Mexico
No Hurry to Ease
February 06, 2008

By Gray Newman | New York

Mexico’s central bank is back in the spotlight following the Fed’s move to accelerate its rate-cutting cycle in January. The Fed’s moves (which in January alone totaled 125bp) − combined with a string of reports showing a slumping US economy – have raised expectations that Mexico’s central bank might not be far behind. Indeed, Mexico’s yield curve, which at the beginning of the year was still pricing in a hike by Banco de Mexico in 2008, is now pricing in at least one cut around mid-year.

While we agree that the next move by Banco de Mexico is likely to be a cut, we are much less optimistic that such a move is coming soon. Depending on the pace of the slowdown in the US and the strength of the link with Mexican economic activity, a rate cut in 2008 is certainly possible. But we doubt that a reduction in rates is coming any time soon.  Indeed, we continue to believe that the most likely scenario is that Banco de Mexico keeps rates on hold during the year.  Further, while the central bank’s talk has taken on a slightly more dovish tone − especially in its quarterly Inflation Report released on January 30 – we expect to see plenty of hawkish talk in the coming months. This could pose a risk to the developing view that a rate cut is nearby.

No hurry…

With the US economy slowing and the first signs that the spillover is also being felt in Mexico, why do we believe that Banco de Mexico is in no hurry to ease? We highlight three reasons to argue that a rate cut by Mexico’s central bank is unlikely in the near term: 

First, demand pressures were never the problem driving Mexico’s inflation in the first place.  Some softening in demand in Mexico is coming − indeed, it is already being seen in private consumption − but that provides Banco de Mexico with limited relief. Why? Because what has been driving Mexican headline and core inflation higher has largely been a series of external, supply-driven shocks, particularly among soft commodities, which have fed through to processed food. Banco de Mexico has argued that it has seen no meaningful demand pressure on inflation in 2007, even before the first signs of slowing consumption and external demand began to emerge in 4Q. 

Unless domestic demand plummets in 2008 − which is not embedded in our forecast of 2.6% GDP growth for the year, nor embedded in the central bank’s forecast of 2.75-3% − Mexico’s inflation dynamic is likely to face more of the same: pressure from grains feeding through to processed foods. And with headline expected to bump back over 4% in the coming months, Banco de Mexico is likely to remain watching for any signs that the uptick in a broad range of food items is putting pressure on wages or on pricing decisions elsewhere in the economy.

Second, we fear that the inflation problem in Mexico will likely appear worse in the coming months before it looks better. Despite the run-up in processed food prices, there appears to be more pressure in the pipeline. In the three months ending in January, international corn prices have jumped 33%, while wheat is up 15%. Unless there is a rapid reversion, those increases are likely to work through from higher input prices into consumer products in the coming months. Whatever your view of where commodity prices are likely to end the year − we are biased towards lower prices later in the year, reflecting weakness in global demand − there are few signs of an immediate reversal in soft commodity prices. 

Further, Mexico’s consumer basket could get hit in April once the voluntary discount campaign launched by Mexico’s principal supermarkets ends in March. And given very favorable produce price behavior in 2Q07, Banco de Mexico has warned that year-on-year comparisons are likely to be skewed to the upside in 2Q08. It is difficult to imagine that Banco de Mexico will ease its tone, much less interest rates, ahead of the May-June period when inflation appears to be on the rise. 

Third and finally, Mexico’s central bank finds itself facing much less pressure to ease than the Fed. While the Fed is battling a downturn in the US, it is also facing the specter of a much more challenging environment for the financial system. In contrast, Mexico’s banking system is well capitalized and facing no subprime turmoil. Indeed, the contrast between the conditions in Mexico and those abroad is so striking that the Mexican operations of foreign financial institutions have come to the aid of their headquarters in recent months. 

