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Friday, November 28, 2003

Protectionism and the Singapore Issues

Pots really shouldn't call kettles black. Is this transparent procurement, or blatant protectionism?

Citing the need to protect local businesses, the state of Indiana terminated a software contract it had awarded to an Indian company--a move indicative of growing opposition to offshore outsourcing.

The cancellation is part of a new initiative, dubbed "Opportunity Indiana," to review the state's procurement process. Governor Joseph Kernan announced the program last week. The program's objective is to offer greater opportunities to local companies.

TCS America, a subsidiary of India's top-ranking software and services company, Tata Consultancy Services, was selected to upgrade the unemployment insurance computer system of the Indiana Department of Workforce Development earlier this year. TCS has won several contracts in the United States, with most of its annual revenue of $1 billion coming from North America.

A TCS representative said calling off the deal "was a decision for the state of Indiana to make, and TCS plans to abide by it."

Outsourcing to offshore companies, particularly to Indian companies, has raised the hackles of local groups that fear job cuts. A number of U.S. corporations have stationed their technical support facilities in Indian cities.

Earlier this week, Dell announced that it was diverting calls for tech support from its call center in India to its centers in the United States, after customers complained.

"The difficulty we had with this contract was not with the company itself," Governor Kernan said in a statement. "After having a chance to discuss our vision of how the state should do business, and how we can provide better opportunities to Indiana companies and workers, we concluded that this contract did not fit in that framework. The procedures we had in place virtually knocked Indiana companies out of the running."
Source: New York Times

Interest rates up in the long run? Think again

The talk grows louder by the day: The economy is recovering, and that means higher interest rates are on the way.

But, in fact, long-term interest rates have already risen in anticipation of the recovery. Here in Singapore the two-year inter-bank interest rate has jumped 1 percentage point since June to more than 2 per cent. Short-term interest rates will tend to follow later. This is the reason why banks are busy nudging up their home mortgage rates for the fixed-rate packages.

Nonetheless, economists and bankers say short-term interest rates in Singapore will rise only gradually at first. DBS Bank, for example, expects the three-month inter-bank interest rate to head towards 2 per cent only by the end of next year.

All agree that local interest rates will take the cue from the United States. Financial markets are betting the US Federal Reserve will start to raise short-term interest rates from May next year, possibly pushing the Fed Funds rate up to 2 to 2.5 per cent by the end of next year from the current rate of 1 per cent.

I believe the Federal Reserve would like to be in a position to raise the Fed Funds rate to 5 per cent, in due course, so that it has sufficient room to lower interest rates to fight the next recession.

But will the Fed be able to? I have my doubts. In 12 months, interest rates could start softening again. This admittedly is not a popular view at the moment because there are many indicators suggesting interest rates could go higher.

Start with rising commodity prices. As Bloomberg reported, the price of soya beans used to make animal feed and cooking oil surged 45 per cent in the past four months. And it's not just soya beans. The Commodity Research Bureau's industrial spot price index is up 38 per cent in the past two years.

Adding fuel to the fire is a world 'awash in liquidity'. At least that's how Dr Edward Yardeni, chief strategist of Prudential Equity Group, described it. And didn't Nobel Laureate Milton Friedman once tell us that inflation is 'everywhere a monetary phenomenon'?

One measure of global liquidity is the non-gold international reserves held by central banks. By this measure, global liquidity is growing at a rate of 18 per cent, the fastest in about seven years.

With commodity prices on the rise and global liquidity greasing the wheels of commerce, you may justifiably argue that inflation is only a matter of time. And you could be right.

But, there's one crease in this neat argument. Over the years, all that extraordinary growth in 'liquidity' has not led to exceptional money creation in the banking system of a growing number of countries.

That's a curiosity.

Let me explain. International reserves at a central bank accumulate partly because of the country's trade surpluses. When the exporter brings his US dollar earnings home and deposits these with his bank, he can spark off an outsized effect on credit creation.

This is because banks need only set aside a fraction of the credit they extend as reserves. So any increase in deposits in the banking system should set off a multiplying effect on loan growth.

However, if you look at Japan, this has not happened. While foreign reserves are growing at a rate of over 30 per cent, money supply is up just 1.3 per cent. And this is not a recent phenomenon: Japan's foreign reserves grew some 70 per cent in the past three years, but money supply grew a paltry 5 per cent.

In Singapore, the same phenomenon: Foreign reserves are rising at a rate of 14 per cent, compared with 3.5 per cent growth in money supply.

So while commercial banks' ability to create money has increased, they are not exercising this option: either because their customers are not keen to borrow, or the banks themselves are hesitant to lend.

Whether this situation will change could depend on how far businesses regain pricing power. For if they can't do so adequately even as the cost of raw materials rises, then deflationary pressures will return.

The industrialised economies would then be in for a squeeze. The release last week of October's US producer prices didn't suggest any improvement in the ability of manufacturers to pass on higher cost. While there was a 14 per cent jump in the cost of crude materials - less food and energy - the price of finished goods rose just 0.4 per cent.

