Too Loose
November 30, 2006
By Serhan Cevik | London
Inflation is back with vengeance and unlikely to ease in the near future. For years, we have kept questioning the sustainability of low inflation in Egypt, where fiscal imbalances remain a major source of inflationary pressures (see, for example, Is It Really Over? October 6, 2005). The latest figures showing a marked acceleration in inflation rates confirm our view that Egypt still faces structural threats to macroeconomic and financial stability. The annual inflation rate, measured by the consumer price index, surged from 3.2% at the end of last year to 11.8% last month. This is indeed a significant change in the behaviour of inflation, after it declined from the peak of 12.6% in 2004 to as low as 3% a year later, thanks to the pound’s appreciation on the back of petrodollar liquidity. Although it may have come as a shock to the consensus, who were expecting inflation to remain around 4% this year, we see nothing surprising in the recent data that still point to a challenging period of high inflation in the near future. Even if we ignore the inadequacy of the official CPI in gauging inflation due to statistical shortcomings and distortions created by government subsidies, the accommodative monetary policy stance and the continuing fiscal imbalances result in unbalanced, inflationary growth and keep Egypt’s economy and financial markets vulnerable to exogenous shocks.
Despite higher inflation, the monetary policy stance remains accommodative. The year-on-year inflation rate has kept surging ahead, especially in the second half of this year, partly because of upward adjustments in food and energy prices. However, we should not exaggerate the role of one-off factors and ignore underlying developments that have led to the overheating of the economy. Let’s start with monetary policy. Even after the acceleration in inflation, the Central Bank of Egypt maintained an expansionary stance and only raised interest rates by 50bp to 8.5% this month. As a result, real rates declined from 5.4% at the end of last year to an average of 3.5% in the first half of this year and then -3.4% last month. No wonder real GDP growth even jumped to 6.9% this year, from 5.6% in the previous fiscal year. But is this a healthy, sustainable pace of expansion? We doubt that, given the country’s fiscal imbalances and habit of monetary financing. The burden of fiscal dominance is still too much for monetary independence. The inflation-targeting framework could be a successful tool in achieving price stability, but it crucially depends on fiscal accommodation and a strong financial balance sheet. Unfortunately, the Central Bank of Egypt still lacks such support from fiscal authorities. The budget deficit, excluding the social security account, stands at 8.3% of GDP in 2006, showing a small improvement from 9.1% in the previous fiscal year, despite the cyclical windfall gains on the revenue front. There are of course encouraging reform attempts (such as cutting subsidies) that should help to improve the fiscal situation. Nevertheless, the pace and depth of fiscal consolidation is disappointingly slow and shallow. The government — anxious to manage social costs of reforms — remains reluctant to deepen the reform agenda. As a result, the budget deficit still hovers well above the comfort zone, worsening debt dynamics and increasing the central bank’s monetary claims on the public sector (see The Burden of Fiscal Dominance, October 12, 2005). Egypt needs tighter monetary and fiscal policies to ensure stability. Monetary financing of fiscal imbalances is always a source of inflation and a threat to financial stability. This is even more problematic when the central bank maintains an expansionary stance against a burst in inflation. So far, favourable global conditions have helped to minimise adverse effects of domestic imbalances. Blessed by petrodollar liquidity, Egypt enjoyed an improvement in the current account balance and a surge in foreign capital inflows, which resulted in the appreciation of the pound and cushioned against certain inflation pressures in the economy. However, since the inadequate depth of fiscal correction may easily undermine the sense of stability, the country still needs tighter monetary and fiscal policies, in our opinion.