…to ease

A slowing domestic economy, along with a slowing global economy, should eventually provide Banco de Mexico room to ease. If we (and Banco de Mexico) are wrong and the downturn in demand in Mexico is even more severe, then there is increased scope for a rate cut sooner. That part is fairly straightforward: watch for signs of plummeting domestic demand that impede companies from passing on increased input costs to consumers or wait until a slowing globe eases input prices. But there are two other cases in which Banco de Mexico could surprise us with an easing move sooner than we have expected, that are not tied to a weakening economy.  Both should be monitored carefully:

First, Mexico’s new alternative minimum corporate tax may prove to have a much smaller impact on consumer prices than the central bank initially estimated. Last year, Banco de Mexico estimated that the one-off impact from the new tax could add 0.4-0.5% to consumer price inflation in 2008. Based on central bank guidance and our initial calculations, we adjusted upward our model-based forecast of 3.3% inflation for 2008 to 3.8%. If the central bank’s calculations turn out to be excessive − as some from the finance ministry have suggested − then even if the economy does not suffer from a more pronounced slowdown than the one currently anticipated, Mexican inflation could end the year lower than our forecast or the range of 3.75-4.25% that the central bank is working with. Faced with the uncertainty over how important the impact would be, the central bank left its inflation forecast for end-2008 and the path during the year and for 2009 unchanged.

Second, Banco de Mexico could ease rates more quickly if the Mexican peso began to break out of its current range and strengthen sharply. The peso has been in a range of 10.70-11.20 for the past 18 months. A gain would likely trigger a lively debate at the central bank, with some arguing in favor of easing. Some might argue that the widening interest rate differential between Mexico and the Fed is attracting speculative inflows and point to the currency’s gain as evidence. Others might argue that the strengthening peso is, in effect, producing a tightening in monetary conditions, and that it is time for the central bank to revisit the right mix between interest rates and the currency.  

While the notion of a monetary conditions index (MCI) is relatively straightforward − in relatively open economies, both the real interest rate and the real effective exchange rate are important transmission mechanisms of monetary conditions to the overall economy − in practice, they are a bit more challenging to produce. Nonetheless, our own work on MCIs suggests that if the peso were to strengthen to 10.40 by year-end, that would represent a significant tightening in monetary conditions. 

What could drive the peso stronger? Topping our list of candidates would be either a view that the US downturn was ending, or that a significant breakthrough on the energy reform front was at hand. Either of these events could not only spark gains in the currency, but also prompt − indirectly − a cut in interest rates. 

Bottom line

For more years than we care to remember, we have been arguing that Mexico does not have an inflation problem.  Mexico does, however, have an inflation-targeting problem. The target set by Banco de Mexico of 3% has only been achieved in one brief period − and even then it was driven by a temporary bout of produce deflation. Given the turmoil last year as Banco de Mexico struggled amid rising food prices to regain control over its message of commitment to its 3% target, we suspect that the central bank will be in little hurry to ease quickly in 2008. We are not arguing that Banco de Mexico can march to its own beat − the links with the US economy rule out any long-term monetary ‘decoupling’. But we would warn against confusing where Mexico’s monetary policy will ultimately end up with an argument over timing.

 

China
Be Prepared For Potential Policy Shift
February 06, 2008

By Qing Wang | Hong Kong

Heightened downside risks

The decisive move by the FOMC to cut interest rates by 125bp in the last two weeks has served as a wake-up call to the Chinese policymakers, making them start to fully appreciate the large downside risk facing the US economy and the attendant negative impact on the Chinese economy, in our view. These latest developments call into question the premise − that the US economy would do just fine − on which the Chinese authorities formulated the macro-control measures back in November 2007.

On the domestic front, the worst winter storms in half a century have swept central and southern China since January 10. The snowstorms paralyzed the transportation system, stranded millions of people on the way home for the forthcoming Chinese New Year, disrupted power supply, damaged crops, especially of fresh food, and led to the disruption of industrial production in some areas. Six provinces in the central and southern region have been hit the hardest. According to the government, direct losses from the storms were estimated at about CNY 54 billion (about 0.22% of GDP) as of February 2, but the damage could rise, as the bad weather conditions continue.

Signs of potential policy shift

On January 30, major Chinese media reported a speech made by President Hu Jintao at a meeting of the Chinese Communist Party’s Political Bureau − the de facto highest decision-making body in China. In the speech, President Hu stated that the government “…should correctly understand the global economic developments and their impact on China, fully recognize the complexity and changeability of China’s external environment, scientifically manage the pace and intensity of macroeconomic controls, with a view to prolonging stable and relatively fast economic growth”.  Separately, Premier Wen Jiabao was quoted on January 28 as saying that “2008 could turn out to be the most difficult year as far as the economy is concerned”, noting in particular the heightened uncertainty in the external environment.

