10.05.03 global economics morgan

In-Depth

Please see important disclosures starting on page 21

Page 1

Economics

Equity Research Global

Morgan Stanley does and seeks to do business with companies covered in its research reports. Investors should consider this report as only a single factor in making their investment decision.

Economic Trends October 5, 2003Stephen S. Roach +1 (1)212 761 7153 [email protected] Global Economics Team

Weekly International BriefingGlobal: Americas Political Gambit Stephen Roach (New York) New Kids on the Block Will They Create or Divert FDI? Rebecca McCaughrin (New York)

Currencies: USD/JPY 100 Is the Only Barrier I Truly Respect Stephen Li Jen (London)

The Americas: United States: Is the Consumer Party Over? Richard Berner (New York)

Europe and the Middle East: Euroland: The Case for Accelerating Growth Eric Chaney &Anna Grimaldi (London) United Kingdom: Faster, but More Balanced Growth Joachim Fels & Melanie Baker (London) Italy: Breakthrough on Pensions Vincenzo Guzzo (London)

Asia & Pacific: Asia Pacific: Brother, Could You Spare a Million? Andy Xie (Hong Kong) China: Gathering Clouds Andy Xie (Hong Kong) Japan: Swaying Expectations Takehiro Sato (Tokyo) Japan: Can High Growth Return in 2004? Osamu Tanaka (Tokyo) Asia Pacific: Second Track Principles -- Malay-Thai Comparison Daniel Lian (Singapore)

Global: Americas Political Gambit Stephen Roach (New York)

Keep your eye on politics. As I see it, the struggle for control of Americas White House and all the policy options that spin out of this struggle could well be the single most important factor shaping world financial markets over the next 13 months.

Timing is everything in Hollywood and Washington. Given the well-known lagged impacts of traditional stabilization policies, actions being taken today could bear critically on the environment a year from now precisely the time frame when presidential politics will be most intense. In my view, that could have been the decisive consideration behind the Bush administrations efforts to bring currency policy into play at the recent G-7 meeting in Dubai. The fiscal and monetary instruments of Americas policy arsenal were already fully engaged. Runaway federal budget deficits and a 1% federal funds rate dont exactly lay open the possibility of much further stimulus from these avenues. Foreign exchange policy is the third leg of the macro policy stool, but one that works in mysterious and often unpredictable ways. Since the start of 2003, the Bush administration has been tinkering with Americas so-called strong dollar policy. The Dubai G-7 communiqu represented a wholesale shift away from this stance an action that I believe was orchestrated by the US to have maximum impact on the upcoming presidential election campaign.

The logic behind this strategy is not hard to fathom. While the US economy is growing very rapidly at the moment, an incumbent Bush administration cannot afford to take the risk that this newfound vigor could give way to a relapse by mid-2004. Another growth scare at that juncture would be the worst of all possible outcomes for a sitting president embroiled in a tough reelection campaign. As is the case in financial markets, the political calculus is all about probabilities in this case, weighing the risks concerning the major macro forces that are likely to be shaping the economic climate a year hence.

In that vein, incumbent politicians cannot afford to dismiss the case for a

Global Economics

Global Economics October 5, 2003


Page 2

relapse. As I see it, there are two big risks to just such an outcome, the first being a payback from the current growth spurt. Thats a distinct possibility in light of this summers surge of consumer spending on durable goods, especially motor vehicles. These items are called durable for a reason; they are long-lasting items that tend to be purchased infrequently. As such, any unusual bursts of durable goods spending invariably bring forward demand that borrows from future sales the core of the classic stock-adjustment models of economics.

Unless there is quick and meaningful relief on the US job front, pressures for the political fix will only grow.

Over the next few months, the risks of just such a payback are hardly inconsequential. Driven by the combination of tax cuts and aggressive sales incentives of hard-pressed producers, motor vehicles sales surged to an astounding 19.4 million unit annual rate in August. Not even the overly indulgent American consumer can sustain such an explosion of buying for long, and the September reading of a 16.7 million unit annualized selling rate for vehicles seems to be the first sign of a fairly normal payback. Bush administration officials have boasted that their latest fiscal stimulus was spring-loaded guaranteed to provide a quick boost to the US economy. The risk is that the spring has now been sprung. If thats the case, the encore of the payback effect could shift the odds back toward a relapse.

The second risk is jobs. If Americas jobless recovery doesnt come to an end by the time the presidential campaign gets under way in earnest, the Bush administration will be facing one of its worst political nightmares. There is hope in many quarters, of course, that hiring is set to rebound, especially now that GDP growth has turned more vigorous. In my view, the puny increase of 57,000 in nonfarm payrolls just reported for September hardly validates such hopes. The issue is the time-honored linkage between aggregate demand and domestic labor input. The structural overlay of what I have called the global labor cost arbitrage draws that linkage into serious question. IT-enabled outsourcing in goods and services provides low-cost offshore options for US-based

multinationals that could crimp hiring indefinitely. Such employment leakages threaten the sustainability of the current growth upsurge constraining wage income generation and thereby eroding the traction that normally converts policy stimulus into the cumulative dynamic of sustainable recovery.

The currency lever does address one aspect of Americas job shortfall. Taken to its extreme, it has the potential to affect relative cost comparisons between domestic and foreign labor input. But problems arise with respect to both long lags and the order of magnitude of the dollar depreciation required to make US labor rates more attractive. Those shortcomings of the weak-dollar cure are what have opened the door to the dangerous alternative of protectionism. Politicians believe it is now up to them to take explicit action to deal with unfair competitive pressures that are impeding US job creation. Both houses of the US Congress have already taken such initiatives, targeting China and its currency policy as the culprit. Senate legislation to impose steep tariffs on China has six co-sponsors, and a comparable bill in the House has over 60 co-sponsors. Lacking the patience to wait for market-based currency realignments to rebalance the world, Americas short-sighted politicians have made China bashing the new sport in this jobless recovery.

Where this stops is anyones guess. But unless there is quick and meaningful relief on the US job front, pressures for the political fix will only grow. The most worrisome aspect of this possibility is that there appears to be no effective counterweight anywhere in the political spectrum. In a jobless recovery, there is no political capital to be gained by standing up for free trade.

Key Risk Events US: Wholesale Trade (10/8), PPI, Trade Balance (10/10) Euroland: EMU - Eurogroup (10/6), ECOFIN Mtg. (10/7); Germany - Unemployment, IP (10/9); France - IP (10/10) UK and Other Europe: UK - IP (10/7), MPC Mtg. (10/9) Japan: Machinery Orders (10/8), BoJ MP Mtg. (10/9-10), Money Supply and Bank Lending, Dissolution of Lower House (10/10) Non-Japan Asia: China - Industrial Output (10/10-13); Hong Kong - Retail Sales (10/7); Singapore - GDP (10/10); Korea - BoK MP Mtg. (10/9) Latin America: Brazil - IP-IBGE (10/7), IPCA (10/9); Mexico - CPI (10/9), MP Mtg. (10/10)



Page 3

Global: New Kids on the Block Will They Create or Divert FDI? Rebecca McCaughrin (New York)

Note: This piece is excerpted from a longer version that appeared in Merging Europe: A Primer on EU Enlargement.

Next years accession to the EU by the ten central and east European economies (CEE) has triggered concerns that capital could be diverted away from the southern EU periphery. The region already competes with southern Europe (SE) on low corporate tax rates, educational standards, labor skills, wages, production costs, and public infrastructure. In theory, capital should flow from capital-abundant to capital-poor economies until relative rates of return equalize, which would suggest that the integration of CEE could detract from investment in the more capital-abundant SE. While we have some sympathy for that view, we believe that slower growth in FDI to SE is more likely to result from a shift toward long-term equilibrium than because CEE siphons off capital. This is consistent with dynamics witnessed in recently liberalized economies, which tend to see inward foreign investment overshoot and then moderate to an equilibrium level once reform momentum and privatization projects peter out.

Past is Not Prologue Studies on the prospects of FDI into the CEE accession economies tend to rely on SE as a benchmark because of the similarities in pre-accession capital mobility, privatization schemes, population, and GDP. But, in our view, the external environment has changed too significantly since the last enlargement period to draw parallels. Moreover, the countries joining the EU during this round are more numerous and have already undergone a significant amount of privatization. Instead, we approach the question of how much potential the candidate economies have to attract FDI by relying on gravity model simulations that measure the expected level of investment relative to the current level.

Gravity models were first introduced in the 1960s and used to analyze international trade flows, but they have since gained in importance in explaining FDI dynamics. In such models, the dependent variable, aggregate FDI flows, is explained in terms of the following determinants: GDP, population (as a proxy for market size), M2/GDP (as a proxy of the size of the host countrys financial system), trade/GDP (as a proxy of the host countrys openness to foreign trade), the distance between the recipient and host countries, and a dummy variable for EU membership. The

level of investment that would be expected given these determinants can then be compared with the current level of investment to determine whether an economy has undershot or overshot its long-term equilibrium.

Accession is not likely to trigger a reallocation of capital away from the EU peripheral economies.

