Policy Support Maximizing Growth but Macro Stability Risks Emerge
June 18, 2010
By Chetan Ahya | Singapore & Tanvee Gupta | Mumbai
India Remains One of Best Growth Stories in the Region
We maintain our bullish stance on India's structural and cyclical growth outlook. Growth momentum has remained strong beyond the initial period (F2009) of payback from weak growth during the credit crisis. Industrial production, which is the best proxy to measure the monthly trend in overall growth environment, has grown by 17.6% seasonally adjusted over the last 12 months. The sharp pace of recovery reflects the strength of India's domestic demand-oriented model, which remains the best in the region. A low goods exports to GDP ratio of 15.5% (as of 2008) meant that the damage from global trade collapse was minimal in India. The services exports did not see the kind of contraction as goods exports as India continues to increase its market share. As we have always highlighted, capital inflows linkages have been more important than goods exports. A quick turnaround in global risk appetite from April 2009 has played an important role in the pace of recovery.
Aggressive Policy Response Maximizing the Growth Opportunity?
In hindsight it appears that, unlike the developed world, India really did not need the kind of push to aggregate demand through loose fiscal and monetary policy. Pre-election spending, a wage hike for government employees and credit crisis-related stimulus meant that consolidated national expenditure to GDP shot up by close to 4% points between F2008 and F2010. Moreover, the government had also provided support through a cut in indirect taxes, which has not been fully reversed as yet. One can argue that the aggressive response during the credit crisis period was justified as there were major uncertainties on the global growth outlook as well as the magnitude of downside to India's domestic demand trend from the sudden stop of capital inflows. However, in the context of the actual trend in global growth and domestic demand in India having surprised on the upside, we believe that withdrawal of stimulus has been very slow. Although the central government will report a reduction in fiscal deficit in F2011, this has been largely supported by one-off items like collection in 3G and broadband wireless access (BWA) license fees and higher collections from divestment in SOEs. Expenditure to GDP (including off-budget oil subsidy) will remain closer to the peak in F2011 and the aggregate demand push remains intact. Ideally, the government should have opted for some reduction in expenditure to GDP or even initiate an inter-budget change. That is unlikely. In this environment, the burden of managing the macro-stability risks is with the Reserve Bank of India (RBI). After cutting the repo rate by 425bp from the peak of 9% between September 2008 and April 2009, the RBI has lifted it up by only 50bp.
If the Global Growth Trend Remains Stable, India's Growth Should Surprise on the Upside in the Near Term
Unless there is a major setback to global financial markets and a sharp slowdown in capital inflows in the near term, the slow pace of exit should increase the upside risks to growth. Industrial production for the month of April was a clear indication of the pace of acceleration in growth due to sustained strong support from fiscal and monetary policy. We believe that the probability of a sharp spike in bank credit and further acceleration in aggregate demand is higher than our base forecast over the next few months if the pace of exit does not quicken.
Why Do We Think the Pace of Exit Is Slower than Warranted?
The policy makers' preference for exit is we believe premised on the argument that they need to allow the private sector to take the lead in driving growth. More importantly, they want private sector investment to accelerate to ensure that growth is on a strong foundation. They are also concerned about the downside risks to growth due to the sovereign debt issues in Europe. We believe that there has already been a very quick recovery in the discretionary consumption from the households. Unlike in many other countries in the region, the credit crisis did not result in job losses in India. There was a temporary cutback in spending due to weak confidence and concerns about potential job losses (which did not happen).
While the government's stimulus measures were directed largely to rural households, the urban consumption recovery was more autonomous. Moreover, private corporate capex has also been on the path of robust recovery. Over the last six months, capital goods components of industrial production have grown at an average of 41%Y.
A Comparison with the 2004 Rate Hike Cycle
The RBI appears to be have been lifting policy rates at the same pace as it did in the initial phase of the 2004 cycle, even while the starting point of policy rates was much lower in the current cycle. Note that the fiscal policy exit was faster in 2004 as the government was already cutting expenditure to GDP before the RBI started lifting policy rates. We believe that timely reversal in monetary and fiscal policy will not take away the momentum of private sector growth, but a delayed exit increases the risks of transient rise in inflation beyond comfort levels and widens the current account deficit to vulnerable levels.