We believe that the remarks by President Hu and Premier Wen signaled an important shift in the policymakers’ tone: from an emphasis on ‘risk of economic overheating’ only about a month ago to attention to downside risks stemming from the unfavorable external environment.

In responding to these calls from the top leaders, the PBoC issued an urgent notice on February 1 asking commercial banks to increase bank lending to support the current effort to combat bad-weather difficulties. Moreover, the CSRC, the securities watchdog, recently approved two new closed-end stock funds, ending a five-month freeze on new funds, and this is widely perceived as an effort to contain the fall in domestic equities. It had suspended the launch of new funds late last year in reaction to the surging domestic stock market. Various other government agencies including the Ministry of Finance have taken corresponding measures to increase financial support to the regions that were affected by the snowstorms.

Déjà vu: 2003 SARS outbreak or 1998 massive flood?

Could this be a repeat of the experience of the SARS outbreak in 2003, which suggested that any policy easing was temporary? Or could it be a repeat of the experience of the massive flood in 1998, which served only to make the authorities more decisive in implementing their policy easing in the aftermath of the Asian financial crisis?

Back in early 2003, while the government was already concerned about rapid credit growth (18%Y in 1Q03), the policy response was delayed by the SARS epidemic in 2Q03, and credit growth was allowed to accelerate to 21%Y in 2Q03 and 23% in 3Q04. With the end of the SARS outbreak in July, the PBoC changed its policy stance swiftly by announcing an increase in the reserve requirement ratio by 100bp effective September 2003 and by a further 50bp in April 2004. The PBoC also engaged in ‘window guidance’, reducing bank lending and tightening lending standards in sectors experiencing overinvestment.

When the massive flood happened in the summer of 1998, China’s monetary policy easing to offset the negative impact of the Asian financial crisis was already well underway, with the 1-year benchmark lending rate having been cut by 216bp from October 1997 to June 1998. This rate was then cut by 99bp in July 1998, in part reflecting the authorities’ effort to boost the economy, which was exacerbated by the flood. It was then estimated that the flood had caused damage to the tune of 1.5% of GDP.

Be prepared for potential policy shift

These latest policy measures initiated in the context of combating the serious snowstorms will likely represent the beginning of policy easing during 2008, in our view. We think that the authorities’ appreciation of the large downside risks to China’s external demand, together with the damage caused by the severe snowstorms, will likely prompt an easing of macro controls as originally envisaged under our ‘imported soft landing’ baseline scenario (see China Economics: Journey into Autumn: An Imported Soft Landing in '08, December 3, 2007).

Under our baseline scenario, we expect the policy stance to remain tight through 1Q or 1H and then turn neutral or ease in the remainder of the year. In short, we expect that the authorities’ macro controls will be front-loaded. In fact, in light of the FOMC’s 75bp rate cut, we changed our original PBoC call from “two more rate hikes in 1H08” to “no rate hike” in 2008 (see China Economics: The Probability of Imported Soft Landing in '08 Rising, January 22, 2008).

These latest developments may even prompt an earlier policy easing than we originally envisaged. In our opinion, the policy shift will likely begin with relaxing the administrative controls over bank lending and investment approval sometime in 2Q. Therefore, the ‘risk of overtightening by policy mistake’ is now substantially lower, we believe (see China Economics: Two Types of Overtightening, January 4, 2008).

When exports weaken, government capex steps in

Would China still be able to achieve a soft landing if external demand were to deteriorate as much as in the previous global downturn in 2001-02? This is the question many clients have in mind. Under our baseline scenario, we expect the authorities to stand ready to ease existing macro controls – as a first line of defense – and even pursue expansionary monetary and fiscal policies, if warranted, to head off any risk of a major economic downturn. We believe that maintaining strong GDP growth is still the highest priority, and the authorities may well intervene, rather than let an external shock do the ‘cooling off’ job, allowing GDP growth to slow cyclically toward 8-9% this year.

Experiences from the last global economic downturn support our arguments. China’s exports have suffered two major downturns in the last decade: during the Asian financial crisis and in the 2001-02 global recession triggered by the bursting of the internet bubble. During the Asian financial crisis, China’s export growth plunged from a peak of 30%Y in May 1997 to -11%Y in November 1998. After the internet bubble burst, China’s export growth dropped from a peak of nearly 40%Y in March 2000 to barely zero growth in October 2001.

