Indonesia
Growth Trend – Too Strong for Comfort
July 17, 2008

By Chetan Ahya & Deyi Tan | Singapore, Shweta Singh | Mumbai

Summary

While several countries across the region are witnessing a softening growth trend, Indonesia continues its strong domestic demand-driven growth. Domestic demand (ex-inventories) grew 7.3% in 1Q08, the highest rate post the 1997-98 Asian crisis. In our view, domestic demand growth is likely to have maintained its momentum during the quarter ended June 2008, supported by low real 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 inflation concerns. We believe that credit growth needs to slow to 20-22% from an estimated level of 33% in June 2008 to avoid the need for a disruptive hike in the cost of capital.

Strong Momentum in Domestic Demand Maintained

Domestic demand (ex-inventories) accelerated to 7.3% during 1Q08 from 2.3% in 3Q06. Consumption as well as investment demand indicators indicate a healthy trend in 2Q08. Car sales grew at an average of 40% during the quarter ended June 2008. Non-oil and gas imports grew at average of 47.9%Y during the three months ending May 2008. Lagged impact of a cumulative 450bp policy rate cut between April 2006 and December 2007 is driving the credit growth, supporting aggregate demand in the economy. Credit growth accelerated to 33.3%Y in June 2008. It is likely to exceed the highest level reached post the 1997-98 crisis (33.8% in April 20001). Real policy rates at -2.5% (as of June 2008) and real prime lending rates estimated at less than 1% (as of June 2008) offer support to this trend.

Isn't Acceleration in Domestic Demand a Positive?

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 policy support to encourage a swift acceleration in capacity growth, particularly infrastructure, is a key hurdle. Administrative hurdles and poor labor laws add to the structural rigidities of Indonesia's production capacity. An acceleration in domestic demand growth over 6% often results in inflationary pressures. In the current cycle (similar to the 2005 cycle), 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 and ex-energy in the region, accelerating to 8.4% from 5.2% about 12 months back. This compares to the average of 3.3% for the region, excluding Indonesia. If domestic demand remains strong, we believe that there exists a high probability of increased pass-through of higher commodity prices (as reflected in wholesale price (WPI) inflation at 27.6%) into CPI.

Inflation Offers No Respite

Inflationary pressures show no signs of abating. Using the new methodology to calculate inflation based on revised weights and base year, June inflation accelerated to 11.0%Y. We note that weights for high-inflation segments in the new base year have been revised downward, which depresses the CPI headline. Indeed, given that prices rose 2.5%M on a sequential basis (versus 1.4%M in May 2008), our rough calculations show that the June inflation would likely have come in about 12.8%Y (versus 10.4%Y in May 2008), using the original base year. Year-to-date inflation stands at 8.9%Y, significantly higher than the central bank’s target of 5%+/-1% for 2008.

Amidst soaring global oil and non-oil commodity prices, cost-push pressures are putting upward pressure on inflation. The government announced a 28.7% rise in fuel price effective May 24. As such, marked acceleration was observed in transportation prices (9.5%Y versus 1.1%Y in June 2007). Food inflation rose further to 19.2%Y (versus 10.0%Y in June 2007). Processed food also accelerated to 9.7%Y from 6.2%Y in June 2007.

Demand-pull factors have also contributed to inflation. Official core inflation (excludes volatile food items and administered price items) had accelerated to 8.7%Y in May 2008, bringing the year-to-date number to a high of 7.9%Y. Our proxy of core inflation (non-food, non-oil inflation) has also moved up to 8.4%Y (May 2008).

