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Peru Peru: On the Right Path China Pork Crisis and Timing of the Next Rate Hike View GEF Archive

		The Global Economics Team

			Qing Wang
Qing Wang is an Executive Director and Chief Economist for Greater China.
		Read about other GEF team members

We suspect that Peru’s recent economic success is not merely an extension of supportive global conditions; rather, Peruvian policymakers deserve part of the credit. Since emerging from a brief recession in 2001, Peru has experienced an enviable mix of strong GDP growth above the 5% mark, muted annual inflation averaging less than 1.5% and, more recently, twin fiscal and current account surpluses.  Meanwhile, Peruvian authorities have taken aggressive steps to improve the public debt’s profile, deepen local markets and build up international reserves; more timid yet positive moves are taking place on the tax and public-spending efficiency fronts.  In addition, from its first day in office, the new administration has shown a commitment to addressing Peru’s wide income inequalities, which represent a challenge to political stability (see “Peru: The Abundance Divide”, GEF, week of March 14, 2006).

On the right path

The talk that Peru is on the brink of reaching investment grade is growing louder.  Peru has made significant improvements in a series of external solvency and liquidity measures.  Indeed, based on our macro radar framework, Peru is converging towards and even exceeds investment grade criteria.  The macro radar charts summarize a series of key credit metrics — which we believe best capture sovereign credit risk — for a given country relative to benchmark values.   Indeed, by these metrics, Peru seems to be ahead of Brazil and Colombia in the race for the next major Latin American investment-grade credit.  First, Peru underperforms the benchmark in only five fields compared to seven for both Brazil and Colombia.  Second, Peru’s average shortfall — as measured by the standard deviation from the benchmark — is comparable to Colombia’s and roughly half in magnitude that of Brazil.   

In several of the areas where Peru falls short of the investment grade benchmark, the country is making meaningful progress, in our view, lending further support to our belief that Peru is on the path towards investment grade.  While the liquidity and solvency measures are not fully independent, we have singled out three solvency areas in which Peru still lags the benchmark: GDP growth rate, investment to GDP ratio and debt service to exports ratio.  Whereas liquidity variables show no clear relationship with ratings, solvency measures — such as the three we are focusing on — do.

Debt service to exports has declined significantly from around 33% of total exports on average in 2000-2005 to half of that in 2006.  A major part of the improvement, of course, comes from the significant terms of trade shock that Peru has enjoyed.  Commodities such as copper, gold and zinc account for around three-quarters of total merchandise exports.  In the 12 months ending March 2007, Peru’s export price index stood 75% above its 10-year average, leading exports to swell to US$24.8 billion, or 26% of GDP, from just 13% of GDP in 2000.  But there is more to the story than just higher export prices. 

Peruvian authorities have embarked on an aggressive liability management strategy, aimed at reducing external debt, extending maturities, reducing interest costs and smoothing out the amortization profile.  In late February, Peru exchanged US$3.6 billion in Bradies and a global 2012 for new, longer-dated securities and cash.   The transaction not only extended the overall maturity of the external debt stock by over one year, but also reduced the heavy amortizations lumped in the 2011-2015 period when nearly half the total external debt stock was due.  Indeed, average amortizations over this period declined to US$1.7 billion from US$2.0 billion. 

On May 23, the Paris Club accepted the offer from Peru’s government to pre-pay some US$2.6 billion in debt due 2007-2015.  The amount represents the commercial portion of the debt owed to the Paris Club, which totaled US$5.6 billion at the end of 1Q.  Assuming that all creditor countries take part in the transaction, we estimate that external debt would decline from 22.5% of GDP at the end of 1Q to less than 21.0% of GDP.  The bulk of the financing for the deal will be in the form of long-dated local currency bonds, with the rest coming from external sources and/or public sector savings.  With external obligations still accounting for a relatively high share of around 70% of total public debt, the Paris Club deal further underscores Peru’s commitment to fiscal prudence and aggressive liability management. 

