Rethinking Country Risk in an Age of Abundance
May 15, 2007
By Gray Newman, Daniel Volberg, Luis Arcentales | New York
When Brazil’s country rating was hiked last week, investors hardly budged. That may have seemed odd at first glance. After all, just a little over four years ago, Brazil was viewed by many as being on the brink of debt default and capital controls. And the move by Fitch Ratings on May 10 to raise Brazil’s long-term foreign currency sovereign rating to within one notch of investment grade was the first move by one of the major rating agencies to this level. It seems all but certain that others are set to follow Fitch’s lead.
And Brazil is hardly alone as external debt appears headed for the endangered species list. A who’s who of emerging markets — from the Czech Republic and Russia to Turkey and Venezuela — have external debt to GDP ratios on average that are nearly half of where they stood six years ago. Country after country has taken advantage of benign market conditions to rebuild international reserves, improve debt profiles and replace external for domestic debt to cut their external debt to GDP ratios. And while Mexico and Indonesia have cut their public external debt to GDP ratios to half of where they stood in 2001, Russia’s debt ratios have declined by 32 percentage points in the past six years to now stand at just 5% of GDP.With an unprecedented number of countries in the past 18 months buying back external debt and swapping it into domestic debt, it should come as little surprise to find that the trading volumes of the emerging markets lead trade association, EMTA, have now flipped. Local debt has now replaced external debt by a wide margin as the instrument of choice for emerging markets practitioners. What’s risk got to do with it?
As external debt continues to be extinguished, the notion of country risk has to be rethought, something we first proposed last August (see “Latin America: Rethinking Country Risk,” in Macro and Micro Radars, August 18, 2006). In the 1990s, when external bonded debt issuance soared, particularly among emerging market economies, country risk and the country ratings from the largest rating agencies seemed almost synonymous. Today, by contrast, as external debt continues to lose ground to local issuance and to increased equity stakes by direct foreign investors, the traditional sovereign credit ratings are becoming less relevant. While forthcoming upgrades might tell us about a sovereign’s ability and willingness to service its shrinking external debt, they tell us less and less about broader country risk. To capture a broader picture of country risk, we have introduced a new set of indicators which focus on micro issues facing emerging markets. The aim of these metrics is to help us understand how strong institutions and the regulatory framework are across emerging markets. While the literature linking institutions to growth has had difficulties in quantifying the precise relationship, there is general agreement that institutions play a major role in long-term growth and general prosperity. Micro radars
Our set of Micro Radar charts is designed to complement the long-standing series of radar charts that Morgan Stanley has used to summarize a country’s key credit statistics relative to benchmark values appropriate to the country’s level of credit risk. The Micro Radar charts are based on the work of the World Bank, which for four years now has published a database of business regulations, publicly available at www.doingbusiness.org. The database provides indicators of the cost of doing business by identifying specific regulations that enhance or constrain business investment, productivity and growth. Unlike other measures of country risk that rely on subjective ratings of the quality of institutions or the business climate, the World Bank data are based on a set of common assumptions used across 175 countries. We have taken 11 of the indicators and updated them with the most recent 2007 dataset — including starting a business, employing workers, credit information and rights, shareholder suits, tax costs and time involved in filing as well as bankruptcy recovery rates and contract enforcement costs. Neither our traditional Macro Radars, which measure solvency and liquidity risks, nor the Micro Radars provide a full picture of country risk. But the Micro Radars are an additional facet of country risk that we think is increasingly important to focus on, especially as emerging markets have made important strides in many of the traditional areas of macro concern. Nonetheless, the micro radars have their limitations as well. The efficiency of application or enforcement of the law is poorly measured, if at all in our Micro Radars. Corruption remains a major problem in emerging markets and is not taken into account in our set of Micro Radars — nor is the issue of security. High crime rates and difficult security situations impose a significant cost on doing business, as do vast informal economies. Still, the Micro Radars should serve to provide investors with another measure of country risk to complement the more widely used ratios of external debt and current account to GDP, reserve adequacy, liquidity, inflation, investment and GDP growth. Findings
