No Landing in Sight
Oct 24, 2006
Luis Arcentales and Daniel Volberg (New York)
The fastest-growing economy in the region, Argentina, is unlikely to land anytime soon. Despite ever-present concerns over distortions introduced by extensive price controls, the sustainability of the fiscal surplus and a host of unresolved issues on the energy front, the Argentine economy is likely to surprise skeptics once again. With the economy likely to expand by near 9% this year, we suspect that there is room for Argentina to have a similar performance next year.
Our upbeat near-term outlook, however, says little about the sustainability of the current policy mix. The failure to establish a policy framework that induces an increase in certainty and in investment spending is detrimental to sustainable long-term growth, in our view. However, given our expectations for a benign global backdrop next year, we suspect that Argentina can have a near-repeat of the spectacular growth it has enjoyed in recent years once again in 2007. Repressed inflation The handling of Argentina’s inflation challenge via price and export controls has generated a fair amount of concerns that the country is on the wrong policy path. Rampant inflation is a threat to growth in any country and, in Argentina’s case, there is no doubt that inflation is a problem. However, Argentina’s inflation challenge is unlikely to cause any major disruptions in the near term. The authorities themselves acknowledge that inflation is a problem in Argentina and have adopted a policy of direct intervention to fight it, forcing price freezes on major corporations, from supermarket chains to leading manufacturers. At the same time, rising costs in conjunction with price controls have created concerns about the sustainability of the policy path. As businesses are forced to absorb the rising costs exclusively through shrinking profit margins, inflation is temporarily repressed. Clearly, such a policy is not viable in the long run. While we do not agree with the wisdom of using price, export controls and strong-arm tactics as inflation-fighting tools, the policy is likely to work temporarily. Currently, we estimate that repressed inflation in Argentina is running at roughly 5% this year, an amount which needs to be added to the official 11.2% average inflation observed in the first nine months of the year. Given the relatively modest magnitude of this hidden inflation, we feel that the government’s strategy is broadly sustainable in our forecast period (see Argentina: Repressed Inflation, EM Economist, September 25, 2006). The fiscal buffer Argentina’s fiscal performance has come under a lot of scrutiny ... And concerns on the fiscal front are not entirely misplaced; after all, Argentina has a long history of failures on the fiscal front, and we have questions about the resolve of authorities to turn off the spending spigot under a less favorable macroeconomic backdrop. Indeed, given the ongoing revenue bonanza and the fiscal adjustment inherited by the current administration, maintaining a surplus has not required a heroic effort. … but the fiscal cushion is likely to carry into 2007. It is true that expenditures are growing at a fast clip — the most recent 3Q data show total expenditures up 28%, outpacing revenue growth by two percentage points. But even if expenditures continue to gain ground, we suspect that the fiscal deterioration will be only modest, and still leave Argentina with a surplus of over 1% of GDP next year. A simple exercise of extrapolating revenues and expenditures using their six-month trend — or even from a more extreme three-month trend — drives this point home. Under an extrapolation from recent six-month trends, Argentina’s annual federal surplus would decline from roughly 1.9% of GDP in the year ending September 2006 to just under 1.8% of GDP by the end of 2007. Given concerns about the increased pressure from the salary and pension hikes awarded this year, as well as the ultimate destination of the public sector’s surplus funds, our forecast for a surplus 1.3% of GDP incorporates a more severe downturn than recent trends suggest. Even so, the point remains: given the starting point of the fiscal surplus and our expectations for a supportive global backdrop in 2007, authorities are likely to have ample room to maneuver without leading to a swing of the fiscal accounts into negative territory. Another source of concern is the potential impact of lower commodity prices on the public accounts. Commodity prices have played a key role in boosting fiscal revenues — direct duties on exports today account for roughly 10% of total tax revenues and two-thirds of the federal primary surplus — but a decline in commodity prices is unlikely to be fatal for Argentina’s fiscal effort. Of the Ar$3.4 billion collected in export duties in the past 12 months, we estimate that roughly two-thirds came from just two sectors, namely energy and the soy complex. If we assume a 25% move down in both products from their average in the year ending August 2006, the annual loss in revenue would have been in the order of Ar$2.2 billion, or 1.6% of total tax revenues. As long as the export taxes — first introduced in 2002 — remain in place, the damage of lower commodities appears to be rather limited. Indeed, even assuming a more extreme case in which oil and soy reverted back to 2002 levels, the decline in export-tax