The rather unique and extraordinary trade model in Asia – buoyant intra-regional trade, leveraged on the different comparative advantages of various Asian countries – is predicated on (i) product specialisation in the Ricardian sense and (ii) a low cost of transport. Asia exports raw and intermediate goods to China, and China, in turn, applies the final phase of production before shipping manufactured goods overseas. This process has made Asia a rather cooperative trade zone with little horizontal competition but a lot of vertical synergy. But with sharply higher and still rising transport costs, this Asian trade model will likely be stress-tested, unless cost savings can be found elsewhere. The net impact is that the ultra-positive long-term outlook many investors may have on Asia should be tempered somewhat. We remain net-net structurally positive on Asia, but recognise that many of the factors and favourable global conditions that have made Asia such a brilliant growth story in the past years are turning – ironically, partly due to Asia’s ascent itself – and will help to temper the familiar Asian story. This does not mean that Asia’s outlook is necessarily dim, but higher transport costs will further pressure Asia to become less reliant on exports as the main engine of growth. In the initial stages of this transformation in Asia, high costs of transport will ‘help to un-flatten’ the world and act as a temporary headwind for many Asian currencies. Intra-Asia Trade and a Massive Export Machine The Asian trade model is by now a familiar story: China runs a trade deficit position vis-à-vis most Asian countries but a huge trade surplus position vis-à-vis most of the rest of the world. Looking at the stark divergence in China’s trade, in 2007 it ran a US$121 billion trade deficit against the rest of Asia, but surpluses of US$167 billion and US$136 billion against the US and the EU. (By the way, in January 2008, China’s annualised trade surplus vis-à-vis the EU surpassed that with the US.) In contrast to widely held expectations five or so years ago that China would overwhelm the rest of Asia with its cheap manufactured goods and squeeze the latter’s trade accounts, China and the rest of Asia have actually turned out to be a strong complementary partnership. Together, they have formed a formidable export machine that has underpinned the Goldilocks global environment witnessed in recent years. This process should be familiar to most investors by now. This trade model is a fantastic reflection of David Ricardo’s thesis that divergent comparative advantages are a key driver of trade. In contrast to the US and Euroland, Asian countries are remarkably diverse, in many ways. In 2007, per capita incomes were US$978 in India, US$2,461 in China, US$3,737 in Thailand, US$19,751 in Korea, US$35,163 in Singapore and US$34,312 in Japan. Further, cumulative foreign direct investment (FDI) from Japan over the past decades has helped to accentuate the comparative and absolute advantages of various countries in Asia ex-Japan. The net result is an Asia that has experienced more harmony in trade than many may have expected five or so years ago. High Energy Prices and High Transport Costs However, in addition to the comparative advantages encouraging trade of intermediate goods within Asia, the low cost of transport has also been an important factor that has permitted such a model to thrive. Asia is large; the distance between Singapore and Shanghai is 3,800 km – roughly the same as that from New York to London. Sydney to Tokyo is 7,800 km – about the same as Los Angeles to Shanghai. The proportion of marginal costs of container ships that is fuel is now close to 70%, up from around 20% in 2001, when oil prices were around US$20 a barrel. Going forward, if oil prices continue to trend higher, so will transport costs. There may already have been material effects from rising fuel costs on the Asian trade model. The ratio of the import content of total Chinese exports, i.e., the proportion of goods that are first imported from elsewhere and then re-exported out of China, reached around 57% in late 2001, but has since declined sharply to 44% now. Superimposing this trend with real oil prices (inverted), we see a rather strong relationship: high and rising oil prices coincided with the decline in China’s re-exports. We have the following thoughts: • Point 1. In the short run, this is not good for Asia, all else equal. Just as low communications costs have permitted the emergence of call centres in India, low transport costs have helped to fuel the Asian trade model in the past two decades. To the extent that transport costs are high and will likely rise significantly further, the Asian export model will be compromised. In the near term, this cannot be positive for Asian economies and their currencies. • Point 2. More regionalisation, less globalisation of trade. High transport costs will erode some differences in labour costs. At some point, it may be cheaper for the large Western European economies to source more goods from Eastern European countries or even from within their own economies, than by going halfway around the world. This may be especially relevant for heavier or bulky products, products with relatively low labour content, and products that require fast turnaround time. In sum, trade regionalisation could accelerate further, at the expense of trade globalisation. The ‘Gravity Model’ of trade may become a better description of trade. • Point 3. In the long run, this could be positive for