Thursday, March 28, 2013

Productivity is key to aspirations of higher economic growth

Amongst the excitement of the recent release of strong economic growth in the last quarter of 2012, a more important set of data got missed – year to March 2012 productivity data.  Sure the data is even more dated than the latest quarterly growth rate, but it tells us much more about our economy’s capacity to grow and the challenges we face to grow faster than it does about the growth rate of the economy at a given point in time.  As long-term investors that’s an important consideration when we are deciding where in the world we want to be invested.

Labour productivity rose 1.0% in the March 2012 year while the productivity of capital rose 0.4%.  Multi-factor productivity (productivity gains that can’t be attributed to labour or capital e.g. technological gains) rose 0.7%.

The increase in capital productivity over the March 2012 year is the first in nine years.  The weak 2008-2012 average of -2.0% for capital productivity reflects growth in capital inputs with no change in output.  Expenditure-based GDP data tells us business investment has been relatively strong over the last couple of years, but increased investment does not always coincide with higher economic output.  In that case we would expect higher investment to be reflected as spare capacity in the capacity utilisation measures.  Assuming firms have made the right investment decisions spare capacity will allow the economy to expand without generating inflation as demand grows.

Longer-term, New Zealand has a problem with the quality (rather than necessarily the quantity) of investment.  That largely relates to strong (non-productive) investment in residential construction.

The 2012 labour productivity result is stronger than the average of 0.6% for the period 2008-2012, but lower than the longer run average of around 1.5%.


Historically we have tended to meet the higher resourcing demands of strong periods of economic growth through greater utilisation of labour (i.e. employing more people) rather than raising the productivity of the existing workforce or through capital deepening (a higher capital-to-labour ratio).  That has tended to lead to skills shortages and over-full employment.  In the last cycle the unemployment rate fell to a low of 3.5% in late 2007. On the surface that’s a great outcome, but at that level of unemployment we witnessed chronic shortages of both skilled and unskilled workers, wages pressures that led to rising inflationary pressures and ultimately tighter monetary conditions.

In economic upswings the Reserve Bank often cops flak for wanting to pull the handbrake on before economic growth really gets going.  It’s not the absolute level of economic growth that’s important for the Reserve Bank, but rather how fast the economy is growing relative to its potential to grow.   If growth runs ahead of its potential, spare capacity is exhausted and we get inflation.  In its latest set of forecasts the Reserve Bank estimates potential GDP to average around 2% per annum over the next few years.  I think that’s probably about right.

That’s why I often say in regard to achieving higher sustainable growth that too much is expected of central banks.  Achieving a higher level of potential growth is not in the central bank’s sphere of influence, other than keeping inflation expectations well anchored.  Post the Global Financial Crisis many developed economies are suffering lower potential GDP.  As I’ve said before, while central banks have done a great job of supporting demand and avoiding deflation, achieving both higher growth and potential growth requires a far broader policy response.

How productive we are is a determinant of potential GDP.  Higher potential GDP means the economy is able to grow at a faster rate without generating inflationary pressures.  Sounds like a relatively simple concept, but a lot is needed from a number of different players to make it happen.

One of my perennial frustrations is the expectation for achieving higher productivity often falls on the Government (and I'm not even a politician!).  Government, firms and individual members of the workforce all have a role to play.  The role of individuals is to invest in their knowledge and skills.  The role of firms is to invest wisely (including in the skills of their staff), be hungry for knowledge and improvement in production processes and to be open to innovation.

In that respect yesterday’s release by Statistics New Zealand of the 2012 Research and Development survey is welcome news.  Total R&D expenditure in 2012 is up 9% from 2012.  While Government R&D fell over the period, greater Government funding for R&D is at least partly responsible for the 25% increase in private sector R&D over the period.  But remember the “R” is only as important as the “D” that follows.

The Government’s role in achieving higher productivity is largely environmental.  Theirs is essentially an enabling role; enabling access to capital, best practice knowledge sharing, ensuring an appropriate level of IP protection, the tax environment and facilitating access to new markets.

But above all, firms and individuals have to want to be more productive and must be prepared to make the investment and take the risks to achieve it.  I know productivity sounds boring, but it is the only pathway to higher economic growth, higher profits and wealth creation and a greater quality of life.  Here endeth my annual productivity sermon.