revenues would have knocked off roughly Ar$2.9 billion from Argentina’s primary surplus of Ar$21.2 billion in the 12 months ending August 2006. Energy tipping point? Argentina’s handling of the energy situation has also come under heavy criticism. Oil, natural gas and electricity — the three main components in the energy sector — all have significant problems in Argentina. With the dearth of private investment in the sector due to price freezes instituted at the time of crisis in 2002, Argentina’s energy sector would appear to be the country’s Achilles’ heel. While our focus is on the macro, we thought it would be worthwhile to provide our initial thoughts on the energy risks and challenges for Argentina in 2007. After all, the single greatest challenge we suspect to our call for another year of strong growth in Argentina is a mishap on the energy front. We doubt that the oil sector is likely to be a major problem in the coming year. Argentina is an oil exporter, and while the government taxes crude oil exports heavily at 45% in order to maintain low domestic prices, we do not see any major cataclysms in 2007. In fact, we project that if production and consumption grow at the 2004-05 average levels, Argentina will remain an oil exporter until 2010. That said, there is a need for investment in exploration if Argentina is to keep a viable energy export sector. Natural gas is another area that we doubt is likely to be a major problem in 2007, despite the fact that domestic prices are frozen at roughly one-fifth of current world market levels. Argentina imports a portion of its gas needs from Bolivia at market prices, and so the price freeze amounts to a hefty subsidy on the part of the government. Another complicating factor in analyzing the gas sector is that gas in Argentina must be transported via pipelines, and thus supply is not very flexible. Thus, Argentina is a net exporter of gas at the same time that the Buenos Aires region is heavily dependent on the Bolivian supply. We project that at 2005 growth levels in production and consumption, Argentina will become a gas importer in 2008. The gas sector experienced problems in 2004 when Argentina had to redirect gas exports destined for Chile to satisfy growing domestic demand. However, investment since then has increased capacity, and a major gas pipeline system, the Gasoducto del Nordeste (GNA), is under construction and scheduled to come online in 2009 or 2010. The sector we believe Argentina watchers should monitor the closest is electricity generation, but once again our preliminary results indicate that 2007 should not be a crisis year. Argentina has nuclear, hydro-electric and thermal (oil, gas and coal) electricity generation capacity, with thermal generation capacity accounting for roughly half of the total. The complicating factor when it comes to analyzing electricity generation is the volatile nature of demand and the limited publicly available data on actual fluctuations. Since the system is vulnerable during peak demand, we build several scenarios by assuming different proportions of peak strength relative to annual demand. We base our estimates on informal consultations given by our energy analysts, Subhojit Daripa and Rudy Tolentino. We find that there is a possibility for problems during the course of 2007, suggesting that they might come during the winter (July or August), but this depends on the current public investment in generation capacity, the revival of the Yacyretá project experiencing delays, as well as the pace of demand growth. In fact, there are public and private investment projects scheduled to come on-stream during 2007, 2008 and 2010 that should expand generation capacity by 15% in 2010 and by nearly 20% in 2011. Thus, if there are no major delays, Argentina should be able to avoid blackouts, even if by a rather small margin. Forecast revisions Given our view that none of Argentina’s challenges are likely to reach a critical point in 2007, we are revising our GDP forecasts higher. In the current year, we see the economy expanding 8.7%, up from 6.0% previously, and expect another year of good growth, although at a somewhat more modest pace of 7.0% in 2007. Given the limited amount of estimated repressed inflation and the authorities’ resolve to keep controls in place, we have adjusted our inflation forecast lower to 10% this year from 15% previously, accelerating slightly to 10.6% over the course of 2007. Bottom line The Argentine economy has sustained four years of growth near 9%, and we see no landing in 2007. Uncertainties abound, from the distortionary anti-inflation strategy to the health of fiscal accounts and the ability of the energy complex to meet demand next year. While we share these concerns, we feel that they are unlikely to become major problems in the coming year. Combined with a supportive global backdrop, we believe that the Argentine growth machine is likely to continue firing on all cylinders into 2007. But the upbeat near-term story says little about the long-term sustainability of the current policy mix. Indeed, Argentina still lacks a set of sound policies conducive to increased certainty and investment spending necessary for sustainable, good growth in the long run. We see no landing for the economy next year. After 2007, however, it is in the hands of policymakers to determine whether the economy’s eventual landing is a soft or a hard one.
