South Africa
Feedback from the World Economic Forum on Africa
May 12, 2010

By Andrea Masia & Michael Kafe, CFA | Johannesburg

The World Economic Forum on Africa was held in Dar es Salaam (Tanzania) over the course of last week (May 5-7, 2010). We attended the summit and provide our thoughts on the most salient points of discussion that have significant relevance to the advancement of the African continent.

Empowerment Through Education

Underpinning most discussions over the three-day summit was the issue of lack of depth and breadth of intellectual capital across the African continent, and the limitations that this imposes on economic growth and development. Investment in education and social infrastructure was therefore a central theme. The so called ‘girl effect', together with the nurturing of young entrepreneurs, were identified as key areas that could contribute meaningfully to development. Advocates of the girl effect thesis often cite an influential World Bank study which estimates that the return on investment in educating young females exceeds that of educating males.

Public-Private Cooperation and the Importance of Courageous Leadership

It was agreed that, outside of creating an enabling macroeconomic environment, governments also play a critical role in supporting and facilitating development programs; and that combined with the innovative spirit of the private sector, much more progress can be made in the achievement of development goals (the Indian experience was frequently cited as a successful example). Some participants, however, lamented that, although numerous such opportunities for partnership had been identified, the lack of effective, ethical and courageous leadership, underpinned by strong institutions, has left these opportunities unexploited. This group of participants stressed that humble and visionary leadership is what the continent needs.

China and the Need for Greater Beneficiation

By far one of the most popular sessions, China's increasingly important role in Africa focused on the nature of the Africa-China relationship, and the necessary transition Africa has to make from being a mere supplier of raw materials to one which adds value through greater beneficiation. The South Africa-China relationship was a key focal point, with South African Minister of Trade and Industry Rob Davies making it clear that South Africa's role should not be limited to that of a mere extractor and exporter of raw materials, but should be expanded to include ownership of a larger share of the supply chain. The growth-supportive role of intra-regional trade was also highlighted.

Deepening Africa's Capital Markets

Most delegates agreed that Africa's capital market could be summarized as a patchwork of some 20 exchanges characterized by low liquidity, different governance and regulatory standards, and high costs of execution. 14 out of the 20 exchanges have less than 20 listings; five exchanges have between 20 and 50 listings; and just four exchanges have more than 50 listings. South Africa is the standout exception here, with more than 400 listings on the JSE.

Delegates recognized the need for deeper and more open capital markets to help mobilize international savings across the continent, but they also acknowledged that the dearth of seasoned financial experts was an even larger constraint than mere infrastructure. Other handicaps discussed were the lack of globally accepted accounting standards, uncompetitive execution costs, inefficient trading platforms and a general lack of transparency in price discovery. Capital controls, liquidity constraints and uncertainty around settlement mechanics were also highlighted as important inhibitors to broader international participation on Africa's exchanges. Some participants also pointed out that deeper markets could also contribute positively to the lowering of balance of payments risks by lowering the volatility of capital flows.

Conclusion

On the whole, the conference objectives can be summarized into three critical investment areas: education, infrastructure and political will. Policymakers agreed that: (a) higher commitment to education is required in most sectors, particularly agriculture, information technology, financial services and travel and tourism;  (b) stronger institutions are required to partner with the private sector in a more effective manner; and (c) Africa needs to graduate from a mere exporter of raw commodities, towards greater beneficiation.

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Brazil
Infrastructure Prospects
May 12, 2010

By Marcelo Carvalho & Giuliana Pardelli | Sao Paulo

Well beyond short-term market gyrations, infrastructure is a key long-term theme for Brazil. While most market participants currently focus on immediate market implications from sovereign debt developments in Europe, we take a step back and look deeper at what we believe is a crucial factor in Brazil's ability to sustain longer-term growth: infrastructure investment. For a full, in-depth, detailed analysis, see our report "Brazil Infrastructure: Paving the Way", Morgan Stanley Blue Paper, May 5, 2010.

Brazil's low infrastructure investment could become a bottleneck to growth. Brazil needs to double its annual investment in infrastructure, to 4% of GDP, we estimate, in order to live up to the expectations for a BRIC member. To grow at 5% per year in the next decade, infrastructure investment must double from the 2% of GDP average in recent years.

We believe that Brazil will rise to the occasion and, over time, deliver increased infrastructure investment. Scheduled projects include: 2014 World Cup, 2016 Olympics, pre-salt oil reserves and the government-backed Growth Acceleration Program. We see the biggest opportunities in areas like road, railway and port infrastructure. Main challenges include improving the business environment, rethinking fiscal spending priorities, reforming the tax system and improving the current fiscal framework.  

The Current Situation: Not Good

Brazil's infrastructure is poor - it ranks at the bottom half of a global ranking, at 74th out of 133 countries, even though the overall economy ranks 56th, according to a World Economic Forum (WEF) survey that asked firms to rank global competitiveness. Within Latin America, Brazil's infrastructure ranking is near Mexico's (69) but it is far behind Chile's (30). In sum, Brazil is a large economy with poor infrastructure.

Brazil's port and transportation infrastructure looks particularly poor, with implications for logistics costs and trade competitiveness. Among 133 countries in the WEF survey, Brazil ranked 127th in the quality of its ports. Only six countries ranked worse in port infrastructure - and two of them are landlocked. Brazil's international rankings in other infrastructure areas are also generally poor, including quality of overall infrastructure (81), air transport (89), railroads (86) and roads (106). In contrast, Brazil's electricity supply ranked higher at 55.

