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Friday, January 17, 2003

Germany in 'Make or Break' Tussle

Or at least that's how Wolfgang Clement the country's economics and employment minister sees it. In an interview with the Financial Times, he said 2003 must be a reform year for Germany. "It will also be decisive in determining the competency and strength of this government. It is a decisive year in all aspects." His declaration came as new data show that the German economy grew by only 0.2 per cent last year, its worst performance since 1993, sparking concern over growth prospects this year for Germany and its Euro zone partners.

"We are certainly going through a difficult phase, no question," Mr Clement said. "No one can accept a situation with 0.2 per cent growth and such high unemployment, myself included." Seasonally adjusted unemployment reached a four-year high last month of 4.2m.Mr Clement's comments came as Josef Ackermann, chairman of Deutsche Bank, last night attacked German reluctance to embrace reforms, insisting the country was "a prisoner of its status quo".

Pitching into the reform debate for the first time, Mr Ackermann said many people did not seem to appreciate "how serious the country's problems really were" and appeared to be trapped by existing social structures.He said Germany had long ceased to be the land of the Wirtschaftswunder, or economic miracle. Now commentators increasingly saw it as another Japan, trapped in a vicious spiral of slow growth and falling prices.Mr Clement said the European Union needed an "American approach" to setting interest rates, arguing that the rates set by the European Central Bank should be lowered to US levels.The ECB's policy of maintaining high interest rates was one explanation for Germany's economic problems, Mr Clement said. "From a German viewpoint, we need an interest rate policy similar to the American approach. That means sharp interest rate cuts."
Source: Financial Times

So does this mean the pressure on Euro zone rates is now really going to be on. And what if Germany needs to head for the zero-bound, where will this leave the inflation riddled Mediterannean trio - Spain, Greece and Portugal - flying upwards out of the window perhaps (as I often comment the Spanish expression 'saliendo disparados' says it all). No idle question this in a week that sees Gustav Horn, Head of Macro Analysis at Germanys leading economic research institute thinking the unthinkable and asking the 'D' question, Germany on the road to deflation?

The outlook for the German economy is bleak. Given the still moderate pace of global economic activity, the deep crisis of confidence on capital markets and a hesitant monetary policy in the euro area, there is not much leeway for a production expansion all over Europe. In addition to that, recently published intentions of the German coalition government point to a marked reduction in public expenditure accompanied by a significant increase in taxes and social security contributions. Consequently, fiscal policy will be very restrictive next year. Against this backdrop, the German economy will almost stagnate towards the end of next year, again falling behind the rest of the euro area.

A matter of great concern is the development of prices. Already the German inflation rate is one of the lowest in the euro area, and accordingly real interest rates are higher than in the rest of the euro area, hampering a recovery. In such a low growth environment prices will be under heavy pressure. In the course of this process the German development is beginning to resemble the Japanese one at the beginning of the 1990s more and more. The Japanese deflation also started with a crash on stock markets, a lack of confidence and reduced wages in line with the cutting of bonus payments. For some years this just led to low inflation rates until price development turned negative during the mid nineties.

The general advice in such a situation is that monetary policy should reduce interest rates swiftly to prevent the unfolding of a deflationary process right from the beginning. However, in a monetary union such a course is only appropriate if the union in aggregate is negatively affected. At some later stage this will doubtless be the case. But a swift loosening may not be possible as long as inflationary tendencies in other countries are close to the stability target. In that case only fiscal policy could deliver immediate help. But the German government has blocked this road by planning to observe self-imposed deficit targets. Therefore there is a danger that the German policy mix may lead to a prolonged phase of stagnation, and this could easily prove to be the beginning of the dead end road to deflation.
Source: DIW Berlin, Economic Outlook

US Inflation: On the Slippery Slope Down

US consumer prices barely budged in December ending a year in which costs other than energy rose by the smallest amount since 1964. Thursday's report on the Consumer Price Index merely confirmed what Alan Greenspan and many other economists have now been saying for some time: inflation isn't a problem for the American economy. In fact given the uneven nature of the economic recovery many companies have limited power to raise prices even if they wanted to. Consumer prices rose a mere 0.1 percent in December from the previous month, marking the same rate for a second month, the Labor Department reported. December's showing was a lower reading on inflation than the 0.2 percent rise many economists were forecasting. For 2002 as a whole, consumer prices rose by 2.4 percent, up from the 1.6 percent increase in 2001. Most of that pickup came from rising energy costs, including petrol, which moved higher on tensions in the Middle East and worries about supply disruptions if the United States went to war with Iraq. Excluding energy prices, consumer prices went up by just 1.8 percent in 2002. That was the smallest increase since a 1.3 percent rise in 1964, and down from a 2.8 percent increase in 2001. Here there is news to some all tastes. What some would call 'tame', others (including yours truly see as frankly preoccupying, especially when there's a 15% drop in dollar value to remember. Down deflations slipperly slope we go, and remember to watch the output gap on the way.

