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Russia
A Blind Eye to Inflation May 23, 2008 By Oliver Weeks | London The macro policy announcements of the new Putin government remain strongly oriented towards growth at the expense of inflation. Official complacency on inflation is likely to be reinforced by a stabilization in headline inflation rates in 2H as food price growth slows. We continue to expect end-2008 headline CPI at 14.0% from a reading we expect at 15.0% in May, but are raising our 2009 average inflation forecast from 12.0% to 13.5%. Hikes in policy interest rates and reserve requirements still look likely to be modest, while RUB appreciation against the basket appears to have been delayed but, in our view, not cancelled by the new FX intervention regime. Given ongoing terms-of-trade gains, Stimulus Continues Inflation remains the clearest longer-term threat to The new government line-up, largely a reshuffle of the existing team between the Kremlin and government, does not seem to augur sharp policy changes or a readiness to restrain domestic demand. It also remains heavy on representatives of industrial interests, who have lobbied hard for loose fiscal and monetary policy, and against limits on foreign borrowing and RUB appreciation. Fiscal loosening certainly seems set to continue, with Putin’s confirmation of plans for oil sector tax cuts coming on top of renewed promises of a significant VAT cut and new tax allowances against spending on education, health and mortgage interest. Most of the rest of the policy program was devoted to promises of further spending increases on infrastructure, industry, agriculture, education, health, housing, minimum wages and social benefits. Federal government expenditure in 1Q is up to 15.2% of GDP, from 14.4% a year earlier, yet it is failing to keep pace with spectacular revenue growth this year. With commodity prices elevated and oil fund reserves already plentiful, it is likely to be increasingly difficult for the Finance Ministry to resist both further tax cuts and upward revisions to spending targets. Automatic sterilization of energy export revenue risks becoming increasingly ineffective. Only Short-Term Food Outlook More Positive The longer-term structural reform agenda of the reshuffled administration looks market-friendly, to the extent that it can be implemented. In particular, Putin has stressed private sector involvement in infrastructure spending, domestic money market development, competition and the efficiency of state spending, while Medvedev has prioritized the rule of law and judicial independence. The weakness of competition and growing capacity constraints are clearly significant contributors to inflation. Yet, we find it improbable that short-term spending gains and tax cut windfalls will all be efficiently invested. The “further stimulus to economic growth” mentioned by the PM looks risky at a time when domestic demand is already booming. Consumption is already stimulated by loose monetary policy and massively negative real interest rates. The sharp slowdown in household credit forced by tighter external funding conditions in the first two months of the year has been more than compensated by state injections into the money market. On the supply side, apart from oil prices, local metal companies are reportedly preparing large new upward revisions to already contracted prices. Regulated utility price hikes for the next three years have already been revised up further, to 25%, 30% and 40% in the case of household gas. In the context of an already tight labor market and a labor force that will fall by 1.8 million (2.5%) over the next two years alone, high wage and inflation expectations risk becoming entrenched (see also Monetary Stalemate, February 14, 2008, and Going for Growth, April 4, 2008). The only short-term good news on inflation appears to be on food, where domestic wholesale grain and food-oil prices (but not yet retail prices) have begun to correct. With food comprising 39% of the basket, this will clearly slow headline growth, and we continue to expect headline inflation to stabilize at around 15.0% in the next few months and end 2008 at around 14.0%. (We also remain bullish on the longer-term outlook for food supply from Russia, with recorded cultivated land down 70 million hectares, 60% of 1980’s level.) In the shorter term, however, headline inflation looks more likely to prompt more complacency. We are raising our average 2009 CPI forecast to 13.5%Y from 12.0%. Sharp Policy Reaction Still Unlikely The main domestic expressions of concern are from the central bank. Deputy Governor Ulukaev has argued that the time has come to shift from a focus on banking sector stability to macroeconomic targets. We still expect limited monetary tightening this year, both 75bp of hikes in the overnight refinancing rate to 7.25% and around 150bp on reserve requirements, but political support for more aggressive action looks unlikely. The CBR remains most tightly constrained by its FX policy. The change in intervention policy announced last week is an interesting attempt to cut speculative positions and avoid moving the present unofficial exchange rate corridor, but to us it appears likely to prove inflationary and ultimately unsuccessful. FX inflows were resurgent in April, and the pipeline of non-speculative FX borrowing and equity inflows looks strong, while US rates look unlikely to rise soon. The Ministry of Economy has raised its full-year net capital inflow forecast to US$50-60 billion, and this is after a US$22 billion outflow in 1Q. At current oil prices, the 2008 current account surplus will be nearly double last year’s US$78 billion. Extra CBR intervention within the current band will raise volatility and reduce some trading limits, but adding to RUB longs on intervention still looks attractive to us. We do not think that intervention within the corridor excludes that the corridor itself is eventually moved. This still looks politically easier once the USD recovers significantly against the EUR, and once exporter lobbyists have been compensated with tax cuts. Our forecast for 3.5% nominal appreciation against the basket by end-2008 remains unchanged. Clearly, this will have only a marginal impact on headline inflation, but the government believes that it can afford to keep raising pensions and benefits above the rate of inflation to reduce the risk of unrest. Real wage growth is still at 14.6%Y in March, though real disposable income growth has slowed to 7.8%Y, its weakest level since 2004. In the short term, strong growth and negative real rates continue to provide a supportive credit and equity environment. However, household deposit growth has slowed significantly, underlining the longer-term risks to investment and growth. While political stability is clearly not at risk in the short term, inflation eventually also has the potential to force painful policy decisions that could test the current duumvirate.
