Rate Fall Is Not Over
November 21, 2006
By Gray Newman | New York
When Brazil’s central bank concludes its two-day monetary policy meeting on Wednesday, November 29, few doubt that it will cut interest rates once again. Even before the expected reduction, the central bank has embarked on the longest cycle of rate cuts since it began to target the Selic rate in 1999. The rate-cutting cycle, which so far has produced 600bp of cuts since September 2005, has been noteworthy as Brazil’s central bank has continued to buck the tightening trend around the globe. Even more remarkable perhaps is that the central bank is likely to cut rates much further still in 2007, we believe, and move to levels below what is currently contemplated by most Brazil-watchers.
Indeed, we are revising our interest rate target for 2007 to 11.25% from 12%. We’ve held our 12% target for 2007 for the past year now — and for most of the year we were criticized as being too aggressive. We now believe that we have not been aggressive enough. Why, however, you might ask, do we believe that interest rates in Brazil can fall much more than the market is currently pricing in? We would like to posit three reasons. Inflation below target First, we believe that once again inflation is set to remain below the central bank’s target in 2007. At first glance, our call for a rate reduction may seem to run counter to our inflation forecast for Brazil in 2007. After all, we are calling for headline inflation to rise in 2007 to 4.1% from 3.1% this year. But that comparison is misleading. This year’s inflation has been exaggerated by a bout of food deflation. During the past year, non-food IPCA has been running at 100-150bp above the IPCA, thanks to food deflation. In recent months, the food deflation has begun to evaporate, and we expect food prices to revert to more normal levels in 2007. Strip out the unusual role that food has played and we estimate that IPCA would have been just above 4% at end-2006. On an apples-to-apples basis, our 2007 inflation forecast does not represent deterioration in underlying inflation relative to 2006. Moreover, even with inflation at 4.1% next year, our forecast is still below the central bank’s target of 4.5%. What is driving Brazilian inflation lower? Not just food. Indeed, non-food inflation has been slowing during the course of 2006, although not as rapidly as food prices, where deflationary forces were present. The strong currency has certainly played a role. It is hard to escape the connection between the strong exchange rate and improving inflation. But with a relatively benign view of the US economy and of the globe in 2007, we suspect that Brazil will find a constructive global backdrop in 2007 and that the Brazilian real is likely to remain strong. Credit also goes to the central bank, which has demonstrated time and time again its steadfast commitment to reducing inflation. With limited credibility in January 2003, the central bank was forced to hike nominal rates and then allow real rates to soar in 2003 to help compensate. Even after that episode, there were still doubts that the central bank could hike rates in the run-up to mid-term elections in late 2004: it did. Slowly but surely the central bank has gained a reputation for being hawkish on inflation. The magnitude of real rates in Brazil may seem extreme, but in many ways real rates have reflected the failed history of controlling inflation in Brazil. Inflation risk premium falls Second, we believe that Brazil’s success in maintaining low inflation should allow real rates to fall as the inflation risk premium is reduced. Up until now, real rates have lagged the drop in nominal rates as inflation has fallen more quickly. There is a view that suggests that the decline in nominal rates should be in line with the fall in inflation. We disagree. The track record that Brazil is building should help to ease some of the uncertainty over the volatility in the path of inflation; that reduction in uncertainty should permit Brazil to live with lower real interest rates as well. It is hard to imagine that we will approach the end of 2007 with inflation near 4%, with inflation expectations for 2008 near 4%, and at the same time have real interest rates near 8%. Yet it is this scenario that is now being priced in by the market. Fiscal progress Third and finally, we expect lower interest rates to be the result of some progress on the fiscal front. While it is still early to detail precisely what kind of reforms the authorities will pursue in 2007, we expect that the rate reduction mode should make it easier to reduce spending and make some progress in dealing with some of Brazil’s more difficult fiscal challenges. After all, the rate reductions in place this year should have helped free up fiscal revenues equivalent to 4% of total fiscal revenues. And if we take average interest rates in 2007 and compare them with 2006, the savings should amount to another 2% or even 3% in freed up revenues. That in turn should free up some additional funding for public investment spending. The improvement should also help fund some easing in the tax burden, which in turn should, along with the impact of lower real rates on demand, help boost private investment spending as well. Subsidized credit We have heard a peculiar argument that the reduction in the Selic is limited by the amount of credit being provided at below-market rates. The argument is peculiar for two reasons, in our view. First, the percentage of total credit available at subsidized rates has fallen sharply in recent years. Indeed, today, for every R$1 of earmarked or subsidized credit, there is R$1.4 of free or market credit. This represents a complete reversal of the situation from the late 1990s, when earmarked or subsidized credit outweighed free credit. Second, we have found that the ‘blended’ interest rate is indeed much higher than the Selic target — as very high rates to consumers and most businesses overwhelm the subsidized credit that is still available. Caveats Of course, all of this is assuming a fairly benign global environment. Give Brazil a terms of trade shock with commodity prices in freefall, and we would expect to see a move in the currency which could complicate both inflation and the rate reduction process. Further, we are assuming some fiscal improvement and that Brazil’s debt profile continues to improve. Brazil has completely eliminated net external debt but needs to do more to boost fixed-rate debt. And finally, we assume that demand is not building to an inflationary