Poor infrastructure is a hindrance to Brazil's agricultural competitiveness. For instance, Brazil is a major producer and exporter of soybeans, and the world's second-largest exporter of soybean oilseed, after the US. Soybeans represent about 11% of Brazil's total exports. The state of Mato Grosso alone contributes about 7% of global soybean production. The state has the lowest production costs in Brazil, but its logistics costs are very high. Our LatAm agribusiness team estimates that logistics costs represent 32% of total costs for soybean exports from Mato Grosso, given the long distances along poor roads that trucks have to travel to reach the Santos port. Further, the poor roads are particularly vulnerable to weather conditions. In the latest harvest - a record for Brazil - heavy rains interrupted traffic in the region, causing soybeans to be stuck at the point of origin. Some studies indicate that soybean transport costs in Brazil can be up to 7 times higher than in the US.

Brazil's freight costs to export to the US are higher than for countries in Europe or the East Asia, including China. This is remarkable, given the distances involved. Brazil and Latin America as a whole spend nearly twice as much in freight costs per ton to import goods as does the US (see "The Age of Productivity", Development in the Americas, Inter-American Development Bank, 2010).

Infrastructure could pose increasing problems for doing business in Brazil, if left unchanged. A global survey asked executives of large global companies to rank the factors that pose difficulties for doing business in different countries. Infrastructure was not the top concern for Brazil. It ranked sixth, after Brazil's arcane tax system, heavy tax burden, restrictive labor regulations, inefficient bureaucracy and access to financing. However, if Brazil grows rapidly amid limited infrastructure investment, we would not be surprised if infrastructure moves up the list in the coming years. 

Infrastructure can also affect an economy's ability to attract foreign direct investment (FDI). A survey conducted by the United Nations finds that Brazil does well in international comparisons of market size and growth rate, but lags the global average in the quality of infrastructure and government effectiveness. Importantly, the object of the survey was to gauge the prospects for FDI in Brazil.

And infrastructure matters for sovereign ratings. When Standard & Poor's reviews Brazil's sovereign rating (currently a foreign currency rating of BBB- and stable outlook), it typically identifies the country's insufficient and inefficient infrastructure as a factor limiting sustainable growth (see "As Brazil Heads for the World Stage, It Looks to Bolster Infrastructure", Global Credit Portal, Standard & Poor's, February 24, 2010). 

Infrastructure Investment Requirements

Infrastructure investment in Brazil has slowed to about 2.1% of GDP on average in recent years. That is down from 5.4% in the 1970s, 3.6% in the 1980s and 2.3% in the 1990s. While the investment slowdown is comparable to the one seen in the Latin American region, the resulting infrastructure picture is worse in Brazil than elsewhere.

Brazil's infrastructure needs are significant. A World Bank study estimates that Brazil would need infrastructure investment of 6-8% of GDP per year to catch up with South Korea in 20 years. While ambitious, such infrastructure investment levels were achieved by Korea, China, Indonesia and Malaysia from the late 1970s through the late 1990s. Some studies suggest that infrastructure investment of about 2% of GDP per year is needed to simply maintain the current infrastructure stock (offsetting depreciation), and to keep up with a growing population.

Brazil needs to double its infrastructure investment ratio, in our view. Building on studies by the World Bank, we estimate that to sustain real GDP growth of about 5% and catch up to infrastructure levels in Chile, the Latin American infrastructure leader, Brazil would need to invest 4% of GDP per year on infrastructure over 20 years, or about twice as much as in recent years.

Prospective Infrastructure Investment by Sector

In electricity, prospective investments are led by hydroelectric plants. According to the national development bank (BNDES), total investment in the sector is projected to be R$92 billion in 2010-13, or annualized growth above 6% in this relatively consolidated sector. The main projects here are hydroelectric plants in the context of the growth acceleration program (PAC). These include Jirau and Santo Antônio along the Madeira River, with a budget above R$23 billion, of which R$20 billion should materialize within the next four years, besides investments in the hydroelectric plant of Belo Monte and in the nuclear plant of Angra III, estimated at R$4 billion.

In telecommunications, investments appear to have stabilized after a privatization-related expansion cycle in 1997-2001, as the sector now looks fairly consolidated, with relatively few players. Investment drivers here are twofold, according to BNDES.

Firms in the sector now appear inclined mainly to maintain minimum investment as required by the regulator. Telecom firms seem to compete for market share in specific niches through the introduction of new technologies, such as the third generation of mobile phones and digital TV.

In water and sewerage, investments could grow strongly in 2010-13, although the regulatory framework could still improve further. Besides projects in the growth acceleration program (PAC), drivers here include strong penetration of the private sector in this area, which is expected to account for 30% of new concession over the next 10 years, according to BNDES. 

As for railways, infrastructure investments are projected at R$30 billion in 2010-13, or an average growth of 13% per year. Drivers here include expansion of the network, with the construction of new lines and expansion of existing railroads, including the Transnordestina, Norte-Sul and Ferronorte-Rondonópolis, besides the planned introduction of a high-speed train between the cities of Campinas and Rio de Janeiro, going through São Paulo.

Planned investments in highways would add up to R$33 billion in 2010-13, for an average annual growth of 7.8%. Highlights here would include new concessions in the existing system, like the second stage of the federal program, and the second stage of the program in the state of São Paulo, which has already added 5,000 kilometers to the 15,000 kilometers under concession. Desperately congested now, airports seem to hold the promise for significant future investments, too, depending on how the authorities handle the framework for the sector in the next administration.

Finally, infrastructure investment in ports would triple in 2010-13, with an average annual growth of 25%, from a very low starting point. While the global crisis and resulting slower trade flows temporarily cooled pressures on port utilization, port improvement and expansion remain a pressing medium-term challenge. For instance, Brazil's national association of containers (Abratec) estimates that the sector saw a volume decline of 14.3% in 2009 after 12 years of uninterrupted growth, but now looks for a rebound of 18.3% in 2010 as global trade recovers and the Brazilian economy expands.

