India
Interest Rates — On a Clear Downtrend
July 26, 2007

By Chetan Ahya | Mumbai

Liquidity conditions changing dramatically

The recent sharp spike in foreign inflows and continued intervention by the RBI in the foreign exchange market has resulted in a sharp rise in liquidity. Having already allowed 9.3% appreciation in the rupee since early March, the Reserve Bank of India has again been intervening in the FX market to moderate the pace of appreciation. This, at a time when credit growth is decelerating, has resulted in market-oriented interest rates declining meaningfully over the last three weeks. The incremental credit-deposit ratio has declined to a 34-month low of 71.2% as of June 2007. The 91-day T-bill and 10-yr G-sec rates have declined by 265bp and 38bp, respectively, in the last three weeks. Indeed, the 91-day T-bill rate has dipped below the reverse repo rate (the policy rate at which the RBI absorbs excess liquidity) for the first time since May 2004. The surplus liquidity conditions have led to a fall in the inter-bank call rate to an all-time low of 0.5% (on average) in July. This trend is now beginning to be reflected in banks’ deposit and lending rates. Many banks have also reduced their one-year deposit rates by about 50bp and have stopped resorting to expensive bulk deposits. ICICI Bank and HDFC have already cut their mortgage lending rates by 50bp and 25bp, respectively.

A sudden reversal in monetary policy?

While just about four months back, the RBI was tightening monetary policy aggressively, in the last few weeks it has chosen to leave the money market awash with liquidity, allowing market-oriented rates to fall sharply. If the RBI had desired to ensure that liquidity conditions remain tight, it could have initiated measures to absorb excess liquidity. Some of the options that the RBI could have used are:

Increase issuance of market stabilization scheme (MSS) bonds: The RBI has been issuing T-bill and dated securities under the MSS to absorb surplus liquidity in the money market. The RBI can issue MSS bonds up to Rs 1,100 billion. However, the RBI has not been aggressive in issuing MSS bonds in recent weeks. Indeed, the outstanding MSS balance has declined to Rs787 billion as of July 13, 2007, from its peak of Rs888 billion on May 18, 2007.

Increase limit for reverse repo: Currently, the RBI has capped the maximum amount it can absorb through the daily reverse repo auctions at Rs 30 billion. The RBI could have increased this limit so as to lift the effective floor rate in the money market.

Increase in cash reserve ratio: Absorbing excess liquidity through both the MSS and reverse repo results in some fiscal costs due to relatively high domestic interest rates. As a result, the RBI could have hiked cash reserve ratio.

However, instead of aggressively sterilizing excess liquidity, the RBI has chosen to allow market-oriented rates to drift lower, as it appears to be less concerned about the overheating of the economy.

Meaningful correction in growth underway

We believe that the RBI is drawing comfort from the fact that growth is slowing and symptoms of overheating are less concerning. Some of the key cyclical indicators show clear signs of significant deceleration in growth, including:

Commercial vehicles and two-wheeler sales are declining (YoY %): The earliest indicator to reflect the slowdown has been automobile sales growth. In all three segments — passenger, two-wheeler and commercial vehicles — growth has decelerated significantly. Indeed, two-wheeler sales growth has been declining on a YoY basis for the past three months now, while commercial vehicle sales growth has slowed to the single-digit level.

Bank credit growth has retraced almost one-third from peak: Bank credit growth has moderated to 24.2% as of July 6, 2007 (the last available data point), from 29.3% as of end-February 2007 and 33.1% as of end-June 2006. Indeed, the key driver of the slowdown has likely been mortgage and other retail credit growth. If the current sequential trend is maintained, credit growth will decelerate to 21% by September, in our view.

Rail freight traffic growth has decelerated to a 22-month low: The combined impact of weakening domestic demand and slowing exports is reflected in the deceleration in rail freight traffic growth. Railway freight traffic growth has slowed to 3.9% in June 2007 from 7.4% in QE-Mar 2007 and 9.5% in QE-Dec 2006.

