Global
Diverging Policy Paths
April 17, 2008

By Joachim Fels & Manoj Pradhan | London

In last week’s The Global Monetary Analyst, we used our preferred measure of the monetary policy stance – the gap between actual rates and the time-varying natural rate – to illustrate that policy is not only expansionary in large advanced economies such as the US and the euro area, but also in the three largest EM economies (China, India and Russia).  This week, we focus on another interesting feature of the current global interest rate cycle – the diverging interest rate paths within the universe of the more than 30 central banks regularly monitored by our global economics team.  A few things stand out:

1. There are still more central banks that are raising their key policy rates than cutting them.  For 21 central banks in our coverage universe, the latest move was a hike, while only 12 central banks’ last step was down.  Since the start of this year, twice as many central banks raised rates (14) than cut them (seven), while 12 kept rates unchanged. 

2. EM the most active hikers. The majority of central banks (12 out of 14) that have raised interest rates so far this year reside in Emerging Market (EM) countries.  Among these, EMEA central banks have been the most active: the Czech Republic, Hungary, Poland, Romania, Ukraine, Russia, South Africa and Nigeria have all raised official rates this year.  In Latin America, rates went up in Chile, Colombia and Peru so far this year, and Brazil is likely to follow today.  The simple reason why most of these countries have tightened policy is that inflation has been running above central banks’ targets and has kept rising (note that Taiwan and Nigeria don’t have inflation targets).  In Emerging Asia, inflation has also been accelerating above central banks’ comfort zones in many countries.  However, with many of the region’s currencies linked more or less tightly to the US dollar, the Fed’s aggressive rate cuts have made it impossible for many Asian central banks to raise interest rates.  Hence, Taiwan is the only Asian country in our coverage universe that has raised interest rates (by a modest 12.5bp) so far this year. 

3. In advanced economies, rate hikes have become the exception rather than the norm, reflecting the credit crisis that has affected virtually all markets in the developed world.  Only two of the central banks under coverage (note that we don’t cover Iceland, where rates have also been raised recently) – the Reserve Bank of Australia (RBA) and the Swedish Riksbank – have raised rates this year.  However, our economists think that both central banks are now at the end of their hiking cycle, which has taken rates up 300bp in Australia and 275bp in Sweden.  The minutes of the April 1 RBA policy board meeting released earlier this week said that members thought that the current level of rates is “exerting restraining influence” on the economy, and the Riksbank’s policy board was already divided on the merits of the February rate increase.

4. Rate-cutters still a minority.  While only seven central banks in our coverage universe have cut rates so far this year, three of them are from the G5: the Fed, the Bank of Canada and the Bank of England.  These three have been most affected by the housing downturn in the US and the UK and the related credit crisis. The other two in the G5 – the Bank of Japan and the ECB – are expected to join in by cutting rates later this year.  Outside the G7, rates have come down only in Turkey (by 50bp since the start of the year to 15.25%), Israel (by 100bp to 3.25%), Hong Kong (which operates a currency board and thus largely shadows the Fed) and the Philippines (by a marginal 25bp to 5%). 

5. Still more hikers than cutters in near term.  In the near future, hiking central banks will still outnumber central banks that are easing policy, on our forecasts, even though the margin is shrinking fast.  In the next fortnight, our central forecast is for four central banks to raise rates – Brazil, Norway, Hungary and Poland.  In Brazil (April 16), Marcelo Carvalho now expects a 25bp hike (but wouldn’t rule 50bp) as a prelude to a total tightening of 200bp this year.  In Norway, Spyros Andreopoulos now foresees a 25bp rate hike on April 23, in line with the Norges Bank’s only preferred policy path, but expects this to be the last hike in this cycle.  In both Poland and Hungary, Pasquale Diana expects the central bank to raise rates by 25bp on April 30 and 28, respectively, but notes the risk that the recent currency strength might induce both the NBH and the NBP to pause instead. 

Fed and Bank of Canada to cut by 50bp this month.  Three central banks are expected to lean the other way and cut rates over the next two weeks: the Bank of Canada, the Fed and (due to currency board system) the HKMA.  In Canada, Charles St-Arnaud is looking for a 50bp cut at the April 22 meeting, reflecting slower growth, continuing financial frictions and below-target inflation.  In the US, Dick Berner and Dave Greenlaw think that the Fed will want to err on the side of easing for now, given the credit market strains, and continue to look for a 50bp cut on April 30, somewhat more than markets are pricing in for that meeting.  This would take the total Fed easing this year alone to 250bp, and to 350bp since the start of the easing cycle last summer, and would finally push the real funds rate firmly into negative territory. 

