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Spillover Risks
February 12, 2007

By Stephen Roach | New York

One of today’s great paradoxes is the perceived lack of spillovers.  Macro theory stresses interrelationships within economies, between markets, and across borders.  Yet most financial market participants now believe in the theory of containment -- that disruptions in one sector, one market, or even one economy can, in effect, be walled off from the rest of the system.  Whether it’s the bursting of the US housing bubble, carnage in sub-prime mortgage lending, or a slowing of Chinese investment, these events are quickly labeled as “idiosyncratic” -- unique one-off disturbances that are perceived to pose little or no threat to the larger whole.  The longer a seemingly resilient world withstands such blows, the deeper the conviction that spillover risk has all but been banished from the scene.  Therein lie the perils of a dangerous complacency.

The post-housing-bubble shakeout of the US economy is an important case in point.  There’s little disagreement on the wrenching adjustments that have already unfolded in this sector -- a 25% drop in new home sales, a 35% plunge in housing starts, a 16% annualized decline in homebuilding activity over the past three quarters, and a reduction of 110,000 jobs in the residential construction industry from its recent peak.  But the broader US economy barely flinched -- at least, so far.  Even in the face of a mild slowdown of 2.3% annualized real GDP growth in the two middle quarters of 2006, the economy still expanded by 3.4% over the four quarters as a whole.  Such are the footprints of what many call the “two tier” economy -- a weak housing sector (maybe autos too) accompanied by persistent resilience elsewhere. 

I don’t question the facts as they have unfolded -- other than noting the obvious distortions to seasonally adjusted construction data during periods of unusually warm winter weather.  What I do question is the conclusion that this shakeout is not likely to have significant spillover effects on the broader US economy.  The most obvious candidate remains the seemingly invincible American consumer, whose real spending growth accelerated to a brisk 4.4% annualized clip in the final period of 2006.  I continue to cling to the seemingly discredited notion that it’s only a matter of time before the consumer responds to the carnage in the US housing market.  The bulk of the income effects are yet to come -- especially since the employment declines in residential construction have unwound only about 14% of the hiring boom of over 810,000 that occurred in this sector over the five years ending January 2006.  As building activity is brought down into alignment with now depressed rates of new home sales and housing starts, commensurate adjustments can be expected in labor input -- and in the income generation driven by such employment.  If that occurs, consumers will be squeezed by the coming housing-related shortfall of purchasing power.

Asset effects are also likely to keep putting pressure on American consumers.  A personal saving rate that has now been in negative territory for two years in a row leaves little doubt of the asset-dependent support to US consumption.  With nationwide house price appreciation now slowing dramatically -- from 13.9% y-o-y in 2Q04 to 7.7% in 3Q06 on an OFHEO basis -- and likely to slow a good deal further in the months ahead, consumers will have considerably less in the way of excess asset appreciation that can be used to support spending and saving.  Net equity extraction from residential property has already fallen from 8.5% of disposable personal income in late 2005 to 6.5% in late 2006.  That’s especially worrisome with debt ratios at record highs and income-based saving rates at record lows. 

Looking through the noise of energy-related gyrations to headline prices and inflation-adjusted household purchasing power, I remain highly skeptical of the consumer resilience call in a post-housing-bubble climate.  And if the consumer finally fades, as I suspect, capital spending will be quick to go as well.  I draw no comfort from ever-abundant coffers of corporate cash flow.  If the demand outlook turns shaky due to spillover effects from housing to consumption, businesses will rethink expectations of future pressures on capacity utilization -- and cut back plans to expand capacity accordingly.  The recent softening of capital goods orders -- average declines of -0.9% in nondefense capital good bookings ex aircraft in the final three months of 2006 -- is especially supportive of that conclusion.

There is also an important financial dimension to the spillover debate -- underscored by the rapidly evolving carnage in America’s sub-prime mortgage lending business.  Like virtually every other credit event that has unfolded in the past several years -- from auto downgrades to the implosion of Amaranth -- our credit strategists have been quick to label the sub-prime mortgage problem as idiosyncratic.  While spreads have blown out in this relatively small segment of the US mortgage market -- with sub-prime loans about 11% of total securitized home loans -- spreads for higher rated mortgage credits have been largely unaffected.  Again, I don’t dispute the facts as they have unfolded so far.  My problem comes in extrapolating this resilience into the future.  With resets on floating rate mortgages likely to put debt service obligations on a rising path for already overly-indebted US homeowners, the case for increased default rates and collateral damage on prime mortgage lenders looks increasingly worrisome.  Indeed, as the recent warning from HSBC just indicated, it’s not just the small specialized lenders that are now being hit.  Spillover effects are quickly moving up the quality scale on the financial side of the post-housing-bubble shakeout story, and their potential for impacts on the broader economy can hardly be dismissed out of hand.

