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Dear Clients,


As a prelude to tonight's presidential debate, I was recently
interviewed by BBC Economics Editor Stephanie Flanders. You can access
the video online by clicking on the following link:
http://www.bbc.co.uk/news/world-us-canada-19809656. I briefly discuss
the negative impact that the prospect of the fiscal cliff is already
having on the US economy.


Following trips to Washington DC, where I confirmed my impression that
in many respects we are already at war with Iran, and to my home state
of Vermont, to speak at the Contrarian Opinion Forum, I will be headed
to Japan at the end of next week for the annual World Bank-IMF meetings.
I will be moderating a panel comprised of the central bank governors
Zhou Xiaochuan of China, Masaaki Shirakawa of Japan, and Choongsoo Kim
of South Korea.


You will find attached our latest monthly report, "Still Muddling
Through: Will Innovative Monetary Policy Revive the Global Economy? "
Key conclusions in the report include:

The US, European, and Japanese central banks have all initiated new
unconventional monetary easing actions in the face of deteriorating
economic conditions

If the election produces an outcome that causes both policy gridlock and
the US to fall off the fiscal cliff, income taxes could increase
significantly and a value-added tax may become a necessity

Eurozone GDP will contract this year, but easing of austerity in the
periphery next year should lead to positive growth in the euro area in
2013

The Japanese economy may actually shrink in the third quarter due to
weak auto sales and exports

China is set to experience a U-shaped recovery in the year ahead instead
of the V-shaped recovery that occurred in 2008-09

While the advanced economies in East Asia continue to grow slowly,
developing East Asian economies are seeing stronger growth


As always, we welcome any questions or comments.


Best regards,

David Hale

Chairman


David Hale Global Economics, Inc.


546 Lincoln Avenue, 2 nd Floor

Winnetka, Illinois 60093 USA


847-386-6009 (tel)

847-386-6011 (fax)

davidhale@davidhaleweb.com


http://davidhaleweb.com

http://davidhaleweb.com/

http://whatsnextbook.com

http://whatsnextbook.com/


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Still Muddling Through: Will Innovative Monetary Policy Revive the
Global Economy?

By David Hale


KEY CONCLUSIONS


The US, European, and Japanese central banks have all initiated new
unconventional monetary easing actions in the face of deteriorating
economic conditions

Although US job growth has been anemic, the housing sector is seeing
accelerating growth and consumer confidence is increasing

If the election produces an outcome that causes both policy gridlock and
the US to fall off the fiscal cliff, income taxes could increase
significantly and a value-added tax may become a necessity

Spanish PM Mariano Rajoy is trying to hold off on applying for a formal
rescue program until he receives assurances that further substantial
austerity demands are off the table

Eurozone GDP will contract this year, but easing of austerity in the
periphery next year should lead to positive growth in the euro area in
2013

The Japanese economy may actually shrink in the third quarter due to
weak auto sales and exports

China is set to experience a U-shaped recovery in the year ahead instead
of the V-shaped recovery that occurred in 2008-09

While the advanced economies in East Asia continue to grow slowly,
developing East Asian economies are seeing stronger growth

Recently announced Indian reforms will increase future growth rates if
they are not diluted over time

The Australian dollar has become a safe-haven asset in the eyes of
central banks around the world

Brazilian economic growth is accelerating, but the finance ministry is
having to actively protect the recent competitiveness gains it has
achieved

If the platinum price continues to decline and miners' wages increase at
double-digit rates, South African mines may be forced to shut down


G-3 CENTRAL BANKS UNLEASH NEW UNCONVENTIONAL MEASURES


The dominant factor driving financial markets during recent weeks has
been monetary policy. The Federal Reserve and the Bank of Japan have
announced plans to expand their balance sheets. The European Central
Bank has indicated that it will support the bond markets of troubled
debtor countries if they seek formal rescue programs from the European
Financial Stability Facility or European Stability Mechanism. The
promise of further monetary accommodation from major central banks has
boosted equity markets and the gold price. There is no guarantee that
these monetary policy changes will directly bolster economic growth, but
investors have learnt from past experience that they can influence
market psychology in a positive direction. The Fed chairman himself has
said that rising equity prices are one of the variables through which a
quantitative easing program can bolster the economy.


WEAK ECONOMIC DATA PROMPTS BERNANKE'S ACTIONS


The Federal Reserve decided to pursue another round of quantitative
easing because much of the economic data released during the past month
has been disappointing. The economy produced only 96,000 jobs in August.
Industrial production fell 1.2%. Core retail sales (those excluding
gasoline, autos, and building materials) fell 0.1%. There has been a
clear loss of momentum in the manufacturing sector and the August level
of production was slightly below the first quarter average. The rise in
gasoline prices since June has also once again squeezed consumer
spending.