Wal-Mart's chief executive officer Lee Scott says US consumers remain cautious, 'timing their expenditures around the receipt of their paycheque, indicating liquidity issues'.

So Wal-Mart, the world's biggest retailer with sales of merchandise worth US$244 billion (S$417 billion), kicked off a price war earlier than usual this holiday season. Prices of 15 popular toys were 12 per cent lower than those of Toys R Us. Some of Wal-Mart's toys are reportedly below wholesale prices.

In Singapore, Ms Noor Aziza Rafeek, 44, says she has halved prices of her baju kurung at the Hari Raya bazaar in Geylang Serai, but sales are slow. Ms Noor is a 13-year veteran at the bazaar and claims to make at least 30 per cent profit in the past. This year, she is hoping just to break even.

So can the irresistible force of rising 'liquidity' bring back inflation and higher interest rates? It could just find itself huffing and puffing against an immovable object.

Eddie Lee is Senior Economics Writer on the Straits Times

Krugman on the Global Long View

For once something from Krugman which I thoroughly endorse: "there is no more important topic in economics than how to raise the standard of living of the world's poor".

Whenever I give talks about my latest book, someone asks whether I still believe in free trade. The answer is yes — not because I have any fond feelings about multinational corporations, but because every one of those development success stories was based on export-led growth. And that growth is possible only if rising economies can expand into new markets. Some critics of globalization seem to be nostalgic for the era before the big growth in third-world exports of manufactured goods. I'm not, because I remember the way that era really felt, our despair over the possibility of development.

That said, the critics of globalization do have some valid points.

First and foremost, the promise of export-led growth has failed in too many places. In particular, Latin America has signally failed to replicate Asia's success: Latin nations have liberalized, privatized and deregulated, with results ranging from disappointing (Mexico) to catastrophic (Argentina). Open world markets, it seems, offer the possibility of economic development — but not an easy, universal recipe.

Meanwhile, competition from newly industrializing economies does hurt some workers in advanced countries. I could tell you how sensible government policies could minimize this cost, but since we don't have those policies and aren't about to get them, free trade is, in reality, a morally ambiguous issue. And someone in my situation has to acknowledge being in a particularly weak moral position, since they aren't yet having newspaper columns written in Bangalore.

Yet I keep coming back to the big good news of the past 25 years: in a world with more or less free trade, development is possible. We are not, it turns out, condemned to live forever on a planet where only a small minority of the global population has a decent standard of living.

Will this good news continue? Growing tensions over world trade worry me. The steady trickle of U.S. protectionist moves, against everything from steel to Chinese bras, hasn't yet become a torrent. But there's a definite sense that the grown-ups have left the building.

What's particularly striking is the contempt this administration has for the rules. I was on the staff of the Council of Economic Advisers during the Reagan administration (those were nonpolitical jobs back then); one thing I remember was that if the experts said a proposed trade restriction violated international trade law, that was that. By contrast, just about every protectionist step taken by the Bush administration has been clearly in violation. And if the major economic powers stop honoring the rules that preserve open global markets, the chances of future development in poor nations will be much reduced.

But none of this cancels the fact that over the past 25 years more people have seen greater material progress than ever before in history. That's something to celebrate.
Source: New York Times

There are things here to quibble about, but for once why don't I just shut up and celebrate: por fin, we actually agree about something important.

Japan's Conflicting Data

I think it is far too early to be calling this battle over. In fact my opinion is quite the contrary: things are likely to get worse, and if the problem is an ageing society, get worse without getting better. I more or less agree with MS's Takehiro Saito, this is a cyclical spike, and almost certainly not sustainable. As for the rest: you see what you want to see.

An end to Japan's battle against deflation came into sight on Friday as the country's consumer price index increased for the first time in four years, though the optimism was tempered by other data showing unemployment rose and industrial output increased less than expected.

The CPI's rise nonetheless supported bullishness on Japan's economy, which is experiencing a cyclical recovery driven largely by growth in exports and domestic corporate spending. But other new data cast doubt on the strength of the recovery's momentum and the extent to which its knock-on effects are being felt in the labour market.

The nationwide CPI rose 0.1 per cent in October from a year ago, and coincided with the first increase in retail sales for 31 months. Together the figures endorsed the view that after more than seven years of deflation, downward pressure on prices was easing.

However, analysts warned against calling an end to deflation too soon as prices last month were lifted by temporary factors such as a higher rice prices stemming from a poor harvest, a an increase in the tobacco tax, and a rise in patients' share of medical costs.

Takehiro Sato, economist at Morgan Stanley, said: "From a cyclical point of view deflation is fading, but I'm not sure about the sustainability of this increase in the CPI."

He forecasts that when special factors are stripped out the price index will not reach positive territory until at least the end of the 2005 fiscal year.

Separate data released on Friday showed industrial production rose 0.8 per cent in October following a 3.8 per cent gain the previous month, but fell well short of consensus forecasts.

Mr Sato said it was a sign of companies still lacking confidence. "Inventories dropped which means demand is strong, but production is not increasing so that suggests companies are cautious."

