NEWS / Foreign Exchange

World: China raises interest rates

Highlights

• The global outlook remains consistent with a moderation of growth in 2007. In China, another sequence of strong economic reports has prodded the central bank to tighten another notch.
• After U.S. Q4 growth was revised down significantly and recent indicators remain consistent with more below-trend growth in Q1. Consumer spending in particular shows signs of deceleration. A sharp deterioration in the solvency of homeowners with subprime mortgages may be undermining the U.S. economic outlook.
• The Canadian economy disappointed again in Q4 with a third consecutive quarter of below-trend growth. Slow growth notwithstanding, the labour market continues to create jobs at a furious pace. Productivity growth, on the other hand, remains dismal.

World: China raises interest rates

The global outlook remains consistent with a moderation of growth in 2007. In China, another sequence of strong economic reports has prodded the central bank to tighten another notch.

The OECD??™s leading economic index of industrialized countries fell in January for the second month in a row. As our top chart shows, the six-month rise in this composite indicator has dropped below 1% for the first time in almost two years (March 2005). The signal of deceleration is not confined to a single region. By our calculation, about half the OECD member countries reported a January decline in their leading indexes, the broadest retreat since early 2005. Such movements in the past have been followed by a cooling of the CRB metals price index within about six months.

That said, the outlook for metals today is arguably much more dependent than before on emerging Asia.

China??™s growth has been extremely resilient so far this year, so much so that Beijing has tightened another notch. On March 17 the central bank, following through on comments by China??™s premier that the country??™s growth was unstable and environmentally unsustainable, raised its one-year lending rate 27 basis points to a seven-year high of 6.39%. That move followed a succession of increases in commercial bank reserve requirements that failed to curb the growth of renminbi-denominated loans. It should be kept in mind that interest rates adjusted for inflation are nowhere near those of the late 1990s, when China went through a bout of deflation. In other words, Chinese short-term rates are hardly restrictive.

Credit expansion continues to be fuelled in large part by an ever-growing trade surplus. Net exports shot to another record in February. As our bottom chart shows, the 12-month cumulative surplus is at an alltime high, both absolutely and as a share of GDP. This development, at odds with the government??™s objective of reducing reliance on external markets for growth, has led some senior Chinese leaders to question the serious environmental and resource constraints caused by the current growth model, now increasingly viewed as unsustainable in the long term.

A sudden change of course is unlikely, since there is little Beijing can do in the short term to alter the country??™s growth mix. Until the foundations of a broader safety net are put in place to encourage domestic consumption, China will continue to rely disproportionably on exports for economic growth to absorb the more than 15 million people migrating annually to the cities.

However, we expect the authorities to keep up the pressure as long as GDP growth, currently about 11%, continues to overshoot the government??™s 8% target. We expect Beijing to introduce further administrative controls, interest-rate increases and currency appreciation in the coming months.

U.S.: Subprime woes

U.S. Q4 growth was revised down significantly and recent indicators remain consistent with more belowtrend growth in Q1. Consumer spending in particular shows signs of deceleration. A sharp deterioration in the solvency of homeowners with subprime mortgages may be undermining the U.S. economic outlook.

U.S. real GDP growth in Q4 was revised down in late February to 2.2% from 3.5%. Most of the adjustment was in business inventories, which grew much less than previously assumed. The revision leaves real GDP growth below the estimated trend rate (2.8%) for a third consecutive quarter, the longest such string in more than three years. As our top chart shows, spare capacity is building in the U.S. economy: the output gap is the largest in more than a year.

Current indicators suggest yet another quarter of lacklustre growth in Q1 (we expect 2%). The vast majority of business surveys at this writing show no imminent rebuilding of inventories. Housing starts in the first two months of the year were down from the Q4 pace and forward indicators such as permits continue to deteriorate. Business investment has yet to show signs of a rebound after the largest quarterly decline in four years. New orders for durable goods plummeted 8.7% in January. Nonmilitary capital goods orders ex aircraft, a key barometer of business capital spending, declined 6.3% on the month and were lower than a year earlier for the first time since early 2003 (chart). Until recently, most economists were arguing that the drag on the U.S. economy from the housing sector in 2007 would be more than offset by business investment in equipment and software. But as our middle chart shows, softness in investment-related indicators since the beginning of the year has prompted significant downward revision of the consensus expectation for capital spending in 2007. By our calculation, the business investment growth now expected in 2007 would be more than offset by a 10% decline in residential investment (which is a fairly conservative assumption at this point).

Although the consensus expectation for 2007 GDP growth has also been marked down recently, the forecast for consumer spending is unchanged at 3.1%.

This could be about to change ??“ spending has been soft so far in Q1. Retail sales rose an anemic 0.1% in February with eight of the 13 major business groupings reporting declines. Discretionary spending (retail sales excluding food, beverage, gasoline and drugstore sales) was down for the second month in a row. While bad weather may have played a role, it is also possible that consumers are starting to cut back on discretionary spending as housing wealth wanes.

