Turkey
The ‘Art’ Side of Monetary Policy
May 13, 2008

By Tevfik Aksoy | London

The number of events related to the future course of monetary policy in Turkey has escalated in recent weeks, especially following the sizeable revision of the CPI inflation by the CBT. We revised our policy rate call on April 30 (see “Turkey: Policy Tightening Likely”, The Global Monetary Analyst) and now expect the CBT to tighten by 75bp in the coming months and the rate to be held unchanged at 16% for quite a while. In our view, the spotlight on the macro scene will be on the central bank in the coming weeks, and arguably its position is once again a very difficult one.

No Policy Impact on Imported Inflation

As recent inflation data suggest, the main drivers of inflation had been energy and food – both processed and non-processed (although the latter seems to be showing encouraging signs in comparison to last year). Clearly, monetary policy has minimal control over these exogenous factors, but it can act as a partial inhibitor for expectations to deteriorate and spill over to core CPI measures. Given the noticeable rise in inflation expectations (which reached 7.76%Y for the upcoming 12 months and 6.61%Y for 24 months), a tightening seems imminent to us. The question is how much, and whether a ‘front-loading’ is necessary.

Our Out-of-Consensus View and Risks to it

Looking at the consensus estimates regarding the next MPC decision (May 15), we see that the general view is for a 50bp move, whereas we expect just 25bp. However, as we had pointed out in our call, the risks are on the upside and the CBT could easily decide to front-load the change, especially in the case of a sharp rise in inflation expectations (which has broadly materialized) and/or a noticeable depreciation in the currency (which is currently not the case). In our view, the CBT would prefer to tighten rates in a gradual and incremental manner, i.e., 25bp, for various reasons:

•           Hiking rates aggressively would have a minimal impact on inflation in the near term, since there is an output gap and no pressure from the domestic demand side. Besides, the external demand is likely to weaken in the wake of signs of a visible slowdown in growth in Europe. Hence, the CBT might opt not to ‘waste’ valuable ammunition right away; as past experience dictates, in the event of higher-than-expected CPI prints in the coming months, the market reaction is unlikely to remain muted just because the CBT pre-empted it.

•           Since the most recent inflation report, the currency actually appreciated. In the absence of another bout of weakness soon, the pass-through on CPI might be lower than the CBT had envisaged.

•           Taking into account the overall sentiment in the market, the difference between 25bp and 50bp seems negligible when it comes to containing the deterioration in sentiment, given other factors such as the political backdrop (not to mention the news flow from the developed economies).

Risks Are Rising Nevertheless

On the flip-side of our view against a 50bp move at the next MPC, the risks are clearly rising, and fairly tilted to the upside:

•           The bond market is pricing some 200-250bp of tightening and, considering that the overall consensus view in the market is calling for a 50bp hike on May 15, the CBT might decide not to risk itself and be blamed for falling behind the curve.

•           Oil prices are rising and the expected price adjustments in electricity prices as well as the second-round effects are likely to feed into expectations. While food price inflation might remain tame, especially during the summer months, the overall rise in non-core inflation might feed into core inflation via backward-indexed pricing practices.

•           More importantly, for the first time in years the tightness of fiscal policy and the policy mismatch compared with monetary policy has come to the fore following the government’s decision to reduce the primary surplus target for 2008 as well as the following four years.

A New 5-Year Fiscal Program: Timing and Signaling Not Ideal

Recently, the government revised down the primary surplus (PS) to GDP target to 3.5% (from 4.2%); this is envisaged to ease to 2.7% in 2010 and further in the coming years. Given that the excellent performance of the past five years had resulted in serious gains on the macroeconomic side – including faster growth, lower inflation and a substantial drop in the debt to GDP ratio – to us it would have been more advantageous for the government to hold on to the ongoing framework for the time being. In a setting where both external and local markets have become highly challenging, and given the CBT’s testing position in combating inflation with limited short-term panacea, fiscal loosening (or at least the perception of it) would be the last thing it needed, in our opinion. Granted, gross debt/GDP had eased to 40% at the end of 2007, with net debt/GDP at around 29%, and so it is natural for the government to try to increase spending after many years of very tight policy. However, both the timing and the way the message was conveyed across seem to have been perceived adversely by the market. As long as the planned spending is geared towards investment in infrastructure and energy sectors, the overall inflationary impact might be fairly limited. However, in order for us to make a healthy assessment, it would have been easier if the government provided absolute levels for the PS, such as was the case with the stand-by arrangement. At this juncture, our approach to the fiscal policy would be cautious until the government announces its growth rate, inflation and/or absolute levels for the revised budgetary data. That said, we are not fully convinced that the new fiscal program is going to be taken as overly challenging by the CBT, simply because the overall PS targets are relatively tight, especially considering the muted state of domestic demand.