Capacity utilization levels are different: Unlike in the previous cycle, when the recovery in growth gradually allowed adequate time for the private corporate sector to initiate capex plans, in the current cycle, the recovery in growth has been sharp and the business investment cycle was hit badly. Although over the last few months investment has picked up, for this work-in-progress to turn into commissioned capacity it could take about 12-15 months. As a result, the transition from low capacity to close to full capacity utilization has occurred in a much shorter period. For instance, in the current cycle the seasonally adjusted IP index has risen 17.6% cumulatively in 12 months from the trough, whereas in the previous cycle, the seasonally adjusted IP index took around 27 months to rise to close to 17.6% cumulatively from the trough. Hence, in the current cycle, while the starting point of interest rates has been lower than in 2004, the pace of growth recovery has been stronger. More importantly, the sequential trend in industrial output over the last 3-4 months also remains very strong, reflecting that the accelerating trend is not just a reflection of payback from the weak trend during the credit crisis period.
WPI inflation pressures may be similar but underlying consumer price pressures are different: The WPI inflation trend appears to be largely similar compared with that in 2004. Headline WPI inflation had reached a peak of 8.5%Y by August 2004. In this cycle, it has reached 10.2%Y in May 2010. Although in this cycle headline inflation has been higher than last time because of food, the fact that food prices have been persistently higher now for many months means the risk of this weighing on generalized inflation expectations is high as food forms a very large proportion of household consumption. As we have explained in Why Do Policy Makers Focus on WPI Inflation More than CPI? May 3, 2010, we believe that the WPI inflation trend needs to be assessed in the context of capacity utilization. WPI is akin to PPI in US and other countries. If the WPI non-food inflation (largely intermediate product prices) is rising above the comfort zone (around 5%Y) and the capacity utilization is closer to full, the risk of pass-through of higher WPI into underlying consumer prices is high.
When the RBI tightens in response to higher WPI, it is not aiming to control WPI inflation, which in the near term may be a given, considering that a large part of it is made up of global commodity-linked products or food items. We believe that RBI tightening aims to ensure that demand pressure does not aggravate the vicious loop of higher WPI into higher underlying consumer prices. In this context, we believe that the risk of WPI inflation resulting in higher generalized consumer prices is much higher in this cycle versus 2004 as the capacity utilization is closer to full.
Current account balance - deficit versus surplus: In 2004, when inflation had reached 8.5%Y in August, IP growth had accelerated to 9%Y during the quarter ended September 2004. The current account was in surplus of 2.9% of GDP (four-quarter trailing as of June 2004) as a starting point. This large current account surplus is also an additional indicator, reflecting that aggregate demand was low relative to capacity. During the 12-months ending March 2010, the current account deficit has already widened to 3% of GDP as per our estimate. Imports have already been much stronger than exports while the capex cycle has much further to go. Over the last six months, seasonally adjusted non-oil imports have grown at 39% compared with exports growth of 13%.
Banking sector liquidity condition: As in 2004, in the initial phase of recovery while bank loan growth is accelerating, deposit growth is indeed decelerating. However, currently the banking system loan-deposit ratio is already high at 71.1% as of May 2010. Considering that statutory liquidity ratio is 25% and cash reserve ratio is 6%, the loan-deposit ratio is close to the levels where a major rise in credit growth will result in significant tightening in interbank liquidity. In December 2004, the banking loan-deposit ratio was low at 62.5%. Over the next 3-4 months, we expect bank credit growth to accelerate to 25%Y, while deposit growth will remain low in the range of 16-17%Y unless the RBI lifts policy rates at a faster pace. Another factor different from 2004 is the trend in asset prices. Asset prices were subdued for a prolonged period of time until mid-2004. In this cycle, asset prices have remained closer to the peak after a dip during the credit crisis period.