Monday, March 25, 2013

A deal in Cyprus

A bailout deal has been agreed in Cyprus.  The deal involves the closure of the country’s second largest bank (Laiki Bank) and losses of up to 40% on deposits over 100,000 at the largest bank (Bank of Cyprus).  Depositors with funds under 100,000 will be protected from losses.  The Bank of Cyprus will receive the smaller deposits of Laiki Bank.  The Bank of Cyprus will also receive €9.0 billion in Emergency Liquidity Assistance from the European Central Bank that had previously been made available to Laiki Bank.

This will be sufficient for Cyprus to access the €10.0 billion bailout package from the troika of the European Commission, the International Monetary Fund and the European Central Bank.  Importantly, the terms of the deal mean that the Cypriot debt to GDP ratio should be held at under the 150% of GDP level indicated in the initial proposal.  How much that forecast has been altered by the events of the last week or what the underlying assumptions are for the Cypriot economy remains to be seen.

Markets have been remarkably sanguine during these negotiations.  On the one hand I get that.  Cyprus is 0.25% of Euro zone GDP, the deposit base of the banking sectors is 800% of GDP, more than twice the ratio for the average of the Euro zone.  Thirty per cent of deposits are from off-shore, mostly Russia.  It was only fair and reasonable therefore that foreign depositors wore some of the pain.  Cyprus is a special case, right?

My other hand worries that a new precedent has been set.  I worry that future runs on banks may eventuate in other Euro zone countries unless the authorities (the troika) get better at dealing with insolvency issues in a far more timely and co-ordinated fashion.

I get the sense that something has changed here, or at least exposed an inconsistency.  The Bankia arrangement in Spain was meant to lead to the end of the negative feedback loops between bank insolvency and sovereign debt.  Yet this week we have the German Finance Minister stating that deposit insurance is only as good as the sovereign backing the insurance.  I also worry about reports of a growing rift between the IMF and the European Commission.

Cyprus has been a timely reminder that Europe is not fixed yet and there is considerable work still ahead.  There is still considerable divergence in opinion about how to deal with issues as they arise, particularly issues of insolvency and who pays.

At least in the near-term we can move on from worrying about a Cyprus Euro zone exit and go back to worrying about that other recent timely reminder of the challenges that still lie ahead: politics in Italy. 

Friday, March 22, 2013

Cyprus Update

The European Central Bank has given Cyprus until Monday to come up with a revised bailout plan.  Earlier this week the Cypriot parliament rejected the original plan which required bank deposits to bear some of the cost of the program.

The government is now left with the challenging task of finding an alternative source of €5.8 billion in order to access the €10 billion from the troika of the European Commission, the ECB and the International  Monetary Fund. 

A new plan appears to be for a reduced levy of 5% on deposits of over €100,000 (previously 9.9%), no levy on deposits below that level (previously 6.75%).  A range of other measures would need to be adopted to meet the shortfall including tapping the reserves of state pension funds,  or possibly a further increase in the corporate tax rate beyond the proposed 12.5%.

Whatever plan the Government comes up with will need the endorsement of the troika.  The ECBs ultimatum means that failure to get that agreement quickly will see the emergency liquidity measures to the Cypriot banks withdrawn, leading to their insolvency and a far greater loss for deposit holders.

I think some arrangement will be found.  Russia , the source of a significant proportion of foreign deposits in the banks, could still yet play a greater role beyond the restructuring of interest payments on an existing loan to Cyprus.

Markets are understandably watching developments closely. Despite its small size (less than 0.25% of Euro zone GDP), the good folk who came up with this plan for Cyprus are the same folk that are in charge of previous and possibly future plans for euro zone countries in trouble.

I accept the argument that Cyprus is a special case and that bank deposit holders should share some of the burden of the bailout.  The Cypriot banking sector is around twice the size of other EU in relation to GDP, with around a third of those deposits coming from off-shore.  However,  contagion fears and market pricing of those fears comes back to the extent to which markets also accept the argument.

Thursday, March 21, 2013

NZ GDP stronger than expected...last year

December 2012 quarter GDP was significantly stronger than expected.  Production-based GDP rose +1.5% over the quarter for annual growth of 3.0% (annual average 2.5%).  I was expecting +0.8% for the quarter.  The expenditure based measure printed at 1.4% (my forecast 1.0%).