The good news has come from the housing sector. Existing home sales rose
7.8% during August after a 2.3% gain in July. The confidence index of
the National Association of Homebuilders rose three points to 40 in
September, the highest reading since June 2006. Housing starts rose 2.3%
in August to 750,000 and are now 29.1% above their level one year ago.
The Case-Shiller Twenty-City Home Price Index rose 1.2% during July and
is now 1.2% above its level one year ago. Fannie Mae conducts a survey
of consumer attitudes towards the housing market. In August 35% of the
respondents expected house prices to increase while 11% expected a
decline. One year ago 20% expected a price increase while 27% expected a
decline. As a result of the recent uptick in home prices, the Federal
Reserve now estimates that the value of the country's residential
housing stock has increased by $700 billion since last December. The
housing sector made no contribution to growth during the first two years
of the economic recovery. It began to revive one year ago and should
contribute 0.2-0.3% to output growth this year. The upturn occurring in
house prices should also bolster household confidence and consumer
spending. As the economy lost 2.3 million construction jobs during the
downturn, the recovery in homebuilding has the potential to create
several hundred thousand jobs during the next two years as well. The
housing recovery has so far produced only 59,000 construction jobs in
the official figures, but the Bureau of Labor Statistics has just
produced a comprehensive revision of the nation's labor data which
suggests that the economy might have produced an additional 85,000
construction jobs.


There has recently been a break in oil prices which should lower the CPI
during the next two quarters and help to boost consumer spending. The
CPI may increase at only a 2.0% annual rate during the fourth quarter
and at less than a 1.0% annual rate during the first quarter of 2013.


As the growth rate of wage and salary income has been restrained by high
unemployment, the household sector needs lower inflation to bolster its
spending. It could not increase discretionary spending during August
when the CPI rose by 0.6%. Real PCE ex-food and energy rose by only 0.1%
as the savings rate fell to 3.7% from 4.1%.


Despite the recent upsurge of gasoline prices, there has been surprising
resilience in surveys of consumer confidence during recent weeks. The
University of Michigan survey of consumer confidence rallied 4.9 points
to 79.2 during early September. The uptick reflected greater optimism
about the job market. The Conference Board confidence survey also rose
nine points to 70.3 during September because of greater optimism about
the labor market. The "jobs hard to get index" slipped to 39.9% from
40.6% the month before while the "jobs plentiful index" rose to 8.3%
from 7.2%. It is remarkable that the household sector is reporting a
better environment for job creation when the government is reporting
weak employment gains. The National Federation of Independent Business
reports that small firms have begun to increase their hiring, but the
gains have so far been quite modest. The improvement in consumer
confidence is a clear positive for the president's reelection campaign.
It suggests that the household sector does not perceive as much weakness
in the labor market as recent government data or the Republicans allege
to exist.


The US trade deficit widened marginally to $42 billion during July as
exports fell for the first time in three months. The level of real goods
exports sagged 2.2% after a gain of 2.0% during the second quarter. The
weakest sectors were industrial supplies (-5.6%) and overseas auto
shipments (-4.9%). Sales to Europe and Canada were down 11.9% while
sales to Japan fell 6.4%. The ISM export index has fallen to 48.5 in
September from 53.5 in May. The weakness of exports is one of the
reasons manufacturing output has stalled. Exports account for one-third
of US manufacturing shipments. The export sector is likely to have
little effect on real GDP growth during the third quarter after
contributing nearly half of output growth during the second quarter.


FISCAL CLIFF BRINKSMANSHIP SET TO INCREASE AFTER THE ELECTIONS


There continues to be little visibility as to how Congress and the White
House will resolve the threat of large tax increases and spending cuts
during the first quarter of 2013. There appears to be little support in
either party for extending the payroll tax cuts another year. If they
expire, there will be an $85 billion tax increase equal to about 0.6% of
GDP. The great disagreement centers on the Bush tax cuts. The
Republicans want to extend them for everyone. The president wants to
increase top marginal income tax rates back to 40% for those earning
over $250,000 per annum. Both the White House and congressional leaders
say they want to avoid the risk of a so-called "fiscal cliff" in
January, but they have not indicated how they will compromise on this
issue. If they cannot reach a compromise, they could simply vote to
extend the tax cuts through March and promise to continue negotiating
through the first quarter.


The November election could influence how the negotiations proceed. If
the president is reelected, he will feel that he has a mandate to
increase taxes. If, by contrast, the Republicans retain control of the
house or gain control of the Senate, they will perceive they have a
mandate to restrain taxes. In such a scenario, it will be difficult to
avoid gridlock in the short term.


The stakes with this issue are high. The CBO is projecting that if
Congress does not intervene, the tax share of GDP will rise from 15.7%
of GDP in 2012 to 18.4% in 2013, 19.6% in 2014, and 20.3% in 2015. If
the tax increases are repealed, by contrast, the tax share of GDP would
increase to just 16.3% next year. The CBO projects that if all the tax
increases and spending cuts occur, real GDP could decline by 1.5% during
the first half of next year and push unemployment back over 9.0%. The
sheer uncertainty about tax policy appears to already be having a
negative impact on business confidence, employment, and investment. The
CEO economic outlook index plunged 23 points during September to its
lowest level since the economy emerged from recession. This pessimism
may help to explain the recent weakness of orders for non-defense
capital goods excluding aircraft.


