Chile
No Time for Inflation Complacency
January 23, 2008

By Luis Arcentales & Daniel Volberg | New York

These are trying times for Chilean central bankers – inflation is running at the highest level in over a decade and inflation expectations are on the rise.  Meanwhile, both domestic and global headwinds suggest that economic growth will remain relatively sluggish over the course of 2008. While these cross-currents cloud the monetary policy outlook, we suspect that upside inflation risks will dominate in the near term, thus requiring further action by Chile’s central bank (BCCh).

Inflation perfect storm

Chile is facing nothing short of an inflation ‘perfect storm’, caused mainly by pressure from soaring grain and energy quotes, in addition to a frost-linked spike in prices for fruits and vegetables. By December, headline inflation was running at 7.8%, the highest rate since June 1996 and well above the central bank’s 3.0% central target. Meanwhile, forecasting near-term inflation in Chile has become little more than a guessing game: monthly CPI surprised to the upside in eight of the past nine months, coming in on average nearly 70% (or 0.4%M) higher than consensus estimates. Not surprisingly, inflation expectations for the year ahead began to deteriorate and, only recently, in the key 24-month forward horizon. On the consumer front, surveys show that almost 60% of Chileans believe that inflation will go up by “a lot” in the coming 12 months. Faced with this challenging inflation backdrop, Chile’s central bank lifted its reference interest rate five times to 6.25% from 5.00%. 

Even after 125bp of cumulative tightening since July, Chile’s central bank has more work to do, in our view. In its monetary policy report, published on January 16, the central bank reiterated that while the next rate move will depend on incoming data, “additional adjustments to ensure the convergence to the inflation target” could be necessary even as it characterized the risks to inflation going forward as “balanced”. The central bank has cautiously paved the way for another hike while still leaving its options open; however, in light of the deteriorating inflation backdrop and risk to expectations, we think that this is no time for the central bank to pause. 

More work to do

There are at least three reasons why we believe that the central bank has more tightening to do.   

First, the argument that the inflation problem remains limited to food and energy is losing strength. Supply shocks have certainly been responsible for most of the surge in inflation to multi-year highs. For example, perishables and fuel quotes alone accounted for 2.0 percentage points of the 7.8% increase in 2007 inflation, despite representing less than 8.0% of the consumer price basket. However, in the final months of the year, the pressure appeared to be broadening. Indeed, measures that better capture ‘trend’ inflation – such as trimmed means or core excluding all food items – have been heading higher and in some cases at an accelerated pace, even as evidence from labor costs has been rather inconclusive. In fact, following its January 25bp rate hike, the authorities highlighted that December experienced “significant increases in (the prices of) a diverse range of products”, suggesting that pressures could be beginning to spread beyond just food and energy. Indeed, our preliminary modeling work suggests that the inflationary pressures could be a more persistent problem over the next two years, thus requiring a more proactive response on the interest rate front. 

Second, there is a risk that expectations could be slowly coming unhinged. In the monetary policy report, the authorities maintained that inflation expectations remain well anchored around the target of 3.0% over the relevant policy horizon of two years. It is certainly testament to the central bank’s credibility that despite the surge in inflation in 2H07, two-year forward expectations have only moved to 3.3% in January from 3.0% previously, according to the central bank’s own survey. However, and while this is a modest move, the fact that this particular metric has been so well anchored – and for such a long time – at 3.0% is a reason for concern. In addition, alternative metrics such as breakeven inflation measures have also been heading in the wrong direction. 

Importantly, inflation is set to get worse before it gets better − likely peaking above the 8% threshold during 1H08. On the energy front, electricity price hikes at the residential level are on the pipeline and gasoline prices have risen to record levels, with only modest relief – to the tune of 6% – coming from the additional US$200 million allocated to the Fuel Price Stabilization Fund. And 1Q08 will bring adjustments to education and to a series of prices that are indexed and thus backward-looking. In all, we see a very difficult near-term picture, before a powerful base effect brings annual inflation rates lower in 2H08.