The strength was broad based. On a sector basis, agriculture and retail trade chimed in with the largest contribution.  Only manufacturing made a negative contribution.  On an expenditure basis consumption and net exports (exports rose, imports fell) made the strongest contributions, while government and inventories made negative contributions.

Just as we warn sometimes not to read too much into downside surprises, the same goes for upside surprises.  It’s important to keep this result in context; it follows two quarters (June and September last year) in which growth was disappointingly soft.  Neither does it change our forecasts going forward.  The tailwinds (construction and stimulatory monetary conditions) and the headwinds (fiscal drag, high New Zealand dollar, drought) remain the same.

The most you can say about this result in terms of the outlook is that we go into 2013 with a higher-than-expected base.  I’m still comfortable with my forecast of 2.6% annual growth for 2013, having already knocked that back by 0.4% with the risk of more given the drought conditions.  Risks therefore remain evenly balanced. 

With respect to monetary policy, I don’t see any significant implications from this result. Sure it’s higher than the Reserve Bank was expecting, but they also hadn’t factored much downside into their latest set of projections for the drought.  They have a bias to tighten, which is appropriate.  As it has been for some time, the only question is when the right time is to start the tightening cycle.  I’m still happy with my call of late this year.

Monday, March 18, 2013

EU Summit and the Cyprus bailout

I like the tone of the latest European Union Summit Communiqué.  Regular readers will know I have often criticised the approach of harsh front-loaded austerity as the ultimate solution to all that ails the Euro zone.  In taking such approach, the balance between growth and austerity has been lost.  While achieving fiscal balance was always going to be a part of the answer, the long-term solution to securing a pathway to lower debt to GDP ratios is higher economic growth.
 
To that end I was pleasantly surprised to see the following paragraph: 

“There should be an appropriate mix of expenditure and revenue measures at the level of the Member States, including short-term targeted measures to boost growth and support job-creation, particularly for the young, and prioritising growth-friendly investment.  In this connection, the European Council recalls that while fully respecting the Stability and Growth Pact (SGP) the possibilities offered by the EU’s existing fiscal framework to balance productive public investment needs with fiscal discipline objectives can be exploited in the preventive arm of the SGP.”

That’s the best paragraph I’ve ever read in an EU Summit Communiqué.  What it tells us is the authorities will be prepared to take a more flexible approach towards setting deficit reduction targets.  That means a better trade-off between austerity and growth.  It therefore paves the way for greater flexibility towards countries that would benefit from less extreme front-loaded austerity.

This has been made possible by the hard work that has already been done at the systemic Eurogroup level but also at the individual member country level where austerity has taken a huge toll on output and jobs.  In particular it has been made possible by the ECB stepping up as lender of last result which has been a key catalyst in reducing financial tensions and Euro zone tail risks.  Once again, while none of this has solved the Euro zone problem, it has provided the politicians with a window of opportunity to get on with the important job of structural economic reform.

The Summit Communiqué has been overshadowed somewhat by the Cyprus bailout which was also agreed over the weekend.  The total package is 10 billion, less than the 17 billion initially requested.  While the initial request was not large in terms of the amount, it was significant in terms of the size of the Cypriot economy.  A 17 billion bailout would be just under 100% of GDP.  That would have taken the debt to GDP ratio to around 185% of GDP, worse than the ratio in Greece and clearly unsustainable. The bailout will take the Cypriot debt to GDP ratio to 145% of GDP.

While Cyprus did not represent a systemic risk, whatever solution was found could be determined as precedent setting.  The Eurogroup was clearly not willing to back-track on previous commitments.  For example a Greek-style PSI was not an option give they had already anointed that particular solution in Greece a “one-off”.  The question then was how the cost of the bailout could be reduced.

The expectation prior to the Summit was that bank deposit-holders would shoulder some share of the burden.  That fact that all deposit-holders are to “participate” was a surprise.  Depositors of local banks will pay an upfront levy of 9.9% on deposits of over 100,000.  The surprise was the inclusion of deposit holders under 100,000, who will pay a levy of 6.75%.  In addition, the Cyprus government will adopt fiscal tightening measures of 4.5% of GDP and embark on a privatisation program. Some taxes will also rise (corporate tax and withholding tax on capital gains).

