Thursday, March 24, 2011

NZ growth: not as bad as it looks

New Zealand GDP data for the December quarter released today continues the trend of flat GDP results over the last nine months.

The best news about December’s small positive result is we don’t have to endure newspaper headlines tomorrow morning proclaiming the return of recession. The thing is GDP data doesn’t give us the full picture about what’s going on in the economy at the moment, and it’s not all bad news.

The fact is households are repaying debt and that’s a good thing. According to Reserve Bank of New Zealand data total household debt as a proportion of total household disposable income is falling. After peaking at 157% just prior to the onset of the Great Recession, the ratio is now down to 153%. It would be good if it kept falling. This ratio was around 60% in 1990, so there’s plenty of downside potential.

Of course while households are retiring debt, growth in consumption will remain hard work. While that makes the going tough for the retail sector now, less indebted households bodes well for more sustainable medium-term growth and reduced external vulnerabilities.

A similar phenomenon is playing out in the business (agriculture) community. You might wonder why strong exports over the last couple of years haven’t been reflected in stronger GDP growth. That’s because recent strong export values have been largely (but not entirely) a price rather than a volume phenomenon. Real GDP measures increases in the volume of activity, not the value.

Higher export prices are reflected in stronger growth in nominal GDP and, ultimately, profits of businesses. But as with households, the farming sector is currently focusing on debt retirement. Again, that’s not a bad thing, but it does keep growth soft in the meantime.

Today’s data did show growth in the right areas. Export volumes are expanding and, despite business sector deleveraging, business investment is growing. That’s a necessary precursor to a strong productive sector export oriented recovery.

I think the going remains tough for GDP growth in the next few months. We had been looking for the Rugby World Cup and the rebuild following the first Canterbury earthquake to provide some impetus to growth later this year. The RWC will still add around 0.3% to GDP in the second half of 2011, but following the February 22nd earthquake, we have shifted the Canterbury rebuild impact out to 2012.

So we see a modest building of momentum through the course of 2011, with annual GDP growth of just under 2% by the December 2011 quarter. That then accelerates sharply over 2012, largely on the back of the Canterbury rebuilding efforts, with growth around 4% by the December 2012 quarter.


We need to interpret this 2012 growth with a little caution. Much of this activity is simply the rebuilding of houses and infrastructure that was already there. Sure it provides incomes for builders and contractors while it’s happening, but it is not going to increase the productive capacity of the New Zealand economy. It simply gets us back to where we were.

This has implications for monetary policy. Our previous story of an early gradual and hopefully pre-emptive move on monetary policy has changed on the back of growth that proved to be lower over the last 9-months than even our miserly forecasts predicted, the series of Canterbury earthquakes which has implications for the pattern of growth over the next few quarter. And of course monetary condition were eased recently so the OCR is now at a lower starting point.

The upshot is that we now see a more aggressive track for interest rate hikes, starting with a 50bp increase in December this year. We expect this to be the start of a series of 50bp increases that will see the OCR up to 4.5% by the third quarter of 2012.


We had previously thought 4.5% might be enough (the “new normal” neutral OCR) at least in terms of an initial target to get to. It’s too early (and indeed too complex!) to make a judgement on whether that remains the case. Much will depend on whether the RWC and the Canterbury rebuilding provide a kick-start to a broader recovery or whether households are still repaying debt. And we won’t know that till we get there.

Wednesday, March 23, 2011

ECB tightening a done deal

The European Central Bank (ECB) remains poised to raise interest rates when it meets next. Recent events in Japan appear to have not deterred ECB President Jean-Claude Trichet from his hinted-at intention to do so at the central bank’s April meeting. Indeed in an address yesterday to the Committee on Economic and Monetary Affairs of the European Parliament, Trichet said:

“As regards our future monetary policy stance, I have nothing to add to what I said, on behalf of the Governing Council, on the occasion of our last monetary policy decision meeting earlier this month.”

I still think this is a risky strategy for the ECB. The economic recovery is not yet robust across Europe (although it is in some parts) and fiscal policy is set to do a lot of the work of starting to remove highly accommodative policy settings. In many developed countries with high debt levels it is desirable that fiscal policy does as much of the “de-stimulus” work as possible.

Much of the current inflation problem, and not just in Europe, is due to the direct and now indirect (second round) impacts of higher commodity prices. The problem in Europe is not tight capacity constraints. Taking on commodity prices requires a co-ordinated global response that should probably begin with the end of quantitative easing in America.

And remember this is a central bank that inherited its strong monetarist tradition (i.e. inflation is always and everywhere monetary phenomenon) from the Bundesbank. You’d think that given anaemic money supply growth in the Eurozone, the ECB would think they have a little time up their sleeve.

