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Vietnam
Vietnam: Reining in the Tiger Cub June 23, 2008 By Chetan Ahya & Deyi Tan | Singapore & Shweta Singh | India Summary In recent weeks, concerns about Loose Monetary Policy at the Heart of Overheating in the Economy… Not surprisingly, credit growth accelerated to 54% in 2007 after growing at an average of 32% in the last four years. We estimate that the credit to GDP ratio spiked to 93% as of December 2007 from 71% as of December 2006. ...Reflected in Asset Market Boom The lagged impact of loose monetary policy was reflected in a major increase in domestic demand (particularly construction) and a sharp rise in asset prices. Even as domestic demand and asset prices rose sharply, there was a delay in hiking policy rates. The VN Index rose from 167 at the end of 2003 to a peak of 1,171 in March 2007 and the index traded at a P/E of more than 50 times in early 2007. Similarly, property prices in …and a Spike in Domestic Demand and Inflation Inflation has continued to accelerate, reaching 25.2%Y in May 2008 from an average of 8.6%Y in QE Sep-07. Core inflation (ex-food and transportation) has risen to 11.7%Y in May from 6.6%Y in QE Sept-07. Indeed, the rise in inflation has meant a sharp decline in real lending rates for the banking sector. The SBV kept the base rate at 8.75% until May 19. Apart from this, the government has always capped lending rates for banks at 1.5 times the base rate. Hence, until May 19, banks could charge a maximum rate of 13.1%. Additionally, from February 2008 to May 2008, banks were directed to offer a maximum deposit rate of 12%. Thus, deposit and lending rates were kept at lower levels than warranted by supply/demand and inflation. While low real lending rates meant stronger demand for credit, low real deposit rates resulted in slower deposit growth. According to a recent World Bank report, credit growth accelerated to 63%Y in March 2008 compared with 33%Y at the start of 2007. Deposit growth decelerated to about 40%Y in March 2008 from about 55% in December 2007 and about 45% in January-February 2007. Indeed, some of the small banks suffered a liquidity crunch, having to borrow in the interbank market at very high rates of 25-30%. Supply-side factors such as food and energy added to the inflation pressures. Of the current inflation rate of 25%, food & foodstuff has contributed 18.6 percentage points. A sharp rise in domestic rice prices has been a key factor driving food inflation. Rice exports have been allowed to continue until recently. Bad weather and its adverse impact on crops resulted in some stress in the domestic market. A spike in international prices and news of increased shortages in various countries in the region heightened anxiety in the domestic market, particularly in March and April. Balance of Payments Stress Strong credit growth resulted in a major spike in imports over the last eight months. Import growth (custom basis) stood at 70.5%Y for January-May 2008 compared with an average of 28.4%Y during QE Sep-07. Import growth has accelerated not only for capital goods such as machinery but also for automobiles, steel and fertilizers. We believe that high inflationary expectations and precautionary advance purchases by residents are key reasons for this spike in import growth. Higher prices of some international commodities also contributed to the acceleration in import growth, as First-Round Corrective Measures Slow in Pace The government initially attempted to control the overheating by taking administrative measures, persuading banks to slow credit growth. Policy rates were lifted by only a minimal amount. On February 1, 2008, the SBV increased the base rate to 8.75% from 8.25% and raised the cash reserve ratio from 10% to 11% for deposits under 12M and from 4% to 5% for deposits between 12M and 24M. Moreover, in the second week of February, it instructed banks to subscribe to 365-T-bills worth US$1.3 billion (around 2% of total deposits) at a coupon of 7.8%. The increased stretch on liquidity forced banks to hike deposit rates. Depositors started moving from one bank to another based on which one could offer higher deposit rates. At the end of February, however, the SBV announced a 12% cap on deposit rates. We believe that the decision to limit the rise in interest rates at a time when inflation was rising fast only added to the complexities. Implementing Aggressive Policy Measures Now While the government delayed implementing measures to control the overheating in the economy, it has recently taken the following steps: (a) Tightening of monetary policy: On May 19, the SBV hiked the base rate to 12% from 8.75%. On June 10, it was hiked further to 14%. More importantly, on May 19, the SBV removed the 12% cap on deposit rates. While the lending rate is still limited to 1.5 times the base rate, with the rise in the base rate, banks can now charge up to a maximum of 21% (1.5 times 14%). Banks have since increased deposit rates to about 15-17% and lending rates to 20-21% from a maximum lending rate of 12.4% in January 2008. (b) Fiscal policy tightening: The government aims to