Undervalued Challenges
May 31, 2007
By Serhan Cevik | from Istanbul
Kuwait’s decision to end the dollar peg is the first official step in dealing with imbalances. With an unprecedented windfall gain from higher oil prices, the six members of the Gulf Cooperation Council have become a global economic powerhouse, generating domestic growth as well as financing the rest of the world. For the first time in a long while, these countries now have an opportunity to push ahead with structural reforms and reduce their daunting dependence on oil. But such a shift in the composition of economic sectors requires macroeconomic stability as much as political vision. This is why we have been concerned about economic imbalances caused, partly, by the abundance of petrodollar liquidity. Unfortunately, until last week when Kuwait decided to end its currency peg to the dollar, the authorities throughout the region dismissed the call for policy response against undervalued exchange rates and the increase in inflation pressures across the board (see The Case for Revaluation, May 15, 2007). Hence, Kuwait’s decision to adopt a more flexible exchange rate regime based on a peg against a basket of currencies is an encouraging, albeit small, step in the right direction, in our view. That said, however, Kuwait’s move has also highlighted the extent of cracks in the GCC’s aspiration to become a viable monetary union à la the EU.
The oil windfall is just like the opposite of a blessing in disguise. Being the biggest gas station to the world has its advantages, especially in a period of strong global growth and geopolitical supply constraints in the petroleum market. With the breathtaking rise in oil and natural gas prices, GCC countries enjoyed a massive surge in export revenues from an annual average of US$154 billion between 1998 and 2002 to US$507 billion last year. As a result, their cumulative current account surplus jumped from 5.4% of GDP to 24.6% over the same period, leading to a marked increase in liquidity. For example, the growth rate of broad money supply in the Gulf region accelerated from 8.4% between 1998 and 2002 to 23.9% last year. And as one would have expected, the abundance of liquidity pushed real GDP growth from an average of 3% in the 1998-2002 period to 7.3% in the last four years. That is all good, but we also need to concentrate on the consequences of liquidity-driven growth. Indeed, the average inflation rate of GCC countries already increased from 0.1% between 1998 and 2002 to 4.5% at the end of last year. Since official price indices underestimate inflation because of measurement errors and administered prices, the extent of underlying inflation pressures is even greater, in our view (see A Dutch Disease in Arabia, October 18, 2006). Undervalued exchange rates have become a source of inflation in GCC countries. The abundance of liquidity and expansionary macroeconomic policies may be the key factors fuelling inflation across the Gulf region, but the situation is also a result of undervalued currencies and these countries’ limited capacity to sterilize growing foreign capital inflows under pegged exchange rate regimes. In fact, despite the widening current account surpluses, GCC currencies pegged to the US dollar kept depreciating (by about 12.5%) in real terms in the past four years. Although this is a reflection the dollar’s sustained depreciation against other currencies, it is nevertheless a serious challenge to GCC countries. In our opinion, as long as there is no policy response, the effect of imported inflation will become more pronounced and threaten macroeconomic stability (see Pegged Pains, February 20, 2007). Indeed, this is why we have argued for the revaluation of GCC currencies and the introduction of more flexible exchange rate regimes. We believe that the realignment of currencies with economic realities would stem the spread of inflation pressures and help to maintain a sustainable growth trajectory. Although Kuwait’s decision to de-peg its currency from the dollar is just too marginal to have any meaningful effect on the macro front, it is nevertheless an important step in the right direction and may well encourage others to follow its footsteps. Even if we ignore the convergence criteria for monetary unification in 2010 (which certainly remains elusive under the current circumstances), the case for currency revaluation and adopting flexible exchange rate systems is getting stronger every day. After all, the most important policy objective — creating jobs — requires an economic environment based on sound principles and institutions.
Important Disclosure Information at the end of this Forum
Weakening HK$ and Rising Interest Rates?
