The world economy, as I see it, remains very much in a state of fundamental disequilibrium. A US-centric global growth dynamic has given rise to extraordinary external imbalances around the world. America, the world’s unquestioned growth engine, is facing unprecedented imbalances of its own; the national saving rate, current account, Federal budget deficit, and private sector debt ratios are all at historical extremes. And an increasingly powerful global labor arbitrage continues to keep high-wage developed economies mired in jobless recoveries. The result is a unique confluence of tensions that have left the global economy in a state of heightened instability. The venting of those tensions could well be the main event in world financial markets in 2004.

The case for global rebalancing has been an overarching theme of our macro call over the past year. The urgency of such a realignment in the mix of world economic growth has never been more compelling. Over the 1995–2002 period, the United States accounted for 96% of the cumulative increase in world GDP — basically three times its 32% share in the global economy. This was, by far, the most lopsided strain of global economic growth that has ever occurred in the modern-day post-World War II era. Two sets of forces have been at work in creating this unsustainable condition — a US economy that has been living beyond its means as those means are delineated by domestic income generation, and a non-US world that is either unwilling or unable to stimulate domestic demand. As a result, an unprecedented disparity has opened up between those nations with current-account deficits (the United States) and those with surpluses (Asia and, to a lesser extent, Europe). Such an unbalanced global growth paradigm is not sustainable, in my view. The debate is over the terms under which the coming rebalancing occurs.

The macro fix for a lopsided economy is very simple — it mainly entails a shift in relative prices. For a US-centric global economy, that implies a realignment in the dollar — the world’s most important relative price. In that vein, a weaker dollar needs to be seen as the principal means by which the tensions of an unbalanced global economy are vented. The broadest trade-weighted index of the US dollar is currently down about 11% in real terms over the past 23 months. History tells us that global rebalancing will undoubtedly require a good deal more dollar depreciation — perhaps twice as much as that which has already occurred. That poses the important question as to who bears the brunt of the dollar’s adjustment. The Europeans and Japanese believe they have suffered enough and are pointing the finger at others — mainly China — to pick up the slack. US politicians are also sympathetic to this line of reasoning. Consequently, the role that China plays in venting global imbalances is also likely to be a key issue in the year ahead. For what it’s worth, I think this debate overlooks a critical consideration: Europe and Japan are wealthy countries that have dragged their feet endlessly on reforms, whereas China is still a very poor country that has been aggressive in embracing reforms. Why should China be called on to compensate for adjustments that Europe and Japan are unwilling to undertake?

America must also bear its fair share in the coming global rebalancing. And the problem is that the US economy is not in the best shape to cope with the requisite adjustments. That’s because it has a record low saving rate, sharply elevated debt burdens, and massive trade and current-account deficits. Nor is growth alone likely to be a panacea for America’s shaky fundamentals. In fact, there are good reasons to worry that another surge of US economic growth could well exacerbate many of these imbalances The pivotal tension point in this regard is America’s anemic net national saving rate — the combined saving of households, businesses, and the government sector adjusted for depreciation. This key gauge measures the saving that is left over to fund the net expansion of productive capacity — the sustenance of any economy’s long-term growth potential. Unfortunately, in the case of the United States, there isn’t any — America’s net national saving rate fell to a record low of 0.6% of GNP in the first three quarters of 2003. To the extent that domestic income generation continues to lag — precisely the outcome in America’s lingering jobless recovery — another burst of private consumption, such as that now under way in the second half of 2004, can only push saving lower. That, in turn, puts greater pressure on foreign saving to fill the void — giving rise to increased trade deficits and private sector indebtedness.

Such an outcome only heightens the tension already bearing down on the US economy. A lasting recovery cannot be built on a foundation of ever-falling saving rates, ever-widening current-account and trade deficits, and ever-rising debt burdens. These tensions must also be vented if America’s nascent upturn is to make the transition to sustainable expansion. The bond market, in my opinion, offers the principal means by which this venting can occur. And the outlook for bonds is not good. A confluence of three bearish forces are at work — the Fed’s eventual exit strategy from a 1% federal funds rate, a weaker dollar, and America’s fiscal train wreck. Ironically, under these circumstances, you don’t have to be worried about inflation to be negative on bonds. At the same time, if financial markets ever did get a whiff of inflation, a real rout in bonds might ensue. Higher long-term real interest rates do not temper all the imbalances that are on America’s plate. But they could help — possibly a lot. The key impact would be a reduction in the growth of the credit-sensitive segments of aggregate demand. That would enable a long overdue rebuilding of domestic saving, which would then act to reduce America’s current-account and trade deficits. A lower pace of consumption growth would also go hand in hand with a reduced expansion of indebtedness. A tough bond market may be just the medicine an unbalanced US economy needs.

The global labor arbitrage is a third major source of tension bearing down on today’s global economy. The accelerated pace of replacing high-wage jobs in the developed world with low-wage workers in the developing world reflects the interplay of three mega-forces — the first being the maturation of outsourcing platforms in goods (i.e., China) and services (i.e., India) on a scale and with scope never before seen. The second factor at work is the Internet — providing ubiquitous real-time connectivity between offshore outsourcing platforms and corporate headquarters. In goods production, the Internet forever changes the efficiency of supply-chain management. But for services, the Internet is a transforming event — effectively converting the once non-tradable sector into a tradable global marketplace. With the click of a mouse, the knowledge content of white-collar workers can now be delivered anywhere in the world on a near-real time basis. The unrelenting push for cost control in a no-pricing-leverage world is the third leg to the stool of the global labor arbitrage. Such environmental imperatives only heighten the incentives for IT-enabled “offshoring.”

While the global labor arbitrage continues to push costs and pricing lower, it does have its dark side. Significantly, it continues to put pressure on job creation and income generation in the high-wage developed world. Largely as a result, consumers in the high-wage developed world end up defending their lifestyles by drawing increasingly on alternative sources of purchasing power, such as asset-driven wealth effects, increased indebtedness, and tax cuts. In my view, vigorous consumption cannot be sustained in the context of the profound income leakage that stems from the global labor arbitrage. That underscores yet another source of disequilibrium that must be vented. In this instance, the venting appears to be exacerbating the pressures bearing down on an unbalanced world. That’s because it has taken the form of heightened trade frictions and growing protectionist risks — developments that only intensify pressures on the dollar and the US bond market.

