What Impact from Global Turmoil?
January 29, 2008
By Marcelo Carvalho | New York
Better placed than before, but not immune
Recent wild gyrations in global financial markets add fuel to the debate on implications for emerging markets like Brazil.To be sure, Brazil’s much improved balance sheet, a large stockpile of foreign reserves and reduced vulnerabilities leave the country in a much better starting position than ever before to weather the global storm. Yet, Brazil is hardly immune to international turbulence. In all, how does the global turmoil affect Brazil? We would underline four main channels. First, the balance of payments will weaken.This is probably the most important channel. A global slowdown would hurt Brazil’s balance of payments through both its current account and its capital account. Morgan Stanley was the first house to warn that Brazil’s trade surplus in 2008 will shrink faster and by much more than the market consensus believes (see “Brazil: Waiting for Godot”, GEF, October 23, 2007, and “Brazil Trade Consensus – What’s Wrong with This Picture?” GEF, November 13, 2007). A global growth slowdown would debilitate Brazil’s export performance (through volumes as well as prices). And strong domestic demand would keep pushing imports up. We see the trade surplus falling by half, from US$40 billion in 2007 to US$20 billion this year. We have strong conviction in this call, and it is not in the price yet. The consensus for the 2008 trade surplus has fallen for more than eight weeks in a row,to about US$30 billion recently, from some US$35 billion before. We think that there is more to go. Disappointing actual trade data and darkening global growth clouds will drive the trade consensus forecast farther down, in our view. As a consequence, prospects for the current account should worsen too. Our out-of-consensus call continues to see a current account deficit of 1% of GDP in 2008, a deficit for the first time after five years of surpluses. Likewise, last year’s record-high capital inflows should not repeat. We see capital flows in 2008 slowing to about a third of their 2007 level (see “Brazil: Balance of Payments – How Sensitive to a Global Slowdown?” GEF, December 4, 2007). Second, global turbulence can complicate monetary policy.The impact from a global growth slowdown on Brazil’s monetary policy is ambiguous. On the one hand, lower net exports would reign in overall aggregate demand, and a weaker outlook for international commodity prices can help slow Brazil’s own inflation. On the other hand, a global slowdown and accompanying global risk aversion can hurt Brazil’s balance of payments, as described above. In turn, this could bring potentially negative implications for the currency, and thus for inflation. In all, if anything, global turmoil probably adds uncertainty to the environment facing Brazil’s monetary policymakers. Third, local financial markets can wobble.Besides implications for Brazil’s currency, global market turbulence can hurt other Brazilian asset prices, as wild recent moves in the Bovespa stock market index make painfully clear. In turn, prolonged declines in the local stock market would risk spooking local retail investors. Luckily, Brazil’s stock market still represents only a tiny fraction of the Brazilian average consumer wealth. Therefore, broader macroeconomic implications for consumption decisions are negligible. For its part, a steeper local yield curve, in part reflecting higher risk perceptions amid less global risk appetite, can work to tighten overall financial conditions. Happily, Brazilian banks have no direct exposure to the issues currently afflicting banks in the developed world. Fourth, local sentiment might be affected.This channel is admittedly the fuzziest, but remains potentially relevant. Consumer and business confidence have risen to record highs over recent quarters, on the heels of very supportive domestic conditions. This shows in strong domestic private sector consumption, as well as in robust investment in the form of ongoing capex expansion. Local sentiment can prove resilient to global jitters, but this remains a potential channel to monitor. Will global turmoil derail Brazil’s growth expansion? Real GDP growth is set to slow in 2008, with a shifting composition.We see real GDP growth slowing from about 5% last year towards around 4% this year. We assume that domestic demand (consumption plus investment) proves resilient. But we see a widening negative contribution from external demand. In fact, net exports have already been a drag on growth for a while, as import volume growth has outpaced export volume growth. Indeed, net exports already subtracted about 2% from overall real GDP growth last year. In 2008, this