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Greece Decoupling Goes Intra-European India Will the RBI Allow Further Rupee Appreciation? View GEF Archive

		The Global Economics Team

			Vladimir Pillonca
Vladimir Pillonca works with David Miles and Melanie Baker on the UK economy.
			Chetan Ahya
Chetan Ahya is an Executive Director and the India & South East Asia economist at Morgan Stanley.
		Read about other GEF team members

We think that the likely resilience to external slowdowns is a valuable attribute at a time when the US and European economies seem to be on the verge of slowing, perhaps significantly.  Our central forecast is for Greece to grow by 3.6%Y this year – two full percentage points faster than the euro area – and by 3.9%Y in 2009.  We think that there is scope for profitable investment opportunities in Greece, both for equity and longer-term fixed income investors.  Privatisations of state-owned enterprises could be a catalyst for M&A activity in the coming years.

Greece’s low exposure to the US is a valuable attribute
Not only is Greece less exposed to a severe credit crunch than other fast-growing economies, but its trade links with the US are also comparatively small.  Greece’s US exports share is under 5%, compared with around 8-9% for Germany and Italy.  Overall, our banks analysts think that the Greek banking system has minimal exposure to a US sub-prime-related fallout, and there are several reasons to be optimistic about the medium-term outlook for this and other sectors.

The speed of catch-up has been rapid so far …
Despite the accelerated pace of growth of recent years, Greek GDP per capita remains below the euro area average by at least 11% on a purchasing power basis (PPS), and is at least 12% less than the EU-15 average, but quite possibly more.   This gap likely suggests further catch-up potential: we can expect higher GDP growth than the euro area average until Greece’s GDP per capita converges further towards the EU average (this well documented economic phenomenon is known as conditional real income convergence).

… and even if the speed of catch-up slows …
Even under our slowdown scenario, Greece will grow comfortably ahead of the euro area.  Of course, the exact speed of catch-up is highly uncertain but, even so, growth is still likely to comfortably outperform the rest of Europe over our forecast horizon (2007-09).  Beyond 2009, the catch-up process should be at a more mature stage, and the pace of growth will therefore depend on the progress made on reforms that help to boost Greece’s supply potential and technical progress (for example, via labour market reforms and deregulation).

… growth is likely to remain well above 3%
On our central estimates, trend growth, though declining slightly towards the 3.5-4.0%Y range, would remain significantly above the euro area average of 2.0-2.2%.  Further, unlike Spain and Ireland, which have been outgrowing the rest of Europe, Greece appears less likely to experience a sharp housing downturn that could materially affect overall economic growth.  For these reasons, Greece appears to us to be an attractive economy to consider investing in both for equity and fixed income investors.

A growth engine that works well at home …
Strong domestic demand – household consumption and investment in particular – has been the major growth engine.  This apparent solidity of domestic demand is good news, particularly when the global outlook is increasingly cloudy, and exports are not a likely source of growth.  For this reason, we consider Greece to be a potentially useful hedge against the risks of a global and even a European slowdown.

… is an insurance against a fragile-looking global outlook …
Greece’s strong growth over the last decade has been driven by fundamental factors – such as rising employment, which has underpinned real wages, and solid investment growth, which has enhanced the economy’s capital stock.

… but cannot be exported
Greece’s strong growth performance has not relied on global external growth.  On the contrary, the contribution of net exports has been broadly zero in the last five years, and somewhat negative over the last decade.  This is demonstrated by the persistently high current account deficit (around 9% of GDP in 2006) and has raised doubts about the longer-term competitiveness of Greek companies.  It also underscores the desirability of and longer-term need for supply-side reforms. 

However, the persistent current account deficit is probably at least partly explained by the transitional (catching-up) high-growth phase that the Greek economy has been experiencing.  Other economies where real incomes are converging have also shown similarly high and persistent current account deficits.  In other words, strong domestic demand growth is the flipside of this imbalance.  While this has to be monitored carefully, at this stage it does not appear sufficient to prejudice our positive growth outlook for the next two years or so.

Solid investment growth
Fixed investment has grown rapidly in Greece in recent years, averaging an annual growth rate of over 9% over the last five years – well above overall GDP growth.  Thus, the investment to GDP ratio has risen sharply over the last decade, and currently accounts for around 20% of the economy.  In the euro area, only Ireland (22.6%) and Spain (26%) have higher ratios.  In Spain’s case, part of this has been driven by construction, which now appears vulnerable to a potentially sharp and/or prolonged downturn.  This scenario is not a major concern for Greece.

Moderate risks from housing
We used a simple framework to give a rough idea of the likely contributions to the rise in house prices of persistent, fundamental factors driving demand and supply, such as income, population growth and real interest rates.  Our analysis shows that much of the increases in real house prices seem to reflect predominantly fundamental, rather than speculative, factors.  Our analyses of the Greek housing market do not make us overly worried about a potential sharp fall in house prices in the near term (see Greece: Intra-European Decoupling, February 4, 2008, for an in-depth discussion).

Overall, we are positive on the outlook for Greece
Even so, it would be foolish to ignore the significant risks surrounding our central forecasts.  We think that it is wise to expect a slight deceleration from the exceptional growth rates witnessed over the last decade, as the catch-up process moves to a more mature phase.  That said, Greece is likely to continue to grow significantly faster than the euro area as a whole. For this reason, we think that there are likely to be significant investment opportunities in this economy.  GDP per capita in Greece is still around 11% below the euro area average, possibly more.  This is a significant gap, although it has narrowed relative to a decade ago when it was around 26%. 