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Money Growth Buoyed by Stock Market Expansion
November 30, 2006
By Denise Yam, CFA | Hong Kong
Money growth edged up further in October... HK$ broad money M3 growth nudged up further in October, to 16.5% YoY, unseen since September 1997 (excluding May 2006, which was spiked up by short-term financing for the Bank of China IPO). ... buoyed by US$17.4 billion of IPOs in the month: We believe that foreign investor subscriptions to IPOs in the Hong Kong equity market have made a significant contribution to money growth. In October, we saw the listing of ICBC, which took the total funds raised through IPOs in the month to a record US$17.4 billion. Though unable to separately estimate the amounts raised from foreign versus local investors, we believe that there was a net capital inflow in the month. The amount of net capital inflow can be derived when the October banking sector balance sheet data are released. Capital inflows have been absorbed by the banking system: Capital inflows year-to-date have been largely absorbed by the banking system in the form of an expanding net foreign asset position, and so the flows have not shown up in the balance of payments data or the change in foreign reserves. The banking system’s net foreign asset position increased by US$11.9 billion in the 12 months ending September, versus the US$7.5 billion increase in official foreign reserves. The loan-to-deposit ratio fell further, keeping interest rates low: Inflows drawn by popular IPOs in the Hong Kong market have lifted deposit growth above loan growth this year. Indeed, in October, HK$ loan growth actually decelerated, to 6.2% YoY, widening the deposit-loan growth differential to 11.3 ppts, from 7.9 ppts in September. The downward-trending HK$ loan-to-deposit ratio has contributed to low HK$ interest rates in recent months, in our view, and also given an additional boost to stock market sentiment. Renminbi breaking through: The imminent crossing of the RMB/US$ and HK$/US$ exchange rates upon further strengthening in the RMB is resulting in a heightened expectation that HK$ appreciation will follow, especially because many people believe that the HK$ could eventually be pegged to the RMB instead, e.g., a 1:1 link will be a convenient one. We believe that the two currencies are managed entirely independently at present, and it is still too early to expect a move towards a fixed bilateral rate. And even if this happens, the HK$/RMB exchange rate need not be 1:1. We sympathize with the psychological impact of the RMB breakthrough on the HK$, but believe it will prove to be temporary. Can low interest rates last? It is unfortunately not possible to estimate the relative size of the capital inflows (into HK$) that are driven by the interest in Chinese equities listed in Hong Kong, versus that driven by HK$ appreciation speculation. Our guess is that the portion speculating on the HK$ is not big, i.e., the expanding HK$ financial asset base (independent of the local economy) is the dominant factor behind the current low interest rate environment. If our belief is correct, low interest rates could be sustained, even beyond the period when speculation for HK$ appreciation subsides. Dependent on global liquidity outlook, nevertheless: Asian markets, especially Hong Kong, have become increasingly reliant on capital flows, which are dependent on US monetary policy. The retreat in energy and commodity prices from their peak levels of late, and the apparent softening in US consumer demand, have eased expectations for further monetary tightening, giving support again to asset market sentiment. We recently upgraded our growth outlook for Hong Kong to 6.6% in 2006 and 5% in 2007 (see From Easy Money to the Volatile Real Economy, November 21, 2006), factoring in friendly liquidity conditions that are sustained for longer. The distinct risk to our outlook remains that inflation surprises on the upside globally, calling for tighter monetary policy by major central banks, and a possible associated withdrawal of funds from emerging markets.
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The Retail Revolution, Part III: An Opportunity for SME Manufacturing
November 30, 2006
By Chetan Ahya and Mihir Sheth, CFA | Mumbai
Summary India’s liberalization program has so far been very successful in developing a large-sized private corporate sector. However, the small and medium-scale sector has underperformed the large-scale sector. A combination of improving demand due to organized retail sector development and an increasing trend of capital deepening is likely to drive a significant change in the SME sector to meet the demand from the emerging middle-class population. We believe that some of the large players in the retail business will encourage the emergence of efficient small and medium-sized suppliers of modern retail goods. Although in the near term, organized retail chain stores could rely on imports for certain segments such as toys, select types of general merchandise and electronics goods, over the medium term most of these players will focus on higher domestic sourcing, boosting demand for small and medium-scale manufacturing. Liberalization program not so beneficial for SMEs so far Although the government has initiated many programs to support the growth of the SME sector, the actual performance of manufacturing SMEs has been relatively poor. Although not by design, the first liberalization program has allowed large-scale manufacturing companies to grow much faster. The two most important factors that caused this difference in performance of the large companies versus SMEs is availability of infrastructure and access to capital. We believe that the poor infrastructure development has affected the SME sector more than the large companies. Many of the large companies have managed to side-step this hurdle by investing in captive electricity, port and transport facilities. However, small players have suffered from this less-supportive environment. Not surprisingly, over the last few years, the share of SME in overall exports has been stagnant. In addition, the share in overall industrial credit has been declining. The overall small-scale sector growth has been reasonable due to relatively strong growth in the services segment, while growth in the manufacturing segment would have been muted. Retail revolution – A potential trigger for restructuring Globally, organized retail players tend to source about 30-50% of the supplies from small-scale industries. A large number of their supplies are in form of private label products, and SMEs are best placed to meet this demand. Below are some of the major structural changes likely to evolve over the next few years, driven by organized retail sector: - Import levels may initially be high: We believe that large Indian retail chains will nurture the SME sector to cater to domestic demand. However, the challenge is to get the SME sector to build capabilities to meet the cost and quality requirements of consumers. Unlike India, China developed a globally competitive SME sector before it developed a major network of the modern retail format chain stores. Moreover, China has already built economies of scale advantages in certain goods where it will be difficult for Indian players to compete in the near term. Hence, we believe that there is a good chance that in the initial stages of development, the reliance on imports may be higher than that witnessed in China.
