Balancing Slowing Growth and Rising Inflation
April 09, 2008
By Deyi Tan & Chetan Ahya | Singapore
Policy Dilemma Rising
MAS will be releasing its semi-annual monetary policy statement on April 10. Like other central banks in the ASEAN region, MAS faces the policy dilemma of having to grapple with an untimely mix of slowing growth and rising inflation. This is likely one of its biggest challenges in the 27 years that the exchange rate has been used as a tool to balance price stability and growth. While MAS’ objectives include maintaining “price stability conducive to sustainable growth of the economy”, inflation really did not pose much of a problem and was mostly contained below 4% even in the oil-shock years of the 1990s. However, inflation picked up to a high of 6.5%Y in February 2008, and GDP growth is likely to post the biggest deceleration within the ASEAN region in 2008 by our estimates. Growing price pressures as inflation gets global: Indeed, inflation pressures are becoming more global at the margin. Before the October 2007 review, inflation was concentrated in the non-tradables segment. Inflation in non-tradables tracked at 3.8%Y in September 2007, while tradables inflation was relatively lower at 2.6%Y. However, while non-tradables inflation remained elevated at 5.0%Y in February 2008, the run-up in commodity prices such as oil and food caused tradables inflation to rise at an even quicker 5.5%Y. Historically, exchange rate appreciation has been more effective in containing tradables inflation compared to non-tradables. The fact that tradables is now the source of price pressure at the margin is the strongest reason why MAS could allow a further steepening in currency appreciation at the upcoming meeting. Downside to growth has become more palpable: Having said that, however, the downside risks to growth have grown more palpable. Compared to the October 2007 meeting, it is now apparent that the US economy is headed for a recession in 2008. In addition, our Europe team is now forecasting below-consensus GDP growth of 1.5% for 2008 and 2009, and our Japan team is expecting a mild recession in Japan. With the Singapore economy the most exposed to global demand within ASEAN through trade and financial market linkages, we have adjusted downward our GDP growth outlook in the past six months from 6.1% to 5.1%Y. The growth aspect is the primary reason why our base case is that the central bank is likely to maintain the status quo of gradual and modest appreciation. The coming slowdown will assuage the overheating concerns that we had two quarters back. Besides, central banks typically do not respond to supply-side inflationary pressures such as weather-induced increases in food prices unless such factors are deemed likely to lead to second-round inflation through wage expectations. While the 1Q08 GDP advance estimate, which is to be announced on the same day, will likely show a rebound on the back of biomedical production (versus 4Q07), the growth cycle is likely to reach a bottom in 2Q-3Q08 and the resulting increase in economic slack will reduce the possibility of a second-round inflation impact from commodity prices, in our view. Inflation will fall; but by how much and how soon? Moreover, we believe that in a matter of months, headline inflation data will likely come down from the highs we are currently seeing. The high inflation has been due in part to policy measures such as the 2% GST hike in July 2007. With 75% of the consumer basket affected by GST changes, the 2% hike in taxes likely contributed 1.5ppt to headline, assuming full pass-through. Ceteris paribus, inflation would also likely decelerate by a similar quantum when the effect is stripped out in July 2008. On commodity prices, Brent oil futures are now slightly backwardated, suggesting that the year-on-year impact from oil on inflation would also likely ease significantly in 4Q08. Non-monetary measures have become a popular tool to help tackle inflation too: Further, the government appears to be of the view that monetary policy cannot take the full weight of tackling inflationary pressures. The Finance Minister, when discussing measures to cope with inflation in the 2008 budget in February, mentioned the following: “We seek to moderate imported inflation through our Singapore dollar exchange rate policy…In October last year, MAS increased slightly the slope of the currency band, meaning that it allowed a slightly faster appreciation of the currency…However, there is a limit to how fast the Singapore dollar can appreciate without hurting our economic performance and growth and eventually causing wages to fall…That is why, while we can mitigate imported inflation through MAS’s exchange rate policy, we cannot insulate ourselves completely from the effects of global inflation passing through to the Singapore economy”. Indeed, several Asian countries have already taken to using non-monetary measures, such as reducing import tariffs, raising export taxes and persuading domestic producers through moral suasion to maintain pricing restraints, to contain inflation. Similarly in Singapore, several non-monetary measures have also been adopted to cope with pressures. They are: 1) diversification of food sources; 2) adding to the income of low-wage workers through Workfare Income Supplement Scheme; and 3) redistribution of budget surpluses either in the form of direct handouts or through instruments such as the Comcare Fund. (It was recently announced that S$1 million would be set aside to help the needy with food costs through this fund.) Risks of potential change in monetary policy stance beyond the April review? There will be risks to the status quo of gradual and modest appreciation beyond the April review if commodity prices continue the current pace of price acceleration we are seeing now. In that case, inflation might not ease as much as we expected. To the extent that this could prompt other central banks in Asia, such as China, to take on an even quicker appreciation of their currencies, MAS could be faced with a de facto steepening of the SG$NEER as well. For now, however, our China economist Qing Wang expects the RMB to end the year at RMB6.60/USD, which is another 6% appreciation from here, and he views the possibility of a one-off revaluation as being remote. When risks become reality, the central bank has three tools: If such risks materialize, the central bank has three tools at its disposal: 1) Widening of bandwidth; 2) Re-setting of mid-point; and/or 3) Steepening the slope of currency appreciation. Options (2) and (3) would be more likely since a widening of bandwidth has typically been used to cope with increased volatility such as in the aftermath of 9/11. We believe that the central bank could opt for (2) if growth conditions remain soft, as this would essentially be equivalent to a ‘one-off revaluation’ in the short term to contain inflation while still maintaining the same pace of appreciation in the longer term.