The key question is that in not breaching previous commitments, to what extent has the terms of this bailout set new precedents.   The surprise was the inclusion of deposit holders under the EU’s deposit insurance benchmark of 100,000.  That raises the spectre of a similar approach being taken in other countries, regardless of assurances that Cyprus was an isolated case.  While such confusion is not an issue right now, it could become so in the future of bank bailouts appears again necessary elsewhere.

Thursday, March 14, 2013

RBNZ more dovish...or is it?

After a December Monetary Policy Statement (MPS) that was widely perceived to be more hawkish than expected, the March MPS is being interpreted as dovish.  However, I wonder if it is quite as dovish as it looks.

The MPS noted the positives of the receding risks around the global outlook, financial sentiment has improved, the Canterbury rebuild is gaining momentum and residential investment, business and consumer confidence are increasing.  On the downside, the labour market is weak, the overvalued dollar is undermining profitability in export and import competing industries, the drought is creating difficulties and ongoing fiscal consolidation will also act to slow overall demand.  Yep – we agree with all of that. 

The question is what that means for monetary policy?  The fact the Reserve Bank believes there are upside and downside risks to the outlook means it’s a balanced outlook.  I try to do the same thing.  Even with a balanced assessment, the interest rate projections indicate the Bank believes the next move in interest rates is up.

The key factor causing the Bank consternation is the high level of the exchange rate.  The Trade Weighted Exchange Rate Index (TWI) has appreciation by around 4% beyond the level assumed in the December MPS, largely due to the recent weakening in the Japanese Yen and the British Pound.  As a result, the Bank’s inflation forecasts are lower than the previous forecasts, despite a growth outlook that is largely unchanged.

I believe the Bank is right to retain a tightening bias.  I agree with them when they say:

 “An elevated dollar will continue to dampen tradeable inflation.  As a result, annual inflation is expected to remain around the lower part of the band over the coming year.  Further ahead, resource pressures are expected to accumulate, in response to a rise in investment spending, strength in the housing market and low interest rates.  As a result, domestic inflationary pressures will begin to build.”

The Bank must keep a medium term focus and not become too pre-occupied with near-term factors.  Again from today’s MPS:

“During previous periods when inflation temporarily rose above the target band, the Bank did not attempt to rapidly reduce pricing pressures.  Analogously, we are mindful that, because of policy lags, efforts to offset the current weakness in inflation may have an only limited impact on near-term conditions.  Furthermore, such efforts could exacerbate medium-term inflationary pressures.” 

For those very reasons I believe the chances of an interest rate cut remain low.  A cut now would simply exacerbate inflation problems further down the track, leading to the risk of even higher interest and exchange rates. 

While it appears macro-prudential tools are firmly on the agenda, we continue to believe such tools are more about financial stability than price stability.  Essentially that means the introduction of such tools will have limited impact on the appropriate level of interest rates: our interest rate forecasts remain the same regardless of whether we see such tool employed or not.

I still see a first hike in the OCR in December this year with a peak at around 4.5% which continues to be our estimate of the “new normal” neutral rate.  Fiscal drag should be sufficient to offset any need for rates to remove beyond neutral.  However, that continues to assume the Bank is sufficiently pre-emptive in removing the current high level of monetary accommodation.  The risks are just about when they start to tighten.

Tuesday, March 12, 2013

China activity data softer than expected

China activity data for January-February period was generally softer than expected.  Fixed asset investment and exports were the bright spots however retail sales and industrial production were disappointing.  Inflation spiked higher in February reflecting the Chinese New Year.  We expect it to reduce in the year to March, but we continue to believe that inflation has passed the low point in the cycle and will trend higher over the course of the year.  Recent actions to contain the residential property market will delay a more generalised tightening in conditions (e.g. higher interest rates) until next year.

Exports grew 21.8% in the year to February.  That data can be somewhat volatile so we tend to pay more attention to the 3-month moving average – even then exports are posting 19.8% growth.  Fixed asset investment was also strong, recording an annual increase of 21.2%.  That growth (especially in the residential property market) was supported by healthy liquidity and credit availability at the start of the year.

Retail sales and industrial production were more subdued.  Nominal sales growth slipped to 12.3% in February from 15.2% in December.  Growth in industrial production came off as well, dropping to 9.9% in February from 10.3% in December.  While that’s a disappointing drop it’s not too far removed from the December quarter average growth rate of 10%.