The Republicans and Democrats have strikingly different platforms for
economic policy. The Republicans want to reduce marginal income tax
rates by 20% and pay for the revenue losses by curtailing unspecified
tax allowances. They also propose to cap the growth of health care
spending by turning Medicaid into block grants for state governments and
privatizing Medicare for those retiring after 2022. The president does
not have a comprehensive plan for reforming personal taxation. He simply
wants to hike the top marginal income tax rate of those earning over
$250,000 per annum. He also has failed to propose any major reforms of
Medicare. His current plan is to appoint a special committee with the
authority to search for ways of economizing health care spending. There
can be little doubt that Medicare is the major long-term challenge
confronting federal fiscal policy. If there are no major reforms, the
Medicare share of GDP could increase by ten percentage points during the
next thirty to forty years. In such a scenario, the US would probably
have no alternative but to introduce a value-added tax in order to pay
for such a large increase in health care spending. There has been no
serious discussion about creating a value-added tax since 1978, but the
US is now the only industrial country not to have one. It will therefore
loom as an obvious policy choice if the government cannot restrain the
growth of health care spending.


Representative Paul Ryan (R-WI) has proposed a bold plan to replace
Medicare with a private insurance scheme which would have more
incentives to control spending. The risk for the Republicans is that the
Democrats will use this proposal to frighten elderly voters into
thinking they could lose Medicare benefits in the near future. If this
strategy works, the president could win reelection by a landslide and
possibly gain several house seats. The Republican landslide in 2010
reflected the fact that they received over 60% of the vote among
Americans over the age of sixty. If they lose the vote of the elderly,
they have no hope of winning the presidency and could lose seats in the
congressional races. Recent polling from Reuters/Ipsos has indicated
that Mr. Romney's support among seniors has declined from a twenty point
lead over Mr. Obama to just four percentage points as of late September.
Other polling firms have been witnessing a similar pattern.


The Republicans want to make the central issue in the election the fact
that the economy lost 8.8 million jobs during the recession and has so
far regained only 4.4 million. The Democrats want to make the central
issue income distribution. Since 1973 the share of national income
accruing to the top 1% of taxpayers has risen from 7.7% to 17.4% in
2010. This is the highest ratio since the 1936, and suggests that there
has been a massive increase in income inequality during the past four
decades. The Democrats want to reverse some of this inequality by hiking
marginal income tax rates. The Republicans counter that higher marginal
income tax rates will fall heavily on the small business sector and thus
retard job creation.


THE FEDERAL RESERVE EMBARKS UPON OPEN-ENDED QUANTITATIVE EASING


The Federal Reserve has made a commitment to purchase $40 billion of
mortgage-backed securities each month until there is a major decline in
the unemployment rate. Fed Chairman Ben Bernanke and some district
presidents take very seriously the Fed's mandate to pursue full
employment. They also do not perceive major inflation risks when the
economy has a large output gap. The dissidents do not believe that
large-scale asset purchases will be effective in stimulating employment,
and they are also concerned about how the Fed will exit from such a
policy. There have been as many as five dissenting members among the
twelve district presidents. There was some political risk in embarking
upon a new QE policy only two months before a presidential election. The
Fed could have waited to see how the risk of a fiscal cliff plays out
during the fourth quarter, but Fed Chairman Bernanke felt that recent
economic data justified a more immediate move. If the fiscal cliff
actually occurs, the Fed might even expand its volume of asset purchases
next year. The Federal Reserve has made it clear that its overwhelming
priority is promoting economic recovery and lowering unemployment. It
appears prepared to live with modestly higher inflation in order to
achieve its goal.


The Fed's policy of de facto financial repression is also good news for
the Treasury. It will help to hold the government's debt servicing costs
close to 1.5% of GDP despite the steady growth of the national debt. In
1991 the government's debt servicing costs were 3.3% of GDP despite a
much smaller national debt. If the Fed allowed short-term interest rates
to once again track nominal GDP growth, the government's debt servicing
costs could triple and make it impossible to hold federal spending at
its fifty-year average of 20.6% of GDP.


IS LOW CEO CONFIDENCE A PRECURSOR TO DISAPPOINTING PROFIT GROWTH?


There is increasing concern that the slowdown apparent in the economy
could depress corporate profits. More firms are now guiding analyst
forecasts down rather than up. The growth rate of non-farm business
productivity perked up to 2.2% during the second quarter, but the
year-on-year gain was only 1.2%. As wages are growing at a 3.7% annual
rate, unit labor costs have increased by 0.9% during the past year.
Pre-tax profits have increased by 6.7% during the past year. The profits
of domestic industries rose 27% while international profits contracted
by 2.6%. Analysts are projecting that profits in the third quarter will
dip to $25.00 per share from $25.43 during the second quarter. They then
expect a rebound to $26.94 during the fourth quarter of 2012 and $30.51
during the fourth quarter of 2013. The large gains projected for 2013
are likely to occur only if the economy's growth rate can accelerate to
3.0% or more.


The new mood of pessimism is apparent in the Business Roundtable survey
of confidence among CEOs. It plunged to 66.0 during the third quarter
from 89.1 during the second quarter, the worst showing since the third
quarter of 2009. Corporate executives are concerned about both the
situation in Europe and unresolved fiscal issues in the US. The
pessimism in the corporate sector explains why non-defense capital goods
orders have been so weak during recent months. Only 30% of the
executives in the CEO survey plan to boost capital spending during the
next six months compared to 43% during the second quarter. Nineteen
percent also plan to reduce capital spending, up from 12% during the
second quarter. The caution in the corporate sector will continue to
restrain hiring and make it difficult to achieve a growth rate higher
than 1.5% during the second half of 2012.


WILL RAJOY'S INTRANSTRINGENCE UNDO DRAGHI'S EFFORTS?