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Three Anomalies
April 09, 2008
By Gray Newman and Daniel Volberg | New York, New York
It looks as if someone forgot to tell the Mexican markets that the US has entered a recession this year. Mexico’s stock market is one of the few equity markets around the globe posting a positive return since the beginning of the year. And Mexico’s peso appears to be trying to make up for lost time: in the first days of April it broke through levels not seen in over two years. The curious behavior of Mexican markets comes as the latest US data releases − especially on the jobs front − appear to settle any debate about whether the US economy has fallen into a recession. Given Mexico’s strong links with the US − more than 82% of all Mexican exports last year were destined for the US − the performance of Mexican equities and the Mexican peso is all the more puzzling. We believe that there are three anomalies playing out in Mexico that may help to explain the unusual start to the year. Each of these anomalies − on the real economy front, on the energy front and on the monetary policy front − should be monitored carefully. We believe that each contains more surprises in the coming weeks and months. Real Economy Anomaly Even as the US economy has weakened, Mexican economic activity has surprised on the upside in the first months of 2008. Indeed, we have been on a search mission for the ‘slowdown smoking gun’ − some evidence of a more pronounced downturn in Mexico that breaks the trend seen in activity during last year − and we still cannot find it (see “Mexico: In Search of the Slowdown”, EM Economist, March 14, 2008). We aren’t arguing that Mexico’s economy won’t slow in 2008. We believe that the pace of Mexican economic activity will slow this year. But the start of the year has produced a series of stronger-than-expected reports. January’s GDP proxy was up 4.2% over a year ago, while industrial production − where the link with the US is strongest − was up 3.1% in January. Comparing Mexican and US data of course is always tricky. Whereas Mexico’s statistical institute usually highlights year-over-year comparisons, most US data headlines are based on month-over-month comparisons using seasonally adjusted series. That can matter a great deal. For example, Mexican industrial production was up strongly in January (3.1%) while US industrial production was stagnant in January (0.1%) and fell by more than expected in February (down 0.5%). Looks like divergence? Look again. Had the US used Mexico’s reporting tradition of year-over-year comparisons, industrial activity in the US would have been up 2.6% in January and up 0.9% in February. Once one compares both the US and the Mexican data points using Mexico’s convention (year over year), the divergence between the two economies begins to fade, with both showing some strength. And comparisons on a month-over-month basis show that Mexican and US industrial production are moving in tandem: both showed an improving trend in January while the US slipped again in February. February IP data for Mexico are not yet available. The trend in industrial production is important: after all, retail sales and IP in Mexico appear to move more closely than in the past. We are not big fans of most of the retail series in Mexico − we believe that they have methodological issues − but it is worth noting that unlike a decade ago when turns in industrial activity appeared to lead turns in retail by four to six months, today they tend to move more closely together. The good news is that we have yet to see a pronounced slowing in Mexico. Despite the string of data points suggesting a much weaker economy in the US late last year, Mexican data at the end of 2007 and, in some cases, in the first months of 2008 are showing a modest rebound. Other data are softening − such as formal employment growth − but even there we are not seeing anything substantially different from the mild easing seen in 2007. The reason for Mexico holding up relatively well is not simply a matter of lags. Mexico’s industrial production levels are moving in tandem with the US, and Mexican retail spending appears to be moving even more closely with changes in industrial production. Instead, we are not seeing the kind of downturn in US industrial activity of the sort seen in 2000. In mid-2000, the downturn in US industrial production (which started in mid-2000) preceded the US recession by nearly nine months. This time US industrial production is sluggish but has not experienced the sharp collapse seen in 2000. A more competitive dollar has helped to boost exports from the US and offset some of the drop-off in domestic demand for manufactured goods. With US industrial production holding up modestly, the impact on Mexico has been more muted, given the fact that the strong US-Mexico link is in manufacturing. Indeed, the US IP cycle may help to explain a number of areas from investment to import demand where the economy is still surprisingly strong. Look for strong reports in February in Mexico, some softness in March given Semana Santa, but overall GDP growth in 1Q likely near 3.5% − not much of a difference from 4Q07. Energy Anomaly With oil trading above U$100 a barrel, it is remarkable that Mexico is even discussing politically sensitive energy reform. Mexico’s history as well as the experience of most emerging economies today suggest that high commodity prices breed complacency and normally make politically difficult reforms all but impossible. In Mexico’s case, the severe drop in oil production − now entering its fourth year − appears to have galvanized support for a rethinking of its model. We have avoided trying to provide a day-by-day update of Mexico’s energy reform. As of yet, the authorities have only recently provided a public diagnosis of the challenges facing Mexico’s oil monopoly and have presented no bill to either house of congress. While the political maneuvering continues to provide surprises, we suspect that the authorities will gain enough support to modify the framework within which Mexico’s oil company, Pemex, operates. The bill − whether passed in April or in an extraordinary session later on − will represent a starting point, but is likely to be approved without a series of accompanying initiatives needed for it to be fully effective. The complementary legislation should come later in the year. We suspect that the changes will be underestimated by many observers. Indeed, we suspect that the administration would prefer to downplay the changes in an attempt to limit the political fallout. We also believe that the changes will represent an important step in allowing a ‘competition of models’ in the energy sector. We hope that it opens the door to greater transparency and begins to provide Mexico’s oil sector with greater access to technology and investment. Monetary Anomaly The final anomaly present in Mexico today is the unwillingness of Mexico’s central bank to join the Fed in cutting interest rates. Few investors expected that Mexico’s central bank would diverge as widely as it has from the Fed in the past six months. Indeed, each Fed cut has brought with it calls from many investors that Banco de Mexico would not be far behind. Instead, Mexico’s central bank has shown that it is in no hurry to cut interest rates (see “Mexico: No Hurry to Ease”, EM Economist, February 8, 2008). We argued early this year and continue to argue that Banco de Mexico is likely to keep rates unchanged for most, if not all, of the year. First, we believed and continue to believe that demand pressures were never the problem driving Mexico’s inflation in the first place. Some softening in demand in Mexico is coming, but we believe that this will provide 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. Unless domestic demand plummets in 2008 – which is not embedded in either our forecast of 2.6% GDP growth for this year or in the central bank’s forecast (2.75-3.25%) – Mexico’s inflation dynamic is likely to face more of the same: pressure from grains feeding through to processed foods. And with headline once again back over 4% in March, Banco de Mexico is likely to be on the alert 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 feared that the inflation problem in Mexico would likely appear worse leading up to mid-year before it improved. Commodity prices are still feeding through to consumer prices of processed food − a trend that many seemed to have thought would stop with the new year but reared its head again in February and in early March. And given very favorable produce price behavior in 2Q07, Banco de Mexico has warned that year-over-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 is still on the rise. We expect headline and core inflation in May to come close to or even break above the 4.5% 2Q upper band. 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. Banco de Mexico’s new-found ‘independence’ from the Fed may have contributed, along with the prospect of some progress on the energy front, to a stronger peso. This is paradoxical, because progress on the energy front could in turn lead to a strong peso, which in turn could produce a willingness by the central bank to ease interest rates sooner. We are convinced that a substantial gain in the Mexican peso − say to 10.0 or stronger − would trigger a lively debate at the central bank on the need to ease. Some might argue that the widening interest rates differential between Mexico and the Fed was attracting speculative inflows and marshal the currency’s gain as evidence. Others might argue that the strengthening peso, in effect, was producing a tightening in monetary conditions, and that it was time for the central bank to revisit the right mix between interest rates and the currency. Bottom Line It is hard to imagine that even as the US economy increasingly shows signs of a recession that Mexico’s currency would begin to gain ground and its stock market would be one of the few with a positive return during the first months of the year. But then again, most investors had begun to worry about Mexico’s links with the US last year when the rest of Latin America was viewed as part of the emerging market ‘safe haven’. The surprise of recent months has been the disappointing performance of the ‘safe havens’ even as the one economy most closely linked to the US has watched its markets perform well. Until, and unless, the US recession produces a much more substantial downturn in industrial production, Mexico is likely to see softening in its economy but not the sharp downturn that many appeared to have feared. This, in turn, has given Banco de Mexico more room to conduct monetary policy with a greater degree of independence from the Fed than most expected. The most positive news in 2008, however, is not likely to come from the real economy or from Mexico’s inflation picture, but from progress in providing greater competition in Mexico’s energy and telecommunication space. Neither of these moves would immunize Mexico from a US slowdown, but both should help to improve Mexico’s greatest challenge − to boost the pace of potential economic growth.
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