Emerging Markets
Replies from Around Emerging Markets
July 28, 2008

By Emerging Markets Team|

Asia – Chetan Ahya

AXJ has no real hawks. The central banks are more focused on the trajectory of core inflation rather than headline inflation. Except for India and Indonesia, core inflation appears to be still manageable for the rest of the region. However, if commodity prices do not fall, the region will face increased pressure from the rise in core inflation, making it more difficult to manage the inflation challenge. The risk of a potential slowdown in exports is already resulting in a few central banks considering the option of not allowing currency appreciation. Indeed, some of the countries with large current account surpluses have already started doing that in the last few weeks. Increased financial market risk-aversion has also meant that capital inflows into the region are slowing, reducing the pressure of appreciation in the exchange rate. A number of emerging Asian countries including China, India, Indonesia and Malaysia have also kept some of the commodity prices (particularly oil) below global market prices. The bottled-up input cost pressures in the region are also quite high. The good news is that the recent fall in oil prices may have indicated that we are probably close to the point where further moderation in global growth could bring down oil prices? A re-emergence of the credit crisis-related growth slowdown could further tilt the balance in this direction. However, this outlook is far from certain.

Moreover, while the US and Europe account for a large share of global oil demand, for other commodities they account for a relatively smaller proportion. (For oil, the US and Europe account for slightly over 40% of the global demand; for aluminum and copper, they account for about one-third; for steel, they account for only about 25%.)  Hence, we do need more slowdown in demand from the emerging markets too. The global aggregate demand trend relative to the historical average also indicates some more tension in this context. As per our own team’s forecasts, global growth will remain significantly higher than the last 30 years’ average of 3.4% in 2008. In 2009, the team estimates growth to be at 3.6%.

Hence, the risk of commodity prices not falling sharply is still real. If we continue to face the stagflation type of environment in the global economy (i.e., growth moderates further, but commodity prices rise, or remain high, at the current levels), Asia could be caught badly on the policy dilemma. Their pro-growth policy stance has meant that central banks have not been pre-emptive in tightening so far. Only India has tightened meaningfully, moving its policy rate above headline CPI inflation. If commodity prices don’t fall by 30-40% in the near term, core inflation could rise further, as aggregate demand in AXJ remains strong. We estimate 2Q GDP growth to be at 8.2%, compared with the five-year trailing average of 7.8%. In this context, the core inflation outlook remains a concern for the AXJ region.

Asia – Qing Wang

The hawkish response by the Latin monetary authorities is as justified as the dovish stance taken by the policymakers in the AXJ EM countries, in my view. Unlike their lucky Latin cousins who are enjoying ‘an era of abundance’, thanks to a powerful positive terms-of-trade (ToT) shock, AXJ EM countries are facing double external shocks: i) a negative ToT shock due to high international oil/food prices; and ii) a negative demand shock from weakening G3 economies. Several countries (e.g., India, the Philippines) even face a third external shock: the reversal of capital inflows.

While the immediate impact of a negative ToT shock is ‘imported’ inflationary pressures, the effect of attendant negative income loss will eventually be disinflationary, in my view. The latter, together with the disinflationary impact of a negative demand shock from a G3-led slowdown, makes the AXJ EM countries much more cautious in taking a hawkish monetary policy stance despite high inflation. They want to avoid potential policy over-tightening.

Several economies in North Asia (e.g., China, Korea, Hong Kong and Taiwan) are instead opting for fiscal (i.e., subsidy) and/or exchange rate (e.g., currency appreciation) policies to alleviate the difficulties of inflation on the economy in general and on some vulnerable groups (e.g., low-income households) in particular. They take this muddling-through approach, mainly by leveraging on the strong balance sheets of the government (i.e., low public debt) and the economy as a whole (i.e., high level of FX reserves, low external debt), which are a result of prudent policy when they were enjoying an ‘era of abundance’ in the past.

To be sure, among the AXJ EM countries, some (e.g., India) have undertaken more aggressive monetary tightening than others. However, these seemingly hawkish stances appear to have been aimed as much at defending their currencies in the face of capital outflows as containing inflation pressures, in my opinion.