The eurozone remains in recession. The eurozone PMI dipped 0.2 points to
46.1 during September, and the quarterly average was the lowest since
the second quarter of 2009. The service sector performed worse than
manufacturing with services output declining 1.1 points and new business
contracting at the fastest rate since June 2009. Manufacturing output
rose 1.0 points, but new orders and employment were still contracting.
Germany outperformed other countries during September. Its PMI rose 2.2
points to 49.2, the first gain in seven months. The French PMI, by
contrast, fell sharply. The composite index fell 4.8 points to 43.2. The
new orders index fell to a forty-one month low and the employment index
fell to a rate of contraction last seen in December 2009. The composite
PMI in the peripheral countries dropped 1.5 points to 42.5 in the flash
estimates. The PMI data suggests that output in the eurozone could have
contracted by 1.0% during the third quarter.


European Central Bank President Mario Draghi has provided further
details about his plans to help troubled debtor countries such as Italy
and Spain with the Outright Monetary Transactions (OMT) program. He
wants them to apply for a formal aid program with the European Financial
Stability Facility or the European Stability Mechanism once it is active
which will then set conditions for assistance. Once a program has been
established, the ECB will be prepared to purchase on the secondary
market the country's debt with a maturity of up to three years. There
was strong opposition to this proposal from the Bundesbank, but Mr.
Draghi had support from all other countries as well as German Chancellor
Angela Merkel. There was a rally in European debt and equity markets in
response to Mr. Draghi's proposals because investors perceived it
greatly lessened the risk of a funding crisis which might compel
countries to leave the monetary union.


The markets are now waiting for Spain to become the first country to
seek a formal aid program since the OMT announcement. Spain is suffering
from a severe recession which is making it difficult to achieve the
country's targets for deficit reduction. Spain has also experienced
massive capital flight during recent months. In the first half of this
year, there was a net capital outflow of €220 billion. There were three
main channels for these outflows. Foreign investors sold €84 billion of
Spanish securities, including €32 billion of bank debt and €36 billion
of government bonds. Foreign banks withdrew €91 billion of loans and
deposits. Banks located in Spain shifted €61 billion of deposits abroad.
The Spanish central bank financed these outflows and the country's €17
billion current account deficit by borrowing €237 billion from companion
central banks in the eurosystem such as the Bundesbank.


This borrowing has changed the composition of Spain's external
liabilities. In June 2011 Spain had net external liabilities of €990
billion, or 93% of GDP. Much of this external debt reflected the fact
that Spain had engaged in €555 billion of net borrowing from foreign
sources between 1999 and 2011. During the past year, the share of
Spanish external liabilities belonging to foreign official institutions
has increased to nearly 40%. Bank of Spain borrowing from the eurosystem
now accounts for about 25% of Spain's €1.7 trillion of external debt.


The Spanish government has been moving cautiously in seeking new aid
from the eurozone because regional elections are scheduled for late
October. The government fears that it could suffer an electoral setback
if it has to seek a formal aid program which imposes yet more fiscal
austerity. The IMF director, Christine Lagarde, has said that the
current economic program is so restrictive that it might not be
necessary to pursue any further austerity. The government announced a
new fiscal program in late September which proposes expenditure cuts
equal to 1.12% of GDP in 2012 and 0.77% of GDP next year. It also
proposes revenue increases equal to 1.43% of GDP in 2012 and 0.56% next
year.


Spanish Prime Minister Mariano Rajoy would like further clarification of
what the eurozone will demand before he seeks a new aid program. Mr.
Rajoy must now also contend with Catalonia's request for €5 billion of
aid because it can no longer borrow in the debt markets. Catalonia's
president, Mr. Artur Mas, is also talking about holding an election to
support demands for greater Catalan autonomy and control over the
province's tax resources. The government in Madrid has rejected these
demands because they could cost it €16 billion of revenue. Current
opinion polls suggest that voters in Catalonia will support demands for
greater fiscal autonomy, if not outright independence. The province
accounts for over 19% of Spain's GDP and almost one-sixth of the
population, so any attempt at seeking independence would pose a major
challenge for Madrid. Spain will probably pursue a formal aid program in
late October or November after the regional elections are out of the
way. There has recently been an uptick in Spanish bond yields because of
the market's impatience with Mr. Rajoy. If yields continue to rise, they
will increase the pressure on him to seek an aid program.


OTHER PERIPHERAL COUNTRIES STILL FACE A DAUNTING ROAD TO GROWTH


Italy has raised its deficit targets for 2012 and 2013 to 2.6% and 1.6%
of GDP respectively. It had previously hoped to meet deficit targets of
1.7% and 0.5% of GDP. Italy has fallen behind because of a recession
which is crippling the growth of tax receipts. Prime Minister Mario
Monti has not yet shown any interest in pursuing an aid program with the
EFSF in order to qualify for ECB intervention in the Italian bond
market. It is difficult for him to seek a multi-year aid program because
Italy must hold an election by next April. At the present time, it is
far from clear who will win. It is possible that a fragmented parliament
could emerge which would ask Mr. Monti to serve another year as prime
minister. As the political outlook is so cloudy, Mr. Monti is reluctant
to announce a new EU-sponsored austerity program.