The means by which this confluence of tensions gets vented will likely be key for global economy and world financial markets in 2004. There are two conceivable paths to resolution, in my view — the benign soft landing and the ever-treacherous hard landing. Macro is not good at making the distinction between these two modes of adjustment. Instead, it basically identifies the forces that have given rise to disequilibrium and then depicts the possible adjustments that must take place to reestablish a new equilibrium. As always, the outcome is more dependent on exogenous shocks. In the current instance, the shocks that worry me the most would be those that might shake foreign confidence in dollar-denominated assets; intensified protectionist actions from Washington would be especially disconcerting in that regard. Equally worrisome is the magnitude of the current state of disequilibrium — and the distinct likelihood that these unprecedented imbalances can only be vented by big movements in asset prices. My deepest fear is that the longer the venting of these tensions is deferred, the larger the ultimate adjustments and the greater the chances of a hard landing.

Early next year, Congress will consider a piece of legislation that could have important implications for recipient countries of US foreign direct investment (FDI).  The legislation, known as the “Homeland Investment Act” (H.R. 767) and the “Invest in the USA Act” (S. 596), is part of the broader international tax bill, and  proposes to temporarily reduce the tax rate on US firms´ repatriated earnings from 35% to 5.25%.  If the legislation is passed ― and the chances are quite good, according to our government relations team ― the tax amnesty could affect those economies that are disproportionately dependent on reinvested earnings as a source of investment. 

The proposed legislation would offer a great boon for US MNCs.  Currently, the income earned by foreign subsidiaries of US corporations is subject to US tax only once it is repatriated, encouraging many multinationals to store their profits overseas in order to defer paying US taxes on their foreign-source income.  As a result, less than one-half of foreign earnings of US companies is returned to the US parent in any given year.  In 2002, for instance, US parents repatriated just 39% of the total $124 billion in profits from their foreign subsidiaries, reinvesting the remainder.  Over the years, this has resulted in the build-up of some $350-400 billion of profits parked overseas. 

No one knows for sure how large the potential windfall of repatriated profits would be if the proposed bill is passed, since not all companies will necessarily take advantage of the provision.  For instance, for companies with cash-strapped foreign affiliates or relatively more attractive overseas opportunities, no excess dividends, or with credits left over from prior years, the amendment might not be a sufficient incentive to repatriate.  In addition, while some overseas profits are stored in passive investments, like government securities, others may be tied up in equipment, property, or other less liquid investments that are not easy to repatriate. 

That said, there is clearly a host of companies that would profit from the legislation.  Indeed, a number of multinationals with significant overseas exposure, including Hewlett-Packard, Eli Lilly, Merck, Intel, Sun Microsystems, and Dell Computer, have formed a coalition to lobby in favor of the repatriation provision.  Congress's Joint Committee on Taxation estimates that the proposal would encourage US companies to repatriate roughly $135 billion in earnings; this is consistent with our own valuation team’s estimates.  There’s a wide range of other estimates in the market, some as high as $400 billion during the year in which the legislation takes effect. 

Outside of the direct impact on individual multinationals, there could also be an indirect balance of payments impact.  The income balance (one of the three components of the current account) would not be significantly affected by a repatriation of overseas profits, since this component only captures income earned during the current year, not the income that has accrued over the last several years.  Moreover, no distinction is made between earnings that are distributed to the parent and those that are reinvested; both have already been accounted for in the income balance.  However, to the extent the HIA provision encourages companies to repatriate more overseas profits and thus reinvest less in foreign subsidiaries, it could reduce the level of US direct investment abroad.  How so?  Reinvested earnings, which represent the value of retained profits in foreign subsidiaries that are reinvested in the host country, are one of the three components of FDI — the other two being intercompany loans and equity capital.  They are distinct from the other two components because they represent both affiliate income and capital flows.  The contribution of reinvested earnings to the overall level of US direct investment abroad is substantial, especially in the last two years, with profitability still on the mend, repayments of intra-firm loans to parent companies increasing, and equity markets still fragile. 

We had already expected reinvested earnings to come under pressure in the near term, since there has been a decline in the infusion of new equity capital in the last few years and thus a smaller pool of capital to reinvest.  With the added tax holiday, the pullback could be more pronounced.  To what extent?  Let’s suppose that the US invests a total of $140 billion of FDI in overseas markets and reinvested earnings represent 40% of that amount.  That’s roughly on par with average levels in the last five years.  If we assume, generously, that firms reinvest half of their earnings in order to avoid the tax incurred from repatriation and half is invested to take advantage of actual overseas opportunities; and if we also assume that nearly all of those firms that have sheltered their overseas earnings will take advantage of the tax amnesty, then repatriation could yield a 20-25% decline in US overseas investment (a bit less if equity markets continue to recover and companies become more willing to use equity capital as a means of financing). 

The impact on recipient countries would not be uniform.  Although reinvested earnings accounted for an average of 42% of total US direct investment outflows on a global basis during the last five years, this figure masks significant regional differences.  For instance, during the period 1998-2002 a number of European countries were disproportionately dependent on reinvested earnings as a mode of investment — i.e., the Netherlands (76%), Ireland (69%), and Switzerland (51%).  These economies are also more dependent on the US as a share of their FDI inflows from the rest of the world relative to other European economies where the ratio of reinvested earnings to FDI is lower, thus posing the possibility of a double whammy.  In Latin America, 31% of total FDI from the US was in the form of reinvested earnings during the same period.  Within the region, though, Argentina and Brazil were clear outliers, as foreign subsidiaries have posted losses in these economies in the last few years, so reinvested earnings have actually been negative.  By contrast, in Mexico, where US multinationals have rapidly expanded their presence in recent years, the ratio is at the high end, at 40%.  In Canada, the ratio of reinvested earnings to total FDI was close to the global average.  In Asia, reinvested earnings proved to be a key means of investment for Singapore (53%), Hong Kong (52%), and Taiwan (35%), but less so for Japan (25%), Korea (18%), and China (14%) during the same period.  We are not suggesting that countries that are more dependent on reinvested earnings as a mode of FDI will be disproportionately affected. Reinvested earnings also reflect confidence in a host country, and that may well outweigh other priorities, including a powerful tax incentive.  However, those countries where the incentive to reinvest earnings is driven more by a desire to defer tax payments rather than by profitability will more likely feel the effects of a pullback in US investment.