CBT’s Choice: Art versus Science

At this point, we are fairly convinced that the CBT will make a move on May 15, and it is likely that it will be a choice between 25bp and 50bp. The CBT can simply hike rates by 50bp in line with the market consensus, try to curb inflation expectations and partially satisfy the pricing indicated by the bond market. Or, it might decide to hike gradually but communicate the message well with careful wording, which is likely to have a similar impact, in our view. Given the unfortunate fact that various factors are exogenous to the system, we continue to believe that the decision between the two is likely to have a marginal impact in the short term.

 

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United States
Review and Preview
May 13, 2008

By Ted Wieseman | New York

Treasuries posted big front end-led gains over the past week, reversing a portion of the drubbing the market experienced in the second half of April and steepening the curve back out a fair amount after it had hit its flattest levels since January at the end of the prior week.  After moving to their best levels since January the prior week to accompany the flattening of the curve, pullbacks in risk markets – stocks, credit, leveraged loans, commercial mortgages, subprime (after their huge rallies from their mid-March troughs when systemic fears were at their peaks) – provided support to the Treasury market.  Heavy corporate issuance also seemed to be a net positive as rate locks were unwound and deals swapped.  More generally, though, the market’s rebound seemed to be driven to a meaningful extent by a realization among investors that the economy remains weak and, aside from a likely short-term pop as rebate checks continue to be distributed, downside risks predominate as the credit crunch rolls on, which was starkly illustrated by the latest Senior Loan Officer survey from the Fed, and energy prices continue to rampage higher.  This supported both renewed buying in Treasuries and a rethinking of the Fed, with the timing of the first expected rate hike shifted out to the January FOMC meeting from December and the total tightening expected next year scaled back somewhat.  It was a light week for economic news, but the rally came despite data that were actually better than expected overall.  Upside in the results from the monthly chain store reports and the trade balance netted against significant weakness in wholesale inventories led us to continue to forecast an upward adjustment to 1Q GDP growth to +0.9% from +0.6%, but with a stronger mix of final sales and inventories than we saw a week ago, while upping our early 2Q forecast slightly (also including a negative impact from lower assumptions for motor vehicle production) to -1.6% from -2.0%.  And the non-manufacturing ISM surprisingly moved back above the 50-breakeven level, though the component mix was not as positive as the overall result.  The longer-tailed implications of the widening credit crunch illustrated by the loan officers survey, however, were more material in our view than these modest adjustments to the shorter-term outlook. 

For the week, benchmark coupon yields fell 4-22bp and the curve steepened substantially after closing the prior week at its flattest levels since January, with 2s-10s up 14bp to 154bp and 2s-30s 18bp to 229bp, near three-week highs.  The 2-year yield fell 22bp to 2.23%, the 5-year 20bp to 2.96%, the 10-year 7bp to 3.765% (with the gain marginally restrained by the roll into the new issue), and the 30-year 4bp to 4.52%.  After a brief setback the prior week, energy prices spiked to a series of record highs through the week, with June oil up nearly US$10 a barrel on the week to US$125.96 and June gasoline up US$0.23 a gallon to US$3.20.  It was only two months ago that US$3.20 a gallon would have been a record high for retail gasoline prices, much less wholesale.  The national average retail price of regular unleaded hit a record of US$3.61 in the latest week and a move towards US$4 seems likely, given what’s happening at the wholesale level.  These further spikes in energy prices helped TIPS perform very strongly, with shorter-dated TIPS leading the whole Treasury market.  Among the benchmarks, the 5-year yield fell 25bp to 0.64%, the 10-year 14bp to 1.36%, and the 20-year 9bp to 1.94%.  Meanwhile, the recent squeeze at the very short end of the nominal market was largely rectified, with the 4-week bill’s bond equivalent yield up 39bp to 1.59% and the 3-month 18bp to 1.68%. 

