Cracking the Credit Puzzle
March 10, 2008
By Elga Bartsch | London
Overview and Conclusion
off-balance sheet items need to be taken into account. A number of other data sets also might hold precious clues in this context.The credit crunch question is also closely connected with the ability of the euro area banking system to fund its balance sheet. In the face of wholesale market dislocations, the role of the ECB’s open market operations and its collateral rules have become even more important. We argue that so far there is little evidence of a credit crunch. But, as this could potentially change, we discuss how to trace such a development. No signs of credit crunch, or even a slowdown, yet On the whole, there seems little evidence so far of a significant impairment in credit supply via the euro area banking system. When debating the credit crunch, our focus is on corporate lending, because that is where two-thirds of the rise in private-sector debt over the last ten years has come from, and where, at 85.7% of GDP, EMU has surpassed the US (68.5%). Capex is also where we expect that the combined pinch of slower global growth, a stronger euro, higher uncertainty, tighter credit conditions and lower profit margins will be felt most acutely. (Even if the ECB were to find itself swamped with too much lower-rated paper, as some observers claim, the bank has a whole range of risk management tools at hand to deal with the situation, ranging for its regular daily mark-to-market and possibility of making margin calls, to imposing limits on the amounts of certain kind of paper that can be handed in etc.) - Lending to non-financial corporates is still brisk. This is particularly visible in quarterly annualised growth rates, which capture the recent dynamics better than year-over-year rates. The year-on-year growth rate in corporate lending reached a new high of 14.5% in January and quarterly annualised growth rebounded to a new high of 19.1% in January, from 10.3% in October. Mortgage lending started to slow long before the credit crisis commenced, in line with cooling house prices and higher interest rates, falling from a high of almost 18% in the summer of 2005 to 5.3% in December. However, it recovered to 6% in January.
- However, changes in outstanding bank loans do not capture dynamics in new loans very well. Looking at the relatively new statistics on new loans and their conditions, compiled by the ECB as part of its MFI interest rate statistic, we see that in December the volume of new loans extended to the corporate sector was up by a total of around €70 billion compared with mid-year 2007, and about €90 billion compared with a year ago. Again, it seems that the downturn is concentrated in mortgages and, to a lesser extent, consumer lending. Unsurprisingly, borrowing has become more expensive, with a rise in interest rates charge of 30-50bp since mid-year, depending on size and interest rate fixation period.
- Finally, the quarterly business surveys indicate that financing their business is, so far, the least of manufacturing companies’ concerns as a factor limiting business operations. At the margin, as a factor limiting production, financial issues seem to be retreating. And to put the numbers into perspective, the 3.5% of companies reporting financial constraints compares with 7% reporting staff shortages or 11% reporting shortages of materials or machinery. Thus, business surveys seem to confirm anecdotal evidence that, at this stage, financing issues are not posing a major restriction on production. A similar message is conveyed by the service sector, which on the whole reports that financing conditions have become much less of an issue.
Credit Dynamics Still Point to Robust Loan Growth… Of course, we will track all of these series very carefully to detect any significant signs of change on the back of the current wholesale market turmoil. The latest ECB bank lending survey signalled a marked slowdown in corporate lending in the coming quarter, partly driven by tighter credit conditions, and partly by slowing demand. The survey also pointed to a further tightening in standards for lending to non-financial corporates during 4Q07. In general, lending to corporates was affected more significantly than lending to households. Compared with the previous survey conducted in October 2007, we think that the further tightening in credit standards can be attributed primarily to a downgrade in expectations regarding general economic activity, and the sector- or company-specific outlook. Considerations regarding bank capital only seemed to play a relatively minor role. …but Lending Standards Might Tighten Noticeably As before, the tightening in lending standards was concentrated on long-term lending to large corporates. For these types of loans a sharp fall in demand was also observed, a trend that banks expect to continue, and one that they attribute to a downturn in the takeover and buyout cycle. Although banks widened their interest margins both on average and on risky loans, non-interest items such as maturity, credit lines and loan covenants and collateral demands were also tightened. Banks were asked about the impact of the financial turmoil. For loans related to M&A transactions, 63% of banks felt the turmoil, compared to 30% for fixed investment and 18% for inventories and working capital. Banks also reported difficulties in wholesale funding – in particular, for the securitisation of mortgages and corporate loans. One in three banks said that their ability to move risks off-balance sheet was reduced significantly. Given that securitisation has shaved off about 1.5 percentage points of lending growth in recent years, the impact would likely be limited. Finally, with respect to funding-impaired SIVs, etc., 30-40% of banks reported this to have a significant impact on their lending policy. For around 60% of banks, drawdowns on ABCP issued by conduits/SIVs are not an issue. Slower Loan Growth Lies Ahead, but Should We Be Worried? Looking ahead, a number of factors will likely cause lending growth to decelerate. A fundamental model of lending to the private sector can be used as a benchmark in judging the dynamics of observed bank lending. First, slower GDP growth will likely cause slower lending growth. Typically, a 1% fall in GDP compared to the base line shaves 1.6% off bank lending in the long run. Our growth forecast pencils in a deceleration in growth of that magnitude this year. Second, a rise in average lending rates usually reduces loan demand. Here, an increase of 100bp in the real lending rate typically causes credit demand to ease by about 0.5% in the long run. Third, an overshoot in the actual lending trajectory of the long-run equilibrium would also call for a deceleration in bank lending in the coming quarters. On our estimates, however, there doesn’t seem to be a significant deviation from the long-run equilibrium path at present. A slowdown in lending growth that would go significantly beyond these estimated levels, and cannot be explained by statistical distortions, should give rise to concerns about credit supply potentially being impaired. Factors that Matter for the Coming Credit Downturn It is virtually impossible to predict the length and the depth of a potential credit crisis in the euro area and its repercussions on the real economy via the banking system. But a few points seem to be pertinent in this respect. First, empirical studies show that the impact of past GDP growth on bank profitability is higher in bank-based financial systems than it is in market-based systems (see
R. Beckmann, Profitability of Western European Banking Systems: Panel Evidence on Structural and Cyclical Determinants, Bundesbank Discussion Paper 17/2007). This would imply that continental Europe, ceteris paribus, could experience stronger negative feedback effects from the current credit crisis for longer. Second, our banks analysts argue that European banks are lagging behind their US counterparts in coming clean on write-downs. Hence, there might be more to come. In part, the bigger write-downs reported reflect the greater exposure to sub-prime mortgages. In addition, quarterly reporting requirements in the US demand greater disclosure, such as for level 3 assets, which essentially are marked to model. Third, the role of wholesale funding differs between banking systems. The higher the proportion of funding through deposits, the smaller should be the problem created by current market conditions. Across the euro area, the share of deposits to loans is 88%, but there are wide differences. Fourth, the yield curve in the euro area is not as steep as it is in the US and might not have the same potential to reach the levels seen in the US, where the Federal Reserve has cut policy rates aggressively. Fifth, some might argue that capital replenishment might be a bit more difficult to administer in Europe than it has been in the US. On the whole, a number of European governments have in the past been rather protectionist regarding their national banking systems. In addition, the EU Commission, while certainly not standing in the way of any emergency operation, will want to make sure that fair competition is not undermined by a government-led bail-out. Finally, the central bank’s reaction function is likely to differ. For the ECB, the primary objective of its monetary policy is price stability. Contrary to the Federal Reserve, it does not have a dual mandate that asks it to balance growth and inflation. Furthermore, the ECB is not in charge of regulation directly. It has to rely on moral suasion, calling on the banking system to report losses as quickly and as fully as possible. Lastly, the ECB’s Liquidity Management Is Key … A key factor in explaining some of the transatlantic differences seems to be the role of the ECB refinancing operations in providing relief to wholesale funding markets. Some of the pressure in wholesale markets seems to be mitigated by the ECB’s liquidity management and the wide range of collateral it accepts in its refinancing operations. Central bank refinancing is likely to play a more important role than it is in the US. The ECB has always accepted a wide range of assets in its regular refi operation and has a wide range of eligible counterparts. This should help, other things being equal, to contain the fall-out from the credit market dislocation. There was a noticeable shift in the ECB’s lending from the weekly main refi operation to the monthly long-term refi operation, underscoring the demand for term financing. Despite this shift, however, the overall amount of financing by the ECB has been relatively steady, with the exception of one big spike late last year. … as Is the Collateral Policy that Backs it Although the ECB does not have to worry about its own