The latest labour market data showed unemployment rose 0.1 per cent to 5.2 per cent in October, moving away from a two-year low of 5.1 per cent and back toward an all-time high of 5.5 per cent hit in January.

Analysts took the figures as confirmation that the cyclical recovery has still not yet created labour conditions likely to give consumers the confidence to step up spending. They have contributed little to gross domestic product growth so far this year.
Source: Financial Times

You can't even be sarcastic these days

When I posted the following eight days ago

So, with luck, we'll not get all caught in another trade war (first the EU, then China... who's next, Japan?)

I was merely trying to vent my momentary vexation with short-sighted policy by using slightly hyperbolic sarcasm, not to prophesy. I guess I should have known better.

Thursday, November 27, 2003

Puzzling Times

For a simple, albeit serious, amateur politician ready to face the political and economic issues from a compassionate, cosmopolitan and realistic point of view, times are puzzling.

Apparently inspired by the 2004 presidential elections, the US-administration gives clear signals of a protectionist nature: the textile quotas on China, the steel-tariffs against Europe and Japan (Japan now too has announced to possibly impose the WTO-legitimated sanctions) and let’s not forget the way the implosion of the WTO-Cancun-conference left the issue of US-cotton-subsidies (so cruel against the economical prospects for a number of poor African nations) untackled.

And along with this the economic growth looks impressive according to this Financial Times article. We are talking about an annual growth rate of 8 %.

Inspired by the homeland electoral considerations France and Germany in the meeting of the Euro-ministers of Finance, Ecofin, seemed to have achieved yet another indulgence towards their non-compliance with the Stability and Growth Pact. China continues to show an astounding growth. Who remembers the would-be devastating effects of the SARS-outbreak? Brazil gets back to growth.

But today my newspaper has a story about the perplexing practice in China, especially in the building industry, where lots of workers are not getting paid for many months now. Only reaching my newspaper because the Chinese government wants to act against it. Is this a part of the bubble-character of the Chinese miracle? Andy Xie chief economist for Greater China of Morgan Stanley wrote about a soft or hard landing already:

"…China’s growth is due to slow down quite sharply in the next two quarters, as a consequence of authorities turning off the easy credit tap. In addition to the weakening of domestic demand that should follow the credit tightening, the de facto re-evaluation of the renminbi in January 2004, by means of the removal of export tax breaks, is likely to amplify the slowdown: we believe that Chinese exporters are currently front-loading exports to beat the tax change. The important point for China’s suppliers is that Chinese exports have a very high import content. Hence, imports, too, are likely to have been swollen artificially by the anticipation of the tax change. "

I am not sure to what extent US-growth has a bubble-character too. Brad deLong quotes the Economist:

"...investors sense a chill beneath the warm glow of the numbers. One cold wind blowing across this particular recovery is that Americans are up to their necks in debt. With short-term interest rates at a 45-year low, households are spending some 13% of their disposable income on servicing their debts; a higher number even than in the sharp recession of the early 1980s, when the Federal funds rate topped 13%. How much longer can they carry on spending at this rate, let alone increase it? If they don't, then someone else will have to spend on their behalf.

The government, perhaps? The Bush administration has turned a budget surplus of 2.4% of GDP into a deficit that official numbers say will amount to 4.3% of GDP next year. Not much room, in other words, to raise spending"

Somewhere else I read that a great part of US-growths is related to houses; probably related to Bush tax-policy to help the rich. Reminds me someway of the Dutch economical “miracle” in the late nineties that turned out to be based for at least 50% on the rise of house-prices that in turn was stimulated by the rapid slow down of subsidized building (according to a report of the National Bank).

In my search for wise words on economic stability and growth (we need some kind of global stability and growth pact in my opinion) I found reports of a conference on Rethinking stabilization policy where Alan Greenspan said in his opening words:

"In conclusion, the endeavors of policymakers to stabilize our economies require a functioning model of the way our economies work. Increasingly, it appears that this model needs to embody movements in equity premiums and the development of bubbles if it is to explain history. Any useful model needs to credibly simulate counterfactual alternatives. We must remember that structural models that do a poor job of explaining history presumably also will provide an incomplete basis for policymaking. (…..) The recent importance of movements in equity premiums and asset bubbles suggests the need to better understand and integrate these concepts into the models used for policy analysis."

The central study that supported the conference (by Romer and Romer) concluded from their research that:

"changes in economic understanding have been central to the evolution of stabilization policy. Throughout the postwar period, policymakers. fundamental goals have been the same: high growth, low inflation, and stability. But as policymakers. understanding of the economy evolved, the policies they adopted in pursuit of those fundamental objectives evolved."

I am trying to keep that in mind (what is the appropraite emotion for understatement?)

Mainland FDI in Southeast Asia

What follows is a brief summary of a talk I've prepared for a Conference on the Impact of WTO Membership on Chinese Workers and the Response of the International Trade Union Movement, to be held at City University of Hong Kong, 29-30 November 2003.