Halfway around the world, a comparable issue is evident with respect to the Chinese investment slowdown.  Like America’s housing shakeout, there can be little disputing the facts of a major slowing of Chinese investment activity -- a year-over-year growth rate that was running at close to 30% at the start of 2006 but that ended the year at 14%.  Despite this dramatic slowing, most still believe nothing can stop China’s growth juggernaut.  However, with investment easily the largest sector of the Chinese economy -- close to 45% of total GDP in 2006 -- it is almost mathematically impossible for sharply slower investment growth not to have impacts on the broader economy.  The recent industrial output trajectory underscores this conclusion -- a slowing from peak rates of growth of 19.5% last June to less than 15% in the final months of 2006.  While 15% growth in industrial output is still quite vigorous, it does represent a meaningful cooling off from earlier overheated gains. 

At the same time, I take the recent softening of commodity markets as further validation of the spillover effects of China’s investment slowdown.  With China accounting for about 50% of the cumulative increase in global consumption of base metals and oil since 2002 -- fully 10 times its 5% share of world GDP -- a China slowdown represents a very important development on the demand side of economically sensitive commodity markets.  The same can be said for the transmission of spillover effects into China’s supply chain.  As Chinese investment slows, cross-border impacts are likely in the other big economies of Asia -- especially Japan, Korea, and Taiwan.  Similar ripple effects should be felt by China’s natural resource providers -- especially Australia, Brazil, Canada, and parts of Africa.  In recent years, China has become such an important engine on the supply side of the global economy that it is difficult to see how a meaningful deceleration in its major source of economic growth won’t produce significant collateral damage elsewhere in the world.

Modern-day macro is a theory of interdependence -- linkages both within and between economies.  As such, spillovers are the norm, not the exception.  Consequently, if an economy is hit with a major shock -- like the bursting of the US housing bubble or a cooling off of China’s investment surge -- it is very difficult to contain the damage before it spreads elsewhere in the global macro system.  The best containment strategy is autonomous support to internal demand -- especially private consumption.  But even in those cases, it would take an acceleration of growth in the resilient sector(s) to offset the impacts of slower growth in the shocked sector.  In my view, that’s highly unlikely for either the US or China.

The biggest risk of all may be the geopolitical spillover.  At a recent Morgan Stanley client conference, Middle East security expert Kenneth Pollock underscored the risk of cross-border spillovers in the aftermath of civil wars.  He argues that was true in the case of recent civil wars in Afghanistan, the Congo, Lebanon, Somalia, and Yugoslavia, and could well occur in response to the current civil war in Iraq (see Daniel Byman and Kenneth Pollack, “Things Fall Apart: Containing the Spillover From an Iraqi Civil War,” Brookings Institution Analysis Paper Number 11, January 2007).  Pollack warned that as Iraq veers out of control, pan-regional spillover effects in Iran, Israel, Saudi Arabia, Jordan, Kuwait, and Turkey could well be unavoidable.  Such a possibility could not only further destabilize an already volatile part of the world but could wreak havoc with oil prices and the broader global economy. 

Financial markets have learned to shrug off spillover risks in recent years.  An ample cushion of excess liquidity has been key in defusing the potential impacts of massive current account imbalances, soaring oil prices, the bursting of the equity bubble, and an escalation of terrorist activity.  Most investors are now of the view that spillover risk is inconsequential for such a Teflon-like world.  History does not treat such complacency kindly.


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A More Relaxed RBA
February 12, 2007

By Gerard Minack | Sydney

The Reserve Bank now has “a little more confidence” in its forecast that underlying inflation will fall from 3%.   That comment in today’s Statement on Monetary Policy effectively signals that the RBA has policy on hold. 

Reflecting that increased confidence, the RBA has lowered its 2007 forecast for underlying inflation to 2.75% from 3% in the previous Statement.   The RBA expects underlying inflation to rise by 2.5-3% through 2008. 

The key change from the previous Statement has been the better-than-expected inflation news, as well as signs that corporate inflation expectations have moderated. 