Estimates derived from simulations confirm that actual investment in the EU accession countries falls short of the expected levels, while for the EU peripheral economies, the stock of inward FDI has already come close to or exceeded expected levels. Spain is the most glaring outlier, with the stock of inward FDI having overshot the long-term equilibrium by 20%. The expected stock of investment in Greece and Portugal is nearing, but has yet to reach, equilibrium levels. This suggests that only incremental amounts of FDI should be forthcoming.

Exhibit 1

Ratio of Actual to Expected Stock of Inward FDI Based on Gravity Model Simulations

0 20 40 60 80 100 120 140

Slovakia

Russia

Bulgaria

Romania

Slovenia

Poland

Czech Republic

Portugal

Greece

Hungary

Spain

Source: Kiel Institute of World Economics Among the most advanced accession countries, the Czech Republic and Poland are closing in on their equilibrium level of expected stock of inward FDI, but still have ample room for expansion. Hungary, by contrast, is closer to reaching 100% of its expected stock of FDI than the other accession economies, and even higher than current EU members, Greece and Portugal. This may be due to the fact that the anticipation effect of EU membership was much greater in Hungary, and as a result, FDI may have overshot to a larger degree and far before the other accession countries. The least advanced accession economies are furthest from their long-term steady state, and thus have relatively more capacity to attract foreign investment, especially as companies seek alternative low-cost production and export platforms.



Page 4

Accessing New Markets While the simulations confirm our expectations, we recognize that this approach is somewhat flawed, as it presents a static picture. While certain determinants, like population and distance, are unlikely to change upon accession, other determinants, like GDP, M2, and trade may well change, and the model fails to incorporate these potential changes. That said, other arguments support the econometric findings.

First, the very concept of FDI diversion lacks theoretical integrity. The fact that SE has seen its pace of FDI from EU slow does not necessarily imply that the rise in investment in CEE is the culprit. If that were the case, then all other economies should have borne the brunt of a slowdown in FDI as CEE economies became more attractive. But that has not been the case. A regional distribution of FDI outward stock by the six major EU countries shows that the stock of investment rose in Asia ex-Japan just as CEE began to attract more investment. The pool of available capital is fluid, not fixed.

Second, FDI into CEE is predominantly market-seeking. This type of investment is less likely to be diverted than efficiency/supply-seeking FDI. Market-seeking FDI is characterized by investment that attempts to tap the consumer market, while efficiency/supply seeking FDI attempts to exploit the cost advantages of the host economy. In the case of CEE, foreign investors are more attracted by the regions growth potential and market size than its low-cost production or cheap resources.

Third, FDI flows in CEE are increasingly gravitating toward the services sector. In the Czech Republic, for instance, 82% of FDI inflows targeted the services sector in 2002, taking advantage of privatization in telecom and banks. Similarly, 80% of Polands inflows and 69% of Hungarys inflows also targeted the services sector, up from roughly 50% in the early 1990s. The predominance of services-related FDI, together with the fact that FDI in CEE is generally market-seeking, suggests that the priority among MNCs is to access new markets, not reallocate manufacturing facilities away from SE.

Bottom Line Our analysis suggests that the EU candidate countries are likely to continue to attract robust levels of foreign investment upon accession, with greater capacity for expansion among the less advanced economies. However, based on gravity-model simulations and given the

specialized nature of FDI targeting CEE, accession is not likely to trigger a reallocation of capital away from the EU peripheral economies. While SE may well experience a moderation in FDI, this pullback is not likely to be related to the process of EU accession. Instead, it may simply reflect an adjustment process as FDI levels converge toward a long-term steady state.

Currencies: USD/JPY 100 Is the Only Barrier I Truly Respect Stephen Li Jen (London)

In my view, the USD will continue to weaken against a broad basket of currencies, including the EUR and JPY, with the EUR rallying by default, the JPY by merit. USD/JPY is likely to eventually drift below 110 and approach 100.

The structural dollar correction. The dollar correction is progressing apace, and playing out roughly according to our script substantial in size, gradual in pace. The first legs of the correction were highly asymmetrical (January 2002-May 2003), with the USD correction 3x larger against the EUR than against the JPY, even though Asia accounts for some 51% of the total US trade deficit, while Euroland accounts for 14%. This lopsided USD correction was not sustainable and peaked out in June this year. I have argued that the final phase of the USD correction would only be possible if USD/Asia were allowed to trade lower. I argued that this leg would not be EUR-led and that the USD would weaken against a broad basket of currencies.

The fears of USD/JPY at 100 undermining Japans recovery and the Nikkei are grossly misplaced.

The idiosyncratic JPY story. Against a backdrop of USD-push factors pushing capital out of USD assets, there are also important JPY-pull factors pulling capital into Japan. My basic thesis remains that there will be a mini-repeat of 1999, when a foreign-capital-fuelled Nikkei rally drove USD/JPY lower, prompting massive intervention by the MoF. This time, we also have the negative USD story:

Economic Recovery. Japans revised annualized Q2 growth rate was 3.9%, making Japan, on paper, the fastest growing economy among the G7, including the US, and on



Page 5

the face of it, the quality of growth is Japan is also superior to the US investment and consumption contributed positively, government expenditures were a detractor. Net exports were also a positive contributor (most of the gains from Asia). Having said this, there is a problem with the GDP deflator which suggests that the real real GDP growth rate in Q2 may be around 1% lower than 3.9%. But with potential GDP growth still considered to be around 1.5%, this would still constitute a compression in the output gap. Further, Japan is enjoying a job-creating recovery. With the strong Tankan and sentiment measures remaining positive, Japan is likely to generate an impressive growth rate for 2003.

Structural Reform. First, non-performing loans (NPLs) continue to be discharged at a rapid pace. Though Japan is not yet out of the woods, the worst is over for the banking sector, in my view. Second, at the same time, banks are not as desperate in unloading their cross-share holdings as they were last year, which should further enhance the outlook of the Nikkei. Third, the FSA is committed to holding banks to their profit targets by the end of this fiscal year. The threat of replacing management should force banks to continue to cut costs and streamline their operations.

Massive monetary reflation. Under Fukuis leadership, the BoJ has endeavored to maximize the supply of liquidity in the market. The BoJ has tried to convey the message to the market that it is in no hurry to start tightening. A super-liquid monetary condition should continue to fuel the rotation from buoyant JGBs to a buoyant Nikkei.

Re-election. As expected, Koizumi won the LDP Presidential election with no difficulty. All along, the key idea has been that, as long as Koizumi sticks to reform, he should have the opportunity to be the premier until 2006. His re-election implies political continuity and also that the momentum for reform should be maintained. Reform momentum also reduces the risk for equities.

Why USD/JPY is likely to fall toward 100. In addition to the structural USD negatives and the JPY positive factors, currency policy is also an important factor. The US and Japan have different interpretations of what the G7 communiqu really means, but the US never said that there should be no intervention. The MoF will likely continue to fiercely intervene. But the combined USD-push and JPY-pull effects should drive USD/JPY toward 100. 100-105 is likely to be a stable resting level for both Japan and the US.

But that wont hurt Japan. The fears of USD/JPY at 100 undermining Japans recovery and the Nikkei are grossly misplaced, in my view. First, the income effect is much more important than the price effect. Thus, to the extent that the global economy does recover, this should more than offset the stronger JPY. Second, the right price to consider is not USD/JPY, but the real trade-weighted value of the JPY. Since the beginning of 2002, USD/JPY has fallen by 17%. However, the real JPY TWI has appreciated by only 2.5%. Uncertainty and volatility in USD/JPY are more important than the level, as long as it doesnt go below 100 in my view.

Bottom line. The only barrier for USD/JPY that I truly respect is 100. The MoF will almost certainly try to defend 110 and 105, but these levels can be broken in the current environment, with USD-push and JPY-pull factors.

United States: Is the Consumer Party Over? Richard Berner (New York)

The economys recent improvement owes much to an acceleration in consumer spending. Indeed, tax cuts and the mother of all mortgage refinancing booms appear to have fuelled a summer spending spree. Over the four months ended in August, spending jumped at a 7% annual rate, compared with a virtually no growth in the first four months of 2003. But with scant job growth to underpin income gains and the one-time benefits from lower taxes and refi allegedly gone, bears fear that the party ended at Labor Day. Indeed, Septembers modest rise in nonfarm payrolls wont likely change their mindset. Im more upbeat. While theres little doubt in my mind that lacking continued job growth, the nascent recovery would ultimately falter, I think theres more to the consumer revival than a summer fling. Heres why.

First, income gains are stronger than the long decline in payrolls implies. To be sure, real pretax wage and salaries declined by 0.1% in the year ended in August, as rising energy quotes eroded real wages. But other sources of income are providing a significant offset. The sum of government transfer payments, like Social Security and unemployment insurance benefits, nonfarm entrepreneurial or proprietors income and dividends, which collectively account for nearly one-third of personal income, jumped by



Page 6

5.1% after inflation adjustment. With Corporate America beginning to raise dividend payouts and profits rising strongly, dividends should continue to outpace other income well into next year. Moreover, corporate plan sponsors once again are contributing cash to shore up defined-benefit pension plans, and that source of income is bolstering personal saving.