Bottom line: If the HIA legislation passes and has the intended effect of inducing US multinationals to repatriate a larger share of their overseas profits, the level of US direct investment abroad could decline, with those economies with a high ratio of reinvested earnings to FDI at greatest risk. 

We are updating our currency forecasts for 2004.  Our two-year-old call for a structural USD correction should continue to play out for a third year.  However, the overshoot in EUR/USD and GBP/USD is likely to be somewhat greater than we had expected, while the trajectories for USD/Asia, including USD/JPY, remain relatively unchanged from the previous forecasts.  Our end-2004 target for EUR/USD is now $1.23 (up from $1.22), and our new target for USD/JPY is ¥102 (down from ¥105).  The more significant change is that we now expect EUR/USD to continue to overshoot in Q1 up to $1.28, before declining gradually for the rest of the year.  With GBP and AUD also exhibiting this overshoot pattern, we anticipate the average value of the Fed's major USD index to decline by 9.5% during 2004, compared to the 4.1% we had expected previously.

Forecast Changes

New	Mar-04	Jun-04	Sep-04	Dec-04	Avg-03	Avg-04
EUR/USD	1.28	1.25	1.24	1.23	1.13	1.25
USD/JPY	105	106	103	102	115	105
EUR/JPY	134	133	128	125	130	131
Old	Mar-04	Jun-04	Sep-04	Dec-04	Avg-03	Avg-04
EUR/USD	1.16	1.20	1.22	1.22	1.13	1.20
USD/JPY	107	105	105	105	116	106
EUR/JPY	124	126	128	128	130	126

Source: Morgan Stanley Research estimates

 

The basic framework behind our previous forecasts

Underpinning our previous forecasts, which were published in September, we had several key thoughts.  First, the USD would remain structurally mispriced, on an index basis, and further correction of the USD index was inevitable.  Second, the rally in the EUR was excessive relative to the JPY: More generally, the Asian currencies needed to 'catch up' to keep the USD correction more balanced.  Third, emerging market currencies, particularly Latin American currencies, were lagging badly behind in the USD sell-off, and would likely catch-up with the majors.  Thus, we were looking for the USD to continue to correct, but for such a correction to be more balanced between Europe and Asia and between the major and minor currencies.

What has changed?

Three key developments since September have altered our outlook for 2004.

Change 1 — The de facto burial of the SGP and the strong EUR policy

The effective burial of the Stability and Growth Pact (SGP) on November 25 was a watershed in this structural USD correction, for it opened the way for EUR/USD to head higher.  Having had difficulties pushing headline inflation down below the 2.0% ceiling, the ECB has consistently opted for a strong EUR policy.  But the consequent spill-over effect of such a policy was to push Euroland into a technical recession in the first part of this year.  Since November 25, EUR/USD can head higher with impunity (since fiscal policy is now more able to compensate for currency strength and a weakening in the economy brought about by currency strength no longer endangers the pact).

Change 2 — Galvanised commitment in Asia to defend soft USD pegs

The G-7 Communiqué issued on September 20 in Dubai was effectively a round of verbal intervention to talk USD/Asia lower.  USD/JPY did decline, but the rest of Asia barely moved.  We are now back in a bi-polar currency world, with Asia running soft pegs to the USD.  In contrast to Euroland, Asia is very sensitive about the risk of a premature appreciation in their currencies undermining their economic recovery.  They are likely to maintain such soft USD pegs until inflation becomes a problem.  This means that Asia, led by Japan, will likely continue to resist the pressure for the USD to correct.

Change 3 — The gradual recovery in Euroland

The third event that changed our outlook on the G-3 currencies is that Euroland has also begun to recover, mainly on the back of the recovery seen in the US and Asia.  While the economic reasons for EUR/USD to rally sharply are not compelling to us, a stronger Euroland economy, even if it is primarily supported by external demand, should allow Euroland to absorb more EUR strength.  EUR/USD may rise by default, not by merit, and Euroland policy makers may have a misguided strong EUR policy, but the bottom line here is that a stronger Euroland will mean the economy can 'afford' to have a stronger EUR.

Our revised forecasts

Notwithstanding the developments mentioned above, our basic story on the USD index remains unchanged.  We still believe that, compared to the fair value that is likely to prevail at end-2004, the Fed's major USD index is around 5-10% overvalued.  The structural correction of the USD will, thus, be sustained well into 2004.  We continue to monitor all three aspects of the USD correction: magnitude, symmetry, and speed.

Our year-end forecasts for both EUR/USD and USD/JPY are not that different from the previous forecasts.  However, we are now looking for a further surge in EUR/USD in Q1.  Because of this prospective overshoot in EUR and GBP, the decline in the average rate for the major USD index is now 9.5% in our revised forecasts, compared to 4.1% previously.  On symmetry, we now look for further upside in EUR/JPY in the first part of 2004.  USD/JPY will likely lag behind EUR/USD in the first part of the year, but will likely continue its gradual decline throughout the year.  While downward pressures on USD/JPY likely will be great, we expect the MoF to continue to conduct massive interventions to smooth out the correction and support USD/JPY above ¥100.  On speed, we continue to look for an orderly adjustment in the USD index.  While some bilateral exchange rates (e.g., EUR/USD and AUD/USD) may overshoot, following Dornbusch's model of overshooting, we do not expect the USD index to do so.

Coordinated intervention a risk in 2004

In a previous note we pointed out that the four potential shocks in 2004 are (1) the US economy, in terms of both size and quality of growth; (2) a slowing China; (3) protectionism; and (4) geopolitics.  With EUR/USD overshooting like this, we thus add to this list the risk of coordinated intervention as the fifth potential shock that matters for the currency markets.  A USD correction concentrated against a few currencies is neither healthy nor sustainable.  It will, however, be difficult for Euroland to reverse its policy on the EUR or exert pressure on Asia for greater burden sharing.  The alignment of interests between various currency blocs will be an important issue in 2004.

While the market is fixated on EUR/USD at this moment, it is only a matter of time before the spotlight turns on USD/JPY.  The MoF may continue to be successful with its interventions in supporting USD/JPY at these levels for the time being.  However, over time, massive interventions could still fail if Japan’s recovery is sustained. We lay out a portfolio-based argument:

1. Japan has a huge amount of foreign assets. 

As a result of massive cumulative trade surpluses, Japan now holds a huge amount of foreign assets.  As of end-Q3 2003, Japan as whole held US$3.5 trillion (¥378 trillion) worth of gross foreign assets (GFA) and US$1.5 trillion (¥172 trillion) worth of net foreign assets (NFA).  