Export growth in rupee terms has decelerated to a 44-month low: Export growth in rupee terms slowed to 6% in May 2007 from 12.3% during QE-March 2007 and 19.3% during QE-December 2006, reflecting the slower growth in the US, stretched domestic capacity utilization in select sectors, and weakening competitiveness due to the rupee appreciation. On a real effective exchange rate basis (REER, trade-weighted rupee adjusted for inflation differentials with trade partners), the rupee is now about 13.8% above its 10-year mean. Indeed, we believe that the full impact of the 9.3% appreciation in the rupee against the US$ (well ahead of other regional currencies) since early March is yet to be reflected in export growth, due to the usual lag from the time orders are received until execution.

The symptoms of overheating have reflected a trend similar to the signs of deceleration in aggregate demand. Inflation excluding food and global commodity-linked products (core inflation) has decelerated to a more comfortable 5.3% during the week ended July 7 from an average of 6.5% in April 2007. Anecdotal evidence suggests that property prices have also stabilized over the last three months after a continued sharp rise over the last three years. There has likewise been a significant decline in property purchase transactions. This is reflected in top mortgage lending player ICICI Bank’s new home loan portfolio, which has declined by 29% during the quarter ended June 2007.

No major change in policy measures on July 31

We believe that the most important indicator for assessing the ‘effective’ monetary policy environment will be banks’ lending rates, which influence the domestic demand and growth outlook. The RBI has been pursuing different types of measures to influence banks’ lending rates. These include adjusting the repo rate (the rate at which the RBI injects liquidity into the banking system), reverse repo (the rate at which the RBI absorbs excess liquidity), cash reserve ratio, risk weighting for bank loans, and issuing market stabilization scheme bonds. The combined impact of these measures on banks’ lending rates determines the ‘effective’ monetary policy environment. In the forthcoming monetary policy statement scheduled to be announced on July 31, we expect the RBI to make no major change in its policy measures.

Our view on the monetary policy outlook is as follows: 

1) We believe that in the coming monetary policy statement, the RBI will convey its comfort with the direction of the current macro trend: At the same time, however, it will probably choose to wait for a few more weeks before giving a clear signal that the issue of inflationary pressures (and overheating) is behind us.

2) No more policy rate hikes: As highlighted in earlier notes, we expect no further policy rate hikes, as growth indicators are already pointing towards a significant further deceleration.

3) The RBI will continue to initiate some measures to sterilize excess liquidity, but may avoid CRR hikes: We think that the decision by the RBI not to sterilize foreign inflows aggressively over the last seven weeks indicates that it is not averse to minor reduction in lending rates, considering the growth outlook. We expect the RBI to continue to sterilize excess liquidity through issuance of MSS and/or increase in maximum limit of reverse repo transactions, ensuring that there is no major decline in lending rates either. Although it would be cost-efficient to hike CRR to manage excess liquidity, we believe that there is a good chance that the RBI will avoid hiking it in the forthcoming monetary policy statement, as this could be perceived to be an aggressive move by market constituents.

4) The RBI will indicate a reversal of monetary policy in 2-3 months: Over the next 2-3 months, as growth trend continues to decelerate, we believe that the RBI will first signal a reversal in the monetary policy stance by announcing softer measures such as a reduction in risk weights for consumer loans and/or reduction in statutory liquidity ratio before opting for a cut in policy rates. Assuming that the current growth deceleration trend is maintained, we see a 40% probability of a policy rate cut in the quarter ended December 2007.

5) We expect banks’ lending rates to fall by 25-50bp over the next two months and about 75-100bp in all from the peak before year-end. 

Over the next 2-3 months, as the growth trend continues to decelerate, we expect the RBI to first signal a reversal in monetary policy by way of softer measures such as reducing risk weights for consumer loans and/or lowering the statutory liquidity ratio (proportion of bank desposits which need to be invested in G-sec) before opting for a cut in policy rates.  