Exhibit 1

Nonwage Income Strength a Partial Offset to Weak "Core" Income

-2

-1

0

1

2

3

4

5

6

7

8

98 99 00 01 02 03-2

-1

0

1

2

3

4

5

6

7

8

Real wage & salaryincome, year-over-yearpercent changeReal nonwage income, year-over-year percent

change

Note: Nonwage income includes transfer payments, nonfarm proprietors' income, and personal dividend income. Sources: Bureau of Economic Analysis, Morgan Stanley Research Second, the benefits from mortgage refinancing endure long after the transaction is done, for three reasons. The reduction in interest expense is semi-permanent, given that about 90% of mortgage originations over the past six years were either fixed-rate loans or so-called hybrid adjustable-rate mortgages (ARMs) that carry several years of interest protection. I estimate that refis will reduce mortgage interest payments by $20 billion this year and those benefits will continue in 2004. As evidence, rental income, which nets the reduced mortgage interest expense against the costs of refinancing, jumped by $13.6 billion in July and August. In addition, consumers used about one-third of the proceeds of cash-out refis to swap high-cost non-mortgage debt for lower-cost mortgage credit. I estimate that such pay-downs will net consumers after-tax interest savings this year of $10 billion. Last, some think that the difference between the increase in mortgage debt and the value of net new construction or mortgage equity withdrawal (MEW) has financed spending, and that thus reduced refinancing equals reduced spending. I disagree. Most MEW accrues to retirees or empty-nesters who move to a smaller house or an apartment. They have just

monetized their biggest asset, and they have 20 or more years of retirement not a one-year spree to finance. If MEW had significantly financed consumer spending, the personal saving rate would be close to zero, not 3.8%.

Betting against the American consumer has usually been costly for their wealth, and I dont think this time will be the exception.

A third factor underpinning consumer wherewithal and thus spending is that, contrary to popular belief, the benefits from tax cuts arent simply a summer flash in the pan. While the accelerated child credit that reduced Federal nonwithheld taxes by $13.7 billion in July and August wont be repeated, the benefits from accelerating tax rate reductions, the expansion of the new 10% tax bracket, and marriage penalty relief will show up regularly in paychecks. And the impact of dividend, capital gains, and alternative minimum tax relief will arrive fully early in 2004. So while cutting payroll taxes in my opinion would have been a more potent source of stimulus, this tax cut makes up in heft what it lacks in bang for the buck, and its impact is far from over.

Last but not least, household wealth is beginning to revive. Thats important because consumers plan their outlays thinking not just about to todays income, but also with some notion of lifetime income. That insight, first advanced by the late Nobel Laureate Franco Modigliani, means that changes in wealth have a powerful influence on consumer spending and saving over time. The stock market revival that is now a year old and ongoing gains in net real-estate wealth have contributed to the strongest increase in consumer wealth in three years. I estimate that real household net worth in the third quarter rose 7.4% from a year ago a marked turnaround from the 6.5% average declines in each of the previous two years. While I firmly believe that consumers will steadily save a rising share of their current income in the next several years, improved net worth likely assures that the rise in personal saving rates will be gradual.

The upshot is that consumer fundamentals in my view are better than many fear. The recent surge in consumer spending is unsustainable regardless of what happens to job or income growth, especially considering that much of the acceleration was concentrated in big-ticket durable goods. A payback from the recent surge is thus inevitable. It may have already begun in September, in part in response to the spurt in gasoline prices that reduced discretionary



Page 7

spending power. However, its worth noting that despite OPECs intent to cut production and the bounce-back in crude quotes, retail gasoline prices continue to move lower. More broadly, investors would be mistaken to think that consumers are about to relapse. Betting against the American consumer has usually been costly for their wealth, and I dont think this time will be the exception.

Euroland: The Case for Accelerating Growth Eric Chaney & Anna Grimaldi (London)

The popular story heard in Europe is expectations are improving, but still nothing is happening. Trading rooms are buzzing with guesses that Q3 GDP numbers might be so bad that the first decision Governor Trichet would have to take would be to cut rates hastily. We are the first to concede that the euro area is not yet out the woods. The first data available for August ranged from gloomy to ugly: French consumption fell from a cliff in August, down 2.7% on the month prompting some analysts to predict a contraction of the French GDP and Spanish industrial production was up only 0.4% on the year, a disappointing outcome from the last growth engine left in continental Europe.

However, a careful analysis of business cycle indicators is telling a different story. Five weeks ago, we signaled that the discrepancy between expectations and current conditions was something natural, in the very first stage of a recovery, and was not some kind of collective hallucination consuming the 20,000 companies surveyed every month (see Have Surveys Fallen to Summer Madness? by Elga Bartsch and Eric Chaney, August 27, 2003). The September crop of business surveys has confirmed our hypothesis. Follow me in the details of the surveys: forensic analysis, not just a brief glance at headline numbers, is required here.

Our qualitative cyclical indicators indicate that GDP growth is likely to surprise on the upside in Q4 and, perhaps, in Q1 too, as the German tax cuts start to kick in. European equity markets, which are still suffering from an abnormally large discount compared to US ones, would likely appreciate then.

Its Not Just Expectations, Its Also Real! First, European manufacturing companies are saying that production growth was still weak in September, but significantly less than it was in July. Our survey-based gauge of current production moved from -1.2 in July to -0.5 in September, all measures being normalized and zero being the long-term average. Interestingly, the German index, taken from the manufacturing section of the Ifo survey, emerged in positive territory for the first time since August 2002. The Euroland PMI survey, which correlates quite decently with actual production growth on a year-on-year basis, was similar, rising to the 50 break-even level, also for the first time since August 2002. Notice that the production component posted a larger jump, from 50 in August to 51.8 in September. Taken together, September surveys and PMIs are consistent, in our view, with manufacturing production still in slightly negative territory in Q3, on a year-on-year basis.

Exhibit 1

The Euroland Surprise Gap Index: Its Coming

-1.0

-0.8

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

1992 1994 1996 1998 2000 2002 2004-1.0

-0.8

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

Difference between business sentiment and 3M laggedexpectations

September 2003

January to April 2002 data were removed from the sample

Unit: Standard Deviation

Source: EU-6 manufacturing surveys, Morgan Stanley Research Something Took European Companies by Surprise Second, companies tell us something important: current business is significantly better than was expected three months ago. This is the very visual conclusion that should be drawn from our surprise gap index, which jumped from the neutral territory where it had been stuck since the beginning of the year (with the short exception of the Iraq war period, during which it fell) to +0.8, signaling an acceleration of growth. For leading indicators, we are testing a prototype for a revamped version of the surprise gap index, measuring more accurately the gap between expected production three months back and current production (instead of current business conditions). The



Page 8

new version of the surprise gap index is not yet ready for full service; however, we were pleased to see that it is telling the same story: Something occurred during August-September that came as a strong surprise for companies.

Orders Explain the Mysterious Surprise The most obvious suspect is that manufacturers have been surprised by a rise of orders that they had not anticipated. Hard data neither confirm nor deny this surmise. German orders have been quite volatile and the demand/orders component of surveys did not indicate any significant improvement, stable at -0.8. On the other hand, the new orders component of the PMI survey improved further in September to 52, from 50 in August. We have some sympathy for this idea, because another famous cyclical indicator from our tool kit sent a strong signal: The inventory component of the Belgian survey literally took off, suddenly signaling largely insufficient inventories (see Exhibit 2). In the past, this indicator has been a good predictor of up and down swings in the inventory cycle. Now, why would companies suddenly feel that they do not have enough inventories? Again, the most logical answer is that order books were filled in much faster than had been expected. Last, not everything is bad on the demand side. For instance, car registrations were up 8.8% on the month in September, according to the Insee measure, indicating that the August slump was exceptional.

Exhibit 2

The Inventory Cycle is Ready to Kick, Says the Belgium Survey

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.51992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

Assessment on inventories

Inverted scale: up means insufficient inventories

Euroland excl. Belgium

Belgium, advanced 3M

Source: BNB, Morgan Stanley Research There is another possible and less reassuring candidate for the positive surprise we have mentioned: Back in June, Euroland manufacturers were highly worried by the rise of the euro against all currencies. In less than six months, the single currency had risen by some 20% against most of the

relevant currencies, not only the US dollar, but also the Japanese yen, for instance. Since, at that time, nothing seemed able to stop the rise, manufacturers might have anticipated very serious damages to their profits and market shares. That was then. Since June, the euro went down in a first stage, then, as a consequence of G-7 statements in Dubai, it went up, but only against the US dollar, a more benign outcome than the solitary ascent that had traumatized European exporters back in May-June. Even so, if the only reason why manufacturers expressed some relief in September were that the euro did not go to 1.30, the recovery would seem to be questionable.

This is not our interpretation. We believe that the recovery in global trade initiated in Asia has reached European shores and started to refill order books. We also believe that consumer spending was hit by the heat wave that paralyzed a large part of Europe in July-August and is now recovering. Accordingly, we believe that GDP growth is currently accelerating. Our early GDP indicator is now flashing +0.6% in Q3 (quarterly growth, non-annualized) and +0.5% in Q4. Since the third quarter was extremely influenced by climatic hazards, we take the Q3 estimate with a large pinch of salt and stick to our 0.3% forecast. However, anything is possible for the next two quarters. Our qualitative cyclical indicators indicate that GDP growth is likely to surprise on the upside in Q4 and, perhaps, in Q1 too, as the German tax cuts start to kick in. European equity markets, which are still suffering from an abnormally large discount compared to US ones, would likely appreciate then.