From the perspective of each individual country, these rather dovish policy stances assumed by the AXJ EM authorities are appropriate and justified, in my view. However, from a global perspective, they are not the optimal policy response. As Chetan pointed out, dovish policy stances will slow the demand-destruction that is necessary to close the output gap and bring global inflation under control. Indeed, tackling global inflation entails global monetary tightening. However, with the US Fed, the de facto leader of global central banks, in the mode of crisis management by adopting a super-loose monetary policy stance, a concerted and coordinated global monetary tightening seems infeasible at the current juncture to us. This lack of global monetary policy coordination is one of the key reasons for the heterogeneous policy responses among the EM countries, in my view.

Central Europe – Pasquale Diana

In Central Europe, real rates have fallen but remain positive in most countries (more so obviously if one looks at rates deflated by core CPI). Admittedly, rate increases have come rather late in countries where tensions in the labor market were already building several quarters prior to the start of the tightening cycle − like Poland. However, in general, central banks across the region do not look to have taken the inflation threat lightly, in my opinion.

Another important dimension is that monetary authorities have not stood in the way of sharp nominal appreciation of these currencies versus the EUR, which has taken overall monetary conditions to quite tight levels across the region. Exchange rates matter for two reasons: i) these economies are overall very open, so the imported inflation channel matters a great deal; and ii) a large portion of new borrowing is done in foreign exchange; this weakens the traditional domestic credit channel, leaving monetary policy relying primarily (almost exclusively in Hungary’s case) on the FX channel.

Lately, signs have emerged that things are changing and that we are close to a peak in rates: i) the monthly data have begun to show clear signs of slowing, prompting some downgrades to growth forecasts (we cut our CEE growth projections two weeks ago); ii) harvests look far more promising this year as compared to 2007, which should alleviate pressures on food components (a very large part of the CPI – around 20% or even higher); and iii) oil prices look to have peaked, though the authorities are understandably not making too much of it at this point.

With inflation close to a peak and FX having tightened overall monetary conditions quite significantly over the last few months, the authorities are set to move their focus to growth, and also be less tolerant of sharp FX gains (see the Czech National Bank’s recent comments, threatening to cut rates soon unless the CZK eases). We no longer think that the NBH and CNB will hike rates this year, and the NBP is only one hike away from the peak, on our estimates.

Turkey – Tevfik Aksoy

In Turkey, both real and nominal policy rates are the highest in the region and one of the highest in the liquid EM universe. This had been the case in recent years, especially in response to the deviation of actual inflation from the official target on a consistent basis since end-2005. The real (policy) interest rate that eased to 7.5% in late 2005 has been rising steadily since then, and has mostly remained in double-digit territory.

Inflation had been rising decisively over the past 12 months; most of this could be attributed to the exogenous factors such as food and energy, but core inflation had been on the rise in recent months, necessitating a monetary policy action. The Central Bank of Turkey (CBT) raised the main policy rate by 150bp, starting in May 2008, to 16.75%, which points to around a 10% real interest rate (ex ante). However, the CBT had been keeping the liquidity in the market very tight. The action had resulted in a surge in money market rates that nearly converged to the CBT’s offer rate of 20.25% (13% real interest rate), making the de facto real interest rate noticeably higher than what is actually perceived in the market. In our view, the policy has been successful and is likely to result in curbing inflation via suppressed domestic demand: consumer spending and sentiment indices have been declining, inflation expectations seem to have peaked (and are easing marginally), industrial production growth is slowing down and the non-energy current account deficit is shrinking − all of which are a manifestation of a macro slowdown. With seasonal declines in food prices, the main risks remain to energy prices, in our view; these had been limited in effect due to the strength of the currency, courtesy of the high carry.

Russia – Oliver Weeks

There are some hawks in Russia, and they are having some influence at the margin – notably in the shift towards greater tolerance of RUB appreciation and slightly tighter monetary conditions. Finance Minister Kudrin is chief among these. This week, he commented that “Inflation is slowing growth. However, in Russia, the peasant doesn’t cross himself until the storm thunders. There is an erroneous idea in Russia that high growth can be achieved with high inflation”.