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Structural Boom
Oct 24, 2006
Serhan Cevik (London)
You should read Nobel laureates Phelps and Pamuk to appreciate Turkey’s transformation. We have always lived in an evolving world, but the pace of change has accelerated in today’s closely integrated environment. The leading engines of this unprecedented period of economic development are, however, no longer those who put it on track ages ago. While advanced economies struggle to overcome structural barriers, a large number of developing countries are breaking taboos and moving ahead with far-reaching reforms. One of those success stories is presented by Turkey, in our view. With political consolidation after decades of instability, the Turkish economy has enjoyed the benefits of rational policymaking and structural changes, growing at an annual rate of 7.5% in the last five years and disinflating from the edge of hyperinflation to the single-digit territory. The country may still be far from internalising macroeconomic gains and introducing microeconomic reforms, but its progress is nevertheless not a ‘sand castle’ that would disappear with a wave of financial shocks. We think that reading two of this year’s Nobel Prize winners — Edmund Phelps in economics and Orhan Pamuk in literature — would help appreciate this exciting work-in-progress. However, before focusing on what Turkey’s own first Nobel Prize means for its institutional and socio-economic future, let us start with the economics of structural change. Professor Phelps helped clarify the relationship between unemployment and inflation. Edmund Phelps, together with Milton Friedman, challenged the prevailing view in the 1960s that there was a stable, negative relationship between unemployment and inflation, illustrated by the so-called Phillips curve, and argued that inflation also depends on inflation expectations. His model, known as the expectations-augmented Phillips curve, provided a general theory for the evolution of the natural rate of unemployment — the lowest level of unemployment at which inflation remains stable. When unemployment is higher (or lower) than its equilibrium rate — indicating a slack (or overheating) in the economy — inflation tends to fall (or increase). However, the non-accelerating inflation rate of unemployment is not constant over time and varies along with changes in the structure of labour markets, relative prices and factors affecting the supply of and demand for labour. Professor Phelps used long periods of unemployment in Europe as an example to highlight the role of structural factors in determining macroeconomic outcomes (see Structural Slumps: Modern Equilibrium Theory of Unemployment, Interest and Assets, Harvard University Press, 1994). Following his footsteps, we argue that the Turkish economy has moved from a long period of structural slump to structural boom in recent years. The acceleration in the trend growth rate of labour productivity has lowered the NAIRU. Turkey has become the fastest-growing OECD country not because of artificial measures or global liquidity but as a result of prudent policies and structural changes. In our view, the normalisation of a highly distorted macroeconomic landscape and increased competition raised productivity and profitability enough to set in motion a private sector-led economic expansion. For example, labour productivity increased by 42.5% in the last four-and-a-half years, bringing sustained profitability gains in core business operations and an extraordinary boom — more than 120% in real terms — in business investment spending. These underlying changes not only help keep higher trend productivity growth on track, but also increase the economy’s potential growth rate. In other words, the acceleration in the trend growth rate of labour productivity has led to a structural decline in the NAIRU and created more slack in the economy. Real factors, not just financial variables, will influence monetary policy. Even though NAIRU projections are not precise, the current unemployment rate of 8.8% is still well above our conservative estimate for the equilibrium unemployment rate. Furthermore, labour market dynamics influencing participation rates and real wages point to a disinflationary outlook. We still do not expect monetary easing in the near future, but real factors, coupled with a more appropriate liquidity structure in domestic money markets, are clearly making the central bank’s hand stronger.