liquidity, it needs to monitor the default risk implied by the collateral it receives. But this isn’t likely to be an acute concern for the ECB because of the considerable over-collateralisation. Euro area banks have deposited €930 billion of collateral at the ECB, while only borrowing an average €430 billion in 2006, the latest available data point. As the weekly financial statements show, margin calls are therefore rare events in the ECB. It also raises questions regarding a major funding crisis for the overall euro banking sector. (The capex slowdown will also affect mortgage lending via less spending on commercial construction investment. Nonetheless, we believe that the key variable to watch in the euro area is corporate lending. The euro area corporate sector debt has overtaken the US by a noticeable margin and banks report much tighter lending standards in the face of rampant lending growth. For mortgage lending, the reported tightening in bank lending standards is more moderate, with only 21% of banks reporting tighter standards compared to a net majority of 41% reporting tighter corporate lending standards. In addition, the tightening in mortgage standards seems to some extent to follow a moderation in actual lending, whereas for corporate lending there is a rising discrepancy between lending standards and lending volumes. Furthermore, the finances of euro area consumers are in solid shape, with gross debt outstanding of 90.4% of GDP compared to 134.3% in the US, according to ECB figures. In addition, the gross household saving rate of 13.8% is way above the 3.2% recorded in the US, which should also provide a cushion.) Some observers claim that the ECB is swamped with ABS paper and that this could force its hand in terms of interest rates. We disagree. The ECB might lower interest rates at some point but, if it does, it won’t be because of unwarranted collateral that it got handed under its refinancing operations. It would be because of the economy. Lost Touch with Reality? We Don’t Think So Occasionally, you hear comments implying that central banks, including the ECB, have lost touch with (financial market) reality. We strongly disagree. In fact, the ECB, like its counterparts elsewhere, has a lot more information than most market participants. From its monetary policy operations it has detailed non-public information on banks’ balance sheets, which it uses to calculate minimum reserve requirements; it sees all bids in the refinancing operations, and knows which kind of collateral is being pledged and by whom. All these factors, and how they change over time, should help the ECB to gauge the situation in the banking sector. In addition, it can use formal and informal communication channels with national regulators to obtain additional information. Bottom Line It’s the macro economy that will likely matter for interest rate decisions by the ECB, and signs of a credit crunch taking hold in the euro area’s private sector due to impaired credit supply have yet to materialise. We therefore continue to believe that the ECB is likely to remain on hold for now. However, if signs of a significant impairment of credit supply on the back of the current market dislocations were to emerge this year, it could potentially pave the way for ECB easing in the second half. It could also call into question our, and the ECB’s, expectation for a recovery in 2009. To trigger such a change in the monetary policy outlook, we would need to see a deceleration of credit growth that goes considerably beyond the slowdown to be expected on back of lower demand growth and higher lending rates. However, if and when signs of a marked shift in credit availability emerge, implying significant downside risks to the growth outlook, this could lead to the ECB easing in late 2008 or early 2009.
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USD: The Dollar’s Undershoot: A Forecast Revision
March 10, 2008
By Stephen Jen | London
Summary and Conclusions In this note, we formalise the change in our outlook for the dollar for 1H, as described in a note last week (Dollar Smile Becoming Fixed, February 28, 2008). We mark to market our exchange rate targets, by showing further dollar weakness in 1H08, though we retain our biases that the dollar will likely reassert itself against the EUR and GBP by 2H as the US economy regains composure and the Fed initiates interest rate normalization, but that the dollar will continue its structural descent against many EM (emerging market) currencies. Against our previous forecasts of 1.32 and 110, we now see EUR/USD and USD/JPY at 1.40 and 105 by year-end. We look for further dollar weakness into the spring, with 2Q targets of 1.55 and 97, respectively. Highlights of the Forecast Changes Our last round of forecasts were announced in The Dollar Smiles in a Recession (December 10, 2008), in which we argued that a prospective US recession and the commensurate sell-off in risky assets would engender so much risk aversion and fear that the dollar would, rather perversely, be supported. For close to three months, the dollar appeared to be smiling. However, the recent sell-off in the dollar is both definitive and justified by economic and policy changes. We are never happy to be marking our forecasts to market. But, as explained in greater detail in our note last week, there have been important developments that were not consistent with the assumptions we had made in our December forecasts: 1. The dollar could undershoot further. Speculative USD shorts are not big and, in theory, the dollar could be propelled much lower if speculative USD shorts grow. Monetary policy divergence is so powerful that fear-motivated safe haven flows have failed to support the dollar. Doubts about the economic recoupling of Euroland will likely take some more time to fade. As a result of all this, USD could undershoot further. 