drag will widen to 3% in our forecast. Domestic drivers look supportive, at least for now.Domestic demand has grown rapidly, on the back of improving labor market conditions and – crucially – expanding credit, with greater availability at lower rates and longer maturities. Ongoing job creation and rising real wages have boosted disposable income and spurred consumer sentiment. Given time lags and the slow-moving nature of labor markets, it would surprise us to see a sudden collapse in the labor market environment soon. For its part, Brazil’s domestic credit has expanded swiftly for years (from a depressed starting point), for reasons that seem to go beyond just cyclical considerations (see “Brazil: What Credit Crunch?” GEF, October 2, 2007). Of course, if domestic credit expansion falters, then the domestic demand outlook would darken. Statistical carry-over supports the headline 2008 growth reading. Because the economy accelerated through 2007, it started 2008 with plenty of momentum. The statistical carry-over for 2008 is about 2.5%. That is, even if the economy stays flat throughout 2008, its average level this year would be about 2.5% higher than the real GDP average level in 2007. Risks around our 2008 growth forecast seem biased to the downside. But it would be hard to see the headline 2008 growth figure falling much below the 3% mark. However, headline average figures can mask growth dynamics through the year. We suspect that year-on-year real GDP growth will have peaked at almost 6% in 3Q07, and we look for a growth deceleration through 2008. We expect average year-on-year real GDP growth of 4.7% in 1H08, slowing to 3.8% in 2H. Long-term potential growth estimates may be called into question.In a sense, the debate about the 2008 growth outlook misses the point. Even if the headline 2008 growth figure proves resilient, a worsening global environment may raise questions about Brazil’s underlying long-run growth potential. Brazil enjoyed an exceptionally favorable global environment over the last several years, since 2003. Indeed, average global growth accelerated from 3.4% during 1998-2002 to 5.0% during 2003-07. Similarly, international prices for non-fuel commodities (highly correlated with Brazil’s own average export prices) had declined 4.0% every year on average during 1998-2002, but jumped 13.3% each year on average since 2003. Perhaps unsurprisingly, Brazil’s annual real GDP growth jumped from 1.7% on average in the five years before 2003 to 3.8% on average since then. But the global environment is changing now. Note that Brazil’s headline growth in 2003 – the first year of transition to better times – was still weak. Will 2008 prove a positive headline growth year in transition to tougher times? Structural reforms hold the key for sustained long-term growth.Years ago, estimates for Brazil’s potential growth used to fall mostly in the 2-3% range. Growth acceleration in recent years has led some observers to upgrade that estimate to as high as the 4-5% range. Under tougher global conditions, however, we would not be surprised to see popular estimates of potential real GDP growth eventually being revised down again − perhaps to 3-4%? In the end, there is little doubt that structural reforms would be crucial to boost Brazil’s long term growth potential in a sustained way. Regretfully, abundance often entails complacency. In retrospect, it would be sad if the exceptional stretch of global abundance seen during 2003-07 enters history as a period of missed opportunities for Brazil’s reforms. What to watch going ahead? What would make us change our mind about Brazil’s 2008 outlook in face of global turbulence? We would keep an eye on three main variables: Watch capital flows.We assume that capital inflows slow down from last year’s record-highs but still remain positive. An outright sudden stop in capital inflows would darken the outlook, through its implications for the currency. Watch signs from monetary policy makers.We assume no rate hikes this year. If we are wrong and the authorities instead quickly embark on an outright monetary tightening cycle, then growth prospects weaken. Watch whether global turbulence starts hurting consumer and business sentiment indicators, as well as banks’ willingness to extend credit. Bottom line Brazilis better positioned than ever before to weather the global turmoil. But it is surely not immune. The main transmission channel is the balance of payments, which is set to weaken from last year’s extraordinary strength. We stick to our out-of-consensus call for worse trade and current account numbers. In turn, net trade is likely to be an increasing drag for real GDP growth this year, which is set to slow from last year’s peak.