Most people will know that China now attracts more foreign direct investment (FDI) than anywhere else. Last year the mainland surpassed the US as the biggest recipient (sucking in over US$52 billion), with cumulative FDI during the reform period exceeding US$400 billion by the start of this year (to which we can add the US$43.6 billion that entered during the first ten months of 2003). China accounts for around 20% of global FDI in developing countries and mainland officials forecast that it will reach US$100 billion for every year during the 11th Five-Year Plan (2006-2010).

It ¡s no surprise then that for the last five years the big story has been about FDI inflow. If Southeast Asia has been mentioned at all it has been in the context of what it has lost to China. In the 1980s and early 1990s, Southeast Asian countries like Thailand, Singapore, Malaysia and Indonesia attracted large amounts of FDI. But by the mid to late 1990s, China had become a monster in their midst, sucking up ever increasing amounts of investment.

The fear in Southeast Asia - whether made public or not - was that China was taking investment away that might otherwise have gone to them. Thus, in 2002, people like Dr Mahathir in Malaysia were bluntly arguing that China was an economic threat to Southeast Asia due to its ability to suck up investment from all quarters. What the Economist magazine in London referred to as a "transfer of affection away from Southeast Asia to China" was perhaps the most striking outcome of the 1997 financial meltdown. Indonesia, for instance, saw a US$6 billion FDI inflow in 1996 - the year before the crisis - turn into a US$4 billion outflow in 2000. With global FDI still growing at that stage (there has been a downward trend in the last few years), the steady rise in the Chinese figures were proof enough to the Southeast Asians that what they lost, China gained.

Given these numbers and the kind of "China fever" they've generated in corporate boardrooms across the globe, it's no surprise that the main story has been on FDI inflows. But there's another story, too; and it's one that hardly rates a mention in the press but is, I believe, becoming much more important. And that story is the increase in FDI outflows.

China has encouraged outward investment since the late 1970s and the start of the reform period, but it was not until the early to mid 1990s that mainland companies began to explore it as a serious option. Official figures state that by 1998 the number of approved projects since 1979 totalled 2,409, with a total cumulative investment of US$2.6 billion. This figure seriously underestimates the outflow of Chinese FDI given that the United Nations Conference on Trade and Development (UNCTAD) World Investment Report 2002 asserts the "top 12 Chinese TNCs, mainly State-owned enterprises [SOEs], now control over US$30 billion in foreign assets with over 20,000 foreign employees and US$33 billion in foreign sales". More important from my point of view, however, is the Report's conclusion that "private enterprises are now following the SOEs abroad, although most of them are small and medium-sized TNCs".

Where does mainland money go in Southeast Asia? The short answer is all over. The Mekong River Region is an obvious target; Cambodia, Burma and Laos have all been the recipients of mainland FDI. In Cambodia, for instance, China is now either the largest or second largest investor. The Chinese government provides "aid" to Cambodia (and Burma and Laos, too) in the form of commercial credit to Chinese companies (a large number of which are SOEs). In the late 1990s, the mainland provided around US$240 million worth of such "aid"; I've been able to trace US$14.15 million worth of credit supporting projects worth US$40.37 million, much of it in the garment sector, which accounts for around 95% of the country's exports of US$1 billion, and employs 200,000 people in around 250 factories. Mainland companies have direct investment in 23 of them (making them the third largest investors in the sector after Hong Kong and Taiwan). For instance, one company, Guangda International Trade Company Ltd has invested US$3 million, double the mean for investment in the sector. Another company, China Jilin Textiles Corporation, was the recipient of a US$500,000 loan by the China Import-Export Bank in 1999 that shored up a US$1 million investment.

Cambodia is the country I've most closely researched to date, but figures across the rest of Southeast Asia are as equally interesting. By September 2003, there were 242 mainland companies with operations in Thailand and cumulative investments of US$258 million (mainly in textiles, garments and home electrical appliances). In Malaysia, which has attracted the most mainland investment in Southeast Asia, there are now 104 established Chinese businesses with US$387 million worth of cumulative investment. In Singapore, 250 Chinese businesses have set up shop, a 56% increase over last year when there were 160. In the case of Singapore, mainland companies are attracted by recent free trade deals (with the US for instance) and the island-state's capacity for high-end laboratory research.

Cumulative mainland investment in Southeast Asia is miniscule compared to either Southeast Asian investment in China (Singapore has poured more than US$40 billion worth of cumulative contractual investment into the mainland) or FDI inflows in general. China may not even account for US$2 billion worth of direct investment across the region (thought the figure is certainly higher than US$1 billion), but the figure is rising rapidly. The Chinese government is encouraging outward investment and the numbers of companies acquiring assets abroad will grow sharply over the next couple of years.

China, not the US, is fuelling global trade

An incredibly interesting analysis of the Baltic Freight Index (now renamed the Baltic Dry Index) from Morgan Stanley's Eric Chaney and Rebecca McCaughrin yesterday. The main conclusion: China, not the US, is fuelling global trade. According to their calculations, over the last three quarters, US imports have been virtually flat, whereas Chinese imports have rocketed by 40%. They estimate that Asia is contributing 55% of global trade growth (measured by imports) this year, versus 15% each for Europe and the US. They also attribute the low contribution of US domestic demand to global trade, especially compared with Europe, to the gain in market shares US producers have been able to achieve as a result of the devaluation of the US dollar.