Third, there is a case to be made for a more activist central bank, at least in the near term. In the December monetary policy meeting, a board member put forward the notion that highly uncertain times could require a degree of policy “fine-tuning” that could even lead to a reversal in the direction of rates in a more proactive fashion. We think that this time could be now; thus, we expect additional rate hikes in February and possibly March, which could be then taken partly back late in the year if the global backdrop deteriorates sufficiently as the impact from the US downturn spreads (see “Latin America: Abundance Faces its First Shock”, GEF, January 8, 2008). Indeed, one takeaway from our recent MacroVision workshop – which included Morgan Stanley’s strategists, economists and clients – is that the US is likely to be already in a recession, and now the uncertainty surrounds the duration and depth of the downturn. 

As our Brazil watcher, Marcelo Carvalho, rightly argued in a recent note, central banks do not like to flip-flop and change monetary policy too often, something that Chile’s central bank had to do following a surprising rate cut in January 2007 (see “Brazil: No Hike, Maybe Cut”, EM Economist, January 18, 2008). However, uncertain times often call for increased flexibility, and we believe that a more activist approach would not harm the bank’s still strong credentials, while going a long way towards strengthening the commitment to the 3.0% target.

Intervention? Not

Unlike Brazil, Colombia or Argentina – which have been actively involved in the currency markets – interventions by Chile’s central bank have been raresince it allowed the peso to float freely in September 1999. The peso’s recent rally – which breached the 470 threshold in intraday trading – has once again sparked speculation of potential intervention by the central bank. Concerns of imminent action, moreover, increased following comments by the central bank’s president, who argued that recent peso gains could not be fully explained by interest rate spreads, thus suggesting a level of overshooting. In our view, both fundamentals and history suggest that intervention does not appear an imminent threat. Importantly, we suspect that in light of the difficult inflation backdrop, some currency appreciation is a welcome development from the central bank’s standpoint.

The degree of real peso appreciation does not appear significantly out of line with fundamentals as to justify intervention. In its most recent monetary policy report (released on January 15), the authorities argued that the real exchange rate was at levels that were only “marginally” out of line with those “coherent with its long-term fundamentals”. Compared to the levels considered in the monetary policy report, the real effective exchange rate at the time of writing was roughly 4% stronger, a move that falls short of what we would consider a fundamental misalignment. In fact, we suspect that the peso could appreciate further before the central bank steps in. Based on the average of the past 15 years – a metric widely cited by the central bank – we estimate that the peso would have to move to near 455 to match the levels that triggered the major episodes of intervention in 2001 and 2002.

Another consideration is that intervention could be misconstrued by marketsas a signal that the policy focus is shifting, even if temporarily, towards the currency and away from the inflation problem at hand. To be fair, unlike the case of Peru’s central bank’s seemingly unsustainable intervention strategy in the past, Chilean authorities have acted in a transparent fashion by announcing the maximum amounts, instruments and length of major intervention periods such as August 2001 and October 2002. In turn, such measured ‘closed-end’ approaches reduce the risk of attracting increased portfolio inflows or boosting liquidity at a time of rising inflationary risks (for a discussion on how central bank policy could exacerbate inflows, see “Brazil: Three, Two, One…”, GEF, May 8, 2007). Still, in the current context of high inflation and deteriorating expectations, the signal that intervention would send is a risky one, in our view.  

Bottom line

Chileis experiencing one of its most pressing inflation challenges in over a decade. With little relief expected in the near term, Chile’s central bank will have more work to do even as downside risks on the economic growth front appear to be mounting. Indeed, more tightening today could prevent the need for more aggressive action down the road.   

Chile’s difficult inflation backdrop, however, has also a positive sideas it partly reflects Chile’s continuous commitment to sound policies. Faced with surging foodprices, Chile has not gone down the road of widespread price controls, trade bans or heavy subsidies, which tend to postpone adjustments and, more often than not, hurt the investment environment. On the energy front, part of today’s price pressure reflects the cost of Chile’s objective of reducing its vulnerability by promoting investment in the sector and by seeking more reliable energy sources away from natural gas from Argentina. The supportive global conditions of the past five years have tended to obscure the line between externally fueled upturns and growth brought about by fundamental improvements. With the region likely to face in 2008 the first test to the abundance enjoyed in the past five years, Chile once again looks well equipped to deal with the coming downturn.