cut spending to slow aggregate demand. It plans to reduce its recurrent expenditure (excluding salary) by 10% and to cut capital spending on projects funded by government bonds. We believe that the government is likely to try to reduce its fiscal deficit to 4% of GDP in 2008 from 5% in 2007. (c) Slowing business activity of SOEs: SOEs are expected to focus on core businesses; their investments in banking and securities are subject directly to the PM’s approval. Large Exchange Rate Adjustment Unlikely We believe that the SBV is unlikely to opt for a major one-off exchange rate adjustment. In our view, the exchange rate adjustment priced in the non-deliverable forwards (NDF) market is unlikely to come through. As of June 19, the one- year forward NDF is pricing in a 33% depreciation of the VND. The SBV will resist making such a large adjustment. First, any major one-off depreciation would increase the risk of instability in the FX market. Second, with inflation already at 25% as of May, any sharp depreciation would seriously damage domestic confidence, and inflationary expectations could intensify. We believe that the SBV will likely allow a further minor depreciation of 4-5% over the next three months. If circumstances warrant, the SBV could choose to hike the prime rate (policy rate) by an additional 2-3% over the next 1-2 months, we think. Real Economy Adjustments Will Likely Be Painful Efforts to restrict banks’ funding of equity share purchases and increased concerns about the macro outlook have pushed the VN Index down 68% from its peak in March 2007. The sharp drop in the equity market has weighed on the property market. According to CB Richard Ellis, residential property prices in Corporate sector earnings are likely to be hit significantly. Companies will be reporting earnings before mid-July. Apart from slowing growth and the higher cost of borrowing, the corporate sector will probably report losses on cash surpluses parked in marketable securities. Additionally, many companies have increased their exposure to real estate. Balance of Payments Stress to Diminish by 4Q08 We expect import growth to slow from the current 70% level to 25-30% over the next 3-4 months and then to 15-20% by year-end. The spike in interest rates will not only slow real business demand for imports but also halt the precautionary and speculative demand. The slowdown in capital inflows, particularly portfolio inflows, means that the balance of payments could be negative during the third quarter. To address this gap over the next 3-4 months, we believe that the government will opt for a combination of (a) a drawdown on FX reserves, (b) increased borrowing from multilateral agencies for infrastructure projects, and (c) encouraging the corporate sector to borrow from the international markets. We expect the trade deficit to narrow to US$4.5 billion during 4Q08 from US$7.05 billion in 1Q08. We believe that this gap will be adequately matched by remittances, FDI and official development assistance from multilateral agencies. Supply-Side Inflation Pressures to Linger Even though the slowdown in domestic demand and asset price deflation should help to reduce core inflation, food and energy prices could continue to keep the headline inflation rate high. The government has already implemented some measures to address food price inflation. It has increased the supply of rice in the domestic market and announced a moratorium on new contracts for rice exports. The government cannot completely block exports, as that would hurt farmers, though it might benefit the urban population. Domestic rice prices have fallen over the last six weeks, but the overall stock of rice in the country is still low. The government hopes to bring rice prices down further post the April-June harvesting season. While the government raised domestic fuel prices by 12-36% in February, international crude oil prices have shot up by 31% since then. The government can afford to continue subsidizing domestic fuel prices, as External Account Vulnerability High, but a Severe Shock Will Likely Be Avoided While there are many signs that Banking Sector Stress Is the Bigger Risk We believe that the banking sector will face major challenges over the next 12 months. Although most banks have recently reported low non-performing loans as per Vietnamese accounting standards, the underlying NPL levels as per international accounting standards are likely to be higher. We believe that the banking sector’s credit risk management systems are yet to be fully modernized. The coming slowdown in growth and increased cost of debt servicing will likely result in a further rise in NPLs from small and medium-sized companies. The declines in the equity market and in property prices are also beginning to translate into more NPLs. Banks’ ability to raise capital from the international market is likely to be further impaired in this environment. The duration of the current downturn will be key in determining the outcome of the banking sector’s problems. Time to Reflect on Difficult Structural Reforms We believe that the government needs to use the current challenging environment as an opportunity to push through a series of difficult reforms. In our view, the government has to address several challenges to ensure sustained 8% GDP growth: First, Second, while Third, Fourth, Fifth, rising income and wealth inequality is likely to increase discontent among the lower- and middle-income population. As per the World Bank’s Gini coefficient measure, inequality in Bottom Line We believe that the government has initiated the right policy measures to address the current inflation and balance of payments challenges head-on. We expect the government to continue to rely on monetary policy as the key tool to reduce the macro imbalances. The growth cycle is likely to see a shock over the next 12 months. However, we believe that