Nonetheless, PM Putin remains firmly on the dovish side, insisting that growth can and should be prioritized over inflation. Aggressive tightening remains unlikely while he holds this view and while budget revenue continues to exceed official projections.  On this see also Russia: Going for Growth, April 4, 2008, Russia Economics: Monetary Stalemate, February 14, 2008, and Joachim Fels and Manoj Pradhan’s “All Easy in EM”, The Global Monetary Analyst, April 9, 2008. In the remainder of this year, the prospect of slight falls in headline inflation brought about by food and oil price corrections look likely to keep advocates of loose policy on top. 

Sub-Saharan Africa – Michael Kafe/Andrea Masia

In sub-Saharan Africa, Ghana set the pace this week by raising interest rates by 100bp, despite rising resistance by local business and unions. This follows earlier tightening of 250bp between April and June this year. Even more interesting is the fact that the Bank of Ghana is able to be this aggressive in the run-up to hotly contested political elections scheduled for December. The Central Bank of Nigeria follows on August 5, where we expect the MPC to raise rates by a further 50bp. Third on the list is South Africa, on August 14. While the recent decline in oil prices and the surprisingly resilient currency could combine with weak growth prospects to elicit the ‘sympathy pause’ from the SARB, we stick to our view that an extension of the MPC’s tolerance period, by another three to four quarters, is entirely consistent with a 50bp rate hike. Contrary to recent EM inflation pressures and associated monetary policy responses, South Africa appears to be approaching the peak of its tightening cycle. Remember that South Africa is arguably well ahead of the EM central bank curve, as it embarked on pre-emptive tightening as early as 2006, and will most likely conclude its cycle before the rest of the EM universe. So it’s not just the Latinos. Africans are taking inflation seriously too, especially those that are inflation-targeters.

Currencies
Winners and Losers from Terms-of-Trade Shocks
July 28, 2008

By Stephen Jen & Luca Bindelli | London

Summary and Conclusions

Energy and other commodity prices have surged strongly, while manufacturing goods prices have remained relatively stable.  The terms-of-trade (ToT) shock – the change in the relative prices of exports and imports – associated with these changes in relative prices should have a significant impact on nominal exchange rates.  In this note, we examine the winners and losers from the outsized ToT shock since 2002. 

What ToT Shocks Are and Why They Matter

The ToT are a relative price measure; they are the ratio of export prices to import prices.  Thus, for a country that experiences a rise in this ratio, it sees two effects.  First, there is an income effect (think Australia), and the wealth of the nation in question should rise.  As a result, the real exchange rate (e.g., AUD) should appreciate.   (Technically speaking, a rise in the income of a country exerts pressure on both tradables and non-tradables prices.  But for small, open economies, the former tend to be determined by the world market.  As a result, non-tradables prices rise, pushing up the real exchange rate.)  There is a second effect.  If the price of exports rises, there should be a resource effect, whereby resources will be diverted to the tradables sector.  For example, Australia’s private investment has been strong (posting a 9.6%Y average from 2002-07), coinciding with high commodity prices, as investments in capacity building in the commodities sector rose.  The overall investment of the country could rise, leading to an increase in output.  Positive economic growth should be positive for the exchange rate, all else equal. 

In short, a positive ToT shock should be positive for the exchange rate and real economic growth, while a negative ToT shock should be negative for the exchange rate and real economic growth. 

Documenting the Size of the ToT Shocks

The size of the ToT shocks on the economies is shown in our sample, cumulatively since 2002, as well as the latest ToT change for selected economies.  2002 was chosen to mark the beginning of the surge in energy prices. 

We make these observations: 

•           Observation 1.  Japan and Korea have been hardest hit.  While Japan has achieved significant gains in energy efficiency since the last major oil price surge in the early 1970s, it is still a major oil importer.  China consumes a lot of oil, but roughly 45% of its crude oil consumption is domestically sourced,  leaving imports accounting for only 55% of oil consumption.  In fact, until 1992, China was self-sufficient in oil.  Japan, on the other hand, imports 100% of the oil that it consumes.  The cumulative negative ToT shock has been the most severe for Japan, Korea and Taiwan, and the 1Q08 shock remained the largest in the sample.