On the real GDP growth front, Peru is likely to catch up with the investment-grade benchmark by 2008.  Based on consensus estimates, Peru’s 5-year average growth will move above the 6% threshold this year.  While this would still leave it short of the projected 2007 benchmark pace of 6.5% — using IMF estimates — such a high average growth rate is unlikely to be a barrier limiting a potential upgrade.

While Peru’s economy will not be immune to a correction on the commodity front, we would argue that Peru’s ongoing boom is today more than just a derivative of high metal prices.  While primary sectors sparked the initial upswing, the drivers of growth have progressively shifted towards non-primary sectors more closely linked to domestic demand. 

In the early stages of the recovery that began in mid 2001, export-linked primary sectors — agriculture, mining, fishing and certain manufacturing industries, which represent around a fifth of the economy — contributed about half of total GDP growth.  Increasingly, however, the ongoing expansion has had a domestic demand flavor to it.  In early 2007, our calculations suggest that the primary sector contributed around 5% of total value added growth, a far cry from the experience of 2001 and the lowest contribution in the current cycle.  In turn, this trend — combined with the cushion from Peru’s dual surpluses — should make the economy less susceptible to a global downturn.  The shift towards domestic demand-led growth is not a new trend; however, it is worth highlighting because the drivers of consumption and investment appear to be consolidating at the same time that export volume growth — in part due to declining output from Peru’s largest gold mine — has come to a standstill.

Investment spending is a third area where Peru ranks poorly, falling short by nearly 1.5 standard deviations from the predicted investment-grade benchmark.  While the underperformance is significant, the trend is moving in the right direction.  Part of the improving story is undeniably cyclical in nature and closely linked to the commodity boom.  Indeed, the central bank notes that in the 2007-2011 period, there is a healthy pipeline of over US$21 billion in major investment commitments — historically representing about 20% of total investment — of which half are mining-related.  With the economy in its sixth year of continuous expansion, moreover, businesses sentiment is riding high.  The most recent March central bank survey of nearly 400 firms showed that 58% of participants expect improved business conditions in coming months, up from 38% a year earlier. 

Against this supportive cyclical backdrop, however, we would argue that authorities also deserve credit for the improving investment conditions.  We would highlight two aspects on the policy front: the new administration’s pro-investment actions and its commitment to prioritize capital expenditures.  

The administration’s commitment to attracting investment is best underscored by its unfaltering support for the free-trade agreement with the US.  Despite a series of setbacks — including local opposition and, above all, US concerns over labor standards and the environment — Peruvian authorities were quick to address them.  Beyond the potential boost to investment and confidence that would accompany a successful ratification of the FTA, historically such agreements have produced significant reform momentum. 

Secondly, since the announcement of the ‘investment shock’ in the second half of the year, fiscal policy has focused on lifting public investment while maintaining current outlays in check.  To be fair, while the government’s commitment is present, the results have so far been rather disappointing.  In the first quarter of the year, for example, public investment contracted 4.3%, underscoring the inability of local governments to execute projects in a timely fashion.  The delays appear to have emerged from a combination of local authorities’ taking office only in early 2007, the aftershocks of recent political scandals linked to misuse of public resources and, more concerning, insufficient technical skill among local authorities.  So far, the public sector has generated significant savings from the current abundance; however, there is a risk that the combination of rising pressures to spend and recent moves to ease the procedures for public investment will not necessarily lead to more efficient, timely execution in the near term.  

With Peru seemingly on a clear path towards investment grade, the question of timing naturally follows.  Our previous work suggests that as the credit approaches the investment-grade threshold, it takes longer for upgrades to take place (see “Brazil: The Abundance Upgrade”, GEF, March 8, 2006).  Historically, it took countries around 27 months to earn an upgrade to investment grade.  Accordingly, an upgrade from S&P, which last moved Peru to BB+ in November 2006, could be an early 2009 event.  A second conclusion is that at least one upgrade by Moody’s, which trails S&P by two notches and last upped Peru in 1999, is long overdue. 