May 31, 2007
By Denise Yam | Hong Kong
Summary and conclusions In recent weeks, much attention has been drawn to the rise in HK$ interbank interest rates and the weakening of the HK$ against the US$. In particular, anxiety over an imminent hike in retail deposit and lending rates has begun to heighten concerns of a negative impact on asset markets, domestic consumption and investment demand. In this report, we review the fundamental ingredients of monetary conditions in Hong Kong, and put forward our thoughts on the near-term outlook. Barring short-term fluctuations, interest and exchange rate trends suggest that there has been a net outflow from the HK$ in recent weeks. Interbank interest rates have risen to levels last seen in 2Q06, prompting banks to reverse the 25bp cut in lending and deposit rates in November 2006. We believe that, with interbank rates sustaining at the current level, and as banks see migration from savings to time deposits, we will soon see a hike in prime lending and savings deposit rates. Fundraising activities in Hong Kong, especially by Chinese and other foreign enterprises, which involve investment inflows into the HK$ from foreign investors, and subsequently the repatriation of these funds, seem to play an increasing role in determining Hong Kong’s monetary conditions. Specifically, the banking system remains flooded with liquidity following a slew of IPOs, before the proceeds are repatriated by the fundraising companies. The subsequent withdrawal of the funds, including the portion raised from Hong Kong domestic investors, could result in net outflows. In other words, the relative timing of IPOs and the subsequent repatriation of the funds raised can result in significant swings in monetary conditions, and hence HK$ interest rates. Understanding trends in HK$ interest and exchange rates Following significant inflows attracted by large-size IPOs in 2006, the HK$ remained on the strong side of its fixed rate to the US$, while abundant liquidity left HK$ interbank interest rates nearly 1.5 percentage points below their US$ counterparts at the end of the year. Some reversal, or normalization, took place in January-February 2007, coinciding with the reported repatriation of IPO funds raised by Chinese companies, after which monetary conditions appeared to stabilize in March-April, with the exchange rate remaining between 7.81-7.82, and the three-month HIBOR-LIBOR discount hovering at around 110bp. Renewed weakness in the HK$ and further narrowing in the HIBOR-LIBOR discount caught much attention in May, with the rise in the absolute level of HIBOR triggering concerns of an imminent hike in retail lending and deposit rates. There are often many alternative explanations for movements in interest and exchange rates. Short-term volatility is often contributed by performance of the asset markets and fundraising activities. How do we go about explaining the movements in May, which appear to be more a trend than short-term volatility? The upward movement in the absolute level of HK$ interbank interest rates can be attributed to two components: (1) the rise in US$ interest rates, and (2) narrowing of the HIBOR-LIBOR spread. With regard to (1), the release of strong US economic data has lowered expectations for imminent rate cuts in the US, as evidenced in the upward shift in the money market curve in the last two months. With regard to (2), we should consider the relationship among capital flows, the HIBOR-LIBOR spread and the HK$/US$ exchange rate. Prior to the May 2005 modifications to the currency board system, capital flows into and out of the HK$ were reflected in the change in the aggregate clearing balance of the banking system, a component of the monetary base, and hence affected interbank interest rates directly. However, since the introduction of the two-way convertibility for the HK$ in May 2005, the banking system has simply served as the counterparty for capital flows driven by the non-banking sector, absorbing the capital flows on its balance sheet instead of passing them on to the HKMA. Indeed, if we break down Hong Kong’s balance of payments into non-banking sector and banking sector flows, we can see that they have become tighter mirror images of each other, resulting in a remarkably steady overall balance of payments since 2H05. As we have put forward in our earlier research (see From Easy Money to the Volatile Real Economy, November 21, 2006, and Money Growth Buoyed by Stock Market Expansion, November 30, 2006), we believe it is the change in the banks’ net foreign asset position, and hence the HK$ loan-to-deposit ratio, that has become a dominant driver of HK$ interest rates. Because capital flows no longer show up readily in interbank