The German constitutional court has ruled in favor of the new European
Stability Mechanism, but it limits Germany's exposure to €190 billion
unless the Bundestag approves a larger number. The court also ruled in
favor of the new fiscal compact allowing some transfer of sovereignty to
Brussels. The only restrictive measure in the ruling was a ban on the
ECB financing the ESM via debt issuance or repo operations. This ruling
is less important than it seemed previously because the ECB has now
promised to intervene in European debt markets through "Outright
Monetary Transactions". If the ECB plays a direct role in the debt
markets, there will be less need to rely on the ESM for intervention.


Greece is still locked in negotiations with the Troika on its deficit
reduction plans. Greece reduced its deficit by €5.3 billion during the
first eight months of the current fiscal year, but as the government is
out of cash it has been accruing new liabilities from unpaid bills.
Greece has asked the Troika to give it two more years to achieve its
deficit reduction targets because of the severity of its recession. It
needs to do a deal with the Troika in order to obtain the financial
assistance which was promised several months ago when it signed a new
EU/IMF austerity program. The Germans are reluctant to make new
concessions which would require further financial assistance, but
President Hollande of France has been supporting the Greek request for
more time. As a result of the severity of the Greek downturn, the odds
are high that the Troika will give Greece additional time to carry out
its program.

WILL HOLLANDE ADDRESS FRANCE'S OWN COMPETITIVENESS CRISIS?


French President Francois Hollande appears to have developed an
effective working relationship with Angela Merkel after she boycotted
him during the election campaign and supported his rival, Nicolas
Sarkozy. Mr. Hollande has tried to reach out to Italy and Spain to play
a more active role in euro decision making. The Germans initially
resisted such actions, but now regard a more inclusive system of
decision making as positive. Mr. Sarkozy had avoided the Southern
European countries for fear that an alliance with them might damage
France's own credit rating. Mr. Hollande is also trying to impress the
Germans by sticking to his promise to reduce the French fiscal deficit
to 3% of GDP. Mr. Hollande has yet to announce any policies to improve
France's competitive position, but they will be essential to enhance his
credibility as a European leader. Officials in the new French government
promise that they will pursue policies to bolster France's competitive
position, but there could easily be tensions with the trade unions on
such reforms. The question is whether a Socialist president can be more
effective at liberalizing the economy than a conservative such as Mr.
Sarkozy. France's weak competitive position is eroding the country's
power within the European Union, so it is essential that it pursues
reforms in order to revitalize the industrial sector.


EUROZONE GROWTH SHOULD TURN POSITIVE IN 2013


The real GDP of the eurozone is likely to contract 0.5% this year. There
is both fiscal drag and high interest rates in the peripheral countries
depressing growth. The ECB has the potential to boost growth by cutting
its core lending rate (0.75%) and reducing bond yields in the debtor
countries. There will be less fiscal drag in Southern Europe next year.
In Italy, fiscal tightening diminishes from 3.0% of GDP to 1.0% while in
Spain it declines from 3.6% of GDP to 1.5%. The reduction in fiscal drag
coupled with ECB easing should be able to produce modestly positive
growth in the eurozone during 2013.


WILL AUSTERITY BE DEFERRED IN THE UK?


The UK economy has benefited from surprising employment gains and signs
of a modest uptick in retail sales. The minutes of the Monetary Policy
Committee's September meeting showed a unanimous vote to maintain the
current policy of asset purchases and to possibly increase it further in
November. The government is finding it difficult to achieve its deficit
targets because of the weakness of the economy. During the first four
months of the new fiscal year, borrowing was £10.6 billion higher than
during the last fiscal year. The deficit is likely to be £129 billion
this year compared to a target of £120 billion. This overshoot will pose
a difficult challenge for the Chancellor when he has to issue a new
report on fiscal policy in early December. He will have to choose
between introducing new fiscal austerity equal to 1.0% of GDP or change
the rules to avoid a further squeeze on the economy. As the economy is
weak, he is likely to change the rules and delay the government's
deficit target one year to 2016-17.


WHY THE JAPANESE ECONOMY COULD CONTRACT IN THE THIRD QUARTER


The Japanese government lowered its estimate of second quarter real GDP
growth to 0.7% from a preliminary estimate of 1.4%. It made large
downward adjustments in its estimates of capital spending and government
consumption. It appears that real GDP could contract during the third
quarter because of weaker auto sales after the expiration of tax
incentives for fuel efficient vehicles and a continued downturn in
exports. METI (the Japanese Ministry of Economy, Trade and Industry)
estimates that industrial production declined 1.3% during August and
could decline a further 2.9% during September. The Bank of Japan
announced in late September that it would expand its asset purchase
program to ¥80 trillion from ¥70 trillion. As a result of this change,
the asset purchase program will expand to approximately ¥65 trillion at
year-end 2012, ¥75 trillion by June 2013, and ¥80 trillion at year-end
2013. The BOJ move was prompted by concerns about weakness in the
economy and the Federal Reserve's decision to pursue a new quantitative
easing program. Japanese politicians have lobbied the BOJ for more
expansionary policies whenever the Federal Reserve adopts more
stimulative policies. The new leader of the LDP, Shinzo Abe, has been
calling upon the BOJ to accept an inflation target as high as 2-3%
compared to its current goal of 1.0%.


