United States
Review and Preview
January 07, 2008

By Ted Wieseman & David Greenlaw | New York

A sharp drop in the manufacturing ISM below the 50 boom/bust line and a decline in private sector payrolls suggested that a recession may have begun in December – in line with our forecast for a modest contraction in GDP growth in the first two quarters of 2008 – sparking a huge front-end-led rally in the Treasury market and a major dovish repricing of the Fed to start off the new year. The non-manufacturing ISM, despite the headline index strangely holding at a relatively high level, also showed significant underlying weakness, with nearly half of the industry groups reporting contraction in December. The fourth quarter as a whole appears to have held up reasonably well, as a significantly better-than-expected construction spending report and a bit of upside in manufacturing inventories in November led us to boost our 4Q GDP forecast to +1.7% from +1.2%. The construction results showed an accelerating collapse in housing, with clearly no end in sight, which was fully offset by surging non-residential building. But a sharp drop in non-residential construction payrolls in December suggested that this offset, which has been seen through much of the housing market collapse, may not last into 2008. And, in general, it’s clear that the expected 1.7% growth rate in 4Q was concentrated in upside early in the quarter. A significant fall-off at the end last year left 2008 starting on a very soft footing – both in the economic data and in major markets, with both stocks and credit tumbling on the week and LIBOR strains reintensifying. The main bright spot in this picture was surprisingly resilient motor vehicle sales in December. The upcoming week’s key economic news will be the monthly sales reports from most retail companies on Thursday, when we’ll see whether this stability in auto sales extended into broader retail spending. If the poor December results reported a week early by the major drug store chains are any early indication of broader chain store sales, Thursday’s reports could be ugly.

Benchmark Treasury coupon yields plunged 16-40bp over the past week and the curve steepened hugely to new multi-year highs. The 2-year yield fell 40bp to 2.72%, the 5-year 36bp to 3.165%, the 10-year 24bp to 3.86%, and the long bond 16bp to 4.36%. TIPS’ relative performance was extremely strong in the face of such a big rally. The benchmark 5-year inflation breakeven dipped just 2bp to 2.32% and the 10-year was unchanged at 2.31%. In addition to the direct impact of the economic data in stoking recession fears, the market was also supported by the big negative impact these worries had on stocks and credit. Stocks are off to one of their worst starts ever to a new year, with the S&P 500 tumbling 4% in 2008’s first three trading sessions. Credit markets did just as badly. In late trading Friday the 5-year HiVol CDX index was 31bp wider on the week at 232bp and the investment grade index 11bp wider at 89bp. These were the worst levels seen yet for both and up massively from closes (for the now off-the-run series 8 versions) of 104bp and 42bp, respectively, at the end of June before the financial market meltdown began. The higher rated subprime ABX indices – AAA (68.93 versus 74.69), AA (38.36 versus 44.76) and A (26.46 versus 31.31) – were also crushed on the week, reversing almost all of the improvement that had been seen from the lows hit around Thanksgiving.

There was a massive dovish repricing of the Fed. A 19bp surge in the February fed funds contract to 3.835% left the market pricing in a 50bp rate cut to 3.75% at the upcoming FOMC meeting instead of 25bp – that is, if the Fed even waits that long, as there’s little chance that the 4.145% level on the January contract can be fully explained by expectations that effective fed funds will undershoot the target so drastically this month. The April contract gained 26bp to 3.605%, pricing the likelihood of a 3.50% funds target after the March meeting, and the July contract gained 35bp to 3.215%, pricing in at least a 3.25% funds target by mid-year. The low-rate Dec 08 and Mar 09 eurodollar contracts gained 35.5bp to 3.08% and 38.5bp to 3.06%, shifting the expected funds rate trough down to 2.75%. The biggest eurodollar gains were posted by the Sep 09, Dec 09 and Mar 10 contracts, which rallied 47bp to 3.26%, 49bp to 3.415% and 48bp to 3.58%, respectively, suggesting that the market sees little prospect for a cyclical recovery of any significance in 2009 after the expected 2008 recession. The extraordinarily low 0.845% yield on the 5-year TIPS is sending a similar message of an expected prolonged period of economic misery to come.

If the bad data weren’t enough, interbank lending conditions resumed their worsening after the steady and significant improvement that had been seen through December. Term LIBOR did move significantly lower over the course of the week, with 6-month falling 18bp to 4.45%, 3-month 11bp to 4.62% and 1-month 11bp to 4.52%. But these declines didn’t come close to keeping pace with the Fed repricing, so the more important measures of stresses in the interbank market moved in the wrong direction. The 3-month LIBOR/3-month OIS (which measures average expected fed funds over the next three months) rose 8bp on the week to 74bp. In light of this renewed deterioration, the Fed’s Friday announcement that the sizes of the two upcoming TAF auctions would only be increased to US$30 billion from US$20 billion was disappointing. There was some good news in the money markets, however. The incredible 20-week uninterrupted run of declines in outstanding asset-backed commercial paper finally came to an end, with a significant increase in the first week of the new year. Term ABCP rates and spreads versus LIBOR also improved massively from the severely strained levels seen heading into year-end, and our desk noted a significant shift back towards term funding after the pre-year-end concentration in overnight issuance. This significantly improved tone in the ABCP market was mirrored in a big sell-off at the very short end of the Treasury market, with the four-week bill’s bond equivalent yield up 72bp on the week to 3.22%.