liquidity and changes in official foreign reserves, we now have to rely on banking sector balance sheet data to gauge the direction and size of capital flows. Unfortunately, this means a one-month time lag, as these data are only released on a monthly basis together with the money supply data (end of each month for the previous month). Before these data are available, we have to rely on observations of trends in interest and exchange rates to deduce what has taken place on the capital flows side. HK$ strengthening and the widening HIBOR-LIBOR discount could be attributable to the significant inflows amid equity fundraising activities in April-May 2006 and 4Q06. We have also experienced periods such as 3Q06, when the exchange rate and interest rate moved in opposite directions (HK$ weakening and HIBOR falling against LIBOR), when we could not draw definitive conclusions on the direction of capital flows. Outflows associated with Chinese enterprises’ repatriation offered a sound explanation for the weakening HK$ and narrowing HIBOR-LIBOR discount in January-February 2007. It follows that the weakening in the HK$ coinciding with the narrowing HIBOR-LIBOR discount during May 2007 suggests that there were likely net outflows from the HK$ in the month. It appears that equity fundraising and IPO proceeds repatriation seem to have played a dominant role in Hong Kong’s monetary conditions over the past year. In the next section, we explore in more detail the dynamics of monetary conditions in Hong Kong associated with fundraising activities. Monetary conditions dynamics upon equity fundraising Here we attempt to use a balance sheet approach to explain the impact on monetary conditions in Hong Kong of fundraising activities by foreign (including Chinese) companies in the Hong Kong stock market. In this model, the four ‘sectors’ concerned are: (1) a Chinese corporate (CC) seeking an IPO in Hong Kong to raise, say, 10 units of capital, (2) Hong Kong households/investors (HH), (3) foreign investors in the Hong Kong market (F) and (4) the Hong Kong banking system (B). Before fundraising starts, we assume that HH has 100 units of HK$ deposits with B, while F has 5 units of foreign currency (FC) deposits with B. For simplicity, we assume that CC raises an equal amount of capital from HH and F. As CC goes for IPO, HH uses its deposits with B to purchase shares, while F converts its FC deposits into HK$, and uses it also to buy CC’s shares. HH and F’s assets become their 5 units of investments in CC, while CC receives 10 units of HK$, which we assume is deposited in B. At this time, B ends up with a currency mismatch in its balance sheet — i.e. net foreign asset position of 5 units, and an equivalent net liability position in HK$. The HK$ loan-to-deposit ratio (LDR) falls from 100% before the IPO to 95%, depressing HK$ interest rates. This is an illustration of the situation towards the end of 2006, after several large IPOs by Chinese banks and enterprises in Hong Kong. The balance sheet changes when CC converts its IPO proceeds out of HK$. Because of a net outflow from HK$ (due to HH’s investment in CC), B ends up with net HK$ assets of 5 units and equivalent net foreign liabilities. The HK$ LDR rises to 105%, putting upward pressure on HK$ interest rates. (Exhibit 6 in the full report on Client Link shows all this.) Thus far, we have yet to observe aggregate net outflows from the HK$ and higher LDR. This is because in the above analysis, we isolated the effects of an IPO and its subsequent fund repatriation, disregarding other flows into and out of the HK$ (i.e., current account flows, fiscal reserves movements and other capital flows). Nevertheless, this exercise was aimed at illustrating how the banking system in Hong Kong has become the main counterparty for the non-financial sector trade and investment flows, and the resulting changes in the HK$ LDR, liquidity conditions and interest rates. Further HK$ weakening to lift interest rates? Under Hong Kong’s currency board arrangement, further weakening of the HK$ to the weak end of the 7.75-7.85 band could trigger the Convertibility Undertaking (CU), where the banking system could put HK$ to the HKMA at HK$7.85/US$. The resulting drain on interbank liquidity would then lift HK$ interest rates and rebalance the demand for HK$. In fact, we believe that strong confidence in the system should halt the current trend before the CU is triggered. Further narrowing of the HIBOR-LIBOR discount should already prompt some unwinding of ongoing carry trades as the HK$ nears its limit on weakness and upside risk to the exchange rate increases[1]. Retail deposit and lending rates — up to the big banks The rise in interbank interest rates has heightened expectations