With investors not paying much attention to a fairly light economic calendar, pullbacks across risk markets after they had hit their best levels since January at the end of the prior week were a significant source of support for the Treasury market.  The S&P 500 fell 1.8% on the week.  In late trading Friday, the broad investment grade CDX index was 19bp wider on the week at 105bp and its narrower HiVol subset was 44bp wider at 247bp.  These were the worst levels in about three weeks (though still vastly improved from the mid-March wides), continuing to move very much in line with the shape of the Treasury curve as it closed the week near three-week steeps.  High yield and leveraged loans fared relatively somewhat better.  Through Thursday’s close the high yield CDX index was 66bp wider on the week at 590bp, and the index was about unchanged on the day late Friday, while the leveraged loan LCDX index was 36bp wider on the week through midday Friday at 366bp.  The commercial mortgage CMBX and subprime ABX markets also showed significant weakness.  The AAA CMBX index widened 31bp on the week to 128bp, the AJ 105bp to 411bp, and the AA 168bp to 600bp.  Weakness in the ABX market was led by the higher-rated indices (which, as close as the lowest-rated indices are to zero at this point was pretty much an arithmetic necessity).  The AAA index fell 2.89 points to 55.42.  This was still about 4 points above the all-time lows hit in late March, but every other index moved again to a new all-time low either Thursday or Friday, with a 4.38 point plunge in the AA index to 15.48 particularly ugly.  It’s astounding that such negligible value is seen remaining in assets that were once somehow considered to merit a rating as high as AA.

There was little change in near-term Fed expectations in the futures markets, with a small chance of one more rate cut still seen, but the expected timing of the first hike was moved out to January from December, and the amount of hiking for all of next year was scaled back to some extent.  In the near term, the July fed funds contract gained 0.5bp to 1.955%, and the low-rate August contract was flat at 1.945%.  Looking towards year-end, though, the January contract rallied 8bp to 2.085%, pricing out the likelihood of a rate hike by the December FOMC meeting.  An 11bp rally in the February contract to 2.225%, however, still almost fully prices in a rate hike by the January meeting.  Eurodollar futures gains were led by the reds (Jun 09 to Mar 10), which surged 29bp to 31.5bp.  The Dec 08 to Dec 09 spread flattened 16bp to 63.5bp, seeming to scale back the amount of tightening expected next year by a decent amount, though with LIBOR strains so severe it’s difficult to disentangle what eurodollar futures are telling us about Fed expectations from what they’re telling us about expected LIBOR/fed funds spreads.  In regard to the latter, an 8.5bp decline in 3-month LIBOR on the week to 2.685%, a low since April 1 (that was helped by TAF auction results that pointed to significantly less strained funding conditions than the dislocated April auctions), well outpaced the negligible changes in near-term Fed expectations, causing the spot 3-month LIBOR/3-month OIS spread to fall 8bp to 70bp, a low since April 2 and down from the peak of 90bp hit April 21. 

While regular incoming economic data over the past week pointed to slightly better near-term growth, suggesting a small upward revision to 1Q GDP growth and a somewhat smaller drop in 2Q, probably the most important news of the week was instead the Fed’s Senior Loan Officer survey, which showed an increasingly severe credit crunch that will likely weigh on growth for some time beyond any modest adjustments to near-term growth estimates.  The survey showed a major and broadly based tightening in credit availability in April on top of the sharp tightening reported in January.  Indeed, according to the report in April, the “net fractions of domestic banks reporting tighter lending standards were close to, or above, historical highs for nearly all loan categories in the survey”.  This included major tightening in standards and increases in costs for business loans, very broadly based curtailment of commercial real estate financing, and a further significant retrenchment in consumer credit availability of all types.  Risks of any sort of systemic meltdown have been greatly reduced over the past month-and-a-half since the Bear Stearns blow-up, and this has reasonably been reflected in the performance of risky assets of various types since mid-March, but the broader credit crunch continues to intensify, with negative impacts on the economy just beginning to be felt in a significant way and likely to continue for some time.  Indeed, our banking analyst Betsy Graseck notes (see Banking – Large Cap Banks: Updated – Sr. Loan Officer Survey: Less Credit Today Means More Losses Tomorrow, May 8) that “Tighter lending standards typically lead to higher losses,” as struggling borrowers are cut off from new credit and therefore increasingly default on outstanding loans, which she expects will lead to accelerating loan losses in the banking sector well into 2009.

The past week’s sparse economic data flow was better than expected overall, confirming expectations at this point for a small upward revision to 1Q GDP growth and providing a slightly more positive early ramp into what should still be a weak 2Q.  Much lower-than-expected wholesale inventory figures initially led us to lower our expectation for the 1Q revision to +0.4%, but this was reversed by the better-than-expected international trade report, and we continue to see 1Q GDP being revised up to +0.9% from +0.6%, with previously reported upside in construction spending (concentrated in business spending) relative to BEA’s assumptions combining with the better-than-expected trade results to offset the likely significant downward adjustment to inventories implied by the wholesale numbers.   Meanwhile, better-than-expected chain store sales results boosted our early 2Q GDP forecast to -1.6% from -2.0%. 