But then (I was almost tempted to say “on the other hand”!) there are other considerations. The ECB does enjoy strong inflation fighting credentials, and these should not be given up lightly. At the end of the day, monetary policy has only one contribution it can make to building sustained economic growth and that is to keep inflation expectations well anchored. Also, monetary settings are a long way from “normal” (wherever that is now). A pre-emptive strike at normalising monetary settings could be justified especially in light of emerging wage claims in Germany.

A tightening in April seems to be a done deal. But it is not necessarily the case that this will be the start of an aggressive tightening cycle.

Monday, March 21, 2011

The slowdown in China

The People’s Bank of China (PBOC) has announced a further increase in the Required Reserve Ratio (RRR). This is the third increase this year. From March 25th the ratio for the major banks will be 20% and 18% for the small and medium-sized banks.

The authorities have been tightening monetary settings on three fronts: increases in benchmark interest rates, a (modest) managed appreciation in the exchange rate and the increases in the RRR. This has been in response to inflation that has been hovering around the 5% mark in recent months, largely on the back of higher commodity (food and energy) prices. However, core inflation has also been drifting higher.

This three-pronged strategy appears to be having some impact on key growth indicators. In particular, money supply growth is slowing. M2, the broadest measures of the money supply rose 15.7% in the year to February. This is down from a peak of 29.6% in the year to November 2009.



The Performance of Manufacturing Index is heading south. The index has now fallen for 3 consecutive months. However, at 52.2 this is still consistent with robust growth, although most likely at a lower rate than the 9.8% GDP growth rate achieved in calendar 2010. We don't put too much weight in the more volatile non-manufacturing index at this point.

This slowdown is coinciding with the recent release of China’s 12th 5-Year Plan. The plan had a number of important elements. Firstly, my reading of it suggests authorities are putting greater weight on the “quality” of growth rather than the “quantum”. By quality, I mean more equal sharing of the benefits of growth, especially between the fast growing coastal areas and the slower growing internal regions.

Secondly, and perhaps more importantly from the perspective of reducing global imbalances, this Plan also has a focus on building a stronger social safety net via improved pensions, enhanced medical coverage in rural areas and social housing programs. These sorts of measures will reduce the need for precautionary household savings and boost domestic consumption.

The 12th Plan is targeting growth of 7.0% per annum. That’s a long way from where we are now, but then the 11th Plan targeted growth of 7.5% per annum, well below the average outcome over the period of just under 11% which included the Great Recession.

In the short-term, we think it is prudent to lower our expectations for China GDP growth this year. That’s based on the view that with key growth indicators already turning down and with further tightening likely, our previous forecast of 9.5% growth looks a tad optimistic. I’m more confident with 9.0%, although that still leaves the risks biased to the downside.

The PBOC has relied on the RRR and other quantitative lending controls to do most of the tightening work thus far. A more balanced approach is desirable. In particular, further appreciation in the Chinese Yuan would take some of the heat out of imported inflation while at the same time aiding the rebalancing of the economy away from the tradeable to the non-tradeable sectors. A more flexible approach on the exchange rate would also allow further increases in benchmark interest rates.

While the recently-reported February China trade deficit might take some heat out of the CNY appreciation argument, we see the monthly deficit as more of an aberration than the beginning of a trend.

While we thing more tightening is likely, it’s also important the PBOC doesn’t overdo the job. The economy is clearly slowing which will relieve capacity pressures. And as we know, much of the recent high headline inflation is due to commodity prices. It is most likely the case that some of the increase in core inflation is due to the second round effects of those higher prices, as we are seeing in Europe currently. It is indeed the second round effect of higher commodity prices that has the European Central Bank trigger-happy.

Tuesday, March 15, 2011

Europe: progress being made

The news out of the weekend’s Eurozone leader summit was lost in the coverage of the devastating earthquake in Japan. The good news is some progress was made.

In our view, Europe’s woes run far deeper than just the sustainability or otherwise of high sovereign debt levels. The broader issue is the lack of macro-economic policy co-ordination across a region that has one exchange rate and a single central bank.

We were therefore pleased to see some progress made on the terms of a “Pact for the Euro”, which was borne out of the initial “Pact for Competitiveness” proposed by France and Germany. At this point, however, there is only agreement in principle that commits to closer economic co-ordination and a range of austerity measures. These include caps on government spending (the “debt brake” in the earlier proposal), close monitoring of pension schemes and limits on public sector wage increases.

The bit we don’t know yet is how these measures will be enforced, or in other words, what happens if you break the rules. No doubt it is this sort of issue that will be discussed and hopefully decided on at the March 24&25 Summit.

