...but it's getting more cyclical. In a sharp contrast with a consensus that is still worried about downside risks for growth, we now think the risks are shifting to the upside through 2011. Three factors are contributing to the potential for a brighter outlook: (1) New foreclosure mitigation proposals could dramatically improve prospects for housing; (2) The administration appears likely to extend current tax rates for all but upper-income taxpayers; and (3) Incoming data have been stronger than expected, supporting our view that a spring snapback from harsh winter weather is underway. The upshot: The recovery still looks sub-par by historical standards, but courtesy of some not-so-traditional key drivers, it is beginning to look more like a time-honored cyclical upswing.
Upside risk #1: Reducing housing tail risks. The first source of upside risk to growth relative to our baseline is the housing market - the biggest wildcard and still the most troubled part of the US economy. We have long recognized that slowing household formation, a "shadow inventory" of yet to be foreclosed homes, the likelihood of strategic defaults and rising joblessness posed downside tail risks to home prices and housing activity. These are the key reasons our forecast for US housing starts has continued to be the lowest of any in the Blue Chip survey of economic forecasts. For example, in the March Blue Chip canvass, our forecast for starts in 2010 was 560,000 (up only about 1% from a brutal 2009) compared with the median expectation of 700,000.
Negative equity is the key factor. It's been clear for years that a cure was needed for the rising tide of mortgage foreclosures. Policies to mitigate them have until now relied on affordability - reducing monthly mortgage payments for delinquent or at-risk borrowers. Under the Treasury's Home Affordable Modification Program (HAMP), all permanent modifications through February 2010 involved a reduction in mortgage rates. About 25% of these mods did receive some form of principal forbearance, but none entailed principal write-downs by the lender. Not surprisingly, in our view, the HAMP and other mitigation programs relying on monthly payment modification have struggled, with ‘redefault' rates as high as 50-60% following modification. This is because improving affordability is helpful but willingness to pay when loan values significantly exceed home values is essential. We and our colleagues Vishwanath Tirupattur and Oliver Chang have talked about this in previous notes. With 10.7 million, or about 23%, of homeowners underwater, the willingness of borrowers to walk away - to default strategically on their mortgages even if they have the wherewithal to pay - has increased significantly. This lack of willingness to pay on the part of the borrowers has upheld our team's bearish view on housing and home prices.
New initiatives. That is now changing. Two policy changes announced on March 26 - a new ‘earned principal forgiveness' initiative in HAMP, and the short refinance program through the FHA - will help reduce the risks of foreclosure. (Bank of America separately announced a similar principal forgiveness program called the Homeownership Retention Program on March 24.) ‘Earned principal forgiveness' gives the borrower a strong incentive to stay current on modified payments by turning a portion of initial principal forbearance into principal forgiveness for each year the borrower stays current. The new short refinance program is meant for currently performing but underwater mortgages and provides for FHA refinancing of such mortgages after the lender agrees to principal forgiveness. If implemented effectively, these changes, by requiring lenders to consider principal write-downs for all HAMP-eligible borrowers that owe more than 115% of the current value of their home, will help reduce the ‘shadow inventory' of yet to be foreclosed homes and the likelihood of strategic defaults. Another new program requires a temporary reduction in mortgage payments (to 31% of income) for unemployed homeowners. This may also help to stem the tide of looming foreclosures.
Game-changer for housing. If these programs meet with even moderate success, they will change the bleak housing landscape for the better. Mortgage modifications involving reduced principal will lower or eliminate negative equity for many homes, making such mortgages far less likely to redefault, and result in those homes dropping off the shadow inventory. These programs will reduce the overhang of supply that burdens the housing market. If, as we expect, principal write-downs permanently reduce the shadow inventory, it will reduce the excess supply in housing and limit downward pressure on home prices. They will significantly lower the incentive for strategic default because earned principal forgiveness addresses the negative equity issue. Finally, the new initiatives should reduce loss expectations on both performing and delinquent loans in non-agency mortgage pools; defaults in the former and redefaults in the latter should both decline. Such a decline in tail risks should boost the values of RMBS, keep mortgage spreads relatively narrow now that the Fed's mortgage purchase program has ended, and help restart the normal flow of housing credit.
