Middle East/North Africa
Limits of Engineering
August 16, 2007

By Serhan Cevik | London

The volatility burst reflects financial fragilities in the global capital markets.Pain is everywhere, as indiscriminate risk-taking has turned into indiscriminate risk reduction. However, unlike the previous episodes of risk aversion, the current wave is not about fear of monetary tightening. Instead, the proliferation of losses linked to the subprime-mortgage market in the US has created a liquidity squeeze and a sudden burst of volatility in the global capital markets. The Chicago Board Options Exchange’s volatility index, for example, surged from an average of 12.9 in April to the peak of 28.3 last week. This may not be as bad as the 1998 incident, but it is still the worst outburst in recent years (including the 2006 scare). In our view, the elevated degree of volatility reflects financial fragilities stemming from imprudent lending and risk-taking. Indeed, realizing the ‘immeasurable’ extent of uncertainty about credit and counterparty risks, financial institutions have simply stopped lending to each other and especially funding structured instruments that have become crucial to the global financial network in recent years. As a result, the liquidity glut has abruptly turned into a credit squeeze, forcing central banks around the world to inject approximately US$325 billion of liquidity into money markets in order to prevent an absolute collapse.

The abundance of ‘market’ liquidity turned out to be a self-reinforcing phenomenon.Central banks’ coordinated attempt to flood money markets with cash may ease the immediate pain, but would not really address systemic threats. This is why we need to dig deeper and identify underlying fragilities in the global financial system. It seems that the ‘original sin’ was the extreme monetary easing campaign that ended up lowering the average short-term interest rate in the world from 4.8% in 2000 to 1.6% in 2003. Of course, with real interest rates declining from 4.3% to 0.8% over this period, it was not surprising to witness the emergence of a global liquidity wave and greater appetite of risk-taking among investors. However, the abundance of ‘market’ liquidity turned out to be a self-reinforcing phenomenon and kept expanding even as central banks tightened the policy stance to 3.7% last year and 4.4% of late. In other words, despite higher (real) interest rates bringing an end to the expansion of monetary liquidity, financial market liquidity increased (with occasional moments of pause) and fuelled the search for higher returns in riskier assets. But what is (or possibly was) behind the disconnection between monetary and market liquidity? We think that a couple of factors have made the most significant contribution to the pool of global liquidity. First, the recycling of current account surpluses has helped to de-link financial conditions from the behaviour of short-term interest rates. Second, financial innovation and the rise of new investors have become far more important in determining market liquidity. As one would have expected, these new financial trends depressed volatility and set the stage for greater risk-taking through highly leveraged derivative-based instruments. However, this type of liquidity is partly a function of confidence and thereby vulnerable to sudden changes in sentiment (see The Curse of Alpha, November 16, 2006). Hence, while structural factors are likely to keep the ‘excess savings’ channel intact, the ‘high-tech market liquidity’ channel is fragile and can quickly disappear when an unexpected shock occurs.

Financial innovation improves stability, but also sets the stage for excessive leverage.Financial engineering may have helped to disperse risk more broadly, but we should not ignore its use as an instrument of extreme leverage. The outstanding volume of derivatives and structured instruments increased from 26% of global GDP in 1990 to an astounding 789% last year, as hedge funds and traditional investors employing similar geared investment strategies have become the dominant force in capital markets (see Alphabet Soup of Liquidity, July 11, 2007). However, as shown by the recent sell-off in financial markets, the nature of market liquidity is vulnerable to risk aversion and contagion. Therefore, a sudden withdrawal of liquidity would intensify volatility and magnify the scale of losses, just as it is happening now in the credit markets and beyond. In our view, the current liquidity squeeze is not just a repricing of risk, but reflects systemic problems and consequently could have an extensive contagion effect, especially if investors start unwinding carry trades amid liquidity concerns in the credit markets.