The Leaders have bought themselves some time by dealing with some of the more short-term issues that debt markets have been fretting about. The main point is that the European Financial Stability Facility (EFSF) is now able to lend up it its full €440b face value. Previously the EFSF has only been able to lend up to €250b given the need to keep cash on hand to preserve its AAA credit rating.

This has been made possible by a combination of guarantees from the AAA countries and callable or “paid in” capital from the weaker rated countries.

This has led some commentators to speculate this may result in the establishment of a two-tier sovereign debt market made up of highly-rated (AAA) Europe bonds and bonds issued by individual sovereign countries that could be lesser quality (lower rating, higher yield). Seems to me the closest we are ever likely to get to the concept of European fiscal federalism.

The €440b available through the EFSF is available until mid-2013, at which point the EFSF is replaced by the European Stability Mechanism (ESM) which will have €500b at its disposal.
As part of the weekend negotiations the two countries already with bailouts, Greece and Ireland, were offered an easing in the terms of their bailout package in exchange for further austerity measures.

Greece took the deal. The Government has agreed to sell €50b in government assets in exchange for which it will get a 1 percentage point reduction in the interest rate on its €110b bailout. It will also now have 7.5 years to pay this back rather than the original 4.5 years.

Ireland rejected the deal put to them. In exchange for a 1 percentage point reduction in its 6% bailout loan, the Irish Government was asked to give up its 12.5% corporate tax rate. That deal was not acceptable to the new Irish Prime Minister.

The lesson for Portugal in all of this is that should it go down the path of a bailout, there will be tough conditions to implement.

Importantly, progress continue to be made on the broader issue of European macro-economic c0-ordination. In many important regards, the rubber is still yet to hit the road in terms of how any of this will actually work. Political compromise was never going to be easy – everybody has to go home with a win. We look forward to further progress later this month. In the meantime, authorities are just doing enough to keep up with market concerns.

Monday, March 14, 2011

Japan Earthquake

We are becoming far too experienced in having to think about the economic consequences of tragic natural disasters.

If you have read your latest QSO, we are thinking about the impact of the Christchurch earthquake on the New Zealand economy in three phases - the short, medium and long-term impacts. At this early stage, this is also the best way to think about the impact of the earthquake in Japan.

The first phase is the initial negative impact of the immediate disruption to the economy, including consumption and production in the Tohoku region. It is too early to predict the quantum at this time. This immediate impact will also include loss of distibution channels and the disruption from the loss of power.

Offsetting this will be the fact that Japan, along with other parts of the developed world, is operating at a low level of capacity utilisation. That means other parts of the Japanese economy may be able to lift production to compenate for the loss of productive capacity in the earthquake zone. While that may be the case, it will take time to organise.

The medium-term impact will be the rebuild phase. But as with the Christchurch earthquake, the growth impact from this phase should be interpreted carefully. This is not building new productive capacity for the economy. Its better described as getting the economy back to where it already was in terms of housing, infrastructure and productive capacity.

The long-term impact for Christchurch was about the decisions still yet to made by families and businesses about their long-term commitment to the city and the possibility they may relocate elsewhere in New Zealand Similar issues may impact the quake-hit regions of northern Japan. In both cases it will remain to be seen whether that becomes a country exodus as well.

The impact on New Zealand of the Japan earthquake is also difficult to ascertain at this point. In terms of exports of inputs into production such as aluminium, the answer will come back to how badly damaged productive capacity is and how readily production can be shifted elsewhere. In terms of exports of primary products, the answer lies in the extent to which distribution channels have been impacted.

In the wake of the Christchurch earthquake, the Reserve Bank of New Zealand eased monetary policy by cutting interest rates by 50bps. With interest rates in Japan at 0.1%, that option was not availabe to the Bank of Japan. The BoJ is largely limited to the provision of short-term liquidity. Indeed the Bank has pumped 15 trillion Yen into money markets. They have also announced a further round of asset purchases.

Economic growth had already dropped significantly at the end of last year on the back of the end of a number of stimulus programs. Forecasts for growth this year were around 1.5% pre-quake. With the short-term impact of the disaster likely to be GDP negative, the BoJ action was appropriate for an economy prone to deflation.

The fiscal implications of this disaster will prove to be significant. Most developed countries are facing significant structural budget challenges. Those challenges in Japan are largely demographic, making them harder to solve. Nevertheless, they just got more difficult.

More later.....

Thursday, March 10, 2011

RBNZ takes out insurance

It's hard to take issue with the RBNZ's decision to cut the Official Cash Rate by 50bps today when given its portrayal as an insurance policy against an economy recovery that was already weaker than anticipated, even before the February 22nd Christchurch earthquake. Setting aside the merits, or otherwise, of today's move, the key question now is: Where to from here?