2. This is not a preferred portfolio mix, from Japan’s perspective. 

Japan has a strong ‘home bias’ for investment, which suggests that the large GFA and NFA positions in Japan may no longer be preferred.  In other words, if Japanese investors had their way, they’d prefer to have lower levels of foreign assets and more JPY assets, not from a carry perspective, but from the perspective of the stock of their portfolios. 

3. The idea of a ‘negative risk premium.’ 

The concept of ‘negative risk premium’ is essentially the point that, because of the aversion to further increases in Japan’s foreign asset position, foreign interest rates will need to be considerably higher than those in Japan to entice Japanese investors to send more of their capital overseas.  Japan’s interest rates have been persistently below those of most foreign countries.  We believe that two main reasons for this are (1) expected JPY appreciation (uncovered interest parity theory — Japanese rates can be below foreign interest rates since after accounting for currency appreciation, returns would be equalised) and (2) the negative risk premium (Japanese rates can be below foreign rates because Japanese investors would prefer not to further invest in foreign assets). 

4.  The yield curve in Japan should rise and steepen as the economy continues to recover. 

I have been arguing since early summer that Japan has seen its multi-year economic bottom.  As long as Japan continues to recover, there should be pressures for the long bond yield in Japan to go up.

5.  Massive MoF interventions in USD/JPY are not consistent with the whole picture. 

As the MoF resists the USD correction through intervention, it buys US Treasuries and helps keep interest rates in the US lower then they would otherwise be.  In addition, the more Japan recovers, the more Japanese interest rates tend to drift higher.  But, as a result, the compressed yield differentials may end up being too small to offset the combined effects of expected JPY appreciation and the negative risk premium.  Theory suggests that this should lead to less private capital heading overseas.  In turn, the Japanese long bond yield may also be kept artificially low as private capital is trapped in Japan.  In other words, the combination of (1) a declining USD, (2) a recovering Japan, and (3) intervention that is not consistent and not sustainable, continued official interventions would be offset by a reduction in private capital outflows.  This is one key structural reason why I believe continued massive intervention will fail eventually. 

Massive interventions are likely in 2004. 

The structural USD correction is not yet complete.  What the currency world needs, however, is a better balance between EUR and JPY and between the majors and the minors, during this structural USD correction.  If we assume that the JPY rises by another 10%, on par with the expected movement in the major USD index, USD/JPY would be below 100.  (This is a conservative assumption as I am not assuming any normalisation between EUR and JPY.)  The MoF will need to be prepared to intervene massively in 2004 to avoid 100 being broken.  But the amount of intervention necessary will have a meaningful effect on US interest rates, just as Japan continues to recover.  This will, as explained above, significantly discourage private capital outflows and raise the risk that such interventions may fail. 

Bottom line. 

The more the MoF intervenes, the more the Japanese private sector will hold back on their foreign investment, making the interventions themselves an exercise with diminishing returns.  Heavy intervention in 2004 will be necessary to hold USD/JPY above 100, but risks to USD/JPY will still be biased to the downside of 100. 

November’s shocking dip in “core” inflation measured by the Consumer Price Index (CPI) has reopened the twin debates about the inflation outlook and what it means for the Fed.  The November decline of 0.1% brought year-over-year core inflation to just 1.1% — the lowest reading since May 1963.  Moreover, the softness in pricing extended to both goods and services, with core commodity prices falling by 0.4% and core services flat.  And given lingering biases in the CPI, core inflation could be below the 1% to 2% range that represents the Fed’s presumed definition of price stability.  As a result, November’s reading seems to up the ante on the risks of an “unwelcome decline in inflation.”

While we are mindful of the downside risks, we disagree.  Core retail inflation probably has bottomed, in our view, as the case for a rebirth of pricing power is intact and signs of it are already visible at earlier stages of the pipeline.  It’s worth remembering that core inflation last declined on a monthly basis in December 1982; and that over the following year cyclical forces lifted core inflation to 3.9%.  Of course, that was then.  The economy and the forces affecting inflation have changed significantly over the past two decades, so over the course of 2004, only a slow rise is likely.  This inflation environment will reinforce the Fed’s determination to stay on hold in the face of strong growth.  While the Fed won’t likely tighten monetary policy soon, these crosscurrents underscore the importance of straight talk from the Fed about its longer-term game plan.

It’s a critical juncture for retail inflation.  At work are two sets of overlapping forces that have so far netted to declines.  The first set is disinflationary: It includes significant slack in the U.S. and global economies, three years of subpar economic performance, and growing supply from new outsourcing platforms in Asia.  One measure of that slack, the so-called “output gap” (the difference between actual and “potential” GDP) currently stands at about 2% of GDP, a spread that in the past has been associated with declining inflation.  And despite the 21% decline in the dollar’s value on a trade-weighted basis against major currencies, prices of imported consumer goods have until very recently declined.  No doubt, the fixity or slow appreciation of several Asian currencies against the dollar and the desire of other exporters to keep US market share has suppressed that “pass through.”

There’s no mistaking the fact that inflation is at historical lows by any measure.  However, just as the CPI may have overstated the slight rise in core inflation in 2000-01 by a factor of two, it likely has overstated core disinflation in the past two years.  Core CPI inflation rose by nearly a percentage point in the earlier period, while it declined by about 160 basis points over the past two years.  In contrast, the core personal consumption price index, which is the Fed’s preferred inflation gauge, showed an acceleration of half a percentage point in 2000-01, and a deceleration of 90-100 bp — as best we can judge given incomplete official revised data — over the past two years.  Equally important, just as the core CPI overstated the rate of inflation in the earlier period, it may slightly understate it currently.  Three factors are especially important in accounting for the divergence between the two indexes: a difference in coverage, the use of alternative price gauges for some spending categories, and the methodology used to calculate each index.  For instance, shelter accounts for 31.7% of the CPI, but little more than 15% of the PCE price index (for details, see “Will the Real Core Inflation Measure Please Stand Up?” Global Economic Forum, July 16, 2001). 