While these proposals could represent a game-changer, they will not magically solve our housing problems. The target size of the programs is 3-4 million borrowers - a far greater number than has been addressed so far, but there are currently 8 million delinquencies and we were expecting an additional 2-3 million before these changes were announced. The key point is that, if successful, these programs are a highly positive step, but home prices will only start to rise consistently when housing imbalances are reduced significantly further.
Upside risk #2: Tax breaks for consumers. The second source of upside risks to growth comes from a prospective fiscal policy change. Looking beyond 2010 and reflecting the pressing need to get started on reducing massive federal deficits, our fiscal assumptions over the past year have been conservative. Specifically, we have long assumed that the administration would sunset the Bush tax cuts and increase the tax rate on dividends and capital gains on January 1, 2011, resulting in roughly a US$120 billion tax hike for individuals. That is one reason why we expected growth to slow to a trend-like pace in 2011 despite several favorable fundamentals.
In his FY2011 budget, however, President Obama has proposed ending the individual income tax cuts begun under EGTRRA and JGTRRA only for upper-income taxpayers. For example, the top marginal tax rate for married couples filing jointly with incomes above US$250,000 would go from 33% to 39.6%, levels last seen in 2000. Married couples with incomes below that threshold would enjoy current tax rates. The Congressional Budget Office (CBO) estimates that this proposal would cost the Treasury US$67 billion in FY11 relative to current law. If implemented, the resulting extra spendable income would likely boost consumer spending and, taking account of the ‘multiplier' effects of such income and spending, we estimate that it would add about half a percentage point to overall 2011 growth.
Could we be overestimating the effects? After all, at first blush this ‘stimulus' seems paltry compared with the US$787 billion in the American Recovery and Reinvestment Act of 2009 (ARRA). Such a comparison is invalid, of course, because the US$67 billion represents the impact over just one year, while ARRA is a multi-year package. Looking at the 10-year window budgeteers use for apples-to-apples comparisons, and assuming the change is permanent, the CBO estimates the cost of this tax change at US$1.169 trillion. Over time, that's real stimulus, and theory suggests that permanent tax actions have bigger and more lasting effects than temporary ones.
In addition, these tax ‘cuts' would benefit lower-income consumers, who would likely spend more of it than would upper-income taxpayers. We believe that multipliers from fiscal actions vary depending on other circumstances. For example, in the heat of the crisis in early 2009, wary consumers saved more of their income; however, as financial conditions and wealth improved, they opened up their wallets a bit more. With market healing likely to be even more advanced in 2011 than it is today, this pro-cyclical fiscal action would probably get substantial traction. More bucks and more bang for each one leave us comfortable with the idea that this change would be one you can believe in.
Upside risk #3: Hearty incoming data provide support for sustainable growth. The third factor pointing to upside risks is the gathering strength apparent in incoming data. The data point to stronger 1Q growth - by about 0.5pp more than we forecast a month ago - and to upside growth risks going into 2Q and beyond. The effects of harsh winter weather on the economy were smaller than we thought. Healthy March levels for domestic and overseas orders and other forward-looking indicators suggest additional momentum for sustainable growth. With inventories getting leaner, there is scope for inventory accumulation. With employment and hours now rising, we see ‘core' wage and salary income beginning to sustain both gains in consumer spending and a rise in thrift.