Over the last 20 years, the Baltic Freight Index, now renamed the Baltic Dry Index, has been tracking very successfully the gyrations of global trade. In the third quarter, the BDI index jumped 120% from one year ago. This growth rate climbed further to 205% in October and did not slowdown in the first three weeks of November. Based on past correlations, this implies that global trade flows in US dollar terms should be up by 40% compared with one year ago. Several special circumstances have probably distorted the link between freight indexes and actual trade. In particular, we believe that very strong demand for raw materials from China must have propelled the index much higher than trade of all goods and services. In addition, the depreciation of the US dollar may have increased dollar-denominated prices. Last, years of downsizing have left the shipping industry in short supply. However, we believe the boom in global trade is a reality that cannot be denied. The vital questions are: where does it come from, and can it last?
Source: Morgan Stanley GEF
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They also note the possible impact of a China slowdown (on this I think it better to adopt a wait-and-see approach) - and argue that if the Asian growth engine pauses next year, the fate of global trade recovery will be in the hands of the two giants of world trade: Europe (19% of global trade in 2002, excluding intra-European trade) and the US (17.5%). The tricky bit is the forecasting: they expect import growth in both Europe and the US to more than double next year, from 2.1% to 5.1% for Europe and from 3.8% to 9.3% for the US. If this were to happen, global trade would accelerate significantly. But as they wryly comment: "at this stage, nothing can be taken for granted". I couldn't agree more.

Japan Ups the Anti: A Little

The US textile tariff problem continues to go the rounds: this time it's the Japanese who are sabre rattling. Let's hope it stops at that.

Japan on Wednesday threatened to impose $85.2m in retaliatory tariffs on US imports in response to America's decision to keep its duties on steel imports intact. Japan officially notified the WTO of a list of "rebalancing" tariffs of up to 30 per cent it would impose on US products including steel, plastics and coal. A Japanese finance ministry committee approved the list of sanctions earlier on Wednesday.

The move by Japan marks the first time it has threatened to impose retaliatory tariffs against its single largest trading partner, and follows a similar threat by the European Union earlier this month to impose tariffs of $2.2bn on US goods. The threat of sanctions by both the EU and Japan come on the heels of a WTO ruling earlier this month that Washington had violated international trade rules by imposing tariffs on steel imports last March. According to WTO regulations, Japan must wait 30 days before it can impose the tariffs, after which point members of prime minister Junichiro Koizumi's cabinet will make the final decision on whether to proceed.
Source: Financial Times

Stability Pact: Quotes of the Day

Theo Waigel

Theo Waigel, former German finance minister who devised the pact, said: "I wasn't disappointed, I was outraged, that Germany, which was responsible with other countries for getting the pact through, should disregard it in this way. Other countries in Europe managed it. Only Germany and France ducked taking the necessary structural reform and consolidation measures because they thought 'we're big enough and no one can touch us'."

Francis Mer

Francis Mer, French finance minister, admitted the events of the past few days showed the fiscal rules of the stability pact were not working and should be re-examined in 2005 after the furore had subsided.

Wednesday, November 26, 2003

EU Growth Forecasts

More surealism: looking at the headline to this article from the FT - EU economic growth 'half that of US next year' - I couldn't work out whether this was meant to be positive or not. I mean if the US is tootling along in the 7-8% range, then half of this would be a real achievement for the EU. But no such luck. It's meant to be bad news all round, and it comes from the OECD. And being serious for a moment, maybe even this is being optimistic.

European Union economic growth next year is likely to be less than half that of the US, the OECD reported on Wednesday.

The Paris-based group of the world's 30 richest nations twice-yearly economic outlook lowered its forecast for EU growth from 2.4 per cent to 1.9 per cent for 2004. However, it raised its expectations for the US from 4 per cent to 4.2 per cent for the same period.

Recent data from the EU have been relatively upbeat - gross domestic product (GDP) grew by 0.4 per cent in the third quarter compared with the previous quarter, according to Eurostat estimates from this month - and the region is widely thought to be over the worst of its economic problems. However questions remain about the sustainability of its recovery.

OECD forecast 1.7 per cent growth for France in 2004, while Germany was expected to grow at 1.4 per cent and Italy at 1.6 per cent. Those were all slight downward revisions, but the OECD expected growth in all those countries to rise above 2 per cent in 2005. The newspaper indicated that 2004 growth forecasts for Japan and the UK were revised up - Japan's from 1.1 per cent to 1.8 per cent, and in Britain from 2.6 per cent to 2.7 per cent.

