Food Inflation: Structural or Cyclical?
June 29, 2007
By Chetan Ahya | Mumbai
Summary
Across many countries, inflation in food products has been one of the challenges facing policy makers. YoY growth in the foodstuff component of the CRB commodity index has accelerated to 29% as of June 2007 from 4.2% as of October 2006. Indeed, the food component of CPI in OECD countries has also accelerated to a 12-year high of 3.6% as of April 2007. India is no different. Despite the recent deceleration, food inflation continues to contribute about 20% of overall wholesale price inflation (WPI). Indeed, the percentage point contribution of food inflation has risen steadily over the past three years – averaging 0.2% points in F2004, 0.4% in F2005, 0.8% in F2006 and 1.2% in F2007. The rise in food prices is also resulting in a sharper acceleration in CPI. Indeed, CPI for rural workers, which has a high weighting to food products, has been around 8-9.5% for the past eight months. Which segments have driven food inflation? The food inflation segment of the WPI has accelerated steadily over the past three years. Inflation for this segment accelerated to an average of 7.7% YoY in F2007 from 4.9% in F2006, 2.7% in F2005 and 1.3% in F2004. The key driver to this acceleration has been the food grain segment. Inflation in food grains has accelerated to an average of 10.1% in F2007 from 1% in F2004. The other key components that have driven food inflation higher have been the milk and poultry products. Within food grains, both cereals and pulses have seen a steady pick-up. Inflation for the cereals segment has accelerated to 7.2% in F2007, while the pulses segment has moved up sharply to 30.4%. This forced the government to initiate several measures to control inflation in food grains. The most important among them has been the government’s focus to increase wheat stocks by importing. However, food inflation continues to remain a threat We believe that the acceleration in food inflation in India was hardly cyclical — there are structural supply and demand-side problems. There has been a clear deceleration in supply growth over the last few years due to host of problems facing the farm sector — most of these are deep-rooted issues. For instance, food grain output has declined at an average rate of -0.1% over the last five years compared with 1.3% growth in five years ending March 2002 and 3.4% during the five years ending March 1997. Indeed, in the last five years, average growth has been below the country’s population growth. In the case of fruits and vegetables as well, production growth has slowed to an average of 2.5% between F2001-06 from 5.5% during the 1990s. In the case of milk, production growth has slowed to an average of 3% of F2001-05 from 4.3% in the 1990s. This, coupled with higher demand from skimmed milk powder exports and higher value products (for domestic consumption), has led to a steady rise in prices. Food imports have increased by 32% YoY during the 12-month period ending January 2007 (data for post January are not available) — a key contributor to this acceleration has been wheat imports. Productivity growth has stagnated. On a trailing five-year basis, yield per hectare for major crops such as rice has increased by only 0.1%, while for wheat it has declined at an average rate of 1.1%. Yields for these two major crops in India are 46% and 19% lower than China (using average yields for five years ending 2005). The state and importance of the farm sector was aptly described by the Prime Minister in a recent speech: “Small and marginal farms have become an unviable proposition and until we make farming as a whole viable at this scale, it would be virtually impossible to reduce rural poverty and distress.” As per a recent survey by National Samples Survey Organisation (NSSO), about 40% of the farmers indicated that they do not want to continue to work in the profession. About 55% of the workforce depends on agriculture for their living. Several issues are affecting the performance of the farm sector. First, the most important factor behind the current state has been low spending by the government on agriculture-related infrastructure services. Public investment in agriculture has only recently picked up to 0.5% of GDP in F2006 after averaging 0.4% of GDP in the preceding three years. Spending on irrigation also has been negligible. Only 40.3% of the farming land is irrigated. The average growth in land brought under irrigation has decelerated to 1.5% during F1991-04 compared with 2.4% in the 1980s and 2.7% during 1970s. Second, agricultural land holdings are highly fragmented. About 60% of the farm land area is with marginal, small and semi-medium farmers (about 107 million land-holdings). The average land size per farmer is only 0.005 square miles (1.4 hectares). As pointed out in the Fifth Report of the National Commission on Farmers, these resource-poor farmers are unable to benefit from the power of scale at either the production or post-harvest phases of farming. These