On a regional basis, Eastern Europe remains on top in institutional and regulatory environment among emerging markets. Specifically, Eastern Europe has very favorable contract enforcement institutions as well as lower-than-average legal and bureaucratic barriers for starting businesses. The picture, however, is far from uniform: Eastern Europe falls comparably short, albeit by a modest margin, on institutions relating to credit information and also in bankruptcy recovery. The generally high marks for the region are not entirely surprising, given the reform momentum generated by the EU accession process. Not only does Latin America have the poorest institutional and regulatory environment, but the pace of reform has also lagged. The World Bank notes that in the 2005-2006 period fewer than 60% of the countries in the region made at least one positive reform, compared to nearly 90% of Eastern European nations. Latin America earns particularly weak marks on the tax category, which includes notoriously arcane tax systems and relatively high tax burdens. Regional aggregates can mask significant differences between their constituents, Latin America’s two largest economies, namely Brazil and Mexico, provide a useful example of contrasts. In Brazil, it takes a whopping 2,600 hours — nearly 13 times the OECD’s average — each year to prepare, file and pay taxes, representing the Doing Business sample’s heaviest administrative burden. Brazil ranks near the bottom in several other metrics with important shortfalls due to low bankruptcy recovery rates, a relatively heavy tax burden, a Byzantine legal framework that creates significant hurdles to start a business and a rigid labor force. Mexico, by contrast, ranked in the sample’s top quartile and, in the 2005-2006 period, was singled out as one of the world’s top ten reformers. The introduction of its new securities law — in effect since June 2006 — helped improve its investor protection ranking by 100 notches to the 33rd spot out of 175 countries surveyed. In contrast, South Africa’s micro indicators look better than the emerging market averages. South Africa’s strong micro grade stands in contrast to the macro challenges its faces, given its large current account shortfall even as global liquidity remains in question. Bottom line
As external debt continues to be extinguished, look for more upgrades to come as the ability and willingness of sovereigns to service their external debt obligations improve. But we would warn against confusing an improving sovereign credit rating with an improvement in country risk. The scarcity value of disappearing emerging market bonds makes them day by day a less relevant benchmark for broader risk. Country risk encompasses much more than sovereign credit risk and includes a valuation of the regulatory and institutional framework in each country. For countries that have made important macro strides, we would argue that there are a host of micro reforms that need to be taken up. The costs associated with developing and maintaining a thriving entrepreneurial base remain one of the most significant obstacles to sustainable growth in emerging markets. A complete listing of more than 30 emerging market countries with their latest Micro and Macro Radars will be available this week.
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The Case for Revaluation
May 15, 2007
By Serhan Cevik | from Dubai
Authorities dismiss the revaluation of Gulf currencies, but the case is getting stronger. Although market participants expect the revaluation of undervalued currencies of oil-producing countries in the Middle East, the authorities keep dismissing the idea and in fact have taken some steps to bring an end to the discussion on pegged exchange rates. Kuwait’s central bank, for example, lowered its short-term interest rate for the second time in six weeks (by a total of 37.5bp to 5.5%) in an attempt to curb ‘speculative’ flows betting on the dinar’s appreciation. In a similar (but somewhat confusing) fashion, the central bank of the United Arab Emirates cut the policy rate by 5bp to 4.85% and then reversed it in the following day. In our view, these marginal moves would not change the fact that economic fundamentals and the strengthening wave of foreign inflows justify the revaluation of Gulf currencies. Unfortunately, it seems that the six members of the Gulf Cooperation Council are still struggling to find a common ground for monetary unification and an exchange rate regime that would be suitable for all. The petrodollar liquidity has unsurprisingly led to a marked increase in inflation. No Gulf country is willing to revalue its currency in a unilateral move, even though all the available data call for immediate action. As the global economic boom and supply constraints in the petroleum market keep pushing oil prices higher, oil-producing countries have enjoyed an unprecedented windfall gain. Export earnings surged from US$251 billion in 2002 to about US$900 billion in the past 12 months, helping to raise the cumulative current account surplus from 5.4% of GDP to over 26% over the same period. Along with the oil windfall, these countries have also experienced a sharp increase in foreign investment inflows. Of course, the resulting liquidity abundance has led to an easing of monetary conditions and higher inflation rates across the region (see A Dutch Disease in Arabia, October 18, 2006). According to official statistics (which underestimate the true level of inflation because of measurement errors and administered prices), consumer price inflation accelerated