Currency Protected by Strong Commodity Price Effect

Unlike in the previous cycles, despite strong domestic demand, the trade balance surplus has not narrowed due to higher realization on commodity exports. This has helped avoid the stress of weaker currency, forcing the central bank to maintain tight monetary policy. Indonesia has been one of the largest commodity exporters in the region, accounting for approximately 20% of total oil-related commodity exports of the AXJ region. Commodities (including food, crude materials, oil, gas, coal, coke, vegetable and animal oil and fats) comprise of more than 50% of Indonesia's exports and account for approximately 60% of the trade surplus (December 2007). Given the commodity price boom, the trade balance (12-month trailing sum as a percentage of GDP) has held at 8.2% (May 2008) in spite of imports accelerating by more than 50%Y.

We analyze two scenarios: 1) commodity prices stay at their elevated levels; and 2) commodity prices come off from the current levels. In our view, case 1 will lead to further upside risks to inflation as domestic demand will continue to be strong, and cost pressures from higher commodity prices will aggravate. Although scenario 2 offers respite to the inflationary concerns, we believe it will adversely affect the trade balance in the face of strong domestic demand-supported imports growth. If commodity prices fall sharply, it will increase the risk of currency depreciation, particularly if the fall in the commodity prices is driven by global demand shock and risk aversion, implying that the capital inflows will also fall sharply in such an environment.

Banking Sector Trend Unsustainable

Real credit growth accelerated to 22.3% as of June 2008, amidst low real interest rates. However, at the same time, real deposit growth stood at a relatively low.5.1%Y (as of April 2008). The incremental credit-to-deposit ratio (ICDR) moved up to a 33-month high of 134% (April 2008). Given the moderate pace of policy tightening and heightened inflationary concerns, we believe that the credit growth is likely to accelerate further to 35-37% amidst low real lending rates. The deposit rate should pickup moderately, pushing up the ICDR further. Our rough calculation indicates that the gap between incremental credit and deposit growth (one-year lag) is likely to reach Rp133 trillion by year-end, thus constraining liquidity and putting significant upward pressure on short-term rates.

Bottom Line

We believe that Bank Indonesia will continue with a gradual tightening policy over the next four months. If commodity prices remain high, we expect inflation to continue to accelerate at a pace faster than the policy and lending rates. The gap between credit growth and deposit growth will continue to widen, lifting the incremental credit-deposit ratio to close to 160-170% by year-end. In such an environment, we believe that core inflation will increase further, thus increasing the risk of a disruptive policy tightening. Moreover, the rise in the incremental credit-deposit ratio would result in short-term rates moving up sharply over the next four to five months.

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United States
The GSEs, Financial Conditions and the Fed
July 17, 2008

By Richard Berner & David Greenlaw | New York

Despite a rescue package from the Treasury and the Fed, ongoing losses in mortgages and uncertainty about the ability of the housing Government-Sponsored Enterprises (GSEs) − Fannie Mae and Freddie Mac − to provide support for mortgage markets could tighten financial conditions another notch.  Together with other economic headwinds, such as slowing global growth and high energy prices, these developments increase downside risks to US economic activity. 

To be sure, Treasury and Fed actions over the weekend to provide the GSEs with short-term liquidity and create a vehicle for a capital injection of public funds should limit systemic threats to the financial system.  Indeed, Monday’s $3 billion auction of Freddie Mac discount notes was very well bid. However, the actions announced by the Fed and Treasury on Sunday night don’t directly address the economic fallout from additional financial restraint.  In our view, that is a key reason why Fed Chairman Ben Bernanke expressed more caution about the outlook for US growth this week than did the FOMC’s statement of three weeks ago.  Along with the upswing in inflation expectations, these developments intensify the Fed’s policy dilemma and seem likely to keep monetary policy on hold for the foreseeable future. Indeed, as of Tuesday afternoon, the federal funds futures market was priced for 17 bp of rate hikes through year-end, down from 32 bp on Friday and a good deal less than a few weeks ago.