Non-farm payrolls rose just 18,000 in December, the unemployment rate jumped to 5.0% from 4.7%, the average workweek was steady at 33.8 hours, and total hours worked were flat. All of the payroll gain was accounted for by another strong rise in government jobs (31,000); private sector payrolls fell 13,000, the first drop since mid-2003. Manufacturing (-31,000), construction (-49,000), retail (-24,000), and writers’ strike-impacted information (-13,000) were particularly weak. Notably, the construction drop was about evenly split between residential and previously resilient non-residential jobs. The one positive in the report was the income numbers. Average hourly earnings posted a solid 0.4% gain for a 3.7% year-on-year rise, and aggregate weekly payrolls – a proxy for total wage and salary income – rose 0.5%. Of course, with energy prices back to surging to new highs again, even such solid gains in nominal income aren’t going to amount to much when retail gasoline prices start to catch up with the spike at the wholesale level.

In addition to private sector payrolls contracting, the manufacturing sector appears to have fallen into recession in December. The manufacturing ISM composite diffusion index plunged to 47.7 in December from 50.8 in November, the first sub-50 reading since the first part of 2003. Weakness was concentrated in significant drops into contraction territory by the key orders (47.7 versus 52.6) and production (47.3 versus 51.9) indices. Employment (48.0 versus 47.8) was little changed, also holding below the 50-breakeven level. Only 7 of 18 industry sectors reported growth in December. The report noted that industries “close to the housing market appear to be struggling more than others, and those involved in exports seem to be doing better”. The prices paid gauge (68.0 versus 67.5) posted a surprisingly small increase, with a number of energy items still reported up in price in addition to metals and plastics. As strong as the export situation has been (although that could now be at risk, judging from a sharp 6-point drop in the export orders index in December to 52.5, though this gauge is far from a reliable indicator for actual export performance), we had expected that the manufacturing sector would come under pressure but hold up much better than in a typical recession during the mild downturn we expect over the first half of 2008. So, if this weak report for December is a harbinger of a more severe and lasting retrenchment moving into this year, downside risks to the overall economic outlook would certainly be increased. Indeed, this surprisingly weak ISM result could be an early warning sign that the ex-US global picture is not nearly as rosy as many believe. In contrast to the manufacturing weakness, the non-manufacturing sector at first glance appears to have held up much better. The headline business activity index in the non-manufacturing ISM survey dipped slightly in December but held comfortably in growth territory at 53.9. This result was rather bizarre, however, considering the industry results, which were far weaker. Only five of 18 sectors reported growth in December. Eight reported contraction.

While the fourth quarter clearly certainly seems to have ended weak, thus providing a poor starting point for 1Q08, 4Q as a whole appears to have held up reasonably well, as we boosted our GDP forecast to +1.7% from +1.2% coming into the week. A better-than-expected construction spending report was the main reason. Construction spending rose 0.1% in November, and October (-0.4% versus -0.8%) and September (+0.3% versus +0.2%) were revised higher. Both the November uptick and the prior revisions showed a stark contrast between collapsing homebuilding and strength elsewhere. Overall residential construction fell 2.5% in November, with the key single and multi-family new homebuilding components plunging a combined 4.2%, the biggest drop in the 15-year history of the data. This severe weakness was offset, however, by a 1.7% gain in private non-residential spending, which, combined with upward revisions to prior months, pointed to a sharp gain in business investment in structures in 4Q, and a 2.5% gain in government spending. Incorporating these results, we now forecast a 28% plunge in residential investment in 4Q (this would be the worst quarter since the housing market collapse that followed the huge rate hikes instituted by the Volcker Fed in the early 1980s), a 19% surge in business investment in structures and an 11% gain in state and local government construction that would be a meaningful contributor to an expected 4.0% gain in overall government spending.

The November factory orders report contained no revisions to a weak trend in non-defense capital goods ex-aircraft shipments, so even with this sharp expected gain in structures investment, we see overall business investment in 4Q rising only 4%, with the equipment and software component expected to be down 1%. Overall manufacturing inventories did come in a bit higher than we expected in November and October was revised up marginally, which had a slightly positive additional impact on our 4Q GDP estimate on top of the more substantial construction spending upside. We still see inventories subtracting 0.7pp from 4Q growth, however, and look for a drag at least that big again in 1Q08.