Money and credit growth both slowed from the high levels reached in January.  Growth in M2 slowed to 15.2% in February, down from 15.9% in January.  However, that’s still well in excess of the new 2013 target growth rate of 13%.  Liquidity condition area still relatively loose, although the PBoC started to mop up some excess liquidity via open market operations in February.  New lending fell from RMB 1.07 trillion in January to RMB 620 billion which was lower than the market was expecting.

The on balance weaker-than-expected February data hasn’t changed our view of a continued modest rebound in GDP growth over the course of the year, but it adds emphasis to the “modest”.  Our forward activity indicator is still pointing to annual growth of around 8.5% later this year, although we are unlikely to see much change in the annual growth rate from December 2012 (7.9%) to March 2013 (our forecast 8.0%).


The authorities will continue to keep a close eye on inflation, especially in light of the new 3.5% target for 2013.  As expected the annual inflation rate spiked higher in February to 3.2% as a result of the Chinese New Year holiday.  We expect it to normalise in March (back towards 2%), but we continue to believe that inflation in China has passed the low point in the cycle and will trend higher this year.

In terms of monetary policy the expected path of inflation this year means the PBoC will gradually shift from its easing bias to a more neutral stance.  We think actions taken already to contain the recovery in the housing market will delay a broader tightening in conditions until 2014.  The risk to that view is that inflation heads higher more quickly than we currently anticipate.    

Monday, March 11, 2013

NZ GDP growth, the drought and the RBNZ

As drought continues to grip a large part of the country, I have shaved a bit off my GDP growth in the March and June quarters of this year.  That reflects a number of factors including reduced milk production and food processing as well as lower value-add in electricity generation.  I’m now expecting 0.6% growth in the March 2013 quarter (previously 0.7%) and 0.5% in the June quarter (0.7%). 


Lower milk production in this latter part of the season follows a strong first half of the season.  Indeed full-year production could still come in just ahead of last year.  That’s no consolation to farmers though whose profitability will be hit by the combination of drought and the persistently firm exchange rate, although rising international dairy prices may assist to some degree.  Dairy prices were up 10% at the most recent auction last week.  Longer term the impact of lower stock levels as farmers reduce stock numbers will be felt through lower production. 

The Reserve Bank may not have yet factored the drought into the GDP forecasts they will release with their March Monetary Policy Statement this week, but I expect they will at least highlight it as a risk.  More generally recent activity data has probably surprised to the upside.  Also, the Bank will likely boost their estimate of growth in the last quarter of 2012 upwards from their initial estimate of +0.4% q/q to something closer to our +0.8%.  That data is released next week with the late surge expected to result in annual growth of 2.2% for calendar 2012.  My forecast for calendar 2013 is 2.6%.

Other factors the Bank will be digesting are the continued strength in the exchange rate (the Trade Weighted Exchange Rate Index has appreciated around 4% since their last set of projections), the continued gradual improvement in global economic conditions, the lower starting point for its inflation projections (the December quarter CPI was lower than expected), the weak labour market and continued signs of strength in the residential housing market.

Collectively those factors are expected to add up to “no change” in monetary conditions this week and likely little change to the Bank’s forward interest rate projections indicating a tightening in conditions from early 2014.  That will be based on a cyclical strengthening in economic growth over the course of the year reflecting a strong rebound in construction activity. Given my predilection to believe there is less spare capacity in the economy, I’ve still got the first tightening pencilled in for December. 

Sunday, March 10, 2013

Good US jobs growth in February

US February payrolls data continued the run of good data out of the US recently.  If nothing else it helps explain how retail spending has been able to hold up well at the start of the year in the face of tax increases.  It also gives credibility to the anecdotal evidence that firms held off hiring at the end of last year as the fiscal cliff loomed. 
The 236k increase in payrolls in the month beat market expectations.  Job gains came across a wide range of industries.  Most notably the construction sector added 48,000 jobs over the month, lending credibility to other data indicating the housing market has turned the corner.

