Denise Yam/Andy Xie (Hong Kong)
The First Wave of Industrial Relocation
To take advantage of the compelling differences in land and labor costs between Hong Kong and Guangdong province, manufacturers have staged a dramatic relocation of their productive capacity across the border over the last 15 years.
The extent to which Hong Kong entrepreneurs have set up factories in China is evident in the rising proportion of trade involved with outward processing (OP) in China. OP trade entails exporting raw materials or semi-manufactures from or through Hong Kong to China for processing, with a contractual arrangement for subsequent re-importation of the processed goods into Hong Kong. The proportion of OP trade in re-exports from China to the rest of the world increased steadily from just over 60% in 1990 to 87.5% in 1998. Guangdong province was the site for 94% of OP in 1997.
The other side of the coin is obviously the decreasing importance of the manufacturing sector in Hong Kong. Compared with the situation in 1984, the sector's most prosperous period, manufacturing's share in GDP declined steadily from 24.3% to 6.5% in 1997 (Table 1). As much as 45.2% of the labor force was employed in manufacturing in 1984; this proportion tumbled to 12.1% in 1998. Manufactured goods' share decreased from 67.4% of all exports produced domestically (including services) to 38.3% in 1998.
Table 1The Decreasing Importance of the Manufacturing Sector % of % of % of Domestic Exports GDP Employment (incl. services)1984 24.3 45.2 67.41990 17.6 32.6 56.41994 9.2 18.8 43.51997 6.5 13.1 37.61998 *6.2 12.1 38.3*Estimate. Sources: Census and Statistics Department, CEIC, Morgan Stanley Dean Witter ResearchThere has been a wide divergence in performance by industry since the mid-1980s. The only industries that have expanded considerably are printing, food and beverage, and electrical and electronic machinery. This is not surprising, as the first two primarily serve the local community.
The Second Wave of Industrial Relocation
The manufacturing sector's contribution to GDP in Hong Kong is already low by international standards (Table 2). The sharp decline at this already low level of activity in 1998 was remarkable; the industrial production index fell 8.6% last year. This raises the question: Can the manufacturing sector shrink much further? We believe that the relocation process is still not complete. Our view is that China will gain WTO membership by the end of the year, and, consequently, the removal of quantitative trade restrictions going forward will further reduce the need to retain manufacturing facilities in Hong Kong.
Table 2Manufacturing, % of GDP 1980 1998China 44 43Hong Kong 24 6Japan 29 24Korea 28 31Singapore 29 23Taiwan 36 27US 23 17Germany NA 26NA = Not AvailableSources: CEIC, Morgan Stanley Dean Witter ResearchIt is unlikely that Hong Kong will reduce its costs of production to the extent that it regains its competitiveness relative to neighboring cities. Over the longer run, the local manufacturing sector will likely shrink to a few industries, which would include printing and publishing for the media and those that provide perishables to the local community.
The implication is, of course, that employment prospects in the manufacturing sector will deteriorate. As much as 10% of total employment could be affected, without taking into account the aging of the manufacturing labor force. As we highlighted in our article, "Employment Restructuring" dated January 22, 1999, surplus manufacturing labor was quickly absorbed into the rapidly expanding financial services sector at the time of the asset price bubble in the 1990s, but restructuring is not likely to be as smooth this time around.
Adding to the labor glut will be the diminishing role of Hong Kong in China trade and the potential influx of mainland immigrants. New industries that leverage on Hong Kong's comparative advantages, namely information-intensive businesses, will have to expand at a fast enough pace to underpin labor demand.
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Asia/Pacific: If the Fed Tightens...
Andy Xie (Hong Kong)
Rate Increase or Steeper Yield Curve
The US saw the largest monthly gain in April in its CPI (0.7%) since October 1990 and in its core CPI (up 0.4%) since January 1995. The unexpected inflationary pressure has created the specter of a change in the Fed policy on interest rates. Dave Greenlaw, our US fixed income economist, expects the Fed to adopt a bias toward tightening during the FOMC meeting this week. Even if the Fed does not tighten, our US economist, Dick Berner, has pointed out that the yield curve is likely to steepen and the treasury yield could reach 6.2% in the second half of the year. He believes that the inflationary expectation in the yield is not adequate.