Critical factors and prospects for infrastructure investment across sectors in Brazil:  BNDES highlights that consolidation of the new regulatory framework for ports, and increases in road concessions are key to attract investments in these sectors. Stable sources of public and private financing are important too for investment in railways and in large sanitation projects. For telecommunications, competition dynamics amid technological innovations seem a key ingredient for investment prospects in the sector. As for the electricity sector, regulatory and bureaucratic procedures, including licenses, are important for implementation of large hydroelectric projects in the north region, like Jirau, Santo Antônio and Belo Monte.

Investments in the oil sector: Beyond infrastructure, BNDES also maps investment prospects in other areas, including the oil sector and other industrial segments. The oil sector already represented a large share of 30.6% of total mapped investments in 2005-08, and is expected to jump to 38.2% of the total in 2010-13. Boosted by pre-salt oil prospects, investments in the oil and gas sector are expected to jump to R$295 billion during the next four years, up 88.2% from 2005-08, or annual growth of 13.5%. 

In all, investment in the oil and gas sector would expand at an annual pace of 13.5% per year in 2010-13, according to BNDES, while other industrial areas would grow 5.6%, and infrastructure investment would increase 6.5% during the same period.

Challenges to Increased Infrastructure Investment

Total investment in Brazil is not high by international standards, and infrastructure investment in particular is low. Total investment in Brazil has been about 17% of GDP on average over the last decade. Investment in infrastructure on average represents about 13% of total investment in Brazil, or about 2% of GDP.

The bulk of total investment in Brazil is conducted by the private sector...  According to the national bureau of statistics (IBGE), the private sector accounts for almost 90% of total investment in Brazil, while the public sector accounts for a bit above 10%.

...but in infrastructure, the role of public sector investment is significantly larger.  One study estimates that the public sector (mainly the federal government) has accounted for about one-half of total infrastructure investment in Brazil during the last decade.

Within the public sector, federal government investment remains low. Despite Brazil's rising overall public sector spending over time, along with a steadily rising tax burden, Brazil's public sector spends relatively little on investment. Investment accounted for just 6% of total federal spending last year, lagging social security expenses (39%) and payrolls (27%).  And federal government investment in 2009 was only about 1% of GDP - although it is not clear how much of that goes to infrastructure specifically. 

State-owned enterprise (SOE) overall investment has been growing. Overall investment by other public sector entities, such as states and municipalities, has been relatively stable over the years. But investment by federal SOEs has been rising, although there is little clarity if any of that goes into infrastructure. Petrobras, Brazil's giant oil company, plays an increasing role, investing about 2.1% of GDP in 2009 and outpacing total investment by the federal government.

Challenges to Increased Public Sector Investment

Public sector investment needs to increase, especially on infrastructure, to sustain faster growth. A key challenge is how to create fiscal room for increased public sector investment in infrastructure, given Brazil's already high tax burden and its rigid budget, where the vast majority of resources are channeled to hard-to-curb current expenditure items. Structural reforms are needed to address Brazil's long-term fiscal constraints, open up room for increased public sector investment in infrastructure, and encourage private sector investment.

We Think the Administration That Takes Power in 2011 Will Face Three Long-Term Fiscal Challenges: 

First, contain spending growth and rethink spending priorities. Besides improving efficiency in the public sector in key areas such as basic health and primary education, the fiscal authorities will need to curb overall spending growth if they seek to free resources to invest in infrastructure. That will require addressing budget rigidities and mandatory earmarking, as well as social security reform (probably the most important challenge facing Brazil's fiscal accounts over the long run).

Second, curb the tax burden and simplify the arcane tax system to limit the public sector's crowding-out effect and improve the local business environment. Brazil's tax burden is high by international standards, once adjusted for the country's per capita income. And the tax system is a glaring outlier in international comparisons of the amount of time required of firms to comply with complex tax rules.

Third, lay out a clear medium-term fiscal framework, restoring transparency to the fiscal accounts and targets, and addressing more explicitly the issue of quasi-fiscal transactions through public sector financial entities. For instance, let's say the Treasury allocates resources via BNDES to support the building by the private sector of a high-speed train system between São Paulo and Rio de Janeiro, while the government also assumes the risks involved in the project. While the headline net debt does not change, the little-watched gross debt increases. 

Challenges to Increased Private Sector Investment

Within Latin America, Brazil ranks as an attractive market for private sector investment in infrastructure, according to an Infrastructure Private Investment Attractiveness index.  The index measures the institutions, factors and policies that attract private investment in infrastructure projects in a number of Latin American countries. It is composed of eight pillars (for a total of 62 variables), including the macro environment, the legal framework, political risk, ease of access to information, financial market enablers for infrastructure financing, track record of private investment in infrastructure, government and social indicators, and government readiness to facilitate private investment. Among the 12 Latin American countries surveyed, Brazil ranks second according to this attractiveness index, just behind Chile.

The legal and regulatory framework is a key challenge to private sector investment into infrastructure in Brazil. According to the WEF survey, Brazil's legal framework scores poorly - in fact, the distinction between Brazil and Chile is the largest in this factor. Brazil ranks 9th out of the 12 Latin American countries in the quality of its legal framework, mainly because of inefficiencies in the regulatory framework and poor public ethics. In addition, given the importance of the judiciary system in determining investment attractiveness, Brazil's poor ranking (ahead of only Venezuela in the survey) raises a flag. 