Despite the sharp decline in export growth in these two downturns, the impact on China’s GDP growth was much less significant, with the respective GDP growth rates declining by about 1.5 percentage points and 0.1 percentage point from their pre-recession levels. A key reason is that countercyclical government-led capex was able to largely offset the weaker exports such that overall economic growth remained robust.

During the Asian financial crisis and when the internet bubble burst, as soon as export growth started to show a marked decline, there was an equally sharp increase in capex financed from the government budget. And when export growth recovered, there tended to be a correspondingly significant decline in government-led capex.

More importantly, government capex appears to have served as ‘seed money’ to catalyze investment from non-government sources such that when exports are down, overall fixed-asset investment tends to pick up the slack. In reality, the increase in government-led capex is an indication of easing in the macro policy stance. 

Moreover, in part reflecting countercyclical investment that dampens the impact of a slowdown in exports and underpins employment and income growth, domestic consumption − as proxied by retail sales − tends to be broadly stable amid deep downturns in China’s exports.

But what about inflation?

Can the Chinese authorities afford to ease policy controls when CPI inflation remains stubbornly high? This is the question many clients raised during our discussion about the prospects of a potential policy shift. In fact, many clients wondered whether we should not expect further tightening measures (e.g., rate hikes) if CPI inflation in January and February were to post new highs. Indeed, another high CPI reading now appears very likely, as the prices for some food items (e.g., fresh vegetables) will likely register sharp increases in the aftermath of the serious snowstorms.

However, even if inflation were to surprise to the upside in the near term, we attach a low probability to additional tightening measures (e.g., rate hikes, tighter administrative controls on bank lending and investment) that could threaten the outlook for 10% GDP growth in 2008. First, as discussed above, the latest developments suggest that in balancing between inflation and lower growth risks, the government now appears to have shifted toward boosting growth.

Second, the fact that China tends to experience disinflation/deflation when there is a significant decline in exports provides some degree of assurance to the policymakers that inflation will eventually be brought under control, albeit with a lag. With a sharp decline in external demand, Chinese producers would have to turn to the domestic market to sell their products. This added supply in the domestic market would likely depress prices.

Third, a one-off jump in the price level due to supply shocks (i.e., bad weather) is normally not viewed by the policymakers as higher inflation, which is defined as a sustained increase in the price level, and thus should not trigger immediate policy actions.

We therefore expect that in combating inflation, the authorities would rely primarily on further hikes in the ratio for required reserves (RRR) to help control money (M2) growth and faster renminbi appreciation to anchor inflationary expectations and ease imported inflationary pressures, as reflected in high international prices for food, energy, raw materials and so on. We expect the RRR to be raised on a regular basis, as was the case in 2007, and we look for the accelerated pace of renminbi appreciation since late last year to be sustained.

Also, in view of the current inflationary pressures, we expect that the current price controls will be maintained well into 2Q, and we think that they may even be broadened to include additional items.

Catalysts for policy shift

The recent signs of policy shift have reflected the authorities’ reaction to news (e.g., the global market sell-off and the FOMC’s sharp rate cuts). The news served as a wake-up call for the authorities to start to appreciate the potentially large downside risks facing the US and global economies and put them on alert.

Going forward, we suggest paying close attention to external developments and key policymakers’ statements to gauge the timing of an actual policy shift. In this context, the NPC annual meeting scheduled to take place on March 5-15 should provide an opportunity for the authorities to formally clarify their policy intentions.

The authorities are unlikely to make a meaningful policy shift until they have an opportunity to reassess the domestic and external economic situation based on 1Q08 data around mid-April. In particular, if export growth were to register a significant decline (say, to below 20% for the first time since 3Q02), the policymakers would likely respond with a meaningful policy shift, in our view.

 

Thailand
Cyclical Recovery Underway
February 06, 2008

By Chetan Ahya | Singapore

Weakest market in EM space so far

Thailand has lagged the ASEAN and emerging markets over the last three years due to political instability and the consequent impact on domestic demand. While we have seen GDP growth accelerating in almost all emerging markets in this period, Thailand’s growth has decelerated to an average of 4.8% over the last two years from an average of 6.7% in 2003-04. The stock market performance has followed a similar trend. MSCI Thailand has underperformed the MSCI EM by 33% over the last three years. Indeed, Thailand is one of the very few emerging markets that has not participated in the three common themes of increased household leverage for consumption and property investments, higher private corporate capex and government spending on infrastructure.