Chain store sales results in April were solid and much improved from the terrible March numbers.  Of particular note, department and clothing stores overall swung to slight increases in aggregate same-store sales after steep declines last month.  Incorporating these results, we now forecast a 0.3% rise in the key retail control component of retail sales in April, up from our prior assumption of a small decline.  This boosted our 1Q consumption forecast to +0.5% from -0.1%.  Meanwhile, wholesale inventories posted a surprising 0.1% decline in March and February (+0.9% versus +1.1%) was revised lower.  These results were far lower than BEA assumed in preparing the advance estimate of 1Q GDP growth.  As a result, we now see the inventory contribution to 1Q growth being revised down to +0.3pp from +0.8pp.  This likely significantly smaller inventory contribution to 1Q growth, however, points to a smaller correction in ex-auto inventories in 2Q.  But incorporating the latest information on motor vehicle assemblies, which continue to be severely hampered by the American Axle strike, we reduced our assumptions for 2Q motor vehicle production significantly and continue to see overall inventories subtracting nearly a point from 2Q GDP growth.  The upside in consumption though boosted our 2Q GDP forecast to -1.6% from -2.0%.

The trade deficit gap narrowed significantly more than expected in March to US$58.2 billion from US$61.7 billion.  Both exports (-1.7%) and imports (-2.9%) were weaker than expected, but imports more so.   The US$2.6 billion drop in exports was concentrated in capital goods (-US$1.2 billion), autos (-US$1.0 billion) and consumer goods (-US$0.7 billion).  Food (+$0.3 billion) continued moving to record highs, and industrial materials (-US$0.1 billion) were little changed.  All of the weakness in capital goods was in volatile aircraft, with ex-aircraft up slightly – a negative for domestic investment.  The weakness in autos likely was in large part a reflection of the disruptions to North American assemblies caused by the American Axle strike.  Imports dropped US$6.1 billion, with major weakness in industrial materials (-US$2.0 billion), capital goods (-US$0.9 billion), autos (-US$2.1 billion) and consumer goods (-US$1.1 billion).  All of the weakness in industrial materials was accounted for by a surprising plunge in petroleum products, mostly a result of much lower real oil imports.  The auto drop also likely was mostly a result of strike disruptions.  The steep decline in capital goods was a further negative indicator for domestic investment.  The constant dollar numbers were even better than the nominal, with the real goods deficit falling to US$47.2 billion from US$50.9 billion on plunges in both exports (-4.4%) and imports (-5.4%).  This sharp narrowing in the final month of 1Q provides a more positive starting point for 2Q net exports, and we now see trade adding 0.8pp to 2Q GDP growth instead of 0.6pp.  On the other hand, the modest rise in ex-aircraft capital goods exports and sharp fall in imports put 2Q investment on a more negative trajectory.  We now see equipment and software investment falling 6% in 2Q instead of 4%.  These impacts netted out and had no impact on our revised -1.6% 2Q GDP forecast.  Meanwhile, BEA assumed a US$72.5 billion nominal goods trade deficit in March, much larger than the US$68.6 billion outcome, pointing to a significant upward revision to the net exports contribution to 1Q growth, enough to fully offset the likely downward adjustment to inventories from the wholesale trade numbers, leaving our estimate for the 1Q GDP revision at +0.9%, up from the +0.6% advance estimate.

The week’s most notable other data release was the non-manufacturing ISM survey, which was better than expected, though largely as a result of a surge in a component that is probably not too reliable.  The composite non-manufacturing ISM index rose 2.4 points to 52.0 in April after having held just below the 50-breakeven level the prior two months.  The biggest contributor to the upside was a surge in the supplier deliveries component (56.0 versus 49.0).  Supplier deliveries are conceptually questionable for many of the industries in this survey, so this jump reduced the importance of the gain in the overall index.  Employment (50.8 versus 46.9) also showed good upside, while orders (50.1 versus 50.2) were little changed and business activity (50.9 versus 52.2) was down a point.  Twelve of 18 industries reported growth in April, up only slightly from 11 in March. 