As I see it, the single most important upside risk to rates is that the apparent tightness in the labour market leads to higher wages growth.  For now, however, almost every labour cost indicator is moderating — something that flies in the face of the strong employment growth seen over the second half of last year. 

With unemployment low, and vacancies high, there is clearly a risk that wages growth re-accelerates.  In this context, the most important upcoming data will be the December quarter Wage Cost Index and Average Weekly Earnings reports (due on February 21 and 22, respectively).  

Looking further out, I continue to expect that the RBA will ease policy in the second half of the year as domestic demand growth slows to below-trend.  Three factors point to below-trend growth this year: 1) the ongoing impact of the drought; 2) the flattening-out in the investment cycle; and 3) continued sluggish consumer spending growth as households continue to lift their saving rate. 

Today’s news largely confirms what was already priced into markets: that the RBA is on hold for the foreseeable future.  Short-end futures barely budged after today’s Statement was released. 


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United States
Will the Subprime Meltdown Trigger a Credit Crunch?
February 12, 2007

By Richard Berner | New York

Soaring defaults signal that the long-awaited meltdown in subprime mortgage lending is now underway, and it likely has further to go.  Fears are rising that this so-far idiosyncratic credit bust will morph into a broader, systemic credit crunch as foreclosures rise, lenders grow cautious, and Congressional efforts to rein in predatory lending further choke off supply.  A credit crunch occurs when lenders deny even creditworthy borrowers access to borrowing.  What are the risks of such a scenario?

Worries about a wider credit crunch are dramatically overblown, in my view.  Spreads may widen further, more subprime lenders may close their doors and the supply of subprime credit likely will tighten.  But the balance sheets of most prime lenders are strong, investors are differentiating among rungs of the mortgage credit ladder, and a limited incipient spillover into prime loans and other asset classes signals that a credit crunch is remote.   Here are details.

Subprime credit is extended to borrowers with high credit risk — those with so-called FICO credit scores less than 620 — either because they have weak credit histories or unproved capacity to service or repay their debts, or both.  According to our mortgage strategy team, subprime loans amount to $605 billion or 11% of the $5.5 trillion in outstanding securitized mortgages (which in turn account for 54% of all mortgages outstanding).  And the growth in subprime lending has been stunning: Originations jumped nearly tenfold between 1994 and 2003, and outstandings have jumped fourfold from $150 billion in 2000.  At work were regulatory changes and financial innovation that greatly expanded access to credit for borrowers and risks for lenders. 

Subprime loans naturally carry higher risk and tougher terms than do prime loans.  Defaults and delinquencies have always been higher.  At the end of 2003, more than 7% of subprime mortgages were in serious delinquency (in foreclosure or more than 90 days past due), while the rate for prime loans was just 1%.   According to our banking research team, the overall delinquency rate for subprime mortgage loans increased to 12.56% in 3Q06 from 11.70% in 2Q and 10.04% in 2Q04.  In contrast, for commercial banks reporting to the Fed, overall mortgage delinquency rates in 3Q06 averaged 1.7% — higher than the 1.4% seen in early 2005 when loan growth was booming but less than at the end of 2003.  Not surprisingly, lenders charge higher interest on subprime mortgages than on prime loans to compensate them for risk, and since 2004, they have been demanding larger downpayments.  According to lender surveys, “a weak credit history alone can add about 350 basis points to the loan rate” (see “Subprime Mortgage Lending: Benefits, Costs, and Challenges,” remarks by Federal Reserve Governor Edward M. Gramlich, May 21, 2004).

The recent jump in defaults, especially for recently-originated loans, has accelerated concerns about the bust in subprime lending.  So-called early payment defaults — loans defaulting shortly following origination — have jumped, forcing some originators to take back dud paper they thought they had successfully packaged off their balance sheets into asset-backed securities (ABS).  The rise in such defaults is hardly surprising: Eager lenders fueled rapid growth in lending during a period of low rates and strongly rising home prices.  With rates up, home prices declining over the year ended in November in seven of twenty major markets tracked by the S&P/Case-Shiller home price indexes, and prepayment penalties affecting recent loans, many subprime borrowers cannot refinance. 