The generally tame inflation climate in 2002 offered some shoppers — especially those buying cars, clothes, computers and airline tickets — some good deals because prices fell for those items. But people paying energy, medical and education expenses, including tuition and books, took a hit in the wallet as those prices rose sharply. Energy prices, which can fluctuate wildly from year to year, rose by 10.7 percent in 2002, a turnaround from the 13 percent drop registered in 2001.

In the CPI report, food prices went up by 1.5 percent in 2002, the smallest increase since 1997, and down from a 2.8 percent advance in 2001. New car and truck prices fell by 2 percent last year, the biggest drop since 1971, as companies offered heavy discounting, free-financing deals and other incentives to lure buyers. Clothing prices declined 1.8 percent as retailers discounted merchandise to attract shoppers. Airline fares dropped 2.4 percent last year as companies sought to motivate would-be flyers. Computer prices plunged 22.1 percent in 2002 as the high-tech industry, hard hit by the 2001 recession, tried to get back on its feet. While the prices many goods were well-behaved last year, it was a different story for some prices in the service sector of the economy. Prices for medical care went up 5 percent in 2002, the biggest increase since 1993. Education costs, including tuition and supplies, rose 6.6 percent last year — more than two and half times the rise in overall inflation. "We do have a dichotomy. It's like a tale of two inflations," said Stuart Hoffman, chief economist at PNC Financial Services Group. "For goods, there is zilch inflation. But for services there is some. But the overall message is that inflation is still very tame."
Source: Yahoo News

Japanese Banks Get Nervous about their Capital Adequacy Ratios

The plan announced Wednesday by Sumitomo Mitsui Financial Group to issue 150 billion yen worth of convertible preferred shares to Goldman Sachs is expected to lead to similar moves by other Japanese banks seeking to raise capital before the fiscal year ends March 31. According to Japanese sources, banking groups including Mizuho Holdings, UFJ Holdings and Resona Holdings are all considering jumping on the capital-raising bandwagon, with their plans to raise capital expected to be announced as early as the end of this month. The Goldman Sachs deal, widely interpreted in European and American news media as an indication of renewed confidence in the Japanese banking sector seems to have more to do with paying an increased risk premium to secure a cash injection and avoid government control. With banks, and many of their non-performing loans being back by goverment guarantees Goldman Sachs in fact seem to be risking little.

As SMFG President Yoshifumi Nishikawa explained during Wednesday's press conference, the current harsh domestic business environment prompted the group to "rely not on (our) clients, but to improve our capital base independently," with help from a major U.S. investment bank. The sluggish domestic stock market was a major factor in SMFG's decision not to issue shares to Mitsui and Sumitomo group companies as well as to other clients, the sources said.

SMFG will pay Goldman Sachs an annual 4.5 percent cash dividend on its preferred shares, more than triple the dividend the group pays to the government for the preferred shares it received in return for an injection of public funds in 1999. Although Nishikawa defended the large dividend payment promised Goldman Sachs as the result of "changes in the market environment," claiming the amount was "adequate given current conditions" as compared with 1999, analysts said the decision reflected Japanese banks' weakness in both financial management and credibility. UBS Warburg analyst Katsuhito Sasajima said, "(SMFG) must have decided to resort to all possible means to avoid another injection of public funds."
Source: Daily Yomiuri

Ageing Society: Time to Recognise the Consequences

Many western economists still stubbornly fail to recognise that the move to the "ageing society" marks a sea change for our economic systems, with important deflationary consequences. This latest round of debate in Japan over the consumption tax and social security subsidies should serve as a timely reminder to all of us of what is waiting, just round the corner.

Debate over a hike in the consumption tax rate is heating up in the government, ruling coalition parties and business sector as the nation's low birthrate and rapidly graying society are expected to make an increase in the tax rate inevitable to cover the rising cost of the social security system. The government's Tax Commission will begin discussing on Friday what form mid- and long-term tax systems should take, but as the government, ruling coalitionparties and business sector hold differing views on the issue, a conclusion is unlikely to be reached soon. Concerns over a consumption tax hike have mounted since the government spelled out pension system reforms that included raising the portion of basic pension covered by public funding from the current one-third to half. The government must compile a reform plan, including measures to secure financial resources, this year. Consumption tax, therefore, is being considered as a source of revenue. With tax revenues accounting for only about 60 percent of annual revenues, the government has been mired in a financial deficit. To raise funds to cover increasing social security costs, the government will have to rely on the consumption tax, the burden of which is spread widely and thinly over the public.
Source: Daily Ymiuri

Japan Government Borrowing Set to Soar

Japanese public finances sit uncomfortably somewhere between a rock and a very hard place indeed. This is brought home again this week by the disclosure that the Council on Economic and Fiscal Policy in its final draft of the revised Structural Reform and Medium-Term Economic and Fiscal Prospectus, prepared by the Cabinet Office, estimates that bond issuance will climb to as much as 40.2 trillion yen in fiscal 2004. This will then be followed by an issuance of 41 trillion yen in fiscal 2005, 40.3 trillion yen in fiscal 2006 and 40.8 trillion yen in fiscal 2007.