of a rebound in bank lending and deposit rates after the cuts in November 2006. Interbank interest rates have already reached a level where deposit and lending rates should be raised. Nevertheless, while retail deposit and lending rates have been completely liberalized, decisions on adjustments remain dominated or led by the big banks in Hong Kong. These large banks generally have lower loan-deposit ratios, and therefore more incentive to keep deposit and lending rates low. In other words, while the current level of interbank interest rates calls for a hike in deposit and lending rates, the timing of such a hike will depend on when a dominant large bank in Hong Kong takes the first step. This is likely to happen when such a bank sees migration away from savings deposits. Thus far, we have continued to see robust growth in HK$ savings deposits (+17.6% YoY in 1Q07). Nevertheless, HSBC and Hang Seng Bank have openly commented that they are in the process of considering a rate hike, depending on the movements in interbank rates over the next two weeks. We believe that a hike is likely within the next few weeks. Monetary conditions outlook and interest rate forecasts Forecasting monetary conditions and interest rates for Hong Kong remains a challenging task, due to the openness of the economy and the large size of its capital markets and capital flows relative to the economy. In particular, fundraising and repatriation activities — and their timing — will continue to result in significant fluctuations in monetary conditions. We continue to expect respectable fundraising activity in the Hong Kong market this year, with our Hong Kong equity strategy team forecasting total IPOs of US$31.6 billion, albeit down from US$42.6 billion in 2006. Allowing for repatriation of the funds raised, and coupled with continued monetary tightening in Europe and Japan, we had forecast generally less buoyant liquidity conditions to halve the three-month HIBOR-LIBOR spread from 146bp at the end of 2006 to 75bp by the end of 2007. This normalization appears to have taken place much faster than we expected, calling for a hike in deposit and lending rates that we did not include in our previous forecasts, as our US economics team expects some easing in LIBOR in 2H07 to price in official rate cuts expected in 2008. Needless to say, monetary conditions and interest rates could well fluctuate a great deal around our normalization trajectory. While IPO candidates do indicate targeted dates for their listings, it is unfortunately extremely difficult to predict the timing of the repatriation of their proceeds. Specifically, on concerns over the rapid accumulation of FX reserves, the Chinese authorities have encouraged companies that have raised offshore funds to hold on to their foreign currency proceeds, and then gradually pace the repatriation. Given the role that Hong Kong continues to play as a fundraising center for Chinese (and other foreign) corporates, the timing of fundraising companies’ repatriation of funds could remain a significant yet unpredictable factor in guiding monetary conditions in Hong Kong going forward.
[1]We believe that this is what took place on May 30, as the unwinding of carry trades triggered by the jump in HIBOR led the HK$ to strengthen by 0.2% to 7.804/US$.
Important Disclosure Information at the end of this Forum
April Current Account Surplus Narrows
May 31, 2007
By Chetan Ahya, Tanvee Gupta | Mumbai
Current account surplus narrowed to nine-month low: Thailand’s April current account surplus stood at US$0.04 billion, compared with US$2.3 billion in March. The weakening in the current account surplus came on the back of decline in the trade balance to -US$0.10 billion (versus US$2.2 billion in March). However, net services, income and transfers expanded to US$140.6 million (versus US$56 million in March). Import growth accelerated across all segments: On a custom basis (baht terms), import growth accelerated to 2.1% YoY following a decline of 9.6% YoY in March. On a BoP basis (US$ terms), imports grew 11.2% YoY (versus +0.5% YoY in March). Specifically, consumer and raw materials and intermediate goods import growth (baht terms) accelerated to 6.3% and 6.5% YoY (versus -5.7% YoY and 3.1% YoY in March). The capital goods import growth (baht terms) remained in negative territory at -2.6% YoY (versus -14.8% YoY in March). Export growth decelerated in April: Export growth decelerated on a BoP basis (US$ terms) to 16.5% YoY (versus +19% YoY in March), while on a custom basis (baht terms) it slowed to 7% YoY (versus 7.1% YoY in March). On the custom basis (baht terms), segments such as chemicals and machinery decelerated to 4.6% YoY and 4.8% YoY (versus +10.2% YoY and 7.2% in March).