There have recently been anti-Japanese demonstrations in China which
have forced some Japanese companies to shutter their operations. The two
countries are at loggerheads over the ownership of some uninhabited
rocky islands which Japan first took possession of in 1895. These
disturbances have the potential to be disruptive because of the close
economic relationship between the two countries. China is Japan's
largest trading partner and took $162 billion of exports last year.
Japan is China's fourth largest trading partner and sent $147 billion of
exports there in 2011. China is also Japan's second largest FDI
destination after the US and 33,000 Japanese firms have operations in
China. Japanese FDI in China rose 74% to $12.6 billion in 2011. METI
data indicates that China accounted for 19% of the total sales of
Japanese foreign subsidiaries as of March 2011. The Chinese government
may regard the upsurge of nationalism as a positive development during a
time of political transition, but it will have to proceed more carefully
if it wants to maintain the close economic relationship with Japan.

WILL CHINESE LEADERS HIT THEIR 7.5% GROWTH TARGET FOR 2012?


The Chinese economy has been weaker this year than most economists
expected nine months ago. The downturn has resulted from weaker exports
and a clampdown on property lending to stop real estate inflation.
Chinese leaders say they have plenty of policy options available to
achieve their target of 7.5% growth this year. The central bank cut
interest rates twice earlier this year and could act again. There is
ample potential to reduce reserve requirements from their current level
of 19.5%. The National Development and Reform Commission has been
accelerating many infrastructure projects in order to sustain a high
level of investment.


The September Markit PMI rose modestly to 47.8 from 47.6 in August. The
output component fell to 47.0 from 48.2 in August. The new orders index,
by contrast, rose to 47.6 from 46.1. The stock of finished goods
component fell to 51.1 from 54.0, confirming that China is in the midst
of a major inventory adjustment.


China pursued an aggressive fiscal and monetary stimulus program during
the 2008-09 global downturn. It now believes that this stimulus was
excessive, so it is reluctant to pursue highly stimulative policies this
year. It has not, for example, yet indicated how it will finance
proposed new transportation infrastructure projects. It is requiring
that the sponsors of these projects come up with capital equal to 20% of
the project. As local government revenues from land sales fell 28% in
the first half of this year, the banks are reluctant to provide loans
for new projects. The NDRC may increase its quota for enterprise bonds
to help fill this gap, but the size of this market is too small to make
a major difference. The issuance of enterprise bonds may reach 800
billion rmb this year versus new bank lending of 8.2 trillion rmb and
total fixed asset investment of 36 trillion rmb. The caution on new
lending suggests that the China will have a U-shaped recovery in the
year ahead, as it did during 1998-2001, rather than a V-shaped recovery,
as occurred during 2008-09.


There are signs that China is experiencing capital flight because of
market uncertainty about the outlook for the renminbi exchange rate.
China had a current account surplus of $83.2 billion during the first
half of this year and net foreign direct investment of $87.5 billion,
but the capital account registered a deficit of $71.4 billion during the
second quarter. These capital outflows reflect a market perception that
the government will not want to encourage currency appreciation at a
time when export growth has slowed sharply. The capital outflows will
sharply curtail the growth of foreign exchange reserves, and thus reduce
a source of liquidity in the financial system. The decline in the growth
of foreign exchange reserves will be one more factor encouraging the
central bank to ease reserve requirements.


ADVANCED ASIA IS LAGGING BEHIND EMERGING ASIA'S GROWTH


The weighted average of East Asian PMIs fell 1.2 points during August,
confirming that regional output will remain soft through the third
quarter. There are significant divergences in national growth rates
because of differences in public policy.


Malaysia appears capable of a growth rate exceeding 5% this year because
of government spending in the run-up to a pending national election.
Exports have weakened, but there is still a large trade surplus because
of oil exports. The trade surplus from oil, LNG, and crude palm oil was
$17.9 billion during the first half while the non-energy balance saw a
deficit of $1.3 billion.


Korea's real GDP grew by only 1.1% during the second quarter because of
weaker exports and domestic demand. The government announced some modest
stimulus measures to bolster domestic demand during mid-September, but
they come from the existing budget, and thus do not represent new
spending. The Bank of Korea surprised the markets by cutting interest
rates during July and is hinting it could ease further because of a
recent decline in inflation. Real GDP is likely to expand by 2.6% this
year compared to 3.6% last year.


Indonesia appears capable of a growth rate higher than 6.0% this year
because of resilient consumption and investment. The major weakness is
exports. They subtracted 1.2% from first half growth and are likely to
remain weak during the second half. The current account is swinging from
a modest surplus to a deficit equal to 3.2% of GDP. The current account
has made the central bank more cautious and it is using macro prudential
tools to restrain credit growth.


The government of Taiwan has reduced its estimates of this year's growth
to 1.7% from 2.1%. Taiwan's exports could decline by 5-6% this year
after a gain of 4.3% during 2011 and 26.5% during 2010. Consumer
spending could grow by 2.5% this year while fixed investment could
decline 2-3% after a contraction of 3.9% during 2011. The government
announced a $333 million support program for traditional industries
during September while the central bank could reduce its overnight
lending rate.