2. JPY an opportunistic buy; but USD/JPY should not stay low. For the JPY to stay strong, the underlying assets in Japan need to be bought and held by foreign investors. However, there are significant cyclical and structural concerns about Japan that make us believe that USD/JPY cannot stay below 100 for long, though risk-motivated corrections could rather easily push USD/JPY below 100. We don’t believe that 100 is special, except for psychological reasons. 3. USD weakness to provoke joint interventions? The verbal interventions from Europe mark the first time since 2000 that European officials have explicitly complained about the level, rather than the speed of change, of EUR/USD. In our view, the risk of joint interventions is rising rapidly, but can take place only when the ECB adopts an easing bias. Japan’s MoF would enthusiastically participate in such a joint effort to support the dollar, but would refrain from doing so unilaterally, we believe. 4. Commodity currencies to perform well by year-end. Commodity prices may be ‘telling the truth’ about the state of the global economy, that it remains robust despite the slowdown in the US. Even if headline global growth decelerates somewhat in 2008, the rotation of leadership from the US to Asia/EM is still likely to keep commodity prices supported. While we suspect that commodity currencies may not perform too well as the US economy weakens, by year-end, when the US economy starts to recover, these currencies should do well. We rank the AUD above the CAD, followed by the NZD. Bottom Line The dollar’s weakness is extraordinary. EUR/USD has reached levels that are difficult to justify by structural fundamentals, but could rise further to provoke joint interventions. We concede that the USD could weaken further in 2Q, but retain the view that EUR/USD should be meaningfully lower by year-end. Against the EM currencies, however, the USD, as well as other major currencies, will likely weaken for structural, not cyclical, reasons. We now have year-end targets of 1.40 and 105 for EUR/USD and USD/JPY, with 2Q targets of 1.55 and 97.
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GCC: Evaluating Exchange Rate Regimes
March 10, 2008
By Stephen Jen | London
Summary and Conclusions The GCC (the Gulf Cooperation Council, which includes Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the UAE) faces a menu of choices of exchange rate regimes that are in operation in various Chinese economies: (i) the fixed exchange rate regime in Hong Kong; (ii) the crawling band regime in Singapore; and (iii) the managed float regime in China. Over the medium term, I believe that the GCC will need to follow China’s footsteps: the structural balance of payments surplus and the associated effects on domestic demand will be too large for the GCC not to have its own monetary policy. Nominal pegs are not likely to be sustainable in the long run, if the GCC wants to contain inflationary pressures. Ideally, the GCC should transit to a managed float regime under a monetary union. But given that the monetary union is unlikely to be launched by 2010, as scheduled, and even 2015 may be a push, this seven or so year gap could expose some of the GCC countries to mounting inflationary pressures, tempting them to consider one-off revaluations. Such revaluations are short-term fixes to a fundamental problem. Though they are not what I propose the GCC countries should do, I believe that there is a rising risk that one or several of the smaller GCC economies may contemplate such a parity change, particularly as oil prices are diverging from the fed funds rate. A ‘Back to the Future’ Approach to Policy Making All too often, discussions on possible changes to the currency regime in the GCC region are fixated on the anxious question of what might be done in the near future, which country might do it first, and what the short-term losses and gains are. While this may be the natural thought process for investors, it does not seem to be appropriate for policy makers. In my view, when it comes to rapidly growing economies facing the set of issues involving the ‘Impossible Trinity’, the thought process for the relevant policy makers should always be to start with the design of the best exchange rate and monetary regime for the country in the long term. Only then, working their way backwards in time, policy makers can devise interim policy shifts that will methodically bring the institutional structure and policies incrementally closer to this long-term policy objective. The Chinese government in Beijing followed precisely this approach. Long ago (in 2002), it had recognized the need for China to have its own independent monetary policy. The partial float of the CNY in July 2005, the temporary period of a ‘basket crawl’ regime, and now the managed float are all incremental steps that will ‘buy time’ for Beijing to develop the necessary monetary instruments and the associated