Rate Cuts Continue
May 08, 2007
By
Chetan Ahya and
Tanvee Gupta and
Deyi Tan | Mumbai, Mumbai, Singapore
BI benchmark rate falls to 8.75%: Bank Indonesia cut the benchmark rate by 25bp to 8.75% in its meeting today. This is in line with our and market expectations.
Loosening to come to end soon: The central bank has been reiterating its year-end target of 8.5% for the benchmark rate. In view of the current favourable macro conditions, we are tweaking our year-end forecast from 8.75% to 8.5%.
Assessment of macro conditions: Inflation has held relatively steady at 6.3-6.5% YoY since the start of the year, with the previous weather-induced impact relatively transient. The latest April reading showed a mild deceleration to 6.3% YoY (versus +6.5% YoY in March). We believe that inflation will be fairly stable in this range for the rest of the year. Our inflation forecast is 6.4% YoY (period average).
In terms of short-term portfolio flows, there are no signs of a reversion in risk appetites. Net foreign equity buying (15-day trailing sum) has remained at elevated levels of about Rp4.0 trillion.
The recent appreciation on the currency front, if it marks a change in currency management as pointed out by our currency analyst, Stewart Newnham, will represent a slight tightening in monetary conditions. Liquidity conditions (as measured by the stock of open-market operation instruments) have grown about three-fold since the ‘mini-crisis’ in 2005. Indeed, a stronger pace of currency appreciation will soften the rise in liquidity at home and reduce liquidity-induced and imported inflationary pressures. However, slowness in supply-side response and the lagged impact from previous rate cuts might hinder the central bank from cutting rates too much at this point, in our view.
Can the Shekel Decouple from Politics?
May 08, 2007
By
Serhan Cevik | from Istanbul
Israel’s fragmented political scene has always been a burden on economic performance. Prime Minister Ehud Olmert is in trouble. The Winograd Commission — appointed by the government to investigate the handling of the war against Hezbollah in Lebanon — published its interim findings and recommendations that are highly critical of Mr. Olmert, Defense Minister (and the leader of the Labor Party) Amir Peretz, and the chief of staff General Dan Halutz (who has already resigned from the military). Even though Mr. Olmert remains undeterred — vowing to supervise the implementation of the commission’s recommendations — he is now in a weaker position, especially as his leading collation partner faces a leadership challenge and the police continue investigating allegations against a number of government officials, including the country’s finance minister, Abraham Hirchson, who is temporarily on leave. Indeed, immediately after the release of the Winograd report, the pressure on Prime Minister Olmert to resign has started expanding across the political spectrum. First, Eitan Cabel, one of the junior cabinet ministers from the Labor Party, left the government in protest at the conduct of the war, and then Foreign Minister and Deputy Prime Minister Tzipi Livni (from Mr. Olmert’s own Kadima Party) has called for the resignation of the prime minister. Mr. Olmert has so far dismissed these challenges, but the pressure is clearly building up and we may eventually witness an outright attempt to restructure the government, if not another round of early elections. While political noise has always been a burden on the economy and financial markets, we think that the state of the Israeli economy is strong enough to minimize the fallout from political disturbances.
Politics is a source of noise, but economic fundamentals support the shekel. The shekel has appreciated faster than even our out-of-consensus projection, partly because of the dollar’s weakness. Of course, the question in everybody’s mind is whether political noise could disturb the prevailing trend. We think not. First, the shekel is still undervalued against the dollar and especially against the trade-weighted currency basket. Second, the shekel’s appreciation is a secular phenomenon, reflecting fundamental gains that would not easily disappear because of an increase in political noise. One of the most important building blocks is fiscal correction. Although populist tendencies remain a challenge, there is a consensus to maintain fiscal discipline. As a result, the budget deficit — narrowing from 5.4% of GDP in 2003 to 0.9% last year — shows no sign of deterioration. In fact, the government budget posted a surplus of 7.1 billion shekels in the first four months of this year, against a deficit target of 18.7 billion shekels for the whole year. The other key factor supporting the shekel is the current account balance which moved from an average deficit of 2% of GDP a year in the 1990s to a surplus of 4.9% in 2006. In our view, this is a structural improvement, revealing the power of technology-intensive sectors in generating higher value-added (see Tech Support, March 6, 2007). Hence, Israel has evolved from being a net external borrower (24% of GDP in the early 1990s) to being a creditor to the rest of the world (21.3% of GDP last year).
The economy remains on an elevated growth trajectory and does not need further monetary easing. Real GDP growth has accelerated to an above-trend pace and shows no sign of deceleration. Even though the linkages with the US business cycle are a source of worry, the composition of Israel’s exports — dominated by capital goods and services — is not immediately exposed to America’s consumption-led slowdown. Further, with low interest rates and improvements in the labor market, domestic demand is fast becoming a more important contributor to overall growth in the economy. Even so, with the shekel’s appreciation, consumer price inflation is still in the deflationary territory and highly unlikely to surge beyond the central bank’s target range. In our view, apart from technical oddities resulting in higher volatility every once in a while, Israel has internalized low inflation. However, that is not a license to keep easing the monetary policy stance, especially when economic fundamentals point to an increase in inflation over the medium term. In short, we realize the challenge of politics, but still argue that the state of the Israeli economy is strong enough to support the shekel.
Three, Two, One…
May 08, 2007
By
Gray Newman and
Daniel Volberg | New York, New York
It has been more than six years since Brazil has seen the dollar-real exchange rate begin with the number one. We suspect that the day is coming back and is coming soon. Indeed, unless the global economy takes a sudden turn for the worse or we have another bout of global risk aversion akin to May 2006, we expect the Brazilian real to break through 2.0 in the coming months. Accordingly, we are adjusting our end-2007 dollar-real forecast to 1.85 from 2.2 previously and 1.9 for 2008 versus 2.3 previously.