So what could go wrong?
We see three main immediate sources of risk:

1. Credit conditions could tighten more sharply than we expect, hitting domestic demand. This could be compounded if house prices were to correct sharply.

2. Growth in Europe and globally could slow more sharply than we anticipate, and for longer.

3. A policy error (for example, sharp rises in income and corporate taxes) and lack of reform are risks for the medium-term outlook (2009 and beyond).

A housing market correction, though less likely than in Spain or the UK, cannot be entirely excluded, and while domestic demand is solid, slower global growth could still dent Greek growth.  Given Greece’s reliance on imported energy, rising energy prices could undermine growth more than we anticipate.  Political instability and anticipated elections are another risk, should they result in a prolonged delay to the economic reform process (the narrow majority that emerged from last summer’s election is, in this sense, cause for concern).  However, we think that a stalling of the reform process is more likely to prejudice growth beyond the next year or two, rather than compromise the more immediate outlook.  More fundamentally, there are solid fundamental drivers behind Greece’s growth performance that should help to buffer the impact of a credit-related shock.

India
Will the RBI Allow Further Rupee Appreciation?
February 14, 2008

By Chetan Ahya | Singapore

Summary
The larger-than-expected cut in the US Fed rate (cumulative 125bp cut in January 2008) and the unchanged stance of the Reserve Bank of India (RBI) at the last monetary policy meeting have widened the rate arbitrage between India and the US. This has increased the risk of attracting more capital flows into the country, thus posing the same old problem of managing the impossible trinity (i.e., capital inflows, exchange rate and interest rates) for the central bank. The key question arising now is whether the central bank will allow further appreciation of the exchange rate. In our view, the RBI is unlikely to allow any meaningful appreciation of the rupee in the near term.

Capital inflows have re-accelerated

We believe that the sharp rise in capital inflows has been driven by significant equity issuance and debt-related flows. On a 12-month trailing basis, capital inflows have increased to an all-time high of US$112.8 billion as of February 1, 2008, as compared with US$40.4 billion during the 12 months ended February 2, 2007.

The RBI is preventing faster rupee appreciation

Despite the rise in inflows, the RBI has continued to intervene in the FX market. There are four key factors influencing the RBI’s decision to prevent further appreciation of the rupee:

·The rupee has already appreciated 10.2% against the US dollar over the last 12 months, as compared with 7.4% appreciation of the Chinese renminbi, 0.8% depreciation of the Korean won and 4.3% average appreciation of the ASEAN-5 currencies.

·The currency remains overvalued on a real effective exchange rate basis (36-country index). The rupee was about 9.2% above the 10-year mean as of October 2007 (the latest data point available). Apart from the adverse demand effect of a US slowdown, the strong currency has already affected export growth. Goods export growth (in rupee terms) on a 12-month average basis decelerated to 7.2%Y during December 2007 from 29.4% during December 2006. Some of the labor-intensive export sectors are already lobbying against further currency appreciation. Similarly, on a trailing four-quarter basis, the C/A deficit excluding remittances (a better measure to assess the implications of the currency’s valuation for trade competitiveness) and trade deficit remain high at around 4.5% and 7.2% of GDP, respectively, as of September 2007.

·Unlike in March-April 2007, when the RBI allowed a sharp appreciation of the exchange rate, the starting point of overall growth does not provide an adequate cushion to allow further appreciation. The three-month moving average growth of industrial production has decelerated to 8.2% as of December 2007 as compared with 12-13% growth registered during February-March 2007.

·The inflation pressures are currently manageable, with the wholesale price index (WPI) at 4.1%Y as of January 26, 2008. In February-March 2007, headline WPI inflation was at an average of 6.4% (significantly above the central bank’s comfort zone of 5%).

Considering the factors we discuss above, the RBI is unlikely to allow any major appreciation in the rupee in the near term. Indeed, we believe that if the capital inflows rise in a sustained manner for more than 2-3 months, the government will again consider some capital control measures to reduce inflows.

What could trigger major rupee appreciation?

We believe that the central bank may allow meaningful appreciation (3-5% in 1-3 months) only under the following circumstances:

·A sharp rise in global commodity prices: The central bank is still concerned about the risks of higher oil and food products prices weighing on inflationary expectations. If there is a sharp rise in oil and other commodity prices, the RBI could choose to allow appreciation in the exchange rate to offset this rise.

·Major appreciation in the RMB and other trade partners in the region: The rupee has appreciated much more than its trade partners and competitors. If the Chinese renminbi appreciates 6-8% in the next 2-3 months, it will result in further appreciation in the other regional currencies, creating room for appreciation of the INR.

Bottom line

Having already allowed a large appreciation of 10.2% over the last 12 months, we believe that in the next 3-4 months the RBI is likely to keep the USD/INR in a narrow band of 39.00-40.25.

Equity market implications: Our India strategist, Ridham Desai, believes that a benign rupee is a good macro backdrop for India’s software services sector, especially with the way the sector has underperformed in 2007 and the valuations at which stocks are trading. The key risk factor is that the US recession gets deeper, which could then hurt the growth outlook.

 

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