There has been increasing speculation in the market as to when China will relax the pegging of the Chinese Yuan to the US Dollar. China is facing increasing pressure, not only from the United States but also from various Asian countries and parts of the European Union, to do so. Beijing, however, say that they will not be rushed. According to a recent report by the US Treasury Department “while China’s 10 year long pegged currency regime may have at times contributed to stability, it no longer does.”
In 2004 China grew by more than 9% for a second year in a row. Contributing largely to this growth were exports, resulting in China’s trade surplus reaching six year highs. This is certainly not good news for countries like the United States and Japan. The American trade deficit with China increased to $162bn in 2004, up from $124bn in 2003. The United States claims that the Yuan is undervalued and that this is giving Chinese export companies an unfair advantage. If the Yuan is indeed artificially depressed, China is able to export goods more cheaply. This also gives goods exported from China a price advantage over many goods produced domestically in foreign countries, pricing a lot of these domestic goods out of the market. Some have gone as far as to speculate that the Yuan may be up to 40% undervalued. Consequently, many Americans blame China for a lot of the job losses in the US.
According to a recent statement issued by John Snow, the US Treasury Secretary, the Yuan’s fixed rate of exchange against the dollar risks unbalancing world trade. Later this year, the US Senate is to vote on a bill “which would impose a 27.50% tariff on all Chinese imports to the United States unless China removes the currency peg within six months.” According to Snow, “China must also play its part in promoting sustained world economic growth and the adjustment to international imbalances. This is where China’s exchange rate is key.”
And of course, South Africa, too, is badly affected by cheap imports from China. More specifically, our domestic clothing industry, which is reported to have lost more than 4 000 jobs since January (when global trade quotas on textiles were removed). Trade unionists estimate that some 17 000 jobs were lost last year in our domestic clothing industry alone. Gert van Zyl, executive director of the Cape Clothing Industry stated recently “we are considering whether to apply to the World Trade Organisation in an attempt to put safeguard measures in place.”
The consequences of the Yuan remaining firmly pegged to the US Dollar going forward are far reaching. It appears as if the Chinese authorities can no longer afford to ignore the increasing pressure being brought on them by the rest of the world to bring about currency reform. Will they do it? Probably, but only when they deem it necessary. Only time will tell.
| UNITED STATES OF AMERICA |
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The “Feds” fund rate, which increased to 3% in May (the eighth increase since June last year), is now at its highest level since September 2001. In their statement following on from the most recent rate increase, the Federal Reserve stated that “recent data suggests that the solid pace of spending growth has slowed somewhat, partly in response to the earlier increases in energy prices.” GDP growth, which slowed during the first quarter of 2005, came in below expectations, at 3.1%.
Higher oil prices have largely been blamed for this reduced number.
The Federal Reserve are keeping a close watch on inflation. In March, CPI recorded its highest gain since October last year – rising by 0,60%. The CPI figure (which includes both food and energy costs) annualised for the first three months of this year, was 4,3% – which is one percent higher than the CPI figure recorded for 2004.
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Based on these figures, concerns have been raised about whether interest rates will continue to increase at a “measured” pace or whether sharper increases will be required. Commenting on the most recent CPI numbers, Robert Macintosh an economist for Eaton Vance Management, stated “you can’t make a decision on an individual number but just based on this one number, this would make the Fed more emboldened perhaps to continue tightening.”
The lower than expected first quarter GDP data, pedestrian first quarter earnings and retail sales, together with a concern about rising inflation, are some of the conflicting trends that have started to raise concerns about the possible onset of stagflation, which typically is a combination of rising prices and sluggish growth.
With growth having remaining sluggish during 2005, it is hoped that the Federal Reserve will not need to raise rates significantly higher (or at a faster pace) as this could have a negative impact on growth.
| EUROPE |
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May marked the two year anniversary of rates having been kept on hold at 2% in the Eurozone. This is despite rates having increased from 1% to 3% in the United States and from 3.50% to 4.75% in the United Kingdom, over the same period.