United Kingdom: Faster, but More Balanced Growth Joachim Fels & Melanie Baker (London)

Summary and key conclusions. Substantially revised national accounts data show the UK economy grew twice as fast in H1 as previously thought. Many have jumped to the conclusion that this puts a rate hike firmly on the agenda for the near future. However, the data also show much more balanced growth, with consumer spending and imports weaker and investment stronger than the old data suggested. In our view, the marked slowdown in underlying consumer spending should help to alleviate some MPC members concerns that consumption may not have slowed at all. This, together with weaker US data and the recent strengthening



Page 9

of Sterling, should help to keep the MPC on hold until next year.

Less of a slowdown in H1 2003 Growth slowed by less than previously thought during H1, with Q2 real GDP growth revised up from an initial 0.3%QoQ to 0.6%QoQ. Regarding the quarterly pattern, we would not overemphasize the jump from 0.2%QoQ in Q1 to 0.6% in Q2. In our view, this pattern was largely due to caution among consumers and companies in anticipation of the Iraq war, followed by a release of pent-up demand in Q2. Thus, the 0.6% growth rate in Q2 probably overstates the underlying pace of GDP growth.

but better-balanced growth. The main message from the revised GDP data, in our view, is that they portray an economy less out of balance than previously thought. Consumption and imports have been less buoyant and investment has been stronger. This is best illustrated by looking at the components on a year-over-year basis. The new statistics show real consumer spending growth of 2.4%YoY between the second quarter of 2002 and the second quarter of this year, against a previous estimate of 3.3%YoY. Thus, consumer spending slowed noticeably from the average 3.6% pace recorded in 2002. Similarly, import growth was revised down from 1.7%YoY previously to -2.4%YoY now. Meanwhile, gross fixed capital formation now appears to have been positive (1.5%YoY in the year to Q2 2003) against a 1.4%YoY contraction on the old data. The better economic balance also shows up in an upward revision to Q2 manufacturing output growth from 0.1%YoY to 0.6%YoY and a slight downward revision in services growth from 2.5%YoY to 2.3%YoY. Last but not least, the better balance is reflected in upward revisions in the household savings rate by between 0.6 and 1.2 percentage points over 20002002.

We expect the MPC to adopt a wait-and-see attitude for some time to come, and we continue to forecast the beginning of the tightening cycle for next spring when the recovery should be more firmly established.

Forecasts barely changed. For some time, our main story on the UK economy has been one of slowing domestic demand on the back of a fading house price boom and slower post-tax income growth, but better foreign demand reflecting sterlings depreciation earlier this year and a reviving world economy. While that story was not fully backed by the old GDP statistics (especially those for Q2), the new data suggest that we were on the right track.

Looking ahead, we foresee a further slowing in consumer spending growth and a gradual pick-up of exports and capex. Our GDP growth forecast has come up by one tenth, to 0.5%QoQ and 0.6%QoQ in Q3 and Q4, respectively, which together with the revisions to the back data, lifts our 2003 growth forecast from 1.7% previously to 1.9%. For 2004, our forecast remains virtually unchanged at 2.5% (2.4% previously).

Bank of England on hold for now. On the face of it, stronger GDP growth in H1 than previously estimated would appear to bring forward the schedule for rate hikes from the Bank of England, especially as some MPC members already expressed a slight bias for higher rates at the September meeting. In our view, however, the new data do not exactly cry out for a rate hike in the near future. In addition to slightly weaker US data and some sterling strength, the reason is that, as described above, consumer spending growth has been revised down significantly for H1 2003. This should have alleviated the concerns among the MPC, evident in the minutes of the September meeting, that consumer spending may not have slowed at all. By contrast, stronger GDP growth in H2 largely reflects a significant upward revision to net trade and investment, which should be largely non-inflationary. We expect the MPC to adopt a wait-and-see attitude for some time to come, and we continue to forecast the beginning of the tightening cycle for next spring when the recovery should be more firmly established.

Italy: Breakthrough on Pensions Vincenzo Guzzo (London)

In a single week the Italian cabinet approved the budget for 2004 and passed a pension reform that represents the most serious structural effort in several years for the country.

Budget headline numbers as expected. It all started on Monday when the cabinet passed the 2004 budget law, which will now be submitted to Parliament for final approval by the end of the year. The document contains corrective measures worth 16 billion, which should take the deficit down to 2.2% of GDP from an estimated 2.5% this year and yet allow investment in research and development of 5 billion. The underlying assumption is a GDP growth rate of 1.9%, up from 0.5% this year. Both



Page 10

budget balance and GDP targets are broadly in line with our forecast. Barring the case for a new severe slowdown, numbers do not look unrealistic. Monthly releases on the state borrowing requirement have so far been consistent with a 2003 year-end deficit of around 2.3% of GDP. Unpleasant surprises in the local government accounts and disappointing tax revenue flows in the key December payments may push this number higher, but it should remain below the 3% ceiling.

The problem is quality, not quantity. Of a total 16 billion maneuver, only one-third comes from structural measures. These include spending cuts to department allocations with education bearing the largest share and rationalization of purchasing procedures of the public administration worth 1.5 billion. The budget also foresees cuts in transfers to regional and municipal authorities of around 1.8 billion. Some marginal savings will originate from a three-year 2% tax hike on pensions exceeding 600,000 per year. The remaining two-thirds of the 16 billion correction will stem from a long list of ad hoc measures. Among these, we find 3 billion of defense property securitizations, 2 billion of lease-backs of other real estate properties (basically the public administration will sell its own buildings and then pay a rent to keep using them), 3.3 billion from an amnesty on illegal building works, and some 3 billion on re-opening and extension of the 2003 tax amnesty.

As the debt keeps draining resources out of Corporate Italy, and tax pressure is arguably expected to decline with time, the only option available is a structural and sustainable reduction in pension spending.

Pension reform as the only option. We think that all these measures will help the government keep its deficit below the 3% mark, much better than countries such as Germany and France. But they will not do much to tackle the structural imbalances. In 2002, Italy made interest payments on its stock of public debt in excess of 70 billion, which is nearly 5.7% of GDP. In the 2004-7 economic plan released last June, the government sees this number approaching the 80 billion mark by 2007. Under the official assumption of a cumulated rise in nominal GDP of just above 20% over the same period, the debt service ratio would still remain firmly above 5%. As the debt keeps draining resources out of Corporate Italy, and tax pressure is arguably expected to decline with time, the only option available is a structural and sustainable reduction in pension spending.

A two-stage proposal: super-bonus now and forty years of contributions from 2008 onwards. The government is well aware of the problem and has just passed a reform of the pension system in return for the soft 2004 budget plan. While the legal retirement age was raised by the Amato reform in 1992 to 65 years for men and 60 years for women, some workers still take advantage of the so-called seniority pensions that allow them to retire as soon as they have turned 57, provided they have paid thirty-five years of social security contributions. The reform is set to follow a two-stage scheme. In a first stage, set to kick off in 2004, workers who decide to work longer will receive a 32.7% tax-free bonus equivalent to the contributions that would normally be paid by employees and employers. In the second stage, from 2008 onwards the minimum requirement would be raised from thirty-five to forty years of contributions. It would have been a tougher reform if this phase had kicked off earlier, but one should not underestimate the impact of the tax incentives.

What about the TFR? Focus seems to have shifted away from another key point, the enhancement of a second pillar of privately funded schemes. The core of a previous proposal sitting in the Senate for ages with no final approval is the introduction of fiscal incentives for those employees who channel their annual flows of severance pay provisions (TFR) currently kept by the firms on their books into private pension schemes. This measure could be a good opportunity for the mutual fund industry and, in our opinion, its impact is likely to be stronger now that it is matched with measures that limit the presence of the overly-generous public first pillar. But the exact role of these schemes will be subject to negotiations with unions and employers.

Unions to go on strike, but 2003 is not 1994. Back then, a reform proposal from the first Berlusconi government led to an open conflict inside the coalition and outside against the union front, which eventually led to the collapse of the cabinet. Today, the coalition has overcome its internal debate before facing the unions reaction. The unions have already called for four hours of general strike for October 24, but chances for the reform to come through are considerably higher now, in our view.



Page 11

Asia Pacific: Brother, Could You Spare a Million? Andy Xie (Hong Kong)

Excitement was brewing over the spectacle of Chinese tourists pouring into Hong Kong on October 1 (Chinas national day) and buying everything in sight. I had to see for myself. I went to Pacific Place, an upmarket shopping mall on Hong Kong Island at noontime on October 1. Few shoppers were visible. I could not give up this easily and moved on to Causeway Bay, the busiest shopping district in Hong Kong. There were throngs of people walking around as usual. But I could tell they were locals. Remembering that Chinese tourists are most likely to end up at electronics shops, I went up to the top floor of a mall with a number of electronics shops. Finally, I spotted some Chinese tourists, usually two parents and one child wearing the same baseball caps. But there were not that many. The shops felt pretty empty.

Will an influx of Chinese money support property? Earlier this week, the Hong Kong government announced policy details on an immigration program for investors, which entails investing HK$6.5 million (US$833,000) in Hong Kong financial assets (e.g., a flat) in exchange for residency status. According to reports, mainland Chinese with permanent residency in a third country would qualify.