 

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Peru
Monetary Policy Dilemmas by Boris Segura
January 23, 2008

By Boris Segura | New York

In the first two weeks of this year, the Banco Central de Reserva del Peru (BCRP) has bought US$2.3 billion in the foreign exchange market, almost a quarter of its full intervention in 2007. This has led to questions about the sustainability and rationale of this policy, as the central bank’s stock of Certificates of Deposit (CDBCRP) ballooned during 2007.

In the long run, this policy is not sustainable. Fully sterilized intervention keeps domestic interest rates high, inviting more portfolio inflows; partial sterilization risks unwarranted boosts in domestic liquidity and inflationary pressures down the road. On top of that, the central bank’s frequent intervention in the currency market dampens exchange rate risk, again inviting further speculation. These are the main dilemmas faced by Peru’s monetary authorities.

In fact, the central bank hiked its reserves requirements on nuevos soles and dollar deposits last week, in view of continued pressure on its balance sheet. This is a policy response designed to increase the central bank’s liabilities at a low cost.

Intervention in the currency market is taking place in a context of rising inflation.Food prices have been a major driver of inflation in Peru, as they make for almost half of the consumer price index. If food is excluded, CPI has only risen by 2%Y, right at the center of the inflation target. We believe that the authorities have overstressed this fact, and run the risk of falling behind the curve.

Headline and core inflation are now above the upper bound of the central bank’s inflation target. In particular, core inflation (which excludes not only volatile foodstuffs but also fuel, transportation and utilities) breached the 3%Y limit last December, a level unseen in the recent inflation-targeting history of Peru. As headline inflation is the target of Peru’s monetary regime, monetary authorities should be vigilant that food price inflation does not contaminate the price formation process in the rest of the economy.

Tools of monetary policy in Peru

As in the case of other countries pursuing an inflation-targeting monetary regime, the central bank’s main operational target is the reference interest rate, which it hiked last January 10 from 5% to 5.25%. Authorities conduct open-market operations so as to keep the interbank interest rate close to its policy rate.

However, in the case of Peru, a high degree of financial dollarization complicates the executionand effectiveness of monetary policy.Although it has decreased steadily during this decade, the proportion of the banking system’s liquidity and credit in dollars remains one of the highest in the region. Authorities are preoccupied with possible balance sheet effects of currency volatility within this context.

The central bank intervenes, at times heavily, in the foreign exchange market in order to accumulate international reserves and to smooth exchange rate fluctuations. Over the last few years, it has mostly purchased dollars; the associated soles liquidity is then sterilized via issuance of CDBCRPs. The central bank handles day-to-day liquidity fluctuations via its overnight window and the use of repos.

We have to question the sustainability of the central bank’s practice of issuing costly liabilities as the main tool of its sterilization strategy going forward. Much of the sterilization of international reserves accumulation last year was achieved issuing CDBCRPs. As evidence of a responsible fiscal stance, fiscal policy – via accumulation of government and Banco de la Nacion deposits at the central bank – has facilitated its sterilization efforts. Accumulation of bank deposits at the central bank, due to reserve requirements on dollar deposits, also helped to sterilize the accumulation of reserves.

Unlike recent years, the central bank now has to incur quasi-fiscal costs for sterilization. Until September 2007, it was profitable for the BCRP to buy dollars and issue CDBCRPs in return. This is not the case any longer, as the central bank has had to hike its reference interest rate for inflation-fighting purposes and the US Federal Reserve is lowering its rate in order to fight off recessionary pressures.

In addition, as explained above, the stock of CDBCRPs has increased materially lately. Doing some back-of-the-envelope calculations, we estimate that if the central bank sterilizes as much this year as in 2007, it will incur a cost of 0.20% of GDP, which seems a manageable amount at the moment. This is the ‘cost of the insurance’ to be paid for reserve accumulation.