Key risk — global risk aversion

Our outlook for monetary policy assumes that the global risk appetite environment remains unchanged over the next 12 months. We believe that India’s macro linkages to global financial markets are high. Any major reversal in global risk appetite would imply a sharp decline in capital inflows and could result in automatic tightening of the monetary policy and cause a sharper slowdown in growth first before interest rates start declining.

Bottom line

We believe that the current high level of lending rates will continue to cause deceleration in domestic demand growth, thus reducing overheating concerns. The RBI is likely to allow marginal drifting of lending rates over the next two months, but may wait for clearer evidence of growth deceleration and inflation remaining around or below 5% in this period before announcing a formal reduction in policy rates. We believe that banks’ lending rates have already peaked and are likely to drift downwards, although gradually. We expect lending rates to fall by about 75-100bp in all from the peak before year-end.

 

 

 

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Japan
An Inconvenient Truth
July 26, 2007

By Takehiro Sato | Tokyo

Growing concerns about economic support from the monetary side

The economy still appears locked into a moderate medium-term growth track, but several ‘inconvenient truths’ on the monetary front have come to light during the now-customary summer economic lull. While not a threat to the overall economy, these inconvenient truths could be enough to lower our faith in our original scenario of easier monetary conditions allowing monetary-side factors to heat up the economy.  So, downgrading our scenario is a possibility. We are in no rush to do so at this time, though, but will cautiously monitor developments for the time being.

Inconvenient truth (1): Rising bankruptcy numbers

The first inconvenient truth is visible in the rising number of corporate bankruptcies. Bankruptcies in May totaled 1,300 cases or so, above the general trend. The bankruptcy value per case, on the other hand, is on a gentle declining curve, with around ¥280 million for May. What this implies is that an increasing number of small and medium-sized enterprises (SMEs), and small companies in particular, are closing shop.  A rise in bankruptcy numbers typically accompanies economic recovery in its very early phase. This is because SMEs often face funding problems as the demand for working capital is boosted after the economy hits bottom.

Now, is this the case today? In fact, as we discuss later, capital demand at SMEs seems to have been falling recently. Thus, we doubt that the present situation will trigger a rash of bankruptcies because of funding difficulties.

Unraveling the truth will require detailed investigation into the reasons for bankruptcies. But one hypothesis is that tighter credit policies in consumer finance may have accelerated bankruptcies at SMEs. From what we hear, it seems that small businesses running restaurants and bars, for instance, often derive working capital from consumer loan borrowings. If the abolishment of grey-zone loan rates aimed at trimming credit volume is causing a ripple effect as described above, that would be an ironic outcome for policy makers.

Inconvenient truth (2): Downward revisions to land purchasing plans in non-manufacturing

Land purchasing plans for large enterprises in the June Tankan showed a stark split between manufacturing and non-manufacturing. While manufacturers still appeared to be aggressive, non-manufacturers were in low gear. Indeed, plans for non-manufacturing were revised down by 5.9% from the previous March survey. This was the first downward revision ever conducted in June since the survey assumed the present format in 2003.  Overall, plans for large enterprises were revised up by only 1.4%, owing to an upgrade in manufacturing combined with a downgrade in non-manufacturing. This is the second weakest figure ever, behind only the 2.5% downgrade in 2003.

We think that the downward revision in non-manufacturing may have been affected by soaring land prices in cities. We hear that expensive land prices have discouraged developers of condos from acquiring new land in city areas. This seems to be causing developers to limit the sale of new properties for fear of inventory depletions. Also, wholesale retailers may well have finished making forward acquisitions of land before the end of the last fiscal year.

Weak sentiment for non-manufacturers to acquire land in cities could affect the momentum of land price hikes going forward. This coincides with our view that actual land prices in major cities are nearing the peak, as indicated by the notable rise in official land prices, a lagging indicator. If the market is indeed beginning to see land prices peaking already, we will have to be rather cautious about future wealth effects for consumption and investment.