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RBI's Monetary Policy Dilemma
Oct 24, 2006
Chetan Ahya and Mihir Sheth (Mumbai)
Should the RBI hike rates or pause? The Reserve Bank of India (RBI) is likely to face a difficult choice between hiking the policy rate once again on October 31 or pausing. This dilemma arises from the fact that pressure from the global rate cycle (led by US monetary policy) is reducing, but domestic macro indicators continue to warrant another rate hike, in our view. Domestic factors point to a little more than even chance of a rate hike. We believe that domestic macro indicators including inflationary pressures, a high level of current account deficit, asset price inflation (particularly property), a stretched banking sector balance sheet and potential credit allocation concerns warrant that the RBI should pursue one to two more rate hikes. RBI’s accommodative bias may tilt the scale towards a pause. The risk to our view is that the RBI chooses to pause. The RBI has in the past chosen to take risks in favor of being accommodative — as was evident in the April policy move, where the RBI preferred to skip a rate hike despite the continued concerning trend from the domestic macro indicators Should the RBI hike the rate again or pause? The Reserve Bank of India (RBI) is scheduled to announce its quarterly monetary policy statement on October 31. The RBI is facing the dilemma of whether to hike the rate again or pause. The dilemma stems from the fact that most other Asian central banks are following the US Fed’s decision to pause, and global rate cycle-related pressure is reducing. However, India’s domestic macro indicators continue to warrant another rate hike, in our view. We believe there is a more than even chance that the RBI will hike the policy rate by 25bp on October 31. The risk to our view arises from the fact that the RBI has in the past chosen to take risks in favor of being accommodative. This was evident in its April monetary policy announcement when it preferred to skip a rate hike only to initiate a reactionary hike post the slowdown in capital inflows in May. Pressure of global environment reducing Change in market expectations that the Fed rate has peaked has clearly raised market hopes of a possible pause in policy rates. Since the last monetary policy announcement by the RBI in July, the US interest rate outlook appears to have changed. The Fed has skipped rate hikes in two consecutive meetings and the fed funds futures, which were discounting a 5.4% rate in December 2006 at the time of the last monetary policy announcement by the RBI, are now discounting a rate of 5.25%. Many other central banks have also paused after steadily hiking rates over the last two years. This trend has reduced the pressure from global factors on the RBI to hike rates. Nevertheless, we believe that the RBI has been lagging the Fed, as reflected in the real spread between the Indian and US policy rates, and this warrants that the RBI continues raising rates. Many of the RBI’s concerns not fully addressed We believe that India has witnessed an unusually loose monetary policy over the last few years. The genesis of this has been large capital inflows into India (and emerging markets in general). With a weak supply-side response, India’s absorption of liquidity for investment has been less than optimal, resulting in excess liquidity — which in turn has been used either to boost consumption or fuel asset prices. The adverse impact of these macroeconomics conditions has clearly been a cause of concern for the RBI, as highlighted in its quarterly monetary policy statements over the last few quarters. The central bank has also initiated a number of measures to reduce the side-effects of the less-than-optimal absorption of liquidity in the financial system. However, we believe that these efforts haven’t yet fully addressed its concerns. Some of the key concerns highlighted by the RBI in its monetary policy statements are: Inflation pressures: With domestic demand (as reflected in strong credit growth) remaining strong, the RBI has been particularly concerned about potential inflationary pressures. Headline wholesale price inflation (WPI) has reaccelerated to 5.2%, close to the RBI’s maximum tolerance level of 5-5.5%. Indeed, we believe that the pressure on headline WPI is only likely to rise further due to increases in global commodity prices (other than oil) in the last few months. At the same time, falling global oil prices are unlikely to have any positive impact on domestic inflation owing to government interference with domestic oil product pricing in the past. The weighted average crude oil realization implied in domestic oil prices is about US$48/bbl (WTI) compared with the current international market price of US$58/bbl. Hence, as the global crude oil prices decline, the government is unlikely to cut domestic prices proportionately. Inflation as measured by the new CPI Index has also witnessed a significant rise in recent months. CPI for industrial workers has increased to 6% as of August 2006 (last data point available) as compared with 4.4% at the start of the year. Current account deficit: We have been arguing for a while that in an open economy environment, aggregate demand being higher than