tendency to keep profit abroad in countries where corporate tax rates are low. In its vision for amendments to the tax system, METI wants to promote tax exemptions in Japan and repatriation of profit retained at overseas subsidiaries by switching the taxation method to one of overseas income exemption. METI appears to be hoping that companies would use the money to fund domestic capex and R&D, dividend hikes and wage increases.

Of course, this is not something that METI can achieve on its own, and it will require screening by the MoF and Diet clearance as part of a bill for F3/10 amendments to the tax system. However, we think there is a reasonable possibility of such a system materializing because it would probably be roughly neutral for tax revenue, given that (presumably for reasons relating to the tax system) the current scale of profit repatriation is only about JPY450 billion per year (2007) and therefore not that large. Rather, a tax cut of this size could eventually generate opportunities for the country to earn fresh tax revenue as repatriated funds well in excess of past amounts were directed into domestic capex, wages and dividends, etc.

Comparisons with the US Homeland Investment Act

The US Homeland Investment Act reduced the corporate tax rate levied when US multinationals remitted profit, dividends and surplus funds to the US from the usual rate of 35.0% to just 5.25% for 2005 only, and targeted income generated during the five years up to the tax year ending at the end of 2002, excluding those when income was highest and lowest, i.e., three years’ worth of income. This was a temporary piece of legislation which ran until the end of 2005 (it was enacted in October 2004), and Congress (House-Senate Joint Committee on Taxation) estimates put the back-flow of funds into the US at US$135 billion per year, which in turn resulted in the dollar trending higher against other major currencies for more or less the whole of 2005. However, there were restrictions that prevented repatriated retained profit being used for share buybacks or to fund dividends. Whether or not certain restrictions on usage are applied in Japan as well will have an important bearing on the investment implications, but at this point, it must be said that much of the detail remains unclear.

How Much Repatriated Profit Could We See?

For Japan, judging at least from the METI minister’s remarks on May 9 and materials on the METI website, it appears that what they have in mind is permanent, rather than temporary, legislation as in the US. If so, this probably limits the possibility of a huge amount of fund repatriation occurring in a single year, as happened in the US. Moreover, where effective corporate tax rates are about the same as in Japan, or where they are higher, it is hard to envisage such a change to the tax system being a direct catalyst for growth in fund repatriation.

Looking at levels of retained profit at overseas subsidiaries based on balance of payments data, we find that the balance stood at JPY14.9 trillion at the end of 2007 (reinvested earnings in the balance of direct investment), with the largest portion located in North America (JPY6.6 trillion or 44.1%), followed by Asia (JPY4.1 trillion or 27.3%) and Europe (JPY2.4 trillion, 16.3%).

In the case of the US, home to the largest share of retained earnings, the lack of marked differences between nominal tax rates in Japan and the US may not give companies any great incentive to actively rechannel profits of US subsidiaries into Japan. We think that the real repatriation will come mainly from Asia and Europe, where effective tax rates are lower. Breaking it down to the individual country level, and looking only at those where there has been a degree of progress with accumulating reinvestment profit, and where effective corporate tax rates are relatively low, besides the Netherlands and Australia, we think that Asian countries like Thailand, Singapore and Korea may offer the most promise for fund recovery. In other words, it is possible that this proposed change to the tax system would invite repatriation of retained profit from virtually all regions apart from the US, on a scale which approached JPY9 trillion at the end of 2007. Even if this was very unlikely to come in a single year, if only around JPY1 trillion, say, was repatriated every year, and returned to investors in the shape of dividends or share buybacks as we consider below, this might also have a stimulating effect on the stock market. Meanwhile, according to the National Accounts for F3/07, dividends were JPY20.5 trillion (including executives’ bonuses), of which about JPY6-7 trillion came from listed companies, in our view.

What Would Repatriated Profits Be Used For?

We expect profits to be repatriated, as noted upfront, for the purposes (in order of priority) of (1) paying dividends and repurchasing stock, (2) making capital/R&D investment, and (3) paying wages. This order of priority takes into account the rationale of shareholders as well as the companies. Taking wages first, there is no obvious incentive for companies, at least, to draw down their retained earnings overseas to channel more funds into domestic personnel costs at a time when global wage levels are converging through arbitrage (‘factor income equalization theorem’). For capex and R&D investment, companies tend to keep their capital investment within the bounds of their extensive cash flow, and it would generally be more efficient to plough earnings generated by overseas subsidiaries back into offshore investment than to repatriate these profits to Japan. Of course, forex trends would also matter. However, there is probably more incentive for companies to use such profits for business investment than for payroll costs, as implied by the call from a major general machinery maker which conducts widespread R&D in Japan for tax code revisions that would facilitate reinvestment of profits earned abroad in R&D at home. From the shareholders’ perspective, on the other hand, the best way of deploying repatriated profits would be to pay dividends and buy back stock, leaving this as the highest priority by a process of elimination. And at least so far, comments from the business world regarding systemic change in this area have primarily cited repatriation of profits to pay for dividends “when the parent company in Japan is making losses and struggling to fund dividends” (Asahi Shimbun, May 10, 2008). But, to date, incentives have not been powerful enough to encourage firms to channel overseas subsidiary profits into dividends by paying the differential between overseas corporate tax rates and Japanese corporate tax rates. Calculations of profits available for dividends have, also under the Japanese system, been based on parent earnings.