Currencies
Enjoy the Energy Subsidies While You Can May 23, 2008 By Stephen Jen & Luca Bindelli | London Summary and Conclusions A quarter of the world’s gasoline consumption is subsidised, and, in terms of population, half of the world uses energy subsidies. (To be precise, the proportion of gasoline consumption in the world that is subsidised is 22%. In terms of population, 51% of the world uses gasoline subsidies. In this note, all the metrics are for gasoline, though the gist of the discussion is more general, and applies to all energy and some food products.) This policy has created an important distortion, whereby rising oil prices have been effectively prevented from destroying oil demand. Subsidies have artificially raised inflation in the developed world (through artificially high oil prices) and suppressed inflation in the developing world (inflation would have been even higher in the absence of subsidies). As fiscal pressures mount, some countries will be forced to incrementally remove these subsidies. The net result will be an unwind of these distortions. For currencies, we believe that the net effect will be negative for EM countries, as this process will be stagflationary for them, and ‘Goldilocksy’ for developed countries. This is yet another reason why USD/AXJ and other selected USD/EM may experience some upward pressures. High Oil Prices and Decelerating Global Demand Macro economists like ourselves who are used to looking from a top-down perspective tend to focus on how the aggregate demand in the world changes, when thinking about oil prices. Economists tend to be less well-versed in supply conditions in the energy sector. But the current oil price increases are curious. They are not quite supply-driven, and the fact that global demand is decelerating appears to be inconsistent with accelerating oil prices. While the logic behind the increasing structural energy demand from EM makes a lot of sense, it is still difficult to justify how oil prices could more than double in 15 months, or rise by six-fold in seven years, unless one subscribes to the ‘Peak Oil Thesis’, i.e., we are at the steep part of the supply curve. Without explicitly taking a stand on where the equilibrium price of oil should be, either close to US$200 or US$50 a barrel, in this note we highlight the role of energy subsidies in emerging economies, and how they have distorted global energy demand and inflationary pressures in the world. We argue that these subsidies will ultimately need to be rolled back. Countries will have different thresholds of tolerance for sustaining these subsidies. When these subsidies are rolled back, we believe that the effects will be stagflationary in the EM markets but ‘Goldilocksy’ in the developed countries, with different implications for the EM and developed market currencies. Implicit and Explicit Subsidies for Energy Products Right now, half of the world’s population enjoys gasoline subsidies, and a quarter of the world’s gasoline consumption is subsidised. While many countries have taxes on gasoline, some major oil consumers do not. In While three-quarters of the world’s gasoline consumption is taxed, the level of ‘net taxes’ has actually declined as oil prices have increased, for various reasons. To show this, we compared early 2008 and end-2006, when crude oil was trading at around US$60 a barrel. Back then, only 10.4% of the world’s gasoline consumption was subsidised (compared to 22.2% right now). Essentially, what this means is that the extent to which the world has been subsidising its consumption of gasoline has actually increased, with the rise in crude oil prices. We have these thoughts: • Thought 1. Insufficient destruction of oil demand. Demand curves are usually downward-sloping because, all else equal, higher prices should lead to lower quantity consumed. This should be no different for energy products. Particularly when the global aggregate demand may be decelerating, energy prices should not, in theory, rise so rapidly. Large energy subsidies as described above could be one explanation. As international energy prices rose, governments tried to shelter local energy consumers from such a shock through the use of subsidies. Energy demand, therefore, has not been ‘destroyed’ by higher prices. The world’s demand for energy products, as a result, is higher than it should be in the absence of subsidies. Energy prices are overshooting partly because energy demand is overshooting. • Thought 2. The developed world’s inflation is artificially high, while developing countries’ inflation is artificially low. Food and energy products make up heavier portions of the consumption baskets in developing countries than in developed countries. So, the fact that headline inflation in EM tends to be higher than that in developed nations should not come as a surprise. However, these subsidies – which are concentrated in EM – should bias headline inflation in opposite directions for developed and developing countries. • Thought 3. These subsidies will be tough to maintain forever. If the energy price shock were transitory, then subsidies should work to smooth out the price shock through the budget. However, if this energy price shock is permanent and if energy prices continue to rise, then it will be quite difficult for governments, especially those with fragile fiscal positions, to maintain these subsidies. Already, • Thought 4. This will add to the stagflationary pressures in EM. Governments will reduce energy subsidies by force, not by choice. In other words, they will be forced to cut back on subsidies precisely when global energy prices rise, and/or the world slows. (Unwinding these subsidies will be politically unpopular. In the case of • Thought 5. Another negative for EM currencies. In previous research, we proposed that there are distinct phases of any financial crisis. The first phase is the pure financial part; the second phase is the real economic adjustments; and the third phase entails significant snap-backs in some asset prices. During the first phase, EM were seen as the safe havens, primarily because the financial systems in EM were not that exposed to the type of assets that were in trouble. EM equities and currencies outperformed for most of this first phase of the crisis. However, in the second phase, we are turning more cautious on EM currencies, especially in AXJ. The prospective unwinding of fuel subsidies in Bottom Line Half of the world now enjoys fuel subsidies, but this will not last. Fuel subsidies prevent oil demand from being destroyed by high oil prices, and have exaggerated inflation in the developed world, while understating inflation in the developing world. As these subsidies are rolled back in these EM economies, these distortions will also abate. The key implication for currencies is that most AXJ currencies, and some other EM currencies, will likely experience negative pressures relative to both the USD and the EUR. Risk-reward no longer supports a short USD/AXJ investment posture for the coming weeks, in our view. |