Apart from political problems, a relatively conservative monetary policy and the almost complete pass-through of higher international oil prices to domestic consumers (many other EMs have subsidized oil prices) have also affected domestic demand growth. Private consumption growth has indeed touched an eight-year low of 0.8%Y in 2Q07. Weak domestic demand in Thailand is also reflected in the current account surplus rising to a seven-year high of 10.0% of GDP (annualized) during the quarter ended December 2007. However, we believe that the country is now poised for a cyclical recovery. The political and economic growth outlook has improved over the last few weeks.

Domestic demand – worst is probably behind us

Weak domestic demand in the last three years has resulted in a significant improvement in Thailand’s macro balance sheet, as measured by reduced financial leverage in the system. The aggregate debt to GDP (leverage of household, corporate and government) for the country has fallen to 91.7% from the peak of 102.9% three years ago. However, domestic demand indicators have started bottoming out over the last four months. Some of the key indicators reflecting this recovery include bank credit, imports, VAT collection and retail sales growth. The four key drivers for this recovery are i) increased pent-up demand; ii) a decline in real interest rates; iii) increased government spending; and iv) improving sentiment on hopes of potential improvement in the political environment.

Uncertainty in the political environment meant a pushback in spending by the corporate sector on capex and households on consumption. However, corporate entities, households and the government are now beginning to increase their spending. Private corporate capex growth reached an eight-year low during the quarter ended March 2007. Capacity utilization in the corporate sector is already stretched at 76.9%, encouraging some spending for capex. While over the last few months the government had started to push through higher revenue expenditure, the formation of the new government should ensure some improvement in capital spending too. The recent sharp decline in real interest rates and improvement in the political outlook should provide confidence to the corporate and household sectors, supporting the recovery in domestic demand over the next few months.

Domestic demand to offset potential slowdown in exports

Despite the strong appreciation of the baht over the last two years, export growth has remained very strong. Meanwhile, on a real effective exchange rate (REER) basis, the baht has appreciated by 13.6% over three years and export growth has outperformed the region. However, a further slowdown in the US, Europe and Japan over the next few months would likely cause some slowdown in export growth. We expect the recovery in domestic demand to help to offset this, ensuring that overall GDP still accelerates to 4.8% in 2008 from 4.6% in 2007. We expect domestic demand growth to accelerate to 5.6% in 2008 from 2.1% in 2007.

Full realization of potential growth needs more stable political structure

While we expect a recovery in domestic demand in 2008 after two straight years of deceleration, we believe that a fully fledged reacceleration of GDP growth to the 6.5-7.0% achieved in 2003-04 would need a strong and stable government. Risk of military intervention is still high. So far the military has chosen to refrain from interfering actively in the formation of the new government. In our view, there is still a risk that the current six-party coalition government led by the PPP (People’s Power Party) may not survive for more than one or two years. We believe that the manner in which the PPP leadership manages some of the critical political issues over the next six months will determine how long the new government will last.

Some of the difficult issues that the PPP leaders will have to manage are as follows:

·The most important challenge is to effectively co-ordinate with the coalition partners, many of whom fought the general elections against the PPP.

·The leader of the PPP, Samak, faces legal cases. If the verdict of the court goes against him, he may have to step down from the premier position.

·The PPP will have to ensure that the conduct of the government is independent and that its decisions are not actively influenced by Thaksin.

·The PPP leaders have indicated in the past that they will seek amnesty for the 111 former executive members of the disbanded Thai Rakh Thai Party, including Thaksin, who were barred from politics for a period of five years. Currently, PPP leaders claim that they will not raise this controversial issue for the next six months. If they raise this issue, there is a risk that it will create some political tension. Similarly, if the new government decides to allow Thaksin back into Thailand, it will have to ensure a smooth entry for him.

We believe that the military coup in September 2006 has caused significant damage to the country’s political outlook. Thailand’s political structure is likely to be perceived as unstable for a long period even if the current government lasts for more than 1-2 years. Taking into account the underlying positive demographics and the strength of its corporate sector, we believe that the country’s potential growth is around 6-7%. However, realizing this growth potential is likely to be difficult until we see stabilization of its political structure.