Domestic upside. Several domestic spending components have recently outperformed our cautious expectations. First, consumer spending excluding motor vehicles through February has been materially stronger compared to the pace we expected a month ago. The strength has lately appeared in discretionary items like big-ticket durables, clothing and restaurant meals. That speaks to a consumer benefitting from improved income, better access to credit and increasing financial wealth. Second, vehicle sales have bounced back sharply to new, post-cash-for-clunkers highs without heavy incentives by legacy OEMs, and upside prospects have improved. We now expect light vehicle sales of nearly 12 million units in 2010, up from our forecast of 11.6 million last month. Third, while construction activity has been weak, February's winter storms did not depress construction activity, infrastructure outlays, hours at work, or production elsewhere by as much as we thought (although December's downward revision to construction activity did reduce the ‘ramp' going into 1Q).
Forward-looking data. Healthy March levels for domestic and overseas orders and other forward-looking indicators suggest additional momentum for sustainable growth. To be sure, orders have a long way to go to reach pre-recession levels, and orders for capital goods have taken a breather with the demise of bonus depreciation at the end of last year. But diffusion indexes of new domestic orders from the ISM and our own business conditions survey are strongly in expansion territory. Further, underscoring our theme that strong global growth will be a key support for US exports and output, ISM export orders in March hit the highest level since 1989.
Leaner inventories. Inventories are getting leaner in relation to sales as the level of demand continues to outpace production, thus drawing down stocks and setting the stage for inventory accumulation a bit sooner than expected. In manufacturing and trade, the real inventory-sales ratio excluding motor vehicles now stands at a four-year low, and will continue to head lower as demand outpaces the growth of inventory. With vehicle sales picking up and OEMs remaining cautious about production, vehicle inventory will likely slip below 60 days' supply soon. Given that we expect the swing in inventories to add only 0.4pp to growth both this year and next, and see outright inventory accumulation beginning consistently only in 3Q10, following liquidation in eight of the nine quarters ending in 2Q - a record unmatched in post-war history - there is scope for upside here as well.
Employment starts closing the loop. Employment has begun to grow and hours have started to rise. Despite slow wage gains, we expect these increases will boost ‘core' wage and salary income needed to sustain consumer spending and a rising saving rate. Although March payrolls rose by a less-than-expected 162,000, the level through February was revised up by 62,000. Excluding the effects of bad weather and Census hires, we estimate that payrolls rose by 14,000 in March versus +71,000 in February and +5,000 in January.
While the March gain as measured above is puny, we believe that March employment may be revised higher and that employment growth is poised for a significant pick-up in the coming months, given the recent spike in government tax collections. Employment measured in the household survey (and adjusted to be compatible with non-farm payrolls) has surged in the first three months of 2010, rising by a monthly average of 459,000 compared with 54,000 for payrolls. Indeed, the jump in household employment has held the jobless rate at 9.7%, well below October's peak of 10.1%. Despite an expanding labor force, we now think that the unemployment rate will rise back to only 9.9% in 2Q, 0.1% lower than our expectations last month. We continue to look for average monthly payroll gains (ex-census) of 150,000 or so over the balance of this year.
As important, the workweek ticked up in March and estimates for prior months were adjusted higher. The average workweek has risen by 18 minutes from the low in September. That may sound trivial, but in fact it is powerful because it applies to the whole workforce, and has turned a 0.2% annualized decline in private payrolls into a 1.1% annualized increase in hours worked. Thus, personal income is likely to show a solid gain in March despite the unusual dip in average hourly earnings, and we think that real after-tax wage and salary income will rise by an annualized 4% in the first half. Given the recent pattern of revisions, there is probably upside risk to this estimate.
Finally, we believe that the recent pick-up in individual withheld taxes may be a sign of strengthening job growth. The tax collection series, from the Daily Treasury Statement (DTS), is a timely gauge of movements in aggregate wages and salaries - and therefore employment. Another advantage is that it is hard data and thus it is never revised (unlike other measures of labor market activity that are based on statistical samples collected at a certain point in the month and are subject to frequent revisions). The disadvantage of the DTS series is that it is very noisy and is heavily influenced by calendar effects. Also, there will be a break in the relationship when significant changes in tax withholding are implemented - as was the case with the 2001, 2003 and 2009 tax cuts. We like to look at a 3-month average of tax payments in order to smooth out some of the statistical noise and the calendar effects. The year-over-year change in the tax collection series (on a 3-month average basis) improved from -5.9% in February to -0.5% in March - and close to +8% for the month alone!