Self-reinforcing financial excesses can turn into a self-fulfilling liquidity crisis.Structural improvements have made the global economy stronger, but it is still vulnerable to a self-fulfilling liquidity shock and the breakdown of financial linkages that helped to fund above-trend growth. Therefore, emerging economies — experiencing currency misalignments on the back of liquidity-driven capital inflows — now face the threat of sudden reversal. In this regard, maintaining prudent macroeconomic policies and accelerating structural reforms becomes even more important to limit the fallout from exogenous risk adjustments. This is why we expect, for example, the Central Bank of Turkey to maintain its cautious policy stance in the near future and the government to start correcting election-related deterioration in fiscal performance. Likewise, we believe that the Bank of Israel will keep raising interest rates in order to normalize monetary conditions.

 

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Japan
Will the BoJ Err on Prices? A Sinusoidal Yardstick
August 16, 2007

By Robert Alan Feldman | Tokyo

What yardstick for price acceleration?

Even if the BoJ holds rates constant this month, the longer-term issue of prices will remain a potential trigger for BoJ policy error. (As my colleague Takehiro Sato has pointed out in the piece that follows, the volatility in global stock markets has most likely taken an August rate hike off the policy agenda for the BoJ.)  But how are investors to judge whether the BoJ has committed a policy error? The key issue is whether price movements, which the BoJ has recently characterized as “near zero”, begin to accelerate. If so, a rate hike could be justified. If not, then a rate hike cannot be justified. So what is the yardstick for judging whether the trend of prices is accelerating?

My answer lies in a sinusoidal approach to modeling the price level, and concomitant price changes. In an earlier piece, I noted that interpretation of data depends on the yardstick against which the data are measured. In the case of industrial production, a sinusoidal trend implies a more optimistic outlook than the normal linear trend (see Good News for TOPIX from the Sinusoidal Trend, August 13, 2007). Applying the same method to prices gives a surprising result: Japan’s core CPI can accelerate from the most recent -0.1%Y figure in June to as high as +0.4%Y in March 2008, without implying any change in the “near zero” trend of prices.

The sinusoidal model

The method behind this statement is simple: First, calculate a sinusoidal trend for the core CPI (ex fresh food) using data for the last two years. (In the two-year sample period, the trend growth of core CPI is 0.03%Y, justifying the BoJ’s characterization that price movements are “around zero”. In anything, this assumption favors the BoJ view, because longer sample periods generate negative trends for core CPI.) Second, extend this sinusoidal trend over the next year, along with a band of two standard errors. Third, calculate the year-to-year growth rates that this sinusoidal forecast would imply. So long as the actual growth rate of core CPI remains within the forecast band, there would be no strong justification for claiming that trend inflation has accelerated from “near zero”.

The sinusoidal model has clear predictions and precise confidence bands. If the core inflation trend remains at zero, the core CPI change should hit 0.22% in February, peak in March, at 0.34%, and then decelerate to 0.26% in April, and further decelerate to 0.17% in May. This is the central forecast against which actual core CPI movements should be evaluated. Adding two standard errors to the underlying estimate yields year-on-year core CPI increases in February, March, April and May of 0.35%, 0.47%, 0.39% and 0.30%, respectively. These latter figures are the yardstick to use, in order to have confidence that price movements are accelerating.

What will BoJ do? What should investors do?

What will BoJ actually do? If core CPI in Feb-Mar next year shows growth rates of 0.4%Y, the BoJ would likely see this as evidence that trend inflation is accelerating, and would likely use the data to justify a rate hike.

What should investors do? If core CPI indeed accelerates in this way and the BoJ does act in this way, investors might be well advised simply to reserve judgment on inflation through April-May. Why? Given past price movements, the peak of price changes in the sinusoidal model (while the trend of prices remains “near zero”) comes in March. If and only if April and May core CPI remain above 0.4%Y in April-May will there be proof that the trend has indeed tilted upward.

Of course, deeper issues of monetary policy remain to be settled. Should the inflation reference band really have zero for a lower bound, especially in light of the many upward biases in price measurement? What is the relationship of fiscal spending and structural reform to monetary policy? How can communication of the BoJ with markets improve? On what criteria should the next governor, deputy governor and future policy board members be chosen? What is the impact of demographics and labor market change on the inflation outlook?

Conclusion

While all these issues remain important, the most important is the forward-looking issue of where price movements are trending. Both policymakers and investors need a clear yardstick for making judgments. The sinusoidal model provides such a yardstick.

 

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Japan
To Move, or Not to Move
August 16, 2007

By Takehiro Sato | Tokyo

Clearly a time not to move

Expectations for a BoJ rate hike at its August 22-23 policy meeting have quickly faded in the wake of the liquidity crunch in overseas markets stemming from subprime mortgage woes. We previously noted that the probability of a rate hike would depend on stock market trends during the O-bon summer holidays (August 13-17), but additional uncertainties have further clouded the outlook. Therefore, we believe that the BoJ should not raise its policy rate, because it does not need to in the first place. We expect the BoJ to postpone a rate hike until the September meeting or later. Below we argue these points:

From the perspective of central bankers

From the perspective of a central bank, affecting interest rates through open market operations and dealing with systemic risk related to market instability are separate issues. Whereas the former is aimed at guiding economic activity and prices along a desirable path, the latter is aimed at preventing a liquidity crunch from becoming a crisis through the provision of ample liquidity in accordance with a predetermined contingency plan. Hence, if it increasingly appears that a liquidity crunch will keep economic activity and prices from moving along a desirable path, then a central bank is likely to try to affect interest rates at the same time (i.e., shift to monetary easing). If a liquidity crunch looks likely to be temporary, however, then a central bank may naturally decide there is no need to affect interest rates to boost the economy and financial markets. At the same time, though, the typical central banker would decide not to raise rates shortly after overseas markets have just been hit by a liquidity crunch.

What has happened in Japan: Far from a liquidity crunch, but...

Japan’s market, not to mention the US and European credit markets, has destabilized, but no liquidity crunch has developed in Japan. To be sure, the overnight call rate rose slightly as some foreign banks in Japan sought to raise a decent amount of yen funds. In response, the BoJ, in accordance with its usual policy directive, increased its supply of liquidity on August 10 and August 13 to get market interest rates close to its target. There were some sensational media reports that the Japanese, US and European central banks had coordinated their responses to this liquidity crisis, but it became clear from the BoJ’s August 14 operations to absorb funds that the situation had been exaggerated. Unlike the ECB and the Fed, the BoJ has five years of experience in dealing with major liquidity crunches during financial system crises in the late 1990s and the early 2000s, using quantitative easing. The BoJ thus has much experience in dealing with financial crises, and it dealt with the situation calmly. The ECB’s response on August 9 appears to have ended up worsening the market’s anxieties and has been criticized by some as amateurish.

Even so, the majority view has a cautious bias

If the focus is only on the risks of a liquidity crunch, then the series of events since last week may not be enough to deflect the BoJ from its forward-leaning stance. However, we believe that the issue for Japan is whether the volatility in overseas markets will continue to negatively affect overseas economies and financial markets through a credit crunch, and thereby keep economic activity and prices in Japan from moving along a desirable path. If the BoJ considers that the impact of the subprime mortgage problems on the economy is serious, then it will come to the conclusion that it should not raise rates. Alternatively, it may consider that there would be no reason to pass on a rate hike in August, since one would come in September in any case. Policy Board member Atsushi Mizuno, who voted for a rate hike at the July meeting, probably takes the latter view. The majority view of the board, however, would naturally be to stand pat on rates in August and cautiously avoid making problems worse unnecessarily, because the subprime mortgage-related problems may be difficult to gauge.

We think that the members who will play a decisive role in decision are the six non-executive members, rather than the governor and the two deputy governors. Since the activist fund investment scandal, decision-making within the Policy Board has become more consensus-driven than dominated by the governor’s initiative. If four of the six non-executive members favor a rate hike, then the three executive members would probably agree, so as to form a consensus. However, we think it is highly uncertain whether three non-executive members other than Mizuno will favor a rate hike at the policy meeting next week, particularly because Miyako Suda and Tadao Noda, who have been in the hawkish camp, are probably very concerned about the subprime mortgage-related problems. It is also unlikely that new board members Hidetoshi Kamezaki and Seiji Nakamura, who came from the business world, will show an independent streak under current conditions, or that Kiyohiko Nishimura will show strong initiative. Common sense thus tells us that a normal central banker would naturally lean toward a wait-and-see stance at this time.

Time for latitude to be used

We believe that the BoJ, unlike the Fed and the ECB, has not provided indications of its schedule of policy changes because of the possibility of unexpected developments like these latest ones. With prices declining slightly and no apparent risks of inflation close at hand, the BoJ stated that it has “latitude in conducting monetary policy” up to the October 2005 Outlook Report. This phrase has not been repeated since the April 2006 Outlook Report, but we do not believe that the BoJ has lost this. Rather, now is the time for the BoJ to emphasize that it has this latitude in monetary policy, in our opinion. If the BoJ were to act hastily and raise rates without any need to, then a market backlash, in the form of further yen appreciation and a further sell-off in stocks, could result.

 

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India
Sub-Prime, Risk Aversion and India
August 16, 2007

By Chetan Ahya & Tanvee Gupta | Mumbai

Summary

In the last 3-4 years, India’s growth acceleration trend has benefited more from the globalization of capital markets than from the globalization of trade. The inflexion point for the current growth cycle was April 2003, which signaled the beginning of the synchronous rise in emerging market equities. We believe that a favourable sustained global risk appetite trend has been at the heart of India’s current growth acceleration cycle: Average GDP growth accelerated to 9.2% during F2006 and F2007 from an average of 6.1% in F2003 and F2004. If the current global risk aversion trend continues for more than three months, we believe that India could face a significant deceleration in growth.

Appreciating the global link to India’s growth story

A positive global risk appetite environment and consequent rise in capital inflows into EMs has been a key pillar of stronger growth in India. The risk-appetite growth linkage is as follows: rise in risk appetite – rise in non-FDI capital inflows – lower real rates – strong credit-driven growth. Indeed, India has increased its outstanding bank credit stock to US$480 billion from US$162 billion in April 2003. However, the trigger for reversal — just like the rise of this growth cycle — will be the global risk appetite trend, and not domestic fundamentals per se.

We believe that market participants arguing for serious decoupling of India’s growth do not fully appreciate that India is excessively reliant on external sources of risk capital and that these suppliers of risk capital tend to be indiscriminate in their behavior at times of turbulence. Unfortunately, the sub-prime problem is threatening to paralyze risk capital, which was supporting risky assets. In addition to direct linkages through global capital markets, we believe that any sustained risk aversion in financial market conditions to global growth will weigh on external demand, adding to the overall growth concerns in India.

A repeat of the 1993-96 cycle?

The current domestic and global macro conditions remind us of the 1993-1996 cycle. Like in this cycle, unusually low global interest rates and large capital inflows into India (and emerging markets in general) have allowed an expansionary monetary policy. In the current cycle, the capital inflows have been even larger, resulting in a much higher growth push. During the 1990s cycle, the capex cycle recovered sharply from lows with the support of positive sentiment for emerging markets. However, it was soon constrained by tightening monetary policy triggered by signs of overheating. A simultaneous reversal in risk appetite for emerging markets and reduced capital inflows caused further tightening in interest rates and affected the corporate sector’s ability to raise risk capital, unveiling a significant deceleration in GDP growth.

We believe that, in the current cycle too, the direction of the global financial markets will be critical to the growth outlook. Indeed, in this cycle India has witnessed both leveraged consumption as well as a capex cycle. Our base-case forecast assumes a soft-landing in consumption and the capex cycle. Domestic overheating problems like those during 1993-96 have already forced the central bank to lift borrowing rates by around 400-450bp from the bottom to the current eight-year-highs. However, if the recent sell-off of risky assets were to represent the beginning of a reversal in global risk-appetite for trade, it could reduce the access to external sources of risk capital and result in a further rise in the cost of capital in the domestic market, causing deceleration in GDP growth below our conservative estimates.

Why India may be more exposed than the rest of Asia?

We believe that, in the event of a sharp risk aversion in the global financial markets and/or a global hard landing, India's growth cycle is far more vulnerable than the rest of Asia. To assess exposure, we compare India’s macro balance sheet with Asia Ex-Japan (ROAXJ) economies on the following parameters:

Inflationary pressures: A high level of aggregate demand growth in India’s case is already reflected in inflationary pressure. While the headline inflation rate already corrected to 4.4% as of July 2007 (average) (below the RBI’s comfort level of 5%), inflation ex-food and energy is still at 5.2%. Both headline and core inflation in India are some of the highest in the region. Sharp appreciation in the exchange rate since early March 2007 has helped to reduce the inflation pressure. Any major reversal in global risk appetite could result in depreciation of the exchange rate, adding to inflation concerns.   

Credit cycle: India is the only country in the region that has witnessed a strong credit growth trend in the current cycle. A sustained slowdown in capital inflows will cause a hard landing in the credit cycle. It will also increase the risk of the credit quality problem. Until recently, banks had not only been lending more to riskier segments but had also been mis-pricing credit. At the peak of the credit cycle in 1Q06, banks were making little distinction in pricing credit risk for various types of loan assets. Almost all loans were being priced in a narrow range of around 7.5-8%, similar to the 10-year bond yields at that time. Indeed, banks’ lending behavior implied that the risk of lending to a low-income-bracket borrower (for whom there is little credit history available) for the purchase of a two-wheeler was not meaningfully different from the risk of investing in government bonds. A significant part of the fresh lending of US$318 billion over the last four years has come at a time when banks have been inadequately pricing credit risk.

Fiscal deficit: India’s headline combined fiscal deficit (central plus state governments’ deficit) is estimated at 7.1% of GDP for F2007. Including off-budget items such as oil subsidies and state electricity board losses totaling about 1.1% of GDP, the deficit estimate rises to 8.2% of GDP for F2007. India’s deficit (excluding off-budget items) is the highest among the major emerging markets and about two-to-three times the levels seen in major developed economies on a percentage-of-GDP basis. Although there has been a significant improvement in the fiscal deficit trend at the margin, there is little evidence that the government is implementing any major structural reforms to reduce revenue expenditure, which we believe is critical to achieving a sustainable reduction in the deficit. Most of the improvement in the deficit is due to the rise in corporate tax to GDP, in line with the corporate profit cycle. In our view, India is running a pro-cyclical fiscal policy. In the event of a sharp slowdown in growth due to global factors, the condition of India’s public finances provides little flexibility to increase public debt aggressively and offset such global pressures.

Current account balance: The most important differentiation between India and the Rest of Non-Japan Asia (ROAXJ) is that while India runs a current account deficit, ROAXJ runs a current account surplus. In India, aggregate demand being higher than supply (domestic capacity creation) is also reflected in the current account balance and inflationary pressure. This makes India more reliant on capital inflows than ROAXJ.

Composition of capital inflows: Unlike other emerging markets, India’s balance of payments surplus (a key source of liquidity supply) has been driven by capital inflows. Almost 82% of the total US$98 billion of capital flows that India has received over the past four years has been in the form of non-FDI flows. As a result, India is more exposed than other emerging countries to a potential sharp reversal in global risk appetite. Non-FDI capital inflows account for only 25% of the total in emerging countries (excluding India).

But there is good news…

While we see the risk of significant deceleration in India’s growth in the event of sustained risk aversion in the global financial markets, we also do not agree with the view that India’s current growth cycle resembles South East Asian countries prior to the Asian crisis. We believe that the levels of excesses are much lower and India’s growth model has inbuilt stabilizing aspects. Some of the differentiating factors are: (a) the exchange rate regime (India has a flexible exchange rate regime unlike in SE Asia prior to the Asian crisis); (b) a significant part of non-FDI inflows have been denominated equity inflows. These liabilities will get marked down in line with asset market corrections (in SE Asia there was excessive reliance on short-term debt); (c) the current account deficit in India is still under 2% of GDP, versus 5-8% in SE Asia (d) the Indian corporate sector balance sheet is in reasonably good shape, with an average debt-equity ratio (for companies under Morgan Stanley coverage) at only 0.3% as of F2007 (debt-equity ratios were unusually high in SE Asia).

 

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