farmers are also more vulnerable to adverse weather conditions and high levels of indebtedness. Hence, they are unable to increase investments to improve productivity and growth. Third, the government’s fertilizer policy has distorted the trend in fertilizer consumption and therefore the mix of soil nutrients. While the government subsidizes nitrogenous (N) fertilizer and has decontrolled phosphatic (P) fertilizer and potassic (K) fertilizers, the prices of decontrolled fertilizers are relatively higher than urea (controlled fertilizer). Farmers therefore use more urea, which has a higher nitrogen content. The result is that the NPK ratio in India has deteriorated to 6.4: 2.5: 1, resulting in low productivity. The ideal usage ratio of nitrogen, phosphorus and potassium (NPK) is 4: 2: 1. According to the Planning Commission of India, this is one of the proven and well-documented reasons for stagnation in the productivity and production growth rate since the early 1990s. Hence, it is imperative that the imbalance be corrected. Although the private sector players are trying to educate farmers, the government also needs to adjust the fertilizer pricing policy to encourage farmers to make this shift in fertilizer use mix. There is little hope for a quick solution to the international price rise problem either. Rising per capita incomes, reducing poverty and increased urbanization is supporting the acceleration in demand for some of the basic food items. In many countries (with a higher proportion of non-vegetarians), as the United Nations points out in its report, as income increases, people tend to eat more food and meat. This in turn requires relatively higher amounts of grain to feed the livestock. Global corn prices have also moved up significantly owing to increased demand from ethanol producers. Additionally, this is driving up wheat and soybean pricing, albeit to a lesser degree, as acreage is lost to corn. Good news is that the government is beginning to respond The political implications of the poor growth in the farm sector have forced the government to respond. The adverse conditions have driven thousands of farmers to suicide each year — with the official number pegged at an annual average rate of 3,800 suicides per year for the past nine years. Indeed, certain organizations have estimated this number to be much higher at 20,000 per year. In September 2006, the central government announced a Rs170 billion (US$4.1 billion) rehabilitation package for farmers in four states which had witnessed a spate of suicides. The package, to be implemented over a period of three years, would be spread among 16 districts in Andhra Pradesh, six in Karnataka, three in Kerala and six in Maharashtra. The package also included a US$0.7 billion interest waiver for farmers in these states. In the Union Budget (February 2007), the central government announced that it would increase spending on irrigation by 54% and on the Bharat Nirman programme (which covers power, roads, telecom and housing in the rural areas) by 38%. Both these measures will cumulatively result in additional capex of US$2.2 billion (0.14% of GDP) in F2008. In addition, the government is targeting a net disbursement of US$7.8 billion (or 0.4% of GDP) in farm credit by the end of next year. The government added that it would take action on the recommendations of the Committee on Agricultural Indebtedness as soon as they are received. The government announced additional measures to train farmers and also launched a subsidized insurance scheme for rural landless households. In May 2007, the Prime Minister announced a Rs250 billion (US$6.1 billion) plan for the farm sector by addressing the needs at a grass roots level over the next four years. The details of this spending will be finalized over the coming two months. More importantly, the government is relaxing regulations for the private corporate sector to participate in farm-related activities. Many states have recently amended the Agricultural Produce Marketing Committee (APMC) Act, which in effect was restricting the private sector from directly transacting with farmers. Sixteen states and five union territories have amended the APMC Act allowing private sector participation in direct purchases of agricultural produce from farmers. We believe that this, coupled with the emergence of the organized sector retailing, can prove to be a significant catalyst for the growth environment in the sector. Indeed, private corporate entities are influencing the government policy to improve the business environment for the sector. Bottom line While there is a distinct change in the government’s focus towards this structural problem due to its implications for farmers and inflation, in the near term the food inflation problem is likely to persist. We believe that the upcoming monsoon season and global prices for agricultural commodities will be the two factors influencing the price trend.
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Credit Crunch: Will This Time Be For Real?