During the current age of abundance, when external public debt is slowly moving into the list of endangered species, it is important to ask what the foreign currency sovereign rating really means.  Should it be strictly limited to the ability and willingness to service the stock of external obligations? This is particularly important for the timing of any future upgrades, since Peru is a country where liquidity and solvency ratios are converging or even exceed investment-grade criteria but where institutional and social challenges remain significant in the context of a still untested administration.  As we have highlighted in the past, Peru’s most significant challenge — from a broader country risk standpoint — is to ensure that the benefits of Peru’s impressive growth lift the living standards of nearly half the population still in poverty.    While actions by the administration have reflected a clear understanding of the urgent need to ease Peru’s vast income disparities, the risk of social unrest — with implications for governability — is one that could delay an eventual upgrade even as external liquidity and solvency metrics improve.

Bottom line

Peru’s boom is not merely a reflection of supportive global conditions; instead, Peruvian policymakers deserve part of the credit as well.  Against this favorable backdrop, we would argue that Peru is on the right path towards an eventual upgrade to investment grade.  But even as the fundamental improvement in the Peruvian economy and sound policymaking are worthy of praise, social stability could remain elusive insofar as the benefits of Peru’s impressive growth run fail to lift the living standards of nearly half the population still in poverty.  Indeed, in a period when external vulnerabilities are falling and solvency ratios are steadily improving, the challenges of strengthening institutions and efficiently channeling public investment to help ease Peru’s vast income disparities could make Peru’s path to investment grade a lengthy one.

China
Pork Crisis and Timing of the Next Rate Hike
June 05, 2007

By Qing Wang | Hong Kong

Summary and conclusions

The recent surge in pork prices and its likely impact on headline CPI inflation in May has raised the prospect of an earlier-than-expected rate hike.  Meanwhile, the A-share market has been under significant selling pressure since the threefold hike in stamp duty from 0.1% to 0.3% last Wednesday (May 30).

In light of the reported surge in pork prices of late, and given pork’s respectable weight in the CPI basket, we expect China’s May CPI statistic to show an acceleration in YoY inflation above 3%, after 2.8% in the first four months.  Another 3%+ YoY headline CPI reading in May would, ceteris paribus, justify another hike in base rates within the next month or two, in our view.  Although headline inflation remains largely driven by the surge in food (e.g., pork) prices, we believe that the latter offers evidence of underlying demand-driven inflationary pressure stemming from loose monetary conditions.  Nevertheless, if the stock market remains under selling pressure relating to the MoF’s hike in the stamp duty on stock transactions, the PBoC will likely choose to hold rates unchanged in the short term.  Eager to effect a soft landing in the stock market, the PBoC would likely be cautious about delivering another rate hike that might exacerbate bearish market sentiment.  Conversely, if the stock market quickly shrugs off the stamp duty hike, rebounds strongly and even tests new highs, the probability of an imminent rate hike would rise substantially, in our view.  We stand by our call for two more rate hikes for the remainder of the year.

At the current juncture, another 3%+ YoY headline inflation reading in May is a necessary but not sufficient condition for an imminent rate hike, in our view. The timing of the next rate hike will hinge on the performance of the stock market.

Pork crisis and monetary policy response

The rapid rise of pork prices in China has caught the attention of the international press, as well as Chinese political leaders.  According to the Ministry of Commerce, the average pork prices in mid- and large-size cities increased by 43% YoY in the first three weeks of May.  Several supply-side factors have been identified as contributing to the surge in pork prices — in particular, widespread disease and the rising cost of raising hogs.

Nevertheless, we are not convinced that this price surge is an isolated event or purely a supply-side story.  We note that, besides pork, other food items — including fresh eggs — also experienced sharp price increases.  We think that these price increases are symptomatic of general demand-side pressure.  Specifically, in our view, the recent sharp rise in food prices — which has pushed headline inflation above 3% since March — actually reflects the lagged effect of strong broad money (M2) growth 12 months ago.