But in my view and in the opinion of my colleagues Ken Posner and Suzanne Schiavelli, who cover the mortgage lenders, early payment defaults are symptomatic of and confined to aggressive lenders that stretched to maintain origination volume to cover a high fixed-cost business model.  “Stretching” in this case means originating or buying so-called stated-income loans — those for which there is no documentation concerning the borrower’s ability to repay, only his or her statement.  Fraudulent representation appears to account for much of the early payment defaults.  In contrast, disciplined industry leaders have experienced almost no early payment defaults, in line with the modest deterioration in overall mortgage credit quality described above. 

Likewise, the meltdown in the prices of the lowest-quality (BBB or BBB-minus rated) subprime ABS over the past few weeks contrasts with the more muted selloff in prime securitized paper, and suggests that investors are finally differentiating among rungs of the mortgage credit ladder.  Spreads on the benchmark ABX index of subprime home equity loans have widened to as much as 600-700 bp over LIBOR in secondary trading, compared with 150-300 bp in early January.  That price action probably represents some overshooting, inasmuch as it reflects protection buyers (sellers of the ABX index) who are betting on damage to the overall housing credit environment rather than much lower prices for single-name ABS.  In contrast, single-A ABX spreads have widened by 20-50 bp, to 80-90 bp, over the same period.  And risk spreads in other credit asset classes, such as the CDX index of 125 large corporate issues, or between investment-grade and junk-rated commercial paper, have hardly budged. 

These developments seem to confirm that the subprime meltdown is showing all the classic symptoms of an idiosyncratic bust with few implications for the overall supply of credit.  Nonetheless, some fear a broader credit crunch for two reasons.  First, they argue that lenders may overreact and significantly tighten lending standards in response to these developments, triggering a widening spiral of foreclosures and defaults and curbing the supply of overall mortgage credit.  Second, they fear a Congressional backlash to the defaults of lower-income borrowers who are often seen as the victims of predatory subprime lending practices.  A swing in the regulatory pendulum to prevent predatory lending could drive lenders out of the subprime market, limiting credit supply.

I think both sets of fears are overblown.  I’ll concede that subprime spreads may widen some more, more subprime lenders may fold, and the supply of subprime credit likely will tighten further.  And there will likely be some sympathetic widening of prime spreads through arbitrage to reflect better their underlying risks.  Although banks aren’t the primary originators of subprime loans, the deterioration in subprime mortgage credit quality may have already triggered sharply tighter bank lending standards to individuals, judging by the Fed’s January Senior Loan Officer survey.  Sixteen percent of responding banks on net reported tightening lending standards for residential mortgages — the biggest surge since 1990. 

But that tightening move followed three years of easing lending standards at a time when regulators have been warning banks about risky lending.  Small wonder: In my view and apparently that of the regulators, faulty underwriting seems more likely to hurt the lenders than the borrowers.  But as I see it, the pain will probably impair lenders’ income more than their balance sheets.  Indeed, balance sheets of most prime lenders are strong and there’s no shortage of willing lenders.  Consequently, I think ultimately some will see opportunity in the bust to enter the business at more attractive prices.  Finally, it’s worth noting that in the Senior Loan Officer canvass, lending standards on bank loans to large firms remained unchanged. 

What about the possibility for a regulatory backlash?  Congressional and regulatory concerns about abusive lending practices are legitimate, in my view.   Regulators sanctioned subprime lending because they believe that the social gains afforded by the expanded access to credit and homeownership outweigh the losses from foreclosure and the risk of predatory lending.   That does not mean that they should not and will not police lending abuses such as charging exorbitant fees, above-market interest rates, or forcing foreclosures to seize cheap collateral.  I strongly doubt that a regulatory overreaction is likely, however.  Legitimate lenders understand that appropriate lending standards and better financial education will improve their profitability by reducing the role of abusive lenders and limiting foreclosures, and they and regulators are working to find the right balance.

Still, I think investors should view these developments as something of a wake-up call.  Reinforced by the perception that the spring 2006 selloff was a buying opportunity, complacency among market participants about credit quality has led to indiscriminate buying of high-risk assets.  Now, our longstanding strategic view that investors should trade up in quality is starting to bear fruit, and the subprime mortgage bust could be a catalyst for a rerating of the riskier portions of other asset classes.  Investors should carefully reassess lender credit quality and monitor risk-free spreads closely for any signs of distress selling or inability to roll over maturing paper, as well as the tone of rating-agency commentary that may affect ability to finance.