Stay Alert on Global Risk Appetite and Oil
To be sure, the risk of a widening current account deficit appears to be a 12-month challenge rather than a structural issue. We believe that the rise in investment will start getting reflected in the form of capacity commissioned, thus reducing the pressure on the current account deficit. However, until that happens, the high level of current account deficit means that India will need the capital inflows trend to be robust. We believe that there is a need to accelerate the pace of exit. Considering that over the last few months the RBI's policy response has been slower than warranted, we believe that upside risks to GDP growth and corporate earnings in the near term have increased. However, at the same time, investors should watch out for rising inflation expectations and a widening current account deficit in the near term. Any decline in capital inflows or a sharp rise in oil above US$100/bbl would cause exchange rate depreciation - only adding to inflation pressure. Moreover, the size of the current account deficit will likely decide the shock to the domestic cost of capital in the event of the sudden stop in capital inflows. A big shock could hurt the domestic private investment cycle and corporate confidence, which the government appears to be aiming to boost right now.
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Headline Inflation Inching Higher
June 18, 2010
By Mohamed Jaber | Dubai
Saudi Arabia's headline inflation inched higher in May, mainly due to higher food and housing costs. Data released this week revealed a 5.4%Y increase in Saudi consumer prices in May, versus 4.9%Y in April. This was the fourth consecutive rise in year-on-year CPI inflation since January 2010. The following three categories, out of a total of eight in the CPI index, contributed to about 90% of domestic inflation:
• Housing costs - which include renovation, rent, fuel and water - increased by 9.4%Y and contributed to about 38% of annual headline inflation. Although significant, this rise in housing costs is still significantly lower than the one recorded in July 2008, when housing costs leapt by 19.8%Y.
• Food and beverage costs - which have a weight of 28% in the CPI basket - rose by 5.4%Y and contributed to about 30% of annual headline inflation. But most of this increase was due to strong base effects and to a rebound in food prices during 3Q09-1Q10. A closer look at monthly price changes shows that the cost of food and beverage in Saudi Arabia actually declined during April and May, partly reflecting the 6% drop in international food prices since January 2010, according to the UN's Food and Agriculture World Food Price Index.
• Other expenses and services - a residual category that contributed to 22% of headline inflation - experienced a significant increase in May, mainly due to a 7% monthly increase in the ‘personal goods' sub-category. No additional details were given on this.
We continue to maintain that inflationary pressures will likely be subdued in the near term: We believe that increases in housing costs will continue to be the main drivers of consumer price inflation in Saudi Arabia. A tight housing market has led to an increase of about 55% in housing costs since 2006. In fact, housing costs have increased during every single month over the past four years. Pressures from the housing market will likely keep headline inflation from dipping back down to its pre-2005 lows any time soon (average annual inflation during 1992-2005 never exceeded 1%). This said, we believe that housing pressures are likely to gradually stabilise over the medium term, as the supply of units in the Saudi real estate market gradually catches up to the strong demand. This should help to keep a lid on prices in this segment, thereby containing domestic inflationary pressures. In light of this, we maintain our outlook for average annual headline inflation of about 5% this year and 4.5% in 2009.
However, the main source of risk with respect to headline inflation is food prices: Food and beverage prices in Saudi Arabia have increase by about 25% since 2006. They have also been quite volatile over that period. However, the correlation of Saudi food prices with international prices since 2006 has been low (0.54 on a scale of -1 to 1), although they have both followed an upward trend. Moreover, the volatility of Saudi food prices has also been significantly lower than that of international prices. This is all the more interesting given that Saudi Arabia imports most of its food supply from abroad. Indeed, the final price paid by Saudi consumers for food depends on a number of factors, including: (i) changes in the international price of food and beverage items; (ii) movements in the US dollar to which the Saudi riyal is pegged (a dollar appreciation could theoretically put downward pressure on food prices); (iii) the international sourcing of food items (a US dollar appreciation will only help if the majority of food items are sourced from countries whose currencies are not closely tied to the US dollar); (iv) the degree of pass-through from an appreciation/depreciation in the trade-weighted exchange rate to domestic consumer prices; (v) the pricing power of food wholesalers and retailers; and (vi) changes in government subsidies or price-fixing mechanisms. Due to all of these factors, and to the advent of the month of Ramadan in 3Q10 during which time food prices could face upward pressure, we view food prices as the main risk driver when it comes to Saudi headline inflation.