Inconvenient truth (3): Further weakening of capital demand

Recently, bank lending figures have been fairly weak, despite 18 straight months of YoY positive growth. In the July ‘Senior Loan Officer Opinion Survey on Bank Lending Practices at Large Japanese Banks’, results indicated that capital demand is receding further, mainly at SMEs and for home mortgages.  Results like this call into question the effectiveness of monetary policies in boosting the economy. The abovementioned survey showed that capital demand sentiment at SMEs turned down for the first time in eight quarters since April-June 2005. Sentiment for households’ capital demand for mortgages also plunged. The survey mentions as the impetus for stagnant capital demand at SMEs: (i) better funding, (ii) higher interest rates on loans, and (iii) reduction of funds in hand. The former, of course, is in conflict with our empirical rule that funding becomes difficult during the initial stages of an economic recovery, as mentioned in ‘Inconvenient truth (1)’ above. The latter two seem to represent the present situation where companies are working hard to pay back loans by reducing funds in hand for fear of rising interest on borrowing. In other words, this could be seen as a sign that monetary tightening has had an unexpectedly strong impact on corporate financing.

Meanwhile, the survey showed that these banks remain proactive on lending, particularly to individuals and SMEs, which is in stark contrast to how US banks are tightening their attitude towards lending. An aggressive lending stance has, for instance, gradually improved corporate sentiment on funding in the Tankan Survey. Even SMEs reported that their view on funding was neutral (i.e., neither easy nor difficult to obtain). With a relatively relaxed environment for funding, and with companies concentrating on reducing debt by even using their funds in hand, we find it hard to imagine bank lending gaining speed ahead.

Impact of both quantitative and interest rate tightening could penetrate deeper than expected

The inconvenient truths detailed above seem to be a consequence of (1) the self-correcting function of asset markets evident recently in real estate and equity markets and (2) deeper-than-expected penetration by tightening, both quantitatively and via interest rates, especially among SMEs and households. These trends are emblematic of the dichotomy of asset markets and the real economy.  In essence, from the perspective of asset markets, the escape from deflation is already ancient history since the stock market rallied two years ago.  But focusing on the real economy, three of the four checkpoints for the escape from deflation (core CPI, GDP deflator, output gap, unit labor costs) are still below sea-level, making it impossible still to officially confirm an end to deflation.  In addition, asset prices do not appear all that overheated currently, as evidenced in downwardly revised plans for land purchasing by non-manufacturers in the June Tankan, and so further tightening policies could dampen the potential for boosting the economy through monetary accommodation.

The risk is not that the pace of rate hikes will accelerate, but will slow

At Governor Fukui’s regular press briefing on June 18, the BoJ outlined its focus on two pillars for monetary policy in which it examines both pillars in tandem, and assigns equal weights to assess the economy.  However, in comparison to the ‘first pillar’, which is a customary assessment of the economy and prices, the ‘second pillar’ seems to have been introduced originally as stringent risk management or as a contingency plan.  The weakening in the real economy during the summer, however, is subverting much of the BoJ’s first pillar-based rate hike strategy.  As a result, the BoJ is leaning further toward the ‘second pillar’ to justify rate hikes, and contrary to its original scenario, the kind of downside monetary-related risks that we detailed above are stepping to the fore. 

Further, failure by the LDP to retain the majority of Upper House seats in the July 29 election would increase the possibility that Deputy Governor Muto’s expected promotion to BoJ Governor does not go smoothly as the consensus now believes.  Both the Governor and Deputy Governor posts require Diet approval (both Houses), creating a mechanism under the current system in which the government is unable to appoint BoJ leadership even if the Lower House approves the nomination but the Upper House does not. Indeed, even if the Lower House approves the nomination again via a two-thirds’ absolute majority, it cannot override the Upper House’s decision.  With public opinion increasingly hostile to the cushy jobs of the bureaucracy, the chance of a rubber stamp on Deputy Governor Muto’s ascension now seems to be receding.  As a result, the next BoJ Governor appointee could prove to be more dovish to an unexpected degree. 