Slowing, but not stopping currency strength
Our currency call may seem to run counter to the actions of Brazil’s central bank, which have intensified in recent weeks. Last week, in an attempt to help prop up the value of the dollar, the central bank’s combined intervention between spot and swap markets exceeded US$5 billion. The sharp uptick in intervention comes after the central bank broke all records in April with purchases we estimate of nearly US$12.7 billion to add to reserves. So far this year, dollar purchases in the spot market alone have probably added more than US$32 billion to reserves.
To put the central bank’s buying spree in context, the purchases in the first four months of the year are more than double the stock of Brazil’s international reserves (net of IMF loans) just four years ago. The central bank’s actions have provided a powerful counterforce to real strength and have left investors cautious about near-term moves in the exchange rate.
But we would caution against the notion that the central bank’s actions will prevent the real from breaking through 2.0. The central bank’s aggressiveness in recent days — both as measured in terms of the magnitude of its purchases as well as its new policy of holding swap auctions without giving the market advance notice — may cause some investors to lighten their Brazil real positions in the near term. Furthermore, there is no doubt that there is a great deal of psychological importance to an exchange rate beginning with the number one. A break below 2.0 would likely send the currency back to the headlines in Brazil and trigger further political pressure from exporters who complain of the loss of competitiveness. But the massive intervention by the central bank to date has been unsuccessful in stopping the real from appreciating. Whether the level was 2.8 or 2.12, the central bank’s dollar buying spree may have slowed the speed of appreciation, but it has not reversed the currency’s trend toward strengthening.
Indeed, central bank policy has probably exacerbated the magnitude of the inflows pressuring the currency to strengthen further. By combining a very measured and very modest pace of interest rate cuts along with massive intervention, the central bank has probably contributed to speculative positions by all but ensuring that investors will benefit from the upcoming currency appreciation. Had the central bank remained out of the currency market, the real would have likely strengthened dramatically or overshot and reached a point that would have caused investors to worry whether it had strengthened too much. But with the large dollar purchases which temper the currency’s gain, combined with high interest rates — even after 21 months of cuts, overnight interest rates now stand at 12.5% — the central bank has slowed (but not stopped) the impact on the currency and hence is allowing investors to take real positions today in anticipation of further strength.
Even while few have been willing to forecast a real below 2.0, the authorities seem to be preparing for the inevitable break below 2.0. Indeed, on Friday, May 4, with the real trading at 2.03 to the dollar, finance ministry officials were cited as stating that strengthening was “inevitable” and that the authorities would only seek to limit “overvaluation”.
Lower inflation, lower rates
Our currency revision has also led us to revise inflation, which we see dropping to 3.2% in 2007, as well as lower our interest rate forecast. With inflation set to come in well below the central bank’s target of 4.5%, along with a new willingness within the central bank to consider reaccelerating the pace of rate cuts, we have cut our 2007 year-end Selic rate forecast to 10.75% from 11.25%. We have revised the Selic in 2008 to 9.75% from 10% previously. We have argued since the beginning of the year that the move to slow the pace of cuts from 50bp to 25bp in January was mistaken, but had ruled out any willingness on the part of the central bank to revisit the issue. The combination of a split decision in the April meeting of the Copom, along with a very benign inflation picture and the prospect of a stronger currency, leads us to believe that the central bank will cut interest rates by 50bp in both its May and July meetings before returning to cuts of 25bp.
There are a number of risks to our view. The central bank has adopted a much more aggressive policy of accumulating reserves. If, for example, we have a sudden bout of risk aversion akin to May 2006, the impact of central bank actions could be magnified. After all, look at the aftermath of last year’s sell-off in the real: it took ten months for the real to return to the levels it was trading at in early May 2006 before the sell-off. Moreover, if global growth slows or commodity prices decline, the expected deterioration on Brazil’s trade front could also weaken the exchange rate.
When the real moves below 2.0, and we believe it is a matter of when and not whether, we expect increased pressure from Brazil exporters for the authorities to respond. While we recognize that the real is now at its strongest point — in inflation-adjusted, trade-weighted terms — in more than two decades, it is remarkable as to how little damage it has had on Brazil’s trade balance. We’ve called the peak of Brazil’s trade surplus before, only to find it on the rise again as export prices have strengthened. However equally important, export volumes have not turned down in the past two years despite the real’s dramatic gains. Indeed, in the first three months of 2007, export prices have largely flattened out even as volumes have once again turned up.
Of course, we expect to see Brazil’s trade surplus and current account surplus shrink during 2007, and have been surprised that it has taken so long. Accordingly, we have revised Brazil’s trade surplus in 2007 to US$37.1 billion from US$39.3 billion previously. The current account shrinks to a surplus of 0.6% of GDP in 2007 and is balanced at 0.0% of GDP in 2008. However, we do not expect this to lead to a substantially weaker real. It is hard to argue that Brazil needs a currency rate to maintain the peak trade and current account surpluses seen in recent years. Brazil needs a currency that is consistent with a current account deficit that can be financed with regular market access.
It is also worth keeping in mind that our forecast is not nearly as strong in trade-weighted terms, given the decline of the dollar. While the real has gained sharply against the dollar, as well as against the euro and other currencies, the gains against the dollar are most pronounced. For example, during the past three years through the first week of May, the real has gained 46% against the dollar while only 33% against a basket of currencies of its 14 principal trading partners that we track.
Bottom line
It should come as little surprise that Brazil’s real breaks through 2.0. After all, with good domestic growth acting as a magnet for foreign direct and portfolio investment flows, a relatively benign global outlook, a large trade surplus and the glaring mismatch between Brazil’s interest rates and its inflation path, the real surprise would be that the real somehow simply stops appreciating.