Chinas per-capita income is US$1,000; thus, US$833,000 in China is equivalent to US$31 million in the US. I would suppose that not many people in China are able to come up with that kind of money. And, for those who can, why would they want to go to so much trouble to come to Hong Kong when countries like Canada and Australia demand less?

[Hong Kong] has the ability to revive its competitiveness in order to remain a major city in China, in my view but if it remains fixated on property, it risks becoming irrelevant to China.

The current price for middle-class housing in Hong Kong is about US$500 per square foot. Similar properties in Shenzhen, a Chinese city one hour away from Central by train and with a larger population, sell for US$100 per square foot. For US$833,000, one can buy a flat of 1,666 square feet in a Hong Kong middle class neighborhood. The same flat would cost US$167,000 in Shenzhen. The difference could be invested in 30-year US Treasury bonds

and earn US$36,000 in interest income per year, enabling the investor to support a lavish lifestyle in Shenzhen.

To me, it seems logical that the Chinese would want to hang onto their hard-earned money. The Chinese had US$922 in bank deposits per capita in August compared with US$62,000 for Hong Kong. The Hong Kong press, however, seem unduly intent on identifying ways how that money could benefit Hong Kong. This begs the question: Should Hong Kong expect Chinese money to make them richer?

The size of Hong Kongs balance sheet (property values plus bank deposits plus stock market capitalization) exceeds Chinas GDP. Even if Chinese leaders wanted to help Hong Kong, would they be able to come up with enough funds to make a difference?

Hong Kong has been shrinking supply to prop up property prices for the past five years with no success, in my view. China, meanwhile, is embracing the high-volume, low-price development model. How can Hong Kong, being a tiny place next to China, sustain a high-price, low-volume model? Every city in China seems to be focused on improving infrastructure, raising education standards, and attracting foreign investment. The competition for capital is fierce among Chinese cities. Hong Kong, on the other hand, has done virtually nothing to improve its competitiveness in the past five years. Its civil service remains bloated and overpriced, in my view. Its mother-tongue education in Cantonese appears to undermine its international ambitions how can it be an international gateway for China if its people cannot speak and write fluently in Mandarin and English?

Instead, many in Hong Kong are focusing on the likely benefits from Beijing and how these can push up property prices. Hong Kong is literally being killed by its property culture, in my view. Most people here seem to be involved in real-estate in one form or the other. The middle class work hard to pay off their mortgages. Newspapers receive advertising dollars from property developers. The government needs revenue from land sales to prevent massive deficits. The property economy worked for a few years when its upward momentum attracted speculative capital from elsewhere. Other peoples money made the property a positive-sum game in Hong Kong. Chinese companies borrowed money from state banks to speculate. Japanese banks lent to the speculators. European investors bought Hong Kong property stocks.



Page 12

Hong Kongs middle class enjoyed paper appreciation even though they went heavily in debt to buy property. Unskilled labor enjoyed plentiful employment opportunities. The government built up budget surpluses. At the top of this pyramid sat the Hong Kong developers and at the bottom the mainland speculators.

A significant chunk of Chinas current bad debt is actually money that Hong Kong developers collected during the bubble. Will mainland money flow back into the Hong Kong property market? Unfortunately, the people who speculated with Chinese banks money in Hong Kong property appear to be out of the equation. Chinese banks seem to have wised up to the dangers of property speculation.

Hong Kong needs to focus on competitiveness. I believe that Hong Kong needs to wake up to revive its economy. Its low tax levels and tradition as an international hub are something to build on. It has the ability to revive its competitiveness in order to remain a major city in China, in my view but if it remains fixated on property, it risks becoming irrelevant to China.

China: Gathering Clouds Andy Xie (Hong Kong)

Clouds are gathering over Chinas economic outlook for 2004. US presidential politics will likely lead to protectionist measures that apply to Chinas exports. Multinational investors seem more hesitant about setting up production in China because of threatening noises about Chinas exchange rate structure.

Exports probably contributed five percentage points and property a further three percentage points to Chinas GDP increase in the first half of 2003. It is conceivable to us that the two sectors contribution to GDP growth will be cut by half in 2004.

Employment in US manufacturing has declined in the past three years to 14.7 million jobs after fluctuating between 17 and 18 million for 15 years. The US political system is feeling intense pressure as presidential politics heat up. Unless the US labor market improves soon through rapid

expansion of service employment, some protectionist measures look inevitable to us.

Clouds are gathering over Chinas economic outlook for 2004.

US manufacturers appear to be using China as an easy target for pushing the US toward protectionism in general. The business reality explains why they have adopted such a stance. Most US manufacturing industries have lost their quality edge in the global market. They must now compete on price to survive. This means that the US should lower wages in manufacturing to levels in developing countries. This is clearly not possible. The US, therefore, has little choice but to resort to protectionism to hang onto most of its manufacturing jobs, in my view.

All the noise on China, especially with respect to its currency, will likely have an impact on foreign investors confidence in Chinas stability as a supply base for the global economy. Multinational corporations were already concerned about supply concentration in China after the SARS crisis. I believe the focus of protectionist sentiment on China increases the perception of risks in basing production in China.

Assuming no interference through political intervention against market forces, China should have 50% or more market share for any industry that becomes rooted in China. Indeed, we have observed such market shares for China in soft goods industries (e.g., shoes, toys, garments). Consumer electronics and telecom equipment are likely to follow a similar pattern, in my view. However, it appears that political forces may be interrupting the process. Even though FDI contracts could exceed US$100 billion in 2003, realized FDI may slow next year.

A slowdown in FDI would have a negative impact on exports. Enterprises with foreign investment accounted for 65% of Chinas export increase in the first eight months of 2003. If FDI slows, Chinas exports will slow.

Property threatens stability. Since China introduced home mortgages in 1998, the property sector has taken off rapidly. We estimate property sales will reach 9.2% of GDP this year compared with 3.9% in 1998. The property sector has accounted directly for one-fifth of Chinas GDP increase since 1998.



Page 13

I estimate loans tied to property developers at 80% of sales value or more. This would put development loans at Rmb2.3 trillion. If the property sector were to grow three times as fast as GDP for a further two years, this could cause a financial crisis, in my view.

The central government is trying to keep the credit increase below the previous years level, which implies a cut in loan growth in the second half of 2003 to Rmb900 billion. I estimate the macro tightening should cut property sector growth by half to about 12%.

The tightening is probably timely enough to prevent a financial crisis. But growth in the property sector will have to be in line with GDP growth in the future to ensure financial stability. I calculate this would reduce Chinas GDP growth rate by at least two percentage points.

Consumption should remain strong. Chinese household wealth is below equilibrium, and so wealth accumulation has to be faster than consumption. This is why retail sales tend to follow household savings deposits with a lag. Retail sales and household savings deposits diverged sharply in 2002 and have continued to do so in 2003. This is not surprising as the property sector has been attracting a rising share of household expenditure.

As the macro tightening lowers property sector growth, household expenditure for consumption should also be normalized. Furthermore, if exports come under pressure, the government would likely respond this time by stimulating consumption.

Chinas growth should remain resilient. China is facing the greatest uncertainty in its economic outlook since 1999. The current situation is perhaps more challenging than in 1998 because the reason for the expected difficulties is the inability of the global economy to digest Chinas rapid growth.

China is pursuing modernization with whatever means or methods are available. It has maneuvered through major difficulties in the past. China should be able to find the right responses this time, in my opinion.

First, China could pursue measures to lessen the political pressure in the US on China. Second, China could announce a timetable for phasing out all tax privileges for foreign investors. Third, China could open up more sectors to foreign investment. Fourth, China should announce a

timetable for opening its capital account. This would, of course, require a similar timetable for financial reforms. Fifth, China should expand its involvement in global affairs, such as peace-keeping missions, to increase its bargaining power in economic matters. I believe Chinas role in the negotiations over North Koreas nuclear program has already generated considerable benefits for the country.

Japan: Swaying Expectations Takehiro Sato (Tokyo)

We expect the market environment to dictate monetary policy in the second half of this fiscal year against the backdrop of a mixture of tightening and easing expectations. The main near-term risk is yen appreciation. The current market environment resembles the situation in September 1999, when rapid yen appreciation led to weaker stock prices and the Bank of Japan (BoJ) faced heavy pressure to take quantitative easing. BoJ officials, meanwhile, seem increasingly enthusiastic about the prospect of a self-sustained recovery following the improvement in Tankan and narrowing CPI negative YoY margin. Although the sharp rise in long-term yields put an end to thoughts about an exit strategy from quantitative easing, there is a good chance of this talk re-emerging as occurred in the ZIRP abandonment debate. Given these circumstances, we looked at near-term highlights from the standpoint of both tightening and easing.

Open discussion of an exit strategy has become taboo. Yet we expect the time to come in the not-too-distant future when exit strategy reappears as a market theme, particularly as the comfort level of authorities and market participants with long-term yields trading in the mid-1% range increases. BoJ officials are especially interested in better-than-expected improvement of the diffusion index (DI) for the economic outlook for small and medium-size enterprises (SMEs) in the September Tankan. Recent contraction of the core CPI decline rate is also building enthusiasm for overcoming deflation. Meanwhile, the Bank is scheduled to release the Outlook for the Economy and Prices and Risk Assessment at the end-October monetary policy board meeting (MPM), clarifying board members views of the economy and prices for F2003-04. While the outlook presents the views of individual board members rather than



Page 14

the Bank itself, it is natural to assume that the governor and deputy governor positions reflect the official stance.