The document, to be submitted to the council Monday before being sent to the Cabinet for approval, includes two fiscal policy scenarios: one in which state coverage of the national pension costs remains at its current one-third, and another in which the government burden is increased to 50 percent. In the latter scenario, the consumption tax is increased to 6 percent from 5 percent. Even then, the additional tax revenue would not reduce the national debt, as it would be used solely to slash the growing burden of the aging society on the social security system.Though the revised version stays faithful to the original pledge to erase red ink from the primary balance by the early 2010s, it projects a slowing down of the decrease in the budget deficit as a proportion of gross domestic product.
Source: Asahi Shimbun

It is this increase in the government tax support for the pension system from one third to one half which is provoking all the fuss about the projected rise in consumer tax which would be the knock-on effect (see Richard Katz artice HERE, since a new medium-term policy plan drawn up by the Cabinet Office includes fiscal projections that assume a consumption tax hike from 5 percent to 6 percent in October 2004. Obviously any such tax increases would make it even more difficult to escape the grip of deflation.

Some policy watchers are taking the estimates as a tacit acknowledgment by the government that a hike is inevitable. The calculations were included by Cabinet Office officials in a revised draft of the Structural Reform and Medium-Term Economic and Fiscal Prospects, considered an outline for the government's policy on midterm economic management.The document will be submitted Monday to the Council on Economic and Fiscal Policy, a key advisory panel headed by Prime Minister Junichiro Koizumi. It is expected to be approved at a Cabinet meeting this month.......... Some officials say the government has no choice except a hike if it ends up expanding state coverage of basic pensions from one-third to one-half, as planned under fiscal 2004 reforms.Observers say the projections reflect the prevailing mood in the government on a tax hike.
Source: Asahi Shimbun

Tuesday, January 14, 2003

Japan: Don't Sqeeze Me Too Tight

Japan economic specialist Richard Katz, writing in today's Financial Times, questions the advisability of turning the fiscal pressure screw in Japan. It's difficult to see how a country suffering deflation (or the imminent threat of it ) can benefit from further fiscal tightening. If in doubt ask the Germans.

It is not easy for a rich country to get itself into as much economic trouble as Japan has. In the postwar era, only Switzerland has stagnated as badly for as long. While the root cause is structural defects, policy blunders have repeatedly made a bad situation worse. They are at it again. Once more, the Ministry of Finance wants to raise taxes in a time of economic weakness. Last week, MoF officials and some business leaders discussed raising the 5 per cent consumption tax by 1 percentage point in 2004 and then another percentage point each year until it reaches 16 per cent. This comes on top of a permanent increase in government fees, equal to 0.5 per cent of gross domestic product, beginning in April that outweighs temporary tax cuts now being considered. In short, Tokyo exhorts consumers to spend more even as it takes away their means of doing so.

The last time Tokyo raised the consumption tax - from 3 per cent to 5 per cent, in 1997 - it triggered Japan's worst postwar recession to that point, caused the ruling Liberal Democratic party to lose the 1998 upper house elections and toppled the prime minister. Since then, GDP has grown a miserable 0.3 per cent a year and private domestic demand is still below the pre-tax peak. Why does the MoF propose to repeat the fiasco? The MoF argues that unless Japan begins closing its fiscal deficit - 7-8 per cent of GDP each year since 1998 - government debt will spiral out of control. Already, the debt-to-GDP ratio has soared from 80 per cent in 1995 to a projected 150 per cent this year. This trajectory, argues the MoF, will ultimately make mounting social security costs unpayable and could lead to financial calamity.The MoF reasoning is flawed. To be sure, Japan cannot keep expanding the debt-to-GDP ratio for ever. Nor can fiscal stimulus alone restore economic vibrancy. But the time is wrong for a contractionary fiscal stance - a cure worse than the disease.
Source: Financial Times