South Africa
Mounting External Account Vulnerability June 23, 2008 By Michael Kafe & Andrea Masia | South Africa Summary The Quarterly Bulletin released by the SARB showed that the country’s current account deficit rose further, to 9% of GDP in 1Q08. As has been the case lately, the bulk of the deficit is made up of net invisible outflows − mainly dividends. However, this time around, the marginal deterioration was driven a lot more by a doubling of the visible trade deficit than the net invisibles. Elsewhere, demand-side data provided in the bulletin were generally higher than we had expected, although the hugely negative external sector deficit provided significant offset. Oil Imports Lift Trade Deficit The balance on visible trade rose from a deficit of R26.7 billion in 4Q07 to R61.5 billion in 1Q08, thanks largely to a strong increase in imports that fully offset relatively modest export growth. Exports rose 7.2% from R572.9 billion in 4Q07 to R614.3 billion in 1Q08, despite a 7.2% fall in volumes as the combination of load-shedding by national electricity producer Eskom, the temporary closure of certain mines due to safety audits and a slow resumption of operations following the Christmas and Easter holidays, hurt mining output significantly. The rise in export volumes was driven by a 16% increase in export prices, particularly commodity prices, which rose some 20% over the quarter. Imports, on the other hand, rose a huge 12.7%, thanks largely to higher oil prices. Dividends and Services Keep Net Invisible Gap Wide Interestingly, there was no deterioration in the net invisible payments − although they still account for the bulk of the current account deficit. In fact, the share of net invisibles in the current account deficit fell from an average of 72% in 2007 to 68.4% in 1Q08. The single largest component of net invisible payments, however, remained dividend payments (53%). These payments have remained uncomfortably high, thanks to the huge tide of portfolio investment inflows in recent years: gross dividends declared and paid out on these inward flows have risen from R55 billion a year ago to R93 billion in 1Q08. As we have pointed out in earlier research (see South Africa: Dividend Payments Abound, December 12, 2007), these chronic interest and dividend payments have dug a permanent hole in the country’s current account balance, with negative consequences for the currency anytime there is a dry-up in capital inflows. This time around, net service payments on transport services (mainly freight and insurance) also rose significantly. Financial Account Excluding FDI Looks Vulnerable The balance of payments on the financial account improved from R34.3 billion in 4Q07 to R44.5 billion, thanks largely to a R40 billion direct investment inflow that was largely driven by the 20% acquisition of Standard Bank by the Industrial and Commercial Bank of Net portfolio investments sank into further deficit from -R6.1 billion in 4Q07 to -R20.6 billion in 1Q08, while net other investments − an increasingly popular category for carry trade players − fell from R34.9 billion to R30.7 billion. This time, even unrecorded transactions − a de facto glorified balancing item that has proven very helpful in the past − were down from R19.8 billion to a mere R3.3 billion. With the capital account excluding direct investments now becoming increasingly weak, at a time where global financial risk aversion is likely to limit foreign investor interest in acquiring South African assets, we would like to stress that prospects for rand strength − outside of what we believe is an overstated carry trade argument − are increasingly bleak. We are therefore inclined to revise our year-end US$/ZAR forecast from 8.20 to 8.50, and regard any short-term dip below 7.60 as an opportunity to buy US$/ZAR. Robust Domestic Expenditure Still Elsewhere, the bulletin showed that annualized gross domestic expenditure (GDE) recovered from the 4Q07 reading of 0.2%Q to post an impressive 14.2%Q reading. This was quite surprising, given prior knowledge that overall GDP had fallen to 2.1%Q in 1Q08. We had expected a GDE reading of some 4.5%Q. The key surprises for us were in inventories, government consumption and, to a lesser extent, household consumption. Moderate Deceleration in Household Consumption Household consumption decelerated from 3.8%Q in 4Q07 to 3.3%Q in 1Q08. We