A change in the direction of US interest rates would have serious implications for Asia. Three fundamental factors are supporting the region's stability and recovery:
The three interest rate cuts by the Fed, which created sufficient dollars to calm emerging market panic over a dollar shortage; Japan's strong fiscal stimulus to support a strong yen; and, China's policy of bottling up its deflationary force through a massive investment program.
A higher federal funds rate and/or a steeper US yield curve may disrupt the delicate equilibrium created by the above three factors. Although US interest rate policy has had a substantial impact on monetary conditions in the region in the past, the difference now is that several countries have adopted flexible exchange rates.
US Interest Rate Scenarios
1) Just the Yield Curve
One possible scenario is that the Fed could tolerate slightly higher inflation in the US than previously. The beneficial impact of the Asian crisis on US inflation (e.g., collapsing Asian export prices and commodity prices) is likely to wear off as the region stabilizes. The tick upward in US inflation is probably due to this one-time effect rather than a changing trend. Under this scenario, the US economy would remain strong. The only consequence would be a steepening in the US interest rate yield curve to correct the insufficient inflationary expectations.
The only major fallout for the region in this scenario would be a stronger dollar. If Japan is willing to absorb this and maintain the current dollar/yen level by additional fiscal measures, the only major currency effect would be a weak euro, which probably does not have to be countered by significant policy changes in the region. If Japan does not absorb a stronger dollar through fiscal actions, the region would have to adopt policies in response to a weak yen.
2) The Fed Funds Rate Up and the Dollar Strong
If the Fed does tighten, there is a good chance that the dollar would strengthen and that US domestic demand would weaken somewhat. The strong dollar, again, could be offset by Japan's fiscal actions. However, weak US demand would require some currency adjustment in the region to maintain the current trend of reflation since protecting trade surpluses in local currency terms is the key to closing the output gap. A strong dollar would pave the way for another round of currency adjustments in the region.
3) The Fed Rate Hike Pricks the Equity Bubble
It is possible that the Fed may use the inflationary pressure as a pretext to prick the equity bubble and accept the consequences. This would probably lead to a sharp correction in the US demand for Asian goods and create a weak dollar for some time. This would be the worst scenario for the region. The US remains the most important market for Asia. The benefit of a weak dollar in trade in other markets would probably not be sufficient to offset sharply weaker US demand.
Haves and Have Nots in Policy Flexibility
The First Two Scenarios
Korea and Southeast Asia still have considerable policy flexibility in dealing with the fallout from rising US interest rates. Because the large output gap keeps inflationary pressure at bay, they can adjust their exchange rates to maintain the speed of reflation. Under the first two scenarios Korea and Southeast Asia can move their currencies together with the dollar/yen rate and protect their domestic liquidity and the speed of recovery. There is a good chance that this is the policy option they would choose. Taiwan may decide to take advantage of a weaker yen to loosen its monetary stance, although this may not be the path selected given the central bank's strong preference for a stable currency.
China and Hong Kong would be the economies most adversely affected by the change in the US interest rate stance because of their fixed exchange rates. China would have three options to offset this impact: (1) sacrificing its forex reserves to maintain its current monetary conditions, (2) additional fiscal spending to keep the economy stable, or (3) an adjustment in the exchange rate.
Hong Kong's liquidity situation would almost certainly be threatened by rising US interest rates. Hong Kong, as we noted in our earlier research, has about US$20 billion in surplus Hong Kong dollar liquidity in the banking system, which is the driving force for declining interest rates and a rising stock market. This liquidity came from the government stock market intervention (US$15 billion) and the budget deficit (about US$5 billion). Both were funded by converting US dollars into Hong Kong dollars. The Fed rate reductions last year and a strong yen have made it possible to hold this liquidity in Hong Kong dollars. Changes in either the Fed's interest rate policy or the strength of the yen would make it tougher to maintain this liquidity situation. It would probably be better for the Hong Kong government to consider taking back some of this liquidity before the market does.
The Third Scenario
The third scenario would put more pressure on Korea and Southeast Asia than on China and Hong Kong. It would be hard for Korea and Southeast Asian to depreciate their currencies in the face of weakening US demand while the yen remains strong. This would probably provoke a response from China. On the other hand, China and Hong Kong would benefit from a weak dollar but suffer from declining US demand. This scenario would be complicated and have considerable potential for surprises, in our view.