Katz is obviously right about the likely negative impact of an increased consumption tax in Japan. He is also right in pointing out that, thanks to ultra-low interest rates, government interest payments today add up to 2 per cent of GDP, compared with 3 per cent in the late 1980s. Whatsmore, for some years to come, the burden will continue to lessen since the average interest rate currently paid on outstanding bonds is 2.2 per cent, which is far above the 0.9 per cent rate on 10-year bonds in the secondary market. So as old high-interest bonds mature and are replaced with new low-interest ones, the average interest burden will continue to fall. Where Katz goes astray, in my opinion, is in not seeing the impact of this on debt dynamics. As government debt continues to rise the cost of eventually raising interest rates becomes horrendous. Thus there will be no incentive to work to produce inflation since the impact on interest rates will be likely to hit government financing so hard that the most probable effect would be to send Japan straight back into recession! At the same time doing nothing, and continuing to sit back and watch the deflation process at work (even if at a rate of only 1% or 2% per annum) will see the debt/GDP ratio moving steadily upwards until it finally becomes unsustainable, even if the cost of servicing the debt remains small. When will people finally wake up and realise that it is the demographic processes itself which lies behind all this, and that if Japan does nothing about its demographic problem (eg opening the doors to immigration) then there will continue to be be no end in sight.

Monday, January 13, 2003

Dollar Up, or Dollar Down

So which way is it this year for the greenback? A bevy of commentators (including the IMF and the OECD) regard the dollar as seriously overvalued. In principle I agree. The real problem is to identify a sound substitute. In this piece Morgan Stanley's Stephen Len argues for the dollar downside effect dominating. (Why is their global economic forum so full of talent, is this another example of a networking effect? Nine times out of ten I would certainly back the 'instinctual' economics of Roach's team over their aforementioned more heavyweight institutional rivals). What makes his argument interesting, and out of the pack, is that he justifies this by countering the weak yen view.

The topic of the month is the change of governor at the Bank of Japan (BOJ). There is a kind of will-he, won't-he debate over whether this will mean that the BOJ will go for that flavour of the month: inflation targeting (IT). What Len suggests, and I think this is a good argument, is that whoever is chosen the likelyhood of IT in the near term is extremely small. This is not only due to conservatism and lack of reform spirit at the BOJ, but because they seriously doubt it is credibly attainable on a sustained basis, hence their reluctance to jump for it. Many American commentators suggest that they are wrong (in fact too often they suggest they aren't even trying which is absurd) and that what they need to do is systematically (and in duly non-sterilised fashion) purchase government debt. Len is a Japan finance and in particular a Japan Government Bond (JGB) specialist and he strongly doubts this would work. The only clear strategy for provoking inflation he argues is by the BOJ purchasing foreign securities, and this they are still far from ready to do (again with reasons which could be argued). Maybe by the time they get round to doing it Bernanke will be leading the Fed into acquiring JGB's so they could do a straight swap. Bottom line: this year it's more probable that the dollars tendency to go down will dominate, but in currency markets sometimes anything can happen! Since I have long held that monetary factors only give part of the story for the thirtees depression, and that beggar-thy-neighbour devaluations and protectionism (especially in the case of labour mobility) also have their part to tell, I can only view all of this with growing concern. When will we get round to discussing the real problem, in the real economy? Meantime watch out Euroland, up you go.

The term of the current Governor of the Bank of Japan (BOJ) ends on March 19. From recent official statements, there is strong support within Koizumi’s government to replace Governor Hayami with someone who is sympathetic to the idea of inflation targeting (IT). If such a candidate is indeed appointed as the next BOJ Governor, the currency market’s initial knee-jerk reaction is likely to be a modest rise in USD/JPY -- modest because the market has already priced in a high probability of this outcome. (Conversely, if it turns out that the new Governor is not a strong supporter of IT, USD/JPY could fall!) However, whether USD/JPY rises further and stays high, against what I expect to be a broad downtrend in the USD this year, depends on a number of considerations. One key point in this note is that, for USD/JPY, the instrument that the BOJ uses to achieve an explicit inflation target is more important than whether there is an inflation target. Only if the BOJ decides to buy large quantities of foreign bonds would USD/JPY rise over the medium-term, in my view. In all other cases, I believe that any rise in USD/JPY will be temporary and psychological, and will eventually be overwhelmed by economic reality, which, in my view, justifies a lower USD/JPY.

The most compelling argument against the BOJ adopting an inflation target is that such a policy objective lacks credibility because it is simply not achievable under the current circumstances. Japan is suffering from "real deflation", not "monetary deflation". Money printing alone cannot get Japan out of this liquidity trap. Having been implicitly targeting an inflation rate of at least zero, the BOJ has already failed at achieving this target. Adding a time frame and making this target explicit would actually hurt the Bank’s credibility, in my view. Further, what if inflation does rise during this period? Should the BOJ tighten to keep inflation contained, given the likely continued weakness in the Japanese economy? Clearly, there are both theoretical and practical complications of adopting IT at this point.
Source: Morgan Stanley Global Economic Forum