Among factors that attract private sector investment, Brazil does well in terms of investor access to information, scoring close to Chile on the WEF survey. This includes aspects such as the quality of statistical information, transparency, and openness of the dialogue and decision-making process. Elsewhere, there is clear room for improvement, ranging from financial market enablers and government readiness for private sector investments to political risk and the macro environment. In particular, while Brazil gets high marks for the soundness of its financial system, the survey indicates that investors express concern about the poor quality of Brazil's educational system and the difficulty in hiring skilled labor.

Bottom Line

Brazil must double its infrastructure investment rate to live up to expectations for faster sustained real GDP growth. To grow at 5% per year in the next decade, we estimate that infrastructure investment must double from the 2% of GDP average in recent years. Otherwise, Brazil's low infrastructure investment could become a bottleneck to growth. We believe that Brazil can rise to the occasion and, over time, deliver increased investment. Challenges include improving the business environment, rethinking fiscal spending priorities, reforming the tax burden and improving the current fiscal framework.

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Mexico
The Two-Tier Economy
May 12, 2010

By Luis Arcentales | New York

The prospects for Mexico's economy keep improving, in great part reflecting a very supportive backdrop for the country's export-focused manufacturers. Given how the recovery has been almost entirely externally driven, it may seem odd that we are becoming more upbeat at a time when last week's financial market turmoil caused by the European sovereign debt crisis essentially wiped out all of the ground the Mexican peso had gained against the US dollar this year, while sending the Bolsa to its lowest level since mid-February. But our US team, which has maintained its forecasts for US growth essentially unchanged for over a year, is now turning more constructive on the US economy, including manufacturing where the link to Mexico is strongest.

Forecast Changes

In part driven by supportive fiscal and monetary policies combined with robust US export activity, our US team has upgraded its growth forecast to 3.4% from 3.2% for 2010 and to 3.3% from 2.8% for 2011 (see US Economics and Interest Rate Forecast, May 10, 2010).  

Echoing the stronger prospects for US activity, we are upgrading our 2011 GDP forecast for Mexico to 4.0% from 3.3%, while maintaining our above-consensus 5.2% call for 2010. On the interest rate front, despite a stronger growth trajectory, we still expect Banco de Mexico to remain on hold throughout 2010 (see "Mexico: Hike Another Day", This Week in Latin America, December 7, 2009). Indeed, we feel more confident about our call now that our US team sees the Federal Reserve on hold until early 2011 - we have highlighted potential tightening by the Federal Reserve, which would have put pressure on Banxico to act, as the main risk to our call (see "Mexico: The Case for the Doves", This Week in Latin America, April 5, 2010). Last, we now see a stronger trajectory for the exchange rate, strengthening to 11.85 versus the US dollar by year-end (12.5 previously) and moving to 12.1 by the end of 2011 (12.25 previously). 

Mexico's recovery so far has been a story of a two-tier economy, with a strong industrial sector accompanied by persistent weakness in domestic demand. Indeed, when in late April Banco de Mexico upgraded its 2010 GDP forecast to 4.0-5.0% from 3.2-4.2%, it acknowledged that consumption "remained at relatively depressed levels" and that fixed investment "had failed to show a significant recovery". Nothing reflects the two-tier nature of the ongoing recovery better than confidence indicators: whereas pessimism among consumers remains entrenched - with the confidence index currently barely above the all-time lows from May 2009 - optimism among Mexico's industrial sector is riding high, approaching levels from early 2007. Still, as the externally driven rebound in industry gains further ground, this recovery is likely to translate into more robust consumption as well. Our call depends heavily on the trajectory for employment: unlike the largely jobless recovery that followed the 2001 recession, today's manufacturing upturn is leading to immediate job creation, which is already having positive implications for income and consumer spending. Indeed, recent evidence from retail sales to consumer goods imports suggests that this handoff from external to domestic strength seems to be already starting to take place, though at a very gradual pace.   

The Industrial Fiesta Is Heating Up

Incoming data from Mexico's industrial sector confirm that the recovery in production is following a V-shaped trajectory, echoing the pick-up in US manufacturing since mid-year. Since turning the corner last July, manufacturing output has expanded at an average pace of almost 16% annualized, the strongest recovery over such a period on record, even exceeding the pace of the post-Tequila rebound. Auto production, where the recovery has been strongest, reached record-high levels of over 2.3 million units annualized in the first three months of the year, eclipsing the previous record from 3Q07, based on our calculations. Other sectors, meanwhile, are catching up: by March of this year, levels of non-auto industrial exports had recovered nearly 75% of the ground lost during the recession and stood just 7% shy of the mid-2008 highs, according to our calculations. 

Mexico's industrial rebound has been associated with strong hiring, which almost coincided with the first signs of a pick-up in exports and output in mid-2009. Industrial hiring accelerated to 11% annualized in the first four months of this year. Since the July 2009 bottom, industry has created almost 250,000 new jobs, recovering during this period almost half the total formal jobs that it lost during the previous two years. Despite the strength in industrial hiring of late, unit labor costs have been very well contained. And the inventory backdrop remains supportive: even as the central bank's monthly industrial survey indicates that inventories have been on the rise since late 2009, the share of participants reporting excessive levels of inventories remains near the all-time lows.