Asia. Though this shock could be negative for Asia in the near term, Asia’s export-centred growth model was never going to be a permanent regime anyway. To the extent that such a shock forces Asia to become less reliant on exports and more on domestic demand, this could help to reduce global imbalances. In fact, we believe that one of the reasons why global imbalances grew to such a massive size was partly a result of cheap oil in the past few years, coupled with buoyant equity and housing markets in the West. To the extent that oil prices and equity and housing wealth are converging, global imbalances should normalise. • Point 4. Financial globalisation to outpace trade globalisation. While trade globalisation, with high shipping costs, could slow, financial globalisation will likely continue to accelerate. In fact, the root cause of high transport costs (high oil prices) will be a main driver of financial globalisation. Not only will sources of excess savings be more geographically diverse, but Asia and the Middle East will also eventually offer increasingly liquid and transparent capital markets. More global capital should be attracted to these regions, and vice versa. From a policy perspective, trade protectionism will naturally become less contentious, but financial protectionism may become more of a problem – a thesis we have promoted for some time now, in connection with SWFs. • Point 5. High oil prices bad for equities of Asian exporters and some Asian currencies. There are several market implications from this line of argument. Asian exporters and importers engaged in this trade model will likely see their margins compressed by high oil prices. Further, the currencies of the countries involved in this type of trade will also experience a new headwind, as overall trade is compromised by this oil shock, i.e., oil affects both imports and exports in Asia. Bottom Line The Chinese and the Greeks were the first to hint that the world was round. Thomas L. Friedman argued in 2005 that the world was flat. We believe that, with rising transport costs, trade globalisation may slow significantly and the world will ‘become more round’. Asia’s trade model will be particularly affected. The near-term impact, in our view, is not positive for Asia; however, in the long run, this shock could coerce Asia into moving away from the export-led growth model.
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Hungary: Views from Budapest
June 30, 2008
By Pasquale Diana | London
Politics: early elections are unlikely, fiscal discipline should prevail. Our discussions indicate that early elections look like a remote possibility at the moment. With the Free Democrats (the former junior coalition partner) polling well below the 5% threshold, it is obviously not in their interest to precipitate the country into early elections, as they would be unlikely to gain any seats. Early elections would become a plausible alternative only if the Free Democrats were to poll much higher, say at around 7-8%. The appetite for major structural reform is gone, so a muddle-through scenario is likely, with the Socialist Party effectively in damage-limitation mode. We think that the approval of the 2009 budget should not be in danger, with the Socialists needing just a few abstentions to get the law through parliament (a simple majority is needed, and they control 190 out of 386 seats). At the same time, the commitment to fiscal discipline looks stronger than we previously thought. The prospect of a correction of the “excessive deficit” and the potential future membership of the “fiscally virtuous” club has had a big impact on the Hungarian psyche, and is effectively the government’s biggest achievement to date. Fiscal easing would attract a lot of criticism from the EC, and more negative press domestically, without a guarantee that it would meaningfully win back electoral support. For this reason, we think that any possible tax cuts in 2009 (worth up to HUF 400 billion) will be mostly financed via expenditure cuts or tax increases. The NBH has a different take on the data than the market. The central bank’s official reading of the recent data has been quite different to the market’s. It found comfort in the recent drop in market services CPI (7.1%Y in January to 5.5%Y in May), seen as a major gauge of CPI expectations. Also, the MPC members have grown increasingly skeptical of the recent wage statistics, as they are affected by whitening and one-off effects. They therefore prefer to concentrate on wage dynamics in large enterprises, where whitening effects are less present. These data (not publicly available) show wage growth steady at 8%Y, still elevated but not as high as headline total wage growth (+10.6%Y). Given the recent shocks to food and energy, the bank remains on full alert for evidence of second-round effects. In particular, the already mentioned market services component will be key to watch; also the bank will be monitoring trends in processed food closely. HUF buys the NBH some time. In addition to the more benign readings of the data (on which we have many reservations), our conversations clearly suggested that the bank feels that the recent move stronger in HUF buys it some time. The NBH’s decision to pause in its tightening cycle, while maintaining a hiking bias, is aimed at avoiding speculation that the bank will continue to increase rates incrementally at a steady pace (as if on auto-pilot). After the recent firming in HUF, the NBH feels that it can now sit back and be in data-watching mode