Others likely on hold in the near term. Another ten central banks in our coverage universe will hold policy meetings in the next fortnight but are expected to keep rates on hold.  A potential candidate for a surprise relative to central expectations for no change is the Reserve Bank of India, where Chetan Ahya notes that recent inflation data and hawkish comments by the governor raise the risk of a repo rate hike on April 29.  Also on the radar screen are the policy meetings in Turkey on April 17, Mexico (April 18), Sweden (April 23), Israel (April 28) and Japan (April 30).  For more details on forthcoming central bank meeting dates, our and market expectations and our risk assessments, see the table on page 4 of The Global Monetary Analyst. 

6. More joining the easing camp.  Looking further ahead, we expect more central banks to join the easing camp in the course of this year.   In total, we see 12 central banks lowering rates between now and year-end, equaling the number of banks that we expect to raise rates over the same period.  In the advanced economies, in addition to the Fed and the Bank of Canada, our economists expect the Bank of Japan (as early as 2Q), the ECB, the Swiss National Bank and the Riksbank (all in 4Q) to cut rates eventually.  In the UK, David Miles’ and Melanie Baker’s out-of-consensus central forecast is for no further reduction in rates; however, they acknowledge that the risks to this view are skewed to the downside. 

7. But still more hikes coming in EM.  Lastly, most of the monetary tightening that we still expect to come will occur in EM, where 11 of the 12 central banks that we expect to raise rates this year reside.  These include four Latin American central banks (Brazil, Chile, Peru and Columbia), four in Central and Eastern Europe (Poland, Hungary. Ukraine and Russia) and three in Asia (Taiwan, Indonesia and the Philippines).  Norway is the odd one out to hike in the advanced economies, but it remains a special story due to the rally in the oil price.

Bottom Line 

Monetary policy paths are still diverging, with a major dichotomy between EM central banks – especially in EMEA and, to some extent, Latin America – battling against strong inflation pressures on the one hand and advanced economies affected by housing slowdowns and the financial crisis on the other.  While hikers still outweigh cutters, we expect the numbers to become more balanced over the course of this year, with more advanced economies joining the Fed, the Bank of Canada and the Bank of England in cutting rates.  Moreover, as we have explained in previous issues of The Global Monetary Analyst, the aggregate global monetary policy stance is very expansionary and, given the economic weight of those likely to join the easing campaign, likely to become even more so this year.

(For full details of our country views that we refer to here, please see The Global Monetary Analyst, April 16, 2008.)

China
Imported Soft Landing in Sight
April 17, 2008

By Denise Yam, Qing Wang & Katherine Tai | Hong Kong

GDP growth moderated on weaker exports in 1Q08: China’s 1Q08 economic report offered yet more solid evidence of an ‘imported soft landing’ that we had envisaged for the economy. Real GDP growth slowed to 10.6%Y, from the revised 11.9% pace in 2007 (+11.2% in 4Q07, before upward revision), on the back of tamer growth in exports, especially those to the US. Though export growth appears to have maintained a robust pace, up 21.4%Y in US dollar terms in 1Q08 versus +22.1% in 4Q07, the slowdown is much more pronounced when we assess export growth in local currency terms (and this is indeed the relevant assessment as far as GDP is concerned), which dwindled to just 12%Y in 1Q08 − the slowest pace since 1Q02. The trade surplus actually shrank by 11%Y in 1Q08 to US$41.4 billion, contributing negatively to overall GDP growth for the first time since 4Q05, by around 0.6 ppts according to our estimates (+0.3 ppts in 4Q07).

Robust growth sustained by domestic demand: Needless to say, sustained vigor in domestic demand helped to offset the negative contribution from weaker external trade. We estimate that domestic demand contributed 11 ppts to overall GDP growth in 1Q. Consumer demand, as reflected in retail sales, grew 20.6%Y in 1Q (+21.5% in March). After adjusting for higher inflation in the period, retail sales gained 12.3% in real terms, similar to that in 2007. Urban fixed asset investment actually accelerated in March, contrary to our expectation, bringing 1Q up 25.9%Y (+24.3% in January-February). This also contrasts with the slowdown in loan growth in the period.