It is interesting to note the rate movements in the different regions. Seven changes have been made to rates by the ECB since the beginning of 2001. From May 2001 rates declined sharply from 4,50% to 2% in June 2003. Over the same period, the Federal Reserve in the United States made 21 changes to interest rates – first by cutting rates from 6% (in January 2001) to 1% (in June 2003) and then by tightening rates, from June 2004. The Bank of England made 16 changes to interest rates over this period, reducing rates from 6% to just 3.5%, before starting to increase rates in November 2003 (currently at 4.75%).
Inflation remains slightly above the 2% target level, largely due to the sustained high oil price. Some economists have indicated, however, that they “see the possibility of a cut in rates later in 2005”. This view may be as a result of the pedestrian growth numbers for the region. However, the rising oil price and the risk that this is likely to pose to an increase in prices (and, of course, to inflation) would ordinarily imply an increase in interest rates. These risks have been evident for some time, with no change in mandate by the ECB. According to ECB President, Jean-Claude Trichet, “there is no contradiction at all between being faithful to our mandate and preserving an environment as favourable as possible for growth and job creation.”
| UNITED KINGDOM |
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Interest rates, which last changed in August 2004, remained at 4.75% for the period under review. This was largely expected in light of the slowdown in consumer spending and inflation remaining contained.
David Frost, Director General of the British Chamber of Commerce said recently “we strongly urge the MPC to persevere with a cautious stance and keep interest rates on hold for the next few months.” There are inconsistent views as to whether interest rates have now peaked, or whether there is still scope for further increases.
According to Marchel Alexandrovich, an analyst at Dresdner Kleinwort Wasserstein, “our view remains that a continued housing market slowdown and its adverse impact on consumer spending means that rates have already peaked and will start heading down later this year.” Andrew Large (deputy governor) and Paul Tucker (executive director), the two MPC members who voted for a rate rise last month, believe that “the consumer slowdown was temporary.”
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However, the National Institute of Economic and Social Research stated recently that “without a rise [in interest rates] it may be hard to keep inflation below the 2% target.” They have forecast that the economy “will grow by 2.7% in 2005, rather than the 3% to 3.5% predicted by Chancellor Gordon Brown.”
Gross domestic product slowed to 0.60% for the first quarter of 2005, compared to 0.70% during the last quarter of 2004. A slowdown in industry inputs and in consumer spending are being cited as the main reasons for the drop in GDP growth.
Despite conflicting reports, it appears as if the housing market is “cooling”. The Nationwide survey in March reported the biggest monthly drop in prices in 10 years, whereas Halifax stated that housing prices had risen by 0,50% during this month. In April, however, Nationwide reported that house prices reversed the 0.60% decline in March and rose by 0.90%.
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Describing the overall trend as “broadly flat” they reported that the annual rate of property price inflation had declined from 7.90% to 7%. “The trend continues to confirm our view of a gentle slowing of the market.”
According to Capital Economics “buyers are no longer willing or able to meet asking prices and sellers are reluctant to lower their expectations.” It appears as if home owners are battling to cope with the latest round of interest rate increases as the Department of Constitutional Affairs have stated that “the number of property repossession orders rose by 25% in the first three months of 2005, against the same period in 2004.”
On the 6th May, Tony Blair won his third term in government for the Labour Party. Despite Mr Blair being the only Labour Party leader to win three elections in a row, the margin of this victory was far less than those achieved in 1997 and 2001.
| JAPAN |
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Mixed signals continue to emerge from this region. The Shoko Chukin Survey (which measures small business sentiment) and the sentiment of large manufacturers showed a modest decline, while the Tankan Survey (which is the most closely watched of all the indicators in Japan) showed that “business confidence in the non-manufacturing sector was unchanged at 11, the highest level ever recorded except during the asset price bubble in the late 1980’s.” The manufacturing sector remains robust, with the strongest areas being industrial machinery, auto and materials. A cyclical slowdown, however, would impact negatively as these particular areas in manufacturing are sensitive to movements in the global economy. Other areas showing an improvement include retail sales and the residential property market. “Real estate prices in Tokyo are rising for the first time in years.”