The major data focus in the coming week will be Thursday’s chain store sales reports from most major companies, which will provide a more complete view of the holiday shopping season after the surprisingly sharp gain in ex-auto retail sales in November (which appeared to partly reflect some seasonal adjustment problems with the timing of Black Friday). Early indications for December sales results have not been good, both in some early warnings from individual companies and dismal same-store sales results reported by the major drug store chains a week ahead of most other companies. On the other hand, December motor vehicle sales proved surprisingly solid, holding steady at a 16.2 million unit annual sales pace. Incorporating this result, we boosted our 4Q consumption estimate a tenth to (all things considered) a very solid +2.9%. The bulk of this upside, however, would be attributable to a very robust November. A reversal of that strength in December would put 1Q08 on pace for a far weaker result. Other data due out in the coming week include the trade balance and Treasury budget on Friday:

*We look for the nominal trade deficit to widen US$1.5 billion in November to US$58.3 billion, but mostly as a result of higher oil prices; the real deficit should narrow slightly. We forecast a 1.1% gain in exports, with good upside in industrial materials and ex-aircraft capital goods partly offset by some moderation in aircraft, as indicated by industry figures, after another record high was posted last month.

Meanwhile, we look for a 1.6% gain in imports. This is mostly expected to be attributable to another sharp, price-driven rise in petroleum products, but port data also suggest some upside in non-energy goods imports after soft recent results.

*We estimate that the federal government ran a US$52 billion budget surplus in December, US$10 billion higher than in the same period a year ago. The bulk of the improvement is attributable to strength in withheld tax payments. Also, corporate tax revenue held up somewhat better than in the prior quarter. On the spending side, the impact of spectrum auction proceeds in the year ago period was about offset by a calendar shift that helped to hold down benefit payments in the latest month. We have updated our budget forecast to reflect our baseline economic scenario for a mild recession and now look for a budget deficit of US$225 billion (or 1.6% of GDP) in FY 2008.

 

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China
China Economics: Two Types of Overtightening
January 07, 2008

By Qing Wang | Hong Kong

Two types of overtightening

Baseline scenario of ‘imported soft landing’: A recap
Amid tremendous uncertainties about the outlook for China’s external demand and the domestic policy stance, we use the metaphor of four seasons of the year to characterize the potential scenarios for 2008: Autumn features ‘an imported soft landing’, summer features ‘overheating’, spring features ‘a policy-induced soft landing’, and winter features ‘an outright hard landing’ (see China Economics – Journey into Autumn: An Imported Soft Landing in ’08, December 4, 2007).

Our baseline scenario is an ‘imported soft landing’. Under this scenario, we forecast China’s GDP growth to decline from 11.5% in 2007 to 10% in 2008 and CPI inflation from 4.5% to 4.0%. Our forecasts envisage a modest rebalancing in growth drivers in 2008: relatively weak exports to be offset by sustained strong domestic demand. Consequently, the current account surplus (as a percentage of GDP) will narrow, as import growth outpaces export growth, albeit both at lower levels.

Under the ‘imported soft landing’ in 2008, the policy-makers’ intention to implement aggressive tightening measures is unlikely to be followed through. Specifically, the welcome downturn in external demand and its attendant cooling-off effect should be able to provide a breathing period for the authorities and ease the urgency to take aggressive policy actions with blunt policy tools.

We therefore expect a continued muddling-through approach in policy implementation in 2008, featuring ‘three No’s’: no campaign-style administrative tightening, no large one-off revaluation of the renminbi exchange rate, and no aggressive rate hikes. We expect the policy stance will remain tight through 1Q or 1H and then turn neutral or ease in the remainder of the year, depending on the pace of the US economy sliding into recession and its attendant impact on China. In short, we think that the authorities’ macro controls will be frontloaded.

Under our baseline scenario of an imported soft landing, the Chinese economy – in adapting to a weak external environment – will likely be able to realize a welcome rebalancing (away from external to domestic demand) that would otherwise be unachievable, thus boding well for a sustained and robust expansion over the medium term. While this growth rebalancing should be positive for the equity market over the medium term (i.e., 1-3 years), the stock market performance will likely be moderately negative in the near term (i.e., 6-9 months). Specifically, low-valued and low-margin export-oriented sectors (e.g., textiles) may be hard-hit. At the same time, domestic market-oriented sectors should do relatively well.

Credit tightening in 2008 shapes up
The most important aspect of the authorities’ tightening policy package is administrative credit tightening. The authorities have reportedly set the indicative target of bank loan growth at 13-14% – which is substantially lower than the 16% growth rate that we estimated for 2007 – and specified loan growth targets for each of the four quarters in 2008 for major state-controlled banks by following a general guideline: 35% of annual quota for 1Q, 30% for 2Q, 25% for 3Q and 10% for 4Q.

If the credit tightening, together with other macro-control measures (e.g., tighter scrutiny over approval of investment projects), is consistently implemented, it will likely result in a significant slowdown in real activity. Taking the 2004-05 round of macro controls for example: as bank loan growth was brought down sharply from 24% in 3Q03 to only about 13% in 1Q05, fixed-asset investment growth plunged from 43% in 1Q04 to 23% in 1Q05.