from 3.9% in 2001 to around 10% last year. The dollar’s weakness has worsened inflation pressures in the Middle East. Although the abundance of liquidity and expansionary macroeconomic policies are the major culprit for rising inflation throughout the region, we must not ignore the inflationary consequences of exchange rates pegged to the US dollar. Indeed, with the dollar’s sustained weakness since 2002, the role of imported inflation has become more and more important for inflation dynamics (see Pegged Pains, February 20, 2007). In our opinion, this is yet another reason why oil-producing economies should not let their currencies depreciate and inflation move well beyond the comfort zone. In fact, there are already signs of inflation pressures spreading out from non-tradables to tradable goods. In other words, this is no longer a temporary risk and, as it becomes an entrenched problem, all the countries will struggle to keep inflation (and inflation differentials) compatible with the convergence criteria for monetary unification. The realignment of currencies would help convergence and global rebalancing. Even if we put aside enormous current account surpluses, the planned monetary integration justifies the realignment of GCC currencies, in our view. While we still have concerns about the sustainability of a currency union in the longer term (mainly because of oil dependency and other structural shortcomings), the immediate threat is rising inflation and widening inflation differentials. Without price stability, there can be no monetary union or a common exchange rate regime. Therefore, revaluing the undervalued currencies and adopting a more flexible exchange rate regime would help ease inflation pressures and set the stage for monetary integration. The other aspect of this story is of course the role of petrodollars in global imbalances. Although China-bashing has become a favorite theme, currency misalignments in the Middle East are no less important. Indeed, as the region’s cumulative current account surplus widened from 0.1% of global GDP in 1999 to 1.4% last year, the world needs greater exchange rate flexibility in oil-producing countries, not just in China (see The Great Arabian Bubble, December 4, 2006).
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1Q Monetary Policy Report: Be Prepared for Rate Hikes
May 15, 2007
By Qing Wang | Hong Kong
The PBOC publishes its Monetary Policy Report on a quarterly basis. In our view, the Monetary Policy Report is one of the best macroeconomic reports that are regularly published by the Chinese authorities. The report provides a comprehensive update of the authorities’ view on recent macroeconomic developments, near-term outlook, issues in the current overall macroeconomic situation, policy objectives, and potential policy actions. While the report primarily focuses on monetary policy-related issues, it also tends to touch on a wide range of other important issues that are relevant to the macro economy, including external, structural and industrial policies. We believe that a careful review of the current report helps us to form a clear understanding of the authorities’ assessment of the current macroeconomic situation and outlook and to gauge the potential course of future policy actions. The recent tendency that the Chinese policymakers — especially the PBOC — have become increasingly willing to communicate their policy intentions in a relatively transparent and formal fashion to the public makes this exercise particularly useful. The PBOC published its 1st Quarter Monetary Policy Report (‘the current report’) on Thursday, May 10. In this note, we present our reading of this report, paying particular attention to changes in language and tone from the 4Q06 report (‘the previous report’) that was published in February. Our reading of the report Overall, the report gives a generally favorable assessment of recent developments. However, the current report identifies several important and relatively immediate issues in the economy to be addressed, including a more pronounced tendency for too rapid growth, the pressure for fixed-asset investment growth to rebound, continued expansion of sizable trade surpluses, excess liquidity, and rapid money and credit expansion. At the same time, the report is notably silent on the potential risks associated with the “irrational exuberance” demonstrated by investors in the domestic A-share market. The report predicts that “the economy will continue to grow at a relatively fast pace” and considers that the risk to the inflation outlook is to the upside. On the policy front, while the report reiterates the authorities’ intention to “maintain policy stability and continuity”, it underscores the need to “guard against the risk of too fast growth turning into generalized economic overheating”. Based on our reading of the report, we believe that despite concerns about the risk of potential overheating, no consensus has yet been reached on the need for the campaign-style, heavy-handed tightening measures that were employed in 3Q06 and 2H04. The authorities appear instead to be contemplating some moderate tightening measures. Mopping up excess liquidity — through a combination of open market operations (OMOs) and raising the ratio for required reserves (RRR) — stemming from persistent and sizable FX reserve accumulation will continue to be the top monetary policy priority. At the