The losses in mortgages experienced to date seem on track with estimates we made earlier this year of $500 billion in total, with $100 billion attributable to prime conforming mortgages (see “Leveraged Losses: Lessons from the Mortgage Market Meltdown,” Greenlaw et al., available at http://research.chicagogsb.edu/igm/events/conferences/2008-usmonetaryforum.aspx).  That estimate assumed that national economic conditions going forward are similar to those that prevailed during three regional housing busts –Texas in late-80s/early-90s, New England in the early-90s, and California in the mid-1990s.  The $100 billion estimate was derived by generating an “excess” foreclosure estimate for prime mortgages and extending this over the next four years (as done in the Greenlaw et al. paper for the entire stock of mortgage debt − i.e., prime and subprime).  Indeed, Morgan Stanley bank analyst Betsy Graseck estimates that US banks will experience roughly $70 billion in prime conforming loan losses.  Even a worst-case scenario in which home prices fall another 30% would suggest losses of roughly $200 billion.

OFHEO maintains that the GSEs are adequately capitalized at the moment, with a total of about $95 billion in capital.  According to interest rate strategist George Goncalves, that is roughly $23 billion over the current OFHEO mandate and $34 billion over the statutory minimum (2.5% of on-balance-sheet assets and 0.45% of off-balance-sheet obligations [the $4 trillion of securitized conforming mortgages that the GSEs guarantee]).  But significantly wider losses than currently estimated could require new capital.  Together with the difficulties faced by private lenders, such losses could lever into a further significant decline in credit availability and/or widening in mortgage spreads. 

Three-part plan from Fed and Treasury.   Faced with losses and concerns about credit quality, GSEs may face short-term liquidity and longer-term capital-access constraints.  To mitigate those headwinds, the Fed and Treasury announced over the weekend a three-part plan.  The Fed and the Treasury will provide the GSEs with liquidity, and the Treasury will also temporarily provide them with capital.  Here are the details:

(1) The Treasury seeks to expand its line of credit (LOC) to the GSEs, with terms and conditions to be specified.  Congress must approve this LOC.

(2) Pending Congressional approval of the Treasury LOC, the Fed will supplement that facility by giving the GSEs immediate access to the primary credit facility − the Fed’s discount window.  The Fed already is empowered to accept agency MBS as collateral for such borrowing, and under Section 13(13) of the Federal Reserve Act it has power to make 90-day loans to the GSEs. 

(3) The Treasury is also seeking temporary authority to purchase equity in either of the two GSEs if needed.  Congress must approve this authority.

The clear intent of this plan is to buy time for the GSEs by offering a backstop of conditional support that rules out failure. Indeed, on Monday the Treasury Department issued a two-sentence clarification of the initial proposal highlighting the fact that while the Treasury would like to have the authority to inject capital into the GSEs, this is intended to serve as a “backstop” that will only be tapped on an “if-needed” basis. The authorities probably want the GSEs to raise additional capital and want Congress to hammer out final details on the GSE reform legislation that is now pending.

The Fed and Treasury also have other options.  The Fed could directly purchase MBS, and Treasury could explicitly guarantee the GSEs’ debt.  Although there is precedent for the Fed to purchase GSE debt directly in Maiden Lane (the entity established to resolve Bear Stearns’ debt), such action would not solve the GSEs’ problem, and given the conditional liquidity support from the Fed, it seems unlikely.  An explicit guarantee of the GSEs’ debt also seems unlikely, but if sufficient steps are taken to circumscribe the risks to the taxpayer, we cannot rule out such an option. 

Some are concerned that an explicit guarantee of GSE debt would reduce the Treasury’s credit rating, prompt a downgrade, and impair the Treasury market. However, we do not believe that the US is likely to lose its AAA rating.  Even if the federal government were to assume the mortgage debt that is guaranteed by Fannie and Freddie, the US government debt/GDP ratio (currently 37%) would rise to 67%. In contrast, when the ratings agencies downgraded Japan's debt in 2001, that country’s debt/GDP ratio was 134%, and S&P indicated that they expected it to rise to 165% within 5 years. Also, it’s worth noting that the $4.2 trillion of mortgage debt guaranteed by Fannie and Freddie is heavily collateralized, whereas little if any of Japan's government debt was collateralized.