There is good reason to focus on the BoJs often-overlooked outlook on the economy and prices. Thanks to upward revision of the base contribution, it is no longer considered unusual to expect growth in the +2% range. What is the view for F2004? Although we anticipate weakening demand from 2H F2004, it is unlikely that the monetary authority will project an economic recession as its official view at this stage. Hence, we expect a +2% median estimate for F2004 growth.

We expect the time to come in the not-too-distant future when exit strategy reappears as a market theme, particularly as the comfort level of authorities and market participants with long-term yields trading in the mid-1% range increases.

The F2004 core CPI outlook is another key point. The Bank envisions a linear relationship between the output gap and CPI inflation rate. Since +2% growth should narrow the output gap by 1pp, assuming a +1% potential growth rate in line with the Bank stance, this translates into +0.4pp upward pressure on the CPI inflation rate. So, it would be strange not to project some narrowing of the core CPI rate despite, two straight years of +2% growth. The board members outlook therefore may include a positive value for the median F2004 core CPI inflation rate estimate. We anticipate the market discounting for an end to ZIRP in F2004 in this case. Bank officials alternatively might strategically set the CPI outlook to foster these expectations. There is also likely to be a general susceptibility to ZIRP abandonment speculation as long as economic sentiment is improving. Given these conditions, we think bond market volatility will remain high and rally selling pressure will work against a sustained decline in the long-term yield.

We have the impression that currency policy since the Dubai G7 meeting has returned to the traditional approach of using currency rate adjustment to correct imbalances. However, we think it is more reasonable to interpret recent current developments as pulling back the defense line for the yen-dollar rate from Y115/US$ to Y110/US$ (or possibly Y105/US$). This differs from Japan completely shutting down market intervention.

A key near-term issue for MoFs new dollar peg stance is the borrowing cap for the foreign currency special account. This program had a Y79 trillion cap in the initial F2003

budget. The current outstanding loan balance from government short-term securities, however, has risen to nearly Y67 trillion with this years sustained massive intervention activity, according to the October 2 Nikkei Shimbun. While this still leaves Y12 trillion in leeway, budget action with National Diet approval is required to expand the program.

The problem is timing. Japan is likely to experience a political vacuum until late November with the anticipated schedule for dissolving the Lower House. This makes mid-December the nearest timing for submission of a supplementary budget proposal to a post-election special Diet session. Yet MoF bureaucrats are likely to feel restricted with just Y12 trillion in leeway, considering the Y13.5 trillion intervention since the beginning of this fiscal year. Increased market awareness of this restriction may even encourage an attack on the dollar/yen rate.

This scenario is turning attention to the BoJs role. For example, we may see the possibility of the swap transaction between the MoF and the BoJ to fund the intervention funds, or renewed discussion of foreign bond purchases to support the dollar. MoF bureaucrats have strongly ruled out the second option up to now as treading on their jurisdiction over currency policy. Yet MoF may have to turn to the BoJ for help in resisting yen appreciation if it does not have access to immediate funds. In this case, yen capital supplied to purchase foreign bonds will enter the market as a kind of unsterilized intervention. While we question whether unsterilized intervention is truly monetary easing given the zero interest rate restriction, the government and ruling coalition are unlikely to turn down this BoJ action, and are instead more likely to welcome it regardless of the issue of policy legitimacy.

We anticipate 2H policy vacillating between tightening and easing expectations in reaction to market trends. Yet it is highly unlikely that Bank officials will implement an exit strategy amid the current economic expansion phase, given the leftover trauma from ZIRP abandonment in 2000. Therefore, we recommend that bond market participants take a cool-headed approach of capitalizing on buy-on-dips opportunities and not going too far on the upside. In our view, while stock market participants do not need to be overly concerned about yen strength, they should recognize that the economy is currently in a cyclical recovery led by external demand, and be ready to absorb the possibility of the recovery already being beyond the halfway point.



Page 15

Japan: Can High Growth Return in 2004? Osamu Tanaka (Tokyo)

The prospect of real growth of close to 3% in 2003 is encouraging hopes that 2004 could see a return to the high-growth era. Our main scenario is that after fiscal year growth in range of 2.4% and calendar year growth of 2.6% in 2003, the economy will slow to fiscal year growth of 0.8% and calendar year growth of 1.4% in 2004, and retreat once again in the second half of next year. Economic conditions usually mirror shifts in a conventional inventory cycle, but the extremely low level of current inventory risk would argue for continued economic upside in 2004. It is true that the current phase looks very similar to past periods of inventory adjustment, but it is doubtful to us that the adjustment this time will have the force to derail the economy. Here we examine the differences between the past and present inventory conditions, and reassess the 2004 outlook in this light.

Judging simply from the pattern of inventories, the current phase looks very similar to past periods of economic retreat. For example, taking year-over-year growth in inventories minus year-over-year growth in shipments to represent the severity of inventory adjustment pressure, such pressure has been on the rise from a trough at the start of the year, albeit contained. In the past, the economy has gone into retreat several months after inventory-adjustment pressure reached its trough, and things seem to be shaping up similarly this time. In the 11 inventory cycles since the 1970s, adjustment pressure has stayed below zero for an average period of 33 months, and if that were to hold this time, it would support our central scenario that inventories will exert downward pressure on the economy in the second half of 2004.

Will history be repeated? Events to date have not gone quite as we predicted. Inventories have been held to extremely low levels, and companies seem reluctant to allow much build-up. In the absence of a demand shock such as an abrupt pullback in the recovery of overseas economies, inventory adjustment risk could soon be dispelled. Corporate sentiment has been improving as a number of economic indicators have been surprising on the upside, confidence in overseas economies is rising, and the stock market seems to have bottomed, but this is based more on relief that the worst is over than on expectations for sustainable future growth, in our view. For this reason, we do not expect companies to start building their inventories aggressively near term.

The economy in 2004 looks set to remain exposed to exogenous factors such as overseas economies and the exchange rate.

However, we do not think the current low level of inventories justifies belief that the inventory cycle has been overcome. There seems to be a view that inventories are at rock-bottom levels in historical terms, but if we index the 2000 average as 100, the inventory ratio since the start of the 1990s has fluctuated between 95 and 115, and even the drop at the end of 2001 came within the scope of cyclical shrinkage to correct build-up from the second half of 2000. So the current low levels to some extent reflect the fact that a bout of adjustment has only recently ended. In the four periods since the 1990s in which inventories stood at the current level or lower (1991-93, 1994-95, 1997-98, 2000-01), a phase of adjustment proved unavoidable each time (although in 1994-95 a recession was not officially declared). Discussion of inventory adjustment should really be based not on inventory levels, but on whether demand seems sustainable. We also note here that though levels are low, there has been an uptick in each of the last three months, which might hint at a change.

Fears that inventory factors will crimp the recovery may indeed prove groundless. Furthermore, as we pointed out in our September 16 note (Japan Economics: Explaining the Non-Intuitive Data), quality adjustment puts constant upward pressure on capex in real terms, and that means we cannot rule out the possibility of upside to our 2004 growth forecast. Even if there is upside, however, we would not look for the return of 3% growth. The growth rate for 2003 has been pushed up by more than 1.0% by the base effect, helped by quarterly patterns of consistent growth for past several quarters, but the base effect will not be able to boost growth by the same extent in 2004, in my view. Even if contrary to our main scenario the inventory situation does not cause growth to shrink, the best we can hope for is probably about 2% (which would still be better than the growth of recent years).

We should not overlook new evidence in support of our scenario of a slowdown in the second half of 2004 either. The danger is that after a four-quarter lag, the impact of ongoing yen appreciation should show up in the second half of 2004. The current phase of yen strength is also coinciding with high oil prices, which threatens to cancel out the positive impact of the former on Japans terms of trade. The sustainability of demand is also being called into question, particularly by overseas factors such as tightening



Page 16

of monetary policy in China, which could cause growth in demand from that source to slacken, and doubts about consumption in the US. The prospect of upside in numbers for real Japans real GDP growth is encouraging expectations for a domestic-demand driven recovery, but the nominal data show how heavily dependent Japan still is on external demand. The economy in 2004 looks set to remain exposed to exogenous factors such as overseas economies and the exchange rate.

Asia Pacific: Second Track Principles Malay-Thai Comparison Daniel Lian (Singapore)

The development challenge for resource-rich Southeast Asia, given the rise of China and its growing dominance in mass manufacturing, is the implementation of a balanced development strategy that lessens its dependence on external demand and mass manufacturing driven by foreign direct investment (FDI) multinational corporations (MNCs). Southeast Asia must better leverage domestic demand and resources to produce inner economic strength, economic winners and pricing power through the growth of local enterprises, rather than positioning their economies as tax havens and cheap labor sites for MNCs. The success of Thailand Prime Minister Thaksin Shinawatras economic program demonstrates the validity of second track principles. Lets trace the major facets of his economic initiatives in the past three years:

(1) Leveraging underleveraged sectors

In order to create structural resilience in domestic demand, the following underleveraged sectors were mobilized:

Southeast Asia must better leverage domestic demand and resources to produce inner economic strength.