Reality Check

Going back to the fundamental uncertainty mentioned in the last post, these numbers only seem to add to the surreality of things. Oh, I'm not doubting they are real enough: but all this is very much a one extreme to the other type situation. Of course the US has different demographics from the other OECD countries, so of course the labour force can grow more quickly, and of course the US company has leveraged IT productivity and China outsourcing better than it's overseas rivals. But still, 8.2% is enormous: it's just like China. Which brings me back to reality. For if the US performance really is so good and so solid as it seems, why is there all this China preoccupation? Why the nascent protectionism? Something somewhere doesn't add up in all this. Or take the confidence index: a ten point jump in November, just when the extent of the difficulties the US faces in Iraq were becoming apparent, and global terrorism was manifestly on the rise. I haven't got any answer to this, but it is weird, very weird.

The US economy expanded at an annualised rate of 8.2 per cent in the third quarter, its fastest for 20 years, with more investment and inventory-building leading to a steep upward revision in official figures. Government statisticians had initially estimated growth of 7.2 per cent.The revised GDP figures, the strongest since 1984, coincided with more evidence of improving consumer sentiment. The Conference Board's confidence index jumped 10 points to 91.7 in November, its highest level for more than a year.
Source: Financial Times

Rest in Peace

Apparently the stability pact is dead. At least this is how the papers have it. Clearly this is not the end of the story, merely the begining.

Last week the euro was at all time highs, now the stability pact is all but dead. Normally the euro should be coming down: but it isn't. So this situation is not normal by any stretch of the imagination. We have what I think they call fundamental uncertainty, and this is characterised by inability to see very far: like one of those dense fogs we used to have in the Liverpool of my childhood. Clearly the political controversy promises to be a stormy one: Zalm must be typing away on his weblog this very moment. But this is not the most important part of the picture now. The important question is what will be the structural implications for the euro-group and for their relations with the non-euro EU countries.

Cutting adrift from the stability pact really is cutting adrift. In one sense it is a gamble, for if Germany and France can 'turn the corner' economically speaking in 2004, then they can end the year smelling of roses. My preoccupation is, however, that this may not be as easy as this. Germany has been staggering along with insipid growth since the mid ninetees, and I don't see anything which convinces me that this is going to change. So the possibility exists that this time next year we will find ourselves in a worse version of the same situation. Short term some kind of institutional identity crisis seems guaranteed, but it is probably only when we get to the back end of next year that we really will be able to see the full implications of what happened yesterday.

Germany and France on Tuesday smashed apart the political deal underpinning Europe's single currency, increasing tensions among European Union member states and prompting warnings of higher long-term interest rates. Less than two years after the launch of euro notes and coins, the EU agreed to suspend the sanctions mechanism of the stability and growth pact - designed to enforce fiscal discipline among member states. The suspension, to protect Germany and France from the humiliation of taking economic instructions from Brussels, was strongly opposed by many smaller EU member states.

The European Central Bank, which indicated that the collapse of the pact could force up eurozone interest rates, said the decision carried "serious dangers". The pact aims to stop governments running excessive deficits, defined as 3 per cent of gross domestic product, and carries the threat of fines for repeat offenders.The European Commission, the guardian of EU law, on Tuesday hinted that it might launch a legal challenge, saying it "deeply regretted" what it regarded as one of the most flagrant breaches of European rules.

Tuesday, November 25, 2003

Oil depletion and economics - part IV.

Part IV

This is the final post on oil depletion and economics. It covers two areas – investment and international flows. The first lays out some of the difficulties investment will have to overcome to counteract depletion. The magnitude of the investments required raise questions about the impact on finance markets and international flows.



There are many investment choices that could counteract depletion. There are some common attributes that make investment opportunities less attractive.

* Scale – In order to fully realize the economies of scale, the projects tend to be large. This isn’t necessarily a problem, but it does decrease the likelihood that the project can be funded from existing revenues. Scale also means that the projects take longer to develop.

* Time –It can be years to more than a decade before a project starts producing revenue. In addition to making risks more difficult to assess, it also introduces a maturity risk. Ideally, the sources of finance (project liabilities) would have the same duration as the revenue streams (project assets). In many cases, companies have to tap outside capital in order to fund a project at the needed scale. However, financial instruments tend to have a much shorter duration than the project’s revenue stream. Although, there is a market for long-term corporate debt, it isn’t as liquid and tends to command a higher premium as a result.

* Risks – These include oil price volatility, political instability, interest rate swings and currency shifts. The longer the project’s duration is, the greater the uncertainties and the higher the premium will be.

* Incentives – The higher the price of oil, the better the return. But the long lead times mean that the relevant variable is not the current price but the future price. In part III, it was mentioned that the market’s history had resulted in the long-term expected price to be sticky and largely unresponsive to gyrations in the spot market.

It’s important to note that some market participants *desire* a sticky price: OPEC makes up about a fifth of world production but has around three fifths of world reserves. It has a strong incentive to keep the expected price low. Otherwise, the price signal would spur investment in other producers and alternative technologies. In turn, this would reduce the value of their reserves. OPEC’s goal is to have current prices as high as possible without raising the long-term expected price. Its ability to perform this balancing act has been aided by a few factors:

Commercial inventories (in terms of days of consumption) are near all time lows.
Several nations have been adding to their strategic reserve. This has masked the decline in commercial inventories and propped up demand.
Suppliers are running close to capacity. The little excess capacity that does exist resides mainly in OPEC, specifically Saudi Arabia.