•           Observation 2.  RUB, ARS, AUD, CAD, MEX, ZAR and NZD are beneficiaries of the positive ToT shock.  These countries have enjoyed very significant favourable ToT shocks.  Not only have these shocks enhanced the income and wealth of the countries in question, and should have already contributed to currency strength, but ongoing investment in these resource sectors should also continue to support GDP and keep their currencies well-supported, even if commodity prices experience a temporary correction.  

•           Observation 3.  The US has experienced a modestly negative ToT shock.  The US runs an annualised trade deficit in oil and oil products of some US$39 billion (1Q08), equivalent to around 46% of its total trade deficit.  Meanwhile, the US non-oil trade deficit has shrunk remarkably since 4Q05: from US$14.5 billion (4.6% of GDP) to US$11.3 billion (3.2%) in 1Q08.  However, the oil trade balance burgeoned, masking the significant improvement in the US non-oil trade balance.  In fact, of the deterioration in oil trade (from US$6.9 billion in 4Q05 to US$9.8 billion in 1Q08), all of the change was attributable to the oil price increase, since the volume of the US oil imports actually declined during this period. 

•           Observation 4.  The negative ToT shock to China has been relatively modest.  The main reason behind this is that China’s oil consumption of 8 mbpd only accounts for some 20% of its total energy use.  For comparison, oil accounts for 40% of the US’s total energy use.  As we pointed out in The Energy Shock to Asia (July 3, 2008), some 70% of China’s energy consumption is centered on coal-fired power plants.  China’s economy will experience an energy shock, but not through the direct effect of higher oil prices, but through the indirect effect of higher coal prices (98% of China’s total consumption of coal is domestically mined).

Why the JPY Should Be Weak

The prevalent investor opinion is that the JPY should strengthen, due to valuation and risk-aversion motivated capital flows.  We have, however, argued otherwise.  The negative ToT shocks from the high energy prices should lower the fair values (FVs) of these currencies.  We believe that, while the very positive policy shifts under the new administration in Taiwan may keep the TWD strong relative to its deteriorating FV, JPY and KRW should be ‘weak’, i.e., not surge higher as easily as many may think, and the recent market pressures driving USD/KRW and USD/JPY higher make a lot of sense to us. 

Further, capital outflows are a key factor dictating the JPY’s structural trend.  Retail investors have not been discouraged or scared from investing in non-JPY assets.  These are not ‘JPY carry trades’, in our view; rather, they are plain vanilla capital outflows involving no more leverage than any other types of outflows.  These demographically motivated outflows have switched from being AUD- and NZD-focused two years ago to being centered on AXJ equity markets last year and, most recently, to the attractive positive carries from BRL and TRY.  In contrast to the last generation of Japanese investors, investors from Japan no longer seem fearful of investing in EM or in places that are far outside their time zone. 

Moreover, we have also highlighted in our past writings that sovereign institutional funds, such as the GPIF (Government Pension Investment Fund), Yucho Bank (the savings bank of the former-Japan Post) and Kampo (the insurance company of the former-Japan Post), have been and will likely continue to diversify away from JPY assets.  These entities have US$1.5 trillion, US$2.0 trillion and US$1.0 trillion of assets, respectively, and they will likely be further diversified out of JPY markets, in our opinion.  These programmed outflows should form a formidable headwind for the JPY, and are likely to be oriented toward the liquid and developed markets, even though retail outflows may have a higher exposure to EM.  Whether these prospective outflows are positive or negative for EUR/USD is rather ambiguous at this point, but they are unambiguously JPY-negative. 

Why the KRW Should Be Weaker

It is the high level of oil prices that will hurt Asia, not the rate of change.  Thus, even if we see a correction in oil prices towards US$100 a barrel, the shock to the industries in Asia will likely be material, particularly when the energy subsidies are lifted.  In contrast to most of Asia, Korea does not have energy subsidies.  Thus, we expect to see the impact of high oil prices become visible in Korea before it does in other countries.  The size of the negative ToT shock impinging on Korea is as large as any country in Asia.  As a result, the KRW should not be strong.  The ongoing correction in oil prices, coupled with further signs of a slowdown in the US, may eventually lead to a re-setting of the ‘intervention line’ by the BoK.  We believe that USD/KRW will be allowed to gradually drift higher, as the world’s growth decelerates, and as the policy focus shifts from inflation-fighting to GDP protection. 