markets to allow the PBoC (People’s Bank of China) to conduct independent monetary policies. I believe that the same thought process applies to the GCC. Policy makers need to ask what the right exchange rate regime will be in, say, 10 years’ time, then ask what is the next step they should take in the next year or so, rather than ‘chronologically’ making policy decisions forced by contemporaneous pressures. Why the GCC Might Need Its Own Central Bank There are many positive and exciting developments in the GCC. But not everything is going well. The biggest macroeconomic problem is inflation (which is above 14% in Qatar, above 10% in the UAE, and above 7% in Saudi Arabia. With the exception of Bahrain, inflation continues to march higher in all the GCC countries). There are many sources of inflation, but I believe that the most powerful and lasting source is monetary creation, fuelled by the high balance of payments (BoP) surpluses in these economies. The only effective way to contain this type of inflation is through positive and adequately high real interest rates. There are also supply constraints. In Saudi Arabia, infrastructural bottlenecks have kept prices high. Larger fiscal spending on infrastructural could, arguably, alleviate some of these constraints in the long run. Similarly, in the rest of the GCC, rents are the key driver of inflation, reflecting limited supply of housing. However, ultimately, it is the extraordinarily strong demand growth that has exposed the supply constraints. I have written several pieces on this subject (see A Managed Float Is the Ultimate Goal for the GCC (November 21, 2007), USD Peggers to Blink, Now the Fed Has Turned Dovish (November 29, 2008) and A 70:15:15 Currency Basket Numeraire for the GCC (January 24, 2008)). Here are some thoughts I would like to add to this important debate: • Thought 1. Oil prices no longer mean-revert. For decades, the dollar pegs had worked well for the GCC countries, primarily because oil prices tended to mean revert. While global growth may still collapse from the 4.0-5.0% average in the past five years, oil prices may not mean-revert because the composition of global growth has fundamentally shifted from the OECD countries to large emerging economies, which have a fundamentally different energy demand profile. Alternatively, one could think of this as mean reversion for oil prices, but now oil prices have a highly positive trend. This notion is intimately related to the ‘economic de-coupling’ argument, that the rest of the world (RoW) will likely show greater resilience to a US economic slowdown. The fact that oil prices and the fed funds rate have diverged is a powerful validation of economic de-coupling, however temporary. Conceptually, for our current discussion, it could be argued that the GCC countries are increasingly exposed to demand from China but its monetary policy is set by the Fed. The unreasonableness and the unsustainability of this mix of demand and interest rate policy should be clear. As a footnote, it is important to appreciate the fortuitous timing of China’s move to a currency float: imagine the predicament China would be in had it maintained its de facto peg to the dollar. • Thought 2. Large BoP surpluses have led to significant leakages to the domestic economy. With oil at above US$100 a barrel, not only do large BoP surpluses translate into rapid monetary growth, the significant fiscal intake from oil-related activities also fuels infrastructural and other spending. Much of this ‘leakage’ is justified, from the perspective of growth promotion. However, a natural consequence of demand growth too rapid for the existing infrastructure is inflation. This, I believe, is the main source of inflation in this region. The weak dollar and world food price inflation are much less significant drivers of inflation. (There are fiscal solutions to inflation. Price caps could be imposed and subsidies paid out of the budget to finance the administrative prices.) • Thought 3. Negative real interest rates pit the haves against the have-nots. In all of the GCC countries, real interest rates are now negative. Negative real interest rates have two broad effects on prices – both asset price inflation and goods price inflation tend to rise with negative real interest rates. However, asset price inflation helps the ‘haves’, i.e., those with exposure to properties and equities or other types of financial wealth, but goods price inflation hurts the ‘have-nots’. Thus, the sustainability of negative real interest rates, besides posing a long-term risk to financial stability and mis-allocation of capital, might have a social bias that will not be sustainable over a long period of time. Hong Kong faces a similar issue, but with inflation at around 4% and HK’s middle class having a reasonably high exposure to properties and equities, this social effect is not severe. (The other difference between HK and the GCC is that HK is already a developed nation, whose economic fundamentals tend not to change so rapidly that its real exchange rate needs to adjust significantly to reflect these changes.) Menu of Choices The Greater Chinese economies – China, HK, and Singapore – offer three distinct exchange rate regimes from which the GCC could choose. For the smaller open GCC economies, the Singaporean model of adjusting the targeted NEER (nominal effective exchange rate) relative to an