It’s too early to take this result as a sign of the start of a stronger upward trend in jobs growth.  There are still a number of headwinds, not the least of which is the hard reality that some of the automatic spending cuts that took effect at the start of this month will be met with job cuts.  However, this result provides a ray of hope that those job cuts will be happening at the same time as we are seeing an underlying improvement in the jobs market.
The unemployment rate fell from 7.9% to 7.7% over the month, another nudge closer to the Fed’s “target” of 6.5%.  That drop was accentuated with yet another decline in the participation rate to 63.5%.   That suggests the improvement in the labour market (and the economy generally) is still not enticing people to remain in, or return to, the labour market.  My view that the unemployment rate doesn’t get to the Feds target anytime soon is based on the assumption the participation rate will soon start to rise.  We’ll see.
The rise in payrolls combined with a small rise in the average work week led to an increase in total hours worked of 0.5% in February.  Add that to the 0.2% increase in hourly earnings and you get a not insignificant gain in wage and salary income over the month. 
But remember, personal incomes took a significant hit in January as a result of the fiscal cliff tax agreement.  That has still yet to show through in the consumer spending numbers.  The lower disposable incomes will inevitably have a dampening effect on consumption growth in the first half of the year.  We expect to see a stronger finish to the consumption year as that component of fiscal drag disipates.

Friday, March 8, 2013

China’s official 2013 policy targets

The members of China’s National People’s Congress (NPC) met this week.  The primary purpose of the Congress is to formalise the senior political appointments that were decided on at the Communist Party Congress in November last year.  Of more than passing interest to economists is the one of the other purposes of the NPC: the setting of the official policy targets for 2013.

The NPC retained the previous GDP target of 7.5%, but lowered the targets for the CPI and growth in the money supply.  The CPI target was lowered from 4.0% to 3.5% and the money supply (M2) growth target was lowered from 14% to 13%.  The fiscal target was set at a deficit of 2%.

We believe the 7.5% growth target will be met. While we think the cyclical upturn that began in the December quarter of last year will remain modest, we have recent revised our GDP growth forecast for calendar 2013 to 8.2%.  In that respect, 7.5% should be easier to achieve in 2013 than it was in 2012 when growth spent the first three quarters of the year on a downward trajectory.  

The fiscal target of a deficit of 2% of GDP for 2013 will likely be mildly expansionary.  The deficit for 2012 was 1.6% of GDP which was an increase from 1.1% of GDP in 2011.  While higher growth this year will result in higher revenues, expenditure will also be higher.  We expect new spending to be concentrated predominantly in social areas.

The most interesting aspect of the announcement was the reduced inflation and M2 targets.  Given that both CPI inflation and money supply growth are passed their respective cyclical lows, the reduced targets confirm a shift from a “bias to ease” to a “neutral” monetary policy stance.  However, we don’t expect a tightening in broad monetary conditions (interest rates hikes) this year – I still think that’s a 2014 story, but the risks have shifted to an earlier move.

Tempering the concern of an earlier hike in interest rates is the recent moves by authorities to contain the nascent recovery in the housing market.  The key word in that sentence is “contain”.  I don’t think authorities are looking to achieve anything more than avoiding another housing market bubble. I also think there is more at play here than just concern about inflation; the politics of housing affordability can’t be ignored.

At this point I’m still comfortable with my forecast of 8.2% growth this year, but much will hinge on the path of inflation over the next few months.  More generally I’m very comfortable with a lower inflation target.  One of the risks we highlighted for emerging markets in the period immediately after the GFC was the possibility they didn’t take inflation risks and costs seriously.  It seems to me the new China targets support the focus on the quality rather than the quantity of economic growth.

Tuesday, March 5, 2013

US sequester

Automatic spending cuts amounting to $85 billion kicked in on March 1st in the US, but that doesn’t change our view of around 2.0% GDP growth in 2013.

The spending cuts represent about 0.5% of GDP.  I had already factored in half that amount in my estimates of US fiscal drag this year, which is now just short of 2.0% in total. 

Tempering my concern about the extra cuts is the fact that a significant amount has already hit GDP growth.  Lower defence spending was a key contributor to lower than expect fourth quarter GDP growth last year.  (I must say it was nice to see the first revision of that result turn that small negative into a positive, keeping the story alive that the US has grown in every quarter since the GFC recession, despite numerous predictions of double dips.)

In fact the first quarter of 2013 is shaping up quite nicely GDP-wise.  The other fact that hit GDP growth late last year was the significant reduction in inventory investment in the face of fiscal uncertainty, particularly the looming tax increases.  With the worst of the tax increases avoided, inventory investment is picking up again.  That view is supported by latest ISM manufacturing data showing the new orders index at 57.8.  I think that result reflects post-cliff restocking rather than a more fundamental shift to a higher level of growth.  Weather volatility will also assist first quarter growth, which looks likely at this point to come in at around a 2.5% annual pace.