had expected a much steeper deceleration to 2.5%Q, given what we knew about vehicle sales, retail trade and general macroeconomic conditions. We were therefore quite surprised when the governor mentioned in the June 12 MPC statement that consumption was in fact as high as 3.3%Q. According to the bulletin, durable goods spending indeed fell 8.1%Q in 1Q08, thanks to a fall in household expenditure on motor vehicles, durable recreational and entertainment goods. There were, however, increased outlays on furniture and appliances, although the latter could not offset the huge declines elsewhere. Semi-durables consumption, on its part, accelerated further from 8.4% in 4Q07 to 10.5% in 1Q08, thanks to strong expenditure outlays on textiles, furnishings and recreational goods, as well as clothing and footwear. After slowing from 5.2% in 3Q07 to 1.9% in 4Q07, non-durable goods rose to 3%Q in 1Q08 as expenditure on recreational goods rose. But this was offset by decelerating food and beverages, tobacco, fuel and power and medical products consumption. We find it interesting that expenditure outlays on discretionary items such as entertainment and recreation appear to have held up despite tight financial conditions. Looking forward, we expect the discretionary components of the household expenditure basket to come under pressure. Chunky Capital Formation Lifts Investment-to-GDP Ratio Gross domestic fixed capital formation accelerated further from 14.1% in 4Q07 to 14.7% in 1Q08, lifting the ratio of gross capital formation to GDP from 21% to 21.5%. The growth here appears to have been rather chunky, as opposed to broad-based, driven in the main by Gautrain-related investments and some agricultural machinery purchases in anticipation of higher food prices. The upgrading and expansion of provincial infrastructure also helped to lift general government consumption, while a general lack of demand led to a sharp increase in manufacturing sector inventories.
Currencies
Some EM Central Banks to Be Stress-Tested by Inflation June 23, 2008 By Stephen Jen | London Summary and Conclusions Energy and food inflation has remained high. As the global economy has continued to exhibit signs of remarkable resilience, investors’ attention has, not surprisingly, shifted from ‘stag’ to ‘flation’. We are of the view that inflationary conditions will likely be negative for the currencies of many EM economies that are experiencing a negative terms-of-trade (ToT) shock. Stagflation would be even worse for these currencies. In contrast to developed markets, whose central banks could stay ahead of the inflation curve, we believe that developing market central banks will likely struggle to stay ahead of both the inflation and growth curves. The macroeconomic challenges to be faced by EM economies will be quite acute, and many EM currencies are likely to be penalised against the dollar. Monetary Policy and Oil Price Shocks Global energy and food price inflation poses a major challenge for monetary authorities around the world, with implications for currencies. Up to a certain threshold, say 6%, inflation should be positive for developed market currencies, in our view. Most central banks enjoy a meaningful enough amount of credibility that upside surprises to inflation should make investors look for eventual monetary tightening. The rule-of-thumb, thus, should be to buy the G10 currencies of countries that have upside surprises to inflation. Having said this, it is important to appreciate the acute dilemma monetary policymakers are facing, and that, at some stage, if these types of global inflation persist and accelerate, central banks in developed economies may have rather diverse reactions and approaches, and the aforementioned simple rule-of-thumb would no longer be appropriate. While much of the rise in oil and energy prices could be attributed to global demand for these products, from the perspectives of individual countries, oil and food price increases are supply shocks. Early work on the relationship on oil prices and developed market GDP suggests oil shocks were the dominant determinants of Since shocks of this type are stagflationary, the Fed and other central banks are obliged to counter these inflationary pressures and not fully accommodate this shock. A reasonable approach for central banks would be to follow the Taylor Rule, i.e., adjust the FFR (fed funds rate) in response to changes in the deviations in core inflation and unemployment from their targeted levels (see Ed Gramlich (2004), Oil Shocks and Monetary Policy, Fed Speech, September 16). It is also important to keep in mind how high oil prices could reduce the potential world growth rate.). In an influential piece of research, Messrs Bernanke, Gertler and Watson (1997) (“Systematic Monetary Policy and the Effects of Oil Price Shocks”, Brookings Papers on Economic Activity 1: pp. 91-142) argued that, at most, only half of the observed GDP declines after oil price shocks could be attributed to the oil shocks themselves, with the other half of the recessionary pressures coming from the monetary reactions to the oil shocks. This exaggerated