As in all the regions, the high oil price has impacted negatively on growth. It is expected that the Japanese economy will grow by 1% in 2005.
| SOUTH AFRICA |
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In April the Reserve Bank reduced the Repo rate by 50 basis points (0.50%), reducing the Repo rate to 7% and the prime lending rate to 10.50%. This move, which was unexpected by the markets, caused the Rand to depreciate by 2% within minutes of the announcement. The interest rate cut appears to have been motivated by three factors – “firstly, the fact that inflation is extremely low and that inflation expectations have fallen further. Secondly, some evidence of softness in the economy, particularly the manufacturing sector. Thirdly, the need for South Africa to have a more competitive exchange rate.” There are conflicting views on how this rate cut could impact on the currency in the weeks ahead – the first is that “the rate cut could result in further Rand weakening as interest rate differentials between South Africa and developed markets narrow, reducing the implied risk premium. Alternatively, strong growth in the local economy, fuelled by the cut, could attract large capital flows, which would help fund the widening current account deficit.”
When announcing the rate cut, the Reserve Bank highlighted a number of positive issues for inflation. They are of the opinion that the current forecast for inflation still looks encouraging. Because of the sustained low level of PPI (producer price inflation), they do not expect significant upward pressure on consumer prices in the short term. The expect CPI to peak at about 5.25% early next year and to then decline towards the middle end of the targeted band (between 3% and 6%).
Once again, however, they highlighted the current risks to their inflation outlook. These include “the uncertainty relating to international oil prices, domestic expenditure continues to be robust, strong growth in money supply and credit extension by the banking sector, the widening deficit on the current account of the balance of payments, the prospects for the international economy have become more uncertain and the IMF and the World Bank have revised down their forecast for growth in 2005, particularly in the Eurozone and Japan.”
| GENERAL – OIL AND GOLD |
The oil price spiked during the quarter under review, but ended the quarter at $50.23 per barrel, compared to $50.14 at the end of February. The spikes in the price were fuelled mainly by supply and demand issues as well as by concerns relating to refinery problems in the United States. In their twice yearly report on global economic prospects, the International Monetary Fund warned of the increasing threat that rising oil prices pose to global economic growth. They reported that “the strength of the demand for oil from China and India had caught the international community by surprise.” Year to date, our domestic petrol price has increased by more than 25%.
The gold price declined further, ending the quarter at $416.65 an ounce compared to a close of $435.85 at the end of February. It is interesting to note that last year, the South African gold mining industry recorded its lowest level of production since 1931, largely as a result of the strong Rand and increasingly high costs.
| CONCLUSION |
The Rand weakened to 7 month lows during May fuelled by a stronger US Dollar, calls from the ANC for a more “competitive” exchange rate and the news that Cosatu are set to strike in June “to protest currency-related job losses”. The Finance Minister, however, has “raised serious concern about adopting an official policy to defend a particular level of the Rand exchange rate” the Business Day reported recently.
Domestic resources, a sector very much out of favour last year, returned 17.50% in the first quarter of 2005, while both financials and industrials were only marginally positive. This “bounce back” in resources was aided by the combination of a weaker Rand and firmer commodity prices. The surprise interest rate cut in April, though, favoured the industrial and financial sectors. The turbulent equity environment continues to make it difficult for domestic fund managers this year. While we believe that the risk premium for domestic equities has risen since our last report, we continue to believe that equities will be the asset class of choice in the domestic market this year. As stated in our last report, it appears as if the “easy” money has been made in this equity cycle.
QUARTERLY QUOTE
“In the business world, the rearview mirror is always clearer than the windshield”
Warren Buffett
This report is based on information sourced from various institutions, both local and international. The report reflects a variety of views and is not intended to convey investment advice. Please consult us to obtain specific advice relevant to your investment portfolio.