June 29, 2007
By Richard Berner | New York
Renewed turmoil in subprime mortgages has evolved into a general — and long-overdue — repricing of risk in other risky assets, including high-yield debt and corporate loans. The troubles at two hedge funds holding CDOs backed by subprime collateral ignited the selloff in subprime mortgages, but the kindling was extremely dry. Rating downgrades in underlying recent-vintage RMBS and CDOs were coming, and the prospect of having a significant volume of CDOs priced in the market made investors realize suddenly that not all of that quality deterioration was in the price of popular indexes of subprime mortgage collateral. The ABX BBB home equity index, which traded at a price over 70 in May, fell to 56 this week, although the stabilizing influence of a cash infusion into one of the troubled funds seemed to calm mortgage markets by week’s end. But high yield and CLO spreads continued to widen, by 10-20 bp on the week. While this renormalization of risk spreads represents a tightening of financial conditions, it is so far proceeding in an orderly way. But in my view, it is far from over; indeed, the events of the past two weeks probably mark the beginning of a significant widening of spreads. Both history and fundamentals suggest than when risk spreads begin to widen after a long period of stability — especially when that stability has encouraged investors to take on more risk — they can overshoot or even turn into a rout. The question now: Could this so-far orderly renormalization now morph into an ugly credit crunch that would slam the brakes on the economy and corporate leverage? I can’t rule that out completely; credit markets are still tender, and a series of shocks could trigger a much more disorderly repricing of risk. And while investors have tested credit derivatives in past credit cycles, like the TMT bust of 2001-02 and the WorldCom/Enron scandals of 2002, new instruments appear constantly. Those associated with the leveraged loan market are untested. But it’s crucial to differentiate between a welcome tightening of lending standards that slows the pace of buyouts and a credit crunch. While evidence of tighter lending standards is growing, there’s no sign of a credit crunch, and I don’t think one is likely. That’s partly because credit quality has yet to deteriorate broadly across the quality or seniority spectrum, and balance sheets in the aggregate are healthy. Importantly, however, fundamentals in lower-rated credits are deteriorating. Financial innovation may have blurred traditional credit-quality metrics, but their verdict is still legitimate: The turn in the credit cycle has begun. There’s no mistaking the very recent and significant tightening of lending standards. In response to rising defaults in subprime mortgages and some deterioration in corporate credit quality, lenders/investors have become more risk averse. The Fed’s Survey of Senior Loan Officers already in April showed that more than half of subprime lenders tightened lending standards, and I have no doubt that recent developments have intensified that risk aversion. By comparison, the same survey revealed that only 15% of surveyed prime mortgage lenders tightened standards. Business lending followed a different path: The Fed survey indicates that on net, business (C&I) lenders actually loosened their standards in the spring, and a smaller share than in January increased loan spreads over bank funding costs. That’s hardly evidence of risk aversion. Three months later, the world has changed. Investors are balking at the narrow spreads, the ‘covenant-lite’ structures, and the ‘payment-in-kind’ issuers’ safety valve in much buyout-related debt. Underwriters are postponing or shrinking debt offerings, and changing terms to favor the growing number of investors who are warily eying a heavy corporate calendar. The next Fed survey, due in July, likely will reflect that sea change in risk appetite. Critically, however, this tightening of lending standards is very different from a credit crunch — when even creditworthy borrowers can’t get ready access to credit. Surveys of credit availability, such as those from small business, show that credit in May was no harder to get than in 2006. And the evidence shows that corporate credit fundamentals in the aggregate remain highly favorable. Nonfinancial corporate balance sheets were pristine at the end of Q1 2007: Credit-market debt in relation to net worth stood close to 34-year lows, while long-term debt in relation to the total and “quick ratios” stand close to record levels. Aggregate earnings growth has slowed to mid single digits in the first half of 2007, but interest coverage ratios are still close to record high levels. Nonetheless, the tails of the credit quality distribution are getting fatter. Look more closely at the high-yield market in the first quarter, and the picture is quite different from the aggregate. As my colleagues Brian Arsenault and Jocelyn Chu noted recently, the fundamentals were already deteriorating significantly last quarter (see “1Q07 Fundamentals — Got Cash?” June 15, 2007). What had been a cash horde has dwindled; cash/debt has fallen a full percentage point over the past year to a below-average level. Leverage (debt to EBITDA) rose to 3.64x as debt outpaced earnings for the second quarter on a row. Slower economic growth and fading operating leverage hurt. In the high-yield universe, top-line growth has turned negative for the first time since 2002, and half the sectors saw margin compression. Finally, these companies are reinvesting aggressively in their businesses, with capex budgets rising by 20%. Such expansion augurs further erosion of returns and margin compression. That deterioration in fundamentals has yet to show up in delinquencies and chargeoffs at banks. They are still close to record lows despite a deceleration in lending, while junk and leveraged-loan default rates are at eight-year lows. Yet Morgan Stanley bank analyst Betsy Graseck and I agree that corporate credit quality has begun to weaken. She is expecting chargeoffs to remain flat this year, but loan provisions to rise 30% as falling recoveries spell the end to the long previous improvement in credit quality. For their part, lenders may now back further away from extending credit for buyout deals. In part, that’s because even a slight reduction in market liquidity will make it more difficult for lenders and underwriters efficiently to lay off risk, so lending standards will likely tighten. Risk spreads should continue to widen significantly in my view, but the process likely will be orderly. A rise in volatility and demands that pricing reflect the underlying collateral rather than structured ratings likely will promote a healthy reordering of relative values. Specifically, CDOs and CLOs that are rated and priced on the basis of their structure may quickly be repriced to reflect the value of their components. Hopefully the ratings will catch up. Some risks are tilted towards a more rapid and less orderly adjustment of the price of and appetite for risk. The uncertainty over the nature and size of investors’ positions and the amount of leverage they hold creates the potential for volatility to rise and risk spreads to overshoot, just as confidence that volatility would stay low kept them persistently tight. Financial or real economic shocks could result in a disorderly repricing. Ironically, however, other risks may tilt in the opposite direction. The frenzied deal environment of the recent past may have given CFOs an incentive to leverage the capital structure at the expense of capital spending to grow their business. It just may be that, so long as the repricing of risk is orderly, a less-favorable deal backdrop may rechannel animal spirits into business capex.