- Increase in regional and national level sourcing: A large proportion of the products distributed today by mom & pop shops or the organized retail sector are sourced regionally and/or nationally. For instance, fast-moving consumer goods (such as soaps, detergents, toothpaste, shampoo, hair oil, biscuits, etc.) are sourced regionally or nationally. However, there are a number of grocery and general merchandise products that are sourced locally. Higher demand from the organized retail sector and increased focused on competitiveness will encourage these players to build scale and specialize. We believe that for number of products currently sourced locally within the state or town, manufacturing will happen regionally or nationally.
- FDI in manufacturing could increase: Increased domestic demand for branded goods should attract higher FDI in manufacturing. Currently, many of the high-end products and their critical components are not manufactured in India due to lack of scale in demand for these products. Over the next few years, as this scale builds up, FDI from multinationals for increased domestic demand opportunities will rise, in our view.
- Growth in exports from SMEs will accelerate: Many large global retail companies are already sourcing products from India. For instance, Walmart directly sourced about US$400 million worth of goods in India in 2005, and expects this number to surpass US$600 million in 2006. Higher domestic demand and subsequent improvement in SMEs’ competitiveness to meet demand of the modern retail format should eventually allow these SMEs to increase their market share in global exports.
Potential restructuring of the supply chain The advent of organized retail chains will cause structural changes in small and medium-scale manufacturing as well as the goods logistics management in the country, in our view. We would classify the SME manufacturing sector into three broad segments: (a) Segments where the supply chain is reasonably well developed: In these segments, the supply chain is particularly well developed at producers’ end and we believe that the restructuring will be limited. The major industries falling in this segment will be fast-moving consumer goods and consumer durables. In these industries, the benefit is likely to occur from better linkages with retail distribution. (b) Segments where manufacturing is partly organized: In these segments, the industry structure is highly fragmented with poor physical capital stock. Apart from the restructuring of logistics, we believe that scale-related benefits that will occur for organized manufacturing as demand from the modern retailing format grows. Some of the examples of industries meeting these criteria are textiles/apparel and gems and jewellery. (c) Segments where the majority of the manufacturing is through unorganized players: These are the segments that will witness complete restructuring right from manufacturing down to the distribution level, in our view. Examples of industries falling in this category are furniture and food processing. Pace of change will depend on infrastructure development … Although one can argue that a rise in demand for infrastructure is due to the emergence of organized sector retailing, we believe it can also be a constraint in the path of the development of the retail sector, particularly in the back-end supply chain. Currently, except for telecom, the cost of most infrastructure services is 50-100% higher in India than in China. For instance, average electricity costs for manufacturing in India are roughly double those in China. Railway transport cost in India is three times that in China! Similarly, the average cost of freight payments as a percentage of imports is about 10% in India, compared with around 5% in developed countries and an overall global average of 6%. High costs aside, the simple lack of basic infrastructure facilities is impeding efficiency of production. Low government spending on infrastructure hurts high employment-generating, labour-intensive small enterprises the most. India is currently spending a miniscule amount compared with its needs, according to our estimates. Our analysis indicates that China is spending seven times as much as India on infrastructure (excluding real estate) in absolute terms. In 2003, total capital spending on electricity, roads, airports, seaports and telecom was US$150 billion in China (10.6% of GDP) compared with US$21 billion in India (3.5% of GDP). A set of measures are being introduced by the government for different sectors to accelerate infrastructure spending growth. We expect infrastructure investment to pick up to US$47 billion (4.7% of GDP) by F2009 from US$24 billion (3.5% of GDP) currently. Although this is still significantly lower than the required levels, it should provide some support to small and medium-scale manufacturing. In addition, the government’s liberal policy for SEZs should also help in the emergence of the large multi-product SEZs to bridge the gap for lack of quality nationwide infrastructure availability. … and legislative reforms Various states are yet to implement legislative reforms in property-related laws such as the Urban Land Ceiling Act, Stamp Duty laws and Rent Control Act. These laws have been slowing property development in the country and hence have been one of the factors resulting in rising property prices (and hence rentals). These high prices could prove to be a major hurdle for the organized sector retail players in acquiring the necessary real estate. In addition, the government also needs to ensure quick implementation of the reform in the inter-state trade-related taxation law. Currently, the central government charges 4% sales tax on all inter-state sales of goods. This regime encourages companies to set up storage facilities in each state to avoid being taxed on these movements. This proves to be a disincentive to the development of a nationwide distribution system, especially via third-party logistics providers. Indeed, the government has announced a roadmap wherein the levy on output by the central government (central sales tax) will be merged into a common nationwide rate by April 2009. Bottom line: India’s organized retail sector is likely to attract major investments over the next few years. The entry of large players like Reliance and the Walmart-Bharti joint venture will hasten the pace of development for the sector. As the scale of front-end distribution builds over the next 3-4 years, we believe that there will be major structural change in the supply chain, including logistics and production line for the agriculture sector and SME sector. We believe that this will help accelerate productivity growth and reduce inflation, increase export competitiveness, and increase productive job opportunities.
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