Why the CNY Should Appreciate at a Slower Pace

In our view, Beijing’s shift in policy focus from inflation to growth is genuine, and will lead to a broadly flatter USD/CNY trajectory.  This prospective flatter trajectory will, of course, not be sustainable, as China will eventually need to guide USD/CNY lower again, but we suspect that when the US trough deepens, USD/CNY will likely be stabilised and not permitted to decline as fast as it has so far this year. 

Bottom Line

Energy and other commodity price changes lead to large positive and negative ToT shocks around the world.  We believe Japan and Korea should see their currencies weaken, given that they have suffered the largest negative ToT shocks.

Korea
Further Normalization to Come
July 28, 2008

By Sharon Lam & Katherine Tai | Hong Kong

2Q08 GDP missed our expectations, but in line with market: Korea reported a rather disappointing 2Q08 GDP report today, with growth slipping to +4.8%Y after the economy peaked at +5.8% in 1Q08.  The YTD growth came up to +5.3%, compared to +4.5% a year ago.  On a seasonally adjusted quarterly basis, GDP growth sustained a similar growth pace as the previous quarter at +0.8%Q (or +3.4% annualized).

‘Good trade balance’ and ‘service trade balance’: We had been arguing that export robustness was not only in dollar terms, but also in volume terms, thanks to vigorous demands from emerging markets and amplified product diversifications and brandings.  The goods balance alone accounted for 58% of the total headline GDP growth while the services balance comprised another 12.4%.  As expected, net exports, the principal growth driver, accounted for two-thirds of growth in 2Q08 by contributing 3.3pp towards the headline economic growth.  Meanwhile, domestic demand remained stagnant, as its contribution fell significantly from 3.1pp to 1.8pp in 2Q08, led primarily by sluggish private consumptions.

Private Consumption Dragged Down by Lower Confidence (+2.4%Y in 2Q versus +3.5% in 1Q)

As consumer confidence plummeted to a three-year low on inflation concerns, growing dissatisfaction with Lee’s administration triggered by the FTA negotiation with the US on beef imports and local stock market correction, growth in private consumption fell to its lowest level since 1Q05.  On a sequential quarterly basis, growth dipped to -0.1%Q.  The deceleration was broad-based across the goods and services sectors.  We have been long arguing for a strong consumption boom in Korea, as consumers have been under-spending in the past years after the financial crisis and credit card bubble.

However, in the absence of any near-term catalysts, we believe that domestic spending growth is likely to soften further in the next quarter before the forthcoming boom kicks off potentially in 4Q08/1Q09.

More Fixed Investment Needed in Korea (+0.4%Y in 2Q versus +0.5% in 1Q)

Disappointingly, as expected, the investment breakdown showed that capex growth cooled further from +1.4%Y to +0.8% in 2Q, while construction activities picked up slightly.  However, when looking at quarter-on-quarter growth, capex expansion actually improved moderately in 2Q, despite the weakening corporate profitability outlook.  Although the latest production data set suggests that industrial output growth might be easing from the peak in 1Q to avoid excessive inventory accumulation amid the global slowdown, it still appears that there is no investment overhang, as the capacity utilization rate is lingering at high levels (average at 81.3% over January-May).  Unlike many industrialized developed economies, Korea actually requires further capex investment, as it still see strong external shipment demands.  Consequently, capex should not falter, given the tight capacity conditions in Korea.