However, the credit tightening in 2004-05 did not do much ‘damage’ to industrial production. Despite a sharp drop in bank loan growth, the growth of industrial value-added did not slow much. One key reason is that export growth during the same period was extraordinarily strong (i.e., nearly 35%Y), having effectively offset the cooling-off impact of tight domestic credit conditions.

Risk of overtightening due to policy mistakes
An increasing number of clients have recently registered their concerns about the risk of overtightening in 2008. In particular, investors fear that were the authorities to carry out the aforementioned austerity measures despite a recession in the US and the attendant synchronized global downturn, the Chinese economy would suffer a serious double-whammy impact and the negative implications to the market would be broad-based: domestic demand- and export-oriented sectors would be equally affected.

Indeed, if export growth were to decline sharply from 26% in 2007 to 16% in 2008 as we envisage, and at the same time, the credit tightening were to be carried out, both investment and industrial production would likely suffer a significant slowdown. The overall impact of the upcoming round of tightening may well be as large as – if not larger than – that in 2004-05.

While this concern about overtightening is not entirely unwarranted, we attach a very small probability to this scenario. This is essentially an overtightening due to policy mistakes: here the policy makers underestimate the negative impact of US recession on the Chinese economy. However, since delivering high growth and job creation is still of paramount political priority, we do not believe that the authorities would tolerate a sharp slowdown in growth, which would have serious political and social consequences. We therefore caution against overreacting to the authorities’ rhetoric to take tough measures to cool off the economy and believe that the authorities will not take any signs of external slowdown lightly and will stand ready to reverse the course of tightening policies.

Risk of overtightening due to policy constraint
We, instead, would like to draw clients’ attention to a different type of overtightening: if there is no meaningful slowdown in the US economy and China’s external demand and the authorities continue to be reluctant to allow a much faster appreciation of the renminbi exchange rate in 2008, the tightening measures needed to cool off the economy will have to be more austere than otherwise, resulting in a much deeper recession in domestic output.

While austere tightening measures (e.g., administrative credit and investment curbs) would help moderate aggregate demand and thus ease inflationary pressures (i.e., ‘expenditure-reducing effect’), appreciation of the renminbi exchange rate can also effectively ease inflationary pressures by shifting demand away from domestic goods to foreign goods (i.e., ‘expenditure-switching effect’). In the absence of a significant renminbi appreciation, the tightening measures would have to be much tougher in order to achieve the objective of easing inflationary pressures than under the scenario where exchange rate appreciation is an important part of the tightening policy package. 

We believe that this is what happened during the 2004-05 round of macro-tightening, which was aggressive and effective in bringing down inflation in a relatively short period of time. However, the real activity adjustment was equally sharp, as reflected in the plunge in the growth rates of investment and imports. This constitutes the ‘overtightening due to policy constraint’, in our view, for had significant renminbi appreciation been employed in the policy package, the tightening measures may not have been so austere and the slowdown in domestic demand may not have been so sharp.

On the other hand, had the external demand been much weaker in 2004-05, there would have been no need for strong macro controls as were implemented in order to achieve the same policy objectives.

We are afraid that if in the current round of macro tightening, allowing a much faster appreciation of the exchange rate (e.g., 20% renminbi appreciation), is ruled out as a policy option, the administrative tightening measures will have to do the heavy lifting: to cool off the economy and ease inflationary pressures entails more austere measures that could render a much deeper recession in domestic output than otherwise. In this context, the austerity measures announced by the authorities will be followed through and even made tougher if inflation does not come down fast enough.

An unintended consequence of overtightening due to policy constraint
The Chinese economy is experiencing two imbalances: internal (i.e., high inflation) and external (i.e., large trade surplus). The current policy package that features administrative curbs on bank lending and investment can help correct internal imbalances (e.g., inflation). However, these tightening measures will also exacerbate the external imbalances: tight bank credit and investment controls will weaken domestic demand and subsequently imports, contributing to even wider trade surpluses, especially when there is no meaningful slowdown in the US economy to ensure continued robust export growth. With persistent large trade surpluses getting even larger, there will be even more FX reserve accumulation and attendant liquidity creation.

If tightening policies are able to help lower expectations of future CPI inflation by bringing down current inflation, headline CPI inflation may stay stable despite excess liquidity. In this context, persistent excess liquidity may manifest itself in the form of asset price inflation to the extent that investors’ confidence is not destroyed by the austerity measures. Chinese investors may become more interested in offshore investment opportunities (e.g., through QDII, QDRI schemes).

Market impact of credit tightening
Distinguishing between the two types of overtightening is important for understanding the broad market implications. Overtightening due to policy mistakes would likely result in a hard landing of the economy, and its negative market impact would be serious and broad-based. On the other hand, overtightening due to policy constraint would have a disproportionately large negative impact on domestic demand-oriented sectors, while export-oriented sectors would be less affected. Therefore, the market implications under the scenario of overtightening due to policy constraint will likely be exactly opposite to our baseline scenario of an ‘imported soft landing’.