Whether to Exit: A Recap of Our Consistent Views on the Renminbi since 2008
The Chinese authorities launched the reform of the renminbi exchange rate regime on July 21, 2005, by de-pegging the renminbi from the US dollar and adopting ‘a managed float exchange rate regime with reference to a currency basket'. However, in practice, the USD/CNY trajectory resembled that under a typical crawling peg regime during July 2005-July 2008. Since July 21, 2005, the renminbi has already appreciated against the US dollar by over 20% from the pre-reform USD/CNY level of 8.27.
However, the USD/CNY rate has been kept very stable at around 6.83 since July 2008, the three-year anniversary of China's exchange rate reform. In fact, the renminbi returned to a de facto hard peg to the US dollar - a new regime that we were among the first to identify back in November 2008 - after three years' practice of a crawling peg (see China Economics: A New Renminbi Regime? November 24, 2008).
Since mid-2009, with the global economic recovery underway and the US dollar under renewed downward pressures, market observers have started to cast doubt over the sustainability of the new regime and wonder what exit strategies exist for the renminbi. Back then, we believed that "the current renminbi exchange rate arrangement will remain unchanged through 2009 and most probably through the next 12 months" (see China Economics: An Exit Strategy for the Renminbi? June 9, 2009).
In particular, when speculation about an imminent renminbi policy move intensified toward end-2009, we cautioned against getting too exited about an imminent policy move on this front by suggesting that "to gauge the potential policy shift on renminbi, one should think more like a policymaker than a fund manager" and reiterated our call that "the current renminbi exchange rate arrangement will remain unchanged through mid-2010" (see China Economics: A Dialogue on the Renminbi, November 11, 2009).
Just as the international financial press and many China observers started to be rather discouraged by the strong defense recently made by Chinese Premier Wen and other senior officials that the renminbi is not under-valued and considered that the renminbi peg is here to stay for a long time, we have instead turned increasingly constructive about the prospect for an renminbi exit from the USD peg, because we have a different interpretation of Chinese authorities' message. We expect that "An exit of renminbi from the US$ peg will take place, most probably in the summer of this year, potentially involving a modest one-off revaluation of 2-3%, followed by gradual appreciation for the rest of the year; cumulative appreciation of the renminbi against the USD could reach 4-5% in 2010" (see China Economics: Takeaways from Premier Wen's Press Conference, March 14, 2010).
Why to Exit
Despite a 20-month-old de facto renminbi hard peg against the USD dollar, Chinese authorities have in fact never changed their official commitment to a managed float exchange rate regime. According to a recent statement by PBoC Governor Zhou, the current arrangement should be considered as part of anti-crisis policy package, which, we interpret, should be temporary by default.
Moreover, there are four key concrete considerations in favor of an exit from the peg and subsequent renminbi appreciation. First, it helps contain ‘imported' inflationary pressures stemming from rapid increase of key international commodity prices. China's non-food CPI inflation is heavily influenced by PPI inflation, which in turn, is closely correlated with international commodities (see China Economics: Inflation Outlook in 2010: A Supply-side Perspective, November 1, 2009).
Second, while Chinese authorities have made a strong case for the status quo, China's major trading partners consider the renminbi undervalued and its hard peg against USD as a symbol of a ‘mercantilist bias' in China's foreign trade policy. An open and free international trade system has proven to be of strategic importance to China's long-run economic development and much more important than a few percentage points gain in market share due to improved competitiveness as a result of an undervalued currency. If this system is deemed threatened by China's current exchange rate practice, it makes a lot of sense for China to demonstrate flexibility and pragmatism on this issue with the objective of safeguarding the global trade system, in our view.