Bottom Line: Further Normalization in 2H Likely on Stagnant Domestic Demand

On the growth front, downside risk is expected to intensify in 2H before we see any improvements coming in mid-to-late 2009.  In the near-to-medium term, we see moderation in Korea’s headline growth, but this should likely be milder than consensus expectations due to resilient export strength.  Indeed, the government has recently revised down its growth forecast from the initial +6% to +4.8%.  We are keeping our 2008 real GDP growth forecast unchanged at +4.7%.  Uncertainties brought about by strong oil prices and internal political instability will likely cast a shadow over corporate earnings, discouraging capex expansion and construction activities, while escalating inflationary pressure exacerbated by the weak won will further erode household incomes, which may in turn trigger a second-round of cost-push inflation through wage inflation.  Such a growth-inflation dilemma constrains monetary policy effectiveness.  We expect the Bank of Korea to keep the policy base rate unchanged at 5% for the rest of the year, as keeping inflation under control is likely to rule over promoting growth on the policymakers’ agenda at the current juncture.  However, our global economics team believes that the global economy may be heading towards a mild recession.  If such a scenario were to materialize, it would very likely have a negative impact on Korea exports.  Therefore, we believe that the government could impose supportive pro-growth policies to promote domestic demand growth to weather such a potential situation. 

Russia
Joining the Slowdown?
July 28, 2008

By Oliver Weeks | London

Sharply slower growth and slightly slower inflation data this week will be seized on by both doves and hawks, whether to argue that recent tentative monetary tightening should be stopped, or, as Finance Minister Kudrin has previously argued, that Russia is already paying the price for complacency on inflation.  We agree that inflation will ultimately slow growth, but expect output to bounce back in the next few months, even with a further oil price correction.  We still think that headline inflation has peaked but that underlying inflation pressure remains threatening and further monetary tightening and FX appreciation are necessary and likely.  While the government’s frustration with rising investment input costs is becoming increasingly apparent, this appears more to reflect pressure for long-term delivery contracts than the start of a new wave of expropriation.

Surprisingly weak economic activity data for June appears to have both temporary and more lasting causes.  The sharp slowdown in industrial production growth to 0.9%Y has been partly ascribed by the think tank CMAKP to Rosstat not repeating last year’s upward correction for under-reporting from small enterprises.  The distractions of Russia’s unexpected football success and a temporary fall-off in lumpy investment projects, notably for turbines, are also likely to have contributed, and may also be reflected in the slowdown of fixed investment growth to 10.8%Y.  A further fall in oil prices is likely to have a minimal short-term impact, given a marginal tax rate still close to 90% on crude exports.  However, with tax cuts on the way and energy companies under strong pressure to step up investment commitments in return, we would expect fixed investment and related output to rebound. 

More worrying is the longer-term impact of inflation, notably on consumption demand.  While nominal wage growth remains strong but flat at 29.9%Y, real disposable income growth has slowed sharply to 6.6%Y.  Real retail sales growth slowed to 13.8%Y and looks less likely to recover.  Construction growth, which slowed to 16.2%Y in June, little more than half the pace of January, may also be hit by inflation in as much as it continues to undermine credit availability.  Credit growth to non-financial corporates slowed to 44%Y in May; however, given that deposit growth has slowed to 28%Y as negative real rates remove saving incentives, credit availability seems likely to tighten further, particularly from banks without access to foreign funding.  We continue to expect GDP growth to slow to around 6.5% in 2009 from around 8.0% in the first half of this year, but do not think that June marks the start of a sharp adjustment. 

While the short-term news on consumer inflation has been, less surprisingly, good, we still do not expect the problem to recede rapidly.  Rosstat’s preliminary estimate of inflation in the third week of July slowed to 0.1% as fruit and vegetable prices fell, pointing to a slowdown to around 14.9%Y for the whole month.  Further declines in food and energy look probable, taking headline inflation to around 14.0%Y by year-end.  However, core inflation continues to accelerate, and monetary pressure looks likely to resume.  Official FX reserves were up another US$10.0 billion last week, continuing the surge since the CBR pre-announced a more flexible exchange rate policy.

Reserves are up US$41.5 billion in the last five weeks, reaching US$588.3 billion.  Clearly, the oil price correction will slow this pace – a US$20 oil price fall cuts export revenue by almost US$1 billion a week.  However, it remains clear that the CBR’s corridor widening has so far been unsuccessful in terms of its anti-inflationary impact, encouraging a wave of speculative and inflationary inflows.  