The rebound in US manufacturing, meanwhile, continues to gain momentum, with output soaring at a 9% annualized rate since bottoming in mid-2009 and the ISM exports orders index, which tends to lead Mexican industrial exports, rising above 60 in March and April. Indeed, our US economists Ted Wieseman and David Greenlaw point out that growth in manufacturing is looking typically V-shaped coming out of recession and they expect a sustained recovery at an average sequential 6.9% annualized pace over the four quarters of 2010 (5.6% in 2011), which would be one of the best annual performances in the past 30 years. The rebound in the auto sector - auto assemblies should continue to ramp in coming months - that started the recovery continues to support factory activity across a broadening number of sectors; meanwhile, there are encouraging signs from exports, the breadth of improvement across industries and the inventory situation. The most recent payrolls data reinforce industry's positive outlook: manufacturing payrolls gained 44,000 in April - the strongest monthly gain in over a decade - on top of a gain of 57,000 jobs between January and March. Rising manufacturing jobs has been an infrequent occurrence since the late 1990s, Ted Wieseman points out, and they reflect how strong the recent growth upturn has been. 

Consumers Showing Some Signs of Life

While Mexico's recovery so far has been industry-centric, this strong external-led upturn appears to be starting to translate into a broader improvement on the consumer front. The modest pace of improvement on the consumer front - which pales in comparison to the sharp turnaround in production - appears to reflect essentially the encouraging pick-up in employment, which began in industry and that, by end-2009, had broadened into other sectors as well. Other determinants of consumer spending, including real wages, credit and remittance inflows, remain weak and have offset some of the benefits from positive employment creation so far, in our view.

Positive employment creation has been a key feature of the ongoing cyclical economic recovery, in contrast to the largely jobless recovery that followed the 2001 recession. Since bottoming last July, formal employment has expanded sequentially for nine consecutive months, running at a pace above 6% annualized in the first four months of 2010. Not surprisingly, in the early stages of the recovery job creation was centered exclusively in industry, but by late 2009, it had broadened into other areas of the economy as well - by March of this year, non-industrial formal employment matched the historical high of October 2008. And whereas temporary workers, which represent 12% of all formal jobs, accounted for a disproportionate amount of job growth between August and March (37% of the total), in April temps contributed with just 18% of all new jobs. 

The tailwind for consumption from job creation has been partially offset by negative real wage growth, leading to only a very gradual improvement in consumer incomes. Slack in labor markets has kept contractual wage increases range-bound, averaging 4.5% this year despite the inflation spike caused by the tax reform and higher administered prices. Indeed, when analyzed through this lens, we don't find much merit in the common concern among many Mexico watchers that there is something inherently wrong with Mexican consumers. While industry turned the corner in mid-2009, our measure of wage mass only began to trend higher in late 2009 - an improvement which coincided with a modest uptrend in retail sales, which experienced positive sequential gains in three of the past four months through February. And swings in the wage mass seem to explain today's apparent ‘disconnect' between production and consumption. For example, in 2001, consumption - as measured by retail sales - was relatively resilient as job losses were offset by gains in real wages as Mexico was in the midst of a multi-year disinflationary process. Industry, by contrast, did not recover until mid-2003.  During the Tequila Crisis, the downturn in industry was short-lived - industry was back on its feet by 3Q95 - thanks to a weaker currency and strong global demand. Consumer incomes, however, were devastated by the one-two punch of massive job losses and severe real wage losses caused by the spike in inflation, which peaked at 52.0% in December 1995. 

Lack of credit and the fall in remittances have been additional headwinds to the consumer. In 4Q09, outstanding credit to consumers plunged by 12.9% in real terms from a year earlier, led by a 21.8% collapse in credit from commercial banks (+1.6% from non-bank institutions). Measured as a share of GDP, consumer credit went from 4.8% in 4Q08 to just 4.2% of GDP a year later. And though non-performing loan ratios peaked around mid-2009 and the outlook for the economy has improved substantially since, on aggregate banks seem to remain quite cautious, as suggested by recent data: as of March 2010, commercial bank loans to consumers were 18.1% below the levels of March 2009, which indicates that bank credit is still contracting sequentially, according to our seasonally adjusted calculations. Last, though remittances have stabilized in recent months at a seasonally adjusted pace of around US$1.7 billion per month, the stronger exchange rate is translating into a massive decline - a decline in excess of 22% from a year earlier - once translated into pesos.  Though employment and wages are the most important determinants of spending, the contraction in credit and remittances have continued to hurt consumers at the margin. 

Our view that the recovery is likely to broaden further from industry into consumption depends heavily on the trajectory of labor markets. With our US team becoming more upbeat about the pace and sustainability of the recovery in the US economy, the steady improvement in Mexican labor markets seems poised to continue. Real wages, meanwhile, are likely to remain flat-to-down this year until the inflation shock from higher taxes and administered prices fades by early 2011. And while we are not ready to make a case for a strong turnaround in credit or remittances, it is also difficult to argue for further deterioration with the US economy on a recovery path and monetary conditions generally supportive.

Bottom Line

Mexico's recovery so far has been a story of a two-tier economy, with a strong industrial sector accompanied by persistent weakness in consumption. Encouragingly, with Mexico's V-shaped industrial recovery poised to gain further ground on the back of a stronger US economy, Mexico's externally driven upswing is starting to translate into a broader improvement on the consumer front, in a context of continuously positive job creation.

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United Kingdom
UK General Election Aftermath
May 12, 2010

By Melanie Baker, CFA | London

Election Results

The Conservatives have won the largest share of the public vote and have the greatest number of seats in parliament.  However, they do not have enough seats to form an absolute majority.  This result in and of itself is not a big surprise in light of the predictions from pre-election polls.