We elaborate on our argument that the recent price surge embodies a demand-side story with a simple example.  Assume that Country A only consumes two kinds of goods, food and clothing, each accounting for a 50% weight in the consumption basket.  Moreover, Country A has a large pool of surplus labor and tends to overinvest in the clothing-producing industry, so that it always produces more clothing than it can consume and thus exports the rest.  In this context, firms in the clothing-producing industry have little pricing power.  If Country A’s central bank runs a loose monetary policy and stimulates domestic demand, the resulting inflationary pressures will manifest itself first and foremost in the increase in food prices rather than in clothing prices.  In a demand-supply framework, because the supply curve for clothing shifts to the right (driven by overinvestment) much more readily than that for food, the price increase in response to a positive demand shock (driven by loose monetary policy) would be much more pronounced in food than in clothing.

Such an example, though rather crude, broadly fits China’s reality, in our view.  Specifically, food items and manufactured goods currently account for about one-third and nearly 40% of China’s CPI basket, respectively.  Based on the above analysis, food items are the most sensitive to change in underlying monetary conditions among the CPI basket components, in our view.  In other words, inflationary pressure stemming from loose monetary conditions tends to be reflected in food price inflation first.  In China’s context, attributing food inflation merely to supply-side factors —as is the usual case in many other countries —tends to underestimate the inflationary consequences of loose monetary policy.

To reiterate, the latest episode of accelerated food inflation should not be attributed to idiosyncratic supply shocks.  It should instead be taken as new evidence of underlying inflationary pressure.  Drawing such a distinction is important.  If the price surge is purely a negative supply shock story, tighter monetary policy is warranted only to the extent that it can help contain the second-round effects.  Further, if the supply shock is temporary, there is in fact no need for a monetary policy response.  However, if it is a demand-side story (positive demand shock), which we believe is currently the case in China, tightening monetary policy through rate hikes is far better justified.  This is why we think that if headline CPI inflation were to post another 3%+ YoY reading in May, it would, ceteris paribus, justify another hike in base interest rates within the next month or two.

Timing of the next rate hike

May CPI data are scheduled to be released next Tuesday, June 12.  Meat and eggs account for more than 10% of the CPI basket, according to our estimates.  A 30% YoY rise in meat and eggs prices already contribute 3 percentage points to overall CPI inflation.  Although we believe that another 3%+ YoY CPI reading would justify a rate hike, the exact timing of the next rate hike will hinge on the performance of the stock market, even if the PBoC considers CPI inflation instead of asset price inflation as its primary policy objective.

There are three scenarios concerning the stock market in the coming months:

Scenario I: The stock market remains under strong selling pressure in the wake of the MoF’s hike in stamp duty on stock transactions.  The PBoC may choose to hold rates unchanged for the time being under this scenario.  Eager to effect a soft landing in the stock market, we believe that the PBoC would likely be cautious about delivering another rate hike, lest it exacerbate current bearish market sentiment.

Scenario II: The stock market quickly shrugs off the stamp duty hike, rebounds strongly and even starts testing new highs.  We believe that, under this scenario, the probability of another imminent rate hike would rise substantially.

Scenario III: The stock market stabilizes at current levels.  Calling the timing of the next rate hike is more difficult.  For the PBoC to hike rates under this scenario, a little extra push or justification is perhaps needed.  We think that this extra push could come from readings of the upcoming fixed-asset investment (May data to be released next Friday, June 15) and bank credit growth (May data to be released any time next week) data.  Data showing a sustained rebound in growth would warrant a hike in base lending rates, and also in base deposit rates, as we believe that future rate hikes should be symmetric (i.e., both lending and deposit rates to be raised by the same magnitude).  On the other hand, should the data show a visible slowdown in fixed asset investment growth, which may not be too surprising in view of the NDRC’s recent policy announcement (see China Economics: NDRC Launches New Administrative Effort to Curb Investment, May 29), the timing of the next rate hike will become much more uncertain, in our view.

Bottom line

At the current juncture, another 3%+ YoY headline inflation reading in May is a necessary but not sufficient condition for an imminent rate hike, in our view.  The timing of the next rate hike will hinge on the performance of the stock market.

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