Looking ahead, we expect that cyclical reflationary forces will begin to gain the upper hand and gradually lift inflation, however it is measured.  Corporate America has reduced capacity; for example, manufacturing capacity apart from motor vehicles and information technology contracted by half a percent over the past two years.  That helps explain why operating rates have jumped by 160 basis points in the past six months on the back of moderate production gains.  Monetary policy is clearly reflationary, evidenced partly by the dollar’s ongoing, orderly decline.  The effects are beginning to show up clearly: For example, non-energy import prices rose by 1% in the year ended in November, the fastest pace in five years.  Finally, above-trend growth is beginning to close the output gap.  Even if potential growth is 4%, if our growth prognosis is close to the mark, the gap will have closed by more than a full percentage point by mid-2004.  And we believe that both the change in the gap as well as its width bear on future inflation. 

But uncertainty clouds our appraisal.  We’ve already noted that, despite improvements, statisticians still measure inflation imperfectly, so we’re not quite sure where we are starting from.  For example, the Schultze report argues cogently that the CPI may understate some important price measures (see At What Price? Conceptualizing and Measuring Cost-of-Living and Price Indexes, ed. Charles Schultze and Christopher Mackie [Washington, DC: National Academy Press, 2001]).  Second, we’re still guessing at potential growth past and future, so the size of the output gap and how fast it will close are unknown.  For example, if potential growth was half a percentage point higher than previously thought over the past four years, the gap would be 4% of GDP, not 2%.  Indeed Fed staff research suggests that errors in measuring the output gap have at times been larger than the gap itself.  

While the Fed won’t likely tighten monetary policy soon, in this uncertain environment the Fed owes market participants and the public at large an explanation of its future game plan.  Three issues are important: Where policy is, where it will ultimately go, and how fast it must get there.  In our view, monetary policy is extremely — and appropriately — accommodative, with the current real Federal funds rate essentially zero.  However, monetary policy is a long way from a “neutral” setting; in a high-productivity growth economy, the “natural” or real long-term Federal funds rate is probably about 3%.  In our view, policy should be back to neutral when the output gap has vanished, as the Taylor Rule suggests.  But there’s no chance that the Fed will feel compelled to return policy to neutral in a hurry.  With ultra-low inflation and only a gradual rise likely, a return to policy neutrality could take two years or more.

Fed officials have recently made progress in communicating that strategy through speeches and statements.  Indeed, the line of reasoning just outlined is consistent with the FOMC 's reference to the fact that "economic performance in line with their expectations would not entirely eliminate currently large margins of unemployed labor and other resources until perhaps the latter part of 2005 or even later" (see the October 28 FOMC minutes).  But that statement, especially on the heels of the FOMC’s shift in its inflation risk assessment, did create confusion.  Some read this passage as an indication that the Fed planned to avoid hiking rates until 2005 or beyond.  In fact, it actually seems to be nothing more than a reasonable assessment of the point at which the monetary authority will need to have a neutral (or close to neutral) policy stance in place. 

From our standpoint, while Greenspan & Co have certainly sent some confusing signals in recent weeks, a careful reading of the FOMC statement and the October minutes does send a clear message.  The FOMC linked the “considerable period” to circumstances, not just the calendar.  The minutes clearly note the differences between today’s too-low inflation environment and those of the past, with straightforward implications for policy.  Yet financial market participants also compounded the problem by misinterpreting a relatively innocuous reference to the output gap. 

Fed officials have convened yet another committee to offer suggestions on how to improve communication of policy strategy and intent.  From that process, more changes are likely, and, we are certain, straighter talk.  We hope the committee will adopt some suggestions we’ve offered before:  Keep it simple.  Be clear about goals.  State what you just did and why.  Clearly state the main medium-term risks to the outlook.  State your policy bias: Are you north or south of equilibrium?  Finally, speed up the release of the minutes, to the end of the second week after the meeting (see “Transparency, Targets and Rules in Monetary Policy,” Global Economic Forum, September 5, 2003).  We think a growing number of Fed officials agree that early release of the FOMC minutes would be helpful.  In a November interview, Fed Governor Bernanke stated: "I would be in favor of moving up the release date of the minutes from the FOMC meetings and thus getting out more timely information about the Fed's deliberations. That would provide much more forward-looking information and reduce the burden on the statement that follows the meetings."

After the dramatic improvement in Brazilian asset prices during 2003, it may seem hard to imagine that there is still more good news to come from Brazil. But we believe that there is: We expect 2004 to be the year of a full-fledged recovery, producing the best growth — real GDP up at least 4.4% — in five years. Indeed, the good news is that the recovery in Brazil has already begun. The first signs of the recovery have come from durable goods consumption, brought about by the combination of enormous pent-up demand and an improvement in consumer confidence as the authorities have begun slashing interest rates. The pent-up demand is hardly surprising. After all, during the past five years, with the exception of 2000, Brazilians have suffered from a weakened economy. The improvement in confidence is also hardly surprising. After a dramatic contraction in private consumption at midyear — consumption saw its sharpest quarterly drop during the second quarter of the year in more than a decade — the central bank has cut interest rates by 1,000 basis points and is likely to continue well into the first half of 2004, as we expect the Selic target interest rate to fall to 14%.

Brazil enters 2004 not only with an unusually effective combination of macro policies, but also with a positive progress report card on structural reforms. On the macro front, the authorities have been able to use tight monetary policy to control inflation while maintaining a strict commitment to fiscal responsibility. The payoff is now coming, and we expect it to be abundant during 2004 as the easing cycle supports an incipient consumption-led recovery. Unlike the aborted recovery in 2001, this time Brazil finds itself with a much more solid external position. Indeed, Brazil will end this year with a record trade surplus near $24 billion, sufficiently large to allow for growth without a significant deterioration taking place. Finally, on the reform front, in an unprecedented move, controversial social security and tax reforms have passed Congress simultaneously.

Notwithstanding progress on growth and reforms, Brazil still needs to address enduring questions over its medium-term outlook. The challenge for Brazil is how to deal with improved fiscal revenues that are likely to accompany the return to growth. While the administration has underscored its fiscal austerity credentials with a larger primary surplus than was ever achieved during the past administration, good growth and improved investor sentiment can be seductive. The magnitude of Brazil’s debt is such that debt reduction must remain the principal priority of the fiscal authorities. Of course, policies designed to produce growth are crucial in order to have the resources to tackle the debt burden, and indeed one should lead to the other, but that vulnerability can easily be overlooked in the midst of a growth rebound.