What's Next

Time until a new government is formed: Hung parliaments are relatively unusual in recent UK history and so it is uncertain how long it might take before the form of the new government becomes clear.  Our central case remains days rather than weeks: The UK electorate (and media) are used to knowing the result of an election very quickly and therefore the pressure to form a new government swiftly is very strong, in our view.  Market pressure is also strong, in our view (particularly given recent sovereign debt issues and some signs of financial stress re-emerging in markets).  In the 1974 UK election, which also resulted in a hung parliament, the outcome from negotiations was known after only a few days.  Our central case is that a similar timescale is likely again.  However, we recognise that in other countries the negotiation process can take weeks rather than days, so the balance of risk is skewed towards a more drawn-out process.  In our view, this would be taken negatively by markets. 

Options for the composition of government: Discussions are ongoing between the Liberal Democrats and both of the major parties.  Either a Labour or Conservative-led government needs the support of other parties to form a government and pass legislation.  This support may come in the form of a formal coalition or on an issue-by-issue basis.  We identify what we think to be the two most likely forms of government:

Scenario 1: A Conservative-led minority/coalition government.  In this scenario, a majority government could be formed with just the support of the Liberal Democrats rather than requiring additional support from other smaller parties. 

In exchange for Liberal Democrat support, there will need to be concessions.  Prior to the election, the Liberal Democrats stressed that they have no preconditions.  However, their manifesto laid out what they called ‘four key policies', including one on political reform.   On the deficit, the Liberal Democrats have said that (based on their working assumptions) conditions will be right for cuts from 2011-12 but not before.  However, they have stressed that the start and degree of cuts should be guided by market conditions, so we can see scope for compromise there and early deficit cutting.

Scenario 2: A Labour-led minority/coalition government.  The support of the Liberal Democrats alone would not be enough to produce a majority government with the Labour Party.  The Labour Party would need to rely on support from the smaller regional parties too.  We think that the more parties involved in any coalition/agreement, the greater the potential for instability and the higher the probability of the government being vulnerable to very specific demands from a small number of MPs.  Moreover, there would now be uncertainty over the leadership of that coalition, given Gordon Brown's recent statement.  Several of the regional parties have stated in their manifestos that they would not form a binding allegiance with any one party, and instead would work with others on an issue-by-issue basis.  Other minor parties have said they would demand a degree of protection from spending cuts, for example (or additional spending), in exchange for their support.

There are, of course, many unknowns and more scenarios are possible.  These include the possibility that the parties fail to reach an agreement, which could lead to a second election.  However, at this stage, we think that scenarios 1 and 2 are by far the more likely outcomes.

After the negotiations: Ultimately, any government must be able to win a confidence vote in parliament.  The first confidence vote effectively follows the Queen's speech, which is scheduled to take place on May 25.  In this speech, the Queen will outline the government's proposed policy programme.  The MPs will then vote on the speech and the government will need to attain a majority of the 650 votes.

Concerns Over a Hung Parliament

The incoming government, regardless of its composition, has a tough challenge ahead.  The UK has one of the largest deficits among major economies.  Moreover, the market's attention at present is very focused upon the issue of deficit reduction.

To avoid an adverse reaction to the UK's fiscal position, markets will ultimately need to be convinced that the government has a credible plan to reduce the deficit and that it can execute that plan effectively.  It will be incumbent on the parties who form the new government to make their determination to cut the deficit very clear to the markets and to do so with minimum delay.  So far, signals from the negotiating parties have been positive on this count.  With that caveat, we do not think that the hung parliament will necessarily impede deficit reduction for the following reasons:

1)         Other countries manage to be effective despite the lack of absolute majority governments.

2)         The initial market reaction to the hung parliament election result was negative.  Combined with a backdrop of increased financial market stress, this arguably increases the probability that we'll see earlier and significant action on the deficit than would otherwise be the case.

3)         All the main political parties are committed to significant fiscal consolidation and there was no huge apparent difference between the deficit reduction platforms of the main parties. 

4)         Multiparty support for a set of deficit reduction proposals could make it more likely rather than less likely that we see significant and successful deficit reduction.

Economic Implications

We do not think that inaction on the deficit is an option.  As a central case, we still anticipate that the UK will be able to significantly reduce its deficit over a multi-year period.  However, the most important determinant of how much time the UK has to make that deficit reduction will be market patience. 

But markets don't like uncertainty and initial market reaction to the election result bore this out, in our view.  Hence, we think that a coalition agreement between the Conservatives and Liberal Democrats would be the most positive outcome for both the markets and the economy at this stage. 

If this coalition outcome (or something very close to it) emerges, we would not significantly change our central case economic forecasts (1.0% GDP growth in 2010 and 1.2% in 2011).  Those forecasts already assume slightly more aggressive spending cuts than were evident in the Budget 2010 numbers and against a weaker economic backdrop than Budget 2010 anticipated. 

However, what then emerges in a post-election budget would have a bearing on our forecasts.  A significantly more heavily front-loaded fiscal tightening than we already expect would almost certainly lead us to push back the anticipated start of monetary policy tightening from 1Q11.

Market Implications

We anticipate that the market reaction will be more positive to a Conservative-led government (scenario 1) than a Labour-led one (scenario 2) because the Conservatives favour earlier and stronger action on the deficit than Labour (and the Conservatives also plan to hold an emergency Budget within 50 days of taking office). 

However, we think that the number of parties that are relied upon to form/support any government (and their concessions) will also have an important bearing on markets' response. 

We think that a coalition agreement would be preferable to markets - seen as less likely to lead to another election within the next 12 months.  We assume that investors would prefer the UK to get on with the business of deficit reduction.

For details, see UK Strategy and Economics: UK General Election Aftermath, May 11, 2010.