Near term, an August rate seems almost secure, but the risk is that the pace of rate hikes will slow rather than accelerate, based on the medium-term view in which the BoJ leadership is reshuffled from next March.

 

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Israel
The Case for Normalization
July 26, 2007

By Serhan Cevik | from Istanbul

A low inflation rate does not reflect the aggregate demand-supply balance, in our view.  Global inflation is back in vogue, but Israel still has deflation.  The annual inflation rate was -0.7% in June, compared to 3.5% last year.  Indeed, over the last 12 months, deflationary pressures deepened and moved inflation from an average of 3.3% in the first half of 2006 to 0.9% in the second half and then as low as -1.3% this year.  As a result, with inflation running even below the lower bound of the target range, the Bank of Israel cut interest rates from 5.5% in last autumn to 3.5% this spring.  In our view, there is one simple reason behind the wave of deflation, and that is the shekel’s appreciation.  The dollar’s weakness and economic improvements in Israel led to the shekel’s revaluation, pushing currency-linked prices lower.  For example, the housing sector — accounting for 22% of the consumer price index — recorded a sudden shift in inflation from around 6% in the first half of last year to -6% this year.  Consequently, the headline figure moved from above 3% into the deflationary territory, although the economy has kept growing at an above-trend pace.  This is why we have argued for focusing on underlying trends.  While currency-linked components of the CPI recorded a 4.5% decline in the first five months, consumer prices untouched by currency fluctuations posted a 3.2% increase.  In other words, excluding the exchange rate pass-through effect, inflation has already been above the central bank’s target range.

The shekel’s normalization will remove the veil over hidden inflation.  The details of the CPI show inflation hidden behind the appreciation of the shekel.  Therefore, as the shekel normalizes and reaches a new equilibrium (around 4.10 against the US dollar), we expect a sustained increase in consumer price inflation.  This shift in inflation dynamics is already underway.  Last month, for example, the CPI posted a 0.7% increase — the highest reading in the last five years.  As a result, the annual inflation rate moved from -1.3% in May to -0.7% in June and the cumulative inflation rate reached 1% in the first half of the year.  Although it is still in low territory, we see the accumulated pressure bringing inflation to around 2.5% by the end of this year.

Global pressures and the rise in domestic demand will push inflation higher.  Higher energy prices present a well-known threat, but the world is also facing the risk of food price inflation.  With the shekel’s normalization, global pressures are likely to have a greater effect on the behavior of inflation in Israel.  However, our main concern on the inflation front is domestic developments.  Real GDP growth has averaged 5% over the last three years and accelerated to 6.3% in the first quarter of this year — significantly above the economy’s potential growth rate of around 4.5%, according to our estimates.  That means there is no longer a disinflationary output gap and underlying inflation pressures will likely build up over time (see Mind the Gap, May 29, 2007).  Indeed, the composition of growth is now dominated by domestic demand, thanks to low interest rates and strong growth in employment and disposable income.  Consumer spending grew at an annualized rate of 11.8% in the first quarter, up from 4.8% last year, and the incoming data point to further strengthening in the remainder of the year.

Economic conditions do not justify accommodative interest rates, in our view.  The Israeli economy shows no sign of moderation, with all the indicators pointing to an inflationary surge in domestic demand.  For example, both wholesale and retail sales recorded strong growth (increasing by 8.5% and 6.8%, respectively) in the second quarter.  In our view, the message is clear: interest rates are significantly below the neutral level and therefore inconsistent with the aggregate demand-supply balance in the economy (see The Gapology of Interest Rates, June 11, 2007).  Indeed, the build-up in inflation is already evident in consumer prices excluding the exchange rate pass-through effect.  This is why we welcome the Bank of Israel’s decision to raise short-term interest rates by 25bp to 3.75% and expect further tightening (about 50-75bp) in the remainder of the year. In our opinion, normalizing interest rates would help keep the economy in a ‘sweet spot’ of high growth and low inflation and support the shekel’s secular appreciation trend.

 

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