Broad money supply growth had recently slowed significantly, to 29.5%Y in May.  This reflects at least three factors that seem to us to be unlikely to continue.  First is the base effects from last year’s surge in inflows around state IPOs and the Yukos auctions.  Second is the capital outflows seen in 1Q08.  Although CBR data point to US$31.8 billion of foreign debt coming due in 3Q, and Russian companies remain acquisitive abroad (most recently Evraz in Ukraine), we still expect net capital inflows in the rest of this year.  Third is the huge accumulation of government deposits on its treasury account – RUB 2,347 billion at the end of June, 6.2% of GDP – which may prove politically hard not to spend. 

Finance Minister Kudrin has continued his own struggle against inflation, commenting this week: “Inflation is slowing growth. However, in Russia the peasant doesn’t cross himself until the storm thunders.  There is still an erroneous idea in Russia that high growth can be achieved with high inflation.”  However, the Finance Ministry has also been forced to concede yet another hike in planned budget spending, this week a further RUB 224 billion, as revenue continues to surprise on the upside.  PM Putin is clearly prepared to step up anti-monopoly enforcement, at least in coal and jet fuel, to limit price rises, but his focus appears to be more on producer prices than the CPI and in relatively narrow spheres.  Coking coal, for which the PPI index is up 96.5%Y in July, may continue to attract government attention, but echoes of tone and personalities from the run-up to the Yukos affair so far appear misleading.  A continuing shift to long-term coke supply contracts looks a more likely outcome to us.  We remain skeptical about the government’s readiness to tackle monopolization more broadly.  More importantly, the PM shows no signs of being ready to choose to slow growth or support significant spending cutbacks. 

In these circumstances, monetary tightening continues to look necessary, in as much as the CBR is allowed to deliver it.  We still expect the CBR to take any opportunity presented by weak equity market sentiment or debt repayments to encourage the RUB temporarily weaker and attempt to stop out some speculative positions.  FX purchases for the Oil Funds as the budget’s share of oil and gas revenue is filled may also provide a useful justification for stepping up intervention.  However, further RUB appreciation against the basket remains likely in the medium term.  Our end-2009 basket forecast remains at 28.10, with risks still on the side of this being achieved earlier.  More volatility within a strengthening trend should also make room for further modest interest rate hikes – we still expect another 75bp on policy rates by year-end, and see risks to current market as now on the upside.

UK
Inflation Peak and Growth Trough Still Ahead
July 28, 2008

By Melanie Baker, CFA | London

The Worst of the Macro Data Still Lies Ahead

We have still to see the worst of this cycle in terms of low GDP growth and high inflation, in our opinion.  Data suggest that the UK economy is now slowing significantly, and we expect that slowing to continue for a couple of quarters yet.  This month, we again nudged lower our UK real GDP growth forecast to 1.4% in 2008 and 1.3% in 2009 (1.5% in both years previously and compared to 1.7% and 1.8%, respectively, at the end of May).  1.3% would mark the lowest GDP growth for a full calendar year since 1992 (when growth was a mere 0.2% with the economy having contracted in 1991) and compares to trend/potential of just above 2.5%.  We still see an early 1990s recession as only about a 20% probability, but we continue to put close to a 50% probability on a technical recession (two consecutive quarters of even slightly negative quarter-on-quarter GDP growth).  See Fear and Loathing in the UK, Graham Secker, David Miles et al, June 26, 2008.

On our central forecasts, we expect the lowest quarter for year-on-year growth to be 4Q07 (0.7%Y) and for the peak of inflation to be in September 2007 (4.8% on the CPI measure, which would be the highest level since March 1992).

The Worst on Inflation Likely in the Next Few Months

The peak in inflation looks likely to be in 3Q.  Base effects are a powerful driver of the expected decline in inflation beyond that.  If one assumes that month-on-month changes simply move in line with their average seasonal pattern, then beyond September, inflation looks likely to decline.  A slower economy will also be an important driver, dampening domestically driven inflationary pressure and leading to further discounting in some sectors as consumer spending slows.  However, between now and the end of the quarter, inflation seems likely to rise further.  The extent of any increase is uncertain, with energy prices a very important driver.  In particular, the profile will be affected by the size and timing of any decisions on gas and electricity prices made by the main suppliers.  Our forecast (made in mid-July) for a 4.8% CPI inflation peak incorporated a 20% increase in electricity and gas bills at the end of the summer.  It also assumed that petrol prices will reflect the 15-day average futures prices for (Brent) oil to July 15.  Recent movements lower in oil prices and futures suggest some downside risk to at least the transport fuel component of CPI if they were to persist. 