Because OPEC controls the excess capacity, its pricing power is much greater than its market share suggests. The limited spare capacity means that increasing supply is going to require investment, either in more production or in substitutes.


Investment in production

The arguments above assume that the required investments are beyond the reach of current producers. Considering that the oil super-majors rank among the largest companies in the world (in terms of capitalization), this seems a bit bold. Their ability to raise capital will depend on their investment rate of return (IRR). The ability to fund further production from current revenues can be gauged by looking at their current exploration and production (E&P) expenditures. The numbers aren’t encouraging.

Somewhere around 90% of current E&P expenditures are used to keep production from falling. The remainder is relatively small, which has both good and bad aspects. The bad news is that a price crash means maintaining capacity entails running an operating loss. The good news is that a relatively small increase in price has a magnified in earnings. The additional earnings could be used to increase production. It could also be used to improve the shareholders return.

In recent years, the IRR has been around ~12%. This is with relatively high oil prices and low interest rates. The number is even more dismal when the factors mentioned above (risks, time) are taken into consideration. The relatively low IRR makes raising capital, in either the debt or equity markets, expensive.

Attracting the investment is only part of the problem. The other issue is the diminishing return on capital. This is understandable since the most economical deposits are exploited first. Deepwater and heavy oils are more expensive to develop than conventional oil.

In summary, even under favorable conditions, oil companies are barely able to maintain production levels. To make matters worse, their IRR and other factors make additional capital very expensive.


Investment in substitutes

Substitutes range from efficiency enhancements to alternative fuels. There has been significant progress in some areas and little in others. Despite the time and money put into developing substitutes, demand for oil has continued to rise. It raises the question on how much more money would be required to keep demand steady, much less reduce demand to match depletion.

Efficiency improvements can help by either reducing the amount of energy required to support a given income, or by reducing the amount of energy required to build the infrastructure for a modern society. Sometimes, technological advances allow a developing country to skip an energy-intensive step entirely (e.g. wireless vs. land line telephones). Along similar lines, legacy capital stock needs to depreciate before switching to a more efficient solution becomes financially viable: If the incremental prices are low enough, a technology will be adopted faster in a less developed country. This is sometimes called leapfrogging.

Alternative fuels have seen less success. Arguably the biggest single problem, above and beyond those already mentioned, is the inability to properly internalize ALL of the costs of a fuel. For example, coal is cheap until its environmental costs are factored in. Similarly, the disposal and safety aspects of nuclear aren’t included in the price. It’s obvious that this subsidy is a detriment to traditional renewable fuels. A bit less obvious is the harm it does to its supposed beneficiaries: Why invest millions in a technology that will reduce coal’s sulfur emissions 60% if the minimum turns out to be a 95%?

There has been progress in the development of substitutes. Despite this progress oil demand has risen and oil’s virtual monopoly as a transportation fuel is intact.


The overall investment picture

A number of institutions have weighed in on how much investment is required to meet future oil demand. Over the next decade, the amount is on the order of 2-3 trillion USD. There are some estimates that are a little less than a trillion, and others that are substantially above three trillion. Taking the middle case, this works out to be 200-300 billion USD a year. Barring very large (200%+) increases in oil price, this is not going to come out of oil companies’ cash flow. The world capital markets are very deep but this amount is not negligible: To put it into perspective, the FDI in China in 2002 was on the order of 60 billion USD. Furthermore, the oil industry will not be the only competitor for the world’s savings.


World savings

A consequence of inelastic demand involves the trade balance: Increased prices mean increased expenditures. This will have a negative effect on the trade balance for oil importing countries. The result is a decrease in the world savings. The shift in the supply and demand for savings would put upward pressure on the cost of capital, interest rate.

[This wouldn’t be true if exporters saved all of their additional earnings. Alternatively, if world growth were fast enough then enough savings would be generated to satisfy the additional demand for capital. However, my sense is that neither of these seems likely.]

The U.S. is the largest importer of oil and has a very low elasticity of demand. A rise in oil price implies an increase in the current account deficits (CAD). The U.S. CAD is presently around 5% of GDP. A number of economists have questioned how long a CAD of this size can be maintained. How much would the CAD change with rising oil prices?

The U.S. imports about ten million barrels of crude oil a day. At current prices, this works out to about US $100 billion/year – a bit less the 1% of GDP. So, even if prices were to double, the CAD would only increase by < 1% of GDP. However, U.S. oil production is in decline. If demand remains inelastic then imports must increase. Thus, even if prices remained constant, the value of oil imports would increase. When coupled with price increases, the overall effect would be a strong ‘headwind’ that the U.S. would have to counter just to keep the CAD from increasing. To exacerbate matters, natural gas – a common oil substitute, is coming close to ‘peak’ in North America. This would lead to further increases in oil demand. Although there is no hard limit on the size of the CAD, it does raise serious questions about how sustainable the status quo is.