These mild inflationary pressures are unlikely to alter the current accommodative policy stance, in our view: As detailed above, more than two-thirds of CPI inflation in Saudi Arabia stems from either exogenous factors (e.g., movements in international food prices) or domestic capacity constraints (e.g., tight housing markets). As such, a more restrictive policy stance is unlikely to have any meaningful impact on easing consumer prices. Moreover, the recent strengthening of the US dollar may have a dampening effect on domestic prices, thereby reducing the need for more direct policy action. This said, the impact of the US dollar's appreciation on domestic prices will likely to be mitigated by: (i) a less-than-perfect pass-through mechanism; and (ii) the fact that around half of the kingdom's exports are sourced from countries whose currencies are closely linked to the US dollar (so their price in riyals will not be materially affected by the US dollar's appreciation vis-à-vis other currencies). Indeed, we would argue that the main monetary concern at this point in time is the weak state of credit markets. Total bank lending in Saudi Arabia contracted in 2009 and grew by less than 2% during the first four months of this year. Increasing policy rates would certainly not help to catalyse credit growth and may even slow down the recovery momentum in the non-oil sector. Moreover, independently increasing policy rates at a time when there seems to be little indication of such a policy move in the US may prove to be difficult, given the riyal's strong peg to the US dollar and the absence of restrictions on capital flows.
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The Lure of Liquidity
June 18, 2010
By Joachim Fels & Elga Bartsch | London
A vicious circle: For some time now, the euro area has been caught in a vicious circle where the sovereign debt crisis and the bank funding crisis are mutually reinforcing each other. Sovereign rating downgrades have eroded confidence in the balance sheets of the banks, most of which own government bonds and are guaranteed, directly or indirectly, by governments. This, together with higher borrowing costs for fiscally challenged countries, has raised funding costs for banks in the interbank market and in the capital markets. In turn, the banking sector woes raise additional question marks in the markets about sovereign creditworthiness, as more banks may have to be bailed out by governments that already run large fiscal deficits and struggle to limit the rise in public debt. Vicious circles don't simply stop - a circuit breaker is needed.
Liquidity buys time, at best: The immediate response thus far has been to provide ever more liquidity. The ECB will provide additional three-month loans to banks at full allotment (i.e., unlimited liquidity), and it looks set to continue to buy government bonds in "dysfunctional" markets for as long as needed. And the newly created European Financial Stability Facility (EFSF) will be operational soon (on July 1) to lend to governments in need. Alas, additional liquidity won't break the vicious circle. At best, it buys time to address the underlying problems. However, as the euro area experience of the last two years suggests, papering over the cracks with liquidity may even reduce the chances of a quick resolution of the underlying issue: the solvency of both banks and governments. A look back at the recent experience is instructive in this context.
Passive QE... When the credit crisis led to the collapse of Lehman Brothers in autumn 2008 and bank funding markets dried up, the ECB and other central banks responded by giving banks virtually unlimited access to central bank loans. Yet, while the Fed and the Bank of England later (in spring 2009) switched to ‘active' quantitative easing (QE) and started to buy public or private sector bonds in size, the ECB continued to focus on what we dubbed ‘passive' QE, i.e., satisfying all of the banking system's need for liquidity through money market operations with maturities of up to one year (from June 2009). The justification for relying entirely on passive QE was that: (i) outright purchases of government bonds would violate the spirit (and perhaps even the letter) of the Maastricht Treaty, which ruled out direct central bank financing of governments; and (ii) with most of the financing of the non-bank private sector coming from banks, the ECB's response should be aimed at the banks rather than corporate or government bond markets.