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Global: World's Money Supplies Still Growing Fast but with Some Signs of Deceleration
John Montgomery (New York)
In an earlier forum (March 25), we highlighted the acceleration of global money supplies. We constructed a measure of the global money supply from a weighted average of money supplies in the United States, Euroland, Japan, the United Kingdom, and Canada. We have updated these numbers with data through March (see table below). On a year-over-year basis, global M3 excluding Japan decelerated somewhat to a 7.2% year-over-year growth rate in March from 8.0% in December. The United States, Euroland, and the United Kingdom all contributed to this deceleration of global M3. Nonetheless, the rate of growth of M3 remains decidedly above both 1998 nominal GDP growth of 5.8% and our projected 1999 nominal growth of 4.7% of the four source economies. This indicates an abundant supply of money to feed global financial markets.
We analyze the aggregate excluding Japan because of the liquidity trap conditions prevalent there. We cannot yet compute global M3 including Japan for March, because we do not yet have March M3 data for Japan. For February, however, it grew at a 7.1% rate, down slightly from 7.3% in December. Our estimate based on other monetary indicators for Japan is that global M3 including Japan will also show deceleration, but less than that of the aggregate excluding Japan.
We have also constructed a global aggregate for M1, a narrow aggregate that comprises only cash and demand deposits. Global M1 grew at an 8.4% year-over-year rate in March (both including and excluding Japan). Growth in global M1 has actually picked up since the end of 1998, when it was growing at a 7.2% rate (or 7.4% excluding Japan). Thus, global M1 is also growing at a fast rate, but unlike M3, it is showing no signs of deceleration. This is not surprising given recent cuts in interest rates in Euroland and the United Kingdom. We would caution, however, that the global M1 numbers are colored by very fast growth in Euroland M1 around the time of the introduction of the new currency at the beginning of the year. This could be due to technical factors that may not be meaningful for the supply of liquidity. Global M3 is less affected by this problem.
At the suggestion of our colleague Ted Wieseman, we are adjusting U.S. reported M1 to take into account "sweep" accounts, in which banks sweep transaction balances from demand deposits (which are in M1) to other (non-M1) accounts. This adjustment raises the growth rate of U.S. M1 in March from 2.0% to 6.0%, and the growth of global M1 from 6.7% to the 8.4% cited above.
Another way of detecting acceleration or deceleration of money supplies is to compare the year-over-year growth rates with growth over shorter periods. This requires the use of seasonally adjusted series. Most of the series we use are seasonally adjusted by their national sources, but this is not true for Euroland aggregates and for Japanese M3. We therefore performed our own seasonal adjustment on these series to allow us to create seasonally adjusted global aggregates. Such comparisons show a deceleration in global M3 excluding Japan in March. Three-month growth (annualized) is 4.7%, less than six-month growth (annualized) of 6.9% and the twelve-month growth of 7.2% cited above. The same comparison for global M1 actually shows continued acceleration (with or without Japan).
These data paint a mixed picture. Broad money is showing signs of slowing down in several countries, although not in Euroland and Japan. Narrow money growth, on the other hand, remains strong, although clouded by the introduction of the euro. It appears that central banks are continuing to provide money generously to their economies, which accounts for strong narrow money growth, but a considerable share of this money is finding its way into securities markets, and not into broad money. The return of global financial stability in recent months is probably contributing to this movement of money into securities markets.
Looking forward, we anticipate a somewhat less benign liquidity environment than in recent months. The deceleration of broad money suggests that the main boost to financial markets from liquidity is behind us. Broad money is now growing at rates that are much closer to nominal output growth than they were a few months ago. In addition, neither our U.S. nor our Euroland economists anticipate further interest rate cuts. The wildcard is Japan. The Bank of Japan is "out of basis points," with its official policy rate at 0.15%, but further quantitative easing is a possibility. If the yen remains stable or depreciates, some of easier Japanese money could find its way abroad. However, any such revival of the Japan carry trade seems unlikely to outweigh slowing liquidity from the United States and Euroland.