Private consumption With the private savings rate at almost 30% of GDP and the household leverage rate only a fraction of corporate debt, Thailand possessed the necessary macro ingredients for a structural consumption boom.

Rural demand and SME growth The Thai rural and SME sectors had been vastly underdeveloped. At end-2000, about 40% of Thai households engaged in farming and

other rural activities but contributed just 10% of GDP. In the past 30 years, there has been little government support for vigorous SME development. At the beginning of Mr. Thaksins economic regime early 2001 the government administered a small dose of fiscal medicine, for example, introducing the village fund and numerous micro credit programs for SMEs.

Housing demand The Thai housing sector has undergone several rounds of stimulation in the past two years driven by the large number of government workers who could not afford homes. Initiatives include (1) a low-cost mortgage scheme for government workers; (2) a low-cost mass market housing scheme; and (3) support measures, including favorable tax policies. The second scheme is to be phased in when the expansionary impact of the first scheme expires.

(2) Reflating assets and changing expectations

Post 1997-98, many Asian economies, including Thailand, were mired in asset deflation. Mr. Thaksins pro-domestic demand policy played a role in changing firms and households pessimistic behavior about future asset prices. Once they reversed their negative expectations on asset prices, domestic demand grew.

(3) Creating Capital

Integral parts of the dual track strategy are initiatives to create capital to facilitate the development of local enterprises with niche pricing power. In the past three years, various capital creation projects have aimed at converting dead capital into productive capital or enabling the capital-deficient sectors to form capital. Such sectors include the urban poor, rural, resource, SME, and the government sectors. In just 32 months, numerous capital projects have been implemented or conceived, including: the Village Fund project, the Capital Creation scheme, housing projects, various SME initiatives, the state-enterprise privatization program, and the latest Vayupak Mutual Fund initiative. Capital creation is still in its infancy, and the effective implementation of these schemes should add further stimulus to domestic demand and local enterprise development.

After witnessing the dwindling effect on output and jobs from substantial fiscal pump priming (1998 to 2003) and the substantial decline in FDI in the past six years, Malaysia has been mulling a change to its development mindset, as it



Page 17

understands pump-priming is no longer sustainable and the single track FDI growth model is defunct. The Malaysia second track forays differ from Thailands in several major ways.

(1) Private consumption and household balance sheet The high private sector saving rate means there is scope for consumption growth. However, lackluster asset prices and an already large household balance sheet do not auger well for vigorous expansion in private consumption and household balance sheets. Asset prices are key to stronger expansion in household leverage.

(2) Rural demand and SME development The underleveraged rural sector of Malaysia is relatively small in terms of population and its contribution to the economy, so scope for rural growth is relatively constrained compared to Thailand. However, the potential of the underleveraged SME sector is quite substantial in Malaysia. Policy should be geared toward SME while remaining selectively focused on the rural sector.

(3) Resources and development Malaysias resources are rich and diverse and quite different from Thailands. Malaysia can create unique, strong niches in these resource areas. Tourism, agriculture and agribusiness are also areas where Malaysia can develop strong niches. These areas are where Thailand is significantly more successful and where Malaysia must learn to compete.

(4) Housing demand The challenge for Malaysia is that home ownership is already quite high, and it has a huge unoccupied but completed housing stock. However, the country is still ripe for mass housing expansion although not of the magnitude of Thailand. To make mass housing an engine of domestic demand growth, the government in our view must once again take charge of low-cost housing rather than leaving it to the private sector.

(5) Capital creation initiative Malaysian policy makers have demonstrated in recent initiatives that they intend to leverage capital creation initiatives. The privatization of Felda is a case in point it serves to monetize value for government, settlers and employees, and enlarges market capitalization and creates a plantation benchmark for the stock market. However, more substantial initiatives to revive dead capital are needed.

(6) Financing for second track growth Compared to Thailand, we believe financing is less forthcoming because of the nature of assets, credit, and the stance of the policy makers. The asset market correction in Malaysia post the Asia crisis was less extensive than in Thailand; hence, asset reflation is more difficult. Malaysian authorities remain quite cautious of credit expansion and may not able to create a credit cycle upswing and a vigorous asset reflation. The weakness of Malaysias second track plan is that policy makers remain cautious about private balance sheet expansion and have not yet conceived a comprehensive capital creation menu to keep second track development on a sustained structural path.

We believe the sensible development options for Southeast Asia ex-Singapore remain second track development, carving a slice of the economic cake away from high-cost Singapore. The resource-rich ASEAN Four Malaysia, Thailand, Indonesia and the Philippines are all ripe for second track development, and their relatively low cost structures means economic activities can be diverted from Singapore. Thailand has been the dual track pioneer, and Malaysia now appears to have the right policy mindset, human resources, infrastructure and economic software to deliver as well.



Page 18

Global Economic Outlook: GDP and Inflation 3 October 2003 GNP/GDP Growth (%) CPI Inflation (%)

2000 2001 2002 2003E 2004E 2000 2001 2002 2003E 2004E

Global Economy 4.8 2.4 2.8 2.9 4.0 2.5 2.4 2.4 2.3 1.9 Industrial World 3.8 0.9 1.6 1.9 3.0 2.3 2.2 1.5 1.8 1.3

US 3.8 0.3 2.4 2.7 4.4 3.4 2.8 1.6 2.3 1.4 Australia 2.8 2.7 3.6 2.7 3.0 3.0 3.0 3.0 2.8 2.2 Canada 5.3 1.9 3.3 2.2 3.7 2.7 2.5 2.2 2.9 2.1 New Zealand 3.5 2.1 4.0 2.5 2.5 2.6 2.7 2.6 2.1 2.3

Europe 3.4 1.6 1.0 0.7 2.0 2.2 2.3 2.1 2.0 1.7 EMU 3.5 1.5 0.8 0.5 2.0 2.1 2.3 2.2 2.0 1.7 Austria 3.0 1.0 0.9 0.4 1.6 2.3 2.7 1.8 1.3 1.3 Belgium 3.7 0.8 0.7 0.9 1.9 2.6 2.5 1.6 1.7 1.9 Denmark 2.8 1.4 2.1 0.6 2.0 3.0 2.2 2.3 2.3 1.8 Finland 5.1 1.2 2.2 1.1 2.6 3.0 2.7 2.0 1.2 1.3 France 4.2 2.1 1.2 0.4 2.0 1.7 1.6 1.9 2.0 1.4 Germany 2.9 0.6 0.2 0.0 2.1 1.3 2.0 1.4 1.0 0.9 Greece 4.1 4.1 3.6 3.8 4.0 3.2 3.4 3.6 3.4 2.8 Ireland 10.0 5.7 6.0 3.0 4.0 5.2 4.0 4.7 4.1 3.2 Italy 3.3 1.7 0.4 0.5 1.8 2.5 2.8 2.5 2.7 2.2 Netherlands 3.5 1.2 0.2 -0.7 0.9 2.4 4.2 3.3 2.2 1.9 Norway 1.9 1.4 1.4 0.0 1.6 3.1 3.0 1.3 2.8 1.3 Portugal 3.7 1.6 0.5 0.0 1.7 2.9 4.4 3.6 3.5 2.8 Spain 4.3 2.7 2.0 2.3 3.0 3.5 3.6 3.5 3.0 2.8 Sweden 3.6 1.5 1.9 1.6 2.5 1.4 2.8 2.6 2.3 1.7 Switzerland 3.1 0.9 0.1 0.0 1.7 1.6 1.0 0.6 0.5 0.7 UK 3.8 2.1 1.7 1.9 2.5 2.9 1.8 1.6 2.9 2.2

Emerging Europe 6.3 1.6 3.6 4.5 4.4 20.9 20.1 16.0 11.3 8.4 Czech Republic 3.3 3.5 2.0 2.4 3.0 3.9 4.7 1.8 0.1 2.9 Hungary 5.2 3.7 3.3 2.7 2.9 9.8 9.2 5.3 4.6 5.8 Israel 6.5 -1.0 -1.4 2.4 4.1 1.1 1.1 5.7 3.3 1.8 Poland 4.0 1.0 1.4 3.5 5.0 10.1 5.5 2.0 0.9 2.4 Russia 9.0 5.0 4.1 6.2 4.6 21.0 21.6 15.1 13.5 10.5 Turkey 7.3 -7.5 6.5 4.2 5.8 56.4 53.5 47.2 25.9 15.4 South Africa 3.4 2.2 3.0 2.1 3.0 5.3 5.7 10.1 6.7 4.2