What are the risks?  It is always hard to identify the tipping point that turns idiosyncratic risk into something systemic.  That’s especially true today when most agree that the structured credit and ABS markets have dispersed risk more broadly, thus increasing the resilience of the financial system.  The dark side of that perception, of course, is that it promotes increased risk taking.  Thus, further overshooting in market prices may promote the appearance of severe stress among subprime lenders, when in fact it is only moderate.  One risk is that such price action could also trigger more significant lending restraint.  And efforts to stamp out predatory lending might magnify those curbs.  But in my view, any such restraint will not materially affect the overall supply of mortgage credit, much less in the broader capital markets.

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Pricing the Unexpected
February 12, 2007

By Serhan Cevik | London

Macroeconomic developments do not justify the stickiness in real interest rates. Remaining optimistic on an emerging economy for the fifth consecutive year is not an easy sell, especially if the country in question has a volatile history shaped by political breakdowns and financial shocks. And it becomes even more challenging in an election year, with all the global imbalances. But here we are — getting paid to have a stance, not to be a two-handed economist who keeps arguing for and against both sides. No one can of course get it right all the time, but still those missed calls could be great lessons — and an opportunity — to improve the analysis. We missed, for example, with our ambitious call to buy Turkish government bonds at 15% in the fall of 2005 (see Buy Bonds, Wear Diamonds a la Turca, September 26, 2005). Although interest rates declined to our forecast of 13% in the following six months and delivered a handsome return, we underestimated Turkey’s exposure to changes in global risk appetite and the unwinding of leveraged positions that resulted in a sudden burst of volatility. Consequently, being a carry-trade magnet, the Turkish lira weakened and rates moved as high as 23% — well beyond what underlying economic conditions implied. Moreover, after declining from an average of 33.5% in 2001 to 7.8% in the first four months of last year, forward-looking real interest rates have risen to 13.5% — a dramatic move almost six times more than the increase in inflation. Though macroeconomic developments do not justify the current level of real interest rates, in our view, the perception gap in financial markets remains intact.

Political noise distorts market expectations and residents’ portfolio choices. Turkey has come a long way since the devastating crisis in 2001, thanks to political consolidation paving the way for structural reforms and prudent economic policies. Despite last year’s setback, the results are quite impressive. The economy still enjoys the longest stretch of growth and there are encouraging signs of disinflation later this year and especially in 2008. So what is behind the stickiness in real interest rates, particularly when foreign investors have already increased their exposure to lira-denominated assets even beyond the levels recorded before the volatility shock last year? We think that the most important reason is political noise influencing residents’ risk perception and therefore portfolio allocations. Indeed, while we have seen a new wave of international capital inflows, (non-bank) residents have accumulated US$17 billion in foreign exchange-denominated assets in the last six months. It seems that local participants, fearing political paralysis, are likely to remain cautious and keep pricing the unexpected.

Fiscal consolidation cushions the economy against exogenous shocks. While growing at an above-trend pace and disinflating towards the single-digit territory, the Turkish economy has weathered a number of exogenous shocks including the staggering increase in international commodity prices. And given its import dependency, higher oil quotes inflated Turkey’s energy imports from US$11.6 billion (or 4.8% of GDP) in 2003 to US$28.2 billion (or 7.3% of GDP) last year, accounting for 60% of the deterioration in the current account deficit. While Turkey certainly needs to diversify its energy infrastructure, the recent fall in commodity prices and the moderation of domestic demand will likely bring a correction in the current account deficit this year. Furthermore, although the country remains exposed to liquidity-driven international capital flows, the quality of external financing has improved dramatically in recent years and long-term inflows now cover more than 70% of the current account deficit. Having said that, fiscal consolidation is still the best cushion against shocks in a world full of imbalances. With the public sector borrowing requirement moving from a frightening 17.5% of GDP in 2001 to a surplus of 3.1% last year, Turkey’s net public debt stock declined from 90.5% of GDP in 2001 to 46.8% in 2006. This is why we think that there is a disconnect between debt dynamics and real interest rates.