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Energy Factors & Falling Core-of-Core to Offset
June 29, 2007
By Takehiro Sato | Tokyo
Tokyo metropolitan core CPI a bit of a negative surprise The May nationwide core CPI was a non-surprise, at -0.1% YoY and unchanged from April, but the June Tokyo metropolitan core CPI dipped unexpectedly, to -0.1% YoY, led by recreational services. The US-style core deteriorated slightly, with both the nationwide and Tokyo metropolitan down to -0.3% (last month: -0.2%). So, the overall impression was slightly weak, despite the headline. The main downside factors in the Tokyo metropolitan CPI were overseas package tours, hotel rates and shirts/sweaters/undergarments. These categories are the most likely to appear similarly in the next June nationwide figures, so we look for the June nationwide core to mark a fifth straight month of negative performance, at -0.1% YoY, even if prices for petroleum-related products rise. Raising our outlook for the Japan-style core due to higher landed oil prices Assuming current levels of landed oil prices, however, we expect the Japan-style core CPI to recover to flat YoY in July and fall back into negative territory (from -0.2 to -0.1% YoY) in August-October, but then return to 0% or higher from November as the oil price factor makes a positive contribution. Consequently, we think that the 0.3% YoY fall in the core CPI in March may well have been the bottom for the current year. If so, we would expect the nationwide core to be 0.0% YoY for the average of F3/08 (-0.1% for C2007), closer to the median forecasts in the BoJ Policy Board’s outlook. Our monetary policy outlook also revised We had expected a pace of one rate hike every six months but no rate hike in the summer because of the negative CPI rate. It has become clear, however, that the current price trends matter less to the BoJ than we expected. In addition, the BoJ maintains that it can smoothly realize sustained economic activity and prices in line with its forecasts if it adjusts its policy rate as the market expects. We thus find it difficult to continue to ignore the fact that the OIS market has priced in an almost 100% probability of a summer rate hike, and we abandon our previous, out-of-consensus forecast, and now expect the next rate hike to come at the August 22-23 meeting, more or less as we expected before the February rate hike. As difficult as it is to take losses on negative-carry positions, it is we who must take responsibility for having misjudged the BoJ’s level of conviction. The BoJ will likely then stick to a pace of one rate hike every six months thereafter, and not particularly pick up or slow down the pace. This policy stance will probably be maintained under the new governor starting in March 2008, assuming it is Deputy Governor Toshiro Muto, as the market expects, and that the economy does not slow substantially. We thus forecast a target policy rate of 1.00% at end-March 2008 and 1.50% at end-March 2009. Even so, we also think there is potential for the kind of policy mistake that we consider below. BoJ has taken the risk of prices not picking up meaningfully for a long time to come An August rate hike, in line with the consensus market expectation, would be a non-event for the market. However, rate hikes in a disinflationary environment would not be steadily supported by fixed-income investors, would tend to lead to further bear flattening of the yield curve, and are incomprehensible to overseas stock investors. Policies that aim to curb overheating of the economy and asset prices come with the risk that ultimately consumer prices will be held down for a considerable length of time. Moreover, in the eyes of overseas investors, they could make it appear that Japan’s monetary and financial authorities are reluctant to have the asset market be propped up by easier monetary conditions. Add this to corporate moves to introduce anti-buyout measures and there is a risk that domestic asset markets could underperform internationally for quite some time. Moreover, according to the aforementioned BoJ logic, one risk is that the market may push the BoJ to raise rates more quickly. The BoJ still believes that raising rates in line with the market’s expectations will lead to sustained growth, which the BoJ outlined in its Outlook Report, but this view suffers from circular reasoning. In other words, if the market expects a rate hike sometime soon, the BoJ feels all the more need to hasten its rate hike cycle, resulting in a situation similar to a dog chasing its own tail. The rate hike cycle would move up regardless of the latest economic trends, but with the YoY change in prices close to 0%, a slowdown in the economy would make further rate hikes difficult. In other words, since BoJ policy has become overly sensitive to the risk of inflation, resistance to the risk of an about-turn into deflation is low. We must assume that this is a risk the BoJ has taken with full awareness of the implications.
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