NEER basket may be a viable option. We have, in a previous note, calculated that, if the GCC were to pursue this regime, the 70:15:15 split over USD, EUR and others may be sensible, based on the directions of trade data. In other words, if a GCC country, other than Saudi Arabia, were to unilaterally move to a more flexible currency regime, the Singaporean model is a viable option. However, all of the GCC members have committed to being members of a monetary union. While the agreed target of 2010 may not be met, the political commitment to take part in the union is undiminished. This means that, the long-term regime for the GCC should be one that is appropriate for Saudi Arabia. For the reasons mentioned above, and in my previous notes, I believe that the managed float regime is most appropriate. What Will Happen to the GCC Pegs This Year I believe that the gap between now and when the GCC will have its monetary union is too long for them to have a ‘hold-my-breath-and-hope-inflation-will-go-away’ strategy. As oil prices and the FFR continue to diverge, the risk of Qatar and the UAE realigning their parities this year will rise. Saudi Arabia is unlikely to contemplate a step revaluation, and its relatively low inflation rate will likely permit it more time to contemplate remedial policy reactions, other than modifying its exchange rate policy. I should stress that I don’t believe that the GCC should have step revaluations, or that it should adopt a EUR or a basket peg. But before it is ready to move to a managed float regime, inflationary pressures could compel currency realignments in some countries, as short-term fixes. Bottom Line Given the large balance of payments surpluses, real exchange rates in GCC will need to rise significantly. Whether this happens through nominal rates (as in China) or through inflation (as in HK) will be a political decision in the short run but an economic decision in the long run. As oil prices and the FFR diverge, pressures will continue to mount for currency realignments, not as lasting solutions but as short-term fixes. I suspect that the risks of these adjustments are higher for Qatar and the UAE, and relatively low for Saudi Arabia.
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CHF: Orderly Slowdown in 2008
March 10, 2008
By Luca Bindelli | London
Summary and Conclusions After experiencing four consecutive years of above-capacity growth, we expect Switzerland to withstand a slowdown, down from a growth rate of 3.1% in 2007 towards 1.9% in 2008. Moreover, we expect the SNB to maintain its mid-target rate for 3-month Libor at 2.75% throughout 2008. We think that a strong labour market will provide support to the consumption growth pattern, though not enough to compensate for the decline in external growth and financial activity. The uncertainty surrounding global economic and financial developments has increased considerably since late last year. We assess various risk scenarios, and suggest that growth performance will critically depend on that of global financial markets. We estimate that already in 1Q, the financial sector alone could shave off more than 0.2% to growth. Growth in 2008 Switzerland is still enjoying above-potential growth. Domestic consumption (roughly 60% of GDP) has been a major driver of growth in 2007, itself supported by a very healthy labour market. From a sector perspective, manufacturing, trade and financials were the leading contributors throughout 2007. The industry capacity utilisation rate remains very elevated still (88.0 in 1Q08), suggesting that capacity constraints are still present (long-term average stands at 84.4). Furthermore, potential output has increased lately, mainly on the back of the incoming foreign (EU) labour input. We estimate potential output to be around 1.9%. Accordingly, we estimate that the output gap is higher than 1% (4Q growth was 3.6%Y). Past interest rate increases and the global slowdown will take their toll on growth in 2008. We expect export growth to moderate, helped by the recent CHF appreciation, while imports should remain more supported by relatively stronger purchasing power. On the positive side, we think that domestic consumption will remain one of the biggest contributors to growth. We think that the labour market will continue to provide the foundations for solid consumption growth in 2008. Employment growth stayed above 2% for the last five quarters, and the unemployment level as of February is at 2.5% and constitutes a 5-year low. We find this development quite remarkable, given the deregulation implemented last year (the Swiss labor market was entirely open to EU nationals). Leading indicators, such as vacancy rates and hiring intention indices, still suggest that further employment growth is in the pipeline. The consumption climate as of January remains stable and in positive territory. Investment growth will continue to moderate, owing mainly to the increased economic and financial uncertainty. However, in light of capacity constraints, and the high utilization rate of inputs, Swiss firms will need to keep a certain level of investment to accommodate these remaining demand pressures. In support of this process, we should note that the real rate of interest will likely decline early this year, as inflation will continue to drift higher and nominal rates will likely stay on hold. Will the Inflation Pick-Up Be Temporary? This