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Consumer Crunch Time
January 29, 2008
By Luis Arcentales | New York
It wasn’t a particularly happy holiday season in Chile, with retail sales up at an anemic 0.9% annual pace in December. This was well below projections by Chile’s retail chamber, CNC, which highlighted that though activity in the first half of December had been “slow”, it still expected growth above November’s solid 4.0% gain. A relatively high comparison base and the calendar – December 2006 had two long weekends and one additional Friday – certainly exaggerated the December downshift; however, we suspect that December’s softness, and in fact the generally sluggish pace of retail activity in 2H07, was not a fluke and reflects mounting pressures on the Chilean consumers. Indeed, echoing the deteriorating consumer backdrop, confidence sank to the lowest level since late 2003, well below the 50 ‘neutral’ threshold. Consumers are facing strong headwinds, ranging from soaring food prices and record energy quotes to tighter lending standards. In addition, jobs growth has shifted to a lower gear, and Chileans are experiencing a persistent crime problem. Under the circumstances, we expect private consumption growth to turn sluggish throughout 2008 following a four-year period of resilient growth in excess of 7%. Inflation perfect storm Chileans are 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% target. Rising inflation and expectations, in turn, prompted Chile’s central bank to lift its reference interest rate five times to 6.25% from 5.00% in June. Surveys show that the sharp run-up in energy and food prices – which is squeezing consumers’ budgets – is one of the chief concerns of Chileans today. In December, almost 60% of Chileans expected inflation to go up by “a lot” in the coming 12 months. While this is lower than the 73% August peak, it represents a sharp break from the 2002-06 period when inflation was no more than an afterthought, with only around 40% of consumers showing concern about future price pressures. And the prevalent inflation angst is not at all surprising – as of last month, electricity bills were 42% higher than in December 2006, gasoline was up 12% while fruits and vegetables were up 33%. Some price relief appears to be on its way, but 2008 will inevitably be another year of high inflation, averaging around 7%, according to our estimates. Some foods are beginning to retreat and the government allocated US$200 million to the Fuel Stabilization Fund, which last week translated into price declines of around 8% for gasoline. In addition, the authorities seem to be exploring other measures to help ease inflationary pressures, with a potential cut in fuel taxes apparently on top of the list. Still, 1Q08 should see meaningful price increases in education and a series of backward-looking indexed prices, which are likely to push annual inflation above the 8% threshold. Credit boom no more? Explosive credit growth has been a major consumer tailwind in recent years (see “Chile: Private Consumption to the Rescue”, GEF, September 19, 2006). The sustained and accelerating double-digit real growth in consumer credit has been impressive, given the central bank’s major tightening cycle that ended in mid-2006 after 350bp of rate hikes, with a commensurate adjustment in the cost of credit to consumers. However, the tide has turned – bank credit to the consumer slowed noticeably during 2007. At least three factors appear to be at work. First, banks have tightened lending standards in response to prospects of deteriorating credit quality. Indeed, the central bank’s 4Q survey of credit conditions showed that 16% (net) of banks making consumer loans had tightened standards. Second, the deteriorating inflation picture has prompted 125bp of cumulative central bank tightening since July – and we suspect that the central bank has more work to do – which has pushed consumer credit costs higher (see “Chile: No Time for Inflation Complacency”, GEF, January 23, 2008). And unlike the experience of 2004-06 when credit steadily accelerated, today higher interest rates seem to be getting more traction: while during 2004-06 on average 40% of banks (net) reported improving demand for consumer loans, that figure was just 13% last year. Lastly, in its most recent Inflation Report – released on January 16 – the central bank suggested that, given Chile’s relatively high level of credit penetration, consumer credit is unlikely to be a major driver of consumption growth going forward, thus suggesting some degree of saturation in a context of slowing income growth. The cautious tone from bank surveys and other credit indicators, however, do not point to a credit bust. By most metrics, the Chilean financial system is in excellent shape. For example, the system’s ratio of past-due loans to total loans ended 2007 at 0.75%, the same level as December 2006 – an all-time low (see Chile Financial Institutions: Monthly Snapshot, by our equity research colleagues, January 23, 2008). Moreover, retailers are playing an increasingly active role in the consumer credit business, supporting our case for a moderation, rather than a bust, in consumer credit growth. Labor market slowdown In addition to high inflation and tighter credit, consumers are facing slowing income growth, mainly in the form of decelerating job creation. The meaningful upturn in the rate of unemployment of late – to the highest seasonally adjusted level since mid-2006 – has been in part exaggerated by an increase in labor participation. But job creation has clearly shifted to a lower gear in recent months, growing by just 1.9%Y in October-November compared to 3.4% at mid-year. Indeed, our measure of trend job growth suggests that after expanding at a monthly pace of around 25,000 jobs in 1H07, total employment has been largely flat since then. And with the global environment poised to deteriorate in 2008, a turnaround in labor markets seems unlikely to us. Underneath the moderating growth in total jobs, however, the data continue to show a positive trend in the form of an improving composition – salaried positions are gaining ground relative to self-employment. A final headwind for consumers is Chile’s persistent crime problem. To be fair, Chile lacks the incidence of violent crime seen in other major economies in the region like Mexico and Brazil. Still, crime is a problem weighing heavily on consumer sentiment. The most recent January survey conducted by researchers from Libertad y Desarrollo shows that 59% of participants are fearful of becoming victims of crime, essentially unchanged from the results of January 2007 (58%). Over the same period, the percentage of households with at least one member that was the victim of crime in the preceding three months rose to 18% from 14%. And Chileans lack trust in the judiciary – more than half of those surveyed (53%) believe that reporting crimes to the authorities is pointless. Bottom line Chilean consumers are facing strong headwinds, ranging from soaring food and energy quotes to tighter lending standards, slower job growth and a persistent crime problem. Some of these pressures should ease over the course of the year – inflation is likely to trend lower – while others are likely to be more persistent. The upshot: We expect private consumption growth to turn sluggish throughout 2008, following a four-year period of growth in excess of 7%.