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United States
Sovereign Credit Risk Means a Lower Path for US Rates
May 12, 2010

By Richard Berner & David Greenlaw | New York

Fed on hold through year-end, lower path for yields: We are changing our long-standing calls for US interest rates: We now expect the Fed to keep policy on hold until early in 2011; previously we thought the Fed would begin to raise rates in September.  And we see a significantly lower path for 10-year US Treasury yields through the end of 2010: We now think that 10-year yields will rise from today's 3.6% to 4.5% by year-end - that's 100bp lower than the 5.5% level we previously expected.

These changes imply dramatic, cyclical changes in the yield curve over 2010-11.  With the Fed on hold, we expect the yield curve will steepen further this year, as we still see a significant rise in real yields, reflecting heavy Treasury borrowing and the pick-up in private credit demands that will accompany an improving economy.  In contrast, we expect a significant flattening of the yield curve in 2011, as the Fed tightens aggressively and 10-year yields move to 5%.

Contagion risk is the driving force for rates...  The European sovereign credit crisis, its threat of contagion beyond Europe, and its effect on inflation expectations is the key reason for these significant changes.  The primary transmission channel for such contagion is via interbank funding markets, as rising concerns about credit quality prompt banks to pull back from unsecured lending on attractive terms.  By raising risk premiums more broadly, the crisis could reverse some of the significant improvement in financial conditions that has revived US growth.  The crisis promoted a flight to quality into US Treasuries and has capped inflation expectations.  While our European economics team anticipated and documented the crisis, we did not anticipate how quickly the fears of contagion could spread to US markets. (Our European team long ago identified the crisis as one of solvency, not liquidity; that solving it would require making tough choices and enormous resources; and that the main issue was whether contagion would spread from the periphery to the core countries. See Elga Bartsch, et al, Whither Greece, January 25, 2010; Greece and EMU: Between a Rock and a Hard Place, February 22, 2010; and Our First Assessment of Greece's Loan and Austerity Package, May 2, 2010.)

...but only a limited brake on US growth: The threat of contagion from the sovereign credit crisis does pose a clear downside risk to our sustainable growth scenario, and with inflation low, gives the Fed ample reason to wait and make sure this risk is limited.  We believe that the spillover to US growth will be muted, as contagion will mainly affect European banks, credit availability in Europe, and European growth.  Most important, European policymakers are adopting aggressive steps collectively to ring-fence the effects of the crisis, limiting the tail risk of a more intense and persistent freezing up of global liquidity and worsening in global risk-aversion (for details, see Elga Bartsch and Daniele Antonucci, Fast-Track to Fiscal Union? May 10, 2010). Barring such tail risks, the further impact of any deterioration in an already limp European economic outlook on the US in our view will be limited. (In February, for example, we argued that a one-percentage-point slowdown in European growth might shave 0.2% from that in the US. Three channels matter: exports, earnings and financial linkages. Europe broadly defined accounts for about 23% of our exports, 8% of S&P revenues, and 4.1% of US banks' total assets. See A European Slowdown Would Only Nick the US, February 12, 2010.) 

Déjà vu 2007-8? No, it's 1997-8 all over again: Following an intense week of market meltdowns and fears that domestic and trade finance will dry up as it did three years ago, our conclusion may seem counter-intuitive.  However, we believe that US monetary and fiscal policies are still supportive of growth.  So, the outcome seems likely to parallel the 1997-98 Asian Financial Crisis, when stimulative policy more than offset any fallout from the Asian meltdown on US and global growth.  Some might argue that the US economy was much more resilient in 1997-98 than it is today, because it was growing strongly back then and did not face today's headwinds from the 2007-9 financial crisis.  Numerically, that is true, but today's resilience is high and rising, in our view.

The real handoff: From global to domestic strength: That's because classic, cyclical tailwinds of recovery are winning the tug of war with secular headwinds hobbling growth.  Those tailwinds reflect an important shift - from reliance on the strength of global growth to domestic forces of output, employment and income gains that make recoveries self-sustaining.  In addition, reduced tail risks from mortgage foreclosures and a likely extension of tax cuts for most consumers in 2011 will reinforce that improvement. 

The upshot: We are revising our forecasts for US real growth somewhat higher both this year and next; from 3.2% to 3.5% over the four quarters of 2010, and from 2.5% to 3% over the four quarters of 2011.  But for the tail risk from sovereign credit contagion, we would likely make more significant upward revisions to our outlook. 

Global growth remains strong: Growth abroad remains a driving force for the US economy.  Despite the spreading European sovereign credit crisis, global growth is likely to be even stronger than the 4.4% we expected in March.  Domestic demand in the fast-growing economies of Asia, Latin America and Canada is driving their expansion, and US exporters will be increasingly leveraged to that rapidly growing pie.  As a result, we think that US (net) exports will add about 0.3% to growth in US output this year, in contrast with the typical drag on US GDP as imports rebound in recovery (see Global Rebalancing Favors US Net Exports, April 28, 2010).

Financial conditions remain supportive: While observers glued to their screens legitimately worried whether the slide in markets will hobble growth, we think that on balance, financial conditions remain supportive.  For example, the Fed's April Senior Loan Officer Survey showed continued improvement, with further easing of lending standards for business loans and a rising willingness to make consumer loans.  Notably, a net 14.0% of respondents said they were more willing to extend consumer installment loans (with a focus on credit cards), the highest level in four years.  The cost of business credit also eased, with a net 7.1% saying they had reduced the spread of loan rates over the cost of funds for large companies, the first decline in the spread since 2007. 

To be sure, market pricing deteriorated dramatically last week, and markets are tender.  Most obviously, risk markets plunged and volatility soared.  The aggressive financial stabilization package announced overnight has reversed some of those moves.  In addition, however, precautionary demands for liquidity pressured LIBOR and other funding spreads over expected policy rates, echoing the experience in August 2007.  Three-month LIBOR surged 8bp on the week to 0.428%, and as the path of policy rates was marked lower, forward LIBOR/OIS spreads widened, with June surging to 38bp, September to 40bp, and December to 42bp.  If continued, the risk is that such developments would tighten financial conditions.