Dilemmas of monetary policy in Peru

Peru’s current monetary policy strategy poses several dilemmas:

There is little exchange rate risk. As Peru has become an attractive place to invest, foreign direct and portfolio investment is entering the country, bringing about appreciation pressures on the nuevo sol.  The central bank then intervenes in the currency market in order to slow it down. However, as inflation has been on the rise, the central bank has been forced to hike its reference interest rate. Therefore, expectations of higher domestic interest rates are attracting portfolio inflows in an environment where appreciation of the currency is a one-way bet, which encourages further portfolio inflows.

We suspect that precisely more volatility in the currency would increase exchange rate risk and thus discourage speculative, short-term portfolio inflows. In a recent working paper (“El Mecanismo de Transmision de la Politica Monetaria en un Entorno de Dolarizacion Financiera: El Caso del Peru entre 1996 y 2006” by Rossini, R. and M. Vega, Working Papers Series: DT No. 2007-017, November, 2007), the BCRP staff rationalizes its “slow as it goes” approach to currency appreciation. In a nutshell, it is willing to slow down movements in the exchange rate so as to allow a more lasting and powerful pass-through to domestic prices and to avoid “bubble-like” behavior of the currency.  

Another dilemma is that heavy intervention in the FX market is bringing about strong increases in domestic liquidity; in 2007, money base grew by 28%Y, well above growth of nominal GDP and despite the swelling CDBCRP stock. We should not assume that the fiscal authorities will make an increased contribution to the sterilization effort, as we expect fiscal accounts to deteriorate marginally this year. Therefore, the authorities would have to rely more on further issuance of CDBCRPs, in an environment of rising local rates.

Good central banking practice suggests that the central bank intervenes at the short end of the yield curve. However, the central bank is making a concerted effort to extend the duration of its CDBCRP stock. This strategy runs the risk of cannibalizing the T-bill and T-bond curves, which is the location of the government’s debt management operations. Therefore, it would be appropriate to suggest that the central bank sticks to the very short end of the yield curve (i.e., its reference policy rate), and uses it as a pivot for the rest of the yield curve in order to solidify the transmission mechanism of its policy actions.

But don’t expect market-unfriendly policy responses, such as capital controls. The authorities understand clearly that, in a context of financial dollarization, it is key that the domestic banking system has ready access to financing abroad and that capital flows freely, subject to reasonable prudential controls.

 

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China
The Probability of an Imported Soft Landing in 2008 Is Rising
January 23, 2008

By Qing Wang | Hong Kong

Feels like winter: The recent sell-off in the Chinese stock market has reflected investors’ concerns about the risk of policy over-tightening in China as well as weaker-than-expected external demand as a result of a US recession, in my view. The market appears to have priced in the ‘winter scenario’: aggressive policy tightening chokes off domestic demand, exacerbating the impact of a global synchronized downturn and resulting in an outright hard landing of the economy. For instance, the property and financials sectors – which are domestic demand-oriented and heavily influenced by domestic tightening – are being hammered as much as the export-oriented sectors that are most vulnerable to a sharp slowdown in external demand. As discussed in our earlier note, we fear that the winter scenario will be “disastrous” for the stock market (see China Economics: Journey Into Autumn: An Imported Soft Landing in 2008, December 4, 2007).

A wake-up call from the US Fed: Last night, the FOMC announced a 75bp cut in the fed funds target. This is the first inter-meeting move since the days immediately following 9/11. Our US economist, David Greenlaw, now expects another 25bp cut at next week’s FOMC meeting. In my opinion, this decisive move will make Chinese policy-makers fully appreciate the large downside risk facing the US economy and seriously consider easing the existing policy controls as a first line of defense. I therefore believe that the risk of the ‘winter scenario’, or ‘over-tightening by policy mistake’, is now substantially lower than before (see China Economics: Two Types of Over-tightening, January 4, 2008).

Changing our interest rate call: In light of these latest developments, we now change our original PBOC call from ‘two more rate hikes in 1H08’ to ‘no rate hike’ in 2008. While the authorities will unlikely make any formal announcement to suspend the current round of macro tightening, we expect the officials’ policy tone to become less hawkish in the next couple of months and the stance to eventually (and quietly) ease by mid-year.