supply (reflecting a slower pace of domestic capacity creation) also contributes to a current account deficit instead of just inflation. The current account balance turned to a deficit of US$6.1 billion (3% of GDP, annualized) during the quarter ended (QE) Jun-06 from a surplus of US$1.8 billion during QE Mar-06, driven by an all-time high trade deficit. This deterioration is offsetting the capital inflows into the country and is, in turn, weighing on the accretion of forex reserves. On a trailing 3-month basis, forex reserve accretion has come down to only US$2-2.5 billion (an annualized rate of US$8-10 billion) as compared with US$23 billion in May 2006. This in turn is resulting in a decline in excess liquidity stock, weighing on the short-term market rates, which have begun to rise again. Stretched banking sector balance sheet: The gap between credit and deposit growth has been a key cause of concern for the RBI. Although credit growth has moderated to 29.7% from the peak of 33%, it remains significantly higher than the deposit growth of 19.7%. In the annual monetary policy statement announced in April 2006, the RBI indicated a target of 20% YoY for total commercial bank credit (including non-food bank credit, investments in bonds/debentures/shares of public sector undertakings and private corporate sector and commercial paper) in F2007 (YE March 2007). However, total commercial credit (bank credit plus corporate bonds) growth has stayed strong at 28.7% as of September 2006, as compared with 29.6% in April. The trailing one-year incremental credit-deposit ratio is also very high at 99.7%. With the banking sector’s holding of government-approved securities (largely government bonds) already at 29.6% (close to the statutory minimum of 25%), there is little scope for banks to continue with the current high credit disbursement rate. The RBI has already taken a number of measures to slow credit growth over the past two years, including a 150bp hike in policy rates. However, we believe that the RBI has been relatively slow in hiking policy rates, which has in turn left more room for the banks to pursue credit growth in an aggressive manner. Indeed, the current credit cycle has been one of the longest that India has witnessed in the past 35 years. Credit quality: Apart from the high credit growth, the central bank has also been worried about the quality of the credit being disbursed. Banks have not only been lending more to riskier segments, but have also been mis-pricing the credit. The RBI is clearly concerned about the strong credit growth creation in the retail and real estate sectors. Although the RBI has initiated administrative measures to reduce the bias towards funding consumption and less productive sectors, we believe that the central bank is still uncomfortable with the mix of incremental credit disbursement. In our view, the key problem is that the cost of capital has not gone up enough to restrict consumers’ borrowing behavior. The issue of mis-pricing is evident from the fact that banks have created over 50% of their current loan book during the past three years, a period during which their lending rate pricing risk curve has been flattening. We believe that public sector banks have not been pricing credit risk adequately and many of them are also not fully equipped with the right risk management systems to match the aggressive retail loan growth pursued. Property market euphoria: As discussed earlier, excess liquidity without an adequate supply response in the form of absorption of investments is resulting in rising asset prices. In the case of the property market, we have seen a not-so-supportive regulatory framework, and the government’s inadequate and slow response to creating urban infrastructure has resulted in weak growth in property supply. As a result, property prices have risen by 100-300% in major cities over the past two years. Global developments and re-pricing of risk: We believe that a combination of loose monetary policy and fiscal policy has supported a large rise in debt to GDP, which in turn has supported a spike in growth rates above sustainable levels. This rise in debt to GDP, without a commensurate rise in market-driven interest rates, has been due to large inflows of foreign capital, particularly portfolio equity flows (driven by growing global risk appetite). Without these large capital inflows, real interest rates would have been higher and growth rates lower. The RBI is clearly cognizant of this fact — in the last monetary policy statement, it mentioned that India has been a beneficiary of the decline in the price of risk, and has recently suffered as the price of risk has risen. We believe that any slowdown (not necessarily outflow) in capital inflows due to a change in the global environment could result in a disruptive rise in interest rates. Bottom line We believe that domestic macro trends warrant the RBI to hike policy rates by another 25bp. However, the risk to our view arises from the fact that the RBI has in the past chosen to take risks in favor of being accommodative — as was evident in the April policy move where it preferred to skip a rate hike despite the continued concerning trend from the domestic macro indicators.
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