Underlying that relatively good quarter will be the fiscal drag effect of higher taxes on consumers which I expect will remain a constraining factor out to mid-year.  I put second quarter growth at around a 1.5% annual pace.

The back half of the year looks stronger as the tax increase impact fades and the emerging tailwinds of an improving housing market, stronger exports on the back of stronger global growth and the end of budget cuts at the State and local Government level all conspire to generate a modest acceleration in growth.  So despite the full force of the sequester coming to bear, I’m still comfortable with my forecast of annual average GDP growth of 2.0% in 2013 (2.3% q4/q4).

That level of growth will be sufficient to see continued modest gains in employment and a continued drift lower in the unemployment rate.  However, we don’t expect the Fed’s 6.5% unemployment rate “target” to be achieved any time soon, at least not this year.  Of course the unknown in that regard is the participation rate which I expect will head higher again as general economic conditions continue to improve.  A rising participation rate will limit declines in the unemployment rate. 

Assuming inflation expectations remain well-behaved, that should see quantitative easing continuing on into 2014, although the first step for the Fed will be a reduction in the quantum of monthly asset purchases which could come later this year.  Fed Chairman Ben Bernanke testified at Congress this last week and allayed fears of a premature end to QE.  While it’s entirely appropriate and healthy for the FOMC to debate the cost/benefit trade-off, Bernanke and his Vice-Chair (and possible successor) Janet Yellen both believe the benefits continue to outweigh the costs.

Monday, March 4, 2013

India growth disappoints, Budget could have done more

India's GDP growth slowed further than expected in the year to December, falling to 4.5% from 5.3% in September.  The good news is that lower than expected inflation in January means there is a bit more room for the Reserve Bank of India to cut interest rates.  The bad news is the 2013 Budget failed to further address India's structural problems.

The disappointing growth rate for the year to December will make it difficult for the Government to meet its forecast growth rate for the 2012/13 (year to March 2013) of 5%.  The weakness was across all broad sectors of the economy.  Net exports remained weak on the back of soft exports, but still high imports fuelled by still high imports of oil and gold.


Inflationary pressures eased somewhat in January with the Wholesale Price Index (WPI) falling to 6.62%, down from 7.18% in December.  The CPI remained elevated at 10.79%, however policymakers continue to focus on the WPI in India.

The Reserve Bank of India (RBI) last cut the policy repo rate by 0.25% in January.  That followed a long 9-month stand-off between the government and the central bank over the need for broader policy changes (particularly lower government spending and reform in the goods market).   The rate reduction was on the back of some moderation in inflationary pressures but was also partly reward for positive moves from the Government late last year to open up the retail and aviation sectors and ease caps on capital inflows.

The lower inflation number in January provides scope for further rate cuts.  However, the RBI has stated that scope for further interest rate reductions remains limited.  I think they will cut rates by another 50 bps.

The RBI's view on its room to move won't have changed with the release of the Government's 2013 Budget last week.  The Budget left deficit projections for the current and next financial year largely unchanged at 5.2% in FY 2012/13 (previously 5.3%) and 4.8% in 2013/14 (unchanged).

But rather than reducing unsustainable subsidy expenditure, the Government increased subsidies from 1.82 trillion rupees in 2012/13 to 2.4 trillion rupees in 2013/14.  That will be funded by a 1-year 10% surcharge on higher income citizens along with higher import duties on some luxury items.  That's not my definition of structural budget reform.

The Government also announced higher spending in education and health and an increase in capital spending.  It's hard to argue about investment in those areas, but he quality of the outputs remains to be seen.  And it would have been preferable for increased expenditure in those areas to be funded by lower spending on subsidies.

In terms of GDP growth, the Government's forecast for FY 2012/13 remains at 5.0% with an increase to between 6.1% and 6.7% expected in FY 2013/14.  My forecasts are 4.8% and 5.8% respectively.

The Government's growth forecasts are still well shy of their stated aspiration of 8.0% growth.  India saw growth rates in excess of that level following the GFC, but with that high growth came sharply higher inflation, indicating that growth of that level was well in excess of potential. 

If the Government wants to achieve sustainable 8% growth, they need to get serious about measures to enhance productivity and improve their budget fundamentals.  In that respect Budget 2013 was a lost opportunity.