The economic calendar is busy in the coming week, with focus on retail sales Tuesday and CPI Wednesday.  The first round of regional manufacturing surveys will also be released Thursday, setting initial expectations for the May ISM, but it will be another week before the jobless claims report covers the late survey period for the May employment report.  The upcoming schedule of Fed speakers is packed, with the most notable appearance being a speech by Chairman Bernanke on Fed liquidity measures Tuesday.  Other data releases include the Treasury budget Monday, business inventories Tuesday, industrial production Thursday, and housing starts Friday:

* We forecast an April budget surplus of US$166 billion, about US$12 billion lower than in the same month a year ago.  However, all of the anticipated swing is attributable to calendar quirks that result in a temporary boost for spending.  More importantly, speedy processing of the April 15 payments submitted by individual taxpayers should lead to a solid improvement on the receipt side of the ledger.  Note that we began the year looking for a US$400 billion budget deficit, then boosted our forecast to US$425 billion in response to a higher-than-assumed spending path in the defense category.  We are now adjusting our estimate to US$405 billion reflecting the somewhat stronger-than-expected April tax season inflows.

* We look for a 0.4% decline in overall April retail sales but a 0.2% increase ex-autos.  A sizeable fall-off in vehicle sales points to a weak reading for headline retail activity.  However, the chain store reports were better than expected, and thus we now look for some strength in key categories, such as general merchandise and apparel.  Still, the gas station component is likely to show a slight dip since the rise in prices seen during the month was a bit less than the seasonal norm.  Moreover, company reports point to some softness in the drug store sector for the second straight month.  Finally, even with the tax rebate program expected to help stimulate discretionary spending over the next couple of months, we still see real consumer spending up only 0.5% for the quarter as a whole.

* We forecast a 0.2% uptick in March business inventories.  The results for the manufacturing and wholesale sectors were unusually mixed in March – with factory stockpiles up a sharp 0.9% while wholesalers posted an outright decline.  We also expect to see a motor vehicle-related decline in the retail component and thus look for a more modest rise in overall business inventories than seen in recent months.  Finally, the I/S ratio should tick back down to 1.27.

* We look for a 0.3% increase in the April consumer price index, overall and excluding food and energy.  Another sharp jump in airfares, together with an expected rebound in the medical care category following some unusually subdued results in recent months, point to an above-trend reading for the core CPI.  Meanwhile, the recent run-up in prices at the gas pump just about matches the typical move seen at this time of the year.  Indeed, on a seasonally adjusted basis, the energy component is actually expected to show a slight decline.  Moreover, lower quotes for dairy and meat items point to some mild relief for food prices.  So, the headline result is likely to be reasonably well contained.  Finally, the core is expected to hold at +2.4% on a year-on-year basis.

* We forecast a 0.7% plunge in April industrial production.  The labor market report, together with a very sharp drop in motor vehicle assemblies, points to a very weak outcome for factory output.  Indeed, the key manufacturing component is expected to post a 0.9% decline, which would represent the sharpest fall-off in about two-and-a-half years.  Roughly half of this swing is directly attributable to the motor vehicle sector, but other categories, such as textiles and chemicals, are also expected to show significant softness.  In fact, the only notable component that is likely to show a gain is computers and electronics.

* We estimate April housing starts of 925,000 units annualized.  Given the sizeable backlog of unsold inventory, we believe that starts will drop another 20% over the remainder of the year. However, the April decline is likely to be a modest 2% or so because weather conditions across much of the nation were relatively favorable and the volatile multi-family category should level off on the heels of an outsized 25% plunge in March.

 

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Latin America
Argentina: Still Time for a Soft Landing
May 13, 2008

By Daniel Volberg and Gray Newman | New York, New York

All eyes in Argentina are on the growing tensions as farmers continue to toughen their rhetoric amid a blockade of ports and roads designed to shut down exports – a key source of tax revenues for the federal government.  But while a prolonged conflict could raise serious questions about Argentina’s fiscal accounts, the upcoming wheat-planting season and ultimately governability, we believe that Argentina is facing a more serious risk on another front – inflation.  Without trying to minimize the risks surrounding the farmers’ conflict or the vulnerability of the current policy framework to external conditions, the single greatest risk in our view is the inflation challenge.