In general, we suspect that the consequences for the Treasury market resulting from the latest GSE policy developments will be far smaller than many currently assume.  That’s because it is the losses, not the GSEs’ debt itself, that would widen the deficit and burden on the taxpayer.  In our view, even using a very pessimistic scenario for losses on prime mortgages, the hit to the budget deficit would “only” be $100 billion or so spread out over a couple of years – in other words, a smaller impact than the recent fiscal stimulus tax rebate program.  And, as we mentioned previously, Fannie and Freddie’s reliance on discount window borrowing from the Fed is unlikely to be significant, meaning that we do not expect to see the type of sterilization operations (i.e., selling of Treasury securities) that the Fed has conducted in order to offset the implementation of the TAF and other special lending programs. 

Other economic headwinds may have strengthened.   Despite the weekend actions to mitigate the GSEs’ short-term problems, recent developments could yet intensify the headwinds confronting the economy.  Courtesy of temporary tax rebates, business investment tax incentives, and still-strong exports, growth accelerated in the spring quarter to an estimated 2.4% annual rate.  But the global economy is now slowing, the rise in energy quotes is hurting consumers, and the payback from tax rebates is coming.

Moreover, financial conditions have tightened again.  As evidence, stock prices have declined and conforming mortgage rates have recently increased close to their March highs.  Impairment of the GSEs’ ability to facilitate the origination of new mortgages would further restrict financial conditions.  It would intensify the ‘adverse feedback loop’ in the interplay between the housing downturn and the credit cycle that undermines consumer wealth through falling home prices and restricts their ability to borrow.  In particular, we suggest monitoring benchmark mortgage rates – such as the 30-year fixed rate series that is published on a weekly basis by Freddie Mac. This rate has held within a fairly narrow range in recent years but any significant impairment of the GSE securitization process would likely trigger a noticeable move to the upside, with resulting collateral damage for the housing market. 

For investors, two implications stand out.  First, despite rising inflation expectations, these developments mean that the Fed isn’t likely to tighten monetary policy soon, a view that is gaining currency again.  This implies that the yield curve may resteepen and that the dollar will soften.  Second, support for the GSEs means that the authorities will continue to protect the financial system from systemic shocks, but they will not protect individual institutions and their shareholders from suffering losses as the credit cycle unfolds.  Losses at financial institutions mean erosion of capital and more capital raising and thus shareholder dilution.  Investors should continue to favor debt over equity in financials. 

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India
Inflation Outlook − Three Scenarios
July 17, 2008

By Tanvee Gupta | Mumbai; Chetan Ahya | Singapore

Inflation Spike − Key Macro Concern

Inflation continues to be a major macro challenge for the policymakers and a key concern for investors. Headline inflation (Wholesale Price Index) accelerated to a 13-year high of 11.89% during the week ended June 28, 2008, compared to the low of 3.1% recorded during the week ended November 24, 2007. Inflation has remained significantly higher than the Reserve Bank of India’s (RBI) comfort zone of 5.5% since mid-February 2008. Core inflation (non-oil, non-global commodities) also accelerated to 6.9% during the week ended June 28, 2008, from the low of 3.6% during the week ended March 29, 2008. The key question investors are asking is when will inflation revert to single digits? In this note, we present an analysis of three potential scenarios for the inflation (WPI) outlook based on varying assumptions.

What Is Driving WPI to Higher Levels?

We divide the WPI items into four groups: 1) food; 2) fuel and electricity; 3) global commodities ex-mineral oil; and 4) non-food, non-global commodities. The bulk of the acceleration in headline inflation from the low of 3.1% during the week ended November 24, 2007, to the current peak of 11.89% during the week ended June 28, 2008, has been driven by the rise in food, oil and global commodities ex-oil prices. Indeed, the rapid increase in oil prices has been the key driver of the recent spike in inflation. Since end-April 2008, while the crude oil price (WTI) has increased by 27.9% to US$145/bbl currently, the CRB Foodstuff Index has risen 7.4% and the CRB Commodities Index has fallen 0.3%.