Third, a stronger renminbi helps effect real appreciation of the renminbi and thus renationalize relative prices between tradable and non-tradable sectors. This helps rebalance the economy away from over-reliance on external demand as a driver of growth towards more domestic-demand, non-tradable-sector-driven growth.
Last but not least, renminbi appreciation in the near term should help China eventually move towards a more flexible exchange rate arrangement, which is a prerequisite for independent monetary policy.
When to Exit
We maintain our long-standing call that the most likely ‘window of opportunity' for renminbi exit from USD peg is early 3Q or the summer, although we cannot completely rule out an early move hinging on the timing of key political events (e.g., US-China Strategic Dialogue in late May).
There are two necessary conditions for an exit from the peg, in our view. First, the strong recovery in export growth should be considered sustainable. Second, inflationary pressures should become significantly strong. The former condition is of particular importance, as it helps soften resistance from within the government to renminbi appreciation. We expect that both necessary conditions would have been met by the summer. For instance, we forecast exports to maintain double-digit growth through 1H10 and CPI inflation to reach a peak at 4.0-4.5% in June-July.
Moreover, in his latest decision on April 3 to delay the issuance of the currency manipulation report, US Treasury Secretary Tim Geithner stated that "There are a series of very important high-level meetings over the next three months that will be critical to bringing about policies that will help create a stronger, more sustainable, and more balanced global economy. Those meetings include a G-20 Finance Ministers and Central Bank Governors meeting in Washington later this month, the Strategic and Economic Dialogue (S&ED) with China in May, and the G-20 Finance Ministers and Leaders meetings in June. I believe these meetings are the best avenue for advancing US interests at this time."
By highlighting the "next three months", Secretary Geithner is giving China another three months (April-June) to form a consensus and make a decision on the renminbi exchange rate, and this effectively sets July as a deadline for such a move, in our view. This is consistent with our long-standing call on the timing of a policy move on this front. Moreover, China's exit from the renminbi peg against the USD during the summer would allow: a) the Obama administration to claim credit of ‘their skillful diplomacy' in the run up to the mid-term election in November; and b) the Chinese authorities to demonstrate its ‘global responsibility' in the run-up to the G20 Summit that is to take place in Seoul in November.
Incidentally, it is worth noting that both the depeg of the renminbi from USD in 2005 and the repeg of the renminbi to the USD in 2008 took place around July 21 of the year. While this may well be pure coincidence, a move in July allows the Chinese authorities to take comprehensive stock of the developments in 1H10 in general and external balance of payments in particular, in our view. Comprehensive data for the latter tend to be available only on a semi-annual basis.
Another potential reason why July is chosen as the month of such an important policy move is perhaps related to the timing of IMF's annual review of Chinese economy, or the Article IV Consultation, in our view. IMF Article IV consultation with China tends to take place in late July and early August each year. IMF is the only international organization that has the mandate to monitor and assess the appropriateness of a member country's exchange rate arrangement, and its opinion therefore carries substantial more legitimacy and authority than any other view expressed by either another sovereign state (e.g., the US) or multilateral groups (e.g., the G7, G20).
How to Exit
There are three potential scenarios when the exit takes place: i) resume gradual appreciation without an initial adjustment; ii) a modest initial adjustment of 2-3% to be followed by gradual appreciation such that cumulative appreciation would be 4-5% for the year; and iii) a large initial revaluation (i.e., over 5%) to be followed by gradual appreciation.
Scenario ii) is most likely, in our view. Specifically, first, the political benefit from scenario i) will unlikely be significant enough to appease major trading partners and demonstrate the Chinese authorities' seriousness, especially given that so much political capital has been expended on this issue. Second, in absence of major inflation (i.e., over 5%Y) or a very large trade surplus, we believe it is very unlikely for the Chinese authorities - who are known for their hallmark gradualist approach - to make such a bold move. We therefore would rank the probability of the three scenarios from the highest to lowest as: scenario ii> scenario i> scenario iii.