Investments in additional production or substitutes are unattractive for a number of reasons. To make matters worse, the sticky price assumption could end up delaying the market signal required to spur investment. This delay is particularly worrisome since many projects have long lead times. This could lead to severe instability in the short-term market. This situation would last for years until the projects came online. Even if the capital markets were spurred to fund them, the increased demand for world savings could heighten other global imbalances.


I’d summarize my view on oil depletion as follows: Initial conditions matter. The short-term market matters. The long-term market solution is not a fixed point that the market magically converges to. It is the interplay of a number of market (and non-market) forces that evolve over time. Because of this, severe instability in the short-term market can have long-term effects.

I’ve tried to make the case for depletion and to describe factors that raise questions about the short-term stability of the market. I’m curious to know what you think.

- Chris Anderson

The Long, the Short and the Tall

Hi everyone, I'm back again in the land of the living, after a long weekend in the country: a busman's holiday doing fieldwork. Meantime back home things don't seem to change much. I think it should be patently obvious to any objective and independent observer that lomg term damage is being done in the ineterest of short term comfort. This damage will at some stage be reflected in the financial markets, it may also be reflected in the euro group composition. When the going really starts to get tough, and push comes to shove, who is going to be in and who is going to be out? Anyone offering odds on whether the Netherlands will still be in five years from now?

Europe's biggest countries will today join forces to save France and Germany from the threat of heavy fines under the European Union's fiscal rules. Italy, Britain and Spain are expected to support France and Germany in their fight against sanctions under the EU's stability and growth pact, which is supposed to punish countries that repeatedly run excessive deficits. The move has infuriated some smaller member states, which see the stability pact crisis as further evidence of the "big five" riding roughshod over small members' interests and EU law.

The Netherlands, Austria and Finland are among those attempting to halt the disintegration of the budget rules, warning that long-term interest rates and inflation would rise as a result. Bosse Ringholm, the Swedish finance minister, said: "It is unreasonable that a country like France, which has shown no willingness whatsoever to do anything, should be allowed to delay their problems further."
Source: Financial Times

Here we go again...

Who, in the name of everything that is profitable and professional and sane, imposes duties of up to 46% on certain Chinese makers of a product that is central to the american lifestyle (TV sets), with imports from the targeted country amounting to 3 million units last year only, just to help a dying, residual industry with mere 4,000 jobs that couldn't even compete with Mexico?

The US Commerce Department, that's who.

Sunday, November 23, 2003

The Eu stability pact and the output gap

A paper by Fedele De Novellis and Salvatore Parlato looks at the status of several EU countries with respect to the output gap, their fiscal policy stance and the restrictions that would have to be enforced in order to comply with the stability pact. It then analyzes four different fiscal policy scenarios for this group of countries.

The authors state that "GDP is lower than potential output for all the countries in the euro area and the average output gap for the European Union is -1.2 per cent for each year. In absolute terms, therefore, a reduction in taxation that would stimulate growth with effects on demand would be desirable for all countries. In relative terms those countries furthest behind with respect to the European average are The Netherlands, Portugal, Finland, Germany, Italy, Austria and to a lesser extent Belgium, all with a greater need to reduce taxation."

The paper proceeds to evaluate the following four economic scenarios:

1) Target: balanced budget in 2005
2) Target: stabilization of the debt to GDP ratio (reduction by 4 per cent of GDP per year for Italy and Belgium), assuming persistent inflation differentials
3) Target: theoretical stabilization of the debt to GDP ratio, assuming the same inflation rate for all the countries
4) Target: theoretical stabilization of the debt to GDP ratio, assuming the GDP growth equals the average cost of debt servicing

One of the results is that "if it is assumed that the gain resulting from revising the pact is used to reduce taxation and that this has the effect of raising GDP with an elasticity of 2, what emerges is an increase in the variation of output gaps with respect to the current situation... Account must therefore be taken of the trade-off between raising GDP growth rates in the European Union (and in the euro area in particular) and the importance of convergence between countries. It is in fact found that the achievement of the former objective is tied inevitably to pursuing policies that favor Germany and which not necessarily involve a reduction in existing differentials in the euro area in the short term."

Therefore, Euroland can choose between a) policy persistence and acceptance of adverse effects on growth (demonstrating that it is basically a treaty-bound assembly of nation-states) or b) policies designed to maximize growth (demonstrating that Euroland is a Federalist project that - while slowly harmonising price levels and market regulation - does not prevent differential growth rates in regions (in this case, the nation-state terminology would, of course, have to be considered as ultimately irrelevant: "favouring Germany" should certainly not be a goal, but would be an effect - just like differential long-term growth rates between regions of the U.S. - let´s say, the Appalachians vs. California - are definitely not a result of policy design and actors´ intentions.)

If the EU really does enforce the stability pact in its present form, however, then it is a virtual certainty that another weakness built into Euroland´s policy framework is going to be exposed: the fact that the ECB is not yet a lender-of-last-resort. A short-term recovery in Germany followed by a massive downturn would likely put the European payments system under pressure. This might even be a desirable outcome, since long-term economic progress in Euroland cannot be envisaged without episodes of creative destruction on the institutional level (including, of course, shifting more budgetary responsibilities to Brussels/Strasbourg.)