Consumer inflation appears to have peaked, easing anxiety over imminent aggressive policy action: As we had forecasted, using high-frequency food price data (see our Food Price Inflation Monitor), CPI inflation eased from a peak of 8.7%Y in February to 8.3% in March. On a month-on-month basis, consumer prices retreated by 0.7%, after surging 2.6% in February amid severe weather. Year-on-year food inflation edged down from 23.3% in February to 21.5% (our estimate) in March. This implies that non-food inflation likely trended upwards to 1.7-1.8%Y in March, also in line with our expectations. Although consumer inflation appears to be easing from the February peak, upstream inflation continued to head higher amid further rises in energy and raw materials costs. PPI (+8%Y in March, +6.9% in 1Q) and RMPPI (+11% in March, +9.8% in 1Q) both exceeded our forecasts, serving as a reminder that inflation pressures are still persistent, justifying the maintenance of a tight policy stance in the short term and an accelerated pace of renminbi appreciation. The latest data on price indices are broadly in line with the trajectory as outlined in our earlier report, Higher Inflation for Longer, March 11, 2008. In our view, prices could remain elevated in the coming months, so headline inflation will ease only gradually. We expect inflation to hover above 7% in 1H before easing to below 5% in the latter part of the year, resulting in a year-average inflation rate of 6.5%. With these assumptions intact, we stand by our call for no interest rate hikes this year.

Reiterating our call for an imported soft landing: The latest data represent further evidence of the dichotomy of external weakness and domestic strength, consistent with our call for an imported soft landing this year. We forecast that export growth will slow to 16% in 2008, and that net exports’ contribution to GDP growth will dip to only 0.4 ppts, from over 2 ppts in the last three years. We reiterate our call for an imported soft landing as the baseline scenario for 2008 and maintain our forecast of China’s GDP growth decelerating to 10%.

Reiterating our policy call – ‘Three No’s’: A central theme in our imported soft landing call is that external weakness will help to cool the Chinese economy without further aggressive tightening actions through blunt policy instruments by the government. Therefore, we stand by our policy call featuring the ‘Three No’s’: 1) no campaign-style administrative tightening; 2) no large one-off revaluation of the renminbi; and 3) no aggressive interest rate hikes. Nevertheless, liquidity management through RRR hikes and open-market operations by the PBoC as well as further renminbi appreciation will be kept up to limit the pass-through of excess liquidity from the balance of payments surplus, and to contain inflationary expectations.

Indonesia
Inflation Risks Warrant Tighter Monetary Policy
April 17, 2008

By Chetan Ahya & Deyi Tan | Singapore

Summary: Domestic Demand Slowdown Is Inevitable

We believe that Indonesia’s domestic demand growth story is likely to face a temporary setback. Domestic demand grew at 6.8%, close to the previous high of 6.7% during the quarter ended September 2005. In our view, domestic demand growth is to maintain its momentum during the quarter ended March 2008, supported by low interest rates. However, the current pace of domestic demand is adding to inflationary pressure. We believe that the central bank will need to tighten monetary policy soon to slow domestic demand to address the inflation concerns. We believe that the central bank should ensure that banks slow the credit growth to 20-22% from the current estimated level of 28-30%.

Inflation Risks Are Rising

Inflation risks continue to be the biggest challenge for Indonesia in the near term. Headline inflation has shot up to an 18-month high of 8.2% in March 2008 from 6.6% just three months back and 5.8% in mid-2007. The acceleration in inflation is due to demand as well as supply-side factors. While food has been one of the main contributors to inflation acceleration, we believe that demand-side pressures also have a large role to play in this acceleration. This is reflected by acceleration in a number of items such as clothing, non-commodity-based food products, housing and healthcare. Inflation has accelerated even as the government has chosen to keep domestic fuel prices unchanged since October 2005.

Weak Domestic Capacity Creation Is a Key Challenge

While the country continues to have higher growth potential, weak capacity growth brings up the challenge of price stability. The government’s inability to provide a policy support to encourage a swift acceleration in capacity growth, particularly infrastructure, is a key hurdle. Acceleration in domestic demand growth over 6% often results in inflation pressures. In the current cycle (similar to the 2005 cycle), the higher commodity prices have added to the challenge of price stability. Indonesia is already suffering from one of the highest rates of inflation ex-food in the region, accelerating to 6.4% from 5.1% over the last three months. This compares to the average of 2.7% for the region, excluding Indonesia. If domestic demand remains strong, we see a high probability of increased pass-through of higher commodity prices (as reflected in WPI inflation at 23.8%) into CPI.