same time, we sense that the PBOC is preparing the market for further hikes in the base lending and deposit rates in the near term. We forecast at least two additional rate hikes in the remainder of the year, with the next one likely to be in a matter of weeks. In addition to containing the upside risk to the inflation outlook, potential interest rate hikes should be viewed as part of the authorities’ efforts to rein in the surge of stock market prices. In this context, the China Securities Regulator Commission (CSRC) issued a strongly worded official circular on Friday, May 11, urging for “strengthening education of investors about the risks related to investing the stock market and tightening market monitoring for irregular market activities”. Meanwhile, the China Banking Regulatory Commission (CBRC) also announced on the same day that the scope of investment instruments under the QDII program would be broadened to include “equity and related structured products” with a view to encouraging domestic retail investors to invest off shore. Our reading of the report is discussed in more detail below: Recent developments: The current report gives a generally favorable assessment of recent developments, featuring “steady and fast growth momentum”, acceleration of consumption growth, and strong overall corporate earnings. At the same time, the current report also notes higher CPI inflation and considers that “although money and credit growth shows signs of slowing, it is still too fast”. Compared with the corresponding assessments made in the prior report, which described the growth momentum as “steady and relatively fast” and considered that “the momentum of too rapid money and credit growth has eased”, these assessments in the current report suggest that the authorities have become less comfortable with the current fast growth pace and certainly uncomfortable with the rapid expansion of money and credit. Issues with the current situation: The current report identifies several important and relatively immediate issues in the economy to be addressed, including a more pronounced tendency for too rapid growth, the pressure for fixed-asset investment growth to rebound, persistent sizable trade surpluses, and excess liquidity. In particular, the statement that “the tendency for too fast growth has become more pronounced” did not appear in the set of issues mentioned in the previous report, which noted inflationary pressures instead. This change suggests that too-rapid growth rather than inflation is a bigger policy concern at this stage. The current report is notably silent on the potential risks associated with the “irrational exuberance” demonstrated by the investors in the domestic A-share market. Near-term outlook: The current report predicts that “the economy will continue to grow at a relatively fast pace”, while the corresponding statement in the previous report was that “the economy will maintain steady and relatively fast growth momentum”. Dropping the word “steady” suggests the authorities now see the faster-than-originally-envisaged GDP growth in 1Q (i.e., 11.1% yoy) likely be repeated in 2Q. Moreover, the current report notes that “the risk to the inflation outlook remains to the upside, and future inflation trend warrants close watch.” Compared with the previous report, this is a broadly unchanged message which, however, is delivered in a slightly dovish tone, suggesting that the authorities are less certain about how long the current relatively high inflation rate can last. Policy objectives: While the current report reiterates the authorities’ intention to “maintain policy stability and continuity”, it specifically underscores the need to “guard against the risk of too-fast growth turning into generalized economic overheating”, which is a rather strong statement. This suggests that despite concern about the risk of overheating, no consensus has been reached on the need for the campaign-style, heavy-handed tightening measures that were employed in 3Q06 and 2H04. The authorities appear instead to be contemplating some moderate tightening policy measures. Policy measures: First, mopping up excess liquidity continues to be of top monetary policy priority. The current report states that the PBOC will “strengthen liquidity management through a combination of open market operations and raising the ratio for required reserves, with a view to guiding reasonable money and credit growth”. Interestingly, the corresponding statement in the previous report attached a few more words — “…as well as stable money market interest rates” — to the end of the aforementioned sentence in the current report. Our interpretation is that this likely suggests that if more aggressive liquidity withdrawal through OMOs and RRR hikes were to lead to higher inter-bank interest rates, it would be tolerated. Second, the current report includes an unusual statement “to strengthen the coordination between interest rate and exchange rate policies” and “further strengthen the role of price-based policy measures”. To our knowledge, this is the first time ever that the need for “coordination between interest rate and exchange rate policies” is explicitly mentioned in any official policy statements. It may signal a shift in the authorities’ existing policy of maintaining low domestic interest rates to serve the objective of maintaining a relatively stable exchange rate. And in discussing the role