point. The unusually strong August and September retail sales reports we believe speak more to post-World Cup liquidation of inventories and less to a consumer that is beginning to accelerate consumption dramatically. On the debt front, one other observation is in order. If the central bank cuts rates to 11.25% by end of 2007 and the authorities adhere to the 4.5% primary surplus, the debt stock would be stabilized even if Brazil were to experience no growth. Were growth to pick up to our forecasted 4% for 2007, the surplus necessary to stabilize the debt stock would dwindle to just near 2% of GDP. Of course, we have often seen rosy scenarios for Brazil’s debt performance which have ended up clashing with a much more messy reality. Given Brazil’s reliance on short-dated and overnight-linked debt, any bout of major market nervousness could once again risk pushing Brazil’s debt off the reduction course. Bottom line Inflation in Brazil has plummeted even as real rates have remained largely unchanged. To some, this may appear to be an indictment of the current policymakers’ stance. We would argue to the contrary: we believe that the policy stance of the central bank is setting Brazil up for a period of extended low inflation, which in turn should allow real rates to drop farther than most Brazil-watchers can imagine today. There is little doubt that Brazil needs more than just a credible central bank. We hope that in 2007 we can see that the fruits of the central bank’s policy stance free up resources that allow the fiscal authorities to boost public investment, even while funding a less distortionary tax environment. That in turn should lay the foundation for stronger investments and an upturn in supply, which ultimately is needed to allow Brazil to grow more rapidly — facing the prospect of stronger demand threatening to trigger an inflation spiral. Progress on that front should allow us to leave behind our 11.25% interest rate forecast and reach single-digit nominal rates in 2008.
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Brave New World
November 21, 2006
By Serhan Cevik | from Dubai
Excess liquidity has helped to create a new global culture of financial risk. Against all the economic and geopolitical shocks, the global economy has expanded at a robust pace over the course of the last two decades, thanks largely to structural changes contributing to a higher potential growth rate. Although the power of converging fundamentals and greater integration is likely to keep the expansion on track, we should not underestimate the overwhelming influence of accommodative monetary conditions in pushing the rate of nominal GDP growth from an average of 6.2% in the 1990s to 10.3% in the past five years. With historically low interest rates, global money supply, measured by the G5 aggregate, increased by 20.8% to 140.9% of GDP in the post-2001 period. Not surprisingly, this surge in liquidity ended up driving returns on traditional asset classes lower and creating a new global culture of financial risk. Just like other bubbles in history, the original trigger — the behaviour of short-term interest rates in this case — has become almost irrelevant to the self-fulfilling nature of liquidity-driven flows. With the recycling of ‘excess’ commodity earnings into financial markets, investors have enjoyed an unusual liquidity cushion and kept employing risky strategies. The global derivatives market grew by 23,102% since 1987 to US$370 trillion this year. It may not be shocking to see, in today’s low yield environment, a phenomenal growth in complex and leveraged financial instruments, but its extent is truly mind-boggling. According to the Bank for International Settlements, the outstanding notional amount of exchange-traded and over-the-counter derivatives contracts increased from US$1.6 trillion in 1987 to US$5.7 trillion in 1990 and then ballooned to US$71.9 trillion by the end of the decade. That was an astonishing 4,406% increase, but still peanuts compared to what happened in the liquidity-fuelled past five years. The latest survey results show that the global derivatives market kept growing at an annualised rate of 63.8% to US$370 trillion in 2006. In the first half of this year alone, the outstanding volume of derivatives contracts increased by US$70 trillion — more or less seven times the size of the US economy. As a result, the global pool of structured financial products now equals to 778.6% of global GDP, up from 27.3% in 1990 and a mere 9.8% two decades ago. In our view, the speed of proliferation cannot be simply explained away by financial innovation, but is also a result of investors’ appetite for leverage (see The Curse of Alpha, November 16, 2006) Is the rapid proliferation of complex derivatives a blessing or a nightmare? The net level of risk-taking is of course much lower than what gross derivatives figures suggest. Furthermore, the disaggregation of risk through financial innovation brings efficiency gains and makes markets more robust and institutions more resilient to possible shocks around the world. However, that would be the case as long as hedging products do not become an instrument of leveraged speculation and moral hazard. And when that happens, ‘insurance’ no longer provides cover against unanticipated events and exposes the entire financial system to amplified losses. Given the marked decline in risk premiums, we may indeed be facing such a risk of mispricing and sudden swings in investor sentiment. Unfortunately, the normalisation of liquidity conditions is likely to take a long time and the authorities — focusing on ‘traditional’ risks — still fail to deal with the underlying causes of today’s global imbalances (see Can the IMF Tame Gorillas?, October 3, 2006). Many emerging economies stand on a stronger footing, but are still vulnerable to liquidity shocks. A growing number of developing countries have addressed their structural problems, implemented sound policies and accordingly enjoyed significant improvements in macroeconomic performance. Nevertheless, despite the cumulative current account surplus of US$425 billion, private capital flows to emerging economies kept surging from US$50 billion a year in the 1980s to US$675 billion last year. Such an accumulation of ‘crowded trades’ in search of higher yields partly reflects excess liquidity in the global financial system and thereby makes these countries vulnerable to sudden changes in liquidity conditions and to the unwinding of leveraged positions.
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