question is of critical importance to most central banks in the current environment. With growth set to decline, the persistence of the inflation shock will alter the central bank’s ‘trade-off’. For instance, if the pick-up in inflation were temporary, then the SNB would be less constrained in lowering rates. We believe that there are significant risks of a more persistent pick-up in inflation in 1H, and that the inflation starting point will be higher than the SNB forecast. Indeed, CPI inflation surged sharply in end-2007 and earlier this year on the back of food and energy products. We think that there are several risk factors to consider: First, as said earlier, domestic consumption is still strong and some capacity pressures will remain in 1H. Similarly, global demand is still robust thanks to emerging economies and the benefits from globalisation (coming from cheaper supply) may already have turned from disinflationary to inflationary. Second, and related to the first point, energy and food products inflation (which together account for 15% of the CPI basket) may stay higher for longer. Food price inflation is possibly more a source of concern for Switzerland. Indeed, the rate of inflation seen so far in food products is lower than in other developed economies, so that there may be room for catch-up (it was 0.6% in 2007 and just peaked at 2.2%Y last month). A risk we highlight here is that food inflation could stay higher for longer (due to this catch-up). For example, this could be the case if we were to observe a durable shift in emerging economies food diet/preferences, which would make the surge in prices more persistent and possibly maintain inflation higher for longer. Third, inflation due to rents (20% of CPI) still constitutes a risk, in my opinion. The legal framework enabling proprietors to increases rental prices following rate hikes has not been fully exploited yet. We believe that many proprietors could increase their asking price in the coming months. We know that more than half of the Cantonal Banks are planning to raise the mortgage reference rate to 3.5% in March/April (a 25bp increase). Theoretically, proprietors would have the ability to raise rents further (about 3%, given the current reference level). We suspect that this pass-through will vary depending on the regional ‘tightness’ in the housing sector. However, with construction set to slow and vacancy rates being low (the national average is 1.1%), risks to prices adjustments lie on the upside. Fourth, while increased domestic deregulation and competition has maintained a low pass-through from input prices to consumer prices, the spread between input price inflation and CPI inflation increased steadily since 2006 and peaked in May last year. This suggests a rather low pass-through and decreasing margins. Since then, the spread has declined, suggesting that firms are increasingly passing on input price pressures to consumers. The need to stabilise margins during an eventual downturn should help to maintain such pressure, as long as demand remains supported. Having said this, there are reasons to believe that the upswing in inflation will not persist in 2H: i) a domestic growth slowdown would remove capacity pressures; ii) current exchange rate appreciation could ultimately help to dampen the pass-through to consumer prices stemming from past depreciation; and iii) energy inflation should ultimately decline with growth. In addition, and all else being equal, this should favour moderation in food price inflation as well. Financial Sector Is a Noticeable Risk In order to understand how important the financial sector could be in affecting domestic growth, we looked at the contribution to growth of the financial intermediation services. The financial sector alone has the ability to overturn growth in other sectors. This is indeed what happened back in 1995 and 2001. While we do not expect such episodes to materialise this time, we decided to take a closer look at the determinants of financial intermediaries’ performance. Our results suggest that the S&P 500, the DAX and a trade-weighted index of the CHF can explain a good deal of the financial intermediaries’ activity. In short, we find that the financial sector does poorly whenever the equity markets underperform and the CHF appreciates (details of our analysis are in the Appendix). Our calculations suggest that using futures prices for the S&P and the DAX (and our own forecast for the CHF), the financial sector alone could cut more than 0.2%Y from growth in 4Q. Accounting for our forecasts on the CHF and our equity analysts’ forecasts for 2008, we suspect that the trough in financial contribution to GDP should be around mid-year. Currency We already laid out a currency outlook in an earlier piece (see “The Revenge of the Low Yielder”, FX Pulse, January 3, 2008). Also, please see “The Dollar’s Undershoot: A Forecast Revision” in this week’s FX Pulse for our revised set of forecasts. In summary, we still think that the CHF will perform well in the first part of the year. The major driver for the CHF remains the higher global economic uncertainty and the global easing cycle initiated by the Fed. However, we think that as global uncertainty settles down and financial markets recover later this year, the CHF should start to depreciate again. SNB Still Slightly Accommodative Last December, the SNB put a halt to a 2-year-long