Sustained Food Price Inflation Will Weigh on Inflation Expectations

Food inflation in Indonesia remained elevated at 13.6% in March 2008. The CRB Foodstuff Index has risen again after declining between September and November 2007. With global and regional food prices continuing to rise, some spillover from this into the domestic market is inevitable, in our view. Most countries in the region are initiating measures to encourage imports and stop/discourage exports of food items. Many countries in the region are planning to increase the stock of staple food items, exacerbating underlying demand. With food and food products accounting for 24.7% of the weighting in headline CPI, we believe that further food price escalation is one of the most important risks to the inflation outlook in Indonesia. With about 90-100 million people in the country living below US$2 (on a PPP basis) per day, the country is very highly exposed to the potential further rise in food inflation.

Sharp Rise in Oil Price Increasing the Inflation Risks

If oil prices cross US$120/bbl, the pressure will increase on the government to hike oil prices. As per our estimates, each US$10/bbl increase in oil prices results in an additional fiscal burden of US$0.7 billion (around 0.15% of GDP). The last revised budget estimates a deficit of 2.1% of GDP in 2008 with the assumption of an US$95/bbl oil price. If we assume an average of US$120/bbl for 2008, the fiscal deficit will increase to 2.5% of GDP. Although the oil and electricity subsidy burden increases by US$3.2 billion for every US$10/bbl increase in oil prices, the government’s net oil revenue also increases by US$2.5 billion.

While the deficit increase is manageable, we believe that the domestic price increase will be inevitable. The increased gap between international and domestic prices (which are marked to about US$60-65/bbl) will encourage indirect pilferage from the domestic public distribution system. The price of oil products is the lowest in Indonesia within the ASEAN region. The disparity between oil prices in Indonesia and its neighbors has widened to levels higher than that in late 2005.

The annualized three-month trailing sum of refined oil balance (imports less export) has already widened to -2.9% of GDP as of February 2008. If the government leaves domestic prices unchanged, this gap in refined oil balance could widen further to concerning levels, forcing the government to resort to a larger price increase later. During the 2005 cycle, the government hiked oil prices sharply as the 3-month trailing sum of the refined oil balance reached -4.7% of GDP in September 2005 (from -2.7% of GDP in July 2005). Any increase in domestic oil prices will only add to the cost pressures, resulting in a further increase in inflation ex-food and energy.

Monetary Policy Tightening Is Inevitable

While the decline in the US policy rates has widened the interest rate differential between the US and Indonesia, implying that there is scope to cut policy rates in Indonesia, we believe that the domestic demand-supply balance warrants tightening, and a delay in tightening could only increase the risk of more disruptive tightening later. We believe that the central bank should ideally combine the hike in policy rates with an increase in the cash reserve ratio (CRR) to ensure that the banks increase lending rates by about 100-200bp over the next 3-4 months. The CRR hike would be ideal, considering that the banking system is still liquid. It would also ensure that the weighted average cost of sterilizing excess liquidity does not increase.

Exchange Rate Appreciation − Not the Ideal Option

With capital inflows slowing because of increased global financial risk-aversion, pursuing an exchange rate appreciation policy will be difficult. Moreover, we do not believe that Indonesia’s exchange rate is undervalued, considering its trade competitiveness. While higher commodity prices have helped the current account balance to be in surplus, traditional manufacturing industries need stable real effective exchange rates, in our view. We believe that allowing an appreciation in exchange rates instead of pursuing a tightening in monetary policy would result in further acceleration in domestic demand in the near term. This would, in turn, result in narrowing the current account surplus, thus increasing the volatility of exchange rates later, in the event of capital outflow and turbulence in financial markets.

Where Can We Go Wrong?

We believe that if global oil and food prices reverse sharply over the next few weeks, it could reduce the inflationary pressure, providing the central bank with some more room to delay the policy rate hikes. Moreover, Indonesia has also been a beneficiary of the relatively favorable global risk appetite environment in the last three years. Hence, we believe that any major improvement in global risk appetite should help the country by way of an increase in capital inflows and easier access to low-cost funding, supporting its investment cycle and, therefore, domestic demand.