We Forecast Near Stagnant QoQ GDP Growth in 2H08

If anything, this slowdown has unfolded more slowly than we originally expected and has not been led by consumer spending.  Investment has so far slowed more decisively than consumption.  We expect consumer spending growth to have weakened more sharply in 3Q, and we expect fairly flat consumer spending for a few quarters beyond that.  With a forecast for close to stagnant quarter-on-quarter GDP growth in 3Q and 4Q this year, we think that there is a near 50% chance of a technical recession this year.

Lower GDP Forecast

We have again nudged lower our GDP growth forecast.  Since the end of May, we have pushed out our expectation of when we think the slowest quarter of GDP growth will occur.  In these latest forecasts, it is our forecast for 4Q which has seen the bulk of the downward revision.  The latest downward revision largely reflects two things: 1) a weaker forecast external growth environment, reflected in corporate investment and exports; and 2) a weaker profile for residential investment.

Following further negative news from the homebuilders and further declines in mortgage approvals for house purchase, we have lowered our expectation for residential investment growth (-8.9% in 2008 and -6.7% in 2009, compared to about a cumulative 8% decline over 2008 and 2009 previously).  Risks remain skewed to the downside for that component, with the pace of housing starts in England down 24%Y in 1Q08.

Drivers of an Eventual Improvement in GDP Growth

It is easy to extrapolate from the general picture of a deteriorating UK economy (and we continue to think that the balance of risks to our central GDP growth forecasts is skewed to the downside).  However, there are several forces that we think will drive an improvement (though not a particularly strong one) in GDP growth in 2H09.  Business investment should start to pick up as some of the worst fears on the UK and global economies are not realised and as businesses look ahead to 2010. The weaker sterling should also help boost export demand as some of its effects come through with a lag.  On consumer spending, although there are many reasons not to expect much of a pick-up in consumer spending (high leverage and a current low savings rate among them), real wage growth should pick up somewhat as inflation passes its peak.  Residential investment growth should also stop contracting – so long as we don’t see significant further increases in mortgage rates, lower house prices should improve affordability.

MPC Likely to Stay on Hold

We have revised lower our best guess as to where the UK’s neutral policy interest rate is following analysis on the cost of raising bank funds and the importance of bank debt in the economy (see The Cost of Bank Debt: Rethinking the Neutral Rate, David Miles, Melanie Baker, Laurence Mutkin and Huw Van Steenis, July 23, 2008).  We had previously thought that the current base rate at 5.00% was a bit below neutral and that therefore the MPC would feel more comfortable raising rates 25bp in early 2009 as the worst of the downturn was over and in light of the fact that inflation would still be significantly above target.  Having lowered our estimate of the neutral rate to 4.5-5.0%, we think that the MPC will keep rates steady at 5.00%.

The minutes to the MPC’s meeting at the beginning of July revealed that “for all members of the Committee, the decision was a difficult one”.  The majority of MPC members are clearly debating whether to keep rates on hold or raise rates.  Although our central case is for the MPC to remain on hold, within a few months, we think that the case for rate cuts will clearly re-enter the debate and that, towards the end of this year, rate cuts will look more likely than rate rises:

•           Inflation will likely have peaked and short-term inflation expectations may start to recede;

•           GDP growth will likely be anemic;

•           Unemployment will probably still be rising.  Spare capacity in the economy will have increased significantly, and wage growth will likely not have risen significantly, given the deteriorating labour market backdrop;

•           Monetary policy will still be neutral to slightly restrictive (rather than accommodative)

But inflation will likely still be above target, and the MPC’s forecast at that point will probably be for improving GDP growth ahead.  We think that the MPC’s decisions are likely to remain “difficult” for some time.