tightening campaign (+200bp in total) and maintained its mid target level at 2.75%. This year, we expect the SNB to maintain this target level. As we elaborated earlier in detail, we suspect that inflationary pressures should remain for some time. The current interest rate is slightly accommodative, we think, and should allow the SNB to take more time in balancing the risks between inflation and growth. As a rule of thumb, the current ‘neutral’ interest rate can be calculated as the sum of potential real output growth (around 1.9%) and long-term inflation (around 1%), suggesting a neutral rate close to 3%. In addition, from a real monetary condition index (MCI) perspective, the SNB stance is still quite accommodative, as despite the 200bp of tightening since December 2005, the real MCI shows real easing of nearly 35bp. Having said that, and as recently acknowledged by the SNB, the CHF appreciation (around 5%YTD) will help dampen the pass-through to import prices and consequently to overall inflation. This exchange-rate-led tightening is rather welcome. A sustained and rapid appreciation could eventually trigger some signs of discomfort at the SNB (especially if accompanied by slower-than-expected growth), but the undervalued nature of the CHF makes it relatively unlikely that the SNB reacts at this stage. A non-negligible risk for the SNB is renewed money market pressure. Risk premiums, as reflected by Libor-OIS, went higher again after having calmed down earlier this year and currently stand at 52bp. Premiums in the interbank business were under minor stress (5bp) though. We think that this remarkably low spread is attributable to the credible SNB policy strategy (which directly targets the 3M Libor rate as opposed to an official policy rate). The SNB let the one-week repo trend higher (reaching 2.4%) before the tensions re-emerged. Since then, it let the one-week repo decline towards 2.2% to alleviate the pressure on risk premiums. This suggests that the SNB is still very alert. Having said this, the SNB can allow the 3M Libor rate (its policy rate) to fluctuate moderately around its target and absorb some of the tensions in the money markets without changing its policy stance. In other words, it does not fine-tune 3M Libor on a very short-term basis. At the margin, and compared to other central banks, this policy strategy could help the SNB maintain a ‘wait and see’ mode, we think. Risk Scenarios We consider two main risk scenarios: a ‘bull case’ and a ‘bear case’: Bear case (25% subjective probability): The US recession is quickly followed by a global economic ‘re-coupling’. Swiss external growth decline extends further and falling consumer sentiment leads to a slower contribution from domestic demand. The financial sector profitability slows sharply. The SNB eases 25-50bp by year-end, while the CHF still appreciates until the US shows signs of recovery. Bull case (15% subjective probability): The US quickly recovers in 2H and poses upsides risks to global growth. Robust domestic demand, further building up of capacity pressures and sticky inflation require more tightening by the SNB by end 2008-early 2009. The CHF depreciates as global short-term interest rates trend upward and global uncertainty recedes. Appendix: Financial Intermediation Sector Growth In the national accounts, the value-added for financial intermediation is decomposed into commissions and fees (called FIDM for financial intermediation services directly measured), and an additional part that comes from charging higher interest rates to borrowers and paying lower rates to depositors (called FISIM for financial intermediation services indirectly measured). The total financial intermediation sector growth (FIDM+FISIM) is heavily related to the exports of bank commissions growth (found in the balance of payments). Indeed, the correlation between the growth rates is as high as 0.75. While this suggests that most of the FISDM value is generated by Swiss banks’ foreign clients, it also suggests that we can assume that the lending-borrowing rate spread is relatively stable though time (meaning that FISIM can be considered as a fixed share of total added value). To understand the financial intermediation growth and its contribution to GDP, we therefore can use determinants of exports of bank commissions. Our analysis suggests that the S&P500 growth, the DAX growth and the CHF (trade-weighted index) performance helps explain financial intermediaries’ contributions to growth. This is rather intuitive, as both equity market performance and the external competitiveness (through CHF) play a role in determining the exports of commissions. To determine the quantitative impact of these variables on our endogenous variable, we use a VAR framework. The model accounts for five lags in each variable (all expressed as annual growth rates). Our impulse responses analysis shows that growth in the financial intermediation sector is unsurprisingly positively affected by both S&P500 and DAX performance. On the other hand, a CHF appreciation reduces the competitiveness of the sector and drives its growth down. Remarkably, a variance decomposition of the financial intermediation growth suggests that more than 50% of the variance in the financial growth is explained by our three explanative variables (with the DAX alone explaining nearly 40%).
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