Reaffirming our ‘imported soft landing’ call: We now attach a higher probability to ‘an imported soft landing’ as the baseline scenario for 2008 and maintain our forecast of China’s GDP growth decelerating from about 11.5% in 2007 to 10% in 2008. The global downturn should help the Chinese economy to cool off without the government taking aggressive tightening actions by resorting to blunt policy instruments, which may bring about a hard landing.

Reiterating our early assessment of market implications: 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 to the equity market over the medium term (i.e., 1-3 years), the stock market performance would likely be moderately negative in the near term (i.e., 6-12 months). Specifically, low-valued and low-margin export-oriented sectors (e.g., textiles) may be hard-hit, as firms in those sectors may attempt to hold onto their market share by squeezing their profit margins in order to remain competitive. At the same time, domestic market-oriented sectors – especially those exposed to capex spending supported by the government – should do relatively well, as the government increases its spending to shore up domestic demand, offsetting external demand.

 

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India
Time for a Meaningful Cut in Lending Rates?
January 23, 2008

By Chetan Ahya | Singapore

The RBI’s right move on tightening monetary policy in late 2006

At a time when many other countries in the region are facing the tough task of managing inflation, India’s central bank has successfully managed to address this challenge.  The RBI has effectively reduced the overheating in the economy by initiating aggressive monetary policy tightening and allowing sharp currency appreciation.  Although many market participants criticized these two policy moves at the time, currently India appears to be well positioned to manage inflation risks. Indeed, the RBI had started discouraging mortgage loans by tightening credit norms well before the subprime crisis started in the US.

Growth slowing significantly, need to cut lending rates

The monetary policy tightening has indeed reduced the overheating and financial instability risks.  The key question now facing the central bank is whether it should cut the policy rates to ensure banks’ lending rates are reduced significantly, which is warranted by the slowing growth trend.  We believe that the relatively high level of lending rates has already resulted in a sharp reduction in consumption growth.  This is evident in the consumer goods production growth, which has decelerated sharply to 3.2% during the three months ended November 2007 from the peak of 18.5% in June 2005. 

The leveraged spending by households has already declined sharply, as reflected in two-wheeler sales, consumer durables production and mortgage lending growth.

In addition to the sharp deceleration in consumption growth, the export sector has also suffered a slowdown because of weakening demand in the developed world and appreciation in the rupee.  Export growth in rupee terms has weakened to an average of 6.9% over the past six months, compared with 23.3% during the 12 months ended March 2007.  With the US economy likely to face recession in the first two quarters of 2008, a further slowdown in exports is inevitable, in our view.

Hence, two out of the three engines of growth (consumption, exports and capex) are already faltering. 

Private corporate capex remains the bright spot. Although some amount of slowdown in consumption was critical to reduce the overheating risk, the extended duration of this weaker growth phase could cause serious damage to the overall growth momentum.  We believe that the risk is that this sharp slowdown in demand for final goods could start to weigh on the corporate sector’s confidence for investment.

The aggressive pick-up in corporate investment two years ago is now beginning to bear fruit in the form of operative capacity available for production.  In our view, weaker sales growth when the capital charge for new capacity is increasing will hurt corporate profitability and sentiment.  We believe that lending rates need to decline by about 150bp soon to ensure that credit growth does not dip decisively below 20%.

Challenges to cutting rates

The RBI, however, has been conveying its challenges in cutting policy rates.  The most important challenge it is facing is managing headline inflation below its comfort zone of 5%. Although headline inflation declined to 3% during the week ended November 24, 2007, it accelerated back to 3.8% during the week ended January 5, 2008. 

First, the headline inflation is hugely understated for oil prices.  According to Morgan Stanley oil and gas analyst Vinay Jaising, 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$90/bbl.  Even assuming that crude oil prices of US$90/bbl are unsustainable and the government needs to mark the domestic prices to US$75/bbl, headline inflation would rise to 4.5% from the current 3.8% before considering the cascading impact of this on other products.