compression in output growth can be interpreted as a price to pay to secure stability in inflation expectations. If, however, there is an underlying stagflationary trend coming from demographic pressures (aging and the shrinkage in the relative size of the work force in the US and other developed nations) and globalisation, the stagflationary proposition confronting central bankers could be more acute than during the last great oil shock in the 1970s. The bottom line here for developed economies is that oil shocks themselves are stagflationary and monetary reactions to these shocks have, during past episodes, exacerbated the declines in GDP growth, in exchange for more restrained inflation. Up to a certain point, inflation should lead to strong currencies as central banks tighten. But how developed market currencies perform as inflation rises will be a function of how stagflationary conditions get and how successful various central banks are seen at handling the stagflationary conditions. Policy Dilemma Will Be More Challenging for EM There are several reasons why central banks in EM will likely have much greater difficulties in the months ahead: • Reason 1. Imported inflation cannot be offset. EM economies’ CPI baskets contain much higher weights for food and energy products than developed economies’ CPI baskets. This is important, because to offset inflationary pressures in these products – which are increasingly determined by international forces – EM central banks will need to somehow generate enough deflationary forces elsewhere in the economy. In other words, for EM central banks to achieve their targets on inflation, in the presence of high internationally determined energy and food inflation, they would need to be willing to drive the domestic economies into deep recession – a proposition that we believe is unlikely to be politically acceptable. The combined weights of energy and food products range between 30% and 70% for many EM economies, compared to around 25% for most developed economies. Further, actual food accounts for a bigger fraction of the retail costs of food items in EM economies, whereas in the developed world, the bulk of the retail cost of food items reflects retail, advertising and other service costs. In fact, it has been estimated that actual food accounts for some quarter to a third of the total cost of food products in the • Reason 2. Rolling back of energy and food subsidies to keep stagflationary pressure sustained. We have pointed out previously (Enjoy the Energy Subsidies While You Can, May 22, 2008) that half of the world’s population now enjoys energy subsidies and about a quarter of the world’s gasoline is subsidised. Our analysis in that note was limited to the gasoline market, but the same logic applies to other energy products and food items. Subsidies mute the impact of high prices on the quantity of demand (i.e., prevent the demand curve from being downward-sloping). With subsidies, global demand for food and energy is not ‘destroyed’. But as food and energy prices stay high and rise further, EM economies will be under pressure to roll back these subsidies. The end result is that stagflationary conditions will persist longer in EM with subsidies than elsewhere. Often governments are forced to roll back on the subsidies and, by construction, the timing of the withdrawal of these subsidies is likely to be bad, both from a macroeconomic and social perspective. This cannot be positive for EM currencies. • Reason 3. Inflation-targeting (IT) in general will be seriously stress-tested. The world’s headline inflation has trended lower over the past decades. Between 1997 and 2007, OECD headline inflation declined from 4.8% to 1.9%; BRIC headline inflation fell from 9.2% to 4.1%. (During this period, core inflation also fell, from 4.4% to 2.1% for the OECD countries, and from 4.4% to 1.3% for the BRIC economies.) While better, more disciplined monetary policies have likely played an important role behind this trend, other factors (such as globalisation, deregulation and luck (this includes the lack of major global military conflicts and absence of other major shocks)) have arguably been at least as important. In this ‘Goldilocksy’ environment of the past, it was relatively easy for IT regimes to look good. But if the structural trend in global inflation is indeed turning, then IT regimes could be stress-tested. In fact, rigid forms of monetary policy will be stress-tested if the natural rates of unemployment and corresponding inflation rates are shifting. Further, if indeed this worry about more rigid forms of monetary policy is justified, then it is reasonable to expect these stress-tests to be more extreme for EM economies than for developed economies, due to Reason 1 mentioned above. We believe that the likes of Bottom Line Inflationary pressures of the type we are dealing with (triggered by energy and food price shocks) will pose a considerable challenge to monetary authorities, particularly those in EM economies. We believe that this is a powerful theme, which will hurt many EM currencies.
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