Let us confirm what funds available for dividend payments are. Under commercial law, these represent the end-of-period net assets (shareholders’ equity) less common stock, capital surplus/legal reserves and the portion of legal reserves, dividends and executives’ bonuses that needs to be set aside for the period. This is all defined by the parent company accounts. Companies that do not have funds available for dividends because of red ink at the parent, even if they are making profits available for dividends on a consolidated basis, under commercial law, at least, are not defined as having funds available for dividends. This means that the aforementioned reports of parent firms paying dividends with the profits received from overseas subsidiaries would, strictly speaking, face hurdles under the current legislation. In practical terms, however, we think there is considerable leeway for paying dividends between parents and subsidiaries if there is greater flexibility on (1) the frequency of dividends and (2) the distribution proceedings under corporate statutes where dividend authority is entrusted to the board of directors.

Do Japan’s corporations have a real incentive to go to the lengths of repatriating the retained earnings of overseas subsidiaries to pay dividends to shareholders and buy back their stock? Since the answer is presumably ‘no’, it will depend in large part on shareholders exercising their rights if dividends are to be extracted in this form. So far, corporate profits would actually have been jeopardized by a company coughing up retained earnings at the cost of a tax liability, and this has made it hard for shareholders to be assertive in demanding that they do so. But in the event that the system is changed, companies would have less justification to resist such demands and pressure on them to step up dividend payments would be likely to intensify. Naturally, this would reduce the wherewithal for capex and R&D investment, and would be detrimental if it ultimately stood in the way of higher corporate value, but the principle of basing distributions to shareholders on appropriate, real funds available for dividends should be positive for the stock market.

Investment Implications

According to METI’s basic survey of overseas business activity, overseas locally incorporated arms of Japanese companies saw a 26.2% increase in recurring profits to a record high JPY9.6 trillion in F3/07, with a tailwind from favorable global economic trends. The breakdown was JPY4.7 trillion for manufacturers (+19.2%Y) and JPY4.9 trillion for non-manufacturers (+33.7%). Within manufacturing, transportation equipment was the runaway leader (JPY2.1 trillion), followed by chemicals (JPY0.9 trillion). Within non-manufacturing, the wholesale sector (JPY2.0 trillion) and mining (JPY1.9 trillion) led the way. By region, Asia generated the highest profits (JPY3.1 trillion), followed by North America (JPY2.8 trillion) and Europe (JPY1.2 trillion). Subdividing Asia, top was the ASEAN 4 (JPY1.1 trillion), followed by China (JPY0.9 trillion) and the NIEs (JPY0.9 trillion). Bottom-line (net) profits originating from overseas increased 33.7% to JPY6.9 trillion, with transport equipment (JPY1.6 trillion) and chemicals (JPY0.6 trillion) leading the field in manufacturing, as one might expect, and wholesale (JPY1.6 trillion) and mining (JPY0.9 trillion) to the fore in non-manufacturing.

The retained earnings ratio (retained earnings for the period/net profit for the period) averaged 71.3% overall in F3/07, with North America at 79.6%, Asia at 63.9% and Europe at 72.3%. These figures suggest that low effective corporate tax rates do not necessarily mean high retained earnings ratios – it is significant that Asia, with its low effective tax rates, has a low retained earnings ratio. Note, however, that the figures above are affected by a multitude of factors other than effective tax rates, including forex and interest rate trends, demand for capital investment and local business conditions.

Drawing qualitative investment implications using these statistics from a macroeconomic perspective, we would expect to see increasing pressure from shareholders to raise dividends in the automobile, chemical, trading company and mining industries. From the micro standpoint, companies in these industries particularly exposed to such pressure would be those for which parent profits in Japan are small, and thus the payout ratio measured against consolidated profit is low, with local overseas corporations generating high relative levels of profit. It is not our place as economists to highlight specific stock names, for which we defer to the views of our strategists and industry analysts.

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