Part of our cautionary note on Brazil in 2004 stems from the track record of Mexico in dealing with its abundance. The oil windfalls of 2000 and 2003 have largely gone to fund current expenditures rather than being used to fund a well-designed oil stabilization fund. Mexico’s strength has been in dealing with adversity: It has shown the prudence to tighten its belt and endure the fiscal pain. Brazil’s recent experience suggests that it has learned the same lesson. However, the jury in both countries remains out on whether they will respond to the good times. The abundance of growth in Brazil is likely to be cheered by investors in 2004; how Brazilian policy makers deal with it, however, will determine whether the cheer remains in 2005.

After running on one cylinder for most of the past three years (with modest consumer demand hampered by the lack of job growth), we are beginning to see solid evidence of a recovery in Mexico’s real economy. We expect the evidence we are now seeing to allow the debate over whether the “link is alive” between the US and the Mexican economies to be put to rest. However, we are unprepared to forecast a return to the robust growth last seen in 2000 because of our residual concerns over the quality and sustainability of the US recovery. The problem of whether the link is alive had reared its head during the second half of 2003, when the headline reports from the US showed an economy on fire while Mexico’s GDP showed little or even negative growth during the third quarter. The problem, of course, is that the US manufacturing sector — precisely where the link between the US and Mexico is strongest — had lagged the broader US recovery. That, plus differences in how the growth rates in the two economies are reported and the bias of much of the first signs of the turnaround in US manufacturing toward high-tech (where links with Mexico are weaker) raised the inevitable question whether China had so damaged the link between the two countries that a US recovery could leave Mexico without growth.

At the end of 2003, however, the first signs — initially on the trade front and now in industrial production — were visible that the US recovery is indeed spilling over into Mexico’s manufacturing sector. In fact, October’s industrial production report—once properly adjusted for seasonality — marks an extremely positive break with the weakness of recent months. Further, October’s trade report, as well as the September report in our analysis, provide strong support that the improvement in US demand seen in the third quarter has begun to spill over into the Mexican economy. And with Mexican consumers in better shape after the recent downturn than coming out of any past downturn — thanks to low inflation, they have not seen their purchasing power destroyed — consumption is set to benefit further.

The problem in Mexico remains that the policy-making class appears unwilling to move forward on a host of reforms that are crucial for Mexico to boost its competitiveness. Investors initially thought the “convergence” thesis held great promise for Mexico. Unfortunately, convergence has become a safety net. Thanks to the forces of integration with the US economy, Mexico continues to enjoy a steady flow of foreign investment. The stability of those flows, accentuated by strong oil prices, tourism revenues, and ever-growing remittances from Mexicans working abroad, have a pernicious side:  They have reduced to urgency facing Mexican policymakers to tackle the competitive impediments facing Mexico.

The good news in Mexico is that by the fourth quarter of 2003, the Mexican economy had begun to respond to the US recovery. Consumers, who so far have kept the economy afloat thanks to credit and modest real wage gains, are now likely to find improvement on the jobs front as well. The cyclical upturn is likely to cause some of the concerns over the threat that China represents to Mexico to recede. That in many ways is a shame. The greatest threat to Mexico, in our view, remains the failure of policy makers and politicians to leverage Mexico’s integration story. In the difficult months of 2003, when many Mexico watchers were concerned that China’s competitive challenge might have severed the link between the US and Mexico, the policy making class in Mexico failed to make progress on the reform front. If strong capital inflows robbed Mexico’s politicians of any urgency to act then, what can we expect now that a cyclical recovery is under way? Not much, I’m afraid. It is hard to be too upbeat on Mexico’s medium-term macro prospects, even if I am wrong for being too cautious regarding the sustainability and quality of the US recovery. Yes, it is true that a turnaround in Mexico is in the works. Much of the growth in 2004 will depend on how strong the US recovery is. But the longer-term challenges for Mexico — challenges highlighted by China’s and India’s ascension — are not being addressed. That should give pause, even as the cyclical upturn begins to gain ground and gives investor reason for good cheer.

We expect Chile’s economy to continue to gain ground in 2004 with growth near 4.5% — its strongest performance since 1997. With real wage growth fairly constant, near 2% per year, Chile’s consumer has benefited from the improvement on the jobs front as well as from greater access to credit. Unemployment is now at its lowest level in five years. Meanwhile, we expect another strong year on the credit front as banks are preparing for an aggressive increase in consumer lending, which has been growing in the double digits during 2003. The prospects for copper prices are also set to benefit Chile in 2004. Our metals team now expects copper prices to average $0.95 per pound in 2004, an 18.8% jump from the $0.80 forecast for 2003. And there are signs that there could be upward pressure to the copper forecasts: By mid-December copper prices had broken above $1.00. Unlike Mexico, which appears to be on the wrong side of the ongoing debate over the importance of China, Chile has benefited from stronger Chinese demand for its commodity exports from copper to pulp and forestry products.

In addition, the prospect of a boost in activity from the free trade agreement with the United States set to go into effect on January 1, 2004, along with the outlook for another strong year of growth in Argentina and a robust recovery in Brazil, should also benefit Chile. While the direct impact from the reduction in trade tariffs from a free trade agreement with the US is likely to be limited — we have seen estimates that it can add anywhere from 0.2% to 1.2% of GDP — secondary benefits from greater market access and increased investment flows are likely to enhance the impact further. But of greatest benefit to Chile in 2004 is likely to be the improvement in the economic conditions of its neighbors. While imports of consumer goods from Argentina and Brazil have risen by nearly one-third in the first half of the year, the benefits from a recovery in both countries are likely to more than offset the additional competition facing Chile’s manufacturing base.

While the rebound in Chile’s real economy for the most part has been anticipated by Chile watchers, the big surprise has been how much ground the currency has gained. Part of the recent rebound in the Chilean peso — from near 700 in late August to 598 by mid-December — appears to be the flip side of the excessive weakening seen during the latter half of 2002 and the first months of 2003, when the exchange rate broke above 750. But if there is a surprise in store for Chile watchers in 2004, we think it is that the Chilean peso is likely to remain strong. After all, the currency has suffered six years of decline. Today, the economy is showing virtually no current-account deficit, unlike its position during 1998 when the deficit exceeded 6% of GDP. With sound fiscal, monetary, and debt fundamentals and its commodity-linked export base, Chile appears to be ideally positioned to benefit from US dollar weakness and the rebalancing of global demand.