But even with those risks, the lower trajectory we now assume for US risk-free interest rates across the maturity spectrum means that wider corporate and mortgage spreads should leave business and household funding costs basically unchanged.  For example, with current-coupon mortgage yields falling well below 4.5%, 30-year mortgage rates are set to drop below 5% soon.  And the long-awaited pick-up in credit demands has in fact begun, with non-financial commercial paper issuance up $35 billion and consumer credit stabilizing since the start of the year. 

US incoming data mostly stronger: Incoming data mirror that strength: Indicators of consumer and business equipment spending are beating expectations, although an uncertain policy environment has depressed sentiment.  Leading indicators of US export demand are at 21-year highs, while inventories are growing leaner.  To be sure, housing imbalances are only shrinking slowly, and labor markets are strengthening gradually, but they are both improving relative to our bearish view on housing and our cautious employment outlook.  Homeowner and rental vacancy rates edged lower in 1Q. 

Most important, the rise in private non-farm payrolls has accelerated sharply to an average 156,000 in the past three months, and the workweek continues to rise.  We estimate that non-farm hours worked will rise by 3% annualized in 2Q, the strongest pace in four years.  Judging by the 276,000 average employment increase in the three months ended in April, as measured in the household survey (adjusted to be comparable with payrolls), along with the recent pick-up in federal government withheld tax collections, further acceleration seems imminent.  We estimate that real, after-tax wage and salary income will run at a hearty 4% clip in 1H10. 

Policy changes to mitigate foreclosures: Two policy changes - a new ‘earned principal forgiveness' initiative in HAMP (Home Affordable Modification Program) and the short refinance program through the FHA - will reduce the downside tail risks to home prices and housing.  If implemented effectively, these changes will help reduce the ‘shadow inventory' of yet-to-be foreclosed homes and the likelihood of strategic defaults, and should help restart the normal flow of housing credit. (For more detail, see Vishwanath Tirupattur and James Egan, ABS Market Insights: Forgive and Forget, March 29, 2010. Much of the commentary on housing is based on their analysis.) Still, these proposals will not magically solve our housing problems. (See Assessing Housing Risks, November 30, 2009, and ABS Market Insights: Understanding Strategic Defaults, April 29, 2010.) Accordingly, our forecast for US housing starts in 2011 continues to be pessimistic, the lowest of any in the Blue Chip survey of economic forecasts. 

Tax breaks for consumers: Reflecting the pressing need to get started on reducing massive federal deficits, we previously assumed that the Administration would sunset the Bush tax cuts and increase the tax rate on dividends and capital gains on January 1, 2011, resulting in roughly a $120 billion tax hike for individuals.    In contrast, we now assume, as did President Obama in his FY 2011 budget, that the individual income tax cuts begun under EGTRRA and JGTRRA will be extended on December 31 for lower- and middle-income taxpayers.  That adds 0.5pp to 2011 growth relative to our prior baseline.

Financial linkages to Europe pose the biggest risk: Rising risk premiums in European markets, especially for banks and in bank funding markets, pose the biggest risk to US financial conditions.  However, US financial exposure to Europe is relatively low: For example, US banks' claims on residents of the European periphery were a miniscule 0.3% of total assets as of 4Q09, and claims on all European residents amounted to only 4.1% of total assets.  Claims on the UK comprise the vast majority of that (3.0% of assets), while claims on other European countries represent the remaining 1.1%. (See Betsy Graseck, US Bank Direct Exposure to EU Is Low, May 5, 2010.) As we learned in the financial crisis, however, such linkages could become extremely important if idiosyncratic risk morphs into something systemic. 

Delaying tightening now gives the Fed more work to do in 2011: The slightly stronger US growth trajectory we now see through 2011 paints a different picture for monetary policy and long-term yields next year.  With narrower slack in the economy, downside inflation risks will be smaller than before.  Also, as our rate strategist Jim Caron notes, the sovereign credit turmoil has stemmed the risk of unwinding or hedging overcrowded long bond positions for now.  But in the wake of a strengthening economy, those technical factors still have the potential to drive yields sharply higher.  Sovereign risks have also recently depressed forward inflation breakevens, and we expect those declines to reverse over the next several months as stronger US fundamentals outweigh those concerns.  With a later start to tightening, the Fed will have more work to do: We think the Fed will raise the funds rate to 2.5% by the end of next year.  And even that increase seems likely to put real short-term rates barely in positive territory.

Real yields are likely to remain high in 2011: One set of factors relates to our story of supply and demand in the credit markets: Treasury borrowing needs, especially in coupon securities, will remain high (see David Greenlaw, Budget and Financing Outlook - A Few Bright Spots in a Dark Tunnel, May 7, 2010). We expect that the incipient pick-up in private credit demands, meanwhile, will mature into a steady flow, reflecting stronger demands for business and consumer credit-sensitive demands, such as capex and inventories.  Thus, while the yield curve likely will flatten, we expect 10-year yields to climb to 5% in 2011. 

But a second, more ominous factor also lurks: namely questions about US resolve to deal with the unsustainable path for fiscal policy.  As global investors seek the safety of US Treasury debt, US sovereign credit risk is far from most investors' minds.  Moreover, a recovery that promotes cyclical shrinkage in deficits may extend comfort with those risks.  In contrast, we believe that the current turmoil in markets is masking the risk that US rates will go significantly higher once the intractable nature of our longer-term fiscal problems resurfaces.

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