The Monetarist Camp

Not all share our concern regarding the extent of the inflation risk in Argentina.  Indeed, there is a large group of economists and analysts in Argentina – many of whom have long been critics of the current policy mix – who believe that inflation is under control.  The monetarist camp argues that current conditions are supportive of inflation stabilizing near its current level, which many believe to be 23%.  The monetarist camp cites four key factors in support of its view:

•           Money supply growth has not continued to accelerate during the course of the past year.  The central bank targets the expansion in the quantity of money, particularly the growth in M2.  In the first four months of this year, average private sector M2 growth ranged from 25-30%.  (We use private sector M2 because we believe that it is a more reliable measure of liquidity conditions than the broader measure that includes public sector deposits.)  Subtracting real GDP growth of at least 5% this year yields an inflation rate in the 20-25% range, in line with our estimates of current inflation.  Indeed, the stronger your estimate of real GDP – real GDP is running near 9% in the first months of the year – the more restrained money supply growth appears to be.  Contrast today with a year ago, the monetarist camp argues.  A year ago, inflation was running near 10%, but with M2 growth of 27% and real GDP near 9%, it was not hard to imagine that inflationary pressures would build.

•           The pace of fiscal spending has fallen.  Last year fiscal spending grew near 40%, nearly double last year’s 24% nominal GDP growth.  In contrast, in the first three months of this year the growth in fiscal spending has been running near 30%.  Compare that with our estimate of first quarter nominal GDP growth at 30%, and there is evidence of policy tightening from last year.  Thus, the monetarists argue, the pace of fiscal spending growth in the 30-35% range could be consistent with inflation stabilizing at current levels.

•           Twin surpluses and the limited rise in labor costs should act as further insurance against an inflationary spiral.  Last year inflation accelerated from near 10% to near 18% (our estimates) as labor managed to negotiate nominal wage increases just above 20% during the usual March-June collective bargaining period.  This year, wage negotiations in March and April have resulted in salary increases of around 20-25%, roughly in line with current inflation. Allowing for the roughly 2-3% total factor productivity growth, inflation appears to have simply caught up with the increase in labor costs.

•           The strong fiscal and external balance sheets are insurance against inflationary pressure getting out of control.  The monetarist camp argues that fiscal and balance of payments surpluses, and the near US$60 billion in public sector deposits (US$50 billion in international reserves and US$10 billion in other deposits) mean that the authorities do not need to rely on seignorage to finance a fiscal deficit – the standard route to an inflation spiral.

Barring a significant external shock, the monetarist camp argues that the outlook for economic growth remains supportive.  If the authorities continue with the current economic policy stance, the economy should gradually decelerate to its potential growth rate and inflation should not begin to spiral.  The main threat under this scenario is a debilitating external shock, in the form of a dramatic commodity price decline, which leads to a reversal in the fiscal surplus.  Thus, while the Argentine financial markets may be currently in turmoil as investors try to gauge the impact of the farmers’ strike, the monetarists argue that the near-term economic outlook is actually sanguine.

Risks Are Rising

We have some sympathy for these arguments, but are much more concerned about the inflation challenge facing Argentina. We would highlight three concerns:

•           We believe that the jump in inflation expectations last month represents a key macroeconomic risk.  Average one-year ahead inflation expectations jumped to near 33% in April, from near 23% in February.  We are concerned that wages could follow suit, ratifying the jump in expectations.  This would be a significant break with the recent history, since nominal wage growth has led inflation expectations.  In our view, the jump in expectations is a consequence of the inflation measurement problem.  We suspect that, lacking a transparent and widely accepted inflation measure, expectations are being driven by higher perceived inflation.  Our surveys of local price data show that food inflation is running near 35%, far ahead of headline and, we suspect, is driving perceived inflation higher.  Although the authorities have announced that a new inflation index may come as soon as June (thus measuring May’s inflation number with the new methodology), we remain concerned that it will not gain widespread acceptance.

•           We worry that the margin for policy adjustment is eroding quickly as the multilateral real exchange rate appreciates via inflation.  The weak exchange rate has been a key economic policy tool for the authorities seeking to protect local industry from import competition and so boost employment, wages and domestic consumption.  But rising inflation is prompting the real exchange rate to converge to its long-run equilibrium.  We do not believe that the Argentine peso has yet converged, but a bout of significantly higher inflation could produce rapid convergence and an ensuing hard landing for the economy.  In contrast, if the authorities continue to pursue nominal exchange rate stability and manage to stabilize inflation at 23%, the real exchange rate would not appreciate to its long-run level – the average for the 1980s and 1990s – until late 2009.  We believe that the authorities still have time to engineer a soft landing, but current inflation and an inflation expectations uptick represent serious risks.