Administrative credit tightening is expected to play a key role in the tightening policy package. In this policy environment, different enterprises in different sectors will be affected differently, depending on how dependent they are on financing provided by the banking system.

We have two general observations based on experiences from the past macro tightening. First, sectors with relatively high debt-asset ratios tend to be more adversely affected. We compared the debt-asset ratio with the magnitude of decline in the fixed-asset investment rate during the 2004-05 tightening and found that sectors with higher debt-asset ratios tend to experience larger declines in fixed-asset investment growth after credit tightening is imposed.  We looked at the most recent debt-asset ratios for 42 industries. Several sectors including the coal mining and other mining, construction, retail and wholesales and real estate have high debt-asset ratios. Among the manufacturing sectors, heavy industries (e.g., machinery & equipment, metals) tend to have higher debt-asset ratios than light industries (e.g., textile, food). These sectors of high debt-asset ratios would likely be – other things being equal – vulnerable to credit tightening.

Second, small- and medium-sized enterprises are generally at a disadvantage relative to large ones in the event of credit tightening. This is mainly because administrative tightening inevitably involves some degree of credit rationing. Large enterprises tend to have close and long-standing ties to banks and greater lobbying power with policy makers, thus providing easier access to bank credit and policy makers’ approval of investment projects. In this context, macro tightening tends to lead to industrial consolidation, with large enterprises taking over small ones or the latter simply exiting the market.

We also think that the direct impact on publicly listed companies tends to be smaller than that on non-listed companies for two reasons: a) publicly listed companies – especially those that have gone public recently – tend to have strong cash positions; and b) it is much easier for publicly listed companies to tap alternative sources of financing, including the placement of corporate bonds. On the latter, despite macro tightening, the authorities have indicated that the development of a corporate bond market will be encouraged in 2008. In fact, since August 2007, publicly listed companies have been allowed to issue corporate bonds under a more streamlined procedure than before.

 

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Japan
Credit Crunch Coming
January 07, 2008

By Takehiro Sato | Tokyo

Liquidity constraint is the key word in 2008

It is time to get ready for a mini credit crunch at small and medium-sized enterprises (SMEs) and tiny businesses. The coming crunch should not develop into a severe credit contraction that envelops large corporations as in 1998, but could deal a body blow to the economy given that it exposes to risk these smaller businesses that vastly outnumber large firms and employ more workers in total. The money markets in the US were malfunctioning at the end of last year, and there is risk that non-financial sectors will also see liquidity constraints lead to freezing or postponement of capex; in Japan, once SMEs and tiny firms face liquidity constraints, their access to capex funds and working capital suffers and in the worst cases their survival is in jeopardy. The definition of SMEs varies, but the proportion of capex made by such firms is about 17% in the BoJ Tankan survey and 26% in the MoF Corporate Statistics, so this impact would be far from negligible. Our views on this issue, and on housing investment, explain why we are more bearish on the economy in 2008 than the market consensus.

What’s new

Unlike the US and Europe, which have been rocked by subprime issues, Japan to date has been suffering virtually no credit impairment. However, for reasons that are entirely unrelated to events in the US and Europe, we believe that the likelihood of a mini credit crunch in the Japanese economy is rising. Fears have already been materializing in consumer financing, but the recent revision of the credit guarantee system could depress the economy further by imposing new credit constraints on SMEs and mom-and-pop firms.

Tighter credit is showing up first in consumer finance. Consumer Financing Law (CFL) revisions were crystallized in December 2006 and take effect in stages between January 2007 (phase one) and mid-2009, raising the regulatory bars. The consumer financing business has already begun to see shrinking credit, as future reductions in loan rates and restrictions on lending relative to borrower income have been already legislated, as assessment standards become stricter. What we did not necessarily expect was that changes under this system would not only affect households, but also have a significant impact on the small businesses that rely on consumer financing to raise working and other forms of capital.

Since voluntary curbs on lending practices were instituted in 2006, the number of corporate bankruptcies has been gradually on the rise. The scale of the debts involved in each, meanwhile, has been gradually diminishing, which suggests that more SMEs and mom-and-pop businesses have been folding. The second phase of the CFL revisions on December 19, 2007 enforced limits on excessive lending. Specific measures are implemented as an independent set of rules for the industry; for example, total monthly repayments may not exceed 1/3 of monthly income or 1/36 of annual income. The aim of the system is to reduce the number of borrowers with multiple debts, but a side effect is that access to credit for SMEs and tiny firms will be constrained.

Looking ahead, lending to SMEs by banks and similar institutions may also be disrupted. Last October, the credit guarantee system was revised, reducing the portion of new loans among guaranteed loans (termed ‘maruho’ loans) underwritten by Credit Guarantee Corporations from 100% to 80%. This means that, since October, banks and others have had to underwrite 20% of the direct credit risk associated with such loans. There has not been a large impact so far, but the move is likely to choke off some of the credit supplied to SMEs and smaller firms.