Where Do We Go from Here?

We performed a simulation exercise to gauge the potential movement of inflation over the next 12 months. Our analysis is based on three possible scenarios for the inflation cycle:

Base case: Our base-case assumption is that the crude oil price (WTI) averages US$145/bbl over the next 12 months (taking oil futures price average). We have assumed that other global commodities (using the CRB Global Commodities Index as the proxy) follow a similar trend. Here we are assuming that the government will initiate one more round of price hikes for domestic oil products of about 10% in September 2008. Moreover, we are assuming a normal rainfall during the ensuing monsoon season (June-September 2008). This means that the farm output should grow at the normal rate of 3-4%. Hence, the pace of acceleration in food prices should moderate. Under this scenario, inflation would first accelerate to 15.7% by end of December 2008. It would then start to moderate and reach around 11.7% by end of March 2009 (the financial year-end) and decline further to about 7.2% by the end of June 2009 from the current 11.89%. In this scenario, even though inflation will ease from current levels, it will remain above the earlier-stated RBI’s comfort zone of 5-5.5%. The key reason for the decline in the inflation rate will be a favorable base effect (going into effect the last week of December 2008).

In terms of policy response, we believe that the policymakers have limited tools available to them. Over the last 18 months, the government and the central bank have used fiscal policy as well as exchange rate policy to soften the adverse impact of higher global commodity prices. However, with the combined state plus central government deficit (including off-budget items) likely to cross 10% of GDP in F2009 (12 months ending March 2009), we do not see scope for using additional fiscal measures to absorb the burden of higher global commodity prices. Similarly, with the current account deficit widening and capital inflows slowing, the RBI is also unlikely to use appreciation in the exchange rate to offset the adverse impact of the rise in global commodities. Hence, we believe that the government will choose to rely on monetary policy to slow aggregate demand and reduce the risk of second-round effects from higher commodity prices. Under this scenario, we maintain that the RBI will likely hike the policy rate (repo rate) by another 50bp to 9% over the next three months.

Bull case: Under this scenario, inflation rate eases to 9.8% by the end of December 2008, and further to 4% by the end of March 2009. This scenario needs crude oil prices to decline gradually to US$100/bbl over the next 12 months. We have assumed that other global commodities (using CRB global commodities as the proxy) follow a similar trend. We are assuming that both crude oil and global commodity prices start declining almost immediately. Agriculture output will be normal and the pace of acceleration in food prices also moderates. Under this scenario, we believe that the RBI may not hike policy rates further and would in fact start cutting policy rates by 1Q09.

Bear case: If crude oil and global commodity prices continue to rise, that would spring up the most worrying macro scenario for India. In this scenario, we assume oil prices rise gradually to US$175/bbl and other global commodities follow a similar trend. In this scenario, assuming normal monsoons, food grain price pressure will continue to moderate; however, the internationally driven food items like edible oil prices will remain high. We are also assuming that the government will be forced to hike domestic fuel prices by about 20% in September 2008 under this scenario. Inflation will continue to spiral upward. Inflation would rise to 17.7% by the end of September 2008, and further to 20.6% by the end of December 2008. Under this scenario, the RBI will likely hike the policy rates by another 150-200bp. This would cause a hard landing in growth cycle with F2010 growth decelerating to 5-5.5%.

Bottom Line

We believe that the trajectory of inflation is very much dependent on the behavior of the global commodity price trend. The policymakers do not have the option to use fiscal or exchange rate policy to soften the adverse impact of higher commodity prices. We believe that monetary policy will be the first line of defense for the government and the central bank.

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