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Emerging Risks to Domestic Demand Story
January 29, 2008
By Chetan Ahya | Singapore
Indonesia has been one of the strongest domestic demand growth stories in the ASEAN region – a theme we have been highlighting over the last two years. One of the key drivers for this improvement in domestic demand has been a steady decline in the cost of capital. This, in turn, was supported by a major change in the macro balance sheet such as a sharp decline in public and external debt, improvement in the current account surplus and steady rise in the foreign exchange reserves balance. However, high oil prices, rising food prices and the echo effect of potential continued volatility in global financial markets have increased the risk of a temporary reversal in this trend. With the December data at 6.6%Y, inflation has continued to stay at the upper end of the central bank’s 5-7% range for 2007. If the inflation rate accelerates further, we think that the pressure on the central bank to reverse its monetary policy stance will rise. Risks to the inflation outlook include: · Higher oil prices: Higher oil prices have resulted in large subsidy burdens. According to government estimates, if oil prices were to stay at US$100/bbl, the fiscal deficit would likely rise to 3.0% of GDP from the government’s 2008 estimate of 1.7%. We believe that if oil prices rise to US$105-110, it will likely increase the pressure on the government to consider a hike in domestic oil product prices, thereby increasing inflation risks. · Spike in global and regional food prices: The CRB foodstuff index has accelerated again after decelerating between September and November 2007. Food inflation in Indonesia remained elevated at 11.3% in December. With regional food prices continuing to rise, some spillover from this into the domestic market is inevitable, in our view. Most countries in the region are initiating measures to encourage imports and stop/discourage exports. Many countries in the region are planning to increase stock of the staple food items only, exacerbating underlying demand. With food and food products accounting for 24.7% of the weighting in headline CPI, we believe that further food price escalation is one of the most important risks to the inflation outlook in Indonesia. · Potential further volatility in global financial markets: Any major rise in volatility of the financial markets could result in capital outflows causing further depreciation of the rupiah, adding to the inflation risks, in our view. Already, the capital account recorded a deficit of US$0.7 billion during the quarter ended September 2007, compared with a surplus of US$2.2 billion during the quarter ended March 2007. Similarities to the mini crisis in October 2005 Some of the emerging challenges are similar to those of late 2005. Oil prices had risen significantly and financial market volatility had increased. The oil subsidy burden was rising and the refined oil balance was deteriorating, aggravated by the leakage of cheap oil products from the public distribution system. The government was pushed to hike domestic oil product prices by a cumulative 149-186% between March and October 2005. A major spike in headline inflation and increased volatility in the exchange rate forced the central bank to hike policy rates to 12.75% by December 2005 from 8.5% in mid-2005, which hurt domestic demand. This time it’s different We believe that the macro balance is in much better shape currently compared with that in 2005: · Public debt has further declined in this period to 32% of GDP as of September 2007 from 47.9% as of March 2005. External debt to GDP has declined to 33% as of 3Q07 from 52% in 1Q05. The external debt service burden has declined to 1.9% of GDP in 3Q07 from 2.9% of GDP in 2Q05. This has helped to improve the balance of payments surplus. · The current account balance and balance of payments position are different. In 2004-05, the current account balance narrowed from +2.1% of GDP as at March 2004 to 0% as at September 2005. This, coupled with the outflow of portfolio investments, caused the exchange rate to depreciate, adding to inflation concerns. However, in the quarter ended September 2007, the current account was in surplus of 2.4% of GDP (annualized), supported by a healthy non-oil and gas trade balance. · Domestic oil prices were at unsustainably low levels for a relatively longer period in 2004-05. This resulted in increased leakage of cheap oil products from the public distribution system. The refined oil trade balance widened sharply from -2.4% of GDP (on a 3M trailing sum annualized) to -4.7% of GDP in just three months in September 2005. The government was forced to plug this hole and hiked domestic prices by an average of 126% in October 2005. We believe that the leakage issue was a bigger challenge for the government than the subsidy burden (or fiscal deficit issue) per se. While the refined oil balance has started to widen again to -2.9% of GDP, it is significantly lower than that of late 2005. On the other hand, fuel subsidy rates for premium fuel, gasoil and kerosene are also about 15-25% lower compared to the peak in September 2005. Hence, we believe that an oil price hike, if necessary, could be much smaller this time. Bottom line The risks of a temporary setback to the domestic demand growth story are increasing, in our view. However, we believe that the macro fundamentals are very different currently compared with 2005, implying that any setback to the domestic demand story will likely be small and temporary.
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