of price-based measures, the current report also tones up, changing from “gradually allowing price-based policy measures to play an important role in monetary policy control” in the previous report to “further strengthening” such a role in the current report. It is noted that five weeks after the previous report was published on February 9 and mentioned — for the first time — the need for “coordination between price-based and quantity-based money policy measures”, the PBOC announced its first base rate hike of the year on March 17. We interpret that the wording change suggests that the authorities are again preparing the market for further interest rate hikes in the near term. Third, on the renminbi exchange rate policy, the current report sticks to the familiar policy lines to “continue with the reform of exchange rate formation mechanism and maintaining the renminbi exchange rate basically stable around a reasonable and equilibrium level”. This suggests that no meaningful change in the renminbi exchange rate policy should be expected and that the current strategy of allowing gradual, controlled renminbi appreciation against the US dollar will be maintained. In particular, the accelerated appreciation (to about a 5-6% annualized pace) since September last year will be sustained in 2007. Along the trajectory of gradual appreciation, the USD/CNY rate will likely be allowed to slide at a faster pace during some “widows of opportunities” such as some important international political events (e.g., the China-US Strategic Economic Dialogue) that may put the renminbi exchange issue under the spotlight. Fourth, the current report continues to stress the importance of encouraging capital outflows through “multiple channels” and in particular calls for speeding up the “going-out” process (i.e., encouraging outbound direct investment by domestic enterprises). Not surprisingly, immediately after the publishing the current report, the China Banking Regulatory Commission (CBRC) announced last Friday that the scope of investment instruments under the QDII program would be broadened to include “equity and related structured products” with a view to further encouraging domestic retail investors to invest offshore. Moreover, the current report also mentions the need to “enhance official FX reserves management”, suggesting that the plan to establish a State Foreign Exchange Investment Corporation is being carried out. Last, the current report makes the case that these macroeconomic issues have to do with several deep-seated structural factors, which should be addressed as early as possible. Specifically, the current report identifies the following policy biases that need to be corrected: a) the bias in trade policy toward “encouraging exports while discouraging imports”; b) the bias in capital control policy toward being “ease for inflows and difficult for outflows”; and c) the bias in industrial policy toward promoting import-substitution.
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Can QDII Lead to Lower HK$ Interest Rates?
May 15, 2007
By Denise Yam, CFA | Hong Kong
Commercial banks’ QDII can finally invest in Hong Kong When China’s QDII (Qualified Domestic Institutional Investor) scheme was formally introduced in mid-2006, many were disappointed with the restrictions on the scope of investment. For the Hong Kong asset markets in particular, the initial rollout dashed immediate hopes for the flood of Chinese money to buoy stock prices in Hong Kong. Nevertheless, the restriction to fixed income and money market products met with limited investment appetite and severe underutilization of the quotas granted thus far. Amid rapid accumulation of foreign reserves on the back of the huge balance of payments surplus (US$247 billion in 2006), and increasing international pressure for faster appreciation in the renminbi exchange rate, China finally gave the official go-ahead to commercial banks’ QDIIs to widen their exposure to foreign equity. Specifically, according to the Notice of the Adjustments to the Offshore Investment Scope of Overseas Wealth Management Business of Commercial Banks on Behalf of Their Clients (the ‘Notice’) issued by the China Banking Regulatory Commission (CBRC) on May 10, “the commercial banks shall only invest in overseas stock markets supervised by the regulatory authorities which have already signed with the CBRC an MOU (Memorandum of Understanding)”, and Hong Kong is currently the only qualified “overseas market” under this arrangement. Still one of the ‘Chinese goodies?’ The expansion of QDII, or China’s capital account liberalization in a broader sense, has been one of the more significant items on Hong Kong’s ‘Chinese goodies wishlist’ following CEPA (Closer Economic Partnership Arrangement) and other supportive economic measures after the SARS crisis (see Realizing the Pipeline of Chinese ‘Goodies’, July 20, 2003. In securing its status as a regional and international financial center, Hong Kong has long had its eyes on opportunities from financial intermediation for China. It has already played a key role in raising international capital for Chinese enterprises and accelerating China’s development over the last decade. Renminbi banking services, introduced since February 2004, kick-started the much-applauded investment theme of Hong Kong capitalizing on opportunities from becoming an offshore Renminbi trading center, although progress on