The risk premium prices in backward-looking inflation expectations and more. Inflation will remain high in the first quarter, but then should start moving within the central bank’s uncertainty band by the end of the second quarter, mainly as a result of the accumulated of effect of monetary tightening. However, market expectations point to an elevated inflation path, reflecting the possibility of currency weakness that may or may not occur later in the year. This is indeed a challenge for the central bank waiting for inflation expectations to converge to its own target profile (see The Notorious Chicken-and-Egg Problem, August 14, 2006). But even such a dilemma is not enough to explain the extra risk premium on lira-denominated bonds. In our view, the ‘fair’ real interest rate for the Turkish economy should be around 7-8% until price stability is achieved on a sustainable basis, and remain no more than 10% in an election year. Therefore, there is now an additional risk premium of 350bp — factoring in a variety of exogenous and endogenous risks to currency, inflation and bond prices. But this extra real interest rate should also provide a cushion against a re-pricing of emerging-market risk in general and ‘carry erosion’ in Turkey, at least until political risks start disappearing from the horizon.



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Inflation Rate Rising Above the Comfort Zone
February 12, 2007

By Chetan Ahya and Mihir Sheth | Mumbai, Mumbai

Headline inflation rate spikes up to 6.58%

The wholesale price index (WPI)-based inflation rate (provisional) has accelerated to 6.58% during the week ended January 27, 2007 (from 5.58% five weeks ago), well above the RBI’s comfort zone of 5-5.5%.  Month-on-month trend analysis indicates that only a small proportion of the recent rise in inflation is due to denominator effects.  Moreover, we believe that revised inflation estimates, to be announced in two months, could be even higher than provisional estimates of 6.58%.  The government has been revising previous weeks’ inflation rate upwards by about 20bp.  For instance, the inflation rate for the week ended December 2, 2006 (the last available revised number), which was earlier estimated at 5.16%, is now estimated to be 5.36%.

Stronger demand growth is the key reason for rising inflationary pressure

Unusually low global interest rates and large capital inflows into India (and emerging markets in general) have been the anchor to India’s current strong credit cycle.  Initially, credit-funded spending was driving growth without causing any excesses as the domestic productive capacity was under-utilized.  However, we believe that, over the past 12-18 months, signs of overheating are evident.  Unlike China, India’s response to productive capacity creation has tended to be weak.  This has resulted in India’s absorption of liquidity for productive capacity being less than optimal, resulting in excess aggregate demand.  The adverse impact of these macroeconomic conditions has already been a cause of concern for the RBI, as reflected in a number of measures taken to reduce the side-effects of the less-than-optimal absorption of liquidity in the financial system.

Analysis of price trends for various WPI components indicates that a major part of the recent acceleration in overall inflation is due to manufacturing products.  Over the past 12 months, while the headline overall inflation rate has accelerated to 6.58% from 4.04%, inflation in the manufacturing products basket has accelerated to 6.21% from 1.97% (manufacturing products have a weighting of 63.75% in the WPI).  During the same period, inflation in food articles, which have a weighting of 15.4% in WPI, has accelerated to 9.97% from 7.61%.  More importantly, inflation excluding food and global commodity-linked products (a proxy for core inflation) has accelerated to 5.5% as of January 27, 2007, compared with 2.5% in the corresponding week last year.

Underlying inflationary pressure is even higher

The WPI is biased towards to intermediate products and does not adequately represent the consumer’s spending basket.  For instance, WPI has does not fairly represent shelter costs, transportation, health and education costs, which have witnessed sharper rises than inflation as represented by the WPI, in our view.  Although the RBI still targets inflation as measured by the WPI (due to the absence of a reliable long-term series of countrywide CPI-based inflation measure), we believe that the accuracy of the WPI as a measure for excess aggregate demand is low, given that global commodity-related intermediate products (not final consumption goods) account for 37% of the index.

Although not a perfect measure, we believe that CPI industrial workers (CPI-IW) is a relevant indicator, as financial penetration is significantly higher in urban areas than rural areas.  Inflation, as measured by the new CPI-IW, has also witnessed a significant rise in recent months.  The three-month moving average CPI inflation for industrial workers has increased to 7.0% as of December 2006 (the last data point available) compared with an average of 4.7% in December 2005.

Monetary policy to remain in tightening mode

We believe that headline and underlying inflationary pressure will ensure that the central bank maintains its current tightening stance in the coming weeks.  We believe that if the WPI inflation rate (especially manufactured products) continues to rise in the coming weeks, the RBI could hike the CRR by 25-50bp prior to its next scheduled meeting on April 24, 2007.  In addition to these measures to slow credit-funded aggregate demand, we believe that the Ministry of Finance will also be cutting import tariffs as well as domestic production tariffs on food and other manufactured products (which are inflation-sensitive) in the Union Budget on February 28.


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