Second, the RBI is concerned about food prices.  With international food prices reaccelerating recently and the possibility of a potentially weak crop output during the winter season (harvesting for which is due in February-March), the risk of food inflation rising from the recent lows of 2.3% during the week ended November 10, 2007 is increasing.

The third and most important issue worrying the central bank is potential continued risk aversion in the global financial markets, which in turn could result in capital outflows (see Subprime, Risk Aversion and India, August 16, 2007).  Note that unlike many other emerging markets, India runs a current account deficit.  If capital outflows accelerate, the rupee would depreciate, resulting in added concerns for inflation.  The rupee has been trading in an over-valued range for a while, only with the support of large capital inflows.

Political system’s tolerance for inflation is low

We believe that the Indian political system has lower tolerance for even supply-side inflationary pressures from oil and food, even if the second-round effects are manageable.  Although general elections are held after a gap of five years, the frequent state elections result in great concern for headline inflation among the politicians.  Although strong GDP growth benefits higher income groups more than lower income groups, the rise in inflation hurts the poor more than the rich.

With the proportion of poor outnumbering the proportion of rich in the population, policy-makers would prefer to err on the side of caution to ensure that inflation remains low.

Moreover, in India the politicians focus on headline inflation rather than core inflation.  This is because the consumer cares little whether the source of inflation is demand-side or supply-side pressure and whether it is due to local or global factors.  In other words, the politicians would like to keep demand-side inflation even lower if the risks of a supply shock are high.  This discussion assumes greater importance as general elections are likely to be held in the next 12-15 months.  With headline inflation having already spiked above the comfort zone of 5% before retracing to the current 3.8%, the government appears to be determined not to allow it to rise above this level again before the general election.

Risk of reverting to lower equilibrium growth rates

The cost of interest rates staying higher for longer would be significant if it results in a slowdown in the capex cycle, as weak consumption would damage confidence in the corporate sector.  In many ways, the root of this problem lies in India’s weak political system, which prevents the country from transitioning to higher equilibrium growth rates.  A large pool of capital inflows into the country since the second half of 2003 provided a great opportunity for the country to move to 9%-plus growth on a sustainable basis, from 6-6.5% growth levels prior to this period.  However, the weak supply-side response (capacity creation) from the government restrains the pace at which India can lift its sustainable growth rate.

Although large inflows pushed real interest rates lower, a weaker response from the government to accelerate infrastructure investment resulted in this liquidity getting absorbed for consumption and fueling asset prices (particularly property).  At the start of the current growth cycle in 2004, the GDP growth trend was below potential (GDP for the five years ending F2003 rose just 5.3% compared with the potential growth of 6.5% at the time).  This meant that strong consumption growth in the initial phase did not cause any overheating. However, we believe that, by early 2006, the economy was overheating as capacity growth remained slow.  Moreover, even as private capex has picked up significantly to an estimated 13.7% in F2007 from 5.9% in F2003, infrastructure capex has improved at a relatively slower pace, to 4.2% in F2007 from 3.5% in F2003.  We believe that infrastructure spending should be 7-8% of GDP to sustain 9%-plus GDP growth.  This slow pace of infrastructure investment growth restrains the overall ‘effective’ capacity growth.  The overheating in the economy caused by stronger growth in demand relative to effective capacity growth forces early monetary policy tightening. This in turns brings down demand growth.

In others words, this slow response from the government keeps sustainable equilibrium growth below the underlying potential of the economy.  We believe that the current effective capacity growth can sustain 7-7.5% growth without overheating.

Outcome of this cycle to depend on global factors

The outcome of the current cycle will depend on the trend in global commodity prices and global risk appetite.  India needs a fall in commodity prices to reduce the inflation pressure.  The decline in commodity prices could reduce the supply shock concerns, allowing the RBI to cut policy rates and thus reviving domestic private consumption.  However, at the same time, India needs the global risk appetite trend to be constructive so that the capital inflow trend does not reverse.  This would ensure that the government gets more time to respond on accelerating infrastructure investment and overall effective capacity growth.  If the recent global market turmoil lasts longer, it will affect the trend of capital inflows into India and therefore the near-term growth trend, in our view.

 

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