Japan 2.8 0.4 0.1 2.6 1.4 0.3 0.9 0.8 0.4 -0.5 Asia Ex-Japan 7.4 4.1 5.9 5.2 6.0 1.5 2.2 1.4 1.5 1.8 China 8.0 7.3 8.0 7.5 7.8 0.4 0.7 -0.8 0.1 0.1 Hong Kong 10.2 0.5 2.3 2.4 3.5 3.7 -1.6 -3.0 -2.7 -0.5 India 5.1 4.1 4.7 5.8 6.0 4.2 3.8 4.3 4.1 4.4 Indonesia 4.9 3.4 3.7 4.0 4.5 3.8 11.5 11.9 7.5 7.0 Korea 9.3 3.0 6.3 3.0 4.9 2.3 4.1 2.8 2.5 3.1 Malaysia 8.5 0.3 4.1 4.3 4.8 1.6 1.4 1.8 2.0 2.2 Philippines 4.4 4.5 4.4 3.5 4.2 4.3 6.1 3.1 3.5 3.7 Singapore 9.4 -2.4 2.2 1.0 4.3 1.3 1.0 -0.4 0.9 1.2 Taiwan 5.9 -2.2 3.5 2.0 3.4 1.3 0.0 -0.2 -0.4 0.5 Thailand 4.6 1.9 5.2 6.0 6.0 1.6 1.7 0.6 1.8 1.8

Latin America 4.1 0.5 -0.3 0.9 3.6 6.5 5.4 12.9 8.6 6.3 Argentina -0.8 -4.4 -10.9 5.8 4.3 0.7 -1.5 41.0 7.0 7.9 Brazil 4.4 1.4 1.5 0.5 4.4 6.0 7.7 12.5 9.6 6.2 Chile 4.2 3.1 2.1 3.6 4.5 4.5 2.6 2.8 2.9 3.5 Colombia 2.9 1.4 1.5 2.1 2.7 8.7 7.6 7.0 6.5 6.0 Mexico 6.6 -0.3 0.9 1.9 2.6 9.0 4.4 5.7 3.8 4.0 Peru 3.1 0.6 5.2 3.3 3.2 3.7 -0.1 1.5 2.2 2.5 Venezuela 3.2 2.8 -8.9 -15.0 3.0 13.4 12.3 31.2 40.0 20.0 E = Morgan Stanley estimates.



Page 19

Global Economic Outlook: Interest Rates, Bond Yields, and Currencies 3-Month Euro Rates (%) 10-Year Bond Yields (%) Exchange Rates Oct 3 Dec03 Mar04 Jun04 Oct 3 Dec03 Mar04 Jun04 Oct 3 Dec03 Mar04 Jun04

G-3 Countries US 0.93 1.25 1.3 1.4 4.2 4.7 4.9 5.1 Euro 2.1 2.2 2.3 2.4 4.1 4.4 4.7 4.8 1.17 1.19 1.16 1.20 Japan 0.08 0.05 0.04 0.04 1.4 1.0 0.9 0.9 110 107 107 105

Dollar Bloc Canada 2.7 2.8 2.8 2.9 4.7 5.0 5.2 5.3 1.34 1.33 1.35 1.28

Non-EMU Europe Denmark 2.2 2.5 2.5 2.5 4.3 4.7 5.0 5.1 7.43 7.46 7.46 7.46 Switzerland 0.25 0.2 0.2 0.2 2.6 2.6 2.9 3.0 1.54 1.56 1.54 1.57 Sweden 2.9 3.0 3.1 3.4 4.7 5.0 5.2 5.3 8.99 8.70 8.60 8.70 UK 3.7 3.8 3.9 4.2 4.7 4.9 5.2 5.4 0.70 0.69 0.67 0.68 $/GBP 1.67 1.72 1.73 1.76 Note: Data are end-of-period values. European exchange rates are against the Euro except where noted. E = Morgan Stanley Research Estimates More detailed exchange rate forecasts are available in Morgan Stanleys FX Pulse weekly.

-70

-60

-50

-40

-30

-20

-10

0

10

20

Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02 Jan-03

NikkeiS&P 500Euro Stoxx 50

Percent Return, local currency

70

80

90

100

110

120

1999 2000 2001 2002 2003100

110

120

130

140

150

160

170

EUR (left)USD (left)JPY (right)

Trade-weighted currencies

Index 1990 = 100 1990 = 100

-10

0

10

20

30

40

50

CAN US AUD NZD EUR JPN SWI UK

Dec 2003Mar 2004

Futures Implied Monetary TighteningOctober 3, 2003

bps

Futures rate - 3-month LIBOR; In US, Fed Funds futures rate - Fed Funds Rate Source: Morgan Stanley Research, Bloomberg.



Page 20

Weekly International Briefing Global Data Calendar w/c 6 October 2003 Date MS Cons Last 6-Oct EMU Eurogroup meeting (Luxembourg) - - - - Debate on France failing to comply with EDP 7-Oct EMU ECOFIN Council Meeting (Luxembourg) - - - - New requests for France GER Manufacturing orders, sa Aug -1.0%M 0.5%M Unch. Clustering of summer holidays affecting data UK Industrial production, sa Aug 0.3%M 0.2%M 0.3%M Currently tracking 0.7%Q in Q3 UK Manufacturing production, sa Aug 0.3%M 0.2%M 0.5%M Surveys point to a good month for manufacturing US Consumer credit Aug N/A $6.0bn $6.0bn JP Real household spending Aug +1.7%Y +2.0%Y -3.9%Y Rebound in average propensity to consumer JP Index of business conditions (leading) Aug 55.6 55.6 80.0 Improvement in 5 of 9 available components JP Index of business conditions (coincident) Aug 55.6 55.6 80.0 Improvement in 5 of 9 available components 8-Oct NET Manufacturing production, sa Jul/Aug -1.2%M -1.0%M 2.9%M Correction after June surge US Wholesale inventories Aug N/A +0.1%M 0.0%M JP Machinery orders (core) Aug +1.9%M -0.6%M -3.1%M Rebound from July decline 9-Oct EMU ECB - Monthly Bulletin Oct - - - EMU EU Commission-GDP Indicator forecasts Q3/Q4 - - - No major revisions expected EMU Real GDP, sa (2 nd release) Q2 -0.1%Q -0.1%Q Unch. No revision expected GER Unemployment, sa Sep +10K +10K Unch. Labor market conditions lagging economy GER Unemployment, nsa Sep -73K N/A -38K Seasonal drop GER Industrial production, sa Aug -2.0%M -1.9%M 2.7%M Correction after July surge GER Trade balance, nsa (Eur bn) Aug 10.3 10.3 14.1 Exports and imports to rise slightly in sa terms GER Current account (Eur bn) Aug 2.7 1.7 1.1 Seasonal improvement in factor income balance GER Consumer prices, nsa (final) Sep 1.1%Y 1.1%Y 1.1%Y In line with preliminary estimate UK MPC meeting - - - Likely on hold, though risk of early hike increasing UK Global visible trade, sa Aug N/A -3.6bn -3.3bn US Import prices Sep N/A -0.3%M +0.2%M JP BoJ MPM JP Current balance ( billions) Aug 1,370.0 1,357.2 1,079.8 Goods & services surplus of 650bn 10-Oct FRA Industrial production, sa Aug -0.4%M Unch. -0.3%M Manufacturing output up 0.3%M FRA Consumer prices, sa Sep 1.8%Y 1.9%Y 1.9%Y Consumer prices to rise by 0.2%M US Producer price index Sep +0.1%M +0.0%M +0.4%M Energy likely to retrace portion of August gain US Core PPI Sep +0.1%M +0.1%M +0.1%M Motor vehicle prices finally showing stability US Trade balance Aug -$42.0bn -$41.0bn -$40.3bn 1.5% fall in exports; 0.1% dip in imports JP BoJ MPM JP Money supply (M2+CDs) Sep +1.9%Y +2.1%Y +2.0%Y Drop in bank lending continues JP Dissolution of the Lower House


Page 21

Important US Regulatory Disclosures on Subject Companies The information and opinions in this report were prepared by Morgan Stanley & Co. Incorporated and its affiliates (Morgan Stanley). The research analysts, strategists, or research associates principally responsible for the preparation of this research report have received compensation based upon various factors, including quality of research, investor client feedback, stock picking, competitive factors, firm revenues and overall investment banking revenues.


Page 22

Global Stock Ratings Distribution (as of September 30, 2003)

Coverage Universe Investment Banking Clients (IBC)

Stock Rating Category Count % of Total Count

% ofTotal IBC

% of Rating Category

Overweight 577 31% 243 39% 42%Equal-weight 854 46% 274 44% 32%Underweight 411 22% 99 16% 24%Total 1,842 616

Data include common stock and ADRs currently assigned ratings. For disclosure purposes (in accordance with NASD and NYSE requirements), we note that Overweight, our most positive stock rating, most closely corresponds to a buy recommendation; Equal-weight and Underweight most closely correspond to neutral and sell recommendations, respectively. However, Overweight, Equal-weight, and Underweight are not the equivalent of buy, neutral, and sell but represent recommended relative weightings (see definitions below). An investor's decision to buy or sell a stock should depend on individual circumstances (such as the investor's existing holdings) and other considerations. Investment Banking Clients are companies from whom Morgan Stanley or an affiliate received investment banking compensation in the last 12 months.

Analyst Stock Ratings Overweight (O). The stocks total return is expected to exceed the average total return of the analysts industry (or industry teams) coverage universe, on a risk-adjusted basis, over the next 12-18 months. Equal-weight (E). The stocks total return is expected to be in line with the average total return of the analysts industry (or industry teams) coverage universe, on a risk-adjusted basis, over the next 12-18 months. Underweight (U). The stocks total return is expected t

10.05.03 global economics morgan

Documents