this front has been very gradual. It is important to remind ourselves of the difference between (1) the relaxation of the geographical location of renminbi transactions (not involving forex), which is what leads to Hong Kong functioning as an offshore renminbi center, and (2) the relaxation of the capital account, which involves lifting restrictions on forex transactions for investment purposes, specifically leading to the channeling of China’s outbound portfolio investment to HK$ assets. While the former spells opportunities for financial institutions in Hong Kong to further their provision of financial intermediation services to China, the latter involves the potential for the actual movement of capital into and therefore providing support for HK$ assets. Impact on HK$ interest rates Our outlook for interest rates in Hong Kong has been subject to global liquidity conditions, which we believe would affect capital flows into and out of HK$ assets. Coordinating views from our global economics team, we expect further interest rate hikes in Europe and Japan in the remainder of 2007, while the US is not expect to cut interest rates until 2008. Meanwhile, although the IPO pipeline in the Hong Kong stock market is still respectable in 2007, at US$31.6 billion according to estimates by our Hong Kong equity strategy team, it is nevertheless smaller than the US$42.6 billion achieved in 2006. All in all, we had expected the less buoyant liquidity conditions to lead to a gradual normalization in interest rates over the course of 2007, i.e., narrowing the negative spread between HIBOR and LIBOR. Specifically, we had forecasted that the 3-month HIBOR-LIBOR spread would halve from 146bp at the end of 2006 to 75bp by the end of this year, bringing 3M HIBOR back up to 4.5% by year-end, similar to the level in mid-2006 before the spread widened at the surge of capital inflows. The opening of the channel for China’s commercial banks’ QDII to invest in the Hong Kong equity market means a new source of liquidity into HK$ assets, and should be, at the margin, positive for liquidity conditions and hence could mean downward pressure on interest rates. However, it is important not to get overexcited about this prospect, as the probable fund inflows are likely to be small compared to what Hong Kong is accustomed to. There is no net increase in QDII quotas announced along with the Notice unveiled last week. In other words, this was not yet a further liberalization in the capital account. At present, the total QDII quota held by Chinese commercial banks is US$14.5 billion. The Notice provides that each overseas wealth management product can invest up to 50% of the total net asset value in listed equities, i.e., US$7.25 billion. It is of course not likely that the Hong Kong market will see an immediate flood of the full amount. Here we also attempt to evaluate how the potential US$7.25 billion compares to flows associated with movements in HK$ interest rates since the May 2005 modifications to the currency board system. We have been following the change in the banking system’s net foreign asset position as an indicator of liquidity. Since May 2005, this net foreign asset position has varied between HK$134.2 billion (US$17.3 billion) and HK$402.3 billion (US$51.7 billion), the peak reached in October 2006 amid the ICBC IPO. This suggests that the potential QDII inflow of US$7.25 billion is not that significant. Meanwhile, the 3-month HIBOR-LIBOR spread has ranged between +25bp and -150bp (across the US$34.4 billion range), and stands at around -100bp currently. We are skeptical whether an additional inflow of US$7.25 billion could widen the spread again significantly. Still the good old gradualist approach Needless to say, the future potential for the Hong Kong market from Chinese investment funds is unlimited, as China further relaxes and encourages outbound investment. Amid rapid accumulation of foreign reserves on the back of the huge balance of payments surplus (US$247 billion in 2006), and increasing international pressure for faster appreciation in the renminbi exchange rate, China is set to further encourage capital outflows and speed up outbound investment. Nevertheless, it is likely that the Chinese government will adopt a gradualist approach in terms of approving quotas. According to our China equity strategist, Jerry Lou, it could be a few years before Chinese banks use up their current quotas and apply for more from the regulators. In addition, the investment scope is likely to further widen in the future, with the increasing diversity of investable assets eventually sharing the pie with the Hong Kong market. Another possible offset — slower renminbi appreciation? As we have argued in our previous research, part of the positive sentiment on HK$ assets and Hong Kong-listed Chinese stocks is attributed to the expectation for further appreciation in the Renminbi. Should the increase in capital outflows from China — as the QDII scheme expands further — slow the pace of Renminbi appreciation, this could weaken the attractiveness of HK$ assets and slow inflows. All in all, while we expect further liberalization in China’s outward investment to bring valuable opportunities to the Hong Kong financial sector and markets, we do not think that potential flows in the short term will lower HK$ interest rates by a significant magnitude.
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