Thailand had a sharp recovery from last year's floods with a growth rate
of 10.8% during the first quarter. Growth remained firm at 3.3% during
the second quarter as domestic demand compensated for weakness in
exports. Consumer spending could increase by 6.0% this year while fixed
asset investment could expand by 13.5%. The government has bolstered
business confidence by reducing the corporate tax rate from 30% to 23%
and plans to drop it to 20% next year. The government is boosting
consumption by increasing the minimum wage in the face of a tight labor
market. As a result of the resilience of domestic spending, the central
bank is likely to leave interest rates unchanged.


Singapore is a country which has been directly hit by the downturn in
global trade. Growth will probably come in at the lower end of the
government's forecast of 1.5-2.0%. Industrial production fell 2.2% year
on year in August because of weakness in electronics and transport
engineering. Despite the slowdown, inflation has been sticky because of
rising housing costs and new taxes on automobiles. The labor market is
also relatively tight. The Monetary Authority is cautious because of the
higher inflation rate, but it could decide to ease if the downturn in
the global economy intensifies because of problems in Europe or the
fiscal cliff in the US.


INDIAN REFORMS COULD PROPEL FUTURE GROWTH IF FULLY IMPLEMENTED


After a long period of paralysis, the Indian government has announced
some radical reforms to rejuvenate the economy. Prime Minister Manmohan
Singh wants to reduce fuel subsidies by raising diesel prices 14%, open
the multi-brand retail sector to 51% foreign ownership and the aviation
and power exchange sectors to 49%, and raise $4 billion by divesting
some public sector assets. The policy changes followed the appointment
of Palaniappan Chidambaram as finance minister. The announcement of the
measures triggered an immediate rally in the stock market and the value
of the rupee. The changes produced a negative response from Mamata
Banerjee, the leader of the Trinamool Congress of West Bengal. She
withdrew nineteen MPs and six cabinet ministers from the United
Progressive Alliance. Parliament is in recess until November, so she
cannot force a vote of confidence on these issues. There are other
regional parties which Congress can turn to in order to avoid losing a
vote of confidence. One possibility is the Samajwadi Party, which has
twenty-two seats and supports the ruling coalition without being a
formal member. The leader has expressed some concern about the proposed
reforms, but has not rejected them completely. The challenge for Mr.
Singh will be to find a compromise that eliminates the risk of a no
confidence vote that could force a general election, which would be
highly inconclusive. The Reserve Bank recently delivered a 25 basis
point reduction in its cash reserve ratio to 4.5%, but it has left its
repo rate at 8.0%. Inflation in India is high and there is a risk that
rising food prices could push it higher late this year or early next
year. The Reserve Bank is therefore likely to remain cautious despite
the sharp slowing in India's growth rate to 5.5%.


AUSTRALIAN GROWTH OUTLOOK REMAINS NEAR TREND RATES


The Reserve Bank of Australia has lowered its official cash rate 150
basis points since November 2011. It has acted in response to concerns
about the global economy, including the debt crisis in Europe and signs
of slowdown in China. The economy grew by 0.6% during the second quarter
or 3.7% year on year. Household consumption, business investment, and
public spending were the key growth drivers. There are now expectations
that the investment boom in the resource sector will slow, but there is
still a large backlog of projects to be completed, especially the LNG
projects in the northwest. The official statement from the latest
Reserve Bank policy meeting showed that officials were generally
satisfied with the economy's performance. They used familiar phrases
such as that growth would be "close to trend" and that inflation will be
"consistent with the target". Their stated rationale for cutting the
cash rate in October was the deterioration in the global economic
outlook. They expect that resource investment spending will peak next
year, and that it may do so below the previously expected peak of about
9% of GDP.


One of the great surprises during the past three months has been the
resilience of the Australian dollar in the face of a large decline in
iron ore and coal prices, which are Australia's largest exports. There
are two explanations for this resilience. First, there has been an
upsurge of FDI in the resource sector which has given Australia its
first basic balance surplus since the early 1970s. (The basic balance is
the current account plus FDI). Secondly, foreign central banks are
increasingly regarding the Aussie dollar as a safe-haven reserve asset.
There has been buying of the Australian dollar during recent months by
the Swiss National Bank, the Bundesbank, the People's Bank of China, and
other East Asian central banks. The Aussie dollar has become a
safe-haven asset because the country still enjoys a triple-A credit
rating while the yields on Australian debt are much higher than in the
G-7 countries. The Reserve Bank does not know exactly how much foreign
central banks have invested in their currency, but they do know that 82%
of the government debt stock is now foreign-owned. Foreign central banks
probably account for a large share of this ownership. If foreign central
banks continue to buy Aussie securities, the dollar could remain firm
despite the deterioration occurring in the country's terms of trade.


IS THE CANADIAN HOUSING MARKET STARTING TO DEFLATE?


The Canadian economy appears to be tracking a growth rate close to 2.0%.
Domestic demand has been resilient, but exports have weakened and are
producing a monthly trade deficit of over $1 billion compared to a $5.5
billion surplus before the global financial crisis. There are signs that
the housing market is cooling after a period of strength which drove the
residential construction share of GDP to 7.3% compared to 2.4% in the
US. Home re-sales fell 5.8% between July and August because of the
government imposing tougher rules on government-backed mortgage
insurance. The level of new home sales in Toronto fell to a record low
during August. Retail sales rose 0.7% during July, and thus fully offset
the contraction of 0.3% during June. The most robust sector was auto
sales. The Canadian economy added 34,300 jobs in August after losing
30,400 jobs in July. The service sector added 70,600 jobs while
construction employment fell by 44,000 jobs and manufacturing clipped
2,700 jobs. Construction employment is now down 30,000 from one year ago
while manufacturing employment is still 93,000 above its November 2011
low. The Canadian central bank continues to pay lip service to the
notion it could withdraw monetary stimulus, but with the Federal Reserve
committed to holding interest rates close to zero until mid-2015 it is
difficult to imagine any moves to tighten monetary policy during the
next several months.