The weakest link is the lack of progress in boosting total factor productivity, which raises some concerns about the magnitude of the peso’s upside. Indeed, were it not for our concerns over the progress of global rebalancing, we would be even more optimistic on Chile for 2004. We are not in the camp that expects a global derailment, but we are not ready to embrace an uneventful, smooth recovery in global trade. Unlike Brazil and Argentina, which we expect to post strong growth in 2004 as part of a rebound, our forecast of 4.5% growth for Chilean GDP in 2004 is all the more impressive because it is coming off a good year in 2003.

It should come as little surprise that Argentina is leading the way in the rebound in activity in Latin America. After all, the robust growth of 2003 comes after having suffered a dramatic collapse of nearly 20 percentage points of real GDP between late 1998 and 2002. But perhaps more surprising is that Argentina is likely to have a repeat of strong growth in 2004, despite the lack of resolution of a host of issues stemming from Argentina’s default and devaluation two years ago. Indeed, we expect real GDP to grow by 6.0% in 2004.

The magnitude of the rebound is largely a function of Argentina’s large output gap, which combined with a competitive currency, low interest rates, and greater room for fiscal stimulus is likely to produce the second consecutive year of the strongest growth since the beginning of the era of convertibility in 1991. Thanks to the large output gap, Argentina should be able once again to post dramatic growth in 2004 without a significant pickup in investment spending. There is little agreement on the size of the output gap in Argentina. We have seen a wide range of estimates for 2004, from 6% (assuming growth near 7% in 2003) to 14% and some as high as 20%. Even at the low end of the range, however, our 6% growth estimate for GDP in 2004 appears plausible with only limited investment.

During the past year, the motor of growth in Argentina’s economy has rapidly changed from net exports to investment (largely residential construction) and now has moved to private consumption. The move to stronger consumer-led growth should ease some of the concerns that the output gap is quickly evaporating. Relative to net external demand, domestic demand is satisfied with a greater amount of services versus goods. While both industrial output and the services sectors fell by roughly 10% in 2002, industrial output has soared, up 17.3 % in the first half of 2003, while services has so far lagged, up only 2.2%. The lag on the services front suggests that there is significant room for growth in Argentina before capacity constraints become an issue.

The turnaround is also be supported by a very competitive currency. With inflation having rapidly come down from 41% in December 2002 to under 4% now, while the currency has depreciated by 65% since the break with convertibility, Argentina’s currency remains substantially undervalued. Again, we have seen a range of measures of just how undervalued the Argentina peso is; what seems clear, however, is that the currency is likely to continue to provide a substantial boost to import-substitution industries and to aid net exports.

While it is hard to be critical of the much-needed rebound in the real economy, we would highlight three risks that today’s temporary boost to activity poses for long-term growth prospects. First, with a repeat of strong growth in 2004, there is the risk that the political will to move forward on the debt restructuring process may be reduced. While it is difficult to imagine that policy makers or politicians can mistake the bounce-back in 2003 as the beginning of a sustainable growth path, we fear that another year of good growth may reduce the incentives to tackle the difficult challenges surrounding debt restructuring. That, in turn, can be expected to delay the recapitalization of the banks. With an economy growing without any significant financial intermediation from abroad or from local banks, it may be easier for politicians to postpone the issue of how to finance long-term growth. Second, good growth may create an additional stumbling block to progress on the debt front as bondholders demand higher recovery values for the defaulted debt. The longer and stronger the recovery in the Argentine economy, the greater the demands of bondholders are likely to be. Finally, good growth (helped along by new distortional tax measures and a reduced interest burden) may delay the day that policy makers tackle Argentina’s fiscal challenge, which requires a rethinking of the revenue sharing arrangement with the provinces.

At the core of Argentina’s fiscal challenge of living within its own means is to revamp the relationship between the provinces, which dominate government spending, and the federal government, which dominates the tax base. This imbalance provides provincial governments with few incentives to moderate spending, while attempts by the federal government to increase taxes often create a new entitlement to the provinces. Unfortunately, policy makers may feel less urgency to tackle the politically charged issue with the provinces given the jump in revenues tied to growth and new distortional taxes.

Argentina is unlikely to relinquish its status as the fastest growing major economy in Latin America in 2004. Ultimately, however, we believe that Argentina needs to address the residual damage of the meltdown two years ago, starting with debt restructuring, a new agreement with the utilities, and a plan to recapitalize the banking system. It also needs to deal with one of the sources of the meltdown — the asymmetric relationship between the provinces and the national government, which prompted it to live beyond its means. Otherwise, the rebound that we expect to continue in 2004 is likely to turn into a growth trap and leave Argentina ill-prepared for the future.

The euro area is entering 2004 at a fast speed

Our business-cycle indicators recently converged to acknowledge that the euro economy is eventually picking up steam.  On our estimates, GDP growth accelerated from 1.5% (quarterly annualized) in the third quarter to 3.0%, at least, in the fourth one.  This bodes well for growth and corporate profits.  Indeed, we expect GDP to grow 2.2% in 2004 (on a non-calendar-adjusted basis), the fastest speed since the bubble year 2000.  Even though the recovery was kick-started by a spectacular acceleration in global trade growth in late 2003, that was then, and looking forward we think that domestic demand will be the main driver of growth in 2004.

We count on consumers to fuel domestic demand

After the burst of the technology bubble, which had fuelled both consumers’ appetite and ambitious capital spending plans (remember the 3G frenzy?), domestic demand slowed down very sharply, from 3.2% on average in the 1998-2000 period to 0.9% on average in 2001-2003.  Squeezed between debt and deflation, companies cut capital spending and as well as headcount, wealthy consumers were hit by stock market debacles and wage earners were scared about their jobs.  Since then, corporate restructuring has gone far and fast, and companies are in better position to anticipate the recovery, increase spending and, in some cases, start to hire workers.  In addition, the rise of the euro since late 2002 is a lasting powerful disinflationary force, to the benefit of consumers.  We expect consumer spending, which already surprised on the upside in 2003 (1.3%), to accelerate further to 2% in 2004, thanks to stable labor market conditions, stronger purchasing power stemming from lower inflation (not higher wages) and, last but not least, income tax cuts in Germany and France worth €17 billion or 0.3% of GDP.