Global Monetary Aggregates (year-over-year percent changes) Dec 96 Dec 97 Dec 98 Jan 99 Feb 99 Mar 99M3Aggregate G-7 and Euroland 5.6 6.6 7.3 7.2 7.1 ...Aggregate excluding Japan 6.1 7.3 8.0 7.9 7.8 7.2 United States 7.3 9.1 11.0 10.5 10.5 9.2 Euroland 4.0 4.3 4.5 5.4 5.1 5.1 Japan 2.8 2.8 3.5 3.5 3.5 ... United Kingdom (M4) 9.6 11.8 8.2 7.6 7.2 6.9 Canada 5.5 5.8 3.4 0.9 1.0 2.2
Aggregate G-7 and Euroland 7.5 7.1 7.2 8.5 7.8 8.4
Aggregate excluding Japan 6.9 6.7 7.4 9.1 8.2 8.4
United States(1) 6.0 6.2 6.2 5.9 5.8 6.0
Euroland 7.5 6.6 9.4 14.2 12.0 12.2
Japan 10.4 9.1 5.8 5.1 5.6 8.1
United Kingdom (M0) 6.7 6.4 5.8 5.6 5.2 5.6
Canada 13.2 14.2 7.8 8.6 8.7 8.6
(1) Adjusted for sweep accounts
Sources: Federal Reserve Board, European Central Bank, Bank of Japan,
Bank of England, and Bank of Canada
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UK: What Is and What Should Never Be
Kevin Gardiner (London)
The IMF has joined the club. It looks as if the Financial Times has been briefed on the Fund's latest Article Four review of the prospects for the UK economy. Apropos sterling and EMU, the FT reports that the Fund is arguing that "specific actions close to the time of entry may be required to influence the entry rate". Like the rest of us, then, the Fund is grappling with the divergence between where sterling is and where it should be.
Today's report follows a smaller, less high-profile article in the Independent last Friday which argued that Treasury officials themselves are beginning to address the issue of how best to get the pound down from here. Neither the FT nor Independent report should be viewed as near-term trading signals: there is nothing in either article to suggest that policy changes are imminent (and our best guess remains that UK entry is still unlikely before 2002/3).
Indeed, it is not clear that there is anything that the UK government can easily do about the situation. Direct intervention might work for a while, and it would of course be nice to book a profit on those Black Wednesday purchases; but with the cyclical fundamentals beginning to strengthen, such a direct course of action could not hope to succeed for more than a few months (let alone 3-4 years!). It's not as if the Bank of England hasn't been trying to talk the currency down at every opportunity: time was when an explicit Bank "forecast" for the pound would have been rapidly self-fulfilling, but not these days it seems...
And as Mervyn King said in an interview at the weekend (Sunday Times), if Mr Brown were to alter the Bank of England's mandate to give a sterling target priority over the inflation target, the results could be counterproductive. For example, it might take massive rate cuts to bring sterling down (after all, roughly 300-bp of relative easing in official rates vis-a-vis Germany hasn't done much good to date), and this might in turn push economic growth up to levels which result in the UK breaching the Treaty inflation criterion!
Moreover, this is not a unilateral decision for the UK to be taking: it's not a case of tea for one. Its partners will have to be consulted, and are unlikely to agree easily to a big fall in the pound unless the UK economy is faltering to a greater extent than currently seems likely.
Our guess at an appropriate entry rate has been the equivalent of DM2.4-2.5, more than 15% below where the pound is currently trading and (more relevantly) roughly 10% below the forward rate at end-2002. We've been assuming this on the basis that (a) sterling is expensive on most measures at present and (b) "fair value" today has to be modified by the likely cumulative UK inflation differential to work out what "fair value" would be at the time of entry.
Increasingly, however, we've been wondering whether the pound really is that expensive to begin with. In 1992, I argued that the pound was expelled from the ERM not because it was fundamentally expensive, but because the domestic recession meant that interest rates were incredible at then-current levels. More recently, I'm surprised that similar arguments didn't pull the pound down by more last autumn -- but then there hasn't been a hard landing, and the underlying performance of the economy vis-a-vis Euroland probably hasn't been better since the 1960s. We're reviewing our assumption on the likely entry rate.
That said, there is still plenty of time for another cycle before entry, and it wouldn't be the first time that the currency market has bought on the rumour to sell on the fact. UK repo rates actually going up again (early 2000?), and or a turn in the dollar cycle, might yet prove more potent in pushing sterling down than big cuts in UK rates to date. Our average forecasts for the pound were raised by roughly 5% a few weeks back (see Ravi's comments at the time), but they still include a dip between now and 2002/3...
Don't want to ramble on, but note that the FT also reports that the IMF is suggesting that the "five economic tests" set by the Chancellor in October 1997 to decide whether the UK economy is ready to join will have to be interpreted "loosely". This will come as no surprise to our readers. We've long argued that the real determinant of the UK's entry date will be not the state of the economy (structurally or cyclically) but the state of public opinion, and the British public may not care four sticks for the economic niceties. But equally we've also noted that it should not be beyond a clever Treasury press officer to fudge the tests -- a point now made by the Fund.