BRAZIL'S ECONOMY IS REBOUNDING


The Brazilian economy is showing signs of recovery and could return to a
growth rate close to 4.0% from 0.4-1.3% annualized during the past three
quarters. Consumption is benefiting from the unemployment rate dropping
to 5.2%. It could increase by over 3.2% this year compared to a GDP gain
of 1.5%. Industrial production has been declining since late last year
on a year-over-year basis because of weaker exports and capital spending
as well as increased import penetration. The government is considering
new measures to bolster investment and is seeking partners for large new
infrastructure projects to prepare for the World Cup and Olympics. The
finance minister has once again expressed concern about the Federal
Reserve's new QE policy and has vowed to hold the real in its recent
trading range of 2.0-2.10. In the aftermath of the Fed's announcement,
the central bank proactively begun to conduct swaps in this trading
range. Officials also said they would not hesitate to use capital
controls to keep the recent competitiveness gains from being eroded by
speculative capital inflows. They will attempt to restrain the exchange
rate until there is a recovery in the Brazilian economy strong enough to
provoke concerns about inflation.


STRIKE RESOLUTIONS COULD SET A DANGEROUS PRECEDENT FOR SOUTH AFRICA


The South African economy has been rocked by a wave of strikes in the
platinum, gold, and coal sectors. President Jacob Zuma has said the
strikes could cost the economy 4.5 billion rand ($563 million) in lost
mining output. The strikes began at the Marikana platinum mine owned by
Lonmin. There was violence which led to the deaths of forty-five people.
It is unclear whether the violence resulted from competition between
rival unions or some other factor. Lonmin ended up resolving the
conflict by offering a 22% pay increase. This settlement set a dangerous
precedent for the mining sector because workers will reclaim all their
lost wages within one year. In 2011 there were strikes in the diamond,
coal, and gold sectors which produced far more modest settlements. The
risk posed by the Marikana settlement is that it could encourage strikes
at more mines. Indeed, such strikes are now occurring at both gold and
platinum mines. As a result of the decline in the price of platinum,
several South African mines are now operating on very thin profit
margins. If they are forced to accept large pay increases, there will be
strong pressure to close some mines. This development poses considerable
risks for the economy because platinum now accounts for 27% of mining
output compared to 25% for coal and 17.2% for gold. The mining share of
GDP is only around 5.0%-8.0%, but the sector employs over 500,000
people. The push for large wage increases could lead to widespread
layoffs by making marginal mines unprofitable.


South Africa's economy has been growing at a 2.5% annual rate this year.
The Reserve Bank cut interest rates during July because inflation
moderated to 4.9% as of July from 6.3% in January. The current account
deficit has widened sharply to 6.4% of GDP from a trough of 1.5% during
the fourth quarter of 2010. The rise in the deficit is surprising
because investment spending is still subdued. There has instead been an
increase in private and public consumption resulting from low real
interest rates. There is speculation that the Reserve Bank could ease
again early next year because of weakness in the global economy, but
such a policy action could render the rand more vulnerable to a sell off
because of the large current account deficit and the uncertainties now
gripping the mining sector.


DEVELOPING COUNTRIES CONTINUE TO DIVERSIFY RESERVES WITH GOLD


The Federal Reserve's decision to pursue further quantitative easing led
to an immediate dollar correction, but it has not gone very far because
of problems in other countries. The European currency has been
constrained by uncertainty about when Spain will pursue a formal rescue
program. The decision of the leader of Catalonia to hold an election has
added a further element of uncertainty to the Spanish outlook. The ECB
cannot intervene in the Spanish bond market until Spain has a program
with the EFSF. The Bank of Japan announced its own quantitative easing
program in part to lessen upward pressure on the yen. The Australian and
Canadian dollars experienced modest rallies, but both remain sensitive
to the impact of the global economy on commodity prices. The Asian
countries will not want their exchange rates to appreciate at a time
when they are suffering from a trade downturn.


Central banks in emerging market countries continue to seek alternatives
to the US dollar and euro by purchasing gold. The central banks of
Kazakhstan, Turkey, and the Ukraine have purchased 9.9 tonnes of gold.
Paraguay bought 7.5 tonnes after having almost no gold. Korea purchased
an additional 16 tonnes after making purchases at various times last
year. It is not known if the People's Bank of China has bought any gold
since 2009, but China has such large gold imports it is possible the
central bank is quietly adding to its reserves. China is now also the
world's largest gold producer, so the central bank could simply buy
domestic output. The QE policies of the Federal Reserve, the ECB, and
the Bank of Japan are likely to continue encouraging emerging central
banks to diversify their foreign exchange reserves into gold.


________________________________________

©2012 David Hale Global Economics, Inc.

All rights reserved. This document may not be quoted, forwarded,
disseminated, distributed, or published without the express written
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