to see whether some FX gains filter through to CPI or, more simply, it just wants to see whether HUF can consolidate its recent gains in the 235-240 area. At current levels (6% stronger versus EUR than assumed in the May Inflation Report), the disinflationary pressures from HUF are sufficient to offset the inflationary pressures from oil (trading more than US$30 above assumptions), according to the NBH. Given the speed of the recent move in HUF, the bank feels that there is no urgency to continue to raise rates, and we think that, assuming HUF remains in this range in the coming months, the bank will remain on hold at least until August, when the next Inflation Report is published. How far are we from a neutral bias? Inflation may edge a bit lower from current levels (7%Y) in the next few releases, but not by much. We believe that a more meaningful slowdown will take place in September-October, and CPI should end the year at 5.5%Y. A move to a neutral bias could be triggered by the combination of two events: i) a drop in oil to roughly the levels assumed in the May IR (around US$106/barrel); and ii) evidence of serious growth faltering in the euro area. For now, our base case remains for a bit more tightening in this cycle (+50bp by year-end), but for the first time in a long time we see downside risks to our interest rate view. There is even a non-trivial chance that the next move in the Hungarian base rate will be down. No real opposition to HUF firming, so far. As we wrote numerous times before, it is clear that the bank thinks of FX as the main disinflationary channel. As such, it may be unhappy about the recent pace of HUF gains, and it may feel the need to avoid stoking it by hiking rates, unless absolutely necessary. At the same time, we sense that there is no opposition on the part of the bank to the direction of the move. The central bank thinks that it is important to focus on real exchange rate trends: the same REER outcome can be achieved via a combination of FX appreciation and lower inflation, or FX weakness and much higher inflation. Obviously, the central bank is biased in favor of the former outcome. True, there is no explicit recognition that steady nominal appreciation is needed to cap inflation (this is the Czech model, for example), but we suspect that this is where the NBH is heading now that the band is gone. From the exporters’ point of view, we were surprised to hear that there are no major complaints yet about the latest move in EUR/HUF. This is likely because Hungarian exports have a very high import component and a number of corporates have borrowed in FX, so they benefit directly from HUF gains versus EUR and CHF. Interestingly, the NBH also mentioned a study which indicates that nominal FX movements have no meaningful impact on the trade balance. Finally, a word on relative performance of HUF. It is often suggested that the forint has underperformed its regional peers and is due to move significantly stronger. The speakers we met have suggested that this is incorrect (we agree), as nominal exchange rates only tell half the story. On a REER basis, it is much less clear that HUF has been a laggard in the region (due to higher ULC and higher CPI than its peers). This supports our view that there is no compelling argument to suggest that HUF is still due for rapid catch-up with its peers. External picture and financing composition are likely to improve this year. Last year, the Hungarian current account corrected nicely (to 5% of GDP, after 6.1% in 2006), though net FDI covered just 20% of the gap and debt-generating inflows financed the rest. While acknowledging that this looks bad, the authorities correctly point out that there were large one-off FDI outflows in 2007 that affected the net FDI balance (MOL purchasing its own shares and the change in foreign ownership of Budapest airport). FDI inflows remained pretty healthy last year (4% of GDP) and, barring more one-off outflows this year, net FDI should finance a more sizeable portion of the 4.8% C/A deficit we forecast for 2008 (around 60%). Of course, a severe slowdown in Germany would represent a risk for corporate spending and FDI inflows, though the FDI news recently has been good, with Mercedes having recently agreed to an €800 million investment in Hungary. A more general point is that in Hungary, where the FDI cycle began earlier than in the rest of the region and the FDI stock is higher than elsewhere, domestic companies are now looking elsewhere for investment opportunities. This means that the net FDI balance suffers, but it is not obviously bad for the country’s long-term economic prospects (these investments abroad will generate profits, part of which will be repatriated to Hungary). What about FX loans, another important C/A financing item? Here, we still sensed some unease on the part of the authorities. They remains concerned by FX loans (loans in JPY in particular, though these have slowed in recent months), but a total credit stop is still deemed unlikely. Also, there is no sense that Hungary experienced a housing boom like other regional neighbors, so a sharp fall in the value of the collateral is unlikely. An interesting opinion we heard was that HUF loans are not inherently safer than FX loans, due to the rates/FX link. If the HUF weakens substantially, FX loan repayments would be directly hurt, but HUF borrowers would also be hurt due to the likely increase in interest rates (the NBH’s most likely response to FX weakness).
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