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Japan: Stunned Silence
Robert Alan Feldman (Tokyo)
In recent seminars in Tokyo, estimates of the excess levels of labor (and capital) in Japanese corporations are beginning to take center stage. The estimates turn out to be similar to those presented in the Global Economic Forum (April 23 "Raising RoA: Hobbes Got It 2/3 Right," and April 27, "A Whole Lot of Excess"). In those pieces we showed that raising the RoA of the Japanese corporate sector from the current level of 2.0% to the pre-1990s average of 4.0% would require either (1) a 13.4% cut of personnel costs, or (2) a cut of assets by about 50%. To the extent that labor cost cuts are lower, asset cuts would have to be larger. Whatever combination, the intensity of required effort will be huge. If one makes the extreme assumption that all of the labor cost cuts came from redundancies, for example, the cuts would add 13.3 percentage points to the unemployment rate, bringing a total unemployment rate of about 18%.
Such figures were presented at a recent seminar, an independent think tank ventured that it had calculated that gross excess employment is currently about 7 million, but that new job creation of about 4 million can be envisaged. Thus, the net increase of unemployment would be about 3 million -- roughly double the current level. In this case, the unemployment rate would be nearly 10%. A similar presentation of our numbers at a government sponsored commission subcommittee meeting was met with stunned silence. Heretofore, the maximum figure for the potential unemployment rate was seen as 8%. Now figures well above that would have to be contemplated. The labor representatives at the subcommittee meeting showed particular interest in the estimates, and particularly ill-informed about the realities of profit levels at corporations.
Indeed, just in the last few weeks, the focus of the restructuring debate has shifted from preservation of current jobs to overall employment. The reasons for the shift are twofold. First, there is a growing realization that current jobs in many cases simply cannot be protected -- the cost to the economy and to the taxpayer would be too high. In addition, there is a growing realization that pensioners and labor are becoming adversaries. Pensioners have an inherent concern with the return on assets, since it is from the return on assets that their income and living standard derives. However, improving rates of return will necessarily cause cuts of wages, which labor desires to constrain to the lowest possible amount. This is not merely a zero sum game. Should the rules by which the allocation decisions are made be incorrect, then the game would become a negative sum game. That is, as pensioners and labor fight over allocation, the economic pie itself would shrink.
In this context, MITI and other ministries are beginning to shift their focus, and produce new ideas to help contain costs, and to help ease transfer of labor to new jobs. In particular, MITI is now considering a "cafeteria plan," under which a firm would be allowed to choose the set of tax-deductible benefits to offer workers within an overall cost constraint, rather than be forced to offer certain benefits despite the demographic, geographic, and business characteristics of the firm. Retraining support will be given added emphasis. And new interest subsidies for firms that scrap capacity will likely be introduced as well.
Nevertheless, the light at the end of the tunnel is moving farther away. It is gradually dawning on the economics community that the national restructuring effort will require not one or two years, but perhaps five or more. Some analysts see the worst stage of the restructuring period coming about two years after the start, which they see as early this year. The reason for the extended period of adjustment is the size of the task: Reformulation of labor practices will be particularly sticky, and there are huge downside risks to macroeconomic demand as wages are cut. Because of the poor fiscal position of the country, demand oriented support policies will be difficult to implement without risking a bond market explosion. Hence, an extended period will be needed to complete the restructuring effort.
For investors, the key questions involve will and patience. How strong is the will, both political and social, to see through the restructuring effort, to share the pain involved, and to develop new rules and rights for economic interaction? How patient will investors be as the inevitable bumps in the road are hit? For now, there is adequate courage and adequate patience to make a major equity market retracement unlikely. However, in political circles, 6% is viewed as the likely high for the unemployment rate, a level that seems outlandishly low in light of the size of the RoA improvement needed. When faced with realities, political will may fade. If it does, investor patience will likely fade with it.
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Canada: Monetary Policy Report Preview
Jim Johnson (New York)
The Bank of Canada will release its twice-yearly Monetary Policy Report on Wednesday. Since the Bank's primary policy objective is to control core inflation to within a range of 1% to 3%, the course of monetary policy over the next six months will essentially key off of how inflation behaves in the coming months relative to the Bank's inflation expectations.