We continue to see the housing market as a major risk to consumer spending. The Mortgage Bankers Association reports a significant increase in mortgage delinquency and foreclosure rates in Q4. Most of the deterioration was in the subprime market ??“ households with lower credit scores. Until recently this segment was considered too small to derail the overall housing market, but in the past seven years it has surged from 2% to more than 13% of all mortgage loans outstanding (top chart). As a result of this steep growth, variations in foreclosure rates need no longer be so large for the subprime segment to significantly affect the supply of homes for resale. In Q4, 4.5% of subprime loans were in foreclosure versus 0.5% of prime loans. Although that subprime rate is well below the 9% of 2001, the segment now accounts for a large majority of U.S. homes in foreclosure. A further rise in foreclosures could hasten the adjustment of home prices and significantly reduce the share of consumption financed by home-equity extraction. As of Q4, active mortgage equity withdrawal was 3% of disposable income, down from 6% last year (chart).

We accordingly expect the current woes of the housing market to slow consumer spending growth in the coming months. The extent of deceleration will depend on labour income and employment. The February jobs report was not the most encouraging on that front. It showed net job growth of 97,000, the slowest in two years. Most of the weakness was in construction, whose loss of 62,000 jobs was the worst since January 1991. The Bureau of Labour Statistics attributed most of the setback to harsh weather rather than deteriorating fundamentals. If the Bureau is right, construction jobs will rebound in March. Our own view remains that recent widespread weakness in cyclical industries (manufacturing, construction, retailing, temporary help) heralds an overall deterioration of the labour market (chart). That development would be consistent with our prediction of a significant slowdown in consumer spending growth in the second half of 2007.

We have made no significant changes to our U.S. outlook this month.

Canada: Productivity-deprived?

The Canadian economy disappointed again in Q4 with a third consecutive quarter of below-trend growth. While job creation has been stellar so far this year, productivity growth remains dismal.

Canadian real GDP expanded in Q4 at an annual rate of 1.4%, the slowest in 3?? years. Business inventories were by far the biggest drag, subtracting close to four percentage points from real growth. Consumer spending, nonresidential investment and exports were the main positives. For the first time in six quarters, net exports were not a drag on growth. This picture is likely to be reversed in Q1 by lower automotive production and railway labour strife that disturbed shipments in February.

Slow growth notwithstanding, the Canadian economy continues to create jobs at a furious pace. More than 14,000 were added in February, a performance all the more surprising as it came on the heels of two strong months. The employment growth of 103,000 in the first two months of the year was the best January-February showing since 1981. Two-thirds of the new jobs were in Western Canada (30% of the Canadian labour market). So while the domestic economy as a whole is well-supported, there is a large regional divide.

This divide has significantly affected Canadian labour productivity, which in the business sector was up only 0.4% from a year earlier in Q4. As our bottom chart shows, this was the worst performance in more than two years. What is happening?

Last year??™s productivity growth slowdown was mainly in resource industries, where the meteoric rise of commodity prices has brought previously uneconomic lower-grade or remote deposits into production. Extracting oil from tar sands, for instance, requires much more labour per barrel than pumping it from a well. As oil from the sands replaces oil from conventional deposits, productivity falls apace. Theoretically, a country??™s standard of living is a function of its productivity. At this time in Canada, however, the deceleration of productivity growth, mainly in resource production, has been more than offset by improvement in the terms of trade. The net result is an increase in Canadian wealth. Looking ahead, there is scope for optimism on the productivity front. A study by an analytical group recently set up at Statistics Canada concluded that most of the factors in the recent productivity deceleration were short-term and transient rather than structural.

If this is the case, the Bank of Canada need not be overly concerned with lacklustre growth in output per hour worked. Inflationary pressures remain wellcontained. As our top chart shows, the deflator for core personal consumption expenditures is still up only 1% from a year earlier, more than 1 percentage point below its U.S. equivalent. The Bank of Canada??™s policy rate is just as high as the Fed??™s after adjustment for inflation.

Though inflation is tame, the Bank recently flagged Canada??™s robust real estate market as an inflation risk. It fears that households could spend more than expected by borrowing on their increased home equity. It is true that credit growth has been strong in recent years, with rapid increases in home prices creating a wealth effect that households can tap through homeequity lines of credit. In recent months, however, the growth of personal lines of credit at chartered banks has slowed significantly (middle chart).

In our view, the recent dynamic of the housing market does not suggest a major threat to price stability. It is true that the average price of a new home increased in January for Canada as a whole, but it was flat or lower in six of the 10 provinces. By our calculation, the median (as opposed to average) home price was unchanged in January for a second consecutive month, the first time this has happened since December 1998. As our bottom chart shows, 12-month home price inflation in Canada is still driven essentially by red-hot Alberta. Excluding that province ??“ where price increases have begun to decelerate ??“ 12-month home price inflation subsided to an eight-month low of 6.1% in January.

We have made no significant changes to our Canadian outlook this month.