...created perverse incentives for banks... With hindsight, the continuation and extension of passive QE postponed a solution of banks' solvency issues and even contributed to the sovereign debt crisis. For the banks, virtually unlimited liquidity at 1% seemed like a panacea. Rather than raising capital more aggressively in the markets or through the various national TARP-like programmes that European governments had put in place, they were playing the carry game - borrow short from the central bank at near-zero interest rates and buy longer-dated, higher-yielding assets - hoping that this would restore profitability and thus allow them to generate capital internally over time. As private sector credit demand tanked due to the recession and lending to the private sector seemed too risky anyway while purchasing European government bonds didn't require any capital underlay under Basel II, banks piled into seemingly safe governments bonds, and especially into the higher-yielding ones of peripheral EMU member states such as Greece. According to ECB statistics, euro area monetary and financial institutions (MFIs) bought a cumulative €420 billion of government bonds since October 2008.
...and governments... Virtually free liquidity from the ECB for the banks also provided a nice windfall gain - both politically and financially - for euro area governments. Politically, it appeared to reduce the need to inject more capital into struggling public and private banks, which was a tough sell to a critical electorate and, in countries like Germany and Spain, difficult to push through with the cash-strapped regional or local governments who own many of the public sector banks. This contrasts sharply with the hands-on approach in the US, where bank stress-tests and the following forced capital injections through the TARP into the banks addressed the underlying solvency issues directly.
...thus contributing to the sovereign debt crisis: Financially, governments also benefitted from cheap and plentiful ECB liquidity. The artificially generated demand for higher-yielding government bonds kept bond yields for Greece and others lower than they would have otherwise been. This sent a message to governments that high fiscal deficits, which had swollen due to the recession and governments' responses to it, weren't a problem as the market (read: the banks) seemed willing and able to keep funding them. Thus, passive QE created an incentive for banks to gobble up the bonds issued by fiscally profligate governments, which in turn encouraged governments to keep spending without having to worry about the financing.
Passing the buck on and on: When the markets finally woke up to the fiscal realities earlier this year, and when the ECB set its sights on gradually turning off the liquidity spigot, banks experienced the second round of a confidence and credit crisis. Just as the banking sector crisis and the response to it fed the sovereign debt crisis, the sovereign crisis now fed the bank crisis. Seemingly safe assets - such as Greek government bonds - turned into bad assets. The fact that banks shifted many of the bad assets into the hold-to-maturity bucket and thus didn't have to mark them down to market prices doesn't really help. Markets understand the inherent risks in these positions and have thus refused funding. Again, the response has been similar to the one in 2008: more liquidity from the ECB in the form of additional full allotment tenders and through outright purchases of peripheral bonds. Yet, neither these measures nor the new EFSF for governments in need of funding address the underlying problems of bank and government solvency. We believe that banks will continue to be addicted to ECB liquidity and governments will be less rather than more aggressive on fiscal tightening now that an emergency fund is in place that will lend at subsidised interest rates and will be guaranteed by all EMU members (except those borrowing from the facility). Thus, the crisis looks likely to migrate from the periphery into the core, and the recent widening of bond yield spreads between the core countries may well be a first sign of this happening. And if the crisis migrates to the core, this could well put the whole euro project at risk, an outcome that we have been worrying about for quite some time (see "Euro Wreckage Reloaded", The Global Monetary Analyst, April 14, 2010).
No easy solution: Given the weakness of governments in many EMU member states, and given the size of the fiscal and banking sector problems, the issues are likely to linger rather than be resolved quickly. Massive outright purchases of government bonds by the ECB would be yet another attempt at papering over the cracks and could easily turn the bank and sovereign crisis into a crisis of confidence in the central bank and the liability it issues - fiat money. Hence, we believe that the only way out is much more aggressive consolidation and recapitalisation of the banking sector, especially in the public space, coupled with radical fiscal and structural reforms in several peripheral and also some core countries. Alas, things will probably have to get worse before governments are finally pushed into action. The lure of liquidity - from the ECB or the EFSF - is simply too strong, it seems.
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