•           There is some risk that the authorities attempt to weaken the peso in response to real exchange rate appreciation (see “Argentina: The Currency Conundrum”, EM Economist, February 15, 2008).  We suspect that the authorities are under some political pressure to engineer a devaluation of the peso in an attempt to help protect local industries from potential import competition. This would of course be a high-risk move: the inflation spiral could quickly overwhelm any move in the nominal exchange rate, providing little real benefit to local industries.  Indeed, such a policy could risk producing a hard landing, in our view.

After all, in two past episodes last year and last month, fears of currency weakness prompted an important shift out of peso holdings and into dollars.  Last August-September and this April, depositors shifted from local to foreign currency in response to perceived risks of exchange rate weakness, and the central bank was forced to sell international reserves in order to defend the exchange rate.  As long as the authorities continue to maintain nominal exchange rate stability and the multilateral real exchange rate remains weak, the authorities should enjoy significant capital inflows and limit the potential for these episodes to cause significant economic damage. 

However, a change in market expectations about the ability or willingness of the authorities to defend exchange rate stability could result in significant economic fallout.  Recall that the sum of liquid local currency holdings – public bonds and liquid private sector deposits – is larger than the near US$50 billion stock of international reserves held by the central bank.

Bottom Line

There is still time to adjust economic policy to deal with the threat posed by inflation.  A credible and transparent inflation measure would represent a major step forward, as would further tightening of fiscal spending along with steps to provide for energy price liberalization and a reduction in energy subsidies.  Argentina needs to engineer a soft landing in order to minimize the economic impact of the loss of import protection as the real exchange rate revalues.  However, the failure to act this year is likely to increase significantly the risk that Argentina suffers from a hard landing rather than a soft landing in 2009.  As challenging as the current conflict with the farmers may be today, the coming challenge of engineering a soft landing as the economy loses the protection of a weak exchange rate is likely to prove even more demanding.

 

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Latin America
Venezuela: Macroeconomic Adjustment? Yes, but for How Long?
May 13, 2008

By Boris Segura | New York

It may be hard to believe, but despite the abundance from high oil prices, Venezuela has taken steps to slow inflation and domestic demand.  The good news is that a concerted effort on the monetary and fiscal fronts has yielded some positive results. But the bad news is that we doubt that the bout of macroeconomic adjustment is set to last.  Indeed, with key regional elections coming up later this year, we suspect that the appetite for further adjustment could decrease in the coming months. And there is some evidence that the ramp-up in government spending has already begun.

Better Late than Never

The move to slow demand and inflation was reinforced after the defeat of the constitutional referendum last December.  After a brief slowdown during 3Q07, inflation rebounded sharply, reaching 28.5% by March 2008. We suspect that the inflation bout would have been worse, barring a policy response by the authorities. The political damage could be seen in the polling results, which showed public dissatisfaction with rising inflation and food shortages, even among chavista sympathizers. This led to a cabinet reshuffle early this year, which brought on board a new economic team.

In a concerted effort, monetary and fiscal authorities continued to try to cool down domestic demand.  However, the quality of the adjustment has likely been costly in terms of distortions to the economy.

The central bank increased reserve requirements twice last year, and it has adjusted upwards (controlled) domestic interest rates twice so far this year. Along with a more subdued expansion of public expenditure, monetary aggregates have come down from explosive growth rates in early 2007. The same also applies to credit growth. Still, the growth of liquidity and credit is rapid, as a result of an oil-fueled economic boom within the context of exchange controls.

Fiscal authorities have also reined in primary expenditure. Apart from a brief uptick during the run-up to December’s constitutional referendum, growth of primary expenditure during 2007 was subdued. As a percentage of GDP, public expenditure in Venezuela came down to 25.7% in 2007, from 29.5% a year earlier.

The authorities have been able to bring the permuta exchange rate under control. This was achieved through the placement of structured notes in the banking system by Fonden, the off-balance-sheet investment fund run by the Ministry of Finance, as well as by the issuance of more than US$5 billion in Bonos Venezolanos. Both instruments are denominated in dollars but payable in bolivares and clearable overseas, and as such provide access to dollars for domestic agents. As importers of some goods are being denied dollars at the official rate by Cadivi, the entity in charge of administering the exchange controls regime, importers have had to source dollars at the higher exchange rate in the permuta forex market, feeding inflationary pressures.

This supply of dollars also helps to drain bolivares liquidity from the system. Besides helping to keep the permuta FX under control, these bond issues aid the monetary authorities in their liquidity management, as they are payable in bolivares. It is ironic that a public debt management tool is used both as an exchange rate and a monetary policy instrument – a testament to the distortions embedded in this economy.

A Dual Exchange Rate System?