Important Disclosure Information at the end of this Forum
Disclosure Statement
The information and opinions in this report were prepared or are disseminated by Morgan Stanley & Co. Incorporated and/or Morgan Stanley & Co. International plc and/or Morgan Stanley Japan Securities Co., Ltd. and/or Morgan Stanley Dean Witter Asia Limited and/or Morgan Stanley Dean Witter Asia (Singapore) Pte. (Registration number 199206298Z) and/or Morgan Stanley Asia (Singapore) Securities Pte Ltd (Registration number 200008434H) and/or Morgan Stanley Taiwan Limited and/or Morgan Stanley & Co International plc, Seoul Branch, and/or Morgan Stanley Dean Witter Australia Limited (A.B.N. 67 003 734 576, holder of Australian financial services licence No. 233742, which accepts responsibility for its contents), and/or JM Morgan Stanley Securities Private Limited and their affiliates (collectively, "Morgan Stanley").
Global Research
Conflict Management Policy
This research observes our conflict management policy, available at www.morganstanley.com/institutional/research/management_policies.html
Important Disclosures
This report does not provide individually tailored investment advice. It has been prepared without regard to the circumstances and objectives of those who receive it. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages them to seek a financial adviser's advice. The appropriateness of an investment or strategy will depend on an investor's circumstances and objectives. This report is not an offer to buy or sell any security or to participate in any trading strategy. The value of and income from your investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized.
With the exception of information regarding Morgan Stanley, reports prepared by Morgan Stanley research personnel are based on public information. Morgan Stanley makes every effort to use reliable, comprehensive information, but we do not represent that it is accurate or complete. We have no obligation to tell you when opinions or information in this report change apart from when we intend to discontinue research coverage of a company. Facts and views in this report have not been reviewed by, and may not reflect information known to, professionals in other Morgan Stanley business areas, including investment banking personnel.
To our readers in Taiwan: This publication is distributed by Morgan Stanley & Co. International plc, Taipei Branch; it may not be distributed to or quoted or used by the public media without the express written consent of Morgan Stanley. To our readers in Hong Kong: Information is distributed in Hong Kong by and on behalf of, and is attributable to, Morgan Stanley Dean Witter Asia Limited as part of its regulated activities in Hong Kong; if you have any queries concerning it, contact our Hong Kong sales representatives.
This publication is disseminated in Japan by Morgan Stanley Japan Securities Co., Ltd.; in Canada by Morgan Stanley Canada Limited, which has approved of, and has agreed to take responsibility for, the contents of this publication in Canada; in Germany by Morgan Stanley Bank AG, Frankfurt am Main, regulated by Bundesanstalt fuer Finanzdienstleistungsaufsicht (BaFin); in Spain by Morgan Stanley, S.V., S.A., a Morgan Stanley group company, which is supervised by the Spanish Securities Markets Commission (CNMV) and states that this document has been written and distributed in accordance with the rules of conduct applicable to financial research as established under Spanish regulations; in the United States by Morgan Stanley & Co. Incorporated, which accepts responsibility for its contents. Morgan Stanley & Co. International plc, authorized and regulated by Financial Services Authority, disseminates in the UK research that it has prepared, and approves solely for the purposes of section 21 of the Financial Services and Markets Act 2000, research which has been prepared by any of its affiliates. Private U.K. investors should obtain the advice of their Morgan Stanley & Co. International plc representative about the investments concerned. In Australia, this report, and any access to it, is intended only for "wholesale clients" within the meaning of the Australian Corporations Act.
Trademarks and service marks herein are their owners' property. Third-party data providers make no warranties or representations of the accuracy, completeness, or timeliness of their data and shall not have liability for any damages relating to such data. The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of MSCI and S&P. Morgan Stanley bases projections, opinions, forecasts and trading strategies regarding the MSCI Country Index Series solely on public information. MSCI has not reviewed, approved or endorsed these projections, opinions, forecasts and trading strategies. Morgan Stanley has no influence on or control over MSCI's index compilation decisions. This report or portions of it may not be reprinted, sold or redistributed without the written consent of Morgan Stanley. Morgan Stanley research is disseminated and available primarily electronically, and, in some cases, in printed form. Additional information on recommended securities is available on request.
|