Euro and corporate debt will cap the capex recovery

We are not as sanguine about the next large component of domestic demand, i.e., investment.  Sure, capex will recover in 2004, as new investment opportunities stem from stronger demand and better profits.  This has already started, according to our proprietary European Analysts Survey, which, in its December edition, confirmed that large companies have already started to upgrade investment plans.  However, the capex cycle will be constrained by the strength of the currency, which will translate into lower profitability, and the necessity to reduce further the debt overhang from which large companies linked to the telecom sector are still suffering.  As soon as the euphoria created by the acceleration of growth in the US and Europe is over, we fear that the complacency still prevailing in credit markets might be replaced by scare.  Then, over-leveraged companies would have to refrain from investing as much as they would like to.  With operating profits, measured by the gross operating surplus, up 2.6%, we believe that the traditional recovery script, marked by double-digit capex growth, is not the most likely one: Whereas the so-called accelerator effects are likely to kick in, the other key factor for capex decisions, profitability, is not strong enough.  On balance, we see corporate investment up 3% next year, after a 7% contraction in 2002-2003.

Exiting the zero real interest-rate policy

In many respects, the economic and market environment facing the ECB now is the exact mirror image of the environment it faced a year ago.  Back then, the imminent threat of a war in Iraq, plunging equity markets and a weakening global economy were weighing heavily on the growth outlook and pushed inflation expectations lower.  Consequently, the ECB slashed interest rates by a total of 125 basis points between December 2002 and June 2003.  Now, a strong global economy and buoyant equity markets point to a decent economic recovery, and bond markets have moved to price in inflation above the ECB 2% ceiling in the longer term.  Consequently, we expect the ECB to end its policy of zero real interest rates — which was entirely appropriate in the zero real GDP growth environment of 2003 — and to start nudging policy rates higher during 2004. 

Watch excess liquidity, the euro and politics

As we see it, provided that the economic recovery proceeds roughly as described above, the timing and the extent of the monetary tightening will be largely shaped by the interplay of three factors: (1) the need to mop up some of the excess liquidity that the ECB has pumped into markets before it starts to spill over into prices; (2) the unpredictable gyrations of the euro’s external value; and (3) the potential impact on inflation expectations from the suspension of the Stability and Growth Pact (SGP) and from any political attempts to change the ECB’s mandate.

Money and credit growth will matter again

For more than two years now, the ECB has not only accepted but — by cutting interest rates — actively nurtured M3 money supply growth well in excess of the 4.5% reference value.  Until recently, the Bank has argued that excess liquidity was not a concern for price stability because strong M3 growth was partly due to temporary portfolio shifts into liquid assets, reflecting high equity market volatility and declining stock prices between 2001 and mid-2003, and because the weak economic environment would keep price pressures muted.  However, with stock markets having risen sharply since the spring and the economy now on the recovery path, the ECB is likely to become increasingly concerned about a potential build-up of inflationary pressures resulting from ample liquidity over the coming quarters.  Thus, the stronger M3 growth remains and the more credit growth picks up in the upcoming economic recovery, the earlier the ECB is likely to start tightening the monetary reins again.

At least one eye on the euro

Another important factor determining the timing and the extent of any monetary tightening in 2004 will be the gyrations of the euro.  Our currency team is looking for a further moderate appreciation of the euro in the next few months, followed by a correction later in the year, which would leave the euro’s trade-weighted index up some 3% in 2004 compared to the 2003 average.  If the euro were to appreciate significantly more sharply over the next few months, the ECB would likely react by reiterating that it is interested not only in a “strong” but also a “stable” euro and by putting any deliberations of an early rate hike on the back burner.  Moreover, the ECB may well decide to surprise markets by forex intervention if the euro rises too fast, too soon.  Conversely, a correction in the euro (which, given the almost uniform consensus for a further appreciation, could be quite sharp) could provide the trigger for an earlier-than-expected rate hike because it would be seen by the ECB as adding to the upside risks for price stability over the medium term. 

The political wildcard

Third, but not least, the outlook for ECB monetary policy is clouded by the emerging threat to Europe’s ‘stability culture’ from recent political developments.  First, the de-facto suspension of the SGP by the ECOFIN softens the constraints on fiscal policy, which may well result in a loosening of the fiscal policy stance in some member countries in the year(s) ahead.  If so, the ECB would have to consider this when setting its monetary policy stance with a view to preserving price stability.  Second, while initial proposals that allow for the amendment of the ECB’s statute by a simplified procedure (no longer requiring the ratification of changes to the ECB’s statute by all national parliaments) were not included in the draft of the EU constitution, some politicians (most prominently the Italian Premier Berlusconi) have recently floated the idea of changing the ECB’s mandate to a Fed-type model that would require the ECB to target not only inflation but also growth or employment.  Following the burial of the SGP, a broadening of this debate could easily lead to a rise in long-term inflation expectations and would thus become directly relevant to the ECB’s monetary policy decisions.

Moderate ECB tightening from the spring, unless the euro overshoots

Taken together, with growth likely to surprise on the upside in the next several months, inflation sticky at around 2%, liquidity abundant and a conflict between the ECB and governments brewing, we expect the ECB to start raising rates from the spring of this year.  However, given the potential upward pressure on the euro and the structural factors weighing on labor costs and core inflation, we do not expect an aggressive tightening cycle.  In total, we see the refi rate rising by 75 basis points to 2.75% during 2004 and thus less than halfway back towards what we deem a roughly neutral rate of 3.75% (2% potential GDP growth plus a 1.75% inflation objective) for the euro area.  Bond yields should push higher during the first part of the year, testing the 5% threshold at some stage, but should settle back close to what we deem as fair value of around 4.75% during the second half.  But again, if the euro were to overshoot significantly, rate hikes would likely be postponed and, depending on the impact on the economy and the inflation outlook, rate cuts might event reappear on the agenda.

Mind the euro, global trade gyrations and interest rates, but trust consumers

We see three main downside risks to our macro forecast.  First, our working assumption is an average euro/dollar exchange rate at $1.23 and, more importantly a 3% appreciation of the euro, on a trade-weighted basis.  In other terms, we have assumed that the spirit of the G-7 agreement in Dubai would be respected.  A lasting overshoot of the euro vis-à-vis the US dollar and the yen would probably be fatal to our recovery scenario, and we would not exclude a “triple dip”.  Second, an early global trade downturn would undermine business confidence before the recovery becomes self-sustainable.  Third, the loss of fiscal credibility might push long-term rates higher than what we have assumed, harm the capex recovery and depress housing investment.  However, to end this outlook on a brighter note, we also see an upside risk to growth: Consumers could be the trump card of the euro zone.  As they get more used to euro-denominated price tags, realize that inflation is declining and that pension reforms are making their future less uncertain, they could well produce a surprise by breaking open their piggy banks.