We have been staunch advocates of the "This time it's different" view of the economic recovery. This has had, at least for us, obvious implications for monetary policy. The series of seismic events that have hit Canterbury have complicated the outlook.

Our starting point has always been the only contribution monetary policy can make to a sustained economic recovery is to keep inflation expectations well anchored. That is no less true today than it has been at any time in the past, or is indeed likely to be in the future.

Given our belief that the recession and subsequent recovery have been largely structural in nature, potential growth is now lower than it has been previously. That means capacity constraints would get hit earlier in the cycle this time. Furthermore, given the significant (and appropriate) easing in monetary policy that occurred during the GFC, monetary settings have been exceptionally stimulatory.

For those reasons, we long favoured an early and gradual removal of the very accomodative monetary conditions that have been in place. We were, you may recall, in favour of the tightenings delivered by the RBNZ last year (leading some of you to comment that we were overly hawkish). Our support was driven by the fact that with a preemptive and gradual tightening, a lower overall interest rate cycle was possible, unlike the previous cycle where the RBNZ was constantly behind the inflation problem.

So here we are back with an OCR at 2.5% and an economy in a very different place. But the point remains that the best contribution monetary policy can make to a sustained recovery is to keep inflation expectations in check.

We are, today, further away from wherever the new normal neutral OCR is (another complicated and uncertain question!!). So we now remove the "gradual" part of our preferred "early and gradual" approach to exiting the exceptionally accomodative monetary policy settings. It now seems likely that when the time is right, later this year or very early next year, monetary tightenings will be far more aggressive. A move to an OCR of around 4.5% still seems an obvious place to head, at least in the first instance.

I like the fact the RBNZ Governor went to have a chat with the Minister of Finance before determining his course of action. You will recall that one of our Themes for 2011 was (and still is) the relationship between fiscal and monetary policy as accomodative policy settings were removed. If conversations between the Governor and the Minister lead to a greater degree of co-ordination between monetary and fiscal policy, that's gotta be a good thing.

Friday, March 4, 2011

ECB: Too hawkish?

European Central Bank President Jean-Claude Trichet has signalled an interest rate increase as early as next month.

Regular readers will be aware of our view that given the structural nature of the recession in developed markets, spare capacity may not be as large as we think. That means potential growth is lower – so capacity constraints will get hit earlier in the cycle this time around.

But at the moment it seems to us that the growth outlook in Europe and in other developed economies is still too fragile and uncertain to be tightening monetary policy. Importantly we still don’t know what impact tighter fiscal policy will have on growth. Core inflation is ticking up in some countries, but it is still low and wage pressures are generally contained.

Current inflation pressures are a commodity price phenomenon. To be fair, Trichet has indicated his primary inflation concern is with the second-round effects of higher commodity prices.

If we are concerned about the inflation impact of rising commodity prices we need to believe prices are now moving structurally (rather than cyclically) higher. If that’s the case, inflation has become a global phenomenon, requiring a co-ordinated global response. The first phase of that fight would obviously be to end quantitative easing in the US and more flexible exchange rate policies in emerging economies. We will talk more about this in QSO.

Tuesday, March 1, 2011

US recovery back to new-normal

At the time of the release of US fourth quarter GDP, we warned the recovery in consumption was unlikely to be sustained into 2011. In the absence of anything remotely like strong income or jobs growth, the boost to consumption in Q4 came from a reduction in the personal savings rate. The saving rate dropped from an average of 5.9% in Q3 to 5.4% in Q4. While 5.4% was still relatively high, it was too early for households to pull back on the deleveraging process, which we expect to play out for a few more years yet.

We put the stronger Q4 consumption spending down to pre-Christmas deleveraging fatigue – i.e. a bit of an opening of the wallets after a tough year. Into the New Year, retail sales rose only 0.2% in the January month, at the bottom end of the forecast range and median forecast of 0.4%. US analysts are putting the weaker than expected out-turn down to storms and higher petrol and food (commodity) prices. While that is undoubtedly the case to some extent, we think it’s also due to the fact that households are still primarily focussed on balance sheet repair.

Interestingly, incomes were up 1% in the month. Disposable incomes were up 0.7%. This reflects tax changes including the payroll tax cut. Without this, incomes would have been up only 0.1% in the month. And the personal saving rate has gone back up to 5.8%, from 5.4% in December. All good.

The good news is that the manufacturing sector continues to improve. I don’t normally watch the regional ISM surveys, but last night’s ISM-Chicago Inc business barometer deserves special mention. The index rose to 71.2 in February. That’s the highest level since July 1988 too. Remember, this recovery needs to productive sector led and export oriented – so this is all good too.

In short, everything’s back to new-normal. While that means the US recovery will remain subdued by traditional standards, there is good repair work going on behind the scenes which bodes well for growth further down the track.