In reality, banks and similar lenders have in the past been extending loans to SMEs on the condition that these are underwritten by Credit Guarantee Corporations. Banks have been able to lend comparatively smoothly to SMEs with this backing, regardless of the credit status of the borrowers. Use of the credit guarantee system was promoted aggressively as part of economic rescue package by the Obuchi administration in 1998, and delivered results which are fresh in the memory. Lenders must be more cautious now that they assume responsibility for 20% of the loan, and the need for additional safety measures such as evidence of collateral may arise. Most SMEs and family firms probably have scant wherewithal to provide this, or are already using their collateral to back other loans. This means that when credit guarantee-backed loans become due for repayment, lenders will need to charge appropriate spreads adjusted for the credit risk of the borrowers when loans are rolled over, and that it will become difficult to roll over when unsecured lending does not meet qualifying standards. Credit lines may thus be cut off. In any event, the SME and tiny firms that are the main beneficiaries of the credit guarantee system are likely to suffer in some form, from higher loan rates or tougher loan conditions.

Where we differ

The credit guarantee system applies only to loans for SMEs and tiny businesses, and the proportion of lending backed by these guarantees among overall bank and credit association lending is not high at about 6%. Loans to very small outfits also have a safety net (in the form of ‘the System that Guarantees Small Loans to Small Businesses’), so the market may be dismissing the impact of changes. However, the existing loan guarantees in the latter safety net are capped at ¥12.5 million in total, so it is debatable whether it serves the intended purpose – that is, it is likely that small businesses covered by that system are already benefiting from the credit guarantee system.

The total balance of credit guaranteed loans at the end of F3/07 was some ¥29.3 trillion (¥8.5 million per loan), and the amount of guarantees authorized during the year was about ¥13.7 trillion (¥11.6 million per loan), which implies an average turnover period of a rather short 2.1 years. This rapid turnover means that there is frequent refinancing. So, although demand to refinance existing loans will increase as the end of March approaches, when corporate funding become tighter, we expect higher loan rates as discussed above, and more cases of credit lines being withdrawn.

Upcoming events

Tightening of SME financing can already be seen from a number of data points. The corporate finance-related DI in the December BoJ Tankan, for example, showed a one point drop from the September reading in the DI for lending attitudes of financial institutions for both medium-sized and small firms (indicating less willingness to lend). The small firms’ financial position DI also dropped by one point more than that for large firms (so their funding situation is getting worse). A similar pattern emerges from the July-September survey of nationwide trends at small businesses by the National Life Finance Corporation. In the same survey, the financial position index for these firms this term dropped by a relatively large 3.4 points from the previous reading in April-June. Overall, however, we do not have an impression of severe credit contraction for SMEs. The BoJ’s bank lending data up to November does not show a meaningful drop in lending after the system for shared loan underwriting responsibility was introduced in October. However, these figures come only just after the new system arrived, and the future impact may be greater. BoJ bank lending date for December come out on January 11, and SME loan data for the same month are due at the end of January. Even if these do not confirm an accelerating decline, SME financing is likely to become increasingly tight in the January-March quarter.

Policy implications

The credit tightening above is a prime example, alongside the recent crash in housing investment, of a policy-induced problem (‘kansei fukyo’). The objectives of the system changes are probably right, in other words, but the bureaucrats have not paid sufficient heed to the implications for the real economy. The system of shared responsibility for loan underwriting is also a move in the right direction, in that it encourages lenders to monitor credit risk more strictly when loaning to SMEs. If risk management is inadequate, costs to the nation’s taxpayers ultimately increase as Credit Guarantee Corporations foot the bill. But the timing of this system change could hardly have been worse, with the economy now on the brink of a negative spiral. This recent measure to jack up the risk liability of the lending institution to 20% also seems too sudden, and could have been phased in more gradually. The authorities are likely to be on the back foot, addressing the problems created by the changes in the financing of SMEs and small businesses hurriedly and only after they emerge, when it is too late. The same is likely for the revised consumer finance regulations and the revised regulations for credit guarantee system, repeating the errors made in handling the changes in the system for verifying building standards.

On the monetary policy front, we have already rescinded our forecast for a rate hike during 2008 due to deterioration in the home and overseas economies. Since the end of last year there has been a stream of data from the US pointing to a possible recession, such as durable orders, new home sales, ISM manufacturing figures and job data, and declines in the US stock market have brought bearishness to Japan. This has come together with a strengthening yen. Under such conditions, we think that the market’s near-term focus is likely to switch from a rate hike to a rate cut. The market consensus is currently for hikes to be resumed in the second half of the year, but we view that as too optimistic. Rising energy prices are generating upside risk for the core CPI, and year-on-year inflation in the January-March quarter on this measure may well be close to 1% (about 0.8%), but rising prices at a time of slack demand serve to lower real incomes and may exacerbate demand weakness. This does not build a case for tighter monetary policy. The recent JGB rally should therefore be sustained even if prices in the near term move up.