The initial adjustment could be in the form of a high-profile announcement of a one-off revaluation of the central parity by 2-3%, i.e., exactly like the policy move on July 22, 2005. Alternatively, a de facto one-off revaluation could be engineered such that the USD/CNY spot rate is allowed to decline by 2-3% in a matter of weeks upon exit from the peg.
While the exit may involve some minor modification of existing mechanism (e.g., widening the trading band), its initial impact will likely be largely symbolic. It is important to understand how the existing (or pre-crisis, pre-new peg) trading band works technically. At the beginning of each trading day, the USD/CNY central parity of the current trading day is determined based on the weighted average of the price quotes provided by the market markers. The central parity rate is announced 15 minutes before trading begins each morning. The trading band is one for the intra-day moves only in that the USD/CNY rate is constrained within now ±0.5% of the renminbi-US dollar central parity of that trading data. However, the central parity rate may, in theory, vary by any magnitude from the closing rate of the previous trading day. In another words, the inter-day changes are not constrained by the band (see China Economics: Band Widening ≠ Faster Renminbi Appreciation, May 21, 2007).
Although the central parity of renminbi-US dollar exchange is, in principle, determined based on the weighted average of the quotes from market makers, it is still heavily managed by the PBoC, which has considerable discretion over determining the weights when the weighted average is calculated. Thus, the pace of renminbi appreciation ultimately hinges on how comfortable the Chinese authorities are with allowing faster appreciation of the central parity rate instead of the intra-day volatility around the central parity rate.
If the Chinese authorities were to announce a widening of the existing trading band upon the exit from the peg, it would relax a non-existent constraint on the pace of renminbi appreciation against the US dollar. While the trading band widening per se may not necessarily lead to faster renminbi appreciation, it would signal Chinese authorities' renewed commitment to a more flexible exchange rate regime.
USD/CNY Forecasts
We envisage that the exit will take place in early 3Q, such that the USD/CNY rate will likely reach 6.64% by end-3Q10 and 6.54 by end-4Q10, implying about 2.83%Y and 4.50%Y appreciation against the USD in 3Q10 and 4Q10, respectively. We forecast that the USD/CNY rate could reach 6.17, implying another about 6% appreciation the USD through 2011.
With these USD/CNY forecasts through 2010, we estimate - based on the exchange rate forecasts made by Morgan Stanley's Global FX Strategy team - that the trade-weighted nominal effective exchange rate (NEER) for the renminbi would appreciate by about 7-8% by the end of 2010 to a level still below the highs reached in 1Q09 and by another roughly 1% in by end-2011 (see FX Pulse: How's the Year Going? April 1, 2010). The faster NEER appreciation in 2010 than 2011 is warranted by the need to catch up, in our view.
FX Market Implications
If our forecasts were to turn out to be right, the offshore NDFs would be wrong. As of end-March, the offshore renminbi NDF market has priced in only modest appreciation of the renminbi against USD, with the 6-month and 12-month outright NDFs at 6.74 (or 1.19% appreciation relative to the spot) and 6.66 (or 2.42% appreciation relative to the spot), respectively.
Why is the pricing on offshore NDF market ‘wrong'? Who is long USD/CNY on the NDF market when short USD/CNY seems a rather safe one-way bet at the current juncture? Our understanding is that the long USD/CNY trades on the offshore NDF market are mainly put on by two types of onshore players: a) those corporate accounts who want to lock in cheap CNY funding cost; and b) onshore/offshore USD/CNY forward market arbitragers.
Regarding onshore companies' effort to lock in cheap CNY funding, since the interest rate spreads between onshore renminbi loans and US loans are nearly 300bp, many Chinese enterprises prefer to borrow ST FX loan at much lower rates and then sell the US dollar borrowed on the onshore spot market and at the same time buy US dollar forwards from the NDF market to hedge FX exposure. As a result, they lock in very cheap financing cost.
Read Full Article »