Authorities dislike the rapid growth of imports. Even when decelerating throughout the year, imports still grew by 37% in 2007, a reflection of strong domestic demand and a minimal domestic supply response. In Venezuela, one-step devaluations have a stigma attached to them, and aside from that, they are more a fiscal tool than a means to restore competitiveness. The authorities are thus grappling with the dilemma of how to slow down imports without incurring the inflationary and reputational costs of an actual devaluation.

Slowly but surely, the authorities are moving in the direction of a dual exchange rate system. In particular, they have defined three basic categories of goods that are to receive dollars at the official rate: food, medicines and capital goods. Implicitly, all other transactions would have to source dollars in the permuta exchange rate market. There has been no actual announcement yet, but Cadivi is decidedly slow in authorizing dollars for non-priority imports.

The authorities are channeling imports out of Cadivi and into the permuta market. This is why it is key for them to strengthen the permuta exchange rate; otherwise, the inflationary impact would have been severe. Now that the spread between the official and the permuta exchange rates is more reasonable, the government is likely to start moving transactions out of Cadivi and into the permuta, without fearing a major inflation backlash. The fiscal accounts won’t benefit from this effort, which constitutes a disguised devaluation, but it would allow the authorities to save face.

The administration is likely to keep supplying dollars to the permuta FX market going forward. Fonden still has US$1.5-2.0 billion in structured notes that it can place with the banking system, and we might even get issuance from PDVSA in 2H08.

We now expect the official exchange rate of 2.15 to remain at least until the end of next year. We previously called for an adjustment of the official exchange rate to 2.60 in 2009, but given fiscal trends and the reputational cost associated with devaluation, the authorities are likely to keep the official exchange rate at 2.15 through the end of 2009. It remains to be seen what percentage of imports gets access to dollars at VEF 2.15.

The Case of ‘Loading the Fiscal Gun’

One of the major shortcomings of Venezuela’s economic policy framework is the pro-cyclicality of public expenditure; 2008 is likely to be no exception. Venezuela’s economy has become ever more dependent on oil, in large part due to the lack of strong fiscal institutions that foster public saving during extraordinarily good times, as we are seeing currently.

We revise our fiscal figures for the central government for 2008 and 2009. We now use a price for the Venezuelan oil basket of US$98/bbl for 2008 and US$107/bbl for 2009, based on estimates provided by our colleagues on Morgan Stanley’s Global Economics team. Late last year, we were hopeful that Venezuela’s oil production was poised to increase, as the joint ventures in the Orinoco Belt would ramp up their extraction. However, the recently imposed windfall tax on oil production discouraged investment by the current operators, and we thus assume flat oil production.

The authorities have a ‘piggy bank’ in the form of considerable liquid assets. Liquid public sector assets rose to an estimated US$59 billion at the end of 1Q08. The government is likely to draw these assets down if need be.

Public expenditure is likely to show explosive growth in 2H08. We are already getting signals to that effect. Our preliminary estimates of primary expenditure, derived from payment orders issued by the Oficina Nacional del Tesoro for February-April 2008, are already showing a substantial acceleration. Also, the creditos adicionales (additional budget appropriations) requested by the authorities in the first three months of this year are running at 14% of the initial budgeted expenditure, way above the mean for recent history but close to 2006’s pace on an annualized basis.

As happened in 2006, November’s regional elections could trigger fiscal stimulus.  To win votes, we think that the authorities are likely to embark on a major fiscal drive starting soon (if it has not already begun). From a fiscal point of view, we believe that 2008 is going to look a lot like 2006 – the year of President Chavez’s re-election. That year, primary government expenditures soared by 40% in real terms.

In light of this expected fiscal splurge, we are raising our GDP growth forecast for 2008 to 6.7% from 6% and for 2009 to 5.1% from 3.8%.  Similarly, we stick to our 30% inflation forecast for the year, despite some potential moderation in the next few months. In fact, the recently granted 30% hike in wages is an acknowledgement by the authorities that inflation is likely to come in close to that level.

Bottom Line

Surprisingly, Venezuela has been on a ‘diet’ of domestic demand restraint for a while now. However, as the business environment remains challenging, the supply response in the economy has not been robust enough, and inflation has remained on an upward trajectory.

The authorities are likely to break the ‘diet’ and move to a more expansionary fiscal stance. Maybe another metaphor is apt for this oil-rich country.  The fiscal car’s fuel tank is full; it’s just a matter of deciding when to drive it. We suspect that the time is soon approaching – fasten your seatbelts.

 

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