Risks

According to news reports (Nikkei Shimbun, December 18, 2007), the Ministry of Economy, Trade and Industry (METI) wants to augment the functions of the Credit Guarantee Corporations and bring in a new system to guarantee collection of accounts receivable. The aim is to make it easier for SMEs to transfer sales credits to financial institutions and turn them into cash. For the sales credits of large companies with high credit standing, this type of business is already well established, but low creditworthiness has prevented a similar development for SMEs. If such a system proves to be effective, about ¥73 trillion in SME accounts receivables could be turned more easily into cash and this could ease funding problems considerably, making our credit concerns redundant. But to implement such a system would require related bills to revise legislation such as the Small Business Credit Insurance Law, and the chances of this getting approved by the end of the fiscal year, when demand for funds picks up, are extremely remote. There is a swathe of budget and budget-related bills (so-called sunset bills) in process, and the possibility that regular Diet proceedings will be dissolved from mid-January leaves very little time. We need therefore to focus on the downside risks ahead.

 

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India
Food Inflation Risks Rising Again
January 07, 2008

By Chetan Ahya | Singapore

Inflation concerns building up again

Headline inflation (WPI) has risen to 3.5% during the week ended December 22, from the low of 3% during the week ended November 10, 2007. Core inflation (non-oil non-global commodities) has also accelerated to 5.2% during the week ended December 22 from the low of 4.4% during the week ended November 24, 2007. We believe that with a 2-3-month lag, consumer price inflation is also likely to start rising again. The recent rise in global food and energy prices has increased the risk of a further rise in inflation, in our view.

Recent rise in global food prices a key concern
After remaining stable for a period of five months, the CRB foodstuff index has shot up again. The index has increased by 4.5% in the last six weeks, taking the pace of year-on-year rise to 23.7% as of December 2007. Global wheat, rice and soybean prices have increased to new highs. Except edible oil for most other major agricultural items, India is largely self-sufficient, though it has again started importing wheat. However, healthy buffer stock and the government’s efforts to restrict exports have helped in keeping domestic food prices (especially of grains and pulses) insulated so far. Despite this, we believe that, with a lag, some amount of pass-through of higher international prices in domestic food prices would be inevitable.

With the domestic demand/supply balance being relatively tight, we believe that the adverse impact on output for any staple agricultural commodities could potentially push up domestic food inflation sharply. To that extent, the recent data on sowing for wheat are a cause for concern. As of January 4, 2008, the area under coverage for wheat for winter crop (bi-annual cropping season) has declined by 3.3% compared to the same period last year. Similarly, for oil seeds, the area under coverage has declined by 12%Y as of January 4, 2008. Typically, most of the sowing for the winter season is completed by end-December.

In our view, the root cause of an increasing risk of food inflation is the domestic structural demand/supply imbalance. There has been a clear deceleration in supply growth over the last few years due to a host of problems facing the farm sector, most being 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 the five years ending March 2002 and 3.4% during the five years ending March 1997. Indeed, in the last five years, the average growth in agricultural production has been below the country’s population growth.  Food imports have increased by 56.5%Y during the 12-month period ended July 2007 (last data point available) – a key contributor to this acceleration has been wheat and pulses 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%.

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 has also been negligible. Only 40.3% of the farming land is irrigated. The average growth in land brought under irrigation decelerated to 1.5% during F1991-04 compared with 2.4% in the 1980s and 2.7% during the 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, 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.

There is little hope for a quick solution to the international price rise problem either, in our view. Rising per capita incomes, reducing poverty and increased urbanization are supporting the acceleration in demand for some basic food items. In many countries (with a higher proportion of non-vegetarians), as the United Nations points out in its report 1, as incomes increase, people tend to eat more food and meat, and 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. This is also driving up wheat and soybean pricing, albeit to a lesser degree, as acreage is lost to corn.

Inflation pressure from other commodities – an additional challenge
Apart from rising global food prices, there are two other factors posing risks to the inflation outlook:

(a) Rise in domestic oil products prices: Our estimates indicate that the current weighted average realization of oil products in the domestic market implies an average crude oil price of US$63/bbl (WTI), versus the current international market price of US$100/bbl. This widening gap between domestic and international prices is pushing the fiscal burden up sharply. If oil prices stay at current levels and domestic prices are kept unchanged for the next 12 months, the oil subsidy burden would increase to 2.1% of GDP, on our estimates. We believe that the government is likely to increase domestic oil product prices by 5-10% in the near term. If the government increases crude prices by 10%, it would result in increasing wholesale price inflation by 60-70bp.

(b) Acceleration in the pace of price rise for other commodity products: Domestic steel, coal and iron ore have witnessed highs. Recently, the Coal India Ltd (CIL) increased coal prices by 10% across all grades of coal and all coalfields and 15% for coal produced by North Eastern Coalfields Ltd (NECL) effective December 12, 2007. Similarly, the domestic steel companies also raised their product prices in the range of 2-4% of late. We believe that there will be a cascading effect of higher coal, oil and other commodities input cost prices in sectors such as cement, construction, electricity and other related areas over the next 3-4 months.

Fiscal policy implications
The burden of addressing this food price problem has largely been on fiscal policy. The government is responding with short and long-term measures due to its implications on inflation and farmers.

Short-term measures: Recently, the government has announced a number of short-term measures to address the risk of food inflation:

(a) Wheat: The demand/supply imbalance in domestic wheat production is clearly stretched, in our view. The procurement of wheat by the government from the farmers has been declining every year on account of lower minimum support prices offered and higher private trade offering. The government has been taking steps to stabilize domestic wheat prices by augmenting the domestic availability with imports from the international market through State Trading Corporation (STC). In 2007, the government imported 1.8 million tonnes of wheat (against a target of 2.3 million tonnes) compared to 5.5 million tonnes imported during the previous year. However, the sharp increase in international wheat prices has nudged up the average landing cost of imported wheat in each successive quarter. In December 2007, the STC received offers for importing wheat that were 40-50% higher compared to those fixed a fortnight ago. In October 2007, the government announced a ban on wheat exports for an indefinite period. Similarly, to keep domestic wheat prices low, the government also scrapped the import duty on wheat flour on January 2, 2008, as against the normal applicable duty of 36%.

(b) Rice: In October 2007, the government announced a ban on exports of all non-basmati rice to ensure greater procurement of rice and increase domestic supply. Although this ban was relaxed later, the government gradually increased the minimum free-on-board export price three times between October and December 2007 to discourage exports. Similarly, to increase the domestic procurement of rice stocks, the government issued a notification in December 2007, seeking disclosure of rice stock by private rice purchasers above 10,000 tonnes during the Kharif marketing season (October 2007 to September 2008).

(c) Edible oil: In July 2007, the government reduced import duty on edible oils by about 5-10% to control domestic prices. The measures included a reduction in customs duty on crude palm oil to 45% from 50%. Duty on crude soyabean oil was also reduced to 40% from 45%, while on crude sunflower oil it was lowered to 40% from 50%. The tariff on refined sunflower oil was reduced to 50% from 60%. These measures have helped in reducing to some extent the impact of higher international prices.

(d) Pulses: With effect from June 2006, the government permitted the import of pulses at zero duty and stopped exports.

Long-term measures: The political implications of the poor growth in the farm sector and risk of inflation have forced the government to take some long-term measures too. 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. The government has focused on three sets of measures to improve agricultural output: (a) increasing credit access and restructuring old loans; (b) increasing infrastructure spending; and (c) deregulation of the sector, allowing increased private corporate participation.

Increasing credit access and restructuring old loans: In September 2006, the central government announced a Rs170 billion (US$4.1 billion) rehabilitation package for farmers in four states that 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. However, the project has been lagging on the implementation front, with slow progress achieved so far in rescheduling loans, offering low interest rates on farm loans, funding watershed development and other irrigation projects. In fact, the Radhakrishna Committee Report on rural indebtedness has called for “urgent corrections” over the implementation of this package. The government has announced that a coordinated approach on agricultural indebtedness will be finalized in the near term to help the farming population and avert a further rural debt crisis in the country. According to Times of India, the government is likely to initiate a mega-farm loan-restructuring package covering bad and doubtful debt of about Rs300 billion (or US$7.5 billion) in the upcoming Union Budget to be announced in February 2008.

Increasing infrastructure spending: 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%. These measures would 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 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$6.3 billion) plan for the farm sector by addressing the needs at a grass roots level over the next four years. The package will have state-specific plans for overall development of the farm sector and aims to give incentives to states to invest more in the agriculture sector.

Attracting private corporate sector investments: 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, could 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.

Exchange rate and monetary policy implications
We believe that incrementally the exchange rate policy is unlikely to play a supportive role in managing food price inflation. The RBI had opted for sharper appreciation in the exchange rate in 2007 to offset the increase in the global prices of commodities, including those of agri-products. However, we believe that there is little scope for allowing further major appreciation in the currency, considering its implications on goods exports by small and medium enterprises.

The risk of higher food prices is constraining monetary policy management. Even as consumption growth has slowed meaningfully, the RBI is deferring policy rate cuts. It is concerned about higher food and energy prices weighing on inflationary expectations.

Conclusion 

The rise in international food prices, in addition to the rise in oil prices, has revived inflation concerns. Higher food prices are resulting in: (a) the RBI pursuing a conservative monetary policy. Even as consumption growth has slowed down significantly, we believe that the central bank is unlikely to cut policy rates until there is a clear sign of a decline in global commodities prices, including agri-products; and (b) the government initiating a number of short-term fiscal measures restricting exports and encouraging imports to contain the rise in domestic food prices. The government is also implementing long-term measures to accelerate food output growth by improving credit access to farmers, increasing rural infrastructure spending and encouraging private corporate sector participation in farm-related activities. We believe that these macro policy responses should ensure that headline inflation remains under the RBI’s comfort